As an advocate of separating audit from consultancy, I have to acknowledge that implementing the ring-fence will not be easy, especially as the UK is pioneering this reform.
The first objective set out in the Principles for separation, published by the Financial Reporting Council (FRC) in July, is obvious: the audit practice should focus on ‘delivery of high-quality audits in the public interest’. Note that those last two words pack a punch in detaching auditors from their corporate clients.
To achieve this, an ‘audit board’ will provide independent oversight of strategy and the remuneration and promotion of audit partners. The aim is to ensure the right incentives to put audit quality first, even when this costs money and annoys some clients.
The devil in the implementation detail lies in the second objective: ‘Improve audit market resilience by ensuring that no material, structural cross-subsidy persists between the audit practice and the rest of the firm.’
The regulator may be getting more demanding, but it is in nobody’s interests for audit to be a poor business
The seriousness of this issue has led a few of my contacts (outside the audit profession) to question whether the ‘standalone’ audit practices will be viable.
Asked whether there were persistent cross-subsidies between audit and other parts of the firms, David Rule, the FRC’s executive director of supervision, said: ‘We don’t really know.’
He was discussing the issues in a video organised by the Centre for the Study of Financial Innovation in which another speaker, Paul Lee, a governance expert, expressed disappointment that the ring-fenced firms were being given until 2024 to publish meaningful profit and loss accounts.
At what cost?
The thorniest issues are cost allocation and arm’s-length pricing of services provided by other parts of the firm.
KPMG’s accounts for the year to 30 September 2019 give a few clues. Audit provided a ‘contribution’ of £190m on revenues of £647m (about a quarter of the total). But this profit measure is before its share of £576m of unallocated costs.
Transitional investment in hiring and training staff has been heavy. As auditors enhance scrutiny of management judgments and increase the senior-to-junior ratio, costs will rise but so should fees. The ring-fenced firms will continue to do some non-audit work, including checks demanded by regulators.
Another awkward issue is fines. The FRC’s most recent annual enforcement review showed a drop, after discounts, from £32m in 2018/19 to £11.3m in 2019/20. But fines so far this year – including a record undiscounted £15m of Deloitte for Autonomy from 2009-11 – suggest another jump.
In terms of the top line, the biggest firm, PwC, could have UK audit revenues of around £1bn. Generally, profit margins ought to be well into double figures. The regulator may be getting more demanding, but it is in nobody’s interests for audit to be a poor business.