Like turkeys anticipating Christmas dinner, leaders of the Big Four in the UK await the preliminary findings promised by the Competition & Markets Authority’s Andrew Tyrie and the committee charged by Parliament and led by City grandee Sir John Kingman.
That’s because a much-mooted “solution” to widely-perceived issues of audit quality and competition would require forcible reduction of the firms to “audit only” – that is, stripped of the ancillary services formidably built in the last twenty years.
To see the scale involved – since the late 1990s when all the large firms but Deloitte hived off their consulting practices, the surviving Big Four in the UK have ramped up non-audit services – under such various labels as Advisory, Consulting, Financial Services, Deals, and Tax Pensions & Legal – so that traditional audit and assurance now account for only between 35% (PwC) and 25% (KPMG) of their 2018 revenues.
Further official attention is assured, with the November 12 pronouncement of Rachael Reeves, chair of Parliament’s Business, Energy and Industrial Strategy Committee, that “the audit market is broken … and all options are on the table, including measures to break the stranglehold of the Big Four.”
Conspicuously lacking in the advocacy of radical surgery is reasoned attention to the impacted delivery ability of the large auditors. Two key issues bear on the needs of the UK’s largest companies:
First, audits require many diverse specialist skills, as recognized in the professional standards -- see International Standards on Auditing (“IAS”) 220, PCAOB AS 1201 -- many identified in, e.g., PCAOB AS 1210. Examples were surveyed in Deloitte’s submission to the CMA of October 30, 2018:
“On complex audits we regularly use specialists from across corporate tax, transfer pricing, actuarial, IT and cyber risk advisory, data analytics, valuations and financial instruments together with industry specialists to identify risks and challenge management.”
Non-audit specialists must satisfy criteria on their qualifications, including avoidance of conflicting interests. If housed inside an audit network itself, those requirements are manageable with the imposition of its independence requirements. If hired outside, however, while rules as to conflicting interests still apply (see ISA 620.9, AS 1210.10-.11), no such monitoring infrastructure is required.
So a daunting supply issue is that a provider of expert services such as actuarial, appraisal, petroleum engineering or artificial intelligence would have no incentive to restrict itself from working directly with a large global company, against the uncertain hypothetical possibility that at some unspecified time in the future, it might be asked to support the work of that company’s then statutory auditor.
Ancillary services inside a Big Four firm can sustain themselves, grow and prosper through work for companies that are not audit clients, then being available to support its audits.
But that would not be possible for an audit-only firm, as it would be unable to recruit, train and retain the necessary roster of non-audit skills if only on-call for the limited amount of work needed as audit support. As Deloitte’s CMA submission put it:
“The multi-disciplinary model also provides the best opportunity to attract the highest quality talent and provide for their rounded development. It provides the scale, financial resources and skills needed to innovate and invest in artificial intelligence and technology to continually improve quality and evolve the audit product to meet the needs of 21st century stakeholders.”
Second, to the impact of audit-only on the firms’ global network structures, an audit-only UK firm will necessarily require extensive foreign support, and lots of it. With some 70% of the revenue of FTSE 100 companies derived ex-UK, audits relating to that massive activity must be done outside the reach of the jurisdiction of the UK regulators.[1]
If a UK audit-only firm were forced out of a global network, its ability to engage foreign support would founder on the unavailability of firms from other networks to assist, as many if not most will have disqualifying engagements to provide non-audit services available within their structures.
Perhaps, however, if it were obliged to establish distance from its non-audit brethren, there would be no necessary reason (other than cosmetic) why that newly-orphaned firm could not remain within its international network.
That’s because, as set forth on their websites, the large networks are aggregations of clearly separate legal entities, for reasons of local licensing and regulation. The Big Four networks essentially comprise sheaves of contractual agreements, with numerous examples of member firms doing no audits at all.[2]
Payments of fees for shared methodologies, training, support and licensing would then vary only as a matter of degree and continuity of relationships, across a spectrum from one-off payments for single engagements to full-time or long-standing, preferred-provider obligations.
As a historical note, prior to its collapse in 2002 the Arthur Andersen worldwide organization was in its lifetime the only network whose global partners had truly shared common financial interests in the entire global operation.
Might a newly spun-off firm in the UK, providing ancillary non-audit services, choose and be able to stay inside its old network? Maybe yes, maybe no.
If yes, and a stripped-down audit firm kept working with the network and its newly re-organized co-member, little save literal compliance would have been accomplished, and the optics might likely not satisfy the critics. If no, however, could a newly-isolated non-audit firm be hired by the audit-only firm? Again if so, the effect would be limited, and the cosmetics issues would remain.
How the UK regulators and politicians may manage to stumble through the maze of these confounding questions will make for interesting watching – as we otherwise pause for the holidays and contemplate the approach of a challenging New Year.
[1] As a quick sidebar, on an aspect otherwise avoided here: non-audit services of a UK hive-off could readily be off-shored, with work delivered from a base in Paris or Brussels or Amsterdam – strategic moves separately motivated but feeding into the debate on the consequences of Brexit.
[2] See, e.g, KPMG’s description of its international structure, here, and PwC’s 30-page global list of legal entities, here.
This concludes a series on the state of the UK environment, started back in September. Thanks for joining. Please share with friends and colleagues. Comments are invited and welcome, and subscription sign-up is easy and free, both on the Main page.
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