The ‘big 4’ accounting firms often consult for the same clients they audit. Should that be allowed?

Public trust in the auditing profession is under intense pressure. A series of high-profile scandals, both in Australia^[1] and overseas^[2], has severely damaged its reputation.

This week, Australia’s corporate watchdog – the Australian Securities and Investments Commission (ASIC) – put the entire sector on notice^[3].

In a letter to auditors on Wednesday, ASIC announced it would soon commence a new data-driven surveillance of auditor independence and conflicts of interest. Put simply, any practices that could compromise the integrity of auditing work.

The move comes amid longstanding calls for stronger regulation. Some have gone as far as to call for auditors – particularly the “big four” – to be banned^[4] from offering consulting services to their audit customers. Why? Fears it helps companies unethically game the system.

But our recent research^[5], which specifically examines chief executive pay, offers an alternative perspective and suggests we should tread carefully.

Read more: A year after the PwC scandal, the furore is gone – as well as any real appetite for structural change^[6]

Objectivity and independence

The “big four” – PricewaterhouseCoopers (PwC), Ernst & Young (EY), KPMG and Deloitte – are the world’s largest professional services firms. They offer services in auditing, consulting, tax and advisory services.

Known for their extensive resources and global reach, these firms serve major clients, including many publicly listed companies and governments.

However, some have raised concerns about potential conflicts of interest that may arise when these firms provide both consulting and auditing to the same client.

Auditing is the process of examining a company’s financial statements and processes to ensure both accuracy and compliance with accounting standards.

Conducted by external auditors, it’s meant to give investors, regulators, and the public confidence that a company’s financial picture is accurate and trustworthy.

The key worry is that offering both services risks compromising an auditor’s objectivity and independence.

Auditors may be incentivised to shy away from scrutinising their clients too closely, if it helps preserve lucrative consulting contracts.

How much money should the boss make?

Professional services firms, including the big four, are often engaged as external consultants to help decide on “executive compensation” – how much a company’s chief executive should be paid.

Chief executive pay is highly contentious. They can earn staggering amounts of money, which can sometimes appear disconnected from how well a company is actually performing and what’s in its shareholders’ best interests.

Compensation consultants are hired to help structure these pay packages, ideally by setting up performance targets that align chief executives’ incentives with shareholder value.

The idea is that if you don’t meet a certain goal as the boss, you should miss out on being paid for it.

But these consultants can also be a part of the problem. As chief executives can influence whether a particular consultant is hired or retained, consultants might design favourable contracts to increase their chances of getting hired again.

How? By setting up targets that are easy to hit, or vague enough to avoid true accountability.

Such accountability in executive compensation is extremely important. How much those at the top get paid should reflect the quality of their decisions.

Without proper oversight, pay structures risk incentivising quick wins instead of long-term growth, which could potentially harm investors, employees and the company’s future.

To solve this problem, you need transparent performance metrics. This makes it easier for shareholders to see whether chief executives are truly earning their pay.

When executive compensation consultants do their job well, such transparency gets built in. So how does the big four score?

What we found

Our study^[8], published in the Australian Journal of Management, analysed chief executives’ compensation structures in a sample drawn from the 500 largest companies listed on the Australian Securities Exchange (ASX), between 2005 and 2019.

We found that the big four, when engaged as compensation consultants, appeared to uphold more rigorous standards than their smaller counterparts.

For example, big four firms were more likely to recommend including performance measures like “relative total shareholder return”, which takes the performance of a company’s competitors into account.

This can reduce the likelihood of “pay for luck” – paying a chief executive extra when a company performs well simply due to market-wide factors, such as movements in commodity prices or currency exchange rates.

Non-big four consultants, on the other hand, showed a tendency towards less clearly defined targets, which can open the door to less accountability.

What’s behind this effect?

One possible explanation for our findings is that the big four’s multi-service approach gives them less reliance on securing repeat business from any single client.

With consulting, tax, audit and advisory services across various industries, these firms aren’t as dependent on individual clients, which can give them greater freedom to recommend compensation packages that may not always align with a chief executive’s preferences.

It has been argued^[10], including by former chairman of the Australian Competition and Consumer Commission Graeme Samuel, that the big four’s consulting services pose potential conflicts that could compromise their audit duties.

The same could be said for other advisory services provided by these firms.

However, our findings offer evidence that when it comes to executive compensation, the big four’s reputation and expertise may actually discourage practices that obscure performance metrics or result in excessive chief executive pay.

Any reforms should tread carefully

The auditing sector will be watching the outcomes of ASIC’s forthcoming “crackdown^[11]” closely. The case for stricter oversight is strong.

But we should be careful not to lose the nuance of this issue. In some cases, the big four’s multi-service approach may actually elevate governance standards rather than erode them.

In a market dominated by these firms, the consequences of their exit from consulting services could extend beyond audit independence.

Ironically, forcing these firms out of consulting could make auditing their primary revenue source from many clients, creating the very dependence regulators aim to avoid.

Are we ready to face the unintended effects of limiting these firms’ roles? If our research is any indication, the answer is not so clear-cut.

References

1. ^{^} Australia (www.abc.net.au)
2. ^{^} overseas (www.afr.com)
3. ^{^} on notice (download.asic.gov.au)
4. ^{^} banned (www.afr.com)
5. ^{^} recent research (journals.sagepub.com)
6. ^{^} A year after the PwC scandal, the furore is gone – as well as any real appetite for structural change (theconversation.com)
7. ^{^} GaudiLab/Shutterstock (www.shutterstock.com)
8. ^{^} study (journals.sagepub.com)
9. ^{^} Owlie Productions/Shutterstock (www.shutterstock.com)
10. ^{^} argued (www.afr.com)
11. ^{^} crackdown (www.accountingtimes.com.au)