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Breaking Up the Big 5

For months, the SEC has railed about auditor independence and quality. Is there really a problem?

1May

Stephen Butler is hardly shy. It's just that he's been trying to get along by going along. The chairman of KPMG LLP, the third-largest of the Big Five global auditing and consulting firms, has publicly kept his cool of late while the accounting profession has taken it on the chin.


But now he's ready to come out swinging. During a freewheeling, 90-minute interview in his 40th-floor office high above Manhattan's Park Avenue, Butler lambastes the U.S. Securities and Exchange Commission for relentlessly picking on his beloved profession--for casting aspersions on everything from auditor competence to auditor independence.


Although audit failures are always high profile, only 1 in 10,000 audits is deemed substandard by regulators, he notes: "There will be plane crashes, no matter how sophisticated the equipment and pilots are." He contends that the rules prohibiting nonengagement partners and their families from owning stock in an audit client are irrelevant, archaic, and discriminatory. And he vehemently rejects the charge that auditors' judgments are clouded by their efforts to sell consulting services; indeed, he denies that such efforts go on.


There's more. Butler resents that he has had to sit on the the sidelines during the greatest bull market in history, holding only one stock (which he won't name). "It's too risky that a company would become a [KPMG audit] client at the wrong time," he explains, "and I might be forced to sell at a loss." But what makes Butler positively bristle is the suggestion that KPMG's plan to spin off its consulting operations has anything to do with regulatory pressure to enhance auditor independence.


For more than two years, the SEC has been harping that auditors' backbones have gone soft, even though it has produced no smoking gun to prove that conflicts of interest among auditors were at the root of any recent accounting scandals. "These issues are all about objectivity and confidence," says Gregg Corso, senior counsel to SEC chairman Arthur Levitt. "When you look at how these [consulting] services are marketed by the engagement partner who signs off on the audit, and you know how their compensation is affected, the gun feels warm."


Butler and his Big Five allies counter that no auditor would risk a liability suit for the sake of a colleague's consulting fee. "People in the profession resent that we get characterized as not being serious about independence," Butler gripes. "That's absolutely false. We're more interested [in maintaining independence] than the SEC and the rest of the world. It's part of who we are."


Who the Big Five are--and what the firms may become--is precisely what's up for grabs. Now, the Public Oversight Board (POB), an accounting-profession watchdog group, is set to release a draft of its long- awaited recommendations on improving audit effectiveness--including alternative business structures for the Big Five. "There's no doubt that we will say there must be some split" of the auditing and consulting arms, says Shaun O'Malley, former CEO of Price Waterhouse, who is leading the POB effort. Indeed, three of the Big Five are already in the process of separating their functions. The other two, however, maintain that the separation is not only unnecessary, but also counterproductive.


Warm gun or no, there is scant evidence that audit quality has deteriorated, and no evidence that splitting audit and consulting groups will in any way improve audit quality. Many wonder whether the SEC's crusade could end up doing more harm to the profession than good by browbeating partners to leave and driving away recruits. "The real threat to the quality of the audits over time is that we make the profession so unattractive," says John Wulff, CFO of Union Carbide Corp. and a former KPMG auditor. "Smart students will want to go elsewhere, and inevitably the quality of the audit will be compromised."



Appearances Count
The battle lines between the accountants and the SEC were starkly drawn in 1998, in the wake of spectacular accounting disasters at Cendant Corp., Sunbeam Corp., and Waste Management Corp. That September, in announcing his nine- point action plan to curb earnings management, Levitt fretted that the Big Five were going easy on their audit clients in their quest for more- profitable consulting assignments.


"I need not remind auditors [that] they are the public's watchdog in the
financial-reporting process," Levitt growled. He reminded them anyway. A year later, in a speech in October 1999, Levitt was at it again, expressing "grave concerns" that the audit process was being "sacrificed in the name of more financial and commercial opportunities."


Finance executives suspect that the SEC may be overreacting, but nevertheless take seriously its challenge to the Big Five. "If Arthur Levitt is concerned, I think CFOs should be as well," says Gene Godick, CFO of Horsham, Pennsylvania-based VerticalNet Inc., which owns and operates business-to-business Web sites. Godick was formerly senior audit manager at KPMG and Arthur Andersen, and he finds it hard to imagine that his audit staff would have "rolled over" for a consulting client. But appearances count, he acknowledges. "The issue is not only that auditors are independent in fact, but that they appear independent," says Godick.


That's why there was such an uproar in January, when the SEC issued a 127-page report on more than 8,000 violations of auditor-independence rules at PricewaterhouseCoopers LLP over a two and a half year period. About half of these violations were related to the 1998 merger of Price Waterhouse and Coopers & Lybrand. In all, some 1,885 PwC employees or their relatives owned investments in 2,159 of the firm's 3,170 SEC-registrant corporate audit clients-- including almost half of all partners and 6 of the 11 senior managers who oversee the firm's independence program. (In a letter to the firm's partners, PwC CEO James Schiro and chairman Nicholas Moore said that most of the violations were due to "an honest failure to appreciate the importance of compliance.")


Although the SEC hasn't publicly questioned the reliability of any financial statements audited by PwC, the news shocked the rest of the Big Five as much as it did PwC. "How in the world could this happen? " wonders Michael Cook, who retired as Deloitte's chairman and CEO last May. He recalls that he sold his stake in Scott Paper on the day Kimberly-Clark Corp., a Deloitte audit client, acquired Scott in 1995. "When you see the number of senior people involved, how does that line up with the tone at the top?"


In general, accounting professionals seem to believe that although the rules on equity ownership should not have been broken, those rules may be too strict. Currently, spouses, children, and even nearby in- laws of partners are not allowed to hold stock in companies audited by those partners. In practice, adhering to such strictures is onerous and difficult.


"The SEC is right to expect the profession to adhere to the rules," says AICPA president and CEO Barry Melancon. At the same time, "the profession has a right to expect the regulatory environment to remain modern."


Finance executives tend to agree. Mark King, CFO of Affiliated Computer Services Inc., in Dallas, recently lost a key PwC manager on his audit because the manager's wife was granted stock options at her new company, which was also a PwC client. The manager could have stayed on Affiliated's engagement only if his wife had taken another job, or if he had divorced his wife. "He was forced to quit because of an arcane SEC rule," King complains. "The company that gets hurt is us."


Other companies have found themselves more directly caught in the crossfire, even though none has been forced to restate its financial results. Compaq Computer Corp. replaced PwC as its auditor in February at the SEC's request, while Cisco Systems Inc. has opted to stick by the Big Five firm despite SEC pressure. "Our auditors are telling us that they're independent, and we believe them," says Dennis Powell, Cisco's corporate controller.


In one instance, as part of an earlier investigation of violations in PwC's Tampa office, Pediatrix Medical Group Inc. had PwC and KPMG conduct concurrent audits for fiscal 1998. The reason: A Coopers & Lybrand tax associate on the 1996 audit owned 165 shares of the physician group. The two sets of auditors interpreted certain accounting issues differently, but both firms found the company's books in order. Pediatrix has since rehired PwC as its sole auditor.


In the wake of the SEC's findings on PwC, the Big Five firms have agreed to revamp their internal systems for monitoring equity holdings. But what they also want are updated rules that reflect the rise of two-career households and the global nature of the firms. Butler of KPMG suggests that an engagement partner or associate holding stock in the audit client is an obvious no-no, as it would be for someone like himself in the chain of command. However, someone who works in a different office from the engagement partners with no connection to that client should not be banned from such investments, he argues, nor should relatives of the partners.


The Independence Standards Board (ISB), created by the SEC in 1997 to set new rules on auditor independence, is wrapping up work on new equity- ownership guidelines, as is the SEC's chief accountant, Lynn Turner, at Levitt's request. Some suspect the SEC chairman has begun to doubt the ISB's independence, because among its eight members are the AICPA's Melancon and three Big Five CEOs. But Gregg Corso says Levitt has no plans to undermine the ISB's authority, and Butler, an ISB member, senses nothing more than good old-fashioned politics at work.


"What I see is Levitt waking up to the realization that these rules are outdated and more punitive to working spouses," declares Butler. "You can pound people for technical violations, but there will be a backlash if these rules are not fixed quickly."



My Auditor, My Consultant

The conflict over equity ownership could be overshadowed by a battle fought over so-called scope of service--that is, keeping auditing and consulting businesses under one roof.


Business has never been better for the Big Five. Global revenues for the biggest firm, PricewaterhouseCoopers, reached $17.3 billion in the fiscal year ended June 30, 1999, with US revenue up 18.7 percent, to $7 billion. The growth rate for domestic consulting services (28 percent) was nearly twice the rate for auditing (15.5 percent). And the other four firms enjoyed similar results last year. But that growth has been fueled by the rise of consulting and other nonaudit services: over the past two decades, audit services have dropped to about 33 percent of revenues at the typical accounting firm.


This worries Arthur Levitt. "I can't help but wonder what impact this changing business mix has had on a culture that has prided itself on objectivity," he remarked last October, in a speech to The Economic Club of New York.


The answer of Big Five executives: none. "I'm not aware of a single documented case in which a bad audit happened because the auditors were intimidated" by a consulting project, says Jim Copeland, CEO of Deloitte & Touche. (Of the Big Five CEOs, only KPMG's Butler and Copeland consented to be interviewed for this story.) "We're talking about restructuring an entire profession that's over 100 years old, on the basis of a theoretical concern."


Theoretical or not, the SEC now requires a company's auditors to inform the audit committee about the amount of nonaudit services they perform. Former Secretary of Commerce Barbara Hackman Franklin, who serves on four board audit panels and heads two, says that she's been doing that for several years. In one company for which she chairs the audit committee, the policy is that if consulting fees amount to more than 50 percent of total fees on a three-year rolling average, it's time to take a look. "It's a judgment call about how much consulting is too much before the auditors' independence is impaired," she advises.


CFO King of Affiliated Computer Services suggests that the scope of consulting projects is more relevant than the fees. Appraisals or reengineering projects on financial processes like accounts payable could create the appearance of a conflict, because the auditors would be checking the work consultants from their firm had done. The key there is strong project management, says Steve Reeves, vice president, finance, of Black & Decker Corp., which recently used its auditor, Ernst & Young, on a multimillion-dollar, multiyear technology assignment. "So many decisions are made day-to-day on how the system is set up that you need to manage the process very closely," he says. (Reeves himself is an ex­Ernst & Young auditor.)


To avoid the mere appearance of a conflict, others, like Union Carbide's John Wulff, refrain entirely from obtaining consulting services from their auditors. "I've never heard of a quid pro quo where the auditors sign off on the numbers if the company hires [one of its] consultants," Wulff says. Nevertheless, he adds, "we don't use our auditors for consulting."


But what particularly exercises Levitt is the notion that auditors are expected to cross-sell consulting services, and thus won't jeopardize a sale by challenging an audit client. "When [audit partners] are a marketing channel," says the SEC's Turner, "they can't piss off the client; otherwise, they can't sell the other services."


KPMG's Butler maintains that such fears are fantasy, because competition for consulting engagements is intense and auditors cannot "influence the buying decisions of our clients." On the other hand, VerticalNet's Gene Godick, a KPMG auditor as recently as 1998, confirms that part of his bonus was based on making referrals of audit clients. But Godick adds that efforts at cross-selling in no way compromised his audit work.


While Deloitte's Copeland acknowledges that auditing is not as profitable as consulting, a charge often used to impugn auditor integrity, he disputes the notion that auditing is a loss leader. He says Deloitte's audit business would survive and reward partners handsomely if the firm were forced to sever all ties between its auditing and consulting operations. But he also says that audits would become more expensive and that it would be harder, not easier, for the SEC to ensure independence. The reason, he explains, is that audits rely on help from in-house specialists in such areas as information technology and actuarial science. Without revenue from consulting work, Deloitte couldn't afford to pay those specialists what they could earn for their skills on the market. The firm would have to hire specialists for audits from an outside provider, and consequently, the SEC would have less control over independence in terms of equity ownership.


Some sort of limited separation between auditing and consulting may be feasible, Copeland concludes, "but total separation doesn't help from an independence standpoint."



Breaking Up
Ultimately, Copeland's greatest fear is that the SEC will force Deloitte to split its audit and consulting businesses. Deloitte was the first major accounting firm to provide for separate management and directors for its audit and consulting operations, but Copeland does not want to take the next step and separate economic ownership of the two.


Similarly, Arthur Andersen, which is expected to settle its long- running war with Andersen Consulting this year but which maintains significant consulting operations of its own, also believes that clients are best-served by firms that can offer both audit and nonaudit services. "If we were personally convinced that splitting our consultancy out would make us better auditors, we'd do it," says managing partner Joseph Berardino.


The other three Big Five firms, however, have accepted, even embraced, the notion of spinning off their consulting businesses. In February, Ernst & Young agreed to sell its consulting practice to Cap Gemini SA in an $11 billion sale of stock over five years. (The SEC regards the firm's strategy of exiting certain nonaudit businesses as "a positive development," says Corso.) Also in February, PwC said it would create at least two separate operating units, in part because of the regulatory fallout from the SEC findings. In announcing the split, the firm was vague about how it would structure the relationship between its auditing and consulting businesses. But in a message to clients, James Schiro noted that the reorganization would create a "completely independent global auditing firm."


Ironically, the Big Five firm with the most detailed plan for severing its consulting unit has struggled mightily to win the SEC's approval. Concerned about the intense competition for its consulting talent, KPMG announced in August 1998 that it intended to spin off the unit in an initial public offering. A year later, Cisco Systems, a frequent partner on KPMG's consulting engagements, purchased $1 billion worth of preferred shares in KPMG's consulting business, which will be convertible at the time of an IPO for a stake of up to 20 percent. But the firm is still waiting for an SEC ruling on its plan from an independence perspective.


The beauty of KPMG's IPO strategy, Butler believes, is that the auditing partnership's stake in the publicly traded consulting firm would generate capital to strengthen current audit capabilities and develop new attest services for accounting issues related to New Economy businesses. He suspects the SEC would rather see no ownership interest, but he counters that selling 100 percent of the consulting business would require distribution of the proceeds to the partners, and thus deplete the remaining auditing business of capital.


In the past two years, KPMG's plans have sparked a volley of letters between the SEC, the ISB, and the POB, but no regulatory body has determined what is or isn't allowable. In the meantime, Butler says he has had countless conversations with SEC officials. To ease regulator worries, he agreed to have no involvement of any audit partners in management or on the board of directors of the consulting firm. "We're basically saying we'll have no influence, and our ownership interest will be nonvoting," says Butler.


Brash and blunt, Butler seems at a loss for words to explain why the SEC hasn't backed KPMG's highly anticipated IPO. But just as he's waited long enough to speak his mind, he's waited long enough for an OK. The firm is in the midst of conducting audits of its business and preparing documents, and though market timing and other variables must be considered, he expects to go forward with a registration statement this spring--no matter what the SEC says.


"It's not way off in the future," Butler says proudly of the offering. And when it's done, he wryly adds, "I'll have two stocks in my portfolio."





WHERE WERE THE AUDITORS?

The search for why audit busts happen.


In September 1998, in the wake of several high-profile accounting blowups, Securities and Exchange Commission chairman Arthur Levitt called on the Public Oversight Board (POB), an accounting-profession watchdog group, to review the way audits are performed and assess the impact of recent trends in auditing on the apparent rise in irregularities.


"As I look at some of the failures today, I can't help but wonder if the staff in the trenches of the profession have the training and supervision they need to ensure that audits are being done right," Levitt said. "We cannot permit thorough audits to be sacrificed for reengineered approaches that are efficient, but less effective."


Over the past two years, an eight-member panel made up of two former SEC commissioners and outsiders has visited about a half-dozen offices of each of the eight largest accounting firms. Their objective has been to pick apart the audit process, look at trends in hiring and promotion, get a feel for attitudes toward independence, and probe numerous audits with unusual situations, such as restatements or huge charges.


"We learned as much as we could possibly learn about the current state of things," says Shaun O'Malley, the former Price Waterhouse CEO who led the panel's effort. The panel expects to release its report this spring in the form of a series of recommendations, whittled down from more than 100, that will be subject to public comment.



Blame Fraud, Not Negligence


Still, Big Five partners insist there are not more audit busts now than at any other time in history, and say only rarely is the auditor truly negligent. According to American Institute of Certified Public Accountants chairman Bob Elliott, who is also a KPMG partner, AICPA research has found that only three-tenths of 1 percent of all audits result in a legal claim. The majority of scandals stem from fraud, Elliott adds, and often management has gone out of its way to fool the auditors.


Jim Copeland, CEO of Deloitte & Touche, expects the POB panel to point out areas of concern, but he's hopeful that it won't declare the profession substandard and deteriorating. "The best- case scenario is that they will say the audit process is not broken," he says.


Copeland says that Deloitte, like the POB, has taken apart audit failures piece by piece, and he believes the truth behind most is even more evanescent than any conflict of interest that might compromise independence. One factor is that auditors become complacent when audit after audit comes out clean; another factor concerns management coercion, when a strong executive insists that the numbers should be reported a certain way. "Certain individuals can be intimidated, and that can lead to problems," admits Copeland.


But rules and processes can go only so far to foster integrity and diligence. So perhaps the POB will pursue the suggestion made at a recent public hearing by accounting gadfly Abraham Briloff, professor at Baruch College, City University of New York. "I would like Pfizer to use all the insight it gathered in developing Viagra," he said, "to develop a drug that would stiffen the backbone of all those involved in the financial-reporting process." -S.B.





JUMPING SHIP



What if audit partners couldn't join their clients.


In a recent CFO survey of 75 readers, 47 percent of respondents indicated that they had worked at a major accounting firm during their career (see "Quality Standards," page 64). Of those who have an auditing background, 41 percent rely on their former firm to do their company's audit.


Hiring a partner on your engagement, says Mark King, CFO of Affiliated Computer Services Inc., in Dallas, is "a great way to get people who understand your business." Nevertheless, the onetime Price Waterhouse auditor recognizes the need for tough controls when someone jumps to an audit client and takes a senior finance position. "It's human nature to give someone the benefit of the doubt," King explains, "especially if you're a junior manager and you're dealing with a partner you used to admire."


A recent review of 200 accounting fraud cases from 1987 and 1997 found 44 instances in which there was enough background to determine where the CFO came from. In 5 of those cases, or 11 percent, the CFO had worked for the current auditor. "That number has been touted as high by some and low by others," says Dana Hermanson, an accounting professor and the director of research at the Corporate Governance Center at Kennesaw (Georgia) State University.


It may be hard to prove undue influence when an auditor goes to work for a client, but appearances can get ugly. At least four finance managers at CUC International, which recorded some $500 million in fake revenues before it was acquired by Cendant Corp. in 1997, once worked at Ernst & Young LLP, CUC's auditor. The accounting firm has stated it is "ludicrous" to think that these ties affected the firm's independence. Others aren't so sure. "I've seen a handful of cases where the auditors didn't do the work they should have, out of a false sense of security they gain from having one of their former colleagues working at the client," says Dan Goldwasser, an attorney practicing in the New York office of Vedder, Price, Kaufman & Kammholz.


In December, the Independence Standards Board released an exposure draft on new rules concerning employment with audit clients. The eight-member board had weighed the possibility of a mandatory "cooling-off" period, perhaps a year, during which a partner could not work on an engagement prior to joining the audit client. Big Five partners strongly objected to that proposal; it could scare off recruits if auditing were no longer seen as a stepping- stone to a corporate job, they feared. "You would discourage top-notch people from entering the accounting profession, and that's not good for anyone," agrees Steve Reeves, an Ernst & Young veteran and vice president, finance, at Black & Decker Corp., which E&Y audits.


In the end, the Board opted for additional safeguards when an auditor joins a client, including a review of the next- year's audit by a higher-up in the accounting firm. The guidelines could take effect later this year.

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