Tighter ethics regulations are holding back the growth of Ernst & Young’s lucrative consulting business, a key reason firm leaders are considering whether to separate its global audit and advisory practices.
Regulators in countries including the US, EU, and India have been clamping down on auditor independence—a major investor safeguard—by barring firms from performing certain outside work for their audit clients and limiting the revenue that the firm’s consulting practice can earn.
“There’s work we can’t do,” a source with knowledge of the matter said. Conflict-of-interest rules limit the type of advisory work the firm can provide, including fast-growth technology as long-term outsourcing contracts are barred for audit clients.
EY’s audit practice, which reviews the books of some of the largest companies in the world, could be a further drag on revenues as the firm faces hefty fines and billion-dollar lawsuits over its work for failed German payment processor Wirecard AG and for London-listed NMC Health Plc.
The global accounting network said Thursday it was discussing whether to spin off its global auditing business. Of the firm’s $40 billion in global revenue last year, EY’s assurance practice, which includes public company auditing, contributed $13.6 billion in fees while consulting, including strategy and transaction services, added $15.9 billion combined and the remainder came primarily from tax.
Such a separation would take off the shackles from both businesses, allowing auditors and consultants to compete freely for clients without the need to obtain conflict-of-interest clearances first, said Mark O’Connor, CEO and co-founder of Monadnock Research LLC, which tracks the consulting industry.
Those internal checks span the globe and have become increasingly tricky to navigate amid a boom in the number of companies filing to go public and the explosion in private equity portfolios.
“Stakeholders are telling EY that there needs to be a global solution to audit independence,” the source familiar with the firm’s deliberations said. “So it’s for a global firm to do, not national regulators.” Any formal separation could take over a year to complete, he said.
Jenny Chu, associate professor in accounting at the University of Cambridge’s Judge Business School, described the move as a watershed moment.
“We need to wait and see,” she said. “The devil will be in the details on how the partners in the newly spun off audit firm may or may not retain financial interests in the consulting firm.”
Little Change From Soft Splits
Indeed, some critics were dubious whether EY spinning off its audit arm would change much.
“We’ve been here before,” said Prem Sikka, an accounting professor and member of UK Parliament.
EY sold its global consulting arm to Capgemini in 2000 for $11 billion, only to build up that service line again to the point where it now trumps the audit practice in revenue.
With the exception of Deloitte, the largest accounting firms all spun off their advisory arms worldwide amid intense regulatory pressure in the years just before the US passed tough audit and corporate governance reforms known as the Sarbanes-Oxley Act.
The firms quickly were able to build back those sold practices “as soon as the non-competes expired,” O’Connor said.
“Soft splits like this don’t change anything,” Sikka said. “There needs to be legislation banning auditors from doing consulting work.”
The EU introduced mandatory limits on the consulting work firms could do for their audit clients in 2016 and has altered the structure of work done by the Big Four, Sikka said.
Auditing now accounts for around a quarter of the firm’s UK revenues, for example, and consulting work for audit clients has fallen steadily, according to the Financial Reporting Council. The flip side is that they have emphasized consulting work for outside companies, which are now their biggest source of money.
Advisory fees similarly represent a small fraction of the fees that the largest firms collect from their public company audit clients in the US.
Now regulators around the world are considering whether to introduce additional rules that would bolster audit independence, limiting the amount of consulting work auditors could do. In the US, for example, the Securities and Exchange Commission is pressuring firms about their growing book of consulting work, warning that those lucrative fees could weaken auditor independence, a key investor safeguard that was baked into post-Enron securities laws.
EY paid $10 million last August to settle SEC allegations that it violated auditor independence rules in seeking to win business from a competitor.
“There’s obviously a lot of pressure here from the consulting side,” Sheffield University accounting professor Richard Murphy said, explaining that there was pressure for a split from both auditors wanting to demonstrate their independence and consultants. The firms “are fed up with the hits they’re taking from audit. You can understand the pressure for EY to separate out audit.”
Competitors Not Following
“Splitting off audit must be a good thing,” Murphy said.
“It will force the firm to increase the price of audits to reflect the growing risks, and end the era of cheap prices as audit is subsidized by the consulting side.” He added that the move would only work if the other Big Four firms followed suit.
That seems unlikely in the short-term. The other large firms wouldn’t comment on EY’s possible restructuring plans, but in emailed statements EY’s three main competitors said they would not shift away from their multidisciplinary model, housing many different specialties on top of its audit and accounting work all in the same firm.
Deloitte said it remains committed to its current business model as did KPMG, which said that the multidisciplinary model drives “innovoation and high quality standards.” Similarly, PwC said it has no plans to change course.
“Our view continues to be that access to a wide range of expertise and competencies is essential to serving our clients and all other stakeholders and delivering high quality services,” said PwC, also known as PricewaterhouseCoopers.