Held to Account – Holiday Reprint

Reprinting one of my first and favorite posts.

Happy Memorial Day 
Make Levees Not War
From a recent Financial Times comes this interesting news:
Held to Account
Published: September 12 2006 03:00

PwC, the guardian of fastidious accounting, seems to have let some laxity creep into its own results presentation. A press release put out yesterday champions “UK turnover of £2bn” for the year to the end of June. But just a few pages away in PwC’s annual report lies evidence of some rounding- up. Turnover, it transpires, was a marginally less bombastic £1.98bn. Such behaviour is not uncommon; the FT is itself guilty. But perhaps the UK’s biggest audit firm should be whiter than white. To put the sum in context: £20m is eight times the not insubstantial salary of Kieran Poynter, PwC’s UK chairman.

In the Harvard Business School publication, “Ownership Structure in Professional Service Firms: Partnership vs. Public Corporation,” Professor Ashish Nanda and his research associate Lauren Prusiner discuss the recent wave of partnership owned professional service firms becoming public corporations. In addition to the technology arms of four of the formerly Big 5 accounting firms making the transition from partnership to public corporation, there were others such as two of the five leaders in global executive search, most of the large global advertising agencies, some strategy consulting firms and in the world of investment banking, Goldman Sachs.

However, Nanda and Prusiner go on to state that there are some issues for former partnerships that go public. One of the most difficult is adjusting leadership styles to fit a public corporation. In my opinion, leadership style also includes issues such as corporate governance, transparency and accountability. Although the remaining Big 4 firms are still nominally partnerships they are, in reality, very large, very global, very bureaucratic and very “corporate” firms in all ways but one – they have no requirement to publish their financial accounts to external parties.

Although all have begun publishing annual reports with statistics regarding partner remuneration, headcount, and overall revenues, the reports are not required to follow any standard. The effect is the stuff of satire: the firms responsible for ensuring transparency, quality and veracity of financial information on behalf of more 6000 of the companies with SEC reporting requirements are under no requirement to reveal anything at all about their own finances.

In reality, some financial information about the firms does go to some external parties; their banks, their partners (active and retired), auditors of their pension funds and other regulatory agencies, such as the PCAOB. However, partnerships by their nature have a short-term focus, with an emphasis on income generation to be paid out to partners fairly quickly and an acute awareness of the tax implications of their approach to income generation and distribution to individual partners.

In some ways they’re not unlike a private industrial distributor I once worked for as a Controller. I joined during a period of crisis due to problems with their financial systems. It was really the lack of a good system. An old, custom developed, cobbled together system wasn’t balancing and the external auditors were getting increasingly impatient with management’s promises to fix the issues. The company, although privately owned, had a line of credit with a bank and that line of credit had loan covenants that required an audit by an independent CPA firm as well as the maintenance of certain financial ratios. Without reliable financial sytems there was no reliable financial information. The auditors and the bank were getting nervous.

The problems with the system were fixed within a few months of my arriving, and the crisis with the auditors passed. I then focused on a few more improvements. It seems that since we had had no good information on purchases from specific vendors in the past, we were not claiming contractually agreed-to vendor volume rebates. When the information became available after the system was fixed, I started to claim the rebates. The results went directly to the bottom line, increasing reported net income from 5% of revenues to 10% each month for the first three months. Thinking I had done a really great thing, I was surprised when instead I was asked to leave the company. It seems that the company had been run like a personal investment for the family that owned it. They were upset that the increased revenues meant increased taxes. They had always managed revenues in order to manage tax obligations and used up extra profits by giving benefits to top officers such as first class travel, payment for personal travel, leased luxury cars and fancy office furniture. Managing profit, by spending the excess over a certain amount on a few favored employees (with non-taxable benefits to them), also helped avoid any increases in contributions to the rank and file employees profit sharing plan.

A large global public accounting firm also has revolving lines of credit with banks, agreeements for securitization of receivables, back up funding sources in the event of significant litigation settlements, and other financing arrangements (although not usually any sophisticated hedging instruments for foreign currency or other financial risks.) Although these agreements are for large sums of money, they do not generally require outside audits of the firm’s accounts. (Who would do it? An outside audit would require another Big 4 and the inevitable conflicts and disclosures of proprietary client, partner and employee information.) Although the covenants may require some financial ratios be maintained, information regarding these ratios comes from the firms’ internal reporting and is not independently verified. Keep in mind: The firms (except for Deloitte) sold their technology consulting arms during the last 5-7 years. The internal expertise that is needed to implement and maintain these financial and compliance systems was lost and had to be bought or rebuilt. The recent implementaton of SAP at PwC, for example, required outside assistance from their former consultants now at IBM.

It’s a case of the “shoemaker’s children often have no shoes,” when it comes to the accounting firms (and global law firms in many cases…) The partnership structure means that investments for the longer term and that require payment for common goods (firm-wide not geographic or practice-specific good and services) such as systems, marketing, HR, are the subject of great delays and often great contention due to the massive invesments and the need for consensus. This is the reason that compliance organizations and systems to respond to such issues as independence, risk management and audit quaility were so slow to develop and to stick and still have a long way to go in comparison with the systems being audited at some of the firms’ clients such as banks, insurance and brokerage firms.

One interesting example of the impact of the legacy of partnership structure, partnership leadership style and a partnership approach on technology investment is BearingPoint. On Jan. 31, 2006, BearingPoint announced that it had finally filed its 2004 financial statements and 2004 Form 10K with the Securities and Exchange Commission. For the year, the company said it had a net loss of $546 million on revenue of $3.38 billion. The company said it was focusing now on filing its amended 2004 10Q forms and its 2005 10Qs and 10K. It also said its goal was to be Sarbanes-Oxley compliant by the end of 2006. BearingPoint’s auditor is PwC. (See the article, “How BearingPoint Lost Its Way.”)

The delays, said Harry You their new CEO in a published report at the time, were in large part due to problems implementing a new internal financial accounting software system that was seen as critical in enabling BearingPoint to be compliant with Sarbanes-Oxley regulations. “Our people weren’t quite ready or trained as the new system came on board, and there were some entries that did not get done right,” You subsequently explained. You was the same guy who was CFO of Accenture after its IPO and briefly CFO of Oracle before taking the BearingPoint job. He was also, coincidentally or not, the Morgan Stanley investment banker responsible for both the Accenture and BearingPoint IPOs.

Go back to 2001, when the company first set a course to becoming public. At the time, BearingPoint was known as KPMG Consulting. It had been spun off from KPMG LLC, the 100-year-old-plus “white shoe” accounting firm, a year earlier during a period when the “Big Five” accountancies had come under pressure to separate their auditing and consulting units because of potential conflict-of-interest problems.

This was an established, well-respected consultancy with a track record of providing systems integration and information-technology solutions to big multinational companies. Though it experienced a net loss of $26.9 million in fiscal 2002, BearingPoint still generated just under $2.37 billion in revenue for the period and employed nearly 15,000 people at that time.

There was one major impediment to the aggressive growth strategy of the new CEO of BearingPoint at the time of its IPO, Rand Blazer. At the outset, BearingPoint had no information-technology infrastructure to manage its business and track its myriad client accounts. It also had limited financial resources since former parent KPMG had pocketed most of the proceeds from the IPO in order to resolve significant underfunded partner pension liabilities.

Without the resources to jump-start an information-technology infrastructure of its own, the consultancy had to rely entirely on KPMG’s information resources, including its financial system, called PEAT. (This system was actually a legacy PeopleSoft system, heavily customized, that was inherited when KPMG flirted with the idea of merging with E&Y and then backed out.) In addition, Rand Blazer and his management team were legacy KPMG. Blazer had made his name in their Federal Services practice and was a career KPMG partner, joining the firm after serving as a Captain in the US Army. The new public company, with revenues of more than $2 billion was being run by a management team that had never worked at that level in a publicly owned company.

In “Ownership Structure in Professional Service Firms: Partnership vs. Public Corporation,” Professor Ashish Nanda and his research associate Lauren Prusiner also say that leading a public corporation requires different skills from leading a private partnership. Publicly owned professional services firms (as well as, in my opinion, the largest global partnerships) are more complex than local or national partnerships. Their leaders must be more decisive, more directive. A partnership is built on collegiality, loyalty and consensus. Leaders in a public firm can not continue to work in a partnership style.

In particular in the age of outside regulation by organizations such as the PCAOB, large global accounting firms must be able to make the tough decisions to invest in and successfully implement new infrastructure, systems, and processes that will ensure quality and compliance, as well as transparency and accountability to all of their stakeholders, not just to their partners.