FRC outlines plans for radical Big Four separation

Plans to break up the Big Four audit firms are at the early stages but the regulator is aiming for an operational split of audit practices by 2022. Sara White interviews FRC head of audit firm supervision Claire Lindridge

In a first for the global audit market, the UK audit regulator has signalled its intention to radically overhaul the audit market with a carve-out of the audit businesses of the Big Four firms – PwC, Deloitte, EY and KPMG.

 The FRC has written to the top seven firms in the UK, including mid-tier firms, BDO, Grant Thornton and Mazars, telling them to prepare for a major overhaul of their business model.

This is phase one of a project which will eventually see the mid-tier firms being forced to restructure once the initial phase has been completed.

Claire Lindridge, director of audit firm monitoring and supervision at the Financial Reporting Council (FRC) said: ‘The Competition and Markets Authority (CMA) talked about the Big Four only being the ones that they were focused on so those are the ones that we will be focusing on in the first wave.

‘The first move will be the Big Four, however we expect that the next tier down, the three obvious ones and certainly some of the others will be watching with interest and are likely to be think if it is right for them so they can compete on a level playing field.’

The proposals are now with the Big Four for review, and the FRC is working closely with senior management at the firms to reach agreement on how quickly the changes can be implemented.

As yet, a firm timetable for the operational split has not been set, but the FRC is aiming for a 2021 date for the first reporting under the new rules.

The initial framework will be based on a voluntary code with legal backup included once the government finalises its plans for wider audit reform, which will require amendments to the Companies Act 2006 (CA 2006).

‘What we are doing is moving to do this on a voluntary code basis, but we will get backup powers in legislation.

The FRC acknowledges that this will not be a quick process.

‘We haven’t firmed the date up yet; clearly there is quite a lot of work for the Big Four firms to do in elements as practical as getting their accounting systems able to do what is necessary to publish a P&L for their audit practices as they do not run their businesses like that. So at the very earliest, financial years starting sometime next year, but even that is ambitious target. Most of their financial years are summer-ish so would be impossible for them to do it this year. We would expect to see the new structure from next financial year. It would be impossible for them to do it this year.

‘The key thing is that this is not a full legal separation, we are not suggesting that they move their audit business into separate entities but what we want to achieve is separate audit governance, focusing on audit quality and making sure that the people that are promoted to audit partner status within the firms are people with the appropriate skills and quality to do audit.

‘Their primary focus should be on delivering audit quality, making the audit practice financially independent and it is important for outside stakeholders to see that the audit firms are transparent, so it is clear what is going on.’

Unsurprisingly, the Big Four have had mixed reactions to the proposals.

‘Their reaction has been mixed; they recognise that this the direction of travel. They are very clear that there are going to be issues, both in terms of interaction with their international networks and just in terms of UK structures that they have in place at the moment does not make this an easy restructure.

An important factor for the FRC is to strengthen the ‘resilience’ of the firms.

‘What we mean by resilience is addressing public perceptions – we want to dispel the common concern about audit subsidising the rest of the business.’

One of the main detracting factors for the Big Four has always been their argument that they require access to a full service firm to provide effective and robust audit services. Although on the counterside, this has led to frequent accusations of conflicts of interest.

Access to wider firm specialist services will still be allowed under FRC proposals.

‘They absolutely would be able to buy services from within the firm, it is all about raising the audit quality. By buying specialist services in-house, for example tax, they can control the quality. This would not necessarily the case if they were to outsource.

‘But the crucial thing is about the pricing of the expertise. We are working with the firms on how the audit team pays for these services. It needs to be an arms’ length price for that service and not that it is subsidised.’

The operational restructure creates a number of questions about the composition of the newly hived off audit practices, in terms of exactly what services it will offer under the wider audit and assurance framework.

‘What we are grappling with is what actually is going to fit with the audit practice; obviously tax services does not sit there, but audit and assurance covers a lot of areas. Year end audits will be in the audit practice, as would audits, when required of half yearly statements, there is no question that they should be ringfenced.

‘And in financial services world there is assurance of regulatory returns, should they be included? How far does this need to go? It all helps to build the resilience of the firms.

While there will be an enormous amount of work to divest the audit business from the rest of the firms’ activities, this will not only affect the reporting on the financial statements, but also the impact of profit sharing and overall profitability.

‘The other piece is around separating the profits. We want to be very clear that audit partners are remunerated properly, but it is how to split the aggregate profit share. Getting that right is going to change the price of audit.

‘Audit partners are taking personal risk and that needs to be recognised. We need to reward people for doing good audit; they take the risk of putting their name on the audit report.’ 

The FRC plans to release further details as talks with the Big Four firms proceed and will release copies of the letters to individual firms in due course.

Report by Sara White

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