Big Four split on solutions to industry’s problems

Writing in the Financial Times (FT), David Sproul, the chief executive of Deloitte in the United Kingdom and North West Europe, laid out his firm’s proposals to reform the audit industry.

There were some bombshells: “We propose banning all non-audit services to FTSE 350 and large public interest entity clients. … We have also called for market share caps for the listed market—either taken as a whole or for particular subsets of the FTSE 350.” Almost on the same day, it was revealed in a letter from Bill Michael, KPMG’s U.K. chairman, to the firm’s partners that it was suspending non-audit work to FTSE 350 audit clients right now.

“In terms of a date, we’re stopping the provision of non-audit work to FTSE 350 companies we audit immediately. There are a few tenders for work which we’ll allow to reach their natural conclusion but an absolute hard stop on everything is 1 January 2019,” a KPMG spokesperson said.

Both firms go much further than the others in the Big Four in their comments to the current Competition and Markets Authority (CMA) review of the industry, but in such a tight industry, it seems unlikely that Deloitte and KPMG will do one thing and EY and PwC will do another.

In its submission to the CMA, KPMG said of its recommendation: “Whilst the rules and systems relating to the provision of non-audit services to an audited entity are extensive and complex, a perception of conflicts remain. While further enhanced governance is likely to address this perception to a degree, KPMG recognises that restricting the provision of non-audit services may be desirable. This could address significant public perception of auditors’ judgement being impaired by the nature of non-audit work or the financial benefits derived therefrom. We believe that any such restriction should be limited to FTSE 350 audited companies since these companies tend to be at the level where the public interest—through dispersion of shareholdings and impact on the economy—is greatest.”

Deloitte put forward the following measure as the most effective: a market share cap or caps for particular segments or subsets of the market “which would over time seek to address choice and competition issues, reducing barriers to entry as well as concerns around resilience of the audit market.” In its submission it was clearer, suggesting that such caps would cover the entire listed market as smaller corporations would be more likely to open up to firms outside the Big Four and therefore would be more effective at increasing competition. Deloitte also recommended a stronger, fully accountable governance structure around the audit practice to address issues around incentives and conflicts of interest. Its recommended ban on non-audit services provided to FTSE350 and large unlisted public interest entity (PIE) audit clients also sought to address issues around incentives.

As Sproul said in the FT, these recommendations require a clear definition of what large PIEs are, as well as a clear definition of “audit services.” The submission indicates that audit services should include, as well as the annual audit, the half-year review, bond offerings, grant applications, reporting on historical financial information, work on offering circulars, and similar services.

Rather than additional regulation and/or legislation or regulatory bodies, Deloitte’s suggestion is to create a separate, independent, governance body within each audit firm that has clear public interest reporting responsibilities. The body would need to “monitor and report publically on any potential conflicts and how they have been dealt with to ensure there are no actual or perceived conflicts with the firm’s public interest responsibilities.” It would also be required to ratify certain types of appointments and focus on audit quality “with an emphasis on root cause analysis.”

An EY spokesperson, providing a link to their submission, noted that, “We are not commenting beyond our CMA submission.” But its recommendations are far less specific than either KPMG’s or Deloitte’s and, oddly, suggest that audit quality is a problem that should be addressed by making companies more accountable rather than auditors. EY does not agree with a ban on non-audit services for audit clients, instead suggesting that reporting and disclosure should be able to deal with conflict of interest issues.

Among its recommendations:

• Higher fines and sanctions where audits fail with accountability at senior levels;
• Managers and directors should be held responsible for accounting quality in the same way as The Sarbanes-Oxley reforms in the U.S., where the management of a public company is required to certify the material accuracy of financial statements, could be adapted to the U.K. market;
• Corporate reporting should evolve, “particularly regarding the going concern and viability of companies and the measurement of the long term value creation for stakeholders and other risks;” and
• More regulation and appropriate scrutiny of companies, directors, and auditors.

It also proposes a regime of transparent tendering with reporting on the process and decision to appoint or reappoint an auditor and a broadening of reporting by audit committees to enhance transparency.

PwC, which did not respond to enquiries seeking comment, was vague about where it stands, saying it “appreciates that further commitments to limit non-audit services to audit clients could be necessary to promote confidence in the independence of audit firms.” It also argued that any new restrictions would need to apply to all audit firms, not just the Big Four, since all firms are subject to the same perception issues regarding conflicts of interest.

Of the other potential reforms suggested by the CMA, unsurprisingly none of the four firms wanted to break up the Big Four. Deloitte gave cautious approval of shared audits, but none of the firms wanted joint audits, which they said would allow issues to fall through the cracks. None wanted a national auditor, and none wanted an independent body to make audit appointments.