Wirecard, Enron or the Postbus affair: if something goes wrong, the reputation of the auditors also suffers. EY, which had checked the balance sheet of the scandalous company Wirecard, is now considering a split – other heavyweights could follow.
The auditing company EY could become two companies: a consulting firm and an auditing firm.
Is it realistic for a village policeman to know months before a robbery that a shop is about to be robbed? Of course not. However, this is exactly what the public expects of the auditors, said a manager of a large auditing company in a recent conversation.
Most recently, the industry heavyweight EY was covered with allegations and lawsuits. The auditors had been fooled by the German payment processor Wirecard. Wirecard even faked bank branches in the Philippines in order to get the auditor’s approval. When suddenly there was a hole of almost 2 billion euros in the books and the shareholders suffered total losses, the anger of the investors was also directed at EY.
Such incidents are poison for trust in the “big four” of the auditors, which include EY, PwC, KPMG and Deloitte. It now looks like EY is taking flight to the front. The firm, which employs 315,000 people, is considering splitting into two, recently leaked: a consulting firm and an accounting firm. About 60 percent of the staff would work in consulting. The company confirms such considerations, but does not want to take an official position beyond that.
It would be the biggest change in twenty years. In 2001, the energy trader Enron collapsed, taking the testing company Arthur Andersen with it. Andersen had overlooked Enron’s accounting falsification and destroyed files.
In previous years, American authorities had criticized the auditing companies for possible conflicts of interest between consulting and auditing. EY therefore sold its corresponding business to Cap Gemini in 2000. But over the years, the auditors pushed their consulting business again. Now there is a counter-movement.
Rotation is not a panacea
What is the purpose of audit firms? With an attestation from an independent party, the investor should be able to trust the figures of his company. According to Thomas Nösberger, Professor of Auditing at the University of Freiburg and independent consultant, the tests are designed in such a way that significant errors should be discovered in 95 to 98 percent of the cases. In order for this to succeed, however, the auditors must not be trapped in conflicts of interest. Two stand out:
- Audited pay auditor: In fact, the shareholders should pay the auditors because they benefit when someone scrutinizes their company’s figures. However, since this is not possible given the scattered ownership, the company pays the auditor. But do you bite the hand that feeds you, or do you overlook critical things in fear of losing the job? To reduce this danger, a fresh set of eyes should be looking at the numbers from time to time. A mandatory rotation of the auditing company was therefore introduced in the EU. In Switzerland, only the responsible auditor (but not the auditing company) has to be replaced after seven years.
- Squinting at consulting assignments: The consulting services of the “big four” have become the main source of revenue over the years. For example, customers need support when it comes to takeovers, preventing cyber risks, valuing real estate or clarifying whether the fight against money laundering is effective. Could it be, so the accusation, that the auditor now and then turns a blind eye in the hope that his company will win a lucrative consulting mandate?
However, Nösberger does not see a panacea in the EU’s rotation rule: the auditing company could be keen to initiate consulting contracts before the departure. Is she still the management’s critical sparring partner? However, the fact that the same auditing firm has been working for eleven of the twenty largest Swiss companies for over twenty years may also be viewed critically.
Overall, the business economist considers the risk of conflicts of interest to be much lower than before because companies, auditors and the supervisory authority have now taken precautions to reduce them. This is reflected, for example, in the fact that the additional fees for the 211 listed companies in Switzerland on average less than 20 percent of the audit fees.
The EU has issued a guideline of a maximum of 70 percent – so most listed companies would have no problem with that. However, according to the Swiss Audit Monitor also twelve listed Swiss companies that exceed these limits. High shares are a risk of conflicts of interest, says the Federal Audit Oversight Authority.
Investors can find out from the annual reports of listed companies how much the audit cost and what additional fees were paid for advice. Credit Suisse, for example, paid PwC CHF 69 million for the audit in 2021. In addition, there were more than 3 million audit-related services. This is not a problem.
The audit committee plays a central role in a company’s board of directors. It not only proposes the auditor for election, but also approves additional consulting mandates. A professional and independent audit committee is a sparring partner for the head of finance and the auditing company.
Finally, the principle of independence prohibits an audit firm from accepting consulting engagements that could lead to conflicts of interest. For example, if consultants from a “big four” company have made an appraisal of the value of a subsidiary, they cannot check the balance sheet of the parent company at the same time. This would be problematic because the auditor does not necessarily come to the same conclusion about the correct value as the consultant did previously.
Motivation boost thanks to splitting
In any case, the leeway to sell consulting services in addition to auditing has decreased significantly. This can go so far that it is not even worth submitting an offer for the audit to a corporation because you have to hand over consulting mandates.
In the case of the largest Swiss corporations, it can therefore happen that they only receive two or even just one offer for a tender for the final audit. If, on the other hand, consulting and auditing occur independently of one another, the motivation to win the mandate for the audit is unrestricted. There are three reasons for a split:
- Different business models: Consulting is considered to be more profitable than auditing, which is increasingly becoming a standardized product, not least because of the high level of regulation. However, the income from consulting fluctuates more than from auditing, as the Corona crisis showed. In contrast, liability and reputational risks are higher in auditing than in consulting.
- Cultural differences: The auditor must be familiar with accounting and tax law. He also focuses on the past, while the consultant has to keep tracking down new trends in order to remain relevant to her clients. The whole thing is a bit reminiscent of the discussion at banks, where it is difficult to reconcile the different interests of investment bankers and down-to-earth retail bankers.
- Customers do not necessarily appreciate combinations: You can score less and less with customers if you combine advice and testing under one roof, emphasizes Nösberger. The economist is himself a member of the board of directors of various companies and refuses to give the auditing company any significant consulting assignments. More and more corporations that have an independent audit committee think like him – by the way, Wirecard did not have such a committee until 2019.
The split of EY would still be a radical change. Until recently, industry representatives had invoked the advantages of a combination. One manager said that you are more likely to get top people if you combine both under one roof and talents can also change internally. In addition, the auditors sometimes have to fall back on specialists from IT or the tax area, who are mainly active in consulting. Otherwise you would have to buy this knowledge at great expense.
According to the preliminary plans, even in the event of a split, certain experts who are often consulted by the auditors will remain in the auditing company in order to maintain quality.
The genie is out of the bottle
The 13,000 partners of EY worldwide have the last word, with each national company – in Switzerland that would be around 140 people – deciding for itself whether it wants to change its model. The first response from the Swiss partners was reportedly positive.
Accounting firms are partnerships. This, too, serves the purpose of avoiding conflicts of interest: imagine a fund investing with an auditor listed on the stock exchange. Then this could create pressure on the auditors to be “gracious” in the audit of companies in which the fund has an interest.
In any case, the audit would remain organized as a partnership even after a split. For the consulting business, an IPO is the priority. Part of the proceeds would probably go to the partners who stayed in the audit part. This money would be available, for example, for the high investment requirements in IT. This is the only way to achieve efficiency gains in auditing.
The competitive pressure in auditing has recently increased, as mandates are being advertised more often than before. From 2013 to 2020, the fee for 48 of 66 listed Swiss companies that changed auditors fell by an average of 10 percent.
A division of EY would therefore have a lot going for it: it would prevent conflicts of interest between consulting and auditing and pre-empt regulatory tightening. It could be worthwhile from a business point of view because each area can now seize opportunities without having to consider the other.
Experts surveyed are convinced that not only EY is thinking about a split. If, contrary to expectations, EY were to lose courage, another of the “big four” could soon dare to come out with similar plans.