McKenna Panelist At NYU On Auditor Independence And Consulting

I’m honored to have been asked to join the panel Monday afternoon at NYU Stern School of Business for a Ross Roundtable on the reemergence of consulting practices in the major audit firms. The panel included Bob Herz (a former FASB Chairman and current audit committee and PCAOB SAG member), former Fed Chairman Paul Volcker, professors from Stern, and Christopher Davies of Wilmer Hale who pinch hit for PwC’s Brendan Dougher who canceled at the last minute. Davies represents PwC and Ernst & Young in auditor liability matters.

Yes, the firms sent the lawyer instead!

Here’s the text of my remarks with links. Bob Herz interrupted me in the first few seconds of my remarks to object to my characterization of the independent foreclosure reviews by PwC as a problem. I convinced him to allow me to continue. I suggest he, and Christopher Davies who also said he didn’t get it, read some of my American Banker columns on the subject – consumer advocates, the GAO and congressional members have – or this compilation of all the writing I’ve done on the subject.

If they don’t get it then, they never will.

The remarks also include some new information about HP’s allegations against Autonomy.  All four of the largest global audit firms are involved in the scandal one way or the other by virtue of their roles as auditors or consultants or both.

If they don’t get your money going in, they’ll surely get it going out.

Here’s a link to a nice writeup by Michael Cohn at Accounting Today.

Here’s me:

And here are my remarks:

I’ve worked on the consulting side of two Big Four firms during my career: at KPMG, at KPMG’s spinoff BearingPoint (as a Managing Director and practice leader in Latin America) and at PwC in internal audit of the firm itself.

The last time the audit business was flat, a commodity, and under pricing pressure from clients was when I started working for KPMG Consulting in 1993 after ten years in industry. This was before KPMG Consulting split from KPMG the audit firm and became BearingPoint and just as auditors as consultants became an issue, well before Enron brought it to a head.

I am now watching the second coming of consulting for the Big Four auditors.

Consulting never left Deloitte, only grew bigger while the other three large firms went back to being semi-pure audit firms because they were worried about trouble with regulators. Their concerns were misplaced.

Lane Green writes in a piece called “Shape shiftersin the Economist in September:

“In fiscal 2012 Deloitte increased its revenues from consulting by 13.5% and from financial advisory by 15%—compared with just 6.1% for audit and 3.9% for tax and legal services Barry Salzberg, Deloitte’s boss, says he expects consulting to continue to grow by double digits, whereas the audit market is mature.

If the two businesses continue to grow at the 2012 rate, the firm would do more consulting than auditing by 2017.”

I could make points about auditors and how consulting compromises their independence, professional skepticism and eventually their professionalism using any of the Big Four firms. There are enough cases for each. But Brendan is sitting here on this panel (Dougher did not show up), so, to be polite, I will try to make my points today without picking on PwC too much.

These comments focus on the business model of the Big Four firms and the auditors’ primary public duty to shareholders, via the franchise granted by the public via SEC and exchange regulations that require “certified” audits for all public listings.

At the end of his Economist piece, Lane Green asked Salzberg, Do people perceive Deloitte as a consulting firm with an audit business rather than the other way round?”

Salzberg replied: “We’re not going to take our eye off our professional responsibility with respect to either.”

I think it’s too late, for Deloitte and the rest of the Big Four.  The auditors’ consulting businesses have recovered from the post-Sarbanes scare. Deloitte has been building its business all along including via acquisitions like the carcass of BearingPoint’s public sector business. I reported in American Banker that PwC, who bought the industry side of BearingPoint after the bankruptcy to jumpstart its systems integration practice, has its best Advisory set of engagements ever with four OCC/Fed mandated mortgage servicer foreclosure reviews, expected to bring in more than $1 billion in revenue before its over.

And there are numerous examples of audit firms still earning at least as much of their fees from audit clients, or multiples of their audit fees, from what were, in my mind, supposed to be prohibited services to those companies. For example, auditors provide non-audit related advice on GAAP and SEC reporting for specific transactions and get paid extra for it. Who goes back to check and see if they audited their own advice?

I wrote in March of 2011 about KPMG and its “secondment” of tax staff to audit client GE to help with their returns for a few months every year.  This had been going on for a while, for $10 million extra per year. Less than a year after I wrote about it, the engagement stopped. There were reports of the beginning of an investigation. An order to preserve documents referring to the “loaned staff” was circulated. But we’ve not heard anything from the PCAOB or SEC about any disciplinary actions or sanctions for this clear violation of Section 201 auditor independence rules.

Wal-Mart and News Corp use their auditor, Ernst & Young, for tons of tax services. They’re in big trouble for bribery, an illegal act, but we didn’t hear about it from Ernst & Young. If Ernst & Young knew at some point about the alleged illegal acts, did the firm file a Securities and Exchange Act Section 10A report with the SEC when it was obvious those companies weren’t stopping on their own or self-reporting but instead covering them up?

The SEC and PCAOB have not even minimally enforced the Sarbanes-Oxley Section 201 auditor prohibited services rules against the Big Four and have stopped enforcing compliance with existing rules against inappropriate financial interests and strategic alliances. When was the last time you heard about an independence violation by one of the Big Four other than the insider trading scandals? Clearly they are occurring. But it’s wildly unpopular for regulators to even suggest they may force companies to cut off a favored vendor – the one you can “work” with – as we have seen whenever the subject of auditor rotation comes up.

Almost everyone who speaks out in public on the auditor independence issue has a vested interest in not pushing back too hard. Audit Committees more often feel it’s their job to help management produce results and keep costs for “vendors” down instead of acting as the “check and balance” on auditor independence.

J. Michael Cook and Michelle Hooper helped PCAOB Board Member Jay Hanson provide a PCAOB update at the FEI CFRI conference week before last.  Cook is a retired CEO and Chairman of Deloitte and chairs the Audit Committee of Comcast, as well as serving on other boards. Comcast uses Deloitte as its auditor. Hooper is the Chair of the Audit Committee of PPG Industries. PPG also uses Deloitte as their auditor.

Cook and Hooper responded to a question from the audience at FEI CFRI about auditors and non-audit services by saying they were fine with current levels of services by their auditors and didn’t feel further prohibitions or scrutiny were warranted. In fact, both said, they liked using their audit firm for non-audit services because they were comfortable with them and their auditor knew management and the business best.

Both Comcast and PPG Industries spent more than 10% of total fees to Deloitte on non-audit related and tax services in 2011 and 2010, for example. Some of Comcast’s audit-related fees were for technical accounting consultations related to its merger with NBC Universal. Comcast even spent $500k in 2011 and $300k 2010 for “All other” services that are not explained. Since it’s not for tax and not audit-related it’s probably technology related.

So much for “checks and balances”.

Audit Committee members also enjoy ongoing, free, customized training from their auditor on technical accounting issues relevant to their company. That’s the same audit firm they hire, fire, and decide how to use and compensate. Incentive pay and stock options for directors don’t help. How many will speak up and act independently when that may hurt the stock price and the reputation of the company?

How directors get their jobs doesn’t promote “checks and balances” on external auditors either.  Directors are recommended via the directors’ clique, promoted by organizations like the NACD and the network of current directors including active and retired CEOs. I’ve heard directly from highly experienced retired audit partners that feel shut out. Michael Cook said at the PCAOB SAG meeting that one financial expert, a retired audit partner like him, was all the financial accounting and audit expertise needed on any Audit Committee. One shepherd, the rest sheeple, keeps the tensions and conflicts down, I guess.

Are auditors the only market eunuchs in the capitalist system? They want us to believe they alone are immune from the power of financial incentives such as lucrative consulting engagements that overshadow the fees for their public duty as the auditor.

Audit firm leadership feigns insult whenever anyone questions its desire and ability to be independent, objective and professionally skeptical. The reality, let’s face it, is if you’re not the auditor of the multinational or large financial services firm, you’re doing consulting work for it. If you’re not doing consulting work for it, you are or want to be the auditor. Maybe the firm is out of the running for any work, as a result of a serious falling out, like Deloitte and Navistar or KPMG and Fannie Mae. But even those grudges dissipate eventually out of sheer necessity.

With few exceptions, current and former partners, especially retired partners, are reluctant to speak out about the loss of professionalism and the legal liability their former firms are facing. In addition to social shunning, those critical of the profession may also be shut out of making a post-retirement living. Firms muzzle retired partners by contractually requiring them to get permission for any post-retirement paying activities, under the guise of independence concerns.

Isn’t that ironic?

There have been a few exceptions to the apparent code of silence.

Roger Dunbar, now chairman of Silicon Valley Bank and on its audit committee, told the PCAOB at its West Coast forum on independence and auditor rotation, “I am personally worried about audit firms trying to get you to spend money with them on consulting. It’s a risk.”

Dunbar was caught on tape saying he expected to be ostracized by some former partners for making those remarks.

But there are more auditor independence conflicts than just providing prohibited services to audit clients.

I described the provision of pre-IPO consulting services by the eventual auditors in my Forbes magazine article in May on Ernst & Young and its services to Facebook, Zynga and Groupon.

Another variation is when consulting, especially systems integration activities, require business alliances with firms. You can’t have a business or marketing alliance with an audit client, according to the rules. Marketing agreements, joint ventures and subcontractors can creep up to bite you in the tail if the firm and its client are not monitoring relationships carefully.

The latest scandal, HP vs. former executives from its acquisition Autonomy, is a little bit of everything.  Autonomy followed the more lax British honor code when choosing which services besides the audit to buy from auditor Deloitte. Autonomy is a British company that was not listed recently on any US exchange.

The media didn’t miss a beat in reporting on an Enron-style conflict. The Telegraph of London and Reuters reported Deloitte has been selling Autonomy at least as much in consulting services as they were charging for the audit, such as it was. The Guardian reported Deloitte earned £4.44m in non-audit fees from the technology firm in the last four years.  Those services included tax compliance, due diligence for acquisitions and other services “pursuant to legislation”. Deloitte charged £5.422m for the audits during same period. The implication is that audit independence may have been compromised.

Deloitte is also “Platinum” strategic alliance technology implementation partner for HP, and is now an alliance partner for Autonomy software implementation, too.

Was Deloitte US and/or UK also implementing Autonomy software while Deloitte UK was auditing the company? Sources tell me of at least two large client engagements where Autonomy and Deloitte Consulting worked together before the acquisition. Both Deloitte and HP’s auditor Ernst & Young are also customers of Autonomy.

Client service partners who abuse their role can also cause independence violations. The most recent insider trading violations by partners at big firms – Flanagan and McClellan at Deloitte and Gansman at Ernst & Young – came from the Tax and Advisory side of house. Deloitte’s Tom Flanagan was the client service partner for audit and advisory clients. He was there to walk the halls and drum up non-audit work at audit clients and non-audit clients alike.  He’s going to jail for 21 months. But all of the companies whose information he traded on still use Deloitte as their auditor.  Deloitte told them its independence was not compromised. Maybe too much time and trouble to switch from the devil you know to the devil you don’t know.

How about when the shoe is on the other foot? There’s a risk to the reputation of the audit firm when its consulting business screws up or a potential conflict if the consultants want to do business with past or future audit clients.

The Deloitte/Standard Chartered case, the Deloitte foreclosure reviews at JP Morgan, and the number of lawsuits against Deloitte for its ERP consulting are good examples of how the push for growth on the consulting side can compromise the reputation of the firm as well as confuse the public.  When an audit firm acts as an advisor for compliance monitoring, in particular when they are monitoring their own work as in the JPMorgan foreclosure review case, its difficult to know whose side the firm is really on.

Last but not least, corporate investigations. Auditors, in my opinion should be banned from taking part in corporate investigations that may involve senior management, have a material impact on the financial statements or involve illegal acts. Ernst & Young seems to have a particularly hard time resisting these engagements.  Ernst & Young agreed to question the Lehman Repo 105 whistleblower under the direction of internal audit. That mistake is the reason Ernst & Young is still a defendant in private class action litigation for its role in Lehman. The firm agreed recently to conduct an investigation into slave labor for its audit client IKEA.

The problem is not the audit firm’s ability to perform the investigation in an independent manner. I would say, however, that having the audit partners in the Lehman case question the whistleblower was a profoundly bad idea. The auditor is playing both sides and its work may not be attorney-client privileged.

The problem with the audit firm conducting or participating in investigations for audit clients, on behalf of management and the board, is those activities can inhibit the auditor’s independence as the auditor, its first and most important job, and complicate its audit assessments of financial statement disclosures.

7 replies
  1. M
    M says:

    Unless someone else starts paying the bill, I don’t know how financial statement audits are ever going to serve the public shareholders.

  2. Connie
    Connie says:

    I just read a case about an audit firm that audted Electronic Card Services (SEC against Quintanilla). I am amazed that although the managing partners of the firm were aware of the fraud (thourgh a staff e-mail), the SEC did not pursue them as the firm (Mendoza and Berger) filed chapter 7 this year. Is this righ? Can audit firms get out of the responsibility just by filing chapter 7? The partners for these firm are now parteners in a new CPA firm and are in charge of the SEC practice. See PCAPB contact for WilsonMorgan (Henry Mendoza). I am very concern that auditors can get away by filing chapter 7,

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  1. […] in 2010. PwC is also the largest audit firm, a distinction that must be made given the reemergence of the consulting practices at PwC, KPMG, and Ernst & Young ever since the expiration of non-compete agreements signed when their consulting arms were […]

  2. […] accounting professions, and academia got together last night at NYU Stern School of Business for a Ross Roundtable to discuss the reemergence of consulting practices in the major audit firms. I’m was honored […]

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