MPs want Big Four broken up to remove ‘cash cow’ consulting
MPs are calling for the Competition and Markets Authority (CMA) to aim for the full structural break-up of the Big Four firms into audit and non-audit businesses, along with a market cap and the use of joint audits, in order to tackle conflicts of interest, develop the market for challenger firms and increase professional scepticism
2 Apr 2019
In its report on the future of audit, the Business, Energy and Industrial Strategy (BEIS) committee is highly critical of attempts by auditors—particularly the Big Four and Grant Thornton—to paint the crisis in audit as a perception problem arising from an ‘expectation gap’.
The report notes that 27% of audits reviewed for 2017/18 did not meet Financial Reporting Council (FRC) quality standards, and says there is instead a ‘delivery gap’ and a ‘serious failure of audit to deliver on its own current terms’.
It states: ‘The opaque economics of audit undermine independence, erode trust and stifle competition.
‘Audit can only be transparent and independent when it is fully priced. It will only be fully priced when it is no longer subsidised.
‘Therefore, subsidies must end and audit must stand on its own two feet. We conclude that governance separation does not go far enough on the grounds that it fails to deliver independence and does not end cross-subsidies.’
The committee said it agreed with the CMA that ‘objections to full separation are overstated’, and said that if the operational split is chosen instead, the CMA and the FRC’s successor, Audit, Reporting and Governance Authority (ARGA) should conduct a review of the arrangements after three years to determine whether the split has ended cross-subsidies and improved culture, independence and transparency. If not, the CMA should then move to implement a full structural break-up of the Big Four into audit and non-audit businesses in the UK.
Other recommendations include increasing the frequency of audit rotations to seven-year non-renewable terms and (should the CMA go ahead with an operational split) a cooling off period of three years, in which non-audit services cannot be offered to a former audit client.
MPs want to see joint audits piloted in the upper reaches of the FTSE 100 in conjunction with a market cap for the rest of the FTSE 350. Such audits should include a Big Four and a challenger firm; it should not include two Big Four firms.
The regulator should monitor the quality of these pilots carefully to inform debates on which mechanisms are the most likely to increase competition and choice without damaging quality, while if unlimited liability is a significant deterrent to the challenger firms auditing the largest and most complex companies, the CMA should consider how to remove this barrier.
The committee wants to see the introduction of a segmented market cap offering challenger firms the chance to take up a proportion of audits across the FTSE 350. This should be done on the basis that each firm should have an individual cap to avoid one of the Big Four keeping all of its clients and remaining dominant.
The report says that the detection of material fraud must continue to be a priority and recommends that, in light of the failings at Patisserie Valerie, audits must state how they have investigated potential fraud, including by directors.
It states: ‘As part of his review, Sir Donald Brydon should consider extending the scope of audit to cover the entire annual report, albeit with different levels of assurance and reporting.
‘Critical areas such as corporate governance and payment practices ought to be subject to a robust assurance process and meaningful reporting by the auditor. Auditors should be encouraged and empowered by the new regulator to speak their mind openly and clearly in audit reports, without fear or favour. They should call out poor management when they see it.’
MPs also want audits to be ‘more useful and forward looking’, which they argue would make audit more meaningful and also enhance auditors’ work. The report recommends audits move to include graduated findings, providing more nuanced information to investors and others.
In the future, the report suggests that audits could provide a better picture of a company’s overall corporate governance, including assessments on areas such as pay policy, the gender pay gap, payment practices to suppliers, and on environmental sustainability.
They suggest auditors should present at a company’s AGM in order to explain how they have developed their report.
Audit committees are under fire over a lack of attention to audit, with recommendations for sharper oversight to help ensure that audits are more independent, able to challenge management and address any bias in favour of the Big Four. If problems remain, then the committee says independent appointment of auditors becomes a viable option for reform.
Rachel Reeves, chair of the BEIS committee, said: ‘The reviews from the CMA and Kingman highlight the failings; now we need action.
‘For the big firms, audits seem too often to be the route to milking the cash-cow of consultancy business. The client relationship, and the conflicts of interest which abound, undermine the professional scepticism needed to deliver reliable, high-quality audits. Splitting audit from non-audit business would be a big step to boosting the culture of challenge needed to deliver high-quality audits.
‘The Big Four may not like it, they may seek to undermine the case for reform, but vested interests should not be allowed to get in the way of positive change.’
Responding to the report’s findings, a KPMG spokesperson said it shows ‘that trust in audit is in urgent need of repair’.
KPMG said: ‘To address concerns about possible conflicts of interest, we have already stopped undertaking non-audit work for companies we audit in the FTSE 350. We are not accepting any new non-audit work for these companies, and we anticipate that the vast majority of existing projects will have concluded by the end of 2019.
‘We have already begun to implement graduated findings across our audits, a measure which the committee’s report stated has been “pioneered by KPMG”.
‘It is clear there is a demand for more information on the complex judgements made by large companies in their financial statements, and we believe graduated findings are an important step towards providing this.’
Stephen Griggs, Deloitte’s UK managing partner for audit, said: ‘We welcome many of the recommendations, including extending the scope of the audit and better regulation of audit, but we have concerns about a potential structural split. This will be detrimental to audit quality and could materially damage the UK’s competitive position as a leading capital market.’
Griggs’s views are echoed by Hemione Hudson, head of assurance at PwC UK, who said:
‘Arguing for “break-up” sounds like action, but actually it will reduce quality, weaken resilience and distract attention from more practical steps to ensure auditing keeps pace with society’s expectations.
‘There are likely to be significant unintended consequences from breaking up the large professional services firms, with increased cost and disruption to the economy and businesses which would be damaging to the UK’s competitiveness.’
Hudson said PwC was ‘listening to concerns and responding’, with the firm putting in place steps to strengthen governance and enhance audit quality further.
‘We agree that audit firms and the regulator must focus on increasing trust in audit and the consistency of audit quality. We believe it is also necessary to focus on the changing needs and expectations from audit.
‘We support the report’s recommendation that Sir Donald Brydon should consider extending the scope of audit. This is backed up by our own Future of Audit initiative, in which we have consulted a wide range of stakeholders, including business and investors. Our consultation has revealed a desire for audits to be more forward looking and have a broader scope to cover other areas of reporting beyond the historical financial statements,’ she said.
In its response, EY said it also favoured a multidisciplinary model of services, which the firm said provided the structure, breadth and depth of technical skills and industry expertise necessary to deliver high-quality audits for large and complex companies.
EY said: ‘We, therefore, disagree with the proposals that call for an operational or structural split in the UK as this would undermine the multidisciplinary model and risk unintended consequences to audit quality.’
However, the firm is supportive of measures that improve audit quality, strengthen the role of the audit committee, and modernise the audit product to meet today’s expectations, but said ‘the right changes need to be made in the right order’.
EY highlighted that one of the measures proposed by the BEIS select committee is further investigation into a possible UK version of Sarbanes Oxley, saying it believed that such a framework would increase the accountability of management and directors of large listed and private businesses and further strengthen the UK’s corporate reporting system.
Report by Pat Sweet