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Break Up the Big Four?

It may be time to break up the largest accounting firms; Calpers steps up its shareholder activism; commercial banks provide a viable alternative to IPO underwriting; new rules for overtime pay; more.
CFO Staff, CFO Magazine
June 1, 2004

Companies that are dissatisfied with their current auditor don't have much choice when it comes to picking another. In fact, for the next few months, they may have only one alternative. In April, the Securities and Exchange Commission barred Ernst & Young from accepting new audit clients for the next six months as a punishment for abuse of auditor-independence rules. Companies that have a consulting relationship with one of the two remaining firms and want to switch auditors are down to one option.

The dearth of alternatives has led some critics to advocate splitting the Big Four into as many as eight accounting firms. One such critic is Richard Breeden, former SEC commissioner and court-appointed monitor for MCI. "The next head of antitrust at the [Department of Justice] should just sit down with [European Union competition commissioner] Mario Monti and agree to break the Big Four firms up," he says. "The concentration is too big to be healthy."

Robert Howell, a distinguished visiting professor at Dartmouth College's Tuck School of Business, says, "It's a better solution than trying to cobble together some smaller firms."

Although William McDonough, chairman of the Public Company Accounting Oversight Board, which polices auditors, acknowledges the scarcity of large firms, he stops short of calling for a breakup. Late last year he said, "The lack of competition is a problem… . But what can be done about it?"

Of course, a breakup would be extremely complex, but Professor Howell insists it's a realistic option. Says Howell: "Public accounting leaders who say this can't be done are just trying to save their own necks." —Joseph McCafferty

Big Four, Little More
First-tier firms dominate the accounting world.
Accounting FirmRevenue
(in $ millions)
PricewaterhouseCoopers$13,782
Deloitte & Touche12,500
KPMG10,720
Ernst & Young10,124
BDO Seldman2,395
Grant Thornton1,840
McGladrey & Pullen1,829
Source: Public Accounting Report, 2003



Proxy Fight

The SEC's plan to give shareholders more power to nominate directors to corporate boards has touched a nerve with constituents on both sides of the issue. So far, the SEC has received more than 14,500 comment letters on the proposal, which would give large shareholders and shareholder groups the ability to nominate directors if certain triggers are met.

At a corporate-governance conference in April, former SEC chairman Harvey Pitt called the plan "silly and dangerous in the extreme." And Stephen Bollenbach, CEO of Hilton Hotels, calls it "scary," because it will politicize the boardroom and subject corporate strategy to small shareholders with specific agendas.

So far, though, it's the rule-making process that has become politicized. One observer says the commission has split along political lines, leaving chairman William H. Donaldson with the swing vote on whether or not to water down the initial draft.


Shareholder advocates say the Bush Administration is pressuring the SEC to do just that. "If the SEC effectively guts the proposal," says Patrick McGurn, senior vice president of Institutional Shareholder Services, "we'll go back to the status quo, where shareholders are expected to be seen, not heard." —J.McC.

Investment-grade Conduct

The credit-rating agencies (CRAs) could soon feel a new level of scrutiny, at least if the Association for Financial Professionals (AFP) has its way. The Bethesda, Md.-based industry group has proposed a "Code of Standard Practices" for Moody's Investors Service, Standard & Poor's, Fitch, and upstart Dominion Bond Rating Service, as well as for debt issuers.

Among the AFP's recommendations are that CRAs publish their ratings methodologies, document their firewalls whenever potential conflicts of interest arise, and reveal their nondisclosure policies about confidential data. The draft also asks the Securities and Exchange Commission to clarify guidelines on how other CRAs can achieve the official recognition that the SEC currently bestows on only the four best-known agencies.

The SEC has been delinquent in reining in the CRAs, says Jim Kaitz, CEO of the AFP. "They've been unresponsive for nearly a year."

The Sarbanes-Oxley Act of 2002 requires the SEC to study the CRAs, and the commission issued a preliminary report in January 2003. But it didn't keep its promise to follow up in two months' time with proposed regulations. The agency finally issued a "request for comments" on the appropriate level of regulation for CRAs in June 2003, but it has said nothing since. Spokesman John Nester explains that the commission is still evaluating the comments. "There's nothing unusual about a one-year waiting period," he says.

What is unusual is the idea that AFP members should enforce the new code in their contracts with the rating agencies. After all, the agencies are supposed to evaluate AFP members, not the other way around.

Congress and the SEC have been wrestling with why the agencies didn't move faster to protect investors from Enron and WorldCom, but finance executives are worried about just the opposite: that ratings have become too volatile as agencies try to erase the shame of missing those meltdowns. Kaitz stresses that the AFP's objective is not to challenge the integrity of the CRAs but to codify an as-yet-ungoverned province of the business landscape.

The CRAs are taking heed. Moody's president Raymond McDaniel wrote a letter to Kaitz expressing a desire for dialogue and consensus development. The other three agencies share those sentiments: each is writing a formal response to the AFP's proposal. —Ilan Mochari

The New Belt Tightening

Companies have promoted healthy lifestyles for years, but now they're going a step further to get workers to slim down. Some employers, concerned about the link between rising health costs and bulging waistlines, are offering cash incentives to employees who meet fitness targets or participate in health programs.

The National Business Group on Health estimates that obesity costs U.S. businesses $12.7 billion a year in medical costs, lost productivity, disability, and sick leave. To combat this, employers have added such healthy-living options as better food choices in the corporate cafeteria, on-site fitness centers, and access to weight-loss programs.

But "the major change has been on the incentive side," says Seth Serxner, a principal at Mercer Human Resource Consulting. "A few years ago, companies might have offered T-shirts or mugs," he says. "Now they are offering cash." Some might give discounts on health-care contributions to workers who participate in weight-loss programs; some might increase the deductible for those who don't. "They are using a carrot-and-stick approach," says Serxner.

SparkPeople Inc. favors the carrot. The Cincinnati-based online health-and-fitness coaching company offers employees an annual bonus of up to $1,000 if they meet weekly fitness targets. "The company philosophy is that you have to be in good shape to be productive," says spokesperson Mike Kramer. He says the results have been encouraging: "Our sick-day rate is almost nonexistent."

Another company, Sprint Corp., has added slower elevators and appealing stairways to encourage exercise at its Overland Park, Kans., headquarters.

Few companies have tried to quantify the results of such programs, but Mercer's Serxner contends that a comprehensive program to promote a healthy lifestyle will increase productivity, and it could reduce health-care costs by as much as 5 percent. —J.McC.

Calpers Targets Auditor Conflicts

Shareholder activism reached new heights recently when the $166 billion pension fund California Public Employees' Retirement System (Calpers) began withholding its proxy votes for board members at hundreds of large companies, including Boeing, Coca-Cola, and Merck. Calpers's voting power was not enough to topple Coca-Cola director Warren Buffett and most others who came under attack. But the two primary issues remain: director independence and audit committees allowing a company's audit firm to do tax work.

"The red flags we're looking at are tax planning, tax audits, and tax consultation, among others," says Calpers spokesman Brad Pacheco. While rules revised by the Securities and Exchange Commission in March 2003 allow auditors to provide these services — with qualifications and audit-committee preapproval — Calpers believes they still represent a conflict of interest. Accordingly, Pacheco estimates the issue will push the pension fund to vote down directors at 90 percent, or about 2,700, of the companies in its portfolio.


So far, few companies have publicly announced changes in response to the campaign. However, Calpers claimed victory — and changed its votes — at American Express Co. and Applied Materials Inc. American Express spokesman Tony Mitchell says the company notified Calpers of an effort it began in November 2002 to split tax work away from auditors Ernst & Young. And Applied Materials got its pass by explaining that the $21,000 in nonaudit fees paid to its auditors were for one-time projects.

More generally, Timothy McCormally, executive director of the Tax Executives Institute, says he has not seen a rush to prohibit audit firms from tax work at TEI's 2,700 member companies. Instead, most companies are considering the question on a project-by-project basis. "There's enough flexibility in Sarbanes-Oxley to go either way," he says.

No matter, says Calpers. "Our objective is to push the regulators to consider the issue, too," says Pacheco. "We have a higher standard than the SEC." —Alix Nyberg

Off Wall Street

Investment bankers on Wall Street aren't the only ones who facilitate initial public offerings. Now, they might not even be the best. A new study of IPOs suggests that investment bankers affiliated with commercial banks may hold an advantage.

The study, conducted by academics at Texas A&M and the University of Nevada, examined IPOs issued in the 1990s. It found that when commercial-bank subsidiaries served as underwriters, the shares were generally priced more efficiently.

"One explanation might be that commercial banks have better information," says Paige Fields, an associate professor of finance at Texas A&M and an author of the study. "If the IPO firms were bank customers for other bank products, there may have been inside information that enabled the bankers to price the shares better."

Commercial banks such as J.P. Morgan Chase, Citigroup, and Bank of America have competed in the investment-banking business since the early 1990s, when regulators eased Glass-Steagall Act rules splitting investment and commercial banking. (The law was repealed entirely in 1999.) Since then, the banks have had success in grabbing IPO business partly through their ability to bundle loans and investment-banking
services.

But there are reasons to doubt that commercial banks offer any advantages over investment banks. First, according to the study, commercial banks have lost some of their ability to price more efficiently since they bought investment banks in the late 1990s.

In any case, the choice of banker depends on more than price or easy credit, says Ray Soifer, chairman of Soifer Consulting LLC and a former banking analyst with Brown Brothers Harriman. Companies must consider a bank's IPO track record, its analysts, and its ability to get investors to buy new shares. Such advantages tend to reside with top banks, regardless of affiliation.

Another important factor, adds Henry Graham, CFO of data-communications firm TNS Inc., is whether it's possible to build a relationship that can survive the stress of the IPO process. For its March IPO, TNS chose J.P. Morgan Securities as lead underwriter. Graham says J.P. Morgan won the business largely because of a relationship — one of the firm's bankers had worked with TNS's CEO on an earlier IPO. "You have to ask yourself," he says, "'Who do I want to walk down a dark alley at night with?' " —Don Durfee

New Rules for Overtime Pay

Overtime pay is getting an overhaul. In April, the Department of Labor released the first significant revision of the federal Fair Labor Standards Act in more than 50 years.

The new rules are intended to reduce confusion — and litigation — over overtime exemptions, but instead they have fueled more of both. Concerned that employers will now be able to deny extra pay to midlevel employees, the Senate passed two amendments in early May protecting the overtime status of 55 job categories. The House of Representatives subsequently blocked a vote on the issue.

Barring further congressional action, the DoL's plan is slated to take effect in August. Under the new rules, employees who earn less than $23,660 per year will automatically qualify for overtime pay regardless of their job classification, while those who earn $100,000 or more and perform office work will not be eligible. The plan also prohibits "creative professionals" from receiving overtime. Police officers and firefighters are guaranteed overtime pay.

Critics argue that the changes make it easier for employers to reclassify workers and eliminate overtime wages for those who earn more than $23,660. "The net effect is going to be to exclude more people from overtime coverage than it adds," says Thomas Kochan, a professor of management at MIT's Sloan School of Management. In particular, he takes issue with a new rule that will exclude "team leaders" from overtime eligibility.

Joe Levanduski, CFO of Hawk Corp., an industrial-components maker in Cleveland, expects to make few changes based on the new rules. He says that where the current law is ambiguous, Hawk tends to pay employees overtime.

As wrangling over the final form of the law continues, John Thompson, a partner at Fisher & Phillips LLP, advises employers to review all their employees' classifications and to prepare for questions about overtime status. "The furor over these changes could provoke wage and hour claims that have nothing to do with the new rules," he says. —Kate O'Sullivan


Big GAAP, Little GAAP

Small companies are feeling the pinch of increased regulation these days. Many CFOs of small businesses say they are being unfairly punished for the indiscretions of such large companies as Enron, WorldCom, and Tyco by having to implement new rules that are disproportionately time-consuming and costly to carry out.

To answer these concerns, the Financial Accounting Standards Board recently established the Small Business Advisory Committee, which will advise FASB on the issues that are important to small companies.

"During the last few years, the focus has been on large public companies and international convergence [of accounting standards]," admits FASB chairman Robert Herz. "We want to make sure the concerns of private companies and small public companies are being heard."

One of those concerns is that the cost of the new rules, especially for small firms, is not weighed against their benefits, says Ilene Persoff, an accounting professor at the C.W. Post campus of Long Island University. "Some of the GAAP rules are so costly for small businesses that they are looking at alternatives to the activity that triggers the disclosure, rather than implementing the new rules to account for it," she says.

CFOs welcome the committee, but some remain skeptical about its impact. "I'm not convinced that this is going to solve all the problems," says Harlan Plumley, CFO of Lightbridge Inc., a telecom outsourcing and software provider in Burlington, Mass. "No one objects to the need for transparency and rapid disclosure; the problem is that it is extremely difficult for small firms to implement [the new rules]." He argues that there should be a threshold of materiality for some compliance efforts.

Herz says that FASB has heard the criticism and has "taken it to heart." He says the new committee will help make suggestions about including exceptions for small businesses in its proposals. Considerations could include reduced disclosures or longer adoption times for companies under a certain size. The committee, which is made up of small-company CFOs, controllers, lenders, investors, and auditors, met for the first time in May. —J.McC.




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