In a decision that will change the game for audit firms, the UK Financial Reporting Council on Monday announced a major restructuring of Big Four (PwC, KPMG, Deloitte and EY, formerly Ernst & Young): The audit authority mandates that these firms ringfence audit from consulting activities.
The move could become a model for auditors around the world.
The move comes in the wake of a series of scandalous company failures in which audit firms were involved.
In January 2018, British multinational construction and facilities management services firm Carillion went bankrupt with liabilities of about £7 billion and the loss of thousands of jobs both at the company and at related companies. Its auditor, KPMG, is currently facing a negligence claim of £306 million.
In 2016, British Home Stores (BHS) went bust, at the cost of 11,000 jobs and with a gaping £571 million hole in its pension fund. The firm’s auditor, PwC, was eventually fined £10 million for “poor auditing.”
Those are only two of a long list of this kind of corporate failure, in which boards of directors closed their eyes to trouble, and the auditor, whose job it is to see trouble coming, didn’t act as they should have. The FRC believes that attention to consulting activities was diverting that which should have gone into the audit.
The FRC’s new principles require that auditors are paid based on the profit earned by their audit, and not from the other consulting operations that the firms offer. Audit will from now on be conducted separately from consulting.
“Today the FRC has announced its principles for operational separation of the audit practices of the Big Four firms.
The objectives of operational separation, which is world leading, are to ensure that audit practices are focused above all on delivery of high-quality audits in the public interest, and do not rely on persistent cross subsidy from the rest of the firm. Our desired outcomes include:
- Audit practice governance prioritises audit quality and protects auditors from influences from the rest of the firm that could divert their focus away from audit quality;
- The total amount of profits distributed to the partners in the audit practice does not persistently exceed the contribution to profits of the audit practice;
- The culture of the audit practice prioritises high-quality audit by encouraging ethical behaviour, openness, teamwork, challenge and professional scepticism/judgement; and
- Auditors act in the public interest and work for the benefit of shareholders of audited entities and wider society”.
The FRC is now asking the Big 4 firms to agree to operational separation of their audit practices on this basis and to provide a transition timetable to complete implementation by 30 June 2024 at the latest.”
This is only the first of a number of changes that the FRC is planning, as it completes its transition into the Audit, Reporting and Governance Authority (ARGA), which will have significantly enhanced powers, and greater resources.