FRC gives four-year deadline for Big Four audit separation

The Financial Reporting Council (FRC) has given PwC, EY, KPMG and Deloitte four years in which to agree to operational separation of their audit practices, in a bid to drive up audit quality and end what the regulator dubbed ‘persistent cross subsidy’ from the rest of the firm

The Big Four are required to submit an implementation plan to the FRC for splitting out their audit practice from the rest of the firm’s activities by 23 October this year. The regulator will then agree a transition timetable with each firm.

The deadline for completing implementation of the separation is 30 June 2024.

The move to require separation of audit practices comes in the wake of a series of high profile auditing scandals, including the collapse of government outsourcer Carillion and high street retailer BHS, as well as the discovery of long running problems at Patisserie Valerie and Thomas Cook.

Separation principles

Under the FRC’s separation principles, the Big Four are required to create a separate audit board, which should be chaired by and have a majority of audit non-executives (ANEs).

At least one of the ANEs should not be one of the firm’s independent non-executives (INEs), in order to be what the FRC calls ‘doubly independent’. The chair of the audit board should be an ANE and may also be a firm INE but should not chair any other governance body in the firm.

Remuneration of audit partners and audit partner promotion should be overseen by a subcommittee of the audit board comprising ANEs only. Admissions of partners will remain a partnership responsibility and subject to the governance procedures of the partnership.

Partners and staff in the audit practice should spend the majority of their time on work in the audit practice. This does not preclude the secondment of staff to other areas of the business (in either direction) or the appointment of audit partners to firmwide leadership roles

As part of its annual assessment of whether firms are delivering these objectives and outcomes, the FRC will assess whether the overall distribution of profits to the partners in the audit practice and to those in the rest of the firm is consistent with their respective contributions to firm profits, with no material, structural cross subsidy persisting in either direction.

If the FRC’s assessment is that a material, structural cross subsidy persists, the firm should produce an action plan to remove the subsidy over a period to be agreed with the FRC.

Firms should produce annually a separate profit and loss account for the audit practice to a level which is consistent with the firm’s own published statutory financial statements. This profit and loss account should be assured by the firm’s auditors. Firms should submit more detailed financial information supporting the profit and loss account to the FRC no later than four months after the financial year end.

Outcomes

The regulator said separating out audit work would ensure audit practice governance prioritises audit quality and protects auditors from influences from the rest of the firm that could divert their focus away from audit quality.

The FRC said the development would also ensure that the total amount of profits distributed to the partners in the audit practice does not persistently exceed the contribution to profits of the audit practice.

In addition, the regulator expects to see cultural change within audit practices as a result, by encouraging ethical behaviour, openness, teamwork, challenge and professional scepticism/judgement; and says the division will make it clear that auditors act in the public interest and work for the benefit of shareholders of audited entities and wider society.

Following the June 2024 changes, the FRC will publish annually an assessment of whether firms are delivering the objectives and outcomes of operational separation.

Sir Jon Thompson, FRC CEO, said: ‘Operational separation of audit practices is one element of the FRC’s strategy to improve the quality and effectiveness of corporate reporting and audit in the UK following the Kingman, CMA and Brydon reviews.

‘Today the FRC has delivered a major step in the reform of the audit sector by setting principles for operational separation of audit practices from the rest of the firm.

‘The FRC remains fully committed to the broad suite of reform measures on corporate reporting and audit reform and will introduce further aspects of the reform package over time’

Accountancy firm reaction

Stephen Griggs, deputy CEO and managing partner Audit & Assurance at Deloitte UK, said: ‘Deloitte has been consistent in our support for reform. We remain committed to playing our role in delivering change that embraces audit quality, improves choice and restores trust.

‘Today’s announcement is an important step towards addressing this, but must also be considered alongside a wider package of reform, including in vital areas such as corporate reporting, the role of directors and the regulatory environment in which we operate. While delays are perhaps understandable due to Covid-19, it is crucial that we do not lose momentum.’

Bob Neate, UK head of audit at Mazars, said: ‘As identified through the various Government commissioned reports published in 2018 and 2019, including by the Competition and Markets Authority (CMA), true audit market reform to meet the public interest requires a package of interlocking measures. 

‘We continue to believe the proposals of the CMA, which recommended a package of joint audit, strengthening audit committee oversight and robust operational separation, is the best route to fully achieve these objectives.

‘We would encourage the Government to indicate its support for the CMA’s proposals to restore confidence in the audit market without any further delay.’

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Operational separation principles

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