The increasing reliance of the Big Four accounting firms on their consulting and advisory practices may threaten the independence of their audit practices, according to some auditing experts.
A roundtable discussion Monday at New York University’s Stern School of Business on the re-emergence of consulting practices at major audit firms featured a panel of influential accounting watchdogs. They included former Federal Reserve chairman Paul Volcker, former Financial Accounting Standards Board chairman Bob Herz, NYU professors Sy Jones and Stanley Siegel, journalist Francine McKenna, and attorney Christopher Davies of the law firm WilmerHale.
Volcker, who chaired the Fed during both the Carter and Reagan administrations, noted that the question of who pays the auditor can be a serious problem. “It’s very hard to get an independent review from somebody who gets paid,” he said. “During my days as a bank regulator, when we found something wrong or questionable with a bank, they would say, ‘We’ll investigate it. We’ll have our law firm or auditing firm do a thorough investigation and find out who is responsible.’ Not once did the in-house auditor or legal firm find out who was responsible. Somehow it was the Immaculate Conception. But when you had an outside auditing firm or an outside lawyer, you got voluminous reports that you could aggressively pursue.”
Volcker noted that in 1990, his investment banking firm had the job of mediating a dispute between the auditors and consultants at Arthur Andersen. “They had a longstanding reputation for being the most disciplined auditors,” he said. “This was a very proud firm being torn apart. We were able to reach a harmonious resolution of this struggle, but later it was a very expensive divorce.”
Volcker attributed Andersen’s later problems with clients like Enron to a desire to rebuild the consulting practice after shedding Andersen Consulting, which became Accenture. “They’d gotten rid of the consulting business, but they immediately made a huge investment in rebuilding a consulting practice, thinking that somehow this rebuilt practice was vital to the future of the firm,” he said. “They had the same difficulties that they had in the first place. In fact, it weakened the firm in making such a very large investment in a consulting practice, which exploded on them with Enron.”
Volcker was later involved in helping craft the Sarbanes-Oxley legislation, which still allowed firms to provide both audit and tax services to the same clients.
“Arthur Andersen had been put out of business, and nobody wanted to put another firm out of business,” said Volcker. But he noted that putting auditing and consulting practices in the same firm could lead to problems.
“I will say, from all my observations, there is no doubt that putting these two functions in the same firm has an impact on the culture,” he said. “You are in effect subsidizing the audit function. The tension was palpable in that once great firm of Arthur Andersen. It was enormously frustrating and in the end unproductive.” Volcker believes that if Andersen had not been indicted and ultimately gone out of business, it would have been a much different firm and might have survived as an audit-only firm.
Audit Committee Involvement
Former FASB chairman Herz noted that the quality, credibility and trustworthiness of financial information that goes to investors is essential to the efficient functioning of the capital markets and therefore to the economy. “Auditing is one key aspect of that,” he said. “Whenever it comes to these kinds of issues, I don’t think about it in terms of audit independence per se. I think about it in terms of audit quality, both in terms of the actual quality of the audit and the perceived quality and credibility of the auditing function, and whether people believe the numbers that are audited, that somebody has been actually having a good look at it and you can have some trust in those numbers. We saw a decade ago when there were a number of those cases, there was a real question about whether or not you could rely upon the numbers at all, and that led to Sarbanes-Oxley and a lot of the other actions pursuant to that. I personally think that was necessary at the time to restore both audit quality and the perception in the market that you could rely upon the numbers because it would be a threat to one of the crown jewels of our country, the capital markets. The elements going into audit quality are competence and objectivity. You need somebody who can do a good audit, and you need somebody who is inclined to do a rigorous, objective audit.”
Herz noted that Sarbanes-Oxley created the Public Company Accounting Oversight Board to oversee the inspections of auditing firms and strengthened the responsibilities of the audit committees. “I am on the audit committees of some large companies,” he added. “The auditors are now responsible to the audit committees and not to management. That is what happens, at least best practices. The audit committees make sure that the auditors, from the partner on down, understand that the client is the audit committee, and the audit committees, if they’re good audit committees, their interests are to have a good audit done. The issue at the whole firm level, or maybe the whole industry level, is where do the investment dollars go? If I’m the head of one of the big accounting firms and I want to make an investment, is the investment allocated first to growing consulting services, buying consulting firms, or is it allocated towards training of the auditors, improving the audit methodologies and the like. There are no bright lines here, but you can see what the allocation of investment resources is.”
Another important issue, Herz observed, is how the auditors feel about their position in the firm. “I’m a firm believer that a quality audit is job one of any accounting firm that has a license to do audits, particularly of public companies, and therefore as an auditor you ought to feel like you’re doing job number one,” he said. “The question would be the culture. Does the culture treat them as the most important people or at least as equal, or is it kind of you’re over there in this regulated business, and the glamor part of the business is over there growing the non-audit services. I think over time that can have an impact on the whole culture of a firm. It can have an impact on the quality of the resources eventually choosing to go into the audit profession.”
Self-Regulating Peer Review vs. the PCAOB
NYU professor Siegel pointed out that the alternative to having the PCAOB regulate the profession was the old self-regulating model of peer review by other CPA firms. “One of the reasons why independence and fiduciary duties, as both legal and professional rules, emerged 150 or 200 years ago, was to provide an internal structure that established a disincentive for cheap conduct, self-interested conduct, or careless conduct, and one of the results of seeking to water down those standards, and that’s what happened before the PCAOB, is that you create a vacuum, and you end up getting the worst of all worlds, a structure in which the self-regulation, which was built into the arrangements is no longer there and the government comes in to regulate in its place,” he said.
“All of the evils of government regulation sit on top of this, and so one of the thoughts that we might pay some attention to is that we can’t have a vacuum without regulation,” Siegel added. “The question is where do we want it to reside? Do we want it to reside in the PCAOB or do we want it to reside in peer review? Do we want it to reside internally in the profession with high standards? The argument that you want to get rid of all of it isn’t going to work, and you’re going to have a profession that’s in a shambles.”
Changes Since 2007
NYU professor Jones pointed out that when Sarbanes-Oxley was passed 10 years ago, accounting firms were not supposed to provide consulting and many other non-audit services for their audit clients, although there were some exceptions, such as tax services.
“The firms, particularly the major firms that do work in the federal environment, were asked to give up consulting,” he said. “That’s the way it’s been for about 10 years, or at least it seems that way. The idea was that the major firms could not do consulting work for their audit clients. They could do consulting work for their non-audit clients, but they could not mix the two together for the same client. That kind of reduced the income level for them. Lo and behold, what happened?”
Jones described a recent newspaper article that piqued his interest in the growth of consulting practices at the major firms. “In the year just passed, all four bore some degree of condemnation from the PCAOB and the article said the reason why was that the big firms had now gone back into the consulting business,” he said. “From 2007 on, the major firms started to develop some significant revenues based on consulting. How did they get so big in consulting again given the prohibition in 2002? It seemed odd to me how they could have come back that fast after five years, and then in the next five years leading up to the current time, they were doing extremely well in consulting. And when I dug deeper into the subject, it seemed that they were developing personnel and the capabilities to go out and do consulting work and really focusing a good deal of their time on it. One critic in effect came to the conclusion that when the PCAOB came to review some of these big firms, they found problems with them, and in essence what the critic was saying is that now that the big accounting firms, who are known primarily for audits, should have been focusing on audits in the last 10 years, suddenly there were problems with the work that they had done. I just couldn’t buy that. It didn’t seem logical to me.”
Second Coming of Consulting
McKenna, who writes for American Banker, Forbes, the Financial Times and other publications, as well as her own blog, re:The Auditors, noted that she has worked at two of the Big Four firms, KPMG and PwC, as well as KPMG's spinoff consulting firm BearingPoint.
“I am now watching the second coming of consulting for the Big Four auditors,” she said. “Consulting never left Deloitte. It only grew bigger while the other three large firms went back to being semi-pure audit firms because they were worried about trouble with regulators. Their concerns were misplaced.”
She described how Deloitte has grown its revenue from consulting. “I think it’s too late, for Deloitte and the rest of the Big Four,” she said. “The auditors’ consulting businesses have recovered from the post-Sarbanes scare. Deloitte has been building its business all along including via acquisitions like the carcass of BearingPoint’s public sector business. I reported in American Banker that PwC, who bought the industry side of BearingPoint after the bankruptcy to jumpstart its systems integration practice, has its best Advisory set of engagements ever with four OCC/Fed mandated mortgage servicer foreclosure reviews, expected to bring in more than $1 billion in revenue before it’s over. And there are numerous examples of audit firms still earning at least as much of their fees from audit clients, or multiples of their audit fees, from what were, in my mind, supposed to be prohibited services to those companies. For example, auditors provide non-audit related advice on GAAP and SEC reporting for specific transactions and get paid extra for it. Who goes back to check and see if they audited their own advice?”
McKenna noted that KPMG had sent its tax staff to its audit client GE to help with their tax returns for a few months every year. “This had been going on for a while, for $10 million extra per year,” she pointed out. “Less than a year after I wrote about it, the engagement stopped. There were reports of the beginning of an investigation. An order to preserve documents referring to the ‘loaned staff’ was circulated. But we’ve not heard anything from the PCAOB or SEC about any disciplinary actions or sanctions for this clear violation of Section 201 auditor independence rules. Wal-Mart and News Corp use their auditor, Ernst & Young, for tons of tax services. They’re in big trouble for bribery, an illegal act, but we didn’t hear about it from Ernst & Young. If Ernst & Young knew at some point about the illegal acts, did the firm file a Securities and Exchange Act Section 10A report with the SEC when it was obvious those companies weren’t stopping on their own or self-reporting but instead covering them up?”
McKenna contended that the SEC and PCAOB have not even minimally enforced the Sarbanes-Oxley Section 201 auditor prohibited services rules against the Big Four and have stopped enforcing compliance with existing rules against inappropriate financial interests and strategic alliances. “When was the last time you heard about an independence violation by one of the Big Four other than the insider trading scandals?” she asked. “Clearly they are occurring. But it’s wildly unpopular for regulators to even suggest they may force companies to cut off a favored vendor—the one you can “work” with—as we have seen whenever the subject of auditor rotation comes up. Almost everyone who speaks out in public on the auditor independence issue has a vested interest in not pushing back too hard. Audit committees more often feel it’s their job to help management produce results and keep costs for vendors down instead of acting as the check and balance on auditor independence.”
Sky Isn’t Falling
Davies of WilmerHale has been representing accounting firms for 15 years as a litigator, and he disagrees with blaming audit firms for their consulting work. “I don’t believe the sky is falling,” he said. “I don’t believe we’re at a point of crisis as we might have been in 2002. I think that crisis at the time really involved two separate issues that we need to disaggregate. One was about audit quality, and the question of whether the services being delivered were what the client intended to purchase or what the market desired. That had a whole bunch of subsidiary problems and if you look at Andersen’s performance on Enron, I think there are a series of different questions about how Andersen organized its national office and how consistent they were in the application of professional standards and all those kinds of things which go to audit quality and then the performance of the team. The second thing is the independence question and a bunch of the stuff that you saw coming out of Sarbanes-Oxley really grew out of an SEC order in January 1999 relating to PwC. That order was about having a financial interest in audit clients. That order is an interesting and useful lens through which to examine the question of auditor independence and how to think about when you should fix things. What that order and the subsequent look-back that all of the firms were subject to revealed was that across the profession there was pervasive noncompliance with financial interest rules that had been in place for decades effectively, unintentional for the most part. People didn’t know they were out of compliance, but they were not in compliance.”
Davies noted that consulting services are not entirely proscribed by Sarbanes-Oxley. “Rather the kinds of consulting services that go to audit quality were curtailed,” he pointed out. “So, for example, you can’t provide systems-oriented services to your audit client. You can’t go in and install the accounting system that your client is subsequently going to use and that you’re subsequently going to audit from a controls or a financial statement standpoint, such as testing your controls. That’s an important distinction."
“It’s not a question of delivering services or independence,” Davies said. “It’s a question of what is the service supposed to be and how is it supposed to be communicated to the market. If you want to change that, however, you can’t just amplify the obligation on the auditor.”