EY’s big decision on a structural split could shake up accounting

The much talked about structural separation of the audit and consulting businesses of EY is now on the cards, with the firm announcing its decision to split the two apart in 2023.

Such a separation in accounting firms has all along been considered a fundamental audit reform, as it addresses potential conflicts of interest and enables an exclusive focus on audit quality. A conflict of interest arises because an auditor’s independence and objectivity can be compromised by the company’s efforts to provide better-paid non-audit services to the same client. Terming non-audit services as immaterial or ancillary to audit services may obscure the conflict. But it still fundamentally limits an auditor’s ability to ask the right questions of the management or report the true state of affairs. The focus of audit firms also tilts towards consulting services, which are not only highly remunerative, but also entail less regulatory oversight.For instance, the consulting business of EY constitutes more than 60% of its revenues.

The big four accounting firms have, however, so far successfully ducked the case for structural separation, arguing that with a pool of multi-disciplinary expertise available within the firm, their consulting business has actually helped improve audit quality and reduce audit costs. Instead of separation, they sought to create a Chinese wall between the two businesses. In the absence of requisite regimentation, this has proved to be just an illusionary separation and only added to the conflict of interest.This has been evident in the many audit failures.

A statutory audit market survey done by the UK Competition and Market Authority (CMA) in 2018 observed that the driving motives behind certain non-audit functions are often poorly aligned with the culture of objectivity, professional scepticism and challenge required among auditors to perform a public interest function. Similar has been the view held by various studies on audit reforms in India and elsewhere.

A white paper published by the UK government in May acknowledged that a structural split would pose significant challenges and proposed an operational separation, with a legal mandate for the regulator to develop such a plan and monitor its implementation. It, however, provided for policy flexibility to act (including for structural separation) in the future should operational separation not deliver a sufficient improvement in audit quality. While the white paper’s proposals are subject to legislative approval, the Financial Reporting Council (FRC) has asked the big four firms to carry out, after mutual consultation and the setting out of underlying principles, the operational separation of audit and non-audit services by 2024. The objective is to ensure that no material and structural cross subsidy exists between the audit practice and the rest of the firm.

The EY decision of a structural split should be seen in the context of increasing regulatory and stakeholder pressure and cases of its recent audit failures in the UK and elsewhere in Europe, as also fines of $100 million on its employees imposed by market regulators for alleged cheating in Certified Public Accountant (CPA) ethics exams. These apart, EY sees huge growth opportunities—of about $10 billion a year—in the consulting business, despite independence rules that restrict the kind of work an audit firm can do for audit clients.

EY’s decision is significant as it may change the landscape of the accounting profession worldwide. While the remaining three big firms—PwC, KPMG and Deloitte—have reportedly decided against a structural spilt, they will remain under pressure from regulators, since the success of operational separation or pseudo structural separation has been in question. Guided by the investor community, companies are now increasingly preferring their auditors not to also provide non-audit services. The share of the big four firms in audit fees globally has lately declined by about 10% in favour of challenger firms. Their non-audit fees from audit clients has also fallen.

Non-audit services provided by an audit firm cross-subsidize its audit services, but in the process impair the auditor’s independence. Audit services on their own are not viable, as audit fees are not commensurate with the investment, time and cost needed for a quality audit. EY’s audit business on being separated from the consulting business will thus probably face viability issues. Regulators, while happy with the reduction of a conflict of interest, need to also look at the resilience of a separated audit business and it’s ability to withstand potential litigation damages. As the brand EY will remain with the audit firm, the consulting firm will require huge investment to develop a new brand name, as was the case with Accenture—the separated consulting business of the erstwhile Arthur Anderson.

In sum, EY’s decision will shake up the manner in which audit firms are structured globally. Other firms may follow suit, guided by its success or goaded by regulators or investors. Such a split addresses a potential conflict of interest, but it is not the only condition for improving audit quality. That depends on how audit firms transform themselves to meet future challenges.

These are the author’s personal views.

Ashok Haldia is former secretary of the Institute of Chartered Accountants of India