Chapter 3Structural and governance challenges in the Big Four firms
Introduction
3.1The structure of the large multidisciplinary professional services firms gives rise to two issues: firstly, the governance challenges that arise from the size of the partnership model of the Big Four firms (PwC, EY, Deloitte and KPMG), and, secondly, the conflicts of interest that arise from the provision of non-audit services to audit clients by the firms.
3.2The governance of an organisation is the system by which it is ‘controlled and operates, and the mechanisms by which it and its people are held accountable. Ethics, risk management, compliance and administration are all elements of governance’.
3.3Governance requirements may be externally mandated. For example, governments may require the disclosure of certain types of information to stakeholders, including regulators, shareholders and the public, to help those stakeholders make informed decisions, particularly where a market may not otherwise supply quality information.
3.4The Switkowski review of governance, culture and accountability at PwC Australia was a scathing indictment of governance and cultural failures at one Big Four firm. Nevertheless, broader questions remain about whether the governance structures at Deloitte, EY, KPMG and PwC are suitable for, firstly, the size of such economically significant partnerships and, secondly, their multidisciplinary firm structure spanning multiple professional services including accounting, audit, assurance, tax advice and a wide range of consulting services.
3.5Conflicts of interest may be viewed as both a governance and a structural issue. In terms of their impact on auditor independence and objectivity, they are necessarily serious given the central role that independent audit has in a capitalist economy.
3.6The first part of this chapter discusses the partnership model and governance. The discussion is limited to the Big Four audit firms because other large consulting firms such as Accenture, Boston Consulting Group and McKinsey and Company operate through company structures and are not involved in providing audit services.
3.7The second part of the chapter considers the conflict-of-interest issues arising from the current structure of the Big Four and then discusses the options put to the committee for reform.
What currently happens—Partnerships, their advantages and disadvantages, and issues arising from the current size and structures
3.8Partnerships are governed by the Partnership Acts in each state and territory and the rules of common law and equity. Statutes such as the Corporations Act 2001 (Corporations Act) regulate few aspects of partnerships. Hence, partnerships are not subject to the same transparency requirements and public scrutiny as corporations.
3.9Accordingly, the Australian Securities and Investments Commission (ASIC) does not have general jurisdiction over the activities of the Big Four firms. ASIC has some jurisdiction, such as where the Big Four firms have entities or individuals registered or licensed by ASIC within the accounting, audit, and consulting professions related to financial services.
3.10Partnerships are often established by a contract (sometimes called a partnership deed or agreement) defining the obligations and rights of partners. A partnership is not a separate legal entity, and partners may have unlimited or limited liability for the partnership’s debts, depending on the type of partnership. Each partner is both a principal and an agent of the business. Hence, each partner may incur liabilities on behalf of the business, and all partners share joint liability for debts and obligations.
3.11Partnerships provide advantages such as informality, limited disclosure requirements, smaller establishment costs, pooling of capital and simpler tax arrangements.
3.12Further advantages of partnerships may include the shared obligations that incentivise partners to act in the business’s best interests and the combined ownership and control of partners that creates an interest in overseeing each other. In this sense, ‘traditional partnership arrangements with unlimited liability and where partners have fiduciary obligations to each other…may even appear to provide greater theoretical protection or advantage to clients than the limited liability form’.
3.13However, partnerships can have disadvantages such as unlimited liability, limits on the number of partners, and partners having to share control.
3.14Beyond these general observations, however, concerns were raised about whether the partnership structures in the Big Four firms hampered the effectiveness of their governance arrangements.
3.15For example, the Society of Corporate Law Academics (SCoLA) indicated that ‘the size and scope of the large audit firms and the existence of extensive insurance indemnities may mean that the personal liability of partners and their resultant incentives to monitor each other may not work as effectively as it might in smaller partnerships’. These concerns were also echoed by Treasury.
3.16Treasury also noted that because the interests of owners and managers are aligned in a partnership, no regulator has the power to intervene in the operations of partnerships for accountability to stakeholders.
Governance structure options for the Big Four firms
3.17This section discusses options put to the committee on alternative governance structures for the Big Four firms, including:
partnerships size limits;
uniform regulation of partnerships;
corporate structure and governance requirements;
a Public Interest Entity designation of the Big Four firms;
a Public Interest Firm Code suggested by PwC; and
application of the Global Reporting Initiative Standards.
Partnership size limits
3.18Section 115 of the Corporations Act limits the size of partnerships formed to gain a profit to a maximum of 20 partners. However, Regulation 2A.1.01 of the Corporations Regulations 2001 allows for greater numbers in professional partnerships: for example, up to 400 for legal practitioners and up to 1000 for accountants. PwC Australia has approximately 800 partners. The PwC breach of confidentiality obligations focused attention on the problems associated with large partnerships and governance failures within such firms.
3.19The Treasury consultation paper queried whether the current partnership limits are fit for purpose for accounting firms.
3.20Both Brent Fisse Lawyers and Professor Andy Schmulow suggested the number of partners in accounting firms be limited to 100.
Uniform national regulation of large partnerships
3.21There was general support amongst some members of the Big Four for a review of partnership regulation.
3.22Deloitte supported the government considering the uniform regulation of professional partnerships, including ‘consistency across all professional partnerships included in Corporations Regulations 2001, Regulation 2A.1.01’.
3.23KPMG supported a national review of the regulation of professional partnerships and suggested the review consider overseas approaches, such as the United Kingdom’s Limited Liability Partnership model.
3.24EY submitted that the fragmented approach developed over past decades was a reason to support a single Commonwealth regulator to coordinate the regulatory framework for partnerships and professional services providers, along with the establishment of a partnership disciplinary board.
Corporate structure and governance
3.25Companies are incorporated in Australia under the Corporations Act. Relevant features of companies include the ability to:
operate a business through the use of a legal entity separate from its owners (that can sue, own assets and contract in its own name and can exist in perpetuity);
limit the liability of investors in a business enterprise for acts of the separate legal entity; and
separate ownership and management of a business enterprise and define their respective powers.
3.26The Corporations Act regulates the duties of officers, the formation and operation of companies, takeovers, and fundraising. The scope of regulation of companies depends on whether the company is listed on a stock exchange and the size of the company.
3.27The Corporations Act provides mechanisms to resolve differences in interests between management and stakeholders (such as shareholders) through:
Requirements relating to the provision of a range of information by the company to shareholders and the regulator (ASIC), including audited financial reports and a director’s report for public companies and large proprietary companies;
Requirements for public companies to hold an annual general meeting for management to be accountable directly to shareholders and answer queries.
Requirements to establish governance arrangements in the form of the appointment of director(s) to represent the interests of shareholders;
Directors’ duties which require directors to act in the best interests of the company.
3.28BDO, a mid-tier audit firm with a company structure, argued that companies have greater transparency and accountability obligations than partnerships. BDO noted that the obligations under the Corporations Act address entity reporting and transparency, executive accountability, whistle-blower policies and protections, and governance obligations.
3.29Chartered Accountants Australia & New Zealand (CAANZ) considered that the significance and scale of the Big Four firms means enhanced transparency through regulatory reporting requirements is appropriate, with due regard for the appropriate quantitative and qualitative reporting thresholds.
3.30The Community and Public Sector Union considered that partnerships have fewer reporting and transparency obligations than corporations, making it difficult to assess tax compliance.
3.31The joint submission from the Tax Justice Network, Tax Justice Network Australia and the Centre for International Corporate Tax Accountability and Research suggested that partnership structures mean the Big Four firms are mostly not subject to existing Australian Tax Office (ATO) corporate tax data reporting.
3.32However, the ATO pointed out that the Big Four firms file tax returns, and tax is paid by the partners:
Under Australia’s tax law, a partnership, unlike a company, does not pay income tax on its taxable income. This is because it is not a separate legal entity. Instead, each partner pays tax on their share of the taxable income of the partnership and must return that income in their own personal individual income tax return. Even though the partnership does not pay income tax, it too must file an annual tax return with the ATO.
Similarly, under Australia’s tax law, a trust is also not a taxpayer. Again, this means that the service trust does not pay income tax as separate legal entity and generally the beneficiaries of the trust must include their share of the trust income in their own personal income tax return.
3.33The ATO provided further information on how some partners share their income through Everett assignments:
It is a common practice for the partners in large professional firms to direct their share of income or profit from the partnership or a related service trust to taxpayers who are not partners of the firm through the assignment of all or part of their partnership interest 2 (commonly referred to as an Everett assignment), and the use of service trust arrangements 3. This assignment (or splitting) of income to other parties, will typically result in a portion of the income being taxed at a lower tax rate. Whether such arrangements are acceptable under the law or whether they constitute tax avoidance, will depend on the facts and circumstances of the case.
Under an Everett assignment a portion of the partner’s partnership asset is disposed of, and the disposal may be subject to capital gains tax. On 8 May 2018, the law was changed to limit access to the small business capital gains tax concessions relating to Everett assignments. The change may have discouraged some partners from entering into new Everett assignments.
3.34Dr Kelli Larson suggested imposing corporate governance principles on partnerships, such as disclosure of financial reporting and audit obligations.
3.35The Accounting Professional and Ethical Standards Board (APESB) noted that requiring the incorporation of the Big Four firms would result in significant taxation and operational costs and would require an appropriate transition period.
3.36SCoLA noted that while incorporation would put the Big Four firms under greater ASIC supervision, such a move should be accompanied by sufficient resources to conduct the supervision and enforcement.
3.37SCoLA also cautioned that if a problematic culture exists in an organisation, the corporate form alone cannot counteract it, as demonstrated by recent corporate governance failures seen in Australia.
Designation as a Public Interest Entity
3.38Evidence submitted to the committee suggested that an alternative to requiring structural change in the Big Four partnership model would be to classify those firms as Public Interest Entities (PIEs).
3.39PIEs are defined by the International Ethics Standards Board for Accountants (IESBA) as entities for which there is ‘significant public interest in the financial condition of these entities due to the potential impact of their financial well-being on stakeholders’.
3.40In practical terms, the following entities in Australia will generally satisfy the conditions in APES 110 (Accounting Professional & Ethical Standards 110) as having a large number and wide range of stakeholders and thus are likely to be classified as PIEs:
banks, such as authorised deposit-taking institutions and non-operating holding companies regulated by the Australian Prudential Regulation Authority (APRA);
insurers (including life insurers and private health), as authorised insurers and authorised non-operating holding companies regulated by APRA;
disclosing entities defined in Section 111AC of the Corporations Act ;
superannuation entities and trustees regulated by APRA; and
other issuers of debt and equity instruments to the public.
3.41APESB suggested that the PIE approach would allow the Big Four firms to retain their partnership structures and yet be treated as reporting entities with greater transparency over their finances, operational practices and remuneration arrangements.
3.42APESB suggested this change could be implemented by:
mandating the categorisation of large firms with substantial revenue, assets and workforces as PIEs;
requiring large firms to prepare general purpose financial reports, including the disclosure of remuneration and information relating to their operations, and subject them to audit or alternatively adopting the disclosing entities disclosure requirements of the Corporations Act 2001; and
adopting remuneration and accountability practices observed in APRA-regulated listed entities.
3.43APESB added that the proposed PIEs approach could be informed by the ‘UK reporting requirements for partnership structures in the Limited Liability Partnerships Act 2000, the UK Audit Firm Governance Code and the Principles of Operational Separation’.
3.44PwC noted that when IESBA adopted the PIE concept, ‘IESBA concluded that…determining which entities should be treated as PIEs should be largely left to local regulators or other authorities.’
3.45The Australian Shareholders Association (ASA) supported the suggestion to treat the Big Four firms like PIEs and noted that it benefited from being an existing framework for which the implementation challenges are known. The ASA agreed that a PIE approach could provide appropriate transparency while allowing the Big Four firms to retain the partnership structure.The ASA also supported applying the PIE approach to other largeprofessional services firms.
Public Interest Firm Code
3.46The idea of a Public Interest Firm was raised by PwC, who argued that the development of a mandatory Australian Public Interest Firm Governance Code (PIF Code) would provide more confidence in the professional services industry. PwC suggested that the PIF Code expand on overseas experience, such as the Audit Firm Governance Code implemented in the United Kingdom.
The Global Reporting Initiative standards
3.47The Global Reporting Initiative (GRI) provides businesses and other organisations with a global common language to communicate and take responsibility for their impacts. The GRI developed the GRI Standards which more than 14,000 organizations use in over 100 countries to implement sustainability reporting.
3.48KPMG supported the application of the GRI transparency standards in Australia for large government suppliers. KPMG suggested that participation on a government panel should be conditional on transparency, such as requiring participants to prepare an impact plan under the GRI Standards. KPMG noted that at the time of its submission, it was the only Australian Big Four firm that prepared its impact plan under the GRI Standards.
3.49The Community and Public Sector Union (CPSU) supported the use of the GRI Standards because they:
are highly regarded internationally;
are supported by global corporations and investors;
include greater detail about tax practices and a company’s workforce;
mandate an explanation of a company’s overall strategy on tax and differences between statutory versus effective tax rates;
would remove barriers to addressing corporate tax avoidance; and
are not expected to impose significant compliance costs as they are similar to what multinational corporations already do under the Organisation for Economic Co-operation Development’s base erosion and profit-shifting initiative.
Committee view on the appropriate governance requirements for large accounting partnerships
3.50The committee acknowledges that the impetus for this inquiry was the manifest cultural and governance failures at PwC.
3.51That said, much broader concerns were raised in evidence that the current governance mechanisms in the Big Four professional services firms are simply inadequate for firms that number several hundred partners and are allowed to have up to 1000 partners. Such large partnerships are too large for meaningful engagement with the concepts of joint liability, accountability and ethical oversight.
3.52It is clear to the committee that in large partnership structures, even without the corrosive cultural issues that were manifest at PwC, it is not possible for a partner to exercise the necessary oversight of other partners. In terms of governance and accountability, this is clearly unacceptable.
3.53The committee therefore notes and supports the recommendation by the Senate Finance and Public Administration Committee for the Australian Government to commission an appropriate body to review and make recommendations on the long-term goal of the regulation of large partnerships.
3.54The committee recommends that the Australian Government implement the recommendation of the Senate Finance and Public Administration Committee that the government commission an appropriate body to review and make recommendations on the long-term goal of regulation of large partnerships, including in relation to: the appropriate regulator and its powers, applicable governance principles, transparent reporting obligations, penalties for breach, and a roadmap for implementation given the complexities of overlapping jurisdictions.
3.55However, a review is a longer-term piece of work and other options may offer more immediate results for improving governance and accountability.
3.56Therefore, the committee is of the view that requiring the large accounting partnerships to implement nationally consistent reporting and accountability requirements would be an effective means of improving governance, and rebuilding trust and credibility.
3.57The committee considers the PIE obligations and the Corporations Actrequirements for governance and accountability, especially in relation to the liability of the Chief Executive Officer, have merit. Further, they could be achieved without the disruption that could be caused by requiring a change in firm structure.
3.58There is also the potential to augment these measures with a mandatory PIF Code and/or the Global Reporting Initiative Standards.
3.59Designating the Big Four firms as PIEs through legislation or regulation (as foreshadowed in APES 110) would help achieve greater transparency and accountability within the current partnership models of the large professional services firms.
3.60Ultimately, the principles of shared liability and joint profit incentive which are inherent to partnerships are not designed to accommodate partnerships in the size that currently exists within the Big Four firms. In partnerships comprised of 1000 individuals it is functionally impossible for partners to maintain an adequate knowledge of each other’s ethical behaviours and professional accountability. This fundamental lack of visibility actively promotes a culture of plausible deniability in which partners have an ongoing profit incentive to remain unaware of questionable ethical practices which may drive profit, as all partners share in the profits won as a result of such work. Furthermore, the knowledge that potentially innocent partners would be adversely financially affected in the event of poor firm performance as a result of publicised partner misconduct disincentivises whistleblowing within the firm, further undercutting the capacity for accountability and transparency.
3.61The committee recommends that the Australian Government reduce the allowable size of partnerships for accountants to a maximum of 400 partners, to align with the limits of legal partnerships. The government should establish a suitable transition period of up to 5 years for this change to enable the implementation of this recommendation whilst minimising disruption to the sector. A review of progress to this end should be conducted after 2 years, if at that time the entity has not chosen to incorporate.
3.62The committee recommends that the Australian Government consider increased accountability and response mechanisms, including a suitable penalty regime calibrated to the seriousness of the misconduct, for partnerships who have engaged in misconduct.
3.63The committee recommends that the audit, accounting, and consulting partnerships of firms with greater than 3000 staff be required to implement the Corporations Act 2001 requirements for governance and accountability, if appropriate through the adoption of the Australian Securities Exchange Corporate Governance principles. This should include the requirement for multidisciplinary partnerships to prepare their own general purpose financial reports, including remuneration disclosures and other obligations which may be applicable to partnerships. The government should review the operation of this measure within 3 years, with a view to extending its scope to mid-size partnerships.
3.64The committee recommends that the Australian Government enhance the transparency of large professional service firms by designating them as Public Interest Entities and requiring them to:
subject them to audit if they are not already subject to these requirements, which would be filed with ASIC and be available for public inspection; and
potentially be required to implement the Global Reporting Initiative Standards or the Public Interest Firm Code.
3.65The committee recommends that the Australian Government ensure that the financial statements disclosure requirements cover all relevant fees (that may raise a conflict of interests) paid to the entity’s auditor for audit and non-audit services. This should cover any single entity and their associated entities in Australia or overseas.
The multidisciplinary structures of the Big Four firms
3.66The first part of this chapter considered some of the governance issues arising from the size, scale and partnership model of the Big Four professional services firms. The remainder of the chapter considers the more discrete issue of the conflicts of interest arising from the provision of non-audit services to audit clients by these multidisciplinary firms.
3.67The committee received evidence from the Big Four firms espousing the benefits of the multidisciplinary structure. By contrast, other inquiry participants argued for various forms of separation between the audit arm of the firms and the provision of other services to deal with conflicts of interest.
3.68Existing regulatory and self-regulatory arrangements for addressing conflicts of interest arising from providing audit and non-audit services to the same client are discussed in chapters 4 and 5.
3.69This section summarises the conflict-of-interest issues arising from the current structure of the Big Four. It then discusses the options put to the committee for reform, namely operational separation and structural separation, and finishes with the committee’s views and recommendations.
Conflict of interest issues from a multidisciplinary structure
3.70Treasury identified the conflict-of-interest issues inherent in the current multidisciplinary model:
‘[j]oint governance and sharing of profits between audit partners and non-audit partners may create conflicts of interest which pose risks to auditor independence’; and
existing policies and regulations may not be effective in ‘separating the provision of audit and non-audit services in multi-disciplinary firms, particularly in the context of managing conflicts of interest to maintain auditor independence and objectivity’.
3.71Mr Doug Niven, Chair and Chief Executive Officer, Auditing and Assurance Standards Board, drew attention to two complications arising from the multi-disciplinary firm model, both of which have been raised internationally:
a focus on audit quality may be weakened as the size of the non-audit services grows and leadership of the firm comes from the non-audit areas; and
if the non-audit business areas become larger and generate greater revenues and profits, there may be an incentive to focus greater attention on the non-audit areas and less on audit.
3.72By contrast, APESB noted that audit services appear to be profitable and, therefore, may not be used as loss leaders for non-audit services:
In the December 2019 PJC inquiry into the regulation of auditing, it was noted from the firm leaders’ statements that auditing is profitable. At the time, ASIC obtained information from the firms, indicating that audit services are profitable. An Australian Financial Review article in 2019 also revealed that the gross margins for auditing ASX 300 clients were up to 80%.
Arguments for the current multidisciplinary firm model
3.73Currently, the Big Four firms operate a multidisciplinary model under the self-regulatory independence standards set out in APES 110.
3.74The APES 110 standard requires firms to identify threats to audit independence and:
take actions such as making appropriate safeguards; and
address situations where the threats cannot be eliminated, or there can be no safeguards to reduce them to an acceptable level.
3.75Deloitte, EY and KPMG all argued that the current multidisciplinary structure of their firms is vital in ensuring the cost-effective delivery of high-quality audits due to the availability of all the required specialists on demand at short notice when matters requiring their expertise arise while executing audits.
3.76BDO argued that multidisciplinary firms are needed to manage audit complexity, provide career opportunities for specialists, and maintain competition:
Audits today are increasingly complex and require inputs in excess of traditional auditing skills. Given the specific knowledge and skill auditors require to perform their role, it is unrealistic to expect them to also be across all the legal, technical and organisational requirements of an audit without assistance from specialists. A multi-disciplinary approach is required to deliver a high-quality audit, as auditors must be able to draw on the deep expertise and skills of specialists in other areas, such as taxation, valuations, and complex financial reporting matters (such as International Financial Reporting Standards), to deliver what is required for each unique engagement. If audit-only firms were to engage the services of external experts in other disciplines to obtain the additional expertise they need to deliver an audit, this would come at an additional cost to the firm. This cost, by necessity, would be passed on to clients of audit-only firms, resulting in significant increases in audit engagement costs.
3.77The Institute of Public Accountants (IPA) supported retaining the multidisciplinary structure of the professional services firms because:
requiring the separation of non-audit and audit functions of the Big Four firms would significantly impact the profession;
isolated egregious behaviour does not justify government intervention to separate the firms; and
without identifying a systemic issue to remediate, splitting audit and non-audit functions would be unnecessary, unproductive and costly.
Operational separation of audit from other disciplines
3.78The first reform proposal put to the committee was operational separation, which would implement a prohibition on firms providing audit and other consulting services to the same client.
3.79Professor Graeme Samuel argued that an inherent conflict of interest exists when a firm supplies both audit and non-audit services to the same corporate organisation. Professor Samuel’s view was that this ‘cannot be satisfactorily overcome by the application of “Chinese walls”’. He therefore proposed:
…audit firms or their associated entities (Australian or international) should be prohibited from deriving income from non-audit services provided to the audited corporate organisation, including all associated entities both in Australia and internationally. This prohibition can be simply effected by ASIC in the conditions that it could impose on registration of auditors.
3.80The Australian Shareholder Association supported the approach proposed by Professor Samuel, submitting that a prohibition on a firm (and its associates) providing remunerated services to the same corporation (and its associates) that the firm is auditing could ‘be achieved by defining the list of services which an auditor can provide’.
3.81Professor Samuel also noted that the financial impact of this operational separation should be minimal as ‘it would simply result in the reallocation of non-audit services amongst consultancy firms’.
3.82This seems likely given that the APESB indicated that the provision of non-audit services to audit clients is already a small and declining portion of the revenue earned by the Big Four firms, with the evidence indicating:
audit services make up about 15 per cent of a firm’s revenue;
non-audit services to audit clients lead to 5 to 7 per cent of revenue; and
non-audit services to non-audit clients provide 75 per cent of revenue.
3.83APESB suggested that if operational separation is to be pursued, the government could consider the United Kingdom approach, ‘where a virtual separation of the audit business and the firm’s other businesses has been achieved by the establishment of separate governance and operational structures’.
3.84Mr Mark Babington, Executive Director of the United Kingdom Financial Reporting Council (UK FRC), updated the committee on the implementation of operational separation in the United Kingdom:
The firms have been implementing operational separation progressively from 2021. By the end of this year, the implementation period will be complete...The large firms are able to demonstrate that their audit business is viable and sustainable and pays its own way. We’ve also ensured we have a regime around the provision of non-audit services that mitigate threats to independence.
3.85In October 2024, the UK FRC announced that ‘the four largest audit firms (Deloitte, EY, KPMG, PwC), have concluded the transition period of operational separation’. The UK FRC identified the changes that the Big Four firms have made during the transition period:
Throughout the three-year transitional period, all four firms have made significant improvements to their governance to prioritise the delivery of audit quality. This includes the creation of independent audit boards chaired by Audit Non-Executives, improved transparency on financial transactions between the audit and non-audit business, and greater accountability at firm level for the delivery of operational separation outcomes. The firms have also developed audit specific cultures, with behaviours focussed on challenge, openness and professional scepticism.
3.86The IPA submitted that if more restrictive controls are considered appropriate, a preferred solution would be the operational separation of audit services and non-audit clients. The IPA suggested that operational separation ‘would avoid a perception that commercial pressure from non-auditing revenue might impact the provision of auditing services, without depriving each service of the benefits of co-location in the one firm’.
3.87The committee did receive some criticism of operational separation. Professor Allan Fels preferred structural separation (see next section) because he considered that operational separation had the following issues:
…there are major complications, pitfalls, costs and inconveniences in all compromise measures that are sometimes proposed as an alternative such as internal separation of the functions within one firm. The conflicts can never be entirely resolved and where they go closer to being eliminated (or looking as if they are nearly eliminated) the rules and arrangements are costly to operate with considerable external oversight required to ensure compliance. A clean, clear, sensible solution is preferable.
Structural separation of audit from other disciplines
3.88Professor Fels noted that auditing is critical to the operation of a market system and that audit failure has substantial economic and social consequences. He pointed out that audit failure continues to be a factor in corporate crashes and that regulators consistently find problems in audit reviews’.
3.89Professor Fels argued that auditors should not have, nor appear to have, conflicts of interest, but that cannot be avoided when they provide auditing and consulting services to the same client.
3.90Consequently, Professor Fels supported the structural separation of audit from non-audit services within the Big Four firms. He also suggested that structural separation ‘is far simpler and more effective than alternative methods of dealing with the conflicts of interest that inevitably arise when auditing and non-auditing work are offered by the same firm’.
3.91The CPSU supported structural separation to remove conflicts of interest. Noting that projects within some Big Four firms to structurally separate had failed, the CPSU suggested that structural separation may require government intervention. The CPSU indicated that the limited growth potential of audit functions may have been a contributing factor:
Opposition to a separation is because audit functions have been relatively low growth compared to high growth non-audit functions like consulting. The financial incentive structure of the Big Four, such as payments to partners and eligible retired partners, underpinned by cross-subsidisation, means there will be significant resistance and the partner structure will make it difficult to get agreement.
3.92By contrast, Professor Samuel argued that ‘proposals to require structural separation of audit services and non-audit services into separate organisations are draconian overreach, impractical and ineffective’:
They cannot properly be effected with Australian firms having global associations — the suggestion that Australia might ‘lead the world’ with a requirement of structural separation is unreal and a tacit acknowledgement that the proposal is impractical and ineffective.
3.93SCoLA noted that structural separation may give rise to ‘complicated issues about who owns and/or controls the separated bodies and whether there has actually been an effective separation and demerger or not’.
3.94Dr Simon Longstaff, Executive Director, The Ethics Centre, drew attention to a potential downside of structural separation in that the consulting side may be more market-driven because it would be detached from the professional integrity constraints of the professional accounting bodies:
The other thing about the downside of structural separation could be that you lose that professional commitment. If you just say, ‘They’re going to be completely different,’ then you'd say, ‘One is going to professions and the other is going to be the market.’ That might be the right outcome, but I think we should also understand that that could be an unintended consequence of structural separations.
3.95The Public Interest Oversight Board, an international body that oversees standards setting to maintain confidence in financial markets, had concerns about structural separation because:
…audit firms need lots of other skills and specialties. Firstly, for example, in the audit of mining, which you have a lot of in Australia and here in South Africa, in the audit of a mining company there are experts and specialists necessary—geologists and others. In the audit of an insurance company you need actuaries. The auditors have all those skills. They also use those skills or similar skills in their advisory side. They are already structured separately in legal entities.’
3.96Ms Kristin Stubbins, former acting CEO of PwC, suggested that the potential for market forces to drive separation without government intervention should also be considered.
Committee view
3.97The committee notes the ongoing concerns expressed about audit independence within the Big Four firms: firstly, the current situation where the Big Four firms can provide both audit and non-audit services to the same client; secondly, the dominance of consulting revenue in the Big Four firms, providing incentives for the consulting side of the firms to dominate decision-making; and thirdly, the tensions between the consulting side of the business operating as market actors driven by self-interest and the auditing side of the business, which must be driven by putting the client’s needs first (discussed in Chapter 6).
3.98The committee notes the arguments made by the Big Four firms for maintaining the multidisciplinary status firm model, particularly the benefits that audited companies derive by the auditors having access to a wide range of personnel with different skill sets within the multidisciplinary firms themselves.
3.99The committee acknowledges the self-regulatory independence standards and mitigation actions set out in APES 110 cover a wide range of circumstances that might threaten audit independence.
3.100However, the committee agrees with Professor Graeme Samuel, a former Chair of the Australian Competition and Consumer Commission (ACCC), that these conflicts and their impact on the integrity of the audit service cannot be satisfactorily overcome by the current internal application of ‘glass walls’ by the firms themselves.
3.101The committee reiterates again the evidence from numerous inquiries over the years about the vital importance of auditing to the operation of a market system.
3.102As another former ACCC Chair, Professor Alan Fels, noted, shareholders, investors, consumers, suppliers, the government and the community depend upon audit integrity. If audits fail or are compromised, billions of dollars can be lost, and trust in the economic system will be weakened.
3.103The committee therefore considers it essential that auditors should not have, nor appear to have, conflicts of interest, whether actual or potential.
3.104It is undeniable that an inherent conflict of interest exists when a firm supplies both audit and non-audit services to the same entity.
3.105Professor Samuel AC commented in his Supplementary Submission to the Inquiry: ‘The conflict of interest in a single firm providing both audit and non-audit services to the same organisation must inevitably impact on the integrity of the vital audit service’. He suggested that such built in conflicts of interest could be prevented by requiring that firms choose to provide either audit or non-audit/consulting services to any one client. This is a solution to the challenge of preventing structural conflicts of interest in multidisciplinary entities.
3.106In this regard, the committee is mindful of the data provided by the APESB indicating that the provision of non-audit services to audit clients only represents about 5 to 7 per cent of revenue and appears to be declining. These figures support the proposal put forward by Professor Samuel AC because, as he argues, the financial impact of operational separation should be minimal as it would simply result in the reallocation of non-audit services amongst the multidisciplinary firms.
3.107The practical application of operational separation would involve a prohibition on audit firms or their associated entities (Australian or international) deriving income from non-audit services provided to the audited corporate organisation, including all associated entities both in Australia and internationally.
3.108The committee observes that the choice between structural and operational separation is challenging, and notes that submitters such as Professor Fels made persuasive arguments for structural separation. However, given the global nature of the multidisciplinary firms, it is unclear how such changes would be feasible.
3.109Further, the committee is mindful of the need to ensure competition and productivity, and to maintain stability and reduce risks. The committee suggests further work is needed by an appropriate body to consider long-term options and potentially develop other approaches for government to consider as the sector continues to manage changes to the market.
3.110Finally, the committee notes that operational separation has already been implemented in the United Kingdom. Further, the evidence from the regulator in the United Kingdom indicated that, during the implementation period, all four multidisciplinary firms made significant improvements to their governance arrangements to prioritise audit quality.
3.111Given this encouraging precedent and noting the minimal financial disruption that it would entail, the committee therefore recommends the implementation of operational separation to prevent audit firms or their associated entities (Australian or international) deriving income from non-audit services provided to the audited corporate organisation, including all associated entities both in Australia and internationally.
3.112The committee recommends that multi-disciplinary large accounting firms (and their associated entities both in Australia and internationally) should not be permitted to supply both audit and non-audit/consultancy services to the same client (and their associated entities both in Australia and internationally).
3.113The committee recommends that multi-disciplinary large accounting firms (including those required to lodge annual transparency reports under section 332A of the Corporations Act 2001) should be required to implement operational separation of their audit practice from their non-audit practice. The principles of operational separation should be materially consistent with those applying in the United Kingdom or other global best practice.
3.114The committee recommends that the Australian Government legislate to give further powers to the Australian Securities and Investments Commission to oversee audit to cover all partners within multidisciplinary firms regardless of which part of the firm they work in, as required in the UK Financial Reporting Council Audit Firm Governance Code.