Don Quijones: After a String of Corporate Scandals and Collapses, “Big Four” Accounting Giants Face Breakup in the UK

Yves here. The proposal that Don Quijones discusses in this post, of forcing accounting firms to hive off their audit practices, is likely to face considerable resistance from corporate clients. The reason? Accounting firms would really rather not be in the audit business. Clients don’t like the process much, and more important, have not been willing to pay enough for the liability that the auditor is assuming. However, accounting firms treat it as a loss leader, since the audit process gives them an in-depth knowledge of the company and its personnel. Anyone trying to sell additional services like tax advice would need to find a way to become knowledgeable about the company without having the client pay much for that learning process, which comes as a by-product of doing audits.

The implication is that audits by pure audit firms would be considerably more expensive than ones performed by broad based accountancy practices.

By Don Quijones of Spain, the UK, and Mexico, and an editor at Wolf Street. Originally published at Wolf Street

UK regulators may be on the verge of doing something right, but doubts remain over how genuine their stated intentions are

Following a string of corporate scandals and collapses, the UK’s top accounting regulator, the Financial Reporting Council (FRC), has called for an inquiry to explore the possibility of breaking the audit arms of the Big Four accounting firms — KPMG, Deloitte, Ernst & Young, and Price WaterhouseCoopers — into separate pieces. The Competition and Markets Authority (CMA) should look into the possibility of “audit only” firms in a bid to enhance competition in the sector, saidFRC chief executive Stephen Haddrill.

There’s a strong case to be made for taking such drastic action. Having extended their tentacles into just about every facet of business administration, from accountancy and auditing to legal and tax consultancy, while wiping out or gobbling up many of their smaller rivals, the Big Four firms have grown horrendously large and conflicted.

Time and again they have signed off on accounts that were demonstrably faulty and allowed the management of large companies all over the world, such as the UK’s Carillion, Spain’s Abengoa, Japan’s Olympus, and the UK’s two biggest banking failures, HBOS and RBS, to mask the true state of their financial health. In the case of Spain’s Abengoa, its auditor, Deloitte, was seemingly unable to detect blatant flaws in the company’s accounting that were flagged upa year earlier by a 17-year old student with only “basic secondary school knowledge of economics.”

Despite such embarrassing failures, the Big Four firms continue to cement their domination of the global auditing industry. In the UK, theyaudit99 of the FTSE 100 companies and 97% of the FTSE 350, up from 95% five years ago, despite EU and UK reforms ostensibly aimed at tackling a lack of competition in the sector.

It’s a pattern that is replicated throughout advanced economies. In the US the Big Four audit497 of the 500 S&P 500 companies. In the vast majority of EU Member States the combined market share of the Big Four audit firms for listed companies exceeds 90%. Their global annual revenues reached$134 billion in 2017.

In the UK even the fifth biggest accountancy firm, Grant Thornton, has decided to stop biddingfor audit contracts from big companies after repeatedly coming second to the Big Four. The firm has put in tenders for a number of FTSE 350 audits but only won two since mandatory 10-year audit rotation came into force in June 2016. Since an audit pitch can cost up to £300,000, Grant Thornton has decided to move away from tendering for FTSE 350 audit work, at least until there is a “shift in the competitive landscape that would level the playing field.”

The problem is not just the size of the Big Four firms but also the colossal conflicts of interest they create by having their fingers in so many different pies. A case in point: when Spanish authorities tried to roll seven failed or failing Spanish saving banks into Bankia in late 2010, Deloitte was hirednot just as Bankia’s auditor but also the consultant responsible for formulating its accounts, in complete contravention of the basic concept of auditor independence. In 2012, not long after its IPO, Bankia collapsed and was partially nationalized to bail it out.

There’s also a clear agency problem stemming from the fact that auditors(the agents) are appointed to companies and paid for their services by the managements they audit (the principals). This mechanism creates an inherent conflict of interest for auditors. In a recent FT articlefeaturing reader suggestions on how to improve auditing practices one reader, Owen Wilson, proposed that audit firms should be engaged on behalf of the stock exchange rather then the companies listed on it.

Another FT reader, Robert Hodgkinson of the Institute of Chartered Accountants in England and Wales, arguedthat splitting up the Big Four would be easier said than done given they operate in the UK as part of huge global networks: “Splitting the firms in the UK would achieve little except making Britain a peculiarity — and the UK arms would have to ally with global networks to undertake multinational audits.”

This echoes my observation a few months ago: Due to their sheer size, influence and global reach, the Big Four are not just woefully compromised and conflicted, they may already have grown “too big to replace.” But that doesn’t mean it’s not worth trying to cut them down to size.

The UK may be on the verge of doing just that, though doubts remain over how genuine the regulator’s stated intentions are. The FRC itself has shouldered much of the blame for the Carillion collapse and even faces its own government inquiryfollowing accusations of being too soft on big accountancy firms — no surprise given it is colonized by said firms.

Yet while the UK government and regulators may be excessively beholden to financial interests in the City, every now and then meaningful reform does occasionally slip through — normally when public opinion is close to breaking point. For example, thanks to the Vickers Rule, passed in the wake of the financial crisis, by Jan 1, 2019 all major UK banks must ring fence their core banking business from their investment banking operations — a measure authorities in the EU refuse to even contemplate.

If, on the off chance, something similar were to occur here, resulting in much needed root-and-branch reform of the UK’s audit industry, then perhaps something positive may finally come from the recent corporate scandals and collapses. By Don Quijones.

The London property market is already in trouble. Read…  UK Vows to Crack Down on Money Laundering: What Will This Do to the Property Bubble?

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  1. Katsue

    Just in relation to competition, the EU increased the capital threshold for which companies are required to have their accounts audited a few years ago. The result was of course less business for smaller practices, which can’t possibly have encouraged competition.

  2. Eustache De Saint Pierre

    I often wonder what would happen if big business, particularly banks, had to suffer the external audits I experienced as a young trainee manager before computerisation in the late seventies for British Industrial Sand. A pretty terrifying experience for those at the sharp end which included top management at least at individual plant level. One relatively small mineral plant for which I had to prepare month end figures, in terms of stock & production control was closed down after the results of one such audit exposed it as a bit of a zombie.

    I cannot help thinking that the above cosy relationships & the likes of mark to myth are all part of keeping the current zombie show on the road.

    1. templar555510

      How right you are Eustache. Once the phrase ‘ too big to fail ‘ came into the language , to coin another age-old phrase ‘ the end was nigh ‘ . Once you have eliminated risk from the everyday, operational reality of running a business , any business – banks included – in the knowledge that the government will not only underwrite you, but unregulate you to any meaningful degree, then you can break all the rules and substitute your own, drafted in your own favour . This is precisely where we are now. In a zombie financial world and have been since 2008. Humpty Dumpty had a great fall . It’s coming !

      1. Eustache De Saint Pierre

        It is probably not hard to guess who will be expected to put Humpty back together again.

  3. Marshall Auerback

    If the breakup takes place and the Big 4 try to substantially increase the costs, this is another service that will quickly be offshored. Already, there are firms which use trained accountants in places like Hyderabad to do much of the basis auditing functions for various businesses. Not surprisingly, their costs are much lower. So there’s a real risk if the accounting giants go down this route.

  4. JimTan

    I think a good portion of big four consulting work originates from their audit groups. Most companies must have their financial statements examined by an independent certified public accountant. These accountants interact regularly with the company CFO, and have his or her ear to pitch ‘consulting projects’ which help with regulatory, IT, risk management, or other CFO needs which are outside the scope of auditing financial statements. Consulting tentacles gradually spread from this beach-head. There’s also the revolving door. Many corporate CFO’s and PMO group heads previously worked for big four audit or consulting.

  5. Jesper

    Lower the bar for applying the laws regarding ‘trading while insolvent’ and the directors will suddenly care about about the accuracy of the financial statements. As it is now then the directors have every incentive to paint a rosy picture and no penalty if the painted picture is too rosy.
    Internal audits are a joke when it comes to uncovering wrongs done by others than the most junior or the most disliked employee.

    If the directors at Carillion had been personally liable (ultimate clawback) for all debts incurred after the company was insolvent but still traded then those directors might have been more concerned about the state of the business.
    Limited liabiliy isn’t a right without obligations, trading while insolvent could and should incur severe penalties if the company ends up failing and suppliers end up with huge losses.

    1. Dean

      I think it would be interesting to make the GAAP financial statements the basis for income tax returns.

      Paint the rosiest financial picture you can for the markets or the worst possible picture for the tax man?

      Right now companies can have their cake and eat it too.

      1. Katsue

        This will always present difficulties when a major GAAP is “substance over form” – where the substance of a transaction differs from the legal form of the transaction, an accountant should record its substance in the accounts. Leases are a major example – a leased machine may, substantially speaking, be an asset of the company which is leasing it even if legally it’s owned by another company.

        As far as I recall, most of the other differences between profit according to GAAP and taxable profits relate to timing issues, e.g. utility bills that have been received but not paid. Under GAAP these are expenses which should deduct from profit, but they likely are not under the local tax code.

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