In Conversation: Big Four audit firms conclude transition period of operational separation
Published: 10 October 2024
9 minute read
Listen to this 'In Conversation' podcast episode on the implementation of operational separation in the Big Four audit firms, featuring Kate O'Neill, Director of Stakeholder Engagement and Corporate Affairs, Sarah Rapson, Executive Director of Supervision, and Claire Lindridge, Director of Audit Market Supervision.
You can also listen on Apple Podcasts and Spotify.
Transcript
0:10
Hello there and welcome to another FRC in Conversation podcast.
0:14
My name is Kate O'Neill.
0:16
I'm the Director of Stakeholder Engagement and Corporate Affairs here at the FRC.
0:19
And today I'm joined by our Executive Director of Supervision, Sarah Rapson and the Director of Audit Market Supervision, Claire Lindridge. Welcome Sarah and Claire.
0:30
And I guess it's an important day today because we're talking about the results of the first period that we've asked the firms to do operate separation and of course, as a result of the CMA review.
0:44
But it's really the mark of a huge amount of work by Claire and her team in particular.
0:48
So can you remind us of why operational separation came about and why it's so important?
0:54
Thanks, Kate.
0:55
Operational separation of the audit practises of the four largest firms.
0:59
It's a major step forward in the reform of the audit sector.
1:02
It's a key element of the FRC strategy to improve the quality and effectiveness of audit in the UK.
1:07
Shall I just say a little bit about what it is and what it isn't?
1:09
I think it's important to note that despite the name Operational Separation, it's not full structural and legal separation of the firms.
1:16
The audit practise remains in the same legal entity as the rest of the business and that's important because it enables access to specialists from other services are important for audit quality.
1:25
It means that the whole firm is subject to independence and ethical requirements for audit independence and it increases the financial resilience of the audit practise as well as it's part of a larger diverse business.
1:36
But what it does mean, what operational separation does mean, is that the audit practise is appropriately ring fenced from the rest of the firm with its own independent governance.
1:45
And that makes sure that two things are true.
1:46
1 is that the people within the firm's audit practise are focused above all on delivery of high quality audits because it protects the auditors from that sort of of client service influence of the rest of the firm that could divert focus away from audit quality.
1:59
And secondly, the resilience of the firm's audit practise is improved by ensuring that no material structural cross subsidy persist between it and the rest of the firm.
2:08
Subsidy with talking about financial subsidy, right?
2:11
Yeah, absolutely.
2:12
And when you look at it from an outsider, it would be easy to think, you know, there may be more financially attractive parts of a large consultancy that can't be considered because, as you said, it's got to be in the public interest as doing good work as a professional.
2:27
So how is the operational separation being received by the firm, Sarah?
2:30
Because it's voluntary, right?
2:32
Hasn't been imposed on them, but they have signed up to it.
2:36
All four firms have generally welcomed it and embraced the challenges proposed.
2:39
And you're right, it was done on a voluntary basis.
2:42
We agreed a three-year transitional period with them and we're really pleased that all firms have met the deadline to implement the principles and they like the governance changes.
2:50
In particular, they like the real focus on audit culture and the wider ethical culture.
2:54
So yet really positive.
2:55
We're really pleased that some firms outside of the big four have adopted and adapted part of the governance aspects.
3:01
So for example, some of the other larger firms in the market have created audit boards which include independent non executives because they consider this to be valuable to their own firm.
3:12
I mean the word happy is probably a bit too qualitative, but are we pleased with the progress that the firms have made?
3:19
Yeah, we are pleased Kate, with the progress they've made in the first two years of transition.
3:23
We've yet to assess the transition year of course, but yeah, we're really pleased with the progress being made.
3:27
I'd like to particularly call out the focus that each firm has had on developing a specific audit culture within its overall firm culture.
3:35
Each of the firms have now got specific audit behaviours, which include things like the importance of challenge of management both within teams and management of the audited entities, and also professional scepticism and the consideration of the public interest.
3:47
So some real focus on having a separate distinct audit cultures as distinct from the rest of the firm reflects the importance of culture for the firms and organisations they audit.
3:57
There's not, as we all hate hearing box ticking.
4:01
It really involves rich, very involved conversations where the auditors are in a position of challenge.
4:07
Exactly.
4:08
Claire, what challenges do you think the firms have faced?
4:11
Because you've been here kind of at the very beginning of this process when this was coming to fruition and you saw how firms kind of were reacting to the idea of the operational separation.
4:23
That's right, Kate.
4:23
I've been since the beginning.
4:25
And look, the firms have done a huge amount of work to put this into place, both in getting ready for the start of the transition period and throughout the three years that we gave them to put in place the quite significant changes that they needed to do across their businesses and embed those in order to become properly operationally separate.
4:42
I'd say there's probably 2 main areas where the challenges have been greatest.
4:46
One is around the financial systems of the firms.
4:49
Most of the firms had not really had proper transfer pricing of the specialists that they use in audit before operational separation.
4:56
So those specialists still sit outside the audit practise, but now they're charged across into each audit team at an appropriate price that really reflects the value of that work that's being done.
5:05
And that took some time for the firms to a workout how to calculate that pricing in a fair and sensible way for the firm as a whole and then to make all the back office changes within their financial systems to actually make it happen.
5:16
The other big change that the firms have put into place is around the governance, and that's been challenging in different ways for different firms.
5:23
Audit firms, limited liability partnerships, they're not corporates, they're all structured slightly differently.
5:29
Some of them have got European and global governance as well, overlaying what is in place in the UK.
5:34
So for each firm, working out how to fit in the audit specific governance into the overall picture in a meaningful way was important.
5:42
One of the things that the firms thought was going to be difficult was actually identifying the extra non executives that they needed to sit on the audit board, what we call the audit non executives.
5:52
There was certainly a concern that all four firms go out to the marketplace at one time to recruit some quite senior individuals that actually might be challenging.
6:00
In the end, the firm's managed to get a Carter of really high calibre people to sit on these audit boards in relatively short order.
6:07
So that was was anticipated being a challenge actually turned out to be more straightforward and those audit non executives, as Sarah said, the governance has been really important and the firms have really welcomed it.
6:17
There's audit non executives that sit on the audit boards play a really important role in bringing that independent challenge to the audit practise, building on the I and E role that was introduced to the firms as a whole by the audit firm governance code.
6:28
So now we've got independent eyes and ears on the whole firm from a public interest perspective and also on the audit practises.
6:35
So I think that divide and conquer approach has been really powerful.
6:39
Sounds like it's been incredibly successful, although I'm sure that not every day of the last five years has felt like that on this very important project.
6:47
But what changes has operational separation led to in other parts of the audit market, Claire?
6:52
Well, the key thing, as Sarah referred to earlier, really is that some of the next group of firms have looked at operational separation and decided what might make sense for them, both in terms of remaining competitive in the market and also what advantages, what improvements and benefits will this bring for us.
7:09
And what we've seen most uptake of is the governance changes as the BDOGT and Mazars have all taken steps to increase the governance focus on their audit practise with some sort of audit board being created at all of those firms and the recruitment of some additional non executives to focus on those parts of the firms as well.
7:27
So that's the key thing that we've seen trickling down to the next layer of the market.
7:30
So what are the type of things that the audit boards have oversight of and really add the value as an A&E to well as well as being focused on day-to-day audit quality matters.
7:42
You know what firms big programmes that they have in place to ensure that audit quality is improving.
7:46
They're two of the things that I think have been really important are audit partner remuneration and admissions as an audit partner and then appointment of new heads of audits.
7:54
So an audit board is charged with ensuring that audit quality factors are given really high importance in the decision making when firms are thinking about their annual remuneration for audit partners and also when they're thinking about who should be admitted to the partnership to take on that important role as audit partners.
8:12
So if the audit boards don't look at individuals and decide their remuneration or individuals admissions, but what they do is they oversee the design of the process that people go through when those decisions are made to make sure that the appropriate focus on audit quality is there.
8:25
The other important thing this is a little more ad hoc for the audit boards is the role that they have in the appointment of new heads of audit.
8:31
And that's happened recently at several of the BIG4 firms as they've had changes of leadership at a whole firm level and that often cascades down into new heads of audit.
8:38
So the audit board is consulted on the appointment, on the individual who's going to be appointed as head of audit and will also have the opportunity to object.
8:46
So we've seen over the last 6 to 12 months, a lot of firms going through that process and the audit boards having oversight of it, which has been really important.
8:55
And Claire, have you heard anything from corporates, especially through their audit committee chairs, who are, let's face it, the main interface with audit firms in the work that they do?
9:06
What's been their reaction to operational separation?
9:09
Have they noticed it?
9:10
Have they seen it for the benefits that you've just described?
9:14
Well, that's a really good question, Kate.
9:16
Back in 2020, when we were first thinking about this, I think it's fair to say that the audit committees that we spoke to about it, they were probably a little bit worried that operational separation might reduce access to the specialists that are so crucial for audit quality.
9:29
And that was something that we heard loud and clear from them.
9:31
We reassured them that that was not the intention and that the whole point of operational separation, not structural separation, was that that access to specialists would be absolutely there.
9:40
More recently, like in the last six months or so, I've talked to a number of audit committees to ask them what they think of this.
9:46
And it's been interesting to hear that actually they're almost not noticing the operational separation in that they're not noticing any difficulty in in their audit teams getting the specialists they need.
9:56
Everything is running really, really smoothly.
9:58
So from a practical perspective, none of those worries came to fruition, which is great.
10:02
And I think they also appreciate the general improved focus of on audit quality that the firms have had as a result of operational separation, as I guess they're part of a corporate governance framework.
10:13
They're probably quite happy to see a framework not dissimilar being put into the audit firms.
10:18
Yeah, you're right.
10:19
OK.
10:20
So Sarah, what are the next steps for operational separation?
10:22
I mean, it sounds like it's been, I'm going to say, a huge success, but the work never stops, I suppose, as other firms, as Claire referenced, are looking to take on the challenges and hopefully the successes that have been undertaken by other firms.
10:37
So what's next?
10:38
So I would add credit actually to the firms for stepping in.
10:42
It is voluntary, the credit to the Big four and to the progress that they've made and actually credit to the other three who have taken part of that, that works for them, set up improvements to their own governance.
10:51
So really great progress and that's why it's important to discuss that at the moment.
10:56
So we've got a bit more work to do to assess the farm's final transition year and how they implement the principles over the coming months.
11:02
We will then publish a public statement on our assessment of the firm's compliance in the first half of 2025.
11:09
In the meantime, we expect the firms to continue to embed the principles into their audit practises, building on the focus of quality that we've seen over the past few years.
11:17
And with a fair wind, Kate, we anticipate that led to to put operational separation on a statutory footing will be included in the Argo bill in due course.
11:25
But that doesn't stop us from carrying on, carrying on to deliver what is actually a really good outcome following the CMA's market study.
11:34
Well, I like to end a podcast on such a positive note.
11:37
And also seeing the years of hard work from both Claire's team, but also, as you say, the stepping up of the firms on a voluntary basis is a real credit to the relationship between the FRC and the audit firms.
11:50
So thank you, Sarah.
11:51
Thank you, Claire, and well done for being able to mark this important time in the FRC's work with the firms in creating consistent audit quality, but also a real, as you referenced, audit culture that works to the benefit of its clients.
12:06
Thanks, Kate.
12:07
Thanks, Kate.