Auditor Independence and Management Consulting – Deja Vu All Over Again

To introduce this topic, let’s start with excerpts from a Frontline series, dated June 2002, Bigger Than Enron.

In the segment entitled Congress and the Accounting Wars, the history and politics of independence legislation supported strongly by then SEC Chairman Arthur Levitt and eventually incorporated in the Sarbanes-Oxley legislation of 2002 is described.

At the height of the debate over auditor independence in 2000, Ken Lay sent this eye-opening letter to Arthur Levitt, then chairman of the SEC, urging him to back down on his efforts to eliminate the potential conflicts of interest created when accountants provide both auditing and consulting services to a single client.

The letter argued that Levitt was jeopardizing the productive relationship Enron had built with Andersen, one in which Andersen had become so deeply intertwined with Enron that its staff had moved into the same building, taken over much of the internal auditing usually left to Enron employees, and expanded rapidly into the highly profitable area of consulting. Andersen touted this “integrated audit” as a new paradigm in corporate accounting.

Although ostensibly from Lay, the letter was secretly co-authored by Andersen partner David Duncan in consultation with the firm’s lobbyist in Washington as a part of the accounting industry’s massive lobbying effort against Levitt’s reforms. ðLetters such as this one, coupled with enormous pressure from Congress, forced Levitt to back down on the issue of auditor independence and eventually to adopt a less stringent rule.

Interestingly, as we can see from the excerpt of an interview with Chairman Arthur Levitt in 2000, one of the opponents of any change in the rules regarding auditor independence was Senator Michael Oxley!

In April 2000, you proposed reforming the accounting industry. What happened? What was the industry’s reaction?
The number of cases of financial fraud that we were seeing at the commission had absolutely exploded. Managed earnings became the regular way of going rather than the exception. So I went to the leaders of the Big Five accounting firms. And I said that we have got to change the rules, and that means the conflicts that exist have got to be eliminated.

Two of the firms, Ernst & Young and Price Waterhouse, said that they would try to work with us on trying to change those rules. Three of the firms, KPMG, Deloitte, and Arthur Andersen, at a private meeting that we had, said, “We’re going to war with you. This will kill our business. We’re going to fight you tooth and nail. And we’ll fight you in the Congress and we’ll fight you in the courts.”
And that began a nine-month saga of public hearings, because I felt the public interest was involved in this. We held public hearings in different parts of the country, had witnesses, and an enormous lobbying campaign went along parallel with our efforts to bring this to the public’s attention.

Lobbying campaign on your part? On the industry’s part?No, on the industry’s part. They hired no fewer than seven lobbying firms to represent them on the Hill. I spent probably over half my time in my final months at the SEC on Capitol Hill, responding to queries from members of Congress, talking to congressional committees, trying to explain why this is a matter of national economic interest. …
What kind of clout does the accounting industry have on Capitol Hill?
I guess I learned over coming months that they had enormous clout; that their contributions to members of Congress who never thought about an accounting issue or an accountant and suddenly picked up the cudgels for the profession; where my own congressman was led into the belief that this was an effort that might have been worthwhile and signed on to a letter which he later retracted on the floor of the Congress; where a close friend of mine who I’d climbed eight mountains in Colorado with while he was head of the Outward Bound School signed on to another letter that he later retracted on the floor of the Congress.
This was a broad-ranging campaign that was well-financed, well-structured, and extremely vigorously fought.

Well, speaking of letters, I have a letter that you got in April. What is this letter?

This is a letter from the overseers of the SEC, the congressional committee that oversees the SEC that has a chokehold on the existence of the SEC, that can block SEC funding, that can block SEC rulemaking, that can create a constant pressure in terms of hearings and challenges and public statements, that can absolutely make life miserable for the commission.
And here are the three leaders, Tom Bliley, the chairman, Mike Oxley, the head of the subcommittee, and Billy Tauzin, the chairman of another subcommittee, were directing me to go slow on this issue, to go through a process. And this is, I guess it’s a five- or six-page letter, asking for the kinds of responses that tied the agency up for weeks and weeks to answer questions that were intended to really stand in the way of the rulemaking that we had in mind.

Between 2000 and 2002, in response to the new rules, the IT consulting practices of four of the Big five accounting firms were either sold to public companies or spun off and IPO’d.

– In February 2000, Ernst & Young Consulting was sold to Cap Gemini.
– In February 2001, KPMG Consulting (later BearingPoint, Inc.) was floated with an IPO. (This IPO was delayed and re-priced several times in order to wait until more favorable market conditions after the millennium change, but finally took place and then went nowhere.)
– In July 2001, Accenture (known as Andersen Consulting before its split from Arthur Andersen) also went through an IPO.
– In October 2002, PricewaterhouseCoopers Consulting was sold to IBM. (They failed on their first attempt to sell to HP.)

Only Deloitte Consulting did not, in the end, separate from Deloitte & Touche. However in July of 2002, Deloitte Consulting of New York announced it would change its name to “Braxton.” The new name was drawn from a consulting firm Deloitte purchased in 1984 called Braxton Associates.

“While our competitors are distancing themselves from their consulting roots, we are reaffirming our commitment to the profession,” said Doug McCracken at the time, chief executive officer of Deloitte Consulting.

Deloitte’s name change followed one by PwC Consulting. In June of 2002, PwC announced it would change its name to “Monday” once it was spun off from parent company PricewaterhouseCoopers LLP of New York, a move that was expected expected later that summer. However, it instead attempted to sell to HP and then completed a transaction to IBM later that year.

During the last year or so, however, the firms have been rebuilding their consulting arms. All the big four accounting firms are seeking to re-expand their consulting practices. Fee increases from advising companies on Sarbanes Oxley and other regulatory changes (IFRS, BASEL II) have slowed in 2006, tax revenues are marginal and the independence issues that led three of the four to sell their consulting businesses are felt by them to have eased. Howevever, has anything really changed or is this just another round in the never ending cycle to distract from answering the question, “Does the model of a government sanctioned monopoly on public auditing protect shareholders and other stakeholders?”

Why is there a feeling that regulator concerns about independence have eased? Some of the firms are still operating under SEC consent decrees related to previous violations of independence regulations. They have been forced to develop extensive and expensive infrastructure and systems to manage compliance with new regulations, including independence. PCAOB inspections include review of these policies, procedures and systems and are getting more stringent higher expectations with each round of inspections, as the inspectors become more familiar with each firm, their clients, their professionals and their operations.

From a business standpoint, what opportunity do the firms really see in the consulting business? Given the concentration of the publicly owned firm audits in the Big 4, their market opportunity is limited to only the firms they do not audit or have another independence conflict with. The possibility of independence conflicts with a company is significant even if a firm is not their primary auditor.

First, it’s common for a large company to have more than one Big 4 auditor involved in auditing them. For example, until recently, Deloitte was the auditor for GM, but PwC audited GMAC. Because of this, when GM first realized that Deloitte would probably no longer be able to provide internal audit support as well as external audit, they precluded PwC from bidding on the new contract. PwC was precluded from proposing, given that a major portion of the outside expertise they were looking for was related to financial services expertise and GMAC. The new contract went to KPMG/Protiviti.

Second, many large public companies ask another Big 4 firm to be an external “auditor-in-waiting.” In this case, the Big 4 firm must be very careful which advisory/consulting engagements it accepts from the company, in the event it would be asked to step in as the primary external auditor. In that case, it would have to quickly resign all consulting engagements, including acting as an outsourced provider of internal audit services and perhaps wait a period of time before being sufficiently independent to audit some divisions or business areas where it could not resign fast enough.

An example of this scenario is the February 3, 2006 announcement of the change of external auditors at Delta Airlines to Ernst & Young from Delta’s previous auditors, Deloitte & Touche. Sources report that PwC had a significant co-source relationship with Delta as the provider of internal audit professionals. In late 2005, PwC resigned its internal audit engagement while preparing its proposal for the external audit engagement. They withdrew all consulting teams, including internal audit professionals, from Delta. Unfortunately for PwC, the audit was awarded to Ernst & Young regardless of PwC’s business sacrifice. Their presence at the client has not recovered to its previous levels.

Finally, almost all of the Big 4,some more than others, are auditors of “investment company complexes.” When auditing any entity in an investment company complex, an auditor must be independent of each entity in the investment company complex. So this precludes an auditor of a large private equity fund or the auditor of one of the significant investments of a private equity fund from performing services that would impair their independence from each entity that the fund has significant interest in.

E&Y poaches Capgemini staff
By Barney Jopson, Financial Correspondent
Published: December 24 2005 02:00

“Ernst & Young has poached several senior staff from Capgemini, the group to which it offloaded its consulting arm five years ago, as the accountancy firm tries to break back into the market it deserted.

…E&Y moved quickly to start a new consulting operation after the expiration of a non-compete agreement with Capgemini in May this year (2005). The firm has recruited 10 staff from Capgemini, including four partners, and in September hired Steve Varley from Accenture as its new head of advisory services.

Growth in their tax businesses is marginal.

The big four today offer a range of consulting services, although they are(were) often loath to label them as such (in the past). They advise on strategy, risk management, cost reduction, internal organisation and supply chain management. None of the four are seeking to develop a large business in information technology systems, an important part of the operations that were sold off.
(In the UK) In its most recent business year KPMG’s consulting revenue rose 48 per cent to £225m. PwC made £201m from consulting but did not provide a comparative figure for 2004. Deloitte’s consulting revenue was up 6 per cent at £312m. The big four do not publish detailed profit numbers.

Mr Varley said E&Y was seeking to bridge a gap in the market between “strategy houses” such as McKinsey and Bain and “IT houses” such as IBM and Accenture. “Strategy houses are sometimes disconnected from how you make change happen, while systems integrators are focused on the technicalities,” he said. “Our clients did not have many places to turn to for practical advice.””

COMPANIES UK: Advice arm sales up 48% at KPMG:
By Barney Jopson,Financial Correspondent, Financial Times
Published: Jan 18, 2006

KPMG recorded its fastest revenue growth last year in the UK consulting market, the focus of a new land-grab by the big-four accountants, as operating profit climbed 21 per cent to £305m. The firm said yesterday that turnover from its consulting arm – known as risk advisory services – jumped 48 per cent to £225m in the year to September, surpassing growth in audit and tax.

Large accountancy firms are seeking to re-occupy the consulting sector, which they once abandoned, in a bid to broaden revenue streams. But their aggressive moves are stoking concern about possible conflicts of interest between audit and non-audit work.

KPMG said it still made sense to sell “audit-related” services to audit clients but that most of the growth in its consulting business came from other corporate clients.
Mike Rake, UK senior partner, who was presenting his final annual report before stepping down in September, said the firm was trying to build strong non-audit relationships with companies audited by PwC, Deloitte and Ernst & Young. John Griffith-Jones, UK chief executive, said: “The holy grail of the relationship, when we get it to hum, is selling tax, risk and financial advice to the same company.”

KPMG earned a combined operating profit of £190m from consulting and its better-established financial services advisory group. It declined to disclose a separate profit figure, but Mr Rake acknowledged its expansion had entailed significant up-front spending. “When you bring in a big bunch of new people, you bear some investment costs,” he said. Rival consultants say new ventures often struggle to make money in their early days as they incur large personnel costs but lack lucrative client contracts.

…Company audit committees remain nervous about the independence of auditors, an issue thrown into the spotlight by the collapse of Enron, but Mr Rake said they were taking an increasingly “practical” approach.”

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  1. […] auditing. Audit firms became concerned about the growing regulatory and public criticism and two of the four firms sold their consulting practices. A third sold shortly after. Deloitte Consulting, however, never […]

  2. […] businesses in the wake of the Enron scandal and the regulatory scrutiny that then turned upon perceived conflicts of interest between the firms’ auditing core and their consulting interests. Only Deloitte held on to its […]

  3. […] firms are focusing on growth in their global consulting businesses but the conflicts that drove three out of four of the firms to sell them after Enron are a bigger problem than ever before. Deloitte was the only firm that held on to its […]

  4. […] firms are focusing on growth in their global consulting businesses but the conflicts that drove three out of four of the firms to sell them after Enron are a bigger problem than ever before. Deloitte was the only firm that held on to its […]

  5. […] enough Mr. Levitt has a long and contentious history with PwC. It all goes back to reforms he wanted to make to how the audit firms did and didn’t do […]

  6. […] I joined to bring a more consultative approach to what was already a very successful start up, an independent provider of internal audit and accounting /finance staff augmentation services to Fortune 500 companies. […]

  7. […] tax fees than from the audit itself.  I thought that Sarbanes-Oxley was supposed to prevent the Arthur Andersen syndrome from happening […]

  8. […] couldn’t have said it better myself. Or maybe I already did, here and here. Let’s hope Sir Michael has learned the lessons of Rand Blazer, one of his former KPMG […]

  9. […] have been hired as Directors. The last time the auditors put on a big lobbying push, it was to squelch the push by former SEC Commissioner Arthur Levitt, pre-Enron, to eliminate the conflicts of interest inherent in the firms performing audits and […]

  10. […] the debates in early 2000, prior to Enron, as the Big 6 accounting firms sought to overcome the commoditization of the […]

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