Breaking-up the Big Four
EY said it “strongly opposes” measures that would impose either a full structural or operational split of audit firms, as this could create “a serious risk to audit quality”.
The firm argued it would not improve audit quality, choice or competition, or reduce the risk of corporate failure.
A full structural split would create a less resilient audit business, with reduced capacity for investment which would consequently be less able to withstand exceptional costs, it argued.
The separation of audit and non-audit profit pools, as proposed in both the structural and operational split, risks lasting damage to the quality and resilience of the firms and the market as a whole, the Big Four firm added.
KPMG reiterated its opinion (submitted in previous evidence) that a full structural split would lead to “significant and unmanageable negative implications” and bring “disproportionate risks and costs”.
Deloitte agreed that separating the firms’ structures would not improve culture or remove conflicts, and would instead reduce resilience and investment capacity.
Additionally, PwC said it considers that any operational or structural split of the firms would be a disproportionate response, would not lead to increased choice and would undermine rather than enhance audit quality.
Mid-tier firms BDO, Grant Thornton and Crowe were also opposed to this, arguing it would lead to higher costs or regulation.
Despite not supporting the measure, Mazars said that in the first instance a split should only apply to the Big Four and only apply to challenger firms once they have a significant client base in the FTSE 350 or wider public interest entity (PIE) audit market.
RSM said this was the most controversial measure, but that it was “perhaps easy to understand why so many informed commentators and academic observers may have lost patience and reached the conclusion that it is time to adopt truly radical reform measures, as over many, many years almost every other less-commercially-intrusive avenue for reform has been investigated, then heavily criticised and ultimately effectively blocked or just kicked into the long grass by a formidable Big Four lobbying campaign against change”.
Kreston Reeves said an operational split should be the preferred approach as it could create substantially the same benefits for competition and quality, but at less cost and disruption than a full structural split of firms.
ICAEW opposed the recommendation and warned there would be “significant costs and potentially adverse consequences”. It pointed out that the complexities of contracting independent expertise, often during busy season, and the potential reaction of the international networks should not be underestimated.
Separation would also create further difficulties for integrated multi-disciplinary firms, as they operate to a single standard of professionalism and ethics and work within a consistent professional culture across their firm’s work.
The FRC said it hoped that through its own work on standards regarding independence would create complete separation.
Banning non-audit work for audit clients
KPMG has previously announced it will stop providing non-audit services to its FTSE 350 clients.
During an evidence hearing last week, the Department for Business, Energy and Industry Strategy (BEIS) committee pressured the other firms to disclose if they would be following the lead.
EY and PwC had not included an explicit commitment to this in their submissions, which were sent before the deadline of January 21 and published yesterday, but have since confirmed they will be also imposing the ban.
EY told economia, “We can confirm that EY in the UK will be taking steps to phase out non-essential non-audit services for FTSE350 audit clients and will work with our regulator to agree the definition of such services. We believe this will help to improve trust in the profession and the perception of conflicts of interest.”
This was a change from its previous submission, where it argued that reporting and disclosure should be expanded to include the full range of audit and non-audit services that a company purchases from its auditor and the major audit firms in reasonable detail – along with an explanation of why it has purchased any non-audit services from its auditor.
“If further measures were introduced in relation to restrictions on non-audit services, these should apply to all firms conducting audits of Public Interest Entities (PIEs) and large companies, not just one set of firms or a specific section of any market,” it said at the time.
PwC argued in its evidence – published by the CMA on its website yesterday – that it does not believe the CMA has gathered “empirical evidence” to support concerns that the culture of the Big Four firms is driven by non-audit services, but has since agreed to follow its rivals in imposing a ban.
The firm said, “The CMA found no evidence that non-audit work gives rise to problems. We will continue to provide audit and audit-related services to our FTSE 350 audit clients, but we intend to stop providing other non-audit services directly to those audit clients.
“This won’t improve audit quality, however, we believe it’s the right thing to do as the profession seeks to restore trust in audit.”
KPMG was the first Big Four firm to announce it would stop providing non-audit services to FTSE 350 clients. It said, “We believe that if a similar restriction was implemented market-wide within a regulatory framework, this would be an effective way of mitigating actual or potential conflicts and increasing trust in audit.”
Deloitte agreed with KPMG, saying that, despite limited evidence of conflicts between audit and non-audit work at the client level, such an unequivocal position would address public perceptions about conflicts of interest.
BDO used stronger words, saying that to be truly effective and to restore trust a full ban on non-audit services for PIEs is required.
“Where two divisions of the same firm are performing audit and non-audit services we are not confident that this would be sufficient to change the public’s perceptions about conflicts of interest,” it said.
“We have consistently said this is an area where the profession should go further than regulation and we are therefore against any relaxation.”
Grant Thornton said it supports a general ban in non-audit services for audit clients that aren’t related to delivering a statutory audit to PIE audit clients. It argues practices should be permitted to provide certain non-audit services which it is in the interests of stakeholders for auditors to provide.
Mazars has also supported the ban. Crowe said that, while legally splitting firms is not practical, a clear ban on non-audit services is.
“Such a ban works in other countries and we encourage the CMA to revisit this point,” it added.
ICAEW aligned with the firms supporting the ban, arguing this recommendation is robust enough to deal with independence concerns.
The FRC suggested that firms could ring fence revenues from non-audit services so that they form no part of the remuneration of members of the audit practice, “ensuring there is no incentive to sell services other than the statutory audit”.
Market share cap
EY believed that market share cap should not be pursued due to the risk that it could harm audit quality; the fact that it is untested and unproven; the potential it has to increase audit fees; the risk of “cherry picking” posed; potential legal issues and the additional legislation; and the level of regulatory resources required.
While KPMG disagreed in principal, it had some shared concerns over implementation.
“We consider that a market share cap for a finite period is the better option [than joint audits], although the implementation details are complex,” said Bill Michael, UK chairman and senior partner.
The firm said that any model for a market share cap needs to consider that “at least at the outset of implementation, it may not be appropriate to have smaller firms involved in the audits of particular FTSE 350 companies”.
It also said such a model “should have sufficient flexibility to address the challenges that smaller firms would face in taking on larger numbers of audits in a short timeframe”.
The firm added that “any market share cap would need to have a finite period of operation.”
Laurence Longe, chairman of RSM UK, echoed similar concerns, saying “[RSM] think it is unlikely in the near-term that challenger firms will have the scale or resources to take on a significant number of the very largest audits, in particular for example, many – if not most – of the FTSE 100 companies”.
The firm did say however that it might open up the FTSE 250 market for challenger firms that in itself would significantly help in the medium-to-long term in increasing penetration of challenger firms into the “upper reaches of the capital markets” and give them time to “build scale and competencies”.
“In considering how both to improve choice whilst protecting audit quality we would also be supportive of the introduction of a temporary market share cap for the FTSE 350 audit market,” said Margaret Cole, PwC general counsel and chief risk officer.
Cole said that the firm believed a market share cap “would be more effective than joint audits in increasing choice”.
“We believe that, with careful implementation, market share caps could be introduced in a manner so as to mitigate risk to audit quality and would support the CMA in exploring this further,” Cole added.
Meanwhile, ICAEW contends a cap would be an effective way to achieve “a greater number of participants in the FTSE 350 audit market” and said it did not agree that it is less desirable that joint audits.
“While a market share cap would have some complexities in design and application, ICAEW believes that it could be introduced with significantly less disruption and cost than mandatory joint audit and could be implemented in a shorter timeframe,” ICAEW said.
The firm suggested that a tentative estimate was that a cap could be implemented in as little as two years, compared to at least five required of joint audits.
Deloitte disagreed with the CMA’s position that joint audits are preferable to market share caps in that they increase challenger participation without risk to audit quality in the short term.
Deloitte said that market share caps coupled with shared audits “provide the most effective and low risk option for increasing choice”.
BDO said that its “view is that market share caps will address quality, by ensuring audit quality is the dominant determinant in every tender and effect change more quickly than any of the other remedies”.
“A quick to implement and powerful remedy, market share caps will start to normalise the market perception and position between the firms,” it added.
In contrast, Grant Thornton said it preferred joint audits over the application of a market share cap.
“However, if a market share cap approach were to be implemented as an alternative to mandatory joint audits, then it should be applied to ensure that audit work is allocated across a number of non-Big Four firms, reflecting capacity and quality and does not destabilise audit quality,” Grant Thornton said.
Mazars believed that mandatory joint audits have “substantial advantages over, and carries none of the risks associated with, the alternative market share cap approach […] identified by the CMA”.
Like Deloitte, the firm thought that any market share cap approach should include mandatory joint audit. The firm thought a cap alone would run the risk of Big Four “cherry picking” while not providing the opportunities in enhancing audit quality that mandatory joint audits offered.
The firm also considered that it would limit choice and not address the need for market resilience “unless accompanied by mandatory joint audit at the upper end of the FTSE 350”.
Crowe said that it supported the CMA’s preference for joint audits over a market share cap “as a measure that can have an immediate impact on lessening the concentration of the Big Four in the FTSE 350 market.”
Kreston Reeves thought that such a market share cap would restrict choice as companies will not be able to appoint new providers that are already fully allocated.
“Having reflected further on the merits of implementing a market share cap, we do foresee practical problems that make us question whether it is desirable to introduce such a measure,” the firm said.
“We are of the opinion that other potential remedies such as joint and shared audit engagements offer a better alternative solution to increasing competition and improving audit quality,” the firm added.
Likewise, the FRC said “the market share cap remedy on its own could pose significant short-term risk to quality and competition”.
It said that in order to strengthen mandatory joint audits, market share caps could be included “as a hybrid measure”.
The CMA’s recommendation in relation to mandatory joint audits has been received with mixed reactions, with the biggest firms opposing the measure and most of smaller firms supporting it.
Namely, Grant Thornton (GT), Mazars, RSM and Crowe were in favour of the introduction of mandatory joint audits.
GT believes it would reduce the barriers faced by non-Big Four audit firms to auditing large companies.
“Joint audits can be used to actively develop audit quality and independence through collaboration between firms and allow non-Big Four firms greater prominence and opportunity to demonstrate their capacity and credentials with major companies,” it said in its submission
However, it suggested the FTSE 350 is the most appropriate way to introduce joint audit arrangements, rather than an extension of this remedy to the wider PIE population or large private companies.
Mazars said that mandatory joint audits should be at centre of the reform, with at least one challenger firm involved in each audit. It recommended that those opposing joint audits should provide evidence to support their view and should “not be allowed to rely on asserting long-standing urban myths”, including those relating to material increases in cost, greater complexity for companies and the risk of ‘things falling between the cracks’ which do not bear scrutiny.
Mazars suggested joint audit should be introduced on a phased basis over five years across the FTSE 350 and, apart from the largest 40-or-so audits (with fees above £5m), should be joint audits from when challenger firms are first appointed.
The aim should be for at least 20% of aggregate FTSE 350 audit fees to be those of challenger firms after five years and 30% after seven years, it added.
RSM said in its response that joint audits are “perhaps the only proposed major remedy that is likely to bring about a significant intervention in the audit market”.
It recommended a timescale of five to 10 years to implement this measure.
Crowe revealed it supports the general approach of join audits for FTSE 350 clients but does not support extending the remedy beyond that at the moment. It suggested each joint auditor contribute at least 30% of the planned audit hours, in line with the French market.
EY opposed this measure, arguing there is no evidence from countries that have joint audit regimes to indicate that they improve audit quality.
It believed this would create risks to audit quality, such as management seeking to leverage one firm against the other.
“Joint audits reduce choice, particularly when coupled with mandatory firm rotation,” it added.
KPMG revealed that, while it does not oppose joint audits in principle, these would need to involve equal, or at least reasonably equal, input from each joint auditor, and would – at least in the short to medium term – involve significant implementation and capability challenges. The firm said this would not be easy to implement.
Deloitte also said there is no evidence that joint audits improve choice or encourage new entrants capable of leading large listed audits into the market, adding that they cause significant increases in cost and complexity and do not appear to be welcomed by many companies, investors or other stakeholders.
PwC, for instance, does not think choice would necessarily increase and said it was concerned that the proposals could create significant audit risk if joint audits were introduced.
BDO was the only mid-tier firm on the list without confidence that joint audits would be sufficient on their own to improve competition and choice.
It warned that, under a joint audit regime, there is a very real risk the Big Four will become the majority joint auditor across the whole FTSE 350. This could “lock in” challenger firms to being the minority parties rather than providing a mechanism for these firms to increase their participation and influence to a level that stakeholders are asking for.
Meanwhile, Kreston Reeves lamented that the CMA had recommended joint audits instead of shared audits.
“We are of the opinion that greater adoption of shared audit would be the best means of [gaining greater access to the market],” it said.
“We would not consider ourselves at present to be a challenger firm, lacking the resources or experience at this time, and consequently fee unable to put ourselves as a potential joint audit under the proposals you are suggesting.”
The FRC said in its response that joint audits offer “a mechanism to support growth in capacity of challenger audit firms”, and called it a “clear medium to long term remedy”.
The watchdog said challenger firms should be given three to five years to prepare a capability action plan.
ICAEW had a mixed response to this recommendation, saying that, while it agreed it would be effective in achieving a greater number of participants in the FTSE 350 market, it does have a number of concerns in relation to the impact and implications of mandatory joint audit as a market remedy.
Independent auditor appointment body
Grant Thornton said that in its previous response it supported measures to “improve independence of decision-making in relation to auditor appointments, particularly through the creation of an independent appointment body”.
However, this was not included in the update paper as there are currently barriers to its creation.
“In the absence of an independent appointment and monitoring body we support other measures such as regulation and enhanced oversight of audit committees to ensure that they fully protect the interests of shareholders and are independent when making decisions about auditor selection,” Jonathon Riley, head of quality regulation at Grant Thornton said.
PwC’s position was that a combination of remedies, including oversight in auditor appointments, would help towards reform.
“The introduction of a temporary market share cap combined with changes to the regulatory oversight of auditor appointments and a new regulator with a focus on competition would provide a structure for substantial change,” Cole said.