Ernst & Young split plan will make things awkward in Greater China

Last week EY’s global leaders approved the plan to break up its audit and consulting business, in a move that is set to rock the world of accountants and consultants. But in a surprising development, EY Greater China was quick to announce its decision not to participate in the plan.

But why would the Big Four’s Greater China practice go against all odds to make such decision? Is it a “rebel” as some media have described? Or does it make business sense?

Bryon Tsang, Associate Professor in the Department of Economics at Virginia Tech (a US-based university), shares his view on the matter, and explains why EY’s local partners may have a good case for their decision.

EY has two main businesses: the auditing part is the one that most of us have heard of, and the smaller but more profitable consulting part is less well known. The plan is to split up the two.

Under the plan, EY’s auditing business will keep its current structure of having regional, largely separate offices. The consulting part will appear as one firm to be listed in the US stock market.

Most reports in the media focus on the large windfall that EY partners will get from the IPO and other financial moves. Still, it misses one obvious problem that the plan will create for EY’s businesses in Great China.

For over half a century, regulators have been concerned with auditors providing non-audit services. Their main worry is that auditors may depend financially on their clients and find it hard to maintain their independence when conducting auditing work. EY’s plan to split in two is a preemptive response to such a perennial regulatory demand.

What’s the problem exactly?

While regulators are always eager to intervene and find some problem to fix, academic research shows that there may not be a problem after all. The simple argument is that, if an accounting firm is providing both services to a client, the firm has an incentive to make the client’s numbers “look good”.

Over the past few decades, most empirical studies that look at actual audit outcomes have failed to find evidence that non-audit services impair audit quality, implying that the benefits of synergy outweigh the costs, if there are any, of reduced independence. Indeed, some studies show that audit quality is improved by certain non-audit services.

Such findings are consistent with the argument that knowledge spillovers exist between the two tasks. For example, knowing thoroughly the complications that a tech company faces when navigating the treacherous waters of the tax system, an auditor is in a much better position to advise a similar (or the same) company on those issues.

The synergy explains the growth and success of EY and other major accounting firms, which is also why there is a great demand for such one-stop services.

It is especially true in Greater China, where auditing independence is relatively less of a concern. By removing the synergy, the proposed split will likely hurt the growth of both businesses. The standalone consulting arm will suffer even more if it does not carry the EY brand according to the plan.

It is understandable that EY is partly responding to regulators’ higher expectations in controlling the conflict between audit and consultancy, and by implementing the plan EY will be the first mover to take advantage in the changing landscape.

However, the rest of the Big Four firms (KPMG, PwC and Deloitte) have made it clear that they are not going to split in any similar manner, making EY not just the first but (likely) the only mover. The lack of move from EY’s competitors strongly suggests that the synergy of multidisciplinary service overrides the so-called regulatory pressures.

The China – US connection

The loss of synergy may not be the only loss for EY in Greater China. Though a different US president is now in power, the China-US tension is alive and well. Part of the conflict is ongoing in the financial markets. Chinese businesses that choose to remain listed in the US stock market will or already face increased scrutiny on their books.

One thorny issue between the two countries is that, while China prefers data pertinent to technology, cybersecurity, defense, and other critical information to stay in the mainland, accounting rules in the US require more transparency on such matters.

While the auditing part of EY has long been squeezed between the two institutions, the consulting part of EY, if it is separated out according to plan, will face an even trickier situation. Will any of the major state-owned companies, which constitute a large part of EY’s client base in Great China, provide sensitive data to a company that is listed and regulated in the US?

Even businesses with little to do with the Chinese central government will be smart enough to avoid getting into potential troubles. It also helps to remember that Accenture, a leading consulting firm listed in the US, has a market share dwarfed by those of the Big Four.

The split is lucrative for EY’s partners now, with audit partners set to receive multimillion-dollar payouts. Good for them, but there is no such thing called free payouts. The plan will come at a cost, and it risks EY’s development in the future, with the damage to EY’s Greater China market incredibly foreseeable.

What remains is a battle between the short term and the long run (and, to some extent, between older and younger partners), and it is hard for an outsider to tell which of the two views has the upper hand.