Breaking up is hard to do, so why not put a ring on audit?

Never have there been more eyes on audit.

Sir John Kingman is examining the Financial Reporting Council and how audit can best be regulated.

The Competition and Markets Authority is investigating competition and choice in the listed audit market.

The BEIS Select Committee announced last week that it too will scrutinise audit, and the Audit Quality Forum’s Review is set to explore the future of the audit product, and how it might better meet modern business needs.

So many reviews imply consensus both that change is needed, and that no simple answer exists. This is because there is more than one problem.

On the one hand, there is the issue of competition and choice, on the other of lost trust. The two are linked, but not the same. The danger is that trying to solve one might exacerbate the other.

It is easy to see why “breaking up the Big Four” has become a common refrain. With the market dominated by a few large firms, there are obvious attractions to changing that by diktat.

It also addresses the suspicion that larger firms use audit as a loss leader to gain more lucrative consultancy services, and that this may affect their audit judgements. This is perception, not reality, but continues to be suggested.

ICAEW has long argued that forcible breakup doesn’t necessarily address the choice issue. If smaller firms are looking at the listed audit market and deciding that the risk profile does not work for them, we must ask why creating more such firms is the answer.

The option of audit-only firms is also proffered. But were there such demand, surely the market would have created audit-only firms by now? Also, a multidisciplinary firm has access to a wide range of expertise; audit-only firms would have to buy that in – raising costs for businesses.

But while splitting firms may not work, the banking sector has demonstrated something that might: ring-fencing.

The issues facing banking in the aftermath of the financial crisis were not quite the same as for audit today, but parallels exist.

How could we protect retail banking arms – which provide a public service so vital to our daily lives that it might almost be a utility – from the risks inherent in the investment wings, while recognising that investment banking generated the large profits?

The solution was to ring-fence the core retail banking services. This meant making the retail arm a separate legal entity with its own leadership structure and with dedicated capital, resources, and revenue streams, insulated from other areas of the business.

Something similar could be done with the audit arms of large firms.

First, it would need to encompass investment. A large accountancy firm looking to invest heavily in new or nascent technology might expect larger returns in the consultancy arm than in audit. Giving audit its own ring-fenced investment stream would negate such commercial pressures.

Second, there would be structural issues. Many large multidisciplinary firms do not have auditors in leadership positions. Ring-fencing would mean having a leadership structure where senior managers are empowered to make decisions based around the audit business and its public sector ethics.

There would have to be clear segregation between service lines, but by allowing people to move between arms, and enabling knowledge-sharing, the twin objections to forcibly splitting off firms – access to knowledge and talent retention – would be obviated.

Obviously there would be issues to resolve. Since one of the more frequently raised issues with audit versus consultancy services is how much more profitable the latter is, there would have to be measures to ensure that there were still incentives to enter the audit arm.

And it should be stressed that this would not guarantee an end to all corporate and management failures, nor enable auditors to foretell the future.

It will not fix the problem of choice; we still need more than four players in the market, we still need challenger firms to scale up and enter the market, and in order to enable this we still need to address the disincentives to entry. Ring-fencing, however designed, can only be part of a package of wider measures.

But it would start to address the highly damaging perception that big firms are allowing commercial decisions to unduly affect their audit work. It could provide reassurance to clients and the public around independence, and therefore help rebuild the critical trust necessary for audit to work properly.

And, crucially, it would also go some way to guarding against the risk of market exit by one of the major firms, which would be destructive for both the market and the economy.

Breaking up may be hard to do, but good fences good neighbours make.