Auditors Or Clients – Who Wears The Pants In This Relationship?

I had a wonderful, very long lunch today with Jim Peterson of the International Herald Tribune. As has been mentioned before, Jim writes a column that travels down many similar roads as this blog, but he brings a very seasoned perspective given his legal credentials and senior-level, global, professional services experience at Arthur Andersen. We could have talked all afternoon and into the night, but we agreed to break and regroup again later to discuss the world’s problems over dinner next time.

One topic that came up was auditor changes. They continue to occur at a faster clip than before Andersen’s demise given the scandals, lawsuits, conflicts of interest, restatements and other vexations facing the auditors in the current course of their relationships with their clients. Sometimes the auditor resigns, sometimes the auditor is fired. However, the disclosure is often the same bland statement about no disagreements, blah, blah, blah. It’s a treat when you find a spicy disclosure that points to the conflicts that existed…

Professor Prem Sikka (and John Dunn) in the UK wrote about this problem in his 1999 monograph, “Auditors: Keeping the Public In The Dark.”

“The legislature hoped that at the very least a resigning auditor should
speak up and draw the public’s attention to matters of concern. Legislation to facilitate this was introduced by the Companies Act 1976 (now part of the Companies Act 1985). The law requires the resigning auditors to make a statement on any matters connected with their resignation which ought to be brought to the attention of the company’s shareholders and creditors…A study of a sample of 766 resignation letters issued by auditors of public limited companies showed that only 19 (or 2.5% of the population) contained a statement of any matters that were considered to be relevant to the shareholders or creditors. In other cases, the auditors filed a ‘nil’ return i.e. there were no circumstances in connection with their resignation which either shareholders or creditors needed to be aware of. In 108 cases, the resigning auditors issued qualified audit reports i.e. indicated material disagreements with directors or reservations about company policies and activities, yet remained ‘silent’ in the resignation letter.

The statements containing ‘nil’ responses raise some interesting issues. Firstly, it is a matter of concern that an auditor would find it necessary to resign part of the way through an appointment which would not normally last for more than one year. Secondly, in some cases the ‘nil’ return is followed by public revelations of scandals. This suggests that the resigning auditors had been ‘economical’ with information. Yet no regulator has ever taken the auditors to task. Overall, it appears that the auditor resignation legislation is not being properly complied with. Auditors go through the motions of making statements, but rarely provide any useful information. Auditors prefer silence and keep the public in the dark.”

While talking about this phenomenon, Jim asked me, rhetorically, “Have you ever seen a Fortune 500 company or a FTSE 100 company go hungry for an auditor?”

With all the changes and concern about audit choice, it doesn’t seem that, for the largest companies, there’s really any hardship in finding another firm if one of them quits or has to be fired. Granted, it may cost them more, or they may have to actually do what they had resisted doing under the previous auditor, (restate, change an accounting treatment, record a loss, etc.) But in general, you see very few lawsuits suits by companies complaining that they’ve been left with no choice.

I had this discussion at one point with Christopher Ames of Ames Research Group, too. He was of the opinion that,

Looking at auditor changes on an annual basis, the Big Four firms have collectively had a net loss in public company audit clients every year since 2003. In 2002, they enjoyed large gains but only at the expense of Andersen. Going farther back, only Ernst & Young had a net gain in 2001. The firms will say that this is largely due to “strategic exits,” that is, resigning from risky audit engagements. During 2003 and 2004, even into 2005, this explanation makes sense. The firms began to take a hard look at the clients they took on from Andersen. The full impact of SOX 404 takes hold at company and auditor alike, both realizing they lack the necessary resources. And so, the Big Four began assessing their audit clients for risk in a new way, resigning from engagements deemed risky in relatively large numbers. Firms also left relatively unprofitable engagements to rally the resources needed to handle the 404 workload at their largest clients.

However, since mid-2005, we have observed a turn-around at two of the Big Four. Deloitte and Ernst & Young have significantly narrowed their net loss due to auditor changes. More importantly, both firms have actually gained clients in the largest segment of companies we track.

PricewaterhouseCoopers, on the other hand, continues to have a large net loss, and its losses are greatest at the large-company level. Furthermore, we find that PwC is being invited to propose at about the same rate as the other Big Four, but is converting invitations to engagements at a rate far below its competitors.

You also raise the question of what happened to all of these companies deemed too risky to audit by the Big Four. They went to the second-tier firms—BDO, Grant Thornton and McGladrey. These are good, high-quality organizations. However, they are orders of magnitude smaller than the Big Four. During the 2003-2005 window mentioned above, companies were throwing themselves at the second and third-tier audit firms, hundreds of companies.”

I believe that for every firm that doesn’t want a client, either due to its undesirable economics or risk profile or both, there’s another firm who will take it. For the largest companies, that other firm is most often another Big 4. Ames also stated that his firm sees “competitive” bidding by the firms when an audit becomes available. But I seriously doubt that real competitive bids are entertained, except by the most ornery companies, for several reasons:

1)The switch is often announced same day the resignation or firing is announced. There has to be an “auditor in waiting” in order to effect such a smooth transition in the majority of cases.
2)Companies are loathe to disclose their dirty laundry to more firms than necessary and complete information is needed to make a real bid.
3)The firms don’t make real bids anymore but “value priced” bids. In other words, they charge what the market will bear, with a large fudge factor for the unknown, then negotiate in order to seal the deal or beat off any potential competitors. They don’t know what it costs for them to do these massive global audits, especially in the face of restatements, investigations, SOx, and changing regulatory requirements, as well as unknown risk factors. All they care about is top-line growth, like most of their clients.
4)CFOs, nowadays, have no time to create Requests for Proposal and to sit through multiple presentations or read several firm’s proposals. The clients are in the driver’s seat and know that, in 99.9% of the cases, another one of the firms will step up and take the case, no matter how messy.

Let’s go back to our Enron example and revisit a very informative passage:

“What about those times Andersen did object to an Enron transaction? At such times, Enron put the firm under intense pressure. There were times when Causey and others would ask that certain accountants who weren’t “responsive” enough be moved and Duncan complied. Knowing how important the $1,000,000 per week account was to Andersen, Enron also kept competing firms lurking in the wings. From time to time, Causey would throw small bits of business to Ernst and Young or PwC, just enough to remind Andersen who was running the show.”

Companies still keep “competing firms lurking in the wings.” Only now, due to Sarbanes-Oxley and its Enron rule prohibiting external auditors from also providing other services such as consulting and internal audit/SOx, the “auditors in waiting” are embedded and much more knowledgeable about the companies than they were when they only got small bits. Some firms are aware, very consciously, of their “auditor in waiting ” status and manage their other engagements with the client carefully, in order to be well positioned to step in quickly if needed. And step in quickly, someone always does.