Maintaining Independence Can Be A Sticky Wicket

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Jennifer Hughes’ Accountancy column in the FT this morning reminded me that the Big 4 think they are consultants again. In the UK, (Anyone know what the best comparable figures for the US are???) strong fee growth at the consulting arms of the top tier accounting firms have pushed them back into the top 10 of UK consultancy.

Remember… three of the four – KPMG, PwC and Ernst & Young – sold their consultancy 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 operations.

Now, the non-compete agreements related to the business sales have all passed and this year, according to Accountancy Age, all four are back in the top 10 of UK consulting fee earners. The returnees posted exceptional growth: 25 per cent, 14 per cent and 11 per cent respectively at PwC, E&Y and KPMG, and 10 per cent for Deloitte. The growth picture is little different worldwide; this has been a bumper year for their consulting arms.

“We don’t see them very much in IT, apart from IT assurance and some high-level advisory work,” says John Reeve, a partner in the consulting practice at Deloitte. “They haven’t rebuilt capacity in development and implementation [and] in our view, this severely reduces their credibility as IT consultants and is reminiscent of the scope of services of audit firms in the mid-80s.”

However, has anything really changed with regard to concern over real or perceived conflicts of interest and the required regulatory scrutiny of potential independence violations? I’ve pointed out that thorny issues still exist when a company uses their auditor as a major tax advisor. Those fees can quickly dwarf the audit fees and, perhaps, compensate for them not going up as quickly or as much as in other clients, Sarbanes-Oxley bonanza or not. And then there’s Northern Rock, a case that should be a huge embarrassment for PwC and a wake-up call for regulators.

The only thing that has changed is the current lack of enforcement of the independence restrictions by the PCAOB and SEC. If there were any concerns coming out of PCAOB inspections, we’d never know it. That part of the report is private. And the SEC has been too busy with options backdating (scrutinizing everyone but the Big 4, who always settle), tax shelter prosecutions (and implementing the “too few to fail” policy) and other securities litigation. The SEC has been focusing on the corporate bad guys, leaving the auditors to be sued by shareholders.

So who’s making sure that we don’t have another EY/PeopleSoft episode, E&Y/American Express or a PWC equity-lapalooza, or PWC/IBM kickback party, or an EY/AIG/PNC self-interested round-robin or a perceived independence violation based on alliance relationships?

As I mentioned yesterday, one of the more common ways for the Big 4 to do the kind of business that they can’t do officially or openly is to allow their professionals to freelance, such as helping the “Kite Runner” boy actors escape from Afghanistan in advance of the movie opening.

They can also subcontract.

When the Big 4 is the prime contractor on a large project, whether defense or corporate related, it’s difficult for them to skip the risk management and other independence and conflicts checking that the firms now employ in order to keep their client lists clean and organized. The up-front risk assessment process required when taking on a new client, or a new engagement for an existing client, vets the independence issues, hopefully before a contract is signed. But this task is challenging in even this simplistic example, however, if the project involves multiple countries or if the client is a multinational that may be doing business directly with a local office of the firm rather than working through their global relationship partner. In that case, the right hand may not know what the left hand is doing.

As I have said before, the firms have a hard time keeping track of what their foreign offices are doing. Even if they know what they are doing, they have few tools to enforce rules that, in the end, foreign offices often perceive as being only for the benefit of the US firm.

When money talks, partnership and brotherhood walk out the door…

An even more difficult but increasingly common scenario, especially for Deloitte, is when the Big 4 firm is the subcontractor, rather than the prime, or lead, contractor.

Neither Deloitte nor any of the others are too proud to be a subcontractor, working under the likes of a Lockheed Martin, SAIC or Northrup Grumman.

But when the relationship with the ultimate is once removed, it’s difficult for the Big 4 firm to initially identify and effectively monitor independence conflicts with subsequent ultimate clients. That’s because their client, the one they bill and set up on their systems and vet from a conflicts and independence perspective is the prime contractor, not the ultimate client. If the ultimate client ends up being is another corporate entity or the federal government, there may be an independence conflict.

Another example is when a Big 4 firm goes into business with a software company. Sometimes it’s just a joint marketing alliance and sometimes the Big 4 firm has sold their software to another company. There may have been existing or perceived restrictions on that type of business activity or maybe they just can’t manage and invest appropriately in software. It gets even more complicated when those companies are acquired again and erase all ties to their Big 4 legacy.

Recently, PwC sold their Teammate software, used for audit workpaper preparation to a firm called Wolters Kluwer.

The article boasts of the number of clients and users that the software already has, a very big installed base that PwC developed and, perhaps, are charging the acquirers quite a bit for. However, another nice sweetener often put into this type of contract is the continuing royalty opportunity. PwC may have asked for the ability to continue to benefit from the license fees paid by customers they developed and served all these years as well as allowing the acquirer to pay them the purchase price over time. There may be some offset given the fact that Wolters Kluwer is also acquiring the Teammate business team staff and putting them under their roof.

When the acquisition is structured as a contract purchase, where the acquirer pays PwC over time and/or based on the revenues from the existing client base, it can get messy. At some point Wolters Kluwer will seek to develop their own clients and will want to sell to whomever wants to buy the product, regardless of PwC’s independence restrictions.

This is a very real and very dangerous situation for the Big 4, especially as they seek to expand their consulting businesses and team up or align with other firms like Accenture, CSC, EDS and other system integrators and software firms that have no independence constraints regarding with whom they do business. All of those consulting types they’ve been hiring back don’t usually care that they really work for an audit firm, not a consulting firm. When a conflict arises, audit cmes first. Let’s hope the consultants fess up to who they’re really doing business with before they start sending the bills.