How U.K. Audit Scandals Pushed Big Four Toward Split

A spate of scandals has put accounting firms in the U.K. on the back foot. The collapse of Carillion Plc, and subsequently Thomas Cook Group Plc, have been among cases that raised questions about auditing standards at the so-called Big Four firms. In response, Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers have agreed to separate their auditing and consulting departments by 2024 to avert possible conflicts of interest, a move that critics say doesn’t go far enough.

1. How bad have things got?

Bad enough that the U.K. government promised to reform the audit industry after a Parliamentary report two years ago into the collapse of Carillion, a major outsourcing company. The report panned Carillion’s accounting methods, KPMG’s soft audits and weak accounting regulation. Sidetracked by Brexit, a general election and the coronavirus pandemic, the government has yet to follow through. In the meantime, the accounting firms have taken action, along with the regulator, the Financial Reporting Council, partly to preempt government moves.

2. What have they agreed to?

The plan, announced July 6, to split consultants from auditors aims to ensure the Big Four won’t balk at tough audits so as not to jeopardize lucrative consulting contracts at the same companies. In the regulator’s words, the firms need to do a better job of backing “auditors making tough decisions.” The deal is a significant concession by the Big Four, which fiercely opposed splitting auditing functions. However, it doesn’t convincingly address conflicts of interest between supposedly independent auditors selling consulting work to their clients. Under the deal, the auditors can still earn close to half of their revenues from consulting, staff can switch between audit and consulting positions, and auditors are under the control of the firm’s chief executive officer, who also oversees the consulting divisions.

3. Will it work?

Unlikely. Richard Murphy, an accountant and economics professor at City University in London, says this is a cosmetic exercise designed to make the Big Four look more independent but ignores the lack of independence and competition that have blighted audit quality in the U.K. Critics say the voluntary agreement lacks regulatory muscle and will not be enforceable. Some groups have said that it will fail to stimulate competition from smaller firms or make auditors more independent from their clients.

4. What about the regulator?

The FRC has powers to sanction firms and individual accountants for deficient auditing, and does so. Without legislation, however, the agreement isn’t legally enforceable and has been criticized for allowing the big firms to continue offering consulting services. The move was taken partially to preempt lawmakers from weighing in with their own, likely tougher, solution.

5. Why the need for reform?

The Carillion collapse in 2018 that shocked lawmakers into action came after the government refused to bail it out, costing almost 3,000 jobs and leaving 30,000 suppliers and subcontractors with 2 billion pounds ($2.5 billion) in unpaid bills. Administrators liquidating its assets believe KPMG’s auditing was negligent in relation to its long-term construction contracts and goodwill. Thomas Cook collapsed in September 2019, leading to 9,000 job losses in the U.K. and leaving 150,000 tourists stuck overseas. That also sparked an investigation by the FRC into auditor Ernst & Young.

6. Have things improved since then?

No. Middle Eastern hospital operator NMC Health Plc, listed in London, started unraveling this year after unearthing undisclosed debt amid allegations of fraud, leading to the departure of top executives. The FRC opened a probe into Ernst & Young’s auditing of NMC’s financial statements. And in Germany the admission by payments company Wirecard AG in June that 1.9 billion euros ($2.2 billion) it had reported as assets probably never existed led to the resignation of Chief Executive Officer Markus Braun and his subsequent arrest, with the company filing for court protection from creditors. Ernst & Young’s refusal to greenlight Wirecard’s long-delayed 2019 financial report followed reports by the Financial Times raising questions about Wirecard’s accounting practices. Ernst & Young called it an “elaborate” fraud that even a very rigorous probe may not have discovered.

7. What will the government do?

The U.K. government has promised to replace the FRC with a new regulator, the Audit, Reporting and Governance Authority, as recommended by an independent report in 2018. Unlike the FRC, this will be a statutory body with legal powers granted by parliament to regulate the big accounting firms directly. The government still says it will act on the findings of three reports it commissioned after Carillion’s collapse. Beyond the accounting-consulting split, the recommendations included requiring large listed companies on the FTSE 350, such as Aviva Plc and Tesco Plc, to use joint auditors to help bring other firms into the market, and creating a distinct auditing, as opposed to accounting, profession. All these moves would require legislation, however, and Parliament may not have the time to pass the necessary laws.

8. Does this sound familiar?

Yes, it’s reminiscent of regulatory action taken in Washington almost two decades ago. Since 2002, auditors of publicly traded companies in the U.S. operate under strict rules that bar them from providing most consulting services to their audit clients. The Sarbanes-Oxley Act was part of Congress’s response to accounting scandals that brought down Arthur Andersen LLP and its clients Enron Corp. and WorldCom Inc. It also imposed audit regulations and created the Public Company Accounting Oversight Board, which enforces standards and annually inspects the largest firms. U.S. regulators are increasingly concerned about the patchwork of regulations in force around the world. Securities and Exchange Commission chief Jay Clayton said in December that he wants more financial reporting and audit uniformity worldwide.

9. What’s next in the U.K.?

The Big Four have promised to submit plans to the FRC by October next year, before a split effective in 2024. That gives the government time to pass legislation, and audit reform proposals may be released in coming months. Though legislation would supersede the agreement, there is speculation the government could use this pact as a reason to put audit reform on the back burner.

The Reference Shelf

  • Details on the FRC’s Big Four split plan.
  • How the Wirecard scandal in Germany poses fresh questions about accounting.
  • A podcast on why the Big Four’s breakup is not as tough as it seems.
  • Why the U.K. thinks auditors should be responsible for uncovering fraud.
  • A report on KPMG and Carillion.

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