Parliamentary report prompts Big Four to prepare for forced break-up
The Big Four professional services firms are preparing for state intervention forcing them to separate their auditing and consulting wings in the UK, after a damning parliamentary report further suggested that their sprawling advisory wings are leading to conflicts of interest. The attention drawn to the industry by the world’s largest firms could also have widespread implications for other market leaders in the future.
The largest members of the accounting and advisory world, headed by the Big Four – Deloitte, EY, KPMG and PwC – look increasingly set to face a state-enforced splintering of their businesses in the UK. The Big Four’s share of FTSE 350 auditing has increased from 95% to 98% over the past five years, despite a series of EU and UK reforms aimed at tackling a lack of competition since the 2008 financial crisis. With pressure subsequently mounting on UK authorities to tackle the gang of four’s dominance, the Financial Reporting Council (FRC), which oversees the British auditing market, recently made headlines when it said a break-up of the Big Four may be necessary.
This would not be the first time that state intervention forced the gang of four’s hand when it comes to divesting from consulting work. In 2001, the Enron scandal set a chain of events in motion that would ultimately lead to what was then the Big Five becoming the Big Four. After energy giant Enron filed for what was then the largest bankruptcy in US history, Arthur Andersen – the professional services firm which had audited the group – was convicted by a United States District Court of obstructing justice by illegally destroying documents relevant to an investigation into Enron’s collapse. Arthur Andersen subsequently had its license to audit public companies voided, effectively closing the business – and even when the conviction was overturned as the destruction of documentation was within the firm’s document retention policy, its reputation had been damaged beyond repair, causing the de facto dissolution of the former competitor of Deloitte, KPMG, PwC and EY.
Following the Enron scandal, the remaining Big Four also came under pressure, as the perceived conflict of interest embodied by Arthur Andersen – which both audited and offered consulting services to firms – led regulators to believe that further companies could collapse due to book-keeping irregularities. Concerned that auditors might have gone easy on companies because of lucrative companion contracts for consulting, critics urged the firms to stop consulting for their audit clients.
This resulted in KPMG, PwC, EY and Deloitte all having announced plans to spin off their consulting wings by spring 2002. EY, PwC and KPMG went on to sell their consultancy practices to Capgemini, IBM, and Bearing Point, but Deloitte reneged on their decision by the following year, citing weakened demand for consulting, the declines in the stock market and the risk that added debt would pose to each part of the divided firm.
Despite the seemingly adverse atmosphere Deloitte’s consulting wing found itself in, since then, it has gone from strength to strength. Revenue growth for the UK wing of Deloitte has become increasingly driven by the robust pace of its consulting business, and by 2015, Deloitte was posting revenues of £2.7 billion for its year-end, of which Deloitte Consulting generated £687 million, and the practice has continued to develop in the following three years. Earlier in 2018 it was found to be the leading management consultancy in the UK.
The success of Deloitte’s consulting wing has prompted its Big Four competitors to rapidly return to the consulting space too. In order to boost these efforts, acquisitions have routinely been leveraged by the Big Four, for both niche and mainstream consultancies, to help them develop multifaceted and holistic offerings, which dominate the global consulting market. EY is presently working toward plans to grow its strategy consulting practice to over 2,500 professionals by 2020, while KPMG saw income from consulting in the UK hit as £850 million by 2014, a figure well in excess of its audit revenues of £445 million for the same year. At present, the Big Four make up around 40% of the global consulting market, but now Deloitte, KPMG, PwC and EY look to have become victims of their own success once more.
Mounting pressure
With Grant Thornton’s withdrawal from bidding for FTSE 350 audit tenders, which it claims cost the firm as much as £300,000 per attempt, calls for state intervention in the British auditing market gained further traction. As the Big Four still hold the vast majority of these major contracts, claims that the Big Four’s growing consulting arms make for conflicts of interest in their auditing duties have gained weight.
Stephen Haddrill, Chief Executive of the FRC, has publicly voiced such concerns about regulators’ failure to tackle the dominance of the Big Four. This was perhaps most markedly illustrated by the Big Four’s alleged “feasting” on the collapse of construction firm Carillion. The firms each held numerous auditing and advisory roles with the company, costing a total of £72 million before Carillion entered administration in January – at which point PwC picked up a further lucrative contract to oversee the group’s winding down.
A subsequent Parliamentary report into the collapse of Carillon by two select committees produced a scathing assessment of the work of an auditor KPMG in particular – which also faced an FRC investigation for its role at Carillion – though members of the Work & Pensions and Business committees also bombarded internal auditor, Deloitte, and EY, hired to advise on a turnaround, with criticism in the critical paper. PwC was left to handle the insolvency as the least conflicted among the four, however, it had also advised the company on pensions and the Government on Carillon contracts – implicating the entire Big Four in subsequent calls for action from MPs.
A break-up scenario now appears to increasingly be on the cards, and could involve one of two options. The largest auditing firms either face being forced to split into two smaller multidisciplinary firms; or being made to sell off their consulting wings to create audit-only businesses. This second option is notably the one backed by Stephen Haddrill, as he and the FRC continue talks with the UK’s Competition and Markets Authority about a potential investigation of the audit market, five years after the last competition investigation into the workings of the accountancy industry.
While the Big Four are naturally attempting to assuage such concerns, executives from all four and the next largest UK audit firms, Grant Thornton and BDO, have all confirmed they had planned for a potential break up, in case regulators force them to split their audit and consulting businesses.
The most striking admission came from Bill Michael, Chairman of KPMG’s UK business, who confirmed his firm had been thinking about break-up scenarios “for some time” as the current business model of the Big Four is increasingly becoming seen as “unsustainable”.
He went on to tell the press, “We are an oligopoly – that is undeniable…I can’t believe the industry will be the same [in the future]. We have to reduce the level of conflicts and…demonstrate why they are manageable and why the public and all stakeholders should trust us.”
PwC meanwhile stated it had forged a contingency plan for a break-up, which covers “a range of scenarios that could threaten the existence of the firm”. EY likewise said it was “working alongside regulators and standard setters, the profession can evolve to best serve business, investors and stakeholder needs.” BDO, the UK’s sixth-largest auditor, has also put precautionary plans in place should regulators decide to “ring-fence” audit work.
While the firms have prepared for their worst case scenarios, not every executive took such a conciliatory tone in addressing the matter, however. Speaking to the Financial Times, UK Chief Executive of Deloitte, David Sproul, told reporters from the Financial Times that creating audit-only firms “would be to the detriment of the capital markets”, while Grant Thornton, issued a statement that the UK’s fifth-largest accounting firm, “fundamentally do not believe that this is the solution to the existing systemic issues in the audit market.”
