FOLLOW

FOLLOW

SHARE

They Might Be Giants

It's been nearly two years since Arthur Andersen went under and Sarbanes-Oxley was passed. Have the Big Four audit firms changed since then?

12Jan


Prologue: Back in the early 1970s, the accounting profession was a gentlemanly affair. Work hard, make a decent salary, and play golf on Saturday with your clients. Auditors were like bankers: conservative, straightforward, and ethical to a fault. Indeed, accountants routinely topped the lists of most-admired professionals.

"I was CFO at two companies in the '70s," recalls Robert Howell, now distinguished visiting professor of business administration at the Tuck School of Business at Dartmouth College. "When my accountant said, 'You ought not do that,' that was it. Things have gone 180 degrees out of phase since then."

The shift can be traced to 1978, when the American Institute of Certified Public Accountants (AICPA), under pressure from the Department of Justice, lifted the ban on advertising and solicitation. The end of that prohibition triggered a land grab in the accounting industry, and a big push into consulting services.

The ensuing conflicts of interest culminated in a string of now-infamous accounting scandals and the dismantling of Arthur Andersen. Many observers believed the downfall of Andersen, the passage of the Sarbanes-Oxley Act of 2002 (Sarbox), and the establishment of the Public Company Accounting Oversight Board (PCAOB) would curb the excesses of the previous decade. The tough talk of the PCAOB's chairman, William McDonough, only reinforced that notion. In a press conference in October, he noted that the Big Four accountancies "have a high interest in restoring confidence [in public-company accounting]. If they don't do it themselves, we will do it for them. And it will be painful."

But recent events suggest McDonough will have his work cut out for him. In June, public-interest groups, including Common Cause and Consumers Union, charged that Ernst&Young was advising audit clients to "rubber stamp" the purchase of nonaudit services, a seeming violation of the spirit of Sarbox, if not the law. Soon after, news broke that three of the Big Four (excluding Deloitte Touche Tohmatsu) were being sued by a single client for allegedly padding travel expenses. Then, in September, a former senior partner at E&Y's San Francisco office was charged with destroying documents related to a government investigation of a failed dot-com called NextCard. To some industry watchers, the three incidents suggest that the Big Four are still finding their way in a post-Sarbox world. Barbara Roper, director of investor protection at the Consumer Federation of America, is harsher: "I don't see a lot of evidence that the Big Four firms have seen the light."

Rope-a-Dope

You can't really blame the Big Four for not owning up to any past mistakes. Any admission that previous audits were not as rigorous as they might have been could expose the firms to shareholder lawsuits. Publicly, the four firms have expressed general concern over the tarnishing of the audit profession. PricewaterhouseCoopers vice chairman John O'Connor concedes that he was embarrassed by the accounting scandals of the past few years: "We asked ourselves, 'Have we lost our nobility?'" Even before the scandals hit, the accountancy had instituted PwC University, a five-day seminar to help employees deal with the kinds of stresses auditors experience.

Nevertheless, O'Connor asserts that PwC's biggest mistake during the past few years was that it simply lost sight of the value of its core audit service: "We had underinvested in some of our services, including audit."

Sarbox was intended, in part, to refocus audit firms on auditing. To some extent, it has, by prohibiting auditors from offering certain consulting services altogether and allowing them to offer others only to nonaudit clients. In addition, auditors are meeting more often with corporate audit committees, which are now empowered to hire and fire the firms. That's a definite power shift. "Audit committees are our clients now," notes Susan Frieden, Americas vice chair of quality and risk management at E&Y.

CFOs say engagement partners have become more conservative in the wake of Sarbox as well. At a recent conference at MIT's Sloan School of Management, Howard Smith, CFO of insurer AIG, noted that the amount of time spent getting feedback from the company's auditors has "grown tremendously" for complicated accounting issues. At the same conference, John Millerick, CFO of Analogic, said bluntly: "There are no quick answers [from our auditors] anymore."

Others argue that Sarbox could have gone further. "Sarbox was just triage," asserts Cynthia Smith, a lecturer at Ohio State University and co-author of Inside Arthur Andersen. "It addressed a number of obvious things." Under Section 203 of the act, for example, firms are required to rotate lead audit partners every five years. But critics say legislators should have required companies to change firms every five years (a stipulation E&Y vice chairman Beth Brooke labels "a horrible idea").

What's more, Andersen's downfall has actually proven to be a windfall for the remaining top-tier firms, which picked up the disgraced firms' clients. E&Y, for one, reported revenues of $13.1 billion for its fiscal year 2003, a 30 percent rise from the previous year. And PwC's aggregated net revenue for its fiscal year 2003 was $14.7 billion, a jump of nearly $1 billion.

In fact, it appears the Big Four have managed to neatly ride out the storm of investor and congressional criticism triggered by the Andersen scandal. "The Big Four firms are very good at taking blows, doing the rope-a-dope," says Stephen Giusto, CFO at Costa Mesa, California-based consulting firm Resources Connection Inc. and a former partner at a marquee firm. "But there's been very little change to how they do business."

Auditors disagree, pointing to the creation of the PCAOB as just one example of an industry in flux. "It's a big change from self-regulation to regulation," asserts O'Connor.

Indeed, the end of the peer-to-peer review system has been hailed by both audit firms and their critics. The PCAOB has also garnered praise for its decision, taken early on, to limit the role of the AICPA in the making of audit-industry standards. But the reality is, the Big Four audit the financial statements of the public companies that generate 99 percent of all revenues in the public sector. That's not likely to change anytime soon. Officials of the Big Four think there's plenty of competition in the sector. "It's not unusual to have three or four major players in an industry [that's gone through consolidation]," says O'Connor. "It's still very competitive for clients." Adds E&Y's Brooke: "Four firms is a workable number."

Charles Mulford has a different view. Mulford, a professor of accounting at the Georgia Institute of Technology, recounts the story of one large corporation that recently decided to dump its auditor of record (a Big Four firm). Of the remaining three top-tier firms, one already provided the company with consulting services, knocking that firm out of contention. In addition, Mulford says the chairman of the company didn't like a key partner at one of the two remaining Big Four audit houses. "The company ended up sending out an RFP to one firm," he says.

McDonough acknowledges the scarcity of audit choices for large corporations. "The lack of competition is a problem...," he says. "But what can be done about it?" Very little (see "Return of the Big Eight?" at the end of this article). "Four firms is close to a big problem already," says Giusto. "Anything less would be a complete disaster."

Given that prospect, it's doubtful the PCAOB would put any of the top-tier firms out of commission. "If there's a shortcoming to oversight," says Mulford, "it's that the PCAOB can't let another [big firm] fail. If firms get to a situation where they know this, it could be a problem." Roper thinks it's already a problem. "At this point," she says, "the PCAOB is boxed in."

Oh, Calcutta!

This is not to say the accounting oversight board won't flex its regulatory muscle. Rather than going after firms, however, the board will likely punish individual partners.

There are plenty of those. On average, the Big Four firms (which are set up as limited liability partnerships) employ about 6,600 partners. The LLP structure, which merits full partnership tax treatment, shields the firms' partners from vicarious liability. Unlike a corporation, which is hierarchical, an LLP is by nature decentralized. In some cases, the setup can create a Wild West mentality, in which partners at headquarters-level have relatively little control over conduct at local offices.

While the national offices of the Big Four firms have undoubtedly become more influential in the past few years, the power of local partners remains strong ("they rule with an iron fist," is how one former auditor put it). That power, some worry, could lead to future abuses. "Many of these partners believe they're their own bosses," argues Dartmouth's Howell. "It's pretty hard to keep the screws down."

It's even harder if auditors feel a greater loyalty to the executives who hire them than to the shareholders served by those executives. Congress's demand that corporate audit committees take over responsibility for the auditor relationship may change that dynamic. Moreover, national officers at the top audit firms say they've been extremely forceful in advising partners to back away from potentially risky situations. Such exhortations could be having an effect, too. "Culturally, people are more willing to [drop a client] now," says PwC's O'Connor.

Getting the message across to all of a firm's worldwide partners will be a feat, however. Asks Howell: "You might be able to get a change at the top, but how do you reach Calcutta?"

You'll Never Get Rich

Ohio State's Smith argues that there is still concern that audit firms will remain more focused on revenues than shareholders. A recent academic study would seem to support that view. In a theoretical model devised by professors at Vanderbilt University's Owen Graduate School of Management, researchers found that audit firms are still likely to produce inaccurate audit opinions to benefit a big client—if auditors think they can get away with it. Says Debra Jeter, associate professor of management at Owen and a co-author of the research: "Our study suggests that ethics will translate into behavior only if regulators ensure it is linked to dollar signs."

Whether they can make a whole lot of dollars by selling audit services...well, that remains to be seen. With Sarbanes-Oxley Section 404 and SAS 99 (which requires auditors to take a more-skeptical approach in engagements), billable hours for assurance work have gone up. And the Big Four firms do seem intent on providing more-robust audit products, including some forensics. But audits are still not the moneymakers that nonaudit services are. "Audits are clearly profitable," asserts E&Y's Brooke. "As profitable as [our] other businesses? Probably not."

No doubt PwC, E&Y, and KPMG have been hurt by the sell-off of their management-consulting businesses. In 1998, 45 percent of Big Five revenues (not profits) came from professional management services, according to the General Accounting Office. In 2002, that slice was closer to 10 percent.

Industry watchers say it's only a matter of time before the top firms begin to expand their lucrative nonaudit services. Case in point: Bruce Nolop, CFO at Pitney Bowes Inc., in Stamford, Connecticut, says PwC, the company's independent auditor for 64 years, recently tried to sell it a Sarbox tool. "We had concerns about whether we should use them," says Nolop. "We came down on the side of not using our auditor."

Still, Nolop says Pitney Bowes is relying on PwC more than ever to "help us navigate the new regulatory environment." While that environment should raise the profile of audit partners at the top firms, nonaudit partners still make up a fair share of each firm's total number of partners. Critics worry that those partners will eventually start to dominate the culture of the top firms, exploiting fuzzy areas to maximize profits. Says one former Big Five auditor, "Partners tend to vote with their wallets."

It's appropriate for partners, as owners of for-profit businesses, to focus on making money. But the partnership structure intensifies pressure for revenues, as there are more "chiefs" expecting C-suite compensation. Top partners at the Big Four firms earn about $350,000 a year, says one source, while national practice directors pull in seven-figure incomes. "I remember senior partners telling me, 'You're not going to get rich in this business,'" recalls Giusto of his time at Deloitte. "But some of these top guys [at the big firms] are getting rich."

And while money may not be the root of all evil, it's usually in the vicinity. No doubt recognizing this relationship, PwC has changed its compensation system, essentially eliminating the firm's bonus payouts. But the accounting profession requires rigorous training and demands long hours. Its practitioners should be paid well. Even Mulford argues that the for-profit model "brings the best talent to the firms."

Maybe so. But longtime watchers of the accounting scene say big money has changed the Big Four, and something has been lost. "In the past, auditing was really a professional service," says Howell. "Now, the primary objective of firms is to get bigger—and to make more money for the partners."

Epilogue:
A few weeks after the Enron scandal broke, Vanderbilt University conducted a roundtable on the accounting industry. After the conference, a former student came over to talk to Owen Graduate School's Jeter, who chaired the discussion. She recalls with amazement the conversation she had with the former student. "He told me that he had gone on to become a lawyer, and his wife was a CPA," remembers Jeter. "He then said, in essence, that he and his wife both do the same thing. I asked him what that was. He said: 'Find loopholes.'"

John Goff is technology editor at CFO.

Return of the Big Eight?

How many accountancies do we really need? In a survey of Fortune 1,000 companies conducted by the General Accounting Office, 77 percent of the respondents said there should be four to eight big audit firms.

Although some pundits claim a merger of two of the top second-tier firms would create a viable top-tier audit firm, the numbers simply don't add up. Combining the largest two second-tier firms, Grant Thornton and BDO Seidman, would create a company with 593 partners—slightly more than one-third the size of the smallest Big Four firm.

Robert Howell, a visiting professor at Dartmouth College's Tuck School of Business, suggests that rather than merging second-tier firms, it makes more sense to bust up the existing Big Four partnerships. 'You could make eight out of four," he insists. "There's no reason why you couldn't unwind a [PricewaterhouseCoopers]."

To a lesser extent, such an unwinding of the top firms is already happening. For one thing, new restrictions on the kinds of tax services auditors can provide to audit clients has triggered a minor exodus of Big Four tax partners to law firms. PwC vice chairman John O'Connor claims that most of the firm's lost tax business has gone to other Big Four firms. But he does grant that about 3 percent of PwC's tax business has been lost to law firms. "There's a bit of a market-share grab for the tax business of clients," he notes.

At the same time, a number of boutique accounting firms have opened in the past few years. In some cases, the start-ups have been launched by nonpartners of top-tier firms. Erik Linn, an ex-auditor at Arthur Andersen who started CapAdvisory in 1999, explains that "the intense work schedule and long hours at the Big Four firms, combined with the increased risk, have made partnerships at these firms much less attractive."

More small firms will likely pop up in the coming months. Such new accounting standards as SAS 99 and process refinements wrought by the Sarbanes-Oxley Act of 2002 will provide yawning business opportunities for niche players. Stephen Giusto, CFO of Resources Connection Inc. and a Big Five employee in the early 1990s, sees another reason for the migration from Big Four firms. "It's getting harder to become partner," he asserts. —J.G.

Mind the Gap
First-tier firms still tower over their second-tier cousins.
Accounting FirmRevenue
($ millions)
PartnersProfessional Staff
(nonpartner)
Big Four   
PricewaterhouseCoopers

$13,782

7,020

97,109

Deloitte & Touche

12,500

6,714

73,810

KPMG

10,720

6,600

69,100

Ernst & Young

10,124

6,131

60,713

Second-tier   
BDO Seidman

2,395

2,182

16,078

Grant Thornton

1,840

2,256

14,019

McGladrey & Pullen

1,829

2,245

12,775

Note: This table is limited to U.S.-based firms with global operations. Some foreign firms may have operations comparable to smaller U.S. firms.

Source: Public Accounting Report, 2003

Comments

comments powered byDisqus
Cfoport

Read next:

Finance At BeyondCore

i