Big Four auditors face scrutiny and reform in wake of corporate collapses

In the case of Thomas Cook, EY took over its audit in 2017. Following Thomas Cook’s collapse, the Financial Reporting Council (FRC), which regulates auditors in the UK, announced it was to investigate EY for its audit work involving the company. In a statement, EY said that it is cooperating with the investigation.

Rachel Reeves MP, Chair of the House of Commons’ Business, Energy and Industrial Strategy (BEIS) Committee, sent a letter to the government’s Business Secretary Andrea Leadsom shortly after Thomas Cook’s collapse. She raised questions about EY’s allegedly ‘aggressive’ accounting practices and why they were permitted.

The letter highlighted that similar issues were found in the collapse of Carillion and BHS, ‘including the role of auditors in identifying and addressing problems.’ Reeves called for urgent reform within the audit industry.

Regulators have been acutely aware of the dangers of a lack of choice in the marketplace, but have so far resisted – due to opposition from the Big Four, as well as from their clients who fear onerous compliance and increased fees – to split the firms up, or bar them from cross-selling additional fee-generating work to the companies they audit.

The regulatory intervention there has been so far has had a surprising effect. In 2016 mandatory audit firm rotation came into effect across the European Union to increase competition and to prevent audits being ‘paid for’ opinions rather than independent ones. In the UK these requirements mean that large companies need to put the job of auditing their accounts out to tender once every decade, and must change their auditor at least every 20 years.

Instead of limiting their market share, the Big Four’s dominance has actually grown as they audit every FTSE100 company, increasing their revenues in the process.

The Big Four’s stranglehold on the UK audit market may about to be finally broken, however. In April 2019 the UK’s Competition and Markets Authority (CMA) published several controversial recommendations to increase competition in the sector. Its key proposal is to effectively bar FTSE companies from being able to use a Big Four audit firm as their sole auditor.

Under the CMA’s proposals, if large companies wanted to use any of the Big Four as their auditor, they would need to use a joint auditor arrangement whereby a smaller-tier firm would do some of the work and be jointly liable for the results. To avoid using two firms, a FTSE-listed company would need to choose a challenger audit firm – meaning an auditor outside of the Big Four – to act as its sole auditor.

The CMA also recommended splitting audit firms into two distinct entities, with one providing audit work and the other providing consultancy services. It also suggested regulating audit committees more vigorously regarding the basis upon which auditors are appointed, and how they scrutinise their work and findings.

The British Government, which agrees with the recommendations in principle, closed its consultation on the CMA’s proposals on 13 September. Its proposals to reform the audit market and its supervision are now due in the first quarter of 2020, presuming the current Conservative government is re-elected in December 2019’s general election.

Marcel Willems, a Co-Chair of the IBA Insolvency Section and a partner in restructuring and insolvency at the law firm Fieldfisher, does not think that joint audits are a viable solution if the audit sector in general is considered to perform below standard. ‘Being left with a limited choice of bad firms that you have to use is no choice at all,’ he says.

Willems says that in the Netherlands, just eight audit firms are eligible to carry out audit work for public interest entities – which largely consists of banks, insurers and major listed companies – which means that choice is restricted. ‘And if some of these firms are known to have had a number of incidents, or are unable to meet your needs, what do you do? You face the prospect of engaging two audit firms, already half-knowing that they may not provide the level of service you expect.’

Willems believes that, to avoid the appearance (at least) of dependence or bias, there should be a complete split from audit firms providing external audit work and consultancy services to the same clients. However, he concedes that ‘simply splitting the work that firms can provide is no guarantee that audit quality will improve’. Instead, ‘audit firms need to be subject to much more prescriptive rules about the work they need to carry out and what the expectations are from audit. It is no longer tenable for audit firms to perform poorly performing audits and retain their hold of the marketplace.’

Meanwhile, some jurisdictions are trying to improve the quality of audit reporting by imposing fresh duties on audit firms to evaluate areas of their clients’ businesses that might provide more clues about the organisation’s finances, governance and culture.

Karen O’Flynn, Co-Chair of the IBA Insolvency Section and a partner at Clayton Utz, says that there are numerous ideas under discussion in Australia in connection with an inquiry by a Federal Parliamentary Joint Committee into the regulation of auditing. One suggestion, she says, is to introduce independent assurance of non-financial information such as customer complaints, whistleblower events and staff and customer satisfaction data, which may be leading indicators of underlying control or culture issues within the company being audited.