The accounting watchdog has ordered Ernst & Young to explain its role in how Lehman Brothers hid $50bn of debts, but the regulator has a conflict. It is trying to increase the choice of audit firms so cannot do anything that reduces the current Big Four to just three.

The Financial Reporting Council is both the body that disciplines accounting firms and the body that seeks to ensure the profession remains competitive. It has a specific project to expand auditor choice following the demise of Arthur Andersen when Enron collapsed.

The FRC acted with unusual haste in demanding answers from Ernst & Young after the US court handling Lehman’s bankruptcy published the report on the investment bank’s downfall. That document explained how Lehman window-dressed its accounts by shifting up to $50bn of business off its balance sheet when it had to submit quarterly reports. E&Y, as auditor, oversaw what the New York court termed an “accounting gimmick”.

E&Y claims the now-notorious “Repo 105” transactions conformed to US accounting standards. It will explain that in detail to the FRC, but it cannot afford damaging publicity that encourages clients to ditch it in favour of another auditor. The firm is smallest of the Big Four firms but has 15 FTSE 100 clients and 20 per cent of the next 250 largest companies. If those clients turn away from the firm they will turn towards PricewaterhouseCoopers, KPMG or Deloittes, thus making the other three bigger still.

Chairman are most releuctant to use a firm outside the Big Four: only one FTSE 100 company has shunned the  magic quartet. Big companies like big auditors but medium-size companies also like to associate themselves with the auditors used by big companies.

Ultimately, FRC must find a way to encourage big clients to choose smaller firms or find a way of making the small firms big. Merging the medium-size auditors makes little difference: they are so far behind the Big Four they remain medium-size. Breaking up a big firm is possible but would provoke protests form partners and the break needs to be global. Encouraging groups of partners to break away and changing the ownership rules to allow private-equity firms to back them in creating a new large firm is possible. But perhaps the easiest way is to allow corporates to use a big firm for audit work or advisory work – but not for both.

Some companies would split their work between two large firms but conflicts of interest might just make some firms give work to the smaller accountancy firms: for some it would be the audit work that moved.

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