A possible split of EY into separate audit and consulting firms must confront the problem faced by all breakups: How do you create attractive businesses out of both when one is likely to be seen as inferior? Here, that would be the newly established standalone auditor.
EY—or any Big Four accounting firm that might attempt such a separation—has its work cut out to make pure-play audit a success.
The revelation by Michael West Media that EY is considering the move heralds a potentially seismic shift for the industry. A succession of accounting scandals has long prompted attacks on the Big Four for earning fees from audit clients by selling consulting services such as strategy or restructuring advice. There's an inherent conflict of interest in offering these to the same executives whose homework you're meant to be marking. While regulatory scrutiny is forcing firms to tread carefully, creating distinct companies is the most reliable remedy.
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The UK's competition watchdog called for an "operational separation" of audit and consulting within the existing firms in 2019, stopping short of demanding full breakups because of cost and complexity. For its part, EY is under particular pressure due to its auditing of collapsed German payments firm Wirecard AG—although it's not clear that a breakup would rid it of any liabilities arising from that failure.
Perhaps EY is pre-empting tougher regulation. Or perhaps it just sees an opportunity to monetize some of it assets. One option under consideration is the sale of a stake in the consulting business to a private buyer or to the stock market, creating a windfall for EY's current partners, according to the Financial Times. Demand would likely be strong. Just look at the private-equity money piling in lately. PwC sold a tax advisory practice to Clayton, Dubilier & Rice for a reported $2.2 billion last year, while KPMG offloaded its U.K. restructuring arm to HIG Capital LLC.
But what about the rump that remains? While the underlying economics of the Big Four are opaque, there's a widespread suspicion that consulting subsidizes audit. At the very least, the ability to share costs means audit fees are lower than they would be for a distinct firm, regulators have found.
The biggest challenge is how a standalone auditor would attract and retain talent without offering an in-house career in consulting as an option. Short-sellers and forensic investigators aside, checking company accounts is for many a laborious gateway to other roles. Audit partners accused of getting it wrong have regulatory probes hanging over them for years (an investigation into Rolls-Royce Holdings Plc's 2010 accounts only just closed). No wonder juniors tend to jump ship to better paid and less risky careers in consulting or investment banking not long after they're qualified.
So auditing will have to be made more attractive, both financially and culturally. One place to start is expanding the function beyond checking financial statements to offering sophisticated checks on companies' claims on non-financial performance such as climate and social impact. When the U.S. Securities & Exchange Commission (SEC) is clamping down on "greenwashing" by investment funds, it's clear the future of ESG investing rests on companies proving they're not cooking the books on these issues too.
These public-interest assessments are going to be increasingly scrutinized by investors in the future. They are already offered under the umbrella of so-called "assurance services," but ought to become a more developed part of corporate reporting. That would involve transferring some skills over from the consultancy side. The trick will be to add in parts of the current consulting business that are relevant to a more modern vision of audit, without just recreating a new auditor-cum-consultancy.
Of course, separation won't eliminate all the conflicts in audit. The chief culprit is the way managers often effectively appoint the audit partners who are meant to be their policemen. But the prize for stock-market investors is improved audit quality, and a breakup could support that.
The goal should be to create a virtuous circle. Make audit more enticing as a long-term career, attract people who do the work better—and hopefully cut the number of blowups.
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