Breaking the chains

Wednesday, 29 January 2020

David Walker photo
David Walker

    The findings from a parliamentary joint committee could shake up the audit industry and lead to the dissolving of the stranglehold of the world’s big four accounting firms.

    How much has the Hayne Royal Commission changed the game on conflicts of interest in the finance industry? That’s a question likely to dominate the Australian audit landscape once the Parliamentary Joint Committee on Corporations and Financial Services releases its report on 1 March.

    The committee’s audit inquiry started quietly in 2019, few people expecting it to transform the audit operations of the big four accounting firms — Deloitte, EY, PwC and KPMG. But a string of critical submissions from financial experts, together with new developments in the UK, may change the equilibrium.

    Many critics have zeroed in on possible conflicts of interest within the audit business. Some believe the banking Royal Commission has permanently weakened the industry’s defence of its current structure. The big four were already vulnerable to claims of conflicts of interest between their audit services and their now much larger consulting arms. Auditing was once the bulk of large accounting firms’ work, but today it contributes less than 20 per cent of revenue, overshadowed by consulting and tax work, which earn the lion’s share of their profits.

    Separating audit

    Among the best-known current Australian critics of auditing is Professor Allan Fels AO, former head of the Australian Competition and Consumer Commission, and currently a professorial fellow at the University of Melbourne. He says the review submissions underline that auditing is “critical... to the operation of our whole economic system”.

    Fels argues the audit system needs to reinforce trust. “Investors, consumers, shareholders, suppliers, the government and the community depend on its integrity,” he says. “If audits fail or are compromised, billions of dollars can be lost, and trust in the economic system weakens.” Additionally, he argues, given the need for trust, “auditors shouldn't have, or be seen to have, avoidable conflicts of interest”.

    In years past, the audit industry has successfully argued it can manage conflicts of interest. However, Fels says that argument has been weakened by the banking Royal Commission, which showed “the finance sector — of which audit is a part — is particularly poor at handling conflicts of interest. And it showed that measures to resolve conflicts in this sector usually work badly in practice, are steadily eroded over time, and are poorly enforced by regulators. The incentives for auditors to do their job can, at least in some cases, be distorted by the large profits available with auditing or consulting.”

    Separating audit from non-audit functions “would be a much cleaner, simpler and less costly way to deal with the problem,” he concludes in his submission to the joint committee.

    Other submissions echo this warning. Professor James Guthrie of Macquarie Business School spent many years as an executive at Chartered Accountants Australia and New Zealand (CA ANZ), the professional body with the highest big four membership. In his submission to the committee, he warns that the big four auditors “have incentives to overlook risks in a financial statement audit because it may limit their ability to sell, usually higher margin, non-audit work to audit clients. This is a cultural issue within these partnerships.”

    Commentators outside the inquiry have taken a similar position. Fels’s successor at CA ANZ, Professor Graeme Samuel AC, warned in late 2019 that auditing must adjust to changing community expectations and avoid perceptions of any conflict of interest. In the 2018 book, The Big Four: The Curious Past and Perilous Future of the Global Accounting Monopoly, Melbourne academics Professor Ian Gow and Adjunct Professor Stuart Kells describe self-auditing as a firm reviewing the very systems it designed and helped establish. The situation, the authors write, has been “a live issue for half a century”.

    Kells, however, warns in his submission that a break-up of the four firms would be “very difficult” and “potentially impossible”.

    Unified defence

    The big four’s submissions mount a well-practised defence: Advisory work can help accountants improve their audits; auditors do better when they “know the business”; existing regulations and internal procedures provide sufficient protection against conflicts of interest; and most audit customers don’t want their auditor banned from non-audit work.

    KPMG acknowledged an “increased focus on ensuring the provision of non-audit work does not compromise independence, in reality or perception”. It suggested a cap on the amount of non-audit work that audit firms might do for the ASX 300.

    EY and Deloitte rejected the idea of splitting audit and non-audit work, while PwC recommended a separate review of audit firms’ non-audit work, possibly by the Accounting Professional and Ethical Standards Board.

    Few directors have expressed concerns about current audit processes or results. When surveyed, the AICD notes in its submission, “AICD members were of the view that the audit system is working well.”

    The firms also reject claims the big four act as an oligopoly. By contrast, most outside analysts view the oligopoly claim as straightforwardly true. And they have won a convert or two within the big four. Bill Michael, chair of KPMG UK, was reported in the Financial Times in May 2018 as saying: “We are an oligopoly — that is undeniable”. He wanted to “reduce the level of conflicts and… demonstrate why they are manageable and why the public and all stakeholders should trust us”.

    What will happen next

    The big four have already taken baby steps towards separation between audit and non-audit work. Michael is putting some distance between KPMG UK’s audit business and the rest of the KPMG UK company, although the firm is not creating a full structural separation.

    Fels suspects more national outposts of the big four will follow. He says if pressure builds following the release of the parliamentary inquiry report, it may include Australian big four members seeking to “ward off the more drastic medicine of legislated separation”.

    “The accounting firms are probably playing a waiting game,” he adds. “But if the separation occurs around the world, they'll probably follow.” For anyone thinking a Coalition government wouldn’t pass such legislation, Fels notes its recent interventions in banking and energy.

    Even if the inquiry does not recommend change, a major Australian corporate collapse featuring a controversial audit decision could well spur the government to act.

    It may be that the effects of the banking Royal Commission will fade in the months ahead, and the big four’s audit businesses will weather the parliamentary inquiry and other threats, but at the very least, the chances of disruption seem higher than ever before.

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