Interviews

The impact of the FRC’s Big Four audit regulations

Andrew Tate, a partner at Kreston Reeves, discusses the Big Four’s strategies to ‘operationally separate’ their audit practices from the rest of their businesses, and the impact this will have on the wider sector

February saw the Financial Reporting Council (FRC) release an update on the “operational separation” of the Big Four’s audit practices. KPMG, Deloitte, PwC, and EY had all submitted their separation plans by 23 October 2020, which have now been reviewed by the regulator and progressed onto the next stage of implementation. 

According to Andrew Tate, a partner at Kreston Reeves, the ramifications of these changes to the composition of the Big Four’s auditing practices will not only be felt by those firms directly involved, but will “ripple down” to a section of the wider market.

Last summer when the FRC asked the Big Four to agree to operational separation by June 2024, it came after a number of high profile corporate failures, including KPMG’s failed Carillion audit, that led to Government backed reviews recommending a shake-up of the sector. In turn, the FRC has now set 22 ‘principles’ to guide the separation process, including the creation of independent audit boards at the firms.

Transactions between the Big Four’s audit practices and the rest of their businesses should, according to the audit watchdog, be “conducted and priced on an ‘arm’s-length’ basis,” with an individual from the senior management team held accountable for ensuring the operational separation is “delivered, embedded, and monitored”. While there are many factors at play in the reasons behind the auditing separation, Tate says that “there are really two elements” to look at.

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He explains: “The first is that the FRC and the Government for some time have been concerned about the audit market, the independence of auditors, and making sure the firms that are carrying out significant audit work are also controlling the conflict that could come from advisory work and advisory income.” 

However, Tate adds that there is a second, “more commercial angle” at play. “The larger firms perhaps feel that their restructuring arms are restricted in terms of how they can grow and how they can develop,” he says. “I think that is one of the angles that they’ve looked at.  Obviously, the insolvency work and restructuring work is very carefully controlled in terms of ethics, and so where there are conflicts you have to be very careful, and that’s a restriction for them.”

While the end goals set out by the FRC and agreed upon by the Big Four are the same across the board, the path each firm takes has left them with the freedom to take alternative methods. For Deloitte, an independent Audit Governance Board (AGB) has been established effective from 1 January 2021. Stephen Griggs, managing partner at Deloitte UK, says that the board “has responsibility for providing independent oversight of the UK audit practice, with a focus on the policies and procedures for improving audit quality and ensuring the FRC’s objectives and desired outcomes for operational separation are met”.

An independent board at EY has also been put in place for 1 July 2021, with the appointment of two new non-executives one of “a number of upcoming plans” laid out by the firm. “We continue to engage with the FRC on the application of the principles for operational separation. In some instances, we are going beyond what the principles require,” says Hywel Ball, chair at EY UK.

While by no means an enforced measure, two of the Big Four have also been involved in the sale of their restructuring arms – adding to the overall shake-up of the auditing businesses. Global CEO advisory firm Teneo’s acquisition of Deloitte’s restructuring arm represents the optimisation of proceeds in preference to dwindling growth opportunities as a result of extensive restrictions. Moreover, for KPMG, the sale of its insolvency business to HIG Europe was driven by “significant changes” to the market over recent years, with the increasing “complexity” of stakeholders in distressed and stressed situations making “the navigation of conflicts of interest ever more complex”. 

When asked whether he feels both PwC and EY are looking to follow suit, Tate acknowledges that the firms have said they are not going to sell. He says: “PwC have been involved in a lot of the special manager appointments, like Carillion for example, where the official receiver was appointed the liquidator, and then they came in to do the bulk of that work. I think when you’ve got a firm that is the size of PwC, they can take on these really monster assignments, and they’ve got the people to do so. 

“Whereas if you’ve got a breakaway firm that has a restricted number of people, potentially, they could see that as a competitive advantage to keep a restructuring division in house. So I think both of them would have said, ‘we’re not looking to sell at the moment,’ but I think that they will be keeping a very keen eye on how these new firms are developing.”

The impact of the decisions made by the Big Four regarding the way that they approach the widening audit regulation will, according to Tate, depend on the size of the business. He says that “the restructuring market has changed” through firms such as FTI and Alvarez and Marsal, with those companies acting on the Big Four’s level in terms of personnel gaining from “more competition”. However, he adds that the actions won’t necessarily “have a real ripple effect further down for firms that are doing SME work, certainly not initially”.

While an uptick in opportunities may not occur across the board, Tate says that “it will encourage the move for independent advisory practices to be set up”. However, he notes that “there is still a role” for firms such as Kreston Reeves to maintain their in-house restructuring professionals, rather than always having to use “an external party”.

As for direct regulation stretching to the wider audit market, Tate argues that it could be an arising feature for larger companies where “conflicts [of interest] can be more of a problem”. “I think that there could well be other moves to make divisions independent of the main audit practice,” he says. “What that really looks like I think only time will tell, but I do think that it will ripple down. 

“I think that there is a widening of regulation, there’s going to be more of a spotlight on professionals, particularly post Carillion and Arcadia, and these other situations where professionals are being questioned over their conduct of those client relationships.”

The FRC’s guidelines for operational separation have set in motion a number of key changes at the Big Four’s auditing practices. However, the extent to which each of the firms complies, and the strategies they use, will vary until the June 2024 deadline and beyond. Whether the groups decide to offload their restructuring arms in a bid to negate increasingly complex conflicts of interest, or name a number of external appointments to self-regulate their audit practices will become clear over the course of the next three years.

As market innovators, in the eyes of Tate, the decisions made by KPMG, Deloitte, PwC, and EY will undoubtedly impact other businesses within the audit market. However, Tate argues that the opportunities, and perhaps restrictions, that will fall to other groups will depend on their size and involvement in similar operations to those of the Big Four’s auditing practices. Perhaps more transactions, movement in talent, and regulations will begin to be more evenly spread across the sector.

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