Let’s look at some history. The big audit firms of the end of the last century, the Big 5--namely Deloitte, Ernst & Young (now EY), KPMG, PwC and the now-defunct Arthur Andersen--began to diversify into the consulting business in the 1990s. The activities grouped under this term varied. Roughly speaking, at the time, consulting activities on the other side of the Atlantic were more IT-oriented--it was the time of the implementation of large IT systems--while European consulting was more business-oriented.
The question of independence between these activities was already then being debated within the networks. The aim was to keep them all within the company. Various answers were given. In Luxembourg, the worldwide ban imposed by the PwC network on both keeping accounts and auditing them led to the creation of a spin-off, Alter Domus.
This separation, which seems to be common sense today, was not self-evident at the time... But it was above all the action of regulators that precipitated and formalised things. The Enron scandal caused the loss of the most integrated of the Big 5, Arthur Andersen, and pushed governments to act. The impetus came from the US regulator with the Sarbanes-Oxley Act of 2002.
The steps taken by regulators in the English-speaking world was crucial. The fact that it is the Financial Reporting Council, the regulator of the audit profession in the UK, which is now pushing for the adoption of such a separation, leads many observers to believe that this separation will take now place.
Services 2.0
The consulting and auditing businesses were therefore separated for the first time.
Capgemini bought Ernst & Young’s consulting business, Sintegra bought KPMG’s and IBM Worldwide bought PwC’s. At Deloitte, there was no global split. One was announced in 2002, before being pulled in March 2003, including in Luxembourg. In France, however, consulting activities regained their independence under the name Ineum Consulting before evolving into Kurt Salmon and then Wavestone.
Locally, other arrangements were made. For example, in Luxembourg, PwC kept its consulting activities--local consulting as it was defined at the time, particularly strategic thinking and regulatory consulting--because they were marginal.
And also because there was already the question of reconstituting service divisions that would comply with the separation obligations.
Why was this? Because profitability was not the same. They were, at least at the time, generally significantly higher in advisory services. This difference has always existed and the whole balance of the system was based on the fact that auditing and consulting activities took turns, thus ensuring a certain balance in the profitability of firms.
These ‘new’ consultancy activities were initially developed around the skills of the audit profession, and therefore first of all towards corporate finance. In particular, they set up management control, reporting and account consolidation tools, among others. Then the services diversified, notably through acquisitions, to reach more business sectors, then CSR, strategy, data and others.
So much so that today the Big 4 have reconstituted consulting entities that compete with the sector leaders.
Audit, the ugly stepchild
How is the separation of these activities organised today?
On the face of it, it seems to be going well considering the lack of recent scandals. That is, with the exception of Wirecard, which was a scandal for EY Germany. In fact, EY is at the centre of all the separation speculation.
What you need to bear in mind is that the system in Europe is not based on strict separation, but on a mathematical formula laid down by Directive 2014/56/EU, which sets the percentage of advice that can be provided, subject to conditions, in addition to audit services. In short, a Big 4 firm needs to monitor the lifecycles of its audit and advisory services to balance its business model while complying with the law. It is a question of trade-offs.
What worries some observers--and justifies the FRC’s action--is that these trade-offs may be to the detriment of competition in the audit sector. In the face of dominant consulting, audit would become the poor relation within the Big 4 outfit. Indeed, audit firms are tempted to avoid bidding for potential consulting contracts. And some firms exclude these same firms from an audit contract for the same reasons. It is this risk of reduced competition--and ultimately reduced quality of audit output--that concerns regulators.
We need additional, cross-functional expertise
What concerns audit and consulting firms is whether the skills of an auditor are sufficient in a world that is becoming more heterogeneous and where business is becoming more complex.
, managing partner at KPMG Luxembourg, does not think so: “Additional, specialised and cross-disciplinary expertise is needed,” he says. And he takes as an example ESG, which is creeping into all the workings of companies and which requires an auditor to surround themselves with multidisciplinary teams of experts.
“And that’s how the Big 4 have grown over the years, developing new areas of expertise. [Developing] competence centres that will grow by continuing to provide audit support and by developing their own client base.” According to Capocci, “for this expertise to develop--and become profitable--it is necessary to develop a consulting offer”.
Capocci said that it would make no sense to separate the two. The auditor would be obliged to subcontract certain aspects of his audit because they do not have all the required skills. This will have a cost for the client. “Total auditor independence is possible when you are in an extremely simple business environment. From the moment you manage complex companies, companies that are multinational, that are varied in terms of sectors of activity, in terms of organisation etc., this will require specific expertise that it will be difficult to coordinate with subcontracting companies.”
Are the independence rules too restrictive? “These rules are extremely restrictive, but in the end, I think there are enough opportunities in the market to live with. And it allows us to feel comfortable with our level of independence, to avoid conflicts of interest while still having that opportunity to develop a very broad range of expertise that allows us to deliver quality for our clients.”
Limiting an audit firm to its scope? Capocci wonders whether this is really in the public interest.
For other observers, the ‘Chinese wall’ argument between auditing and consulting activities is “a red herring”. He says that “conflicts of interest have not disappeared.” More than the actual conflicts, it is the conflicts perceived by public opinion that are worrying. In the age of social networks, public opinion is quick to question all powers. A pressure that politicians and regulators have constantly in mind.
What about tomorrow? Officially, nobody wants to move. “But if one player moves, the others will move at the global level,” says one observer. In fact, , it is a safe bet that a domino effect would be set in motion.
The Luxembourg branches of Deloitte, EY and PwC declined interview requests.
This article was published for the Paperjam + Delano Finance newsletter, the weekly source for financial news in Luxembourg.. Read the original version of this article in French on .
Corrected to reflect Deloitte’s Ineum Consulting spinout only took place in France