This article was written for and first featured in International Accountant 

The ‘big four’ firms, PricewaterhouseCoopers, Deloitte, KPMG and Ernst & Young, are widely known to be fearful of EU-level reforms proposed to the statutory audit market.  The EC reforms propose, among other things, to prevent auditors from performing other types of non-audit work, such as consultancy, for their audit clients (which proposed reform largely stands in its original proposed form, despite a general watering-down of some of the other reform proposals).

The timing of the coming into effect of the EU-level reforms is uncertain, given the potential fluidity of the EU legislative process and the possibility of setbacks.  It is not inconceivable that it will take several years before the proposed EU reforms (once they have taken shape) are in force in all members states.  However, it must be said that the detail of the reforms is becoming clearer much quicker than many had predicted only a few months ago and, therefore, a shorter time line cannot be ruled out.  It may also be fair to say that a quicker move by the EU is more likely given the EU’s renewed determination to reform the wider “financial world”, of which the reforms to the audit market might be seen as a key part.

Whilst it may be unfair to describe auditing as a ‘loss leader’, many large firms do treat their auditing practices as a type of ‘client feeder’.  Much of the auditing work large firms take on is to facilitate the firm getting its ‘foot in the door’ with a client so that it gets the first opportunity to provide other, more lucrative, non-audit services.  In some limited cases audit work is taken on as a way of the firm showcasing ‘trophy clients’.  The indirect effect of this model is that smaller firms find it more difficult to compete for audit work since the ‘big four’ are, perhaps unintentionally, operating a predatory pricing model which creates a significant barrier to entry, particularly when one considers the investment that smaller firms will need to make in order to create the global presence that multinational clients require.

One of the most thought provoking suggestions made by the EC is that an accountancy firm which undertakes audit work should not also be able to undertake non-audit work for the same client (despite some recent watering down of some of the other EU-level proposals, this proposed reform still stands).  The intention of this proposal is to stimulate competition in the audit market since a firm undertaking audit work for a client would not have an advantage when it comes to competing for non-audit work from the same client, as it would be prevented from performing non-audit work for the client altogether. The EC also says, in its FAQ paper, that preventing a firm appointed to undertake the audit from providing non-audit work “will ensure that high quality audits are the primary focus of the audit provider”.

However imposing this restriction is likely to have potentially severe negative consequences.  First it will mean accountancy firms are less eager to take on audit work, as doing so will prevent the firm from performing lucrative non-audit work for the same client.  Secondly, once a firm has taken on an audit client; it will be prevented from undertaking other work and will therefore reduce the pool of firms who are able to provide non-audit advice (which, in the case of multinationals, is likely to mean only three rather than four firms competing for their non-audit work).  The overall effect therefore is that the market for both audit and non-audit work will become less competitive and, at least in the short to medium term, fees for both will rise.

There is, however, an alternative option, which might be of interest to the EC given its EU-wide geographical remit (and therefore the increased likelihood that its reforms will force change on a global scale).  Since there will only ever be a relatively small number of firms that can offer truly global accounting services it does not make sense to deter the ‘big four’ from taking on their audits, as this will reduce competition further.  Instead the EU could force the ‘big four’ to ring fence their audit functions, much in the way that Sir John Vickers has recommended that UK banks ring fence their retail and investment banking operations.  An entirely separate engagement and fee would need to be agreed with the client for audit and non-audit work (something which already occurs, but where currently the audit fee is artificially low in light of the lucrative non-audit work which the firm expects to flow from the audit appointment).  The purpose of this ring fence would be to prevent profits flowing within the big accountancy firms, away from partners specialising in more lucrative non-audit practices to the partners specialising in the less profitable audit function. 

The effect of ending such intra-firm ‘subsidisation’ of audit partners is that their profit shares will fall. Subsequently audit partners may seek to increase their fees so as to restore their former profitability and the part of the firm providing non-audit work could, in theory, afford to reduce its fees as it would no longer need to ‘subsidise’ the audit practice.

Over time such ‘ring fencing’ may, therefore, provide an opportunity for a new ‘medium few’ tier of global or semi-global accountancy firms to develop who can successfully bid for the audit work of multinational companies and ‘rise up the chain’.  This is something which is desperately needed given the dominance of the ‘big four’ accountancy firms and the investment required by their smaller peers to challenge that dominance.  It is also likely that increased competition will lead to reduced audit fees in the longer term and, if the new tier of ‘medium few’ accountancy firms can use their new platform to expand their non-audit practices, it could lead to increased competition and reduced fees for that work, too.

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