EY canceled the divorce plan
Things at EY are consistently not good. In March, their auditing license in Germany was suspended for two years. And now the States partners have blocked the plan to separate the consulting from the audit under the mighty name Everest. I wonder if the Ernsts will pull out of these troubles.
- In 2019, the British regulator gave the big four until 2024 to separate auditing from consulting.
- In 2022, EY claimed to be a pioneer and, so to speak, to blaze a trail for its competitors. In 2022, the partners have tentatively agreed on the Everest project.
- And so, a week ago, the US partners of EY buried this ambitious project.
Competitors rejoice. The media mocks the consultants who teach others to reorganize businesses but could not manage a project to reorganize themselves. Added to all this is an entirely new nuisance in the form of a ban on providing audit services in Germany and the global economic downturn.
Let’s determine whether Everest will turn into the Mariana Trench for EY.
EY and audit
The audit market is a very large industry and, at the same time, very tight.
The size of the market is evidenced, for example, by the fact that KPMG, the smallest company of the Four in terms of turnover, earned in 2021 six times more ($36 yds) than the world’s largest law firm by turnover Kirkland & Ellis ($6 yds).
And it is tight because the largest clients have long been divided between the main players: KPMG, PwC, EY, and Deloitte. Precisely 100% of public companies from the Fortune 500 list are clients of the “four”. 497 out of 500 S&P 500 companies ordered an audit from them.
We will further delve into the internals of EY, so it is essential to clarify: despite the fact that in terms of turnover, EY is on the third step (info from Statista above), they are the largest auditor in the USA in terms of the number of clients.
But there is a problem
It is morally tricky to tell the whole truth about your client in an audit report when your left hand tells the client what to do, and then the right hand listens and writes what the left hand and the client f*cked up. Let’s agree this approach to work will not contribute to the increase in customers.
But the number of clients continued to increase because the auditors knew not only how to do their work well but also how to sell it well. Auditors strongly increased non-audit practices: tax, business, financial, IT, and legal consulting.
Well, the conflict of interests turned from purely theoretical into the most practical in the early 2000s.
Ever heard of the big five of auditors? No? There was. Then Arthur Andersen screwed up with the Enron audit, which almost caused an economic crisis in the United States, and the five became a four. Arthur Andersen then broke up, forming Accenture, the top consulting company in the world, and Andersen Tax, which is little known in tax practice.
Remember Accenture, we’ll come back to this example later.
The very next year after Enron filed for bankruptcy, the United States passed the Sarbanes-Oxley Act, or SOX, which was supposed to hit the fingers of the invisible hand of the auditing market and bring the concept of conflict of interest from the ethical plane to the legal plane, for the violation of which sanctions were established.
This streamlined but did not cure the audit. Already within six years of operation, Lehman Brothers screwed up, and as a result, the auditors of the bank (EY) had to settle out of court a class action of shareholders for $99 million and with the New York prosecutor’s office for $10 million.
Subsequently, the EU adopted EU Directive 2014/56/EU, which limited the percentage of permitted additional services outside of audit.
I don’t know what the specific weight of non-audit services would look like if it weren’t for the restrictions in the EU, but now, according to the Statista, the revenue streams of the Fours look like this:
But the auditors continued to fall into scandals. I will not list all the scandals here, I will mention only the last two.
In 2018, there happened the “English Enron” — the bankruptcy of Carillion. It was audited by KPMG, which this year also settled on a lawsuit for 1.3 billion pounds (how much was paid as a result — they did not disclose). British antimonopoly and financial regulators began to express concern and threaten the four with various radical measures, up to the point of forcing the “four” firms to split into the auditing part and the “remaining services”.
The four did not wait for tough decisions from the regulator and, in 2019, began to “restore trust in audit” by limiting the provision of non-audit services to companies that are their audit clients. This did not completely satisfy the FRC, so last year, the “four” gave a deadline to separate auditing in Britain from consulting — until 2024.
Well, two weeks ago, the German regulator deprived EY of the right to provide auditing services in Germany to any public and some private companies for two years due to the fact that they contributed to the fraud of the “German Enron” — Wirecard with their insufficiently high-quality conclusions. We wrote about this story here.
What does this mean for auditors?
In short, there is almost no room for growth. Just imagine: you are a large corporation with as many people as the population of Brovary and Kherson combined. And they all want sacrifices, promotions, annual bonuses, vacation, sick leave, and a permanent place in the spacey office, not some shitty hot desking. How to ensure all this if you have the same clients, and the list of services you can provide them (except audit) is gradually decreasing?
And the global audit services market, as we can see, is growing no less dynamically than the consulting market. Only there are many more players there, and, accordingly, there is competition and huge potential for the Four:
And here they went to Everest!
EY was thinking a lot… and came up with it!
Why wait for the next Arthur Andersen, which will destroy you from the outside, when you can collapse in a controlled way from the inside? Why fight for first place with the rest of the “four”, biting into each other for a large client, but not advancing globally, if you can simply bypass everyone quickly and legally?
In 2022, EY CEO came up with this idea publicly. It consisted in dividing the entire global business of EY into two parts: auditing separately and consulting separately.
Just like Accenture used to. Do you remember, above, we promised to return to this? So, after the collapse of Arthur Andersen, all the consultants and auditors spread to other companies of the four. And the IT department of the Arthurs separated into a separate company and created Accenture: a mix of consulting and IT outsourcing (relatively speaking, EPAM and Deloitte).
It is now a public company (ACN) with a turnover of $61 billion for the last financial year.
Once again: Accenture, which grew out of an auditing company and is engaged only in consulting, earns more than the largest audit company by turnover, Deloitte (as we wrote above, last year they earned $59.3 billion from auditing and consulting combined).
So, the “Everest” project, as they say, was doomed to success: auditors will do their black magic with the papers of a client to whom they cannot provide other services. At the same time, completely different and in no way related to the auditors people will provide the same client with previously “forbidden” services under literally the same brand. Ingenious!
But EY’s ambitious plans were hampered by internal corporate culture and States audit bosses.
“Everest” had to be “sold” within the company to 13,000 partners of various practices, and after that, approval from hundreds of regulators in different countries had to be obtained. Quite an aggressive plan, but we are talking about consultants who drew for clients even larger restructurings in PowerPoint.
Some of these partners, of course, would be happy to receive a healthy consulting business, not limited in sales by the list of clients who receive audit services. The partners of the audit sector, as expected, would not really like such a separation because the audit field itself, as we said above, is already saturated with the “four”, and EY already has the most number of clients: it is not that there is no room to grow, but it’s hard. In addition, the question was which business the tax practice would go to: the auditors did not want to give taxes because they remain naked and barefoot, and according to the plan, the consulting company was supposed to take the taxes almost wholly to an already expensive practice.
After $600 million in expenses, hundreds of PowerPoint slides, thousands of man-hours on internal calls, and decaliters of pumpkin spice lattes from Starbucks, EY’s global committee of 18 elders had to listen to the opinion of the largest group of anti-separatists — the management of EY’s US business (which generates about 40 % of group revenue) led by Julie Boland.
Julie began working in this position only in 2022, replacing Kelly Grier (together with Julie, they are the first two women to head EY’s US business). Kelly stepped down from the post due to a conflict with the global CEO of EY over two issues: the share the US business should pay to maintain the global business and the level of independence of the US business in general.
Obviously, replacing Kelly with Julie failed to solve the last issue because less than a year after her appointment, Julie pushed the idea of abandoning the Everest project to the US, instead promising partners to reduce expenses and other optimization measures in order to preserve the company’s multi-functionality.
And what about other consulting companies?
The four operate in the same environment as EY, where in some jurisdictions, the ability to provide non-audit services to audit clients is minimal.
However, immediately after the announcement of EY’s plan, PwC and Deloitte said that they do not plan to do this because they are okay with it. Already this year, when the failure of “Everest” became more or less known, the CEO of Deloitte recorded a hilarious video (which of course you will not watch, because what 20 minutes, what?) where he says that these are the plans for the separation business auditors look very cool on slides and the arrogant sharpening of consulting partners, but work very poorly in reality.
In MBB (McKinsey, Bain, BCG), Accenture, and the rest of the consulting, there is no such problem due to the lack of audit practice. It is clear that they do not really need it, especially if you compare not the annual turnover but the income per employee of MBB (from 340,000 dollars per year at BCG) with the Four (up to 155,000 at PwC).
In general, both in the “four” and in the rest of the consulting, everything is the same as with their clients: 2022 was the year of price increases, which the companies gladly reported to shareholders/partners, and 2023 became the year of cost reduction (which is achieved you know how). For EY, Julie Boland promised optimization, so the other day they announced the reduction of 3,000 people in the USA (5% of the local staff). This is by far the largest reduction in consulting since the last (KPMG, McKinsey, and Accenture cut to 3%).
McKinsey, Bain, and BCG have stopped hiring new MBA graduates until 2024. You studied at your Ivy League, then you received an MBA, after which you received a unique offer from Bain, and in April, they tell you: “Eeeee, let’s talk after the holidays. Christmas. If you learn a new language, we will give you 30,000, and if you go to work as a yoga instructor for the time being, then 20,000.”
Of course, I’ve piled a little on the Four and EY here, beg your pardon. I am far from the opinion that these are bad companies, and I do not even accuse them of crimes because auditors are not the police; they cannot search the client, they cannot put a thermorectal cryptanalyzer inside the SFO to get true management reporting. Auditors work with the information given to them by the client. A client who pays an auditor for an opinion, sometimes hundreds and millions of dollars. In such conditions, agree, there may be a temptation not to insist on receiving some information or interpret doubts in favor of the client if the opposite is not expressly required by standards and laws. In general, it is difficult to maintain independence when you audit someone who only pays for an independent audit.
But at the same time, the Four is clearly more powerful than law firms and all kinds of accounting and tax advisors in terms of expertise and service, so it hurts to sell related products like accounting, legal, and financial services.
So both the Four and the regulators are, in fact, dealing with a problem that has no simple solution. And this is good for us because it is exciting to observe such processes. At the very least, we — nerds. Well, the memes on the topic are funny.
✍️ Anton Lebediev
