Let’s do some history. The big audit firms of the turn of the last century – the Big5, namely Deloitte, Ernst & Young (EY), KPMG, PwC and the late Arthur Andersen – began in the 1990s to diversify into the consulting sector. The activities grouped under this word were variable. Schematically, at the time, consulting activities on the other side of the Atlantic were rather IT-oriented – it was the era of the implementation of major IT systems – whereas European consulting was more business-oriented.
The question of the independence between these activities was already discussed within the networks. With the objective of keeping them all in the house. Various answers could be given. In Luxembourg, the ban decreed worldwide by the PwC network on both keeping accounts and auditing them has encouraged the creation of a spin-off, Alter Domus. This separation, which seems to fall under common sense today, was not self-evident then… But it was above all the action of the regulator that precipitated and formalized things. The Enron scandal caused the loss of the most integrated of the Big5, Arthur Andersen and pushed governments to act. The impetus came from the US regulator with the Sarbanes-Oxley Act of 2002.
In this area, the action of Anglo-Saxon regulators on firms imbued with this culture is essential. The fact that it is the Financial Reporting Council (FRC), the regulator of the audit professions across the Channel, which is now pushing for the adoption of such a separation, suggests that this separation will take place, believes many observers.
Consulting and auditing activities were therefore separated for the first time.
Capgemini bought the consulting activities of Ernst & Young, Sintegra those of KPMG and IBM Worldwide that of PwC while the consulting activities of Deloitte resumed their independence under the name Ineum Consulting before evolving under those of Kurt Salmon then by Wavestone. Locally, other arrangements may have been made. For example, in Luxembourg, PwC kept its advisory activities – local advice as it was then defined, in particular strategic thinking and regulatory advice – because they were marginal at the time.
And also because the question of the reconstitution of service centers that would comply with the separation obligations had already arisen.
Why? Because the returns are not the same. They were, at least at the time, generally noticeably superior in the council. This difference has always existed and the whole balance of the system was based on the fact that auditing and consulting activities took over in turn, thus ensuring a certain balance in terms of the firms’ profitability.
These “new” consultancy activities were first developed around the skills of the audit profession, therefore first towards corporate finance. With in particular the implementation of tools for management control, reporting, consolidation of accounts and others. Then the services diversified, in particular through acquisitions, to reach more business sectors, then CSR, strategy, data and others.
To the point that today the Big4 have reconstituted consulting entities that compete with the leaders of the sector.
The audit as a poor relation
How is the separation of these activities organized today?
A priori good if we consider the few recent scandals. With the exception of Wirecard which splashed EY Germany. EY who is also at the center of all the separation speculation.
What you need to bear in mind is that the system in Europe is not based on a strict separation, but on a mathematical formula laid down by Directive 2014/56/EU which sets the percentage of advice that can be provide, subject to conditions, in addition to the audit. In summary, a Big4 must monitor the lifecycles of its audit and advisory services to balance its business model while complying with the law. A matter of arbitration.
What worries some observers – and justifies the action of the FRC – is that these trade-offs can be made to the detriment of competition in the audit sector. In short, faced with a dominant board, the audit would become the poor relation within the Big4. In fact, audit firms are tempted not to respond to a call for tenders in order to reserve potential consultancy contracts. And some companies exclude these same firms from an audit market for the same reasons. It is this risk of less competition – and ultimately of lower quality in the rendering of audits – that worries regulators.
Additional and cross-functional expertise is needed.
What concerns auditing and consulting firms is whether an auditor’s skills are sufficient in a world that is becoming more heterogeneous and where business is becoming more complex.
David Capocci, Managing Partner at KPMG Luxembourg, does not think so: “additional, specialized and transversal expertise is needed”. And he takes as an example the ESG which insinuates itself into all the workings of companies and which requires that an auditor surrounds himself with multidisciplinary teams of experts. “And that’s how, over time, the Big4 grew by developing new areas of expertise. Competence centers that will develop by continuing to provide audit support and by developing their own clientele.” According to him, “for this expertise to develop – and to be profitable – it is necessary to develop a consulting offer”.
For David Capocci, redoing a separation would not make sense. The auditor would be obliged to subcontract certain aspects of his audit because he does not have all the required skills. This will have a cost for the customer. “Total independence of auditors is possible when you are in an extremely simple business environment. From the moment we manage complex companies, companies which are multinational, which are varied in terms of sectors of activity, in terms of organization, etc., this will require specific expertise that will be difficult to coordinate with subcontracting companies.”
Are the independence rules too restrictive? “These rules are extremely restrictive, but ultimately I think there are enough opportunities in the market to live with. And this allows us to feel comfortable with our level of independence, to avoid conflicts of interest while always having the possibility of developing a very wide range of expertise which allows us to deliver quality for our customers..»
Limit an audit firm to its sole scope? David Capocci wonders if this is really in the public interest.
For other observers, the argument of the “Chinese wall” between auditing and consulting activities is “a pipe”. “Conflicts of interest have not gone away.” More than proven conflicts, it is the conflicts perceived by public opinion that are worrying. A public opinion which at the time of social networks promptly calls into question all the powers. A pressure that politicians and regulators constantly have in mind.
And tomorrow? Officially, no one wants to move. “But if one actor moves, the others will move at the global level,” said an observer. In fact, if EY went through with its split project, it’s a safe bet that a domino effect would start.
This article is from the Paperjam + Delano Finance newsletter, the weekly meeting to follow financial news in Luxembourg.
You can subscribe by following this link.