The Big Four; PwC, KPMG, Deloitte and EY are the oligarchs of the audit sector. The Business, Energy and Industrial Strategy (Beis) committee claim the Big Four have a stranglehold on the industry and it is clear to see why. In the UK, these four firms audit 99 of the 100 biggest companies and 98% of the biggest 350. In recent months however, there has been growing criticism of the audit giants. A number of landmark scandals have sparked a debate as to whether the Big Four are fit for purpose in their current form. Only 75% of the sample of audits of Britain’s 350 top listed companies for 2017 were deemed good or satisfactory. This fell well beneath the 90% target set by the regulator, the Financial Reporting Council (FRC). Two of the most controversial cases were KPMG’s audit of contractor Carillion and PwC’s audit of BHS. In both cases, the auditors gave the companies a clean bill of health, despite being on the brink of collapse. The two companies later collapsed at the cost of tens of thousands of jobs.
This systemic inadequacy has spurred politicians to wade into the debate, urging for drastic reform. Rachel Reeve’s MP says the “big four’s dominance has fostered a precarious market which shuts out challengers and delivers audits which investors and the public cannot rely on.” MPs claim that the way to solve the problem is to break up the Big Four. The question is, would a break up genuinely improve industry standards or is this merely a political kneejerk reaction? This article will explore the merits of the argument for the Big Four to be split up.
Why should they be broken up?
The primary argument for a breakup is that the Big Four is the conflict of interest between audit and consultancy. A recent report by the Business, Energy and Industrial Strategy (Beis) Committee stated that greater competition is needed within the sector to increase quality. The auditors are failing to provide the necessary “professional scepticism”. At the heart of this, many MP’s believe is a conflict of interest. Rachel Reeves says “audits seem too often to be the route to milking the cash-cow of consultancy business”. MPs argue the firms are not asking the tough questions in audit for fear of losing out on lucrative consultancy work. Consultancy work now brings in significantly more than audit work for the Big Four so MPs claim the firms are willing to accept this trade off. A breakup would see the firms split into whole separate entities with separate CEOs and boards. A breakup could improve standards by creating competition and completely negating the risk of conflicts of interests.
In its review, the Competition & Markets Authority (CMA), did not support a wholesale breakup at this time however, they did note that this option could be revisited within five years if improvements are not made. This shows that the idea has some merits. The CMA proposed alternatives such as joint-audits for the time being. The Beis Committee claims however, that a complete breakup would be most effective at resolving the issue of a conflict of interest.
In addition, the regulator is not well equipped to deal with the giants. The FRC has agreed to push for record fines of up to £10 million for serious failures. It has also issued tens of millions of pounds in fines to the Big Four in the last year alone. Despite this, the FRC’s latest report shows a quarter of audits are falling below required standards. Fines are clearly ineffective as the Big Four have almost guaranteed retention for the big audits. A breakup could improve industry competition and give the regulator more power over the firms.
Why shouldn’t they be broken up?
It is unlikely that a breakup of the Big Four would lead to better audit standards. There are very few industry commentators who believe a wholesale breakup would be beneficial for the sector. This is because the root cause for the poor audits is not a conflict of interest between departments.
The conflict of interest argument for a breakup is fundamentally flawed because in essence, the firms are already separated. The idea that the Big Four are using audit work as a means to obtain consultancy work is not accurate. At PwC for example, revenue generated from audit clients through non-audit work accounted for just 9.5% of total revenue . The reality is they do not provide substantial consultancy work to clients that they audit. While, we cannot completely reject the idea that some conflicts of interest may exist, to suggest this is the root cause of the industry wide failure is simply inaccurate. In addition, different departments within the firms negotiate contracts completely independently. In practice, this means audit teams are under no pressure to lower standards to retain lucrative consultancy clients.
The primary conflict of interest lies within the very nature of auditing and a breakup would not resolve this. The auditors are paid by the very companies they are scrutinising. Furthermore, there has been an increase in competition along with an increasing industry-wide cultural emphasis on maximising revenue. This explains why the issue with poor auditing does not pertain solely to the Big Four. In the FRC latest review Grant Thornton, Mazar and BDO were all highlighted as failing to meet standards. The issue is not idiosyncratic to the Big Four but rather, its an industry wide problem. Breaking up the Big Four is not an effective solution and only a cultural shift within the firms can resolve the issue.
Breaking up the firms could even have a negative impact on the audit sector. The Big Four provide audit services for the biggest companies because they have the most resources at their disposal. Auditors at the Big Four rely on the wealth of expertise and technology they have within their firms to efficiently provide the service. For some audits, a large proportion of the work is carried out by non-audit specialists such as legal, tax and tech experts. A breakup would mean more outsourcing and consequently, slower speeds and potentially lower quality. In addition, combined companies have more funds and therefore more resources to put towards increasing standards. The largest auditor, PwC, posted UK audit revenue of £825m in 2018. This is dwarfed by PwC’s total UK revenue of £3.76 billion. Without the human and financial resources behind them, the capacity and efficiency of fully independent audit arms may be compromised, and industry standards could drop even further.
What other solutions are there?
In December 2018, the CMA proposed imposing market share limits on the Big Four and bringing in joint audits, conducted by a Big Four firm and a challenger firm. These may be effective solutions for increasing competition in the sector. Joint audits or limits on market shares would help smaller firms gain experience in the audit of larger firms. The Beis committee also endorsed the proposals. The Big Four have all however, criticised the prospect of joint audits. Many of the smaller firms simply do not have the capacity or expertise to efficiently undertake the volume or nature of work involved in some of the largest audits. The reality is most challenger firms simply aren’t equipped to take on FTSE 100 audits so limiting the Big Four’s market share or bringing challenger firms alongside the Big Four could prove detrimental to standards. For challenger firms to get involved in this market it will take gradual growth and therefore, this is not a solution for the present.
The FRC agreed that current standards are unacceptable, and no audits should fall beneath a satisfactory level. They have now announced plans to increase the target of satisfactory and above audits from 90% to 100%. This measure is somewhat pointless as low targets are not the root cause of poor auditing. Without an accompanying cultural shift within firms, raising targets would simply increase the margin of failure. This measure could be beneficial if the FRC were given more powers. The financial and reputational cost of seriously poor auditing should outweigh the disincentive to apply sufficient professional scepticism for fear of losing clients. Currently, this is not the case so merely increasing targets would be ineffective.
A breakup of the Big Four simply put, is throwing the baby out with the bath water. It would not resolve the systemic standard issues within the audit sector and could even harm the industry. The Big Four rely on the expansive resources available within their firms to carry out the largest and most complex audits. Cutting or limiting direct access to those resources through a breakup would undoubtedly be to the detriment of the quality of audits. MPs calling for a wholesale breakup are failing to consider such implications and their proposals come across as mere political bravado. The low percentage of audit work done for consulting clients also shows that the conflict of interest is not the primary cause of poor audit. There is no doubt that a cultural shift is needed in audit to improve standards. MPs are pushing for a breakup for as a silver bullet for the issue. There is however, no silver bullet for bringing about this change and breaking up the Big Four would undoubtedly do more harm than good.
The Guardian https://www.theguardian.com/business/2019/apr/18/watchdog-calls-for-uks-big-four-accountancy-firms-to-be-split-up