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Can EY really split off its audit division if no one else does? I doubt it
Those who follow accountancy will have noticed the news that emerged at the end of last week that EY (or Ernst & Young, as it
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EY considers spinning off audit arm
Global consulting powerhouse EY is considering splitting off its audit arm, amid increasing regulatory concerns about the conflict that has risen from the firm and its big four rivals providing non-audit work to auditing clients.
A string of audit-related failures across the world have triggered the regulatory crackdown, including the collapse of EY clients Wirecard and Luckin Coffee and KPMG UK audit client Carillion.
The firms have previously resisted the idea of splitting off their audit arm. Will Willitts
In Australia, regulators have repeatedly complained that the firms have compromised their “appearance of independence” by providing non-audit work for audit clients and the poor quality of corporate auditing.
“We routinely evaluate strategic options that may further strengthen EY businesses over the long term. Any significant changes would only happen in consultation with regulators and after votes by EY partners. We are in the early stages of this evaluation, and no decisions have been made,” EY said in a statement.
The EY plan, which has been in the works for months and would involve spinning out the auditing division into a separate company, was first reported by Michael West Media.
EY is legally structured as a network of independent national firms that pay to use the common brand and systems, and employs about 312,000 staff across more than 150 countries.
Country-by-country vote
Any decision on the split would require a vote of the almost 4000 partners who are scattered across these independent national firms. This might result in some individual national firms keeping their auditing arms, while others are spun out from the auditing business into a separate entity, three people with knowledge of the matter told The Australian Financial Review.
EY partners would have to give up the benefit of sharing the earnings across audit, which is slower growing but steady regardless of the business cycle, and consulting, which tends to be more cyclical.
“The only way this can happen is if the audit partners are willing to give up consulting revenue and vice versa. Any move also raises questions about how the new audit entity would legally be structured and branded,” said Professor James Guthrie, of Macquarie University.
Auditors play a critical role in the function of markets, with investors relying on an auditor’s independent review of the financial statements of a company.
Regulators worry that the provision of non-audit services to audit clients compromises the ability of the firm’s auditors to form an independent view about whether the information presented in the financial report reflects the financial position of the company.
Firms deny this is the case and have been reluctant to stop providing non-audit services to audit clients, arguing they want them to provide these complementary services.
In Australia, the four firms made almost $600 million by doing non-audit work for audit clients in the 2021 financial year – about six per cent of their collective $9.3 billion income.
The EY insiders said the aim of the split was to enable a newly independent audit business and the existing non-audit business to access more capital and expand more quickly.
Any breakaway audit unit would also have a range of non-audit experts to ensure the quality of the service, and an independent large-scale audit firm would provide corporate clients an alternative external auditor.
In Australia, EY made about $550 million from its audit clients, of which about one-fifth, or $120 million, was for non-audit services.
Although the EY insiders acknowledged that the decision was partly caused by the global regulatory crackdown, they denied it had any link to the firm’s involvement in the collapse of Wirecard and Luckin Coffee.
‘Haunted’ by Wirecard
Wirecard, a German payment processor, filed for insolvency in 2020 after admitting that €1.9 billion ($3 billion) of cash on its books probably never existed. Luckin Coffee filed for bankruptcy this month amid allegations the company’s executives inflated income, costs and expenses for 2019.
The scandals have badly hurt EY’s ability to win work in Europe and China, according to rivals. In a partner briefing last year, Deloitte Global chief executive Punit Renjen said EY’s Wirecard issues would “haunt them, certainly in Europe” and that EY was “persona non grata in terms of audit in the Chinese market because of Luckin Coffee and Wirecard”.
Regulators around the world have moved to rein in the non-audit work the big four firms do for audit clients.
Britain’s accounting regulator, the Financial Reporting Council, has already ordered the firms to structurally separate their auditing operation by mid-2024.
In the US, the Securities and Exchange Commission is investigating conflict-of-interest concerns about the audit and consulting arms of the big four, according to a report in The Wall Street Journal.
A split of the big four auditing and non-auditing businesses was inevitable, said Johannes Dumay, an accounting academic from Macquarie University.
The writing has been on the wall for many years as far as splitting auditing and non-auditing work for the same client. For the big four, audit is part of the overall service that they offer all clients, so doing non-audit work goes hand-in-hand with being a one-stop-shop for their customers, and partner profits,” Dr Dumay said.
“While the regulator has yet to act in Australia, the lack of independence just does not pass the pub test and the UK regulator has seen fit to do something about it. Such a move puts pressure on Australian regulators to follow suit.”
“The recent Wirecard and Luckin Coffee scandals are also good reasons to separate audit from non-audit services ... we must also recognise that many of these collapses are perpetrated by management and boards hell-bent on covering up and doing the wrong thing.
Combine that with a lack of due diligence in the audit process for a big fee-paying client seems to be the most lethal cocktail for a corporate disaster.“
ASIC’s most recent quality inspection reportsfound that one in five audits reviewed by the big four lacked the desired assurance that company financial statements were free from material error.
EY had by far the best results of the major auditing firms. ASIC found that the firm did not do enough on 7 per cent of the key areas of work it did on audits of risk-targeted companies in the 2020-21 financial year. In contrast, the findings ranged from 25 per cent for PwC through to 29 per cent for Deloitte and KPMG.
It is understood that about 18 months ago, KPMG’s partnership examined splitting off its audit arm but decided to stick with the multidisciplinary model.
A spokesman for PwC said the firm was not planning to split off its audit business and continues to believe that “access to a wide range of expertise and competencies is essential to serving our clients”. Deloitte declined to comment.
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