CFOs Message To Big 4 – "Gimme Service or Gimme Cash"

It’s that time of year when most people reflect, evaluate their performance and make plans for a better new year.  It’s a healthy exercise, whether on a personal level or a professional one, regardless of your religious beliefs or lack thereof,  a fiscal year end versus a calendar year end,  and everyone’s reluctance to admit mistakes.

When it comes to your relationship with your Big 4 auditors, this is a year when you should drive a hard bargain to either “Get services or get cash.”  No,  I am not suggesting you gyp your vendors by asking them to send back money or withhold future payments for discounts that weren’t agreed to.

Nor am I suggesting that you follow the hard line negotiating tactics of the Big 3 automakers who are notorious, especially in the case of GM, for insisting that vendors agree to prices and terms just for the privilege of doing business with them. As we can see, working as a vendor to Big 3 may be no prize in the end. The politicians are afraid to see what will happen if the auto industry succumbs to actual market forces and takes the consequences of their seriously deficient management and strategy.

You know what would happen? More dislocation, as we already have, but then a market necessity to create something new and better, to innovate, and renounce nasty bad habits (like poor internal controls) and corporate cultures.

Good riddance, I would say.

What I am suggesting for CFOs is this: Put your eyes back on the prize.

Take a look at your Big 4 service provider contracts. Refresh your memory on what you’ve been promised and what you are paying for. Make sure you are getting what you expect and it’s high quality or stop paying.  That may sound harsh, since I’ve been known to sympathize with the staff and employees of the Big 4 firms, castigating the Big 4 for reducing staff when there’s so much work to do.  But hear me out. There’s a lesson in it for some of you.

I recently responded to a post in one of my favorite blogs, A Counting School – Hardcore Chartered Accountancy. Krupo, the author, works for one of the Big 4 in Canada.  Although he’s only in his late twenties, he has been watching carefully during his fairly short tenure.

His post, Profit Margins: How they work, for accountants and others was an attempt to explain to his readers how an audit firm determines “profit.”  Given the complexity of the subject and the curiosity of so many, and given the firms’ lack of transparency on the subject, I couldn’t help myself from adding a few points:

Oh Krupo, Such a complex subject…. I’ve written many posts on this, but let me try to elaborate, in a few sentences on a few of the points raised.

First of all, a “negative profit margin” is a vague term, but I do know you can have a “negative unbilled” situation. That is explained here.

In the post linked to above, I explain the strategy the firms use to take their clients’ money early and often.  (There’s also a reminder of how BearingPoint, a KPMG legacy firm, originally got itself into the downward spiral it’s now in.) I also describe how the firms “revenue recognition” policies and procedures are the kind that would be considered shifty, sloppy, and worthy of audit exceptions in their GAAP reporting clients.  But they serve the partnership and the firm’s business model very well.

“One example of revenue recognition roulette that persists in many private partnerships is the fixed fee/hours contract, the most frequent way that internal audit outsourcing/co-sourcing engagements are proposed and billed by the Big 4. For example, the firm bids an internal audit and/or SOx engagement as a total of hours, estimated based on the audit plan or number of processes and locations that must be reviewed, for example. They use any indicators or information provided that helps estimate level of effort and staffing needed.The firm looks at the type of staff needed to complete the work (usually disproportionately 2-5 year level staff) and the budget the client says they have for the engagement.

After working the expected profit margin into the equation, it’s a simple mathematical exercise to calculate the total bid. That total is divided by the total hours that have been committed during a specific time period to come up with a “blended rate”. In other words, even though there may be a mix of Partner, Manager and Staff time, and even though we’re not talking about the staffing or temporary firms here, the clients often expect to see the average hourly rate based on the total cost divided by total hours committed.

Once those total hours are committed and a blended or overall average rate is also publicly committed to, the firm has the burden to meet that expectation by managing the client, managing the team’s performance and managing their staff mix. Partner and Senior Manager hours are sometimes “given away” in order to keep the blended rate down but, since they will be accounted for anyway via timesheets, the effect is to reduce the expected profit margin internally in order to “come up with the number”.

The work may be performed unevenly, that is, some months are more intense than others, work may be seasonal and extra hours may be expended in a lumpy way to meet deadlines. Billing is, however, often a monthly retainer, cash in advance and the same amount each month. The total contract is divided by twelve months or the life of the contract and billed evenly. Both sides usually like this. However, a financial and performance obligation now exists on both sides.

What happens when a client expects a particular number of locations and/or audits and the associated hours of work to be performed and the firm can not accomplish this due to resource constraints or poor management of the client? What happens if the firm reaches the end of the contract and has billed the full contract but not delivered all the hours they committed to?

In professional services speak, this is called, “negative unbilled.” Instead of the typical business issue of having work done and not billed or collected from the client, professional services firms, sometimes end up in a situation where they owe the clients work. They get away with this because their clients still trust them. But they have an obligation to their clients.

When a contract is multi-year, such as in a co-sourcing engagement or a multi-year audit contract, then the firm may not be pressured to “true-up” each year. Instead, they can roll the obligation over and theoretically deliver later. This is possible because they are not publicly owned firms using GAAP, but private partnerships, entities whose partners probably love getting cash faster than they earn it.”

At this point I’d like to go back to my comment on Krupo’s blog to raise a few more points. I am speaking directly to the situation the audit firms have now and the poor planning and managing that forced their short-sighted reductions in force.

“Think of your internal timesheet and expense report process as contributing firstly to the firms “cost accounting” process, not its calculation of “profit” as in profit that is taxable or that would be reported on financial statements to the public or a bank. Some firms are better at this cost accounting process than others and so they have more accurate information for planning, forecasting, pricing and evaluation of engagements/clients and partner’s/manager’s performance. Some are not.

Your time is billed to clients at a rate which is artificial, but has a method to its madness. It’s usually developed by taking your salary costs plus benefits and adding various profit margins on top and adding/subtracting for competitive factors.So, for example, say that your salary plus your benefits costs $75 per hour total. Let’s assume you work in IT Audit and the market for IT Audit in financial services companies is $150 per hour for someone at your level. Every time you charge an hour on your timesheet, it is valued in the cost accounting system at $75 cost and $150 revenue going out.

Now let’s say that your engagement was sold with a total revenue figure based on a budgeted number of hours that equates to $160 per hour. Your cost accounting system shows a “profit of $75 dollars an hour for each hour charged by you on the timesheet. But depending on total number of hours charged (actual hours that go through the timesheets against that number budgeted) and the mix of hours actually charged versus priced into the revenue number by level of professional (This is where the leverage model comes in) the actual profit on the engagement is the amount you can bill the client (which may be not all the hours charged to timesheets or may be more or may be less) versus the amount charged through on timesheets.

Yes, it gets worse. Suppose you have professionals told to eat hours – not charge hours to your engagement or to the actual charge number. What’s screwed up is the cost accounting information. Overall, as Krupo has pointed out, the firm gets in revenue a certain amount and pays out in expenses, salaries and other types another amount, no matter what you put on your timesheet (or maybe exactly what you do, if an engagement is billed on actual hours charged like a staffing firm.)

The audit firms are partnerships, which throws another monkey wrench into the discussion. Partners get paid as a profit distribution basis and this calculation is very focused on taxable income to them and to the firms. In the US it’s not GAAP. It is also very short term focused, with firms not keeping as many reserves or holding onto cash for common goods as you would see in other types of companies. As much as can be paid out in a year is paid out. A partners chance to earn under this model is limited and varies from year to year. It’s very much a cash flow type of calculation.”

So enough for one comment. I am sure you can take this further and extrapolate to many other kinds of issues, like overtime, paid or not, and what happens when overtime is worked and never paid. How do partners price engagements when they don’t know how long they will really take, such as in new things like Sarbanes-Oxley? How do you manage budgets when you have a deadline and you unexpectedly have to use folks that get paid overtime? And then there is billable and non billable travel time and expense….

Right now, most of the firms acknowledge that the majority of the cuts in staff are due to the current economic situation and their forecast of less work in the pipeline.  This may be very true at some firms.  After all, Deloitte and KPMG saw some large financial services clients disappear when they were bought by Bank of America and JP Morgan. PwC has been the beneficiary, but on a very specific level.  The jobs are primarily on the East Coast.  There’s also the pending merger of Lloyds and HBOS in the UK.  That will add another behemoth to the PwC side of the ledger, in addition to the previously mentioned clients and their huge, long term engagement in the UK managing the Lehman bankruptcy there.

But what does that mean to you, as a CFO? Well, there are reports that professionals are being let-go even if they are assigned to a client. That makes no sense to me and is not, for the most part, performance based.  It is the phenomenon described by one of my commenters this morning as “Taking out the fall guy.”

Cuts are decided at the highest levels in the firms. Then orders are water-falled down, and regions, offices, practices, and individual partners with primary client responsibility are given their quota of cuts to make so that the target headcounts and dollar savings are achieved.   They either shift some cuts down the line or find the cuts on their own team.  They cuts may be made where you would least expect it.

In particular, given the amount of work still to be done related to IT controls, it’s surprising that any of the firms cut IT auditors and security professionals at any level.  It is also disappointing to see cuts of experienced, trained professionals in favor of continued recruiting of new graduates.  Better to stop the flow in from the schools and let everyone make healthier career decisions, than to perpetuate the leverage model.  Better for employee relations and long term viability, but obviously not viewed as better for the short term cash flow and distributions to partners.

For CFOs, this translates into these action steps:

1) Review all fixed rate contracts for terms and conditions and payment policies. If the contract is performance based, make sure performance targets have been hit and that documentation and deliverables have been fully accepted by your team before payment.

If the contract is a retainer type, with a flat monthly amount due as equal payments for a proposed number of hours of work or certain deliverables to be completed before year end, make sure you “true-up ” the contract and see if the firm owes you work or money if the work will never be done due to changes in plans or severely constrained staff availability at the firm. Make a conscious decision whether want the work or the money. Firms and individuals are often tempted to keep rolling over this liability to clients from one year to the next on a multi-year contract. In lean years or expected lean years like right now, they will take the liability into income and consider it “profit” at an engagement level and firm level. Will that firm or those professionals be around when you eventually need the work done?

Whether they ever deliver the “negative unbilled” or have to make good on their contract depends heavily on whether or not their clients are keeping track of what they are supposed to get, what they got and comparing that to what they paid for. How many of these liabilities exist in the Big 4 due to the resource constraints that existed during the highest point of Sarbanes-Oxley demands? Are they “on the books” or informally tracked or blown off?

If the contract is “time and materials,” (you pay the hourly rate for time worked plus expenses,) then make sure someone inside your organization is reviewing that billing in detail and your managers are aware of who is working on what form your vendors. Make sure hours billed were actually worked by professionals named. If you are not accustomed to receiving a detailed invoice with at least levels of staff and hours worked by rate, if not specific names for time and materials engagements, then demand one. Make sure that requirement is in your next contract.  You have the power right now.

2) Make sure you know who is doing the work on your audits or projects. If you were promised, or paid for, partner, senior manager, or higher priced technical professional level work, demand it. If the team mix was budgeted to include experienced hires and senior staff or managers, make sure this is happening. Make sure the teams are being adequately supervised and their work reviewed. The firms will try now swap out higher priced IT auditors for financial auditors, for example, and more experienced staff and managers for less experienced new graduates.  It’s called “leverage.”

What I am not recommending, and strongly disagree with, is abdicating your responsibility to manage the vendor and your requirements. Don’t ask your firm to cut the bill by 10 or 20% and then allow them make the decision how to do that. They may do it by cutting corners on quality and supervision. They may do it by squeezing out higher priced specialists in favor of lower priced staff. They will do it by giving you no meaningful time with senior managers and partners. If you want to cut costs, tell them what you can and can’t give up. Make conscious decisions about the services you are paying for and ask to see the project plans and engagement staffing models and then hold them to it.

Demand IT audit work to be done for the good of your company. Expect specialists and experienced staff and managers to do what you were promised to be done by that level of professional.  Some of these may then keep their jobs at the firms or get them back. Or maybe you can hire them.  Don’t deny the need to have the right work done in order to save a buck. A short term decision to cut costs will bite you in the ass when you least expect it.

3) Whether your engagements are external audit or consultancy, don’t take the Big 4 name as proof of quality. You only have to look at the Mark Olson’s opening speech to the AICPA conference this week in Washington DC that references the PCAOB Inspections Summary report to see that the firms are still making mistakes, big ones, and the regulators are letting them get away with it.

I will briefly highlight two of the five remediation areas discussed in the report. First — partner evaluation and certain other aspects of firm structure, organization, and management. In this area, we have made the following three observations:

Two, firms have also tried to diminish the chances that the economic priorities of the audit business can inappropriately influence decision-making on technical accounting and auditing matters.

Don’t even get me started about all the ways the auditors could have helped us avoid or mitigate the crisis that has occurred in so many, in their opinion, “going concerns.”

“…auditors face a number of exacerbated audit risks in this current environment, and the PCAOB is monitoring these areas closely. In response to concerns, also on December 5, the PCAOB issued an alert that highlights for auditors areas of potential concern in the current audit cycle…I would like to outline a few areas of audit risk this morning. Specifically, I will address three areas of concern that I am hearing a great deal about from auditors and issuers: fair value measurement, other than temporary impairment, and going concern…”

4) If you are considering hiring one of the Big 4 consultancies for system implementation ERP work, think again. The firms, other than Deloitte, are re-starting these practices in a very aggressive way but they are not equipped, in my opinion, at a partner or director level to negotiate and manage the largest and most complex projects given their lack of professionals who have successfully performed this kind of work before.  Remember, they sold all those folks a few years back when they were sure they would make a ton of money from you for Sarbanes-Oxley. Now that Sarbanes-Oxley dollars are being squeezed, “Theyrrrrrrrrrrrrrrrrrre baaaaaaaaaaak.”

In addition, why would you sign a long term (more than six months) mission critical systems implementation project contract (or any other consulting engagement) with a firm that may have to resign the engagement if called to investigate or audit you? Don’t laugh. Stranger things have happened in this very dynamic environment.

In the case of Deloitte, I think their cuts, especially to the consulting side, have been the deepest and are continuing. And they’ve had more than their share of failed projects lately that have ended in litigation. Not a pretty sight.

5) In general, the Big 4 are afraid of the future and of what they see as a general downturn and the bankruptcy and consolidation of significant clients. Bankruptcy trustee work and investigations are good money but typically shorter term and more competitive. They can’t replace the revenue for a big audit. The Big 4 are often conflicted out of working on some oppportunities they would like to. When things happen fast, it is difficult to rearrange long standing consulting arrangements to take on either new audit or litigation related work that quickly.