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U.K. Audit Separation Plan for Big Four Panned as Cosmetic

July 7, 2020, 8:46 AM

A new agreement for the Big Four accounting firms to split their U.K. auditing and consulting arms is a cosmetic exercise that won’t improve audit quality or independence, multiple analysts and investors argue.

“It’s not only voluntary, but parts of it are weak to the point of harmful. No wonder the Big Four signed up to it,” Tim Bush, head of corporate governance at Pensions & Investment Research Consultants Ltd, said in a call voicing a concern echoed by other critics.

The Financial Reporting Council on Monday announced an agreement with the Big Four—KPMG LLP, Deloitte LLP, PricewaterhouseCoopers LLC and Ernst & Young LLP—on an operational separation of their audit and consulting arms by 2024 to avoid conflicts of interest, averting temptation for firms to perform soft audits to chase juicy consulting contracts from their clients.

The pact comes amid pressure on the government to honor a promise to act on the findings of several reports it commissioned into audit market reform after a series of scandals such as the collapse of Carillion Plc in 2018. The reports recommended changes including forcing the big accounting firms to separate audit and consulting activities and creating a more powerful accounting watchdog.

“These principles have been achieved without the need for legislation, hence they are ‘voluntary,’” FRC spokesman Peter Timberlake said in an email about the new agreement.

A spokesperson for the Department of Business, Energy, and Industrial Strategy said the department will set out its “proposals in the coming months and consider bringing forward legislation in due course.”

‘Toothless’ Plan

Michael Izza, CEO of the Institute of Chartered Accountants in England and Wales, called the agreement a “pragmatic response,” with the government failing to pass any audit-reform legislation because of delays from Brexit and Covid-19. “However, it will do little to improve quality or choice in the market,” Izza said in an email Monday.

“It’s an unbelievably weak response that won’t change anything,” Richard Murphy, an accountant and economics professor at City University, said by phone.

Far from ensuring that consulting and audit activities are separate, Murphy pointed out that the new audit arms would still be allowed to perform consulting work: the only requirements are for a majority of revenues and partner pay to come from audit work, with staff allowed to split their time between the audit and consulting arms.

There will be no separate pool of audit arm profits, Murphy said. Audit partners will still be paid out of the wider firm’s cash pot, and the overall firm’s senior partner will still head both the audit and consulting arms, he said.

“The Big Four are trying to head off tougher legislation,” Murphy said.

Prem Sikka, the University of Sheffield accounting professor whose 2018 report on audit reform for the Labour Party called for a full separation of audit and consulting firms, agreed. “This does not tackle any of the fundamental issues,” he said. “Audit firms should only do audit work.”

The agreement is toothless, Sikka said, because it isn’t governed by legislation and so it can’t be enforced.

“I don’t expect much progress over audit reform, or legislation, under the present Conservative government,” he said, adding that the FRC measures were “aimed only at the narrowest possible group of auditors, the Big Four. BDO in particular is picking up more FTSE 350 audits and so they should be included.”

Middle-Ground Solution

Oxford University business professor Karthik Ramanna said the agreement was a compromise, with the government struggling to pass legislation in the middle of the coronavirus pandemic.

“Overall, it is a middle-ground solution with a fairly generous runway to implementation,” Ramanna said by email. “Given the uncertainties with Brexit and Covid, I think the government wanted to avoid cracking down too hard on the industry; but Wirecard forced its hand to be seen doing something.”

Mike Suffield, director of professional insights at the Association of Chartered Certified Accountants, generally supported the FRC agreement as a way of making audit more independent, but said by phone that legislation was necessary and agreed with Sikka that the agreement needs to be extended beyond the Big Four.

“If it works, then why not apply it more broadly?” Suffield asked.

Falling in Line

BDO LLP and Grant Thornton LLP, the fifth and sixth biggest firms, both said that they would broadly follow the terms of the FRC agreement.

“We will fully support any measures which improve audit quality and continue to maintain a constructive dialogue with the FRC,” BDO’s audit head Scott Knight said in an email. “While the operational separation applies primarily to the Big Four, we are proactively considering how the FRC’s principles should be applied to our firm.”

“Whilst we are not required to present our plans for operational separation to the regulator in 2020, we are already working on the practicalities of adopting the principles,” Fiona Baldwin, Grant Thornton’s audit head, said in an email.

Mazars’ U.K. audit head Bob Neate said in an email that he welcomed the FRC measures but warned that they “will not alone achieve the objectives of enhancing audit quality and building a truly competitive and resilient audit market.”

A package of measures, including the introduction of joint audits for listed companies and better audit committee supervision, is necessary to mend the audit market, Neate said.

The FRC agreement calls for the separation of auditing and consulting arms to be completed by June 30, 2024, with an implementation plan submitted to the FRC by Oct. 23 next year.

To contact the reporter on this story: Michael Kapoor in London at correspondents@bloomberglaw.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Sony Kassam at skassam1@bloombergtax.com

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