The Big Four Accounting firms - Deloitte, KPMG, Ernst and Young, and Pricewaterhouse Coopers - are increasingly under pressure to split off their audit business from their other business lines amid global scandals of negligence and misconduct.
The Big Four provide audit services to 99% of U.S. companies S&P 500 index and 97% of the FTSE 350 UK companies, with operations in over 100 countries, effectively making them an oligopoly. In 2017, after the Big Four, the next largest firm made a third of KPMG’s revenue, the smallest of the four.
Earlier this year, UK lawmakers began suggesting a change in the structure of audit firms when British company, Carillion, collapsed, partly due to KPMG’s failure to challenge its aggressive accounting practices. In addition, KPMG is embroiled in scandals with corruption in South Africa, negligence in the United Arab Emirates and theft of confidential information in the United States.
The other firms have also had their share of global controversies but market dominance and the lack of alternatives for clients helps Big 4 firms to endure turbulent times and remain a leading international auditor. In addition to market dominance, across the world, the law requires companies to be audited, thus ensuring a constant demand for audit services.
Calls to spin off non-audit services are based on limiting conflicts of interest, which existing limits and restrictions have failed to minimize. Proponents see the split as a way to ensure that auditors cannot be swayed by the possibility of receiving large non-audit accounts.
The American Accounting Association evaluated audit companies for independence from non-audit services and found them to be lacking. They found compelling evidence that shows the drop in audit-service quality when a situation arises where the client to also seeks non-audit services.
The United States and the European Union have attempted to rectify this with laws imposing a limit on the amount of consulting work that a firm can do for its audit clients and mandating auditor rotation. However, since audit clients only contributed to 30% of total revenue for audit firms in 2017, this undermines the efforts to make audit independent from consulting revenue. Additionally, mandatory rotation only further diminishes the number of audit firms from which a client can choose.
This continuing conflict of interest has prompted calls to spin off the business into a separate firm, thereby ensuring that non-audit revenue does not influence the quality and accuracy of audit services.
Critics of splitting do not see this as a meaningful solution, as the resulting smaller firms will be ill-equipped to handle the needs of the largest companies in the world. Critics include the heads of EY and PWC, Mark Weingberger and Kevin Ellis, who have stated regarding the need to keep audit within the larger firm as it enables the firms to leverage expertise across industries. Unlike other global companies, the Big Four function differently by working as a network of separate legal entities that share a common brand. Firms can reassure clients by maintaining some distance from network firms that are involved in wrongdoing.
Systemic issues with the audit business model would not be addressed merely by spinning it off from the larger company. In cases where auditors felt more accountable to management, instead of shareholders, they were less likely to question unconventional accounting practices. Making audit firms smaller through forced separation is likely to worsen their performance.
Clients with considerable international presence and multi-sector businesses, like Amazon, need auditors who are able to understand and match their regional and industry diversity. Receiving audit services from a smaller company that is unable to serve a client of that size will negatively affect the quality of audit services. Additionally, splitting up the Big Four is expected to be disruptive to the economy and detrimental to capital markets.
Our assessment is that with global pressures mounting, we see changes to the audit business as necessary. Market dominance alone will not be enough to prevent the call for action. However, we feel that spinning off the audit services from existing accounting firms could be too drastic a solution. As Arthur Anderson – a now-defunct accounting firm – shows, the tolerance for pervasive misconduct by audit firms is not unlimited. We feel that the Big Four have a vested interest in retaining their current model but their current strategy of simply refuting the proposed solution is futile without providing a viable alternative. We think clients, of all sizes, are right to demand competent and ethical auditors.