Partner Paul Brehony and Counsel Kate Gee explore the unintended consequences of attempts to end the dominance of the ‘Big Four’ in The Law Society Gazette

By Paul Brehony & Kate Gee

Partner Paul Brehony and Counsel Kate Gee discuss whether regulatory changes will have the intended outcome of ending the dominance of the ‘Big Four’ accountancy firms or whether they will in fact present further obstacles to ‘challenger’ audit firms, in The Law Society Gazette and Accountancy Daily.

Paul and Kate’s article was published in The Law Society Gazette, 1 November 2021, and can be found here. A version of this article was also published in Accountancy Daily, 9 December 2021, and can be found here.

In their efforts to break the dominance of the Big Four in the UK’s audit market, mid-tier accountancy firms are facing increasing regulatory pressure. In 2019, the Competition and Markets Authority (CMA) issued a landmark report on the UK’s audit market, calling for smaller “challenger auditors to shake up the market and end the dominance of the Big Four” in the wake of the collapse of Carillion and BHS. However, those same challenger firms are now themselves encountering greater regulatory scrutiny as they conduct increasingly complex audits in a more stringent regulatory environment – often without historic advantages at the scale that Big Four enjoyed.

In 2019, the CMA acknowledged that it would take time to build up the capacity of smaller firms to audit the largest corporations. At the time, the Big Four – PwC, KPMG, EY and Deloitte – audited 97% of FTSE 350 companies, collecting 99% of their audit fees.

The CMA’s 2019 report stated that, “More choice and competition for the audits of big businesses can and should drive up their quality, but the barriers to entry for ‘challenger’ audit firms are currently large.” The report suggested that it was “widely accepted that challenger firms do not currently have the capability to audit the largest, most complex companies at the top end of the FTSE 350. This is in part because of the size of the audit teams and international networks required to carry out these audits and, in some cases, because the challenger firms do not have the required sector or other expertise.”

The challenger audit firms faced what the CMA called a “chicken and egg” problem. Those firms could not win the audits of leading companies without the necessary track record, but they could not gain that experience without being instructed to conduct the big-ticket audits. To address this problem, the CMA recommended “mandatory joint audit[s], to increase the capacity of challengers, to increase choice in the market and thereby drive up audit quality. Challenger firms should work alongside the Big Four in these joint audits and should be jointly liable for the results.”

Increase of investigations into mid-tier firms

Yet, just two years on, the Financial Reporting Council’s (FRC) growing number of investigations into mid-tier challenger audit firms raises difficult questions. The FRC recently announced that it is investigating the 2020 audit of the fashion company, French Connection. That audit was conducted by the mid-tier accountancy firm Mazars. This is just the latest of a series of FRC investigations into the activities and conduct (or apparent misconduct) of mid-tier accountancy firms such as Crowe and Grant Thornton.

It now seems that the UK Government’s aspiration to disrupt the domination of the Big Four may in reality be having the unintended consequence of transferring disproportionate regulatory pressure and scrutiny on to the challenger firms, while also exposing them to greater litigation risk before they have developed the robustness that comes with experience of and exposure to larger audits. For example, the FRC found that one in three of Mazars’ audits required “more than limited improvements,” which suggests that investigations may continue for some time.

Continued scrutiny on the Big Four

The FRC’s increased focus on mid-tier auditors does not imply that the regulator is no longer investigating the Big Four. Indeed, just last August, the FRC fined KPMG £13 million and ordered it to pay over £2.75 million in costs as a result of its role in Silentnight’s 2011 insolvency. KPMG was found to have facilitated a potential client, HIG Capital, acquiring Silentnight – but without the burden of its £100 million pension scheme. By doing so, KPMG was considered to have preferred the interests of HIG, even though these were “diametrically opposed” to the interests of KPMG’s actual client, Silentnight. Elizabeth Barrett, of the FRC, said that “KPMG and [the KMPG partner leading the matter] Mr Costley-Wood compounded their serious misconduct by advancing a defence to proceedings which was partly untruthful and by failing to co-operate”.

Of course, such strident regulatory scrutiny often leads to litigation, which can be as onerous – if not more so – than any fines imposed. The plain reality is that the Big Four firms are better able to absorb large fines and finance complex litigation than their mid-tier competition: something that was specifically cited as a barrier to entry for challenger firms in CMA’s 2019 report.
That report noted that a “number of challenger firms have suggested that FRC enforcement activity has raised the barriers to them competing for FTSE 350 audits. Crowe told the CMA that ‘one of the principal supply side barriers they have observed was the ‘additional risk and exposure to non-Big Four firms from being caught in litigation and also regulatory enforcement”. The inference is that, given their size and financial resources relative to the Big Four, potential reputational damage, fines and/or litigation arising out of any enforcement action would have a disproportionate impact on challenger firms which in itself may deter them from taking the opportunity to bid for FTSE 350 audit instructions.

ARGA: what does the future hold?

The FRC is shortly due to be replaced by a new regulator, the Audit, Reporting and Governance Authority (ARGA). The creation of this new regulator was prompted by a damning 2018 independent review into the FRC. AGRA looks set to wield enhanced investigatory and enforcement powers, as proposed by a March 2021 government white paper, “Restoring trust in audit and corporate governance”.

There is a real risk that ratcheting up the regulatory pressure will drive mid-tier challenger firms away from working on major audits, thereby undermining the government’s stated objective in relation to the predominance of the Big Four. A couple of years ago GT withdrew from audit services altogether (or purported to). The reality may be that tighter regulation and increased regulatory scrutiny – and the significant litigation risk inherent to major audits – could make auditing the largest companies simply too big a risk for mid-tier challenger firms to take on.

To address these challenges, it may be that some mid-tier audit firms will seek to grow their capacity internally, while others might seek external investment. Ultimately, the solution to the intractable problems of scale and expertise faced by these smaller challenger firms may lie in mergers. In 2019, audit firms BDO and Moore Stephens led the way, by merging to form BDO as a substantial challenger to the Big Four. As regulatory risk increases, other challenger firms may soon consider strategic mergers as a way to develop the scale and expertise they need to compete at the top table.

Litigation risk

Claims arising out of the increased scrutiny on the audit profession are increasingly common. Some recent examples include the following:

• According to a 2018 report by the FRC into the role of BHS’s former auditor, PwC, the company’s audited accounts were misleading and featured unrealistic forecasts before Sir Philip Green sold the business for £1 in 2015. The PwC partner who signed off on the accounts was banned from the profession for 15 years.

• KPMG currently faces a £250m claim for alleged negligence relating to its audits of Carillion before its collapse in 2018. Funding has been obtained for the claim which is brought by liquidators working for the Government: the first time that such a claim has been made in the UK. The official receiver has claimed that Carillion’s board of directors believed that the business was “profitable and sustainable” as a result of KPMG’s audit report.

• Grant Thornton also faces a £200m claim brought by the administrators of Patisserie Valerie. Damages are being sought in relation to the firm’s audit reports for the period September 2014 to September 2017. The company collapsed in 2019 after the discovery of a £40m accounting fraud involving false invoices. A subsequent investigation by KPMG has found evidence of ‘devastating’ fraud and ‘very significant manipulation of the balance sheet and profit and loss accounts’.

• The administrators of JD Classics, a racing car dealership, have sued PwC for allegedly failing to spot fraud that resulted in losses of over £41m.

• There is a potential £1bn claim against EY for its audits of NMC Health, the recently-collapsed FTSE 100 hospital operator.
We anticipate that audit reform and increasing regulatory scrutiny will continue to give rise to claims for professional negligence, where a firm has not provided its services with reasonable care and skill. In that context, raising the bar in terms of regulation will inevitably have an impact on the standards against which a claim for civil liability will be measured. Judgments like that handed down by the UK Supreme Court in Manchester Building Society (MBS) v Grant Thornton UK LLP [2021] is widely considered to have broadened the scope for losses for which civil liability may arise in a claim against auditors, holding that, “in [their] view, in the case of negligent advice given by a professional adviser one looks to see what risk the duty was supposed to guard against and then looks to see whether the loss suffered represented the fruition of that risk”. These factors, together with the rise of group litigation in the UK and the increasing availability of litigation funding, combine to significantly increase the likelihood of claims being brought in the civil courts against auditors and accounting firms.

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