Big Four Face Big Split as FRC Sets Separation Deadline

• Financial Reporting Council wants audit arms split by mid-2024
• Move aimed to end ‘persistent cross-subsidies’ of audit units

The U.K.’s dominant accounting firms must separate their audit units from other operations by June 2024 as the country’s industry watchdog reacts to shortcomings that led to the collapse of several companies.

The Financial Reporting Council is asking the so-called Big Four — KPMG, Deloitte, PricewaterhouseCoopers LLC and Ernst & Young — to agree to operational separation to ensure audit practices don’t rely on “persistent cross-subsidy from the rest of the firm,” it said Monday.

Auditors are under greater scrutiny than ever after a series of high-profile lapses in recent years, with EY’s role in the collapse of German payments provider Wirecard AG now under the microscope. In the U.K., accountants have been criticized in the wake of companies like Carillion Plc and Patisserie Valerie going bust. Wirecard Exposes Big 4 Accounting Lapses Endure Post-Wirecard AG

While commenting on this development, FRC’s Chief Executive Officer, Sir Jon Thompson, said the FRC is committed to reforms on how corporate finances are reported. Further aspects of the reform package will be introduced over time, he said.

“Operational separation of audit practices is one element of the FRC’s strategy to improve the quality and effectiveness of corporate reporting and audit in the United Kingdom following the Kingman, CMA and Brydon reviews. Today the FRC has delivered a major step in the reform of the audit sector by setting principles for operational separation of audit practices from the rest of the firm. The FRC remains fully committed to the broad suite of reform measures on corporate reporting and audit reform and will introduce further aspects of the reform package over time,” Thompson stated.

The guidelines seek to prevent accountants from being influenced by other parts of a firm’s business that could divert the focus away from audit quality, the regulator said.

Fixing the conflict of interest is a good first step, says Karthik Ramanna, a professor of public policy at the University of Oxford. But to work, that needs to be bolstered by genuine cultural change within the audit firms — away from the mindset that auditors are “advisers” to senior executives, he says.

“Junior auditors need to know that their firms will reward and promote them for questioning their clients’ management assumptions,” says Ramanna. “Otherwise, it is easy to see how audit firms can be in compliance with the letter of the FRC’s new rules without honouring the spirit.”

The reaction from all of the Big Four to the FRC’s announcement was broadly supportive.

“It is clear however that operational separation of the U.K.’s audit firms is just the first step on the journey to restoring trust in U.K. Plc,” said Jon Holt, KPMG’s head of U.K. auditing, said in a statement

The accounting firms said they were working with the FRC to develop ways for the separation. They’re expected to submit plans by Oct. 23.

Audit practice culture should encourage ethical behavior, openness, teamwork and professional skepticism and judgment, the FRC said. Profits distributed to partners should not “persistently exceed the contribution to profits of the audit practice,” the FRC said.

After the firms submit their plans, the FRC will set a transition timetable with each, and then publish an annual assessment of how well they are complying with the principles.

The planned reforms present a significant opportunity to improve corporate reporting but won’t be enough on their own, Hywel Ball, EY’s U.K. chair, said in a statement.

“As part of the audit profession’s evolution, a holistic package of reforms, including improved director accountability and changes to the scope of audit, is required to deliver effective and sustainable change,” he said.