Kirsty Dorsey: Will splitting the big four’s audit and consultancy businesses reduce quality and hike costs?

He has been described as “openly hostile to the Anglo-Saxon model of capitalism” and British commentators have lamented over why this key job did not go to one of their own.

Last December the Treasury Select Committee was said to have questioned him as though he were “a village simpleton” and only last month he was the subject of conversation in the House of Lords when former financial services secretary Paul Myners described Barnier as someone who checked “his reflection in the glass on every painting”. He said: “This to me is a man whom we should treat with a very long spoon. I hope the minister will take due care in working with Mr Barnier because we have been forewarned that this man intends to seek even more powers than those he announced today.”

Barnier was forced into a U-turn on that occasion – an ill-fated attempt to curb the power of the credit ratings agencies – but rebounded last week with proposals for financial reforms that have, if possible, even further eroded his credibility among the UK business and political lobby.

Confirmation that Barnier will seek to split the profession’s Big Four – Deloitte, Ernst & Young, PwC and KPMG – into separate audit and consultancy businesses sparked a revolt in the UK, with both practitioners and business groups claiming that little would be achieved except to drive up costs on the statutory review of company accounts.

His proposals also include widely criticised provisions that would force larger quoted firms to hire new auditors after a maximum of six years. This so-called mandatory rotation is aimed at introducing more competition into the auditing market, where the Big Four check the books for about 85 per cent of blue-chip companies in most EU states.

Altogether, Barnier believes these and other related reforms will help instil confidence among investors burned by the fall-out from the banking crisis. “Today’s proposals address the current weakness in the EU audit market, by eliminating conflicts of interest, ensuring independence and robust supervision and by facilitating more diversity in what is an over-concentrated market, especially at the top end,” the 60-year-old claimed last week.

Barnier has not been alone in pointing the finger at the accountancy profession for its role in the financial collapse. A study released last week by the Local Authority Pension Fund Forum (LAPFF) argues that UK and Irish banking losses of more than £150 billion were the result of “a relatively simple error” introduced into the IFRS accounting system a few years before the crisis. “Banks that appeared to be solvent within a few months required an enormous amount of taxpayer support in order to survive,” the LAPFF said. “However, shareholders have not, to date, seriously questioned why the weak position of the banks was not flagged in their financial reporting.”

The LAPFF’s criticisms centre on the wording of the IFRS standards, rather than overly cosy relationships between auditors and their clients. Bosses among the Big Four make the point that despite numerous investigations into the banking crisis, no evidence has emerged of endemic malfeasance across their profession.

“If you read the outputs from the various inquiries that have taken place, it will say that the auditors did what they were required to do as the current legislation stands,” says Lindsay Gardiner, head of assurance services at PwC in Scotland. “The question mark there then becomes whether the legislation is fit for purpose.”

It has become a common theme in the wake of Barnier’s announcement on Wednesday: despite much discussion around how auditing work is won, and the circumstances in which it is then carried out, the current reform agenda all but ignores the accounting framework that auditors are required to operate within.

Even the second-tier players – who theoretically are meant to benefit from this regulatory overhaul – admit the proposals are lacking in scope. James Roberts, senior audit partner with BDO, said in the hours after the announcement from Brussels that what remained from the original draft appeared “to be worse for the market than no proposals at all”.

He said: “There is a legitimate question to be asked about what is being audited and what is not being audited. It is not a debate that has particularly been had yet, but it is a useful one that should be started. When you have got a set of accounts of say 500 pages, you have to ask whether that is digestible for most investors. I think probably not.”

Roberts is joined by others such as James Barbour, director of technical policy at ICAS, in his call for a fundamental change in corporate reporting. Some suggest that more attention should be given to the “narrative” around a company – information provided during analyst briefings, for example – while most agree that a more anecdotal approach should be adopted when writing audited accounts.

Barbour says the latter should include more focus on a company’s business model and key market risks, laid out in a concise and readable manner. Not needed, he insists, are potentially damaging edicts such as mandatory rotation or a complete ban on the provision of tax and other consulting services to audit clients.

“What we have in the UK is different from the European mentality, where rules are more favoured,” Barbour says. “We prefer the more principles-based approach.”

On average, the Big Four firms generate about one-third of their revenues from auditing company accounts. A further one-third comes from doling out guidance on tax issues, and the remainder from other advisory services.

Critics claim that ambitions to sell more lucrative tax and consultancy services by one arm of a firm could pressure colleagues on the auditing side to go easy when picking through a client’s accounts, thus eroding the auditor’s role as an independent watchdog.

Craig Anderson, senior partner in Scotland for KPMG, concedes that any defence of the status quo smacks of self-serving rhetoric by the Big Four. However, he says breaking into separate auditing and consulting businesses would drag down audit quality while at the same time driving up costs.

Unlike the bygone era when most companies had relatively straightforward business structures, large corporations these days face a variety of concerns such as pensions, tax, regulatory and property issues that impact their financial performance. An audit-only firm would have to hire in these specialists when evaluating the accounts, rather than tapping into the expertise of colleagues.

“There is a huge range of specialists that we call on day-to-day to deal with these issues that we would no longer have access to,” Anderson says.

There are doubts as to whether proposals to split up the biggest firms will remain intact as the Big Four bring their lobbying might to bear while the reforms make their way through the European Parliament. It also remains unclear how any changes from Brussels will dovetail with the UK Competition Commission’s examination of the sector, which will be restricted to issues around market dominance but is not due to report until October 2013.

As things stand, there are a couple of elements within Barnier’s widely criticised plans that could help smaller players make the gigantic leap that separates the Big Four from the rest. A relaxation of ownership rules is on the agenda, which would allow smaller auditing outfits to bring in the investment needed for specialists and other resources to cope with the demands of examining large corporate accounts. Martin Gill, Scottish managing partner for PKF, would also like to see the EU make good with a ban on loan covenants that require companies to be audited by one of the Big Four as a condition for securing finance.

“From the mid-tier perspective, there are ‘Big Four only’ clauses on certain areas of work that we would like to see removed,” Gill says. “We come across that in our daily work, whether it is a written or unwritten rule.”