The big four accountancy firms have been told by watchdogs to accelerate the ring-fencing of their audit businesses by bolstering independent governance and improving financial transparency.
Sky News has learnt that the Financial Reporting Council (FRC) wrote to the quartet – Deloitte, EY, KPMG and PricewaterhouseCoopers (PwC) – this week to set out details of the ‘operational separation’ blueprint that it hopes will improve audit quality following a string of corporate scandals.
In the letter, the FRC is understood to have told the four firms, which collectively have a dominant share of the market for auditing major listed UK companies, that they must create separate boards for their audit practices with an independent chairman.
The chair could not be a partner at the firm, although further details of the criteria to determine independence have yet to be finalised.
The big four will also be required to have a majority of independent directors on their audit boards, reflecting the governance code that applies to the quoted companies whose accounts they oversee.
The watchdog is also demanding that the big four begin developing separate profit and loss accounts for their audit practices to provide greater clarity about the financial health of the units.
In a statement following an enquiry from Sky News, Claire Lindridge, the FRC’s director of audit firm monitoring and supervision, said: “The FRC has proactively engaged with the largest audit firms to move them to operational separation faster than can be achieved through legislation.
“We expect that adopting our principles will ensure audit firms implement a culture clearly focussed on audit quality, independence and financial transparency”.
Sources said that the FRC had also sent the letter to a number of ‘challenger’ firms, including BDO, Grant Thornton and Mazars, some of which have ambitions to increase their share of the UK audit market.
The proposed shake-up falls short of the wholesale split that some critics of the audit profession have advocated in the wake of accounting fiascos at companies such as BHS and Carillion.
Nevertheless, the set of principles outlined by the FRC in its letter this week represents a far-reaching shift from the status quo.
The new ring-fenced boards would have responsibility for overseeing audit partners’ pay, while the FRC is also scrutinising the scope of services that will be permissible within the audit businesses.
Under the plans, the big four will also have to provide more detail about the allocation of shared costs such as property and technology to their audit operations.
The FRC has already moved to ban auditors from undertaking consulting work for audit clients because of concerns about conflicts of interest, while a number of firms had already taken steps in that direction.
Last month, it emerged that a number of partners in EY’s restructuring business were moving to AlixPartners, an independent rival, because of the growing restrictions on their ability to operate within an audit firm.
The issue had been thrown into sharp focus at EY – which has largely steered clear of the multimillion-pound penalties for audit transgressions that have beset its rivals – by the firm’s decisions to scrutinise the books of Debenhams and Thomas Cook.
Both clients were taken on less than two years before the companies entered major financial restructurings, which EY was then prohibited from advising on.
The FRC’s latest move to enforce operational separation follows a flurry of government-commissioned reviews aimed at improving quality and competition in the audit market, as well as its regulation.
Last week, the Competition and Markets Authority raised the prospect of more profound reforms if the big four resisted efforts to overhaul the sector.
The FRC itself is in the midst of a major shake-up, with a new chairman and chief executive.
It is expected to become a statutory body called the Audit, Reporting and Governance Authority once the government legislates to implement the recommendations of Sir John Kingman, the former Treasury mandarin.
The FRC is also seeking to improve the chances of challenger firms hoping to gatecrash the big forums audit oligopoly by proposing a system called managed shared audits.
Under the blueprint, all but the very biggest FTSE-350 companies would be required to include at least one challenger firm in their audit tender process.
If a big four firm – one of Deloitte, EY, KPMG or PricewaterhouseCoopers – is appointed, work equating to a substantial minority of the audit fee would then have to be undertaken by a smaller rival.
The new business secretary, Alok Sharma, is expected to decide in the next few months the precise path that the government wants to pursue for reforming the audit sector.