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Are any of the Group B accounting firms in position to challenge the Big 4? As contributing editor Ed Zwirn reveals in his article ''The Second Six: Ready to Step Up?'', the demise of Andersen and the advent of Sarbanes-Oxley have not been an unqualified blessing for those firms that remain. And in ''Same Straw, Smaller Back,'' Zwirn notes how new regulatory burdens that fall heavily on smaller companies (the usual Group B clients) may persuade many of them to go private. More articles about accounting, and about careers in finance, are described below. |
The largest of the Group B accounting firms are facing new challenges and enjoying new opportunities.
Ed Zwirn, CFO.com | US
February 1, 2003
Only a decade ago, an article that mentioned the largest public accounting firms in the United States would most likely refer simply to the Big 8. Today, after several mergers and one very high-profile departure, we're down to the Big 4.
Some of the Big 8 may be not only gone, but forgotten. (Sure you can name them all? Give yourself until the end of this article, where you'll find a complete list). But now, other names are growing in renown:
These firms, which we call the Second Six, are the largest of what are often referred to as the Group B accounting firms. They're a distinct size down from PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, and KPMG, all of which have annual revenues exceeding $3 billion and professional staffs more than 10,000 strong. By comparison, Grant Thornton (number 5 on the top 100 list, and thus the largest of the Second Six) had annual revenues of $433 million for the fiscal year ending last June; its professional staff numbers about 1,900.
Are any of the Second Six in position to move up in the rankings?
Pick Up the Pieces
Andersen's connection with Enron, and its consequent bankruptcy filing, left a taint on the entire industry, but at least it provided a direct benefit to those firms that now serve former Andersen clients. Many of the larger clients fled to one of the remaining Big 4 firms, but the Group B firms saw their share of new business, too. Doug Bennett, director of accounting and auditing at Springfield, Missouri-based BKD (number 7 on the top 100 list), says that after "the Andersen filing we saw opportunities for new business, and we picked up a few companies," some of which were "just too small for the Big 4."
A bigger boon to the Group B firms — at the expense of the Big 4 — is the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley enumerates many prohibited activities that auditors cannot perform for their audit clients. For Crowe, Chizek and Co. (number 8), those restrictions have provided "opportunity in areas where the Big 4 are conflicted from doing work," according to CEO Mark Hildebrand. One of the first accountancies to offer IT consulting services, Crowe Chizek is now picking up other consulting work from Big 4-audited companies being forced to seek those services elsewhere — "things like risk management, systems, tax work, and internal audit," says Hildebrand.
In addition to Big 4 hand-me-downs, Sarbanes-Oxley also entails more work for Group B firms on the audit contracts they already have; how much more is the question. Only last month the Securities and Exchange Commission adopted the final rules on auditor independence to fulfill requirements of Sarbanes-Oxley. And while Hildebrand is "certainly seeing some companies responding very quickly," many smaller companies — that is, the clients of the Group B firms — are taking a more deliberate approach.
"The big companies, like the Pfizers and the Intels, have already started implementing [Sarbanes-Oxley], just to be in the forefront," says Amar Budarapu, chairman of the U.S. securities practice group at law firm Baker & McKenzie. "For a Fortune 100 firm, that's not that big a deal." But Budarapu adds that many smaller companies, "with legal staffs of two or three people," are taking a wait-and-see approach until the dust settles.
Squeeze the Clients?
When those smaller companies can wait no longer, what will they see? "I expect audit fees to go up 25 to 30 percent," said Mike Starr, the U.S. managing partner for strategic services at Grant Thornton (number 5). But the pass-alongs initiated by Sarbanes-Oxley may be only the beginning.
The same professional and ethical questions that inspired Sarbanes-Oxley, and that dogged Andersen out of existence, have brought all accounting firms under "significant scrutiny," says Starr. Those firms are themselves learning that one of their key cost components, liability insurance, may be in for a steep increase. Those costs "have gone up over 50 percent in some cases," says Starr; according to Crowe Chizek's Hildebrand, they "could easily triple."
"What concerns me," says Hildebrand, "is the cost of compliance to these medium-sized and smaller companies." According to BKD's Bennett, the industry is "looking at 50 to 75 percent increases and possible limits on the amounts of coverage." Bennett, whose firm serves companies with annual revenues under $100 million, adds that "what gets passed to clients ultimately" is still unclear.
These increases, of course, have more impact on smaller companies. "It's just ridiculous" that simply because you're a public company, however small, "you have to bear the same costs and burdens as a Fortune 100 company," says John Clary, CEO of Monrovia, California-based Clary Corp. One way to lighten the load, affirms Clary, is to go private.
How many executives at smaller companies will start seeing things the way Clary does? (See "Same Straw, Smaller Back.") If new regulations and poor returns drive many smaller companies from the public markets, Group B firms may end up losing as much business as they gain. But even more tellingly, as Grant Thornton's Starr observes, "we as a profession have lost the public trust." Until the public regains that confidence, liability insurance and burgeoning regulations will remain troublesome, and the Second Six will find it difficult to step out of the second rank.
The Big 8
As of a decade ago, the names of the Big 8 accounting firms were Arthur Andersen, Coopers and Lybrand, Deloitte Haskins and Sells, Ernst and Whinney, Peat Marwick Mitchell (later KPMG Peat Marwick), Price Waterhouse, Touche Ross, and Arthur Young.
New regulatory burdens fall heavily on small public companies. One way to lighten the load: Go private.
Ed Zwirn, CFO.com | US
February 1, 2003
"We're too small to bear the expense of being a public company," says John Clary, CEO of Monrovia, California-based Clary Corp., which employs 40 to 50 people and generates $6 million to $8 million in annual revenue. "Every year the regulations get more complex."
"The federal government and the State of California both seem hell-bent on making sure everything's manufactured somewhere else," adds Clary, whose family-run company produces uninterruptable-power-supply equipment. In a December filing with the Securities and Exchange Commission, Clary Corp. announced its intention to go private in a management-led transaction. In part, says Clary, the reason was to avoid the additional audit costs imposed by Sarbanes-Oxley.
Statistics may be hard to come by at this point, but anecdotal evidence seems to indicate that many more small public firms will go private this year. The SEC, which must approve all going-private transactions, maintains that it doesn't keep count. But Mike Starr, the U.S. managing partner for strategic services at accountancy Grant Thornton, confirms that "certainly, we've had discussions with smaller companies about going private." Many attorneys, consultants, and other industry professionals are also seeing increasing numbers of companies with going-private deals in the pipeline or under consideration.
Typically, the "stock [in these companies] is not widely held," says Starr. In addition, going private will be "more prevalent among companies not listed on a major exchange." Starr adds that considering the relative obscurity of many of these companies and the time required to close a going-private transaction, and allowing for a six-month deal pipeline, the full extent of this trend will not be apparent until later in the year.
"Many smaller firms are going to rationalize whether the cost of being public" is justified, concurs James Haddad, chairman of the Association of Financial Professionals financial reporting committee and vice president of corporate finance at Cadence Design Systems in San Jose, California. "They're looking at whether they need to stay public, particularly with valuations the way they are." (For more on how this may affect the client base of the Group B accounting firms, read "The Second Six: Ready to Step Up?")
Small domestic companies are not alone in voicing their concerns about staying public — or going public — in the United States. In Germany, the source of some of the loudest complaints, automaker Porsche decided against a U.S. IPO because under German law, supervisory boards and audit committees must include employee representatives — who, by definition, aren't "independent" under Sarbanes-Oxley. In Japan, Daiwa Securities Group and Fuji Photo Film Co. of Japan recently delayed planned U.S. listings, citing similar conflicts.
If money could be made hand over fist in the U.S. equity markets, many more companies would willingly jump through the regulatory hoops. But "companies are not having revenue growth of 30 to 40 percent" to compensate for increased costs, especially new audit costs, says William Travers, managing partner at accountancy McGladrey & Pullen. At the same time, their shares "are not trading and not getting the attention of the mutual funds," he adds. Given the present market psychology, "public isn't the place to be unless you have that rocket-ship opportunity."
"When the market goes up," says Grant Thornton's Starr, "I don't think this will be a significant factor." But that's no comfort to John Clary today. Says Clary, "We reached a time when [going private] looked reasonable for everybody." Clary Corp. shareholders, including the approximately 40 percent who were not family members, officially accepted the tender offer for their Pacific Exchange-listed stock in late January. None of these outsiders, says Clary, has reason to complain about the $2-per-share offer: "Our stock's been in the doldrums; it's been about $1 or $1.25 for four years, and that would vary a great deal, based upon whether someone was trying to buy or sell."
"In such an illiquid market, there is no advantage to anybody," adds Clary. "Small companies shouldn't be on the market."
Plan A for Group B accountancies? In the year of the corporate scandal, pick off as much business as possible from Big Four firms.
Joseph Radigan, CFO.com | US
October 2, 2002
Lee Graul says he's starting to see the door open. Open slightly, mind you, but open nonetheless. And that, he says, is better than having his nose pressed up against the glass.
As director of the SEC practice for accountancy BDO Seidman (SEED-man), Graul helps court new audit clients for the Chicago-based firm. Time was, says Graul, that he rarely made a sales pitch to a Fortune 500 company. Although Seidman audits 300 publicly traded companies, it and the other handful of second-tier accountancies never had the cachet or market clout of the Big Four (nee Big Six) auditors.
In fact, many of these second-tier firms were classified as "Group B" auditors by the accounting industry's leading trade group, the American Institute of Certified Public Accountants. (They're also often referred to as "national" and "regional" firms.) But the last 12 months or so have presented these Group B firms with an A-1 opportunity to pick up major new clients.
The most obvious source of this opportunity: the demise of former accounting stalwart Arthur Andersen. Andersen's inglorious fall from grace left 1,400 publicly traded companies without an independent auditor. And Group B firms have rushed in to fill the void.
According to Arthur Bowman, editor of the Atlanta-based Bowman's Accounting Report, some 500 to 600 of Andersen's former clients have opted to do business with one of the surviving Big Four accountancies. But, he says, Group B firms have picked up at least 81 Andersen accounts — a huge number by past standards.
What's more, roughly one half of Andersen's former clients have not yet announced who their new auditors will be. In this year of front-page accounting scandals, SEC investigations, and revenue restatements, industry watchers say Group B firms will likely scoop up their fair share of ex-AA clients.
Indeed, in the past six months, Graul says he's participated in sales presentations to three multibillion-dollar companies — prospective clients who in years past never would have even looked at a Group B auditor.
This phenomenon isn't just limited to BDO Seidman, the fifth-largest accounting firm in the United States. Ed Nusbaum, CEO of Grant Thornton, says his company has gained at least 200 clients this year at the expense of Big Five firms, half from Andersen. In addition, the Chicago-based Group B firm has hired 60 former partners and 500 other former employees of the now defunct accounting firm. Nusbaum says those Andersen alumni have brought additional clients with them.
Even regional accounting firms, which make up the lion's share of the 1,200 bookkeeping companies listed in the AICPA's SEC Practice Section, have seen an uptick in interest from small-cap clients of Big Four firms.
Says Grant Thornton's Nusbaum, "The situation for accounting firms has changed dramatically in the last six months."
Rules of Engagement
If the accounting landscape is changing, so too are the rules of engagement.
Large-cap companies such as Walt Disney and Apple Computer, for instance, have announced they will no longer purchase non-audit services from their independent auditors. In the past, top-tier accounting firms have been accused of trying to parlay audit contracts into consulting contracts — things like ERP implantations and financial reengineering. And in a number of cases, it appears that the financial rewards from non-audit engagements have outstripped the cash generated from bookkeeping services.
At Disney, for example, the company's independent auditor, PricewaterhouseCoopers, took in $8.7 million in auditing fees from the Magic Kingdom in 2001. By contrast, PwC booked $32 million in non-audit fees from Disney that year.
Critics charge that the lure of greater profits has led some of the larger accountancies to direct more attention to consulting services than audit services. During the pitches he's made to large-cap companies this year, claims Graul of BDO Seidman, prospective clients have repeatedly complained about the level of service they've received from a Big Four auditor.
In addition, he says, those prospective clients also expressed consternation about the bad publicity their current auditors have been receiving lately. "All of them said they were concerned about the number of times their auditors were named in news stories about accounting scandals," insists Graul.
The BDO Seidman director did not offer specific examples to back up his claims. But industry watcher Bowman says it's not uncommon for CEOs and CFOs to gripe about a lack of attention from Big Four auditors. Specifically, he says, some clients feel they rarely see lead audit partners after a contract's been signed. Says Bowman, "I've heard people complain that 'I get shunted off to a senior auditor or a junior associate, and I [end up] spending more time training them' " than actually reviewing the financial statements.
Such complaints tend to emanate from executives at less-sizable companies. "There is so much pressure on the lead auditing partners to generate revenue," explains Bowman. That pressure can leave those auditors little time to devote to individual clients who aren't paying seven-figure fees.
Not surprisingly, Group B firms appear to be playing up the service angle when courting Big Four clients. Still, partners at the top-tier firms dispute the argument that they spread themselves too thin to provide good service to all but the largest of clients.
"What's new in that?" asks Mike Ascolese, a spokesman for PricewaterhouseCoopers. "The smaller firms have been making that argument for years."
A Thinning Out
Maybe so. But this is the first time that second-tier accounting firms have actually made inroads into Big Four territory.
And make no mistake, it's tough turf to crack. According to Bowman, some 97 percent of the 15,000 to 16,000 publicly traded companies and mutual funds registered with the SEC are audited by Big Four firms. Of the remaining 1,200 members in the AICPA's SEC practice section, only two (BDO Seidman and Grant Thornton) audit more than 100 publicly traded companies.
Below the ranks of the ten largest auditors, the number of publicly traded clients thins out. By Bowman's count, the seventh-largest auditing firm in the United States, Minneapolis-based McGladrey & Pullen, has only 95 publicly held companies on its client roster.
What's more, say some current clients of Group B accountancies, there are trade-offs in not using a Big Four firm. Take Memry Corp., which makes shape-memory alloys used in components of medical devices. According to Bob Belcher, CFO at the Bethel, Connecticut-based company, Memry's management has at various times looked at cross-border acquisitions.
Each time, he says, the company's management and board have discussed whether Memry would be better served by a Big Four firm that operates globally. Like other Group B accountancies, McGladrey & Pullen has a very limited international presence.
"We've struggled with that," says Belcher. "And if we buy another firm, we would make that move."
Itzhak Sharav, an accounting professor at Columbia Business School, says the global reach of the marquee accountancies is a big selling part to audit clients — particularly to managers of multinational corporations. "That's where the Big Four have an advantage," Sharav asserts. "That's a handicap to the smaller auditors — and they'll have to overcome it."
They'll also have to overcome a lack of sway on Wall Street. Notes Belcher, "If you're a public company looking to go public, or a public company looking to get sold, there's some perceived value to using a Big Four auditor."
Even Group B auditors readily acknowledge the massive resources available to each of the Big Four auditors — resources that dwarf the capabilities of smaller firms. In fact, admits Nusbaum, partners at Grant Thornton would not even consider bidding for the business of a General Motors or General Electric.
Client Server
For managers at some publicly traded companies, though, bigger is not necessarily better. In fact, a number of CFOs at midsize public companies — that is, companies with $500 million to $1 billion in annual sales — prefer working with local auditing firms.
Take Freehold, New Jersey-based Foodarama Supermarkets, with $945 million in revenues. In 1996 the grocer switched to Amper Politziner & Mattia, a Edison, New Jersey-based accounting firm. Previously, Foodarama had used a top-tier auditor for most of the company's 50-year existence.
CFO Michael Shapiro explains the move: "We felt we were better off being a big fish in a small pond than being a little fish in a big pond. Otherwise, you don't get the attention you need."
Memry's Belcher has similar feelings. Currently, Memry still has most of its operations in the United States and therefore doesn't require a lead auditor with a large overseas presence. Moreover, he says, the smaller McGladrey & Pullen is a good fit for the company, which recorded sales of $32 million in the fiscal year ending June 30, 2002.
Concedes Belcher, "We would just be a tiny, tiny client of a Big Four firm."
Industry watchers are predicting a massive shake-out in the accounting business over the next few years. This may not be great news for CFOs.
Joseph Radigan, CFO.com | US
October 2, 2002
In the wake of the year's many accounting scandals, CFOs at some publicly traded companies have been seeking auditors from outside the shrinking ranks of the top-tier accounting firms. But finance chiefs may soon find that the ranks of non-Big Four firms is thinning as well — thanks to the very reforms that are supposed to restore confidence in the auditing profession.
Lee Graul, director of the SEC practice for BDO Seidman in Chicago, says he attended an American Institute of Certified Public Accountants (AICPA) meeting in early August where the participants concluded that their ranks would contract by as much as two-thirds in the next few years. Such a consolidation would bring the number of members in the AICPA's SEC Practice Section from 1,200 to around 400.
Graul says the sentiment at the group's August meeting was that the cost of insurance and regulatory compliance will prove too great for the bulk of these audit firms. "The expectation is that the Public Company Accounting Oversight Board will be much more aggressive than the SEC has been in regulating auditors," says Graul. "You will see firms drummed out of the business."
Even accountancies that don't run afoul of the board, created by Sarbanes-Oxley, won't want to bother with the heightened cost of compliance. Asserts Graul, "They won't want the cost of insurance."
Observers say auditing firms have yet to feel the true impact of the new wave of accounting laws and regulations. But according to Ray Ball, an accounting professor with the Graduate School of Business at the University of Chicago, complying with the new industry requirements has "raised the cost of being in business."
Ball says that auditors will "need an internal staff to ensure compliance, the cost of which will not be totally proportional to the number of clients a firm has." Small accountancies that can't distribute their fixed costs across a long list of customers will see per-client expenses go up dramatically. Big Four firms, on the other hand, should be able to parse the increased costs over their huge roster of multinational corporates.
"The smaller firms will either drop out of serving public clients, or they will merge into larger companies who will incur the costs," predicts Ball.
Regional firms will likely find themselves squeezed on another front as well. The economic downturn could drive a host of smaller, entrepreneur-driven companies out of business. And those are exactly the type of clients that second-tier and regional accountancies cater to.
"Quite honestly, the degree of regulation has really caught people by surprise," notes Dana Hermanson, professor of accounting and director of research at the Corporate Governance Center for Kennesaw State University's Michael J. Coles College of Business. "This has all been in just the last three months."
Raise High the Roof Beam, Auditor
None of this is real great news for CFOs, who work more closely with independent auditors than does any other officer in the executive suite. Hermanson expects that 2003 and 2004 will be a period of tremendous turmoil as many auditors — and clients — grasp the impact of the new regulatory regime.
One smallish change: The cost of audits will go through the roof. "Audits may cost 40 percent more in 2002 than they did in 2001," forecasts Hermanson.
That very large spike in the cost of filing audited annual and quarterly reports may convince managers at small, privately owned companies to avoid the public markets entirely. Likewise, it might sway executives at some small-cap public companies to take their businesses private.
The dustup in the audit industry itself will be equally dramatic — particularly for smaller accounting partnerships. Says Hermanson: "You'll see some firms from the audit side that may conclude, 'Hey, we only have two audit clients. Let's get out of the business.' " Some of those firms may simply resort to providing ancillary accounting services, tax work, and compensation and benefits consulting.
In addition to a pending spike in overhead costs and shrinkage in the number of clients, some of the procedural changes under the Sarbanes-Oxley Act will also take their toll. Charles Elson, director of the Center for Corporate Governance at the University of Delaware, notes that "the rotation of partners required under Sarbanes-Oxley is going to force some consolidation."
Indeed, many regional outfits simply don't have enough partners to go around. Industry watchers say a fair number of those firms will have little choice but to jettison their auditing offerings and focus instead on ancillary accounting and bookkeeping services.
At the same time, observers believe that some national auditors will merge with other firms to gain the scale they'll need to satisfy the constant stream of regulations coming out of Washington.
There's Got to Be a Morning After
This is not to say it's all fear and loathing in the auditing industry. Firms that emerge from the impending cataclysm will probably find it easier to make money off their audit services. "Auditing public companies had become a commodity business," notes Elson. "But if there's a rise in fees, there will be profits to be made again."
Bolstering that trend: An increasing number of corporate clients now say they will no longer purchase consulting services from their independent auditors. Such a shift will make it far less likely that accounting firms will treat audit services as a loss leader. In the past, some firms have been willing to take a hit on audit contracts because the engagements gave them an entree to flog more-lucrative consulting services to clients.
In fact, Julia Grant, an accounting Professor at the Weatherhead School of Management at Case Western Reserve University, believes the new regulatory regime may reinvigorate the entire profession.
"It's too soon to say that firms will quit doing the auditing work," Grant insists. "It's the auditing work that gives them such a rich, in-depth knowledge of the business. If you're a general-purpose, all-service firm, you'll still need to hang on to the audit services."
Grant also points out that Sarbanes-Oxley was intended to purge the industry of auditors who had either let their skills erode — or engaged in unethical practices.
"From the standpoint of the auditing industry," she says, "that's a good thing."
Just don't tell that to the 800 or so auditing firms that will be getting out of the business in coming years.
Among the Group B accounting firms, six lead the pack. Will any make the Final Four?
Joseph Radigan, CFO.com | US
October 2, 2002
Every CFO knows the Big Four firms. Less familiar are the scores of accountancies that rank below the top four in revenues — but well above the sales of much smaller regional firms.
Like the Big Four, this band of second-tier accountancies, known in the industry as Group B firms, provide auditing and tax work to publicly traded companies in the United States. Unlike the Big Four, however, the Group B accounting firms typically don't possess a true global reach. Instead, many of the firms rely on partnerships with local accountants to service multinational clients.
Of the hundreds of firms classified as Group B accountancies, six stand out — both in revenues and the number of publicly traded clients. With the help of Arthur Bowman, editor of Bowman's Accounting Report, CFO.com has compiled snapshot profiles of these firms. We call them the Second Six.
BDO Seidman
Headquarters: Chicago
International Affiliation: BDO International
Total Sales Audited: $27.9 billion
Total Clients Audited: 280
Average Sales per Client: $99.7 million
Offices: National
Strengths: Tax services have become an important market for BDO in the past few years.
Skinny: With Denis Field becoming chairman, company settled down after period of management turmoil, says Bowman... BDO Seidman, Grant Thornton, and McGladrey & Pullen all trying to become dominant provider of audit services for middle market companies — that is, businesses with annual revenues between $500 million and $1 billion. Right now, BDO Seidman and Grant Thornton appear headed for showdown... Firm tops Second Six in average sales per customer — key figure.
Grant Thornton
Headquarters: Chicago
International Affiliation: Grant Thornton International
Total Sales Audited: $29.6 billion
Total Clients Audited: 344
Average Sales per Client: $86 million
Offices: National
Strengths: Construction, consumer and industrial products, government, nonprofit, real estate.
Skinny: Went through long period of management stability in the 1980s and 1990s. Also saw some turnover in top management turnover — until current CEO Ed Nusbaum took over. Since then Nusbaum has become something of a visible spokesman for auditing profession as a whole... Sale of firm's IT consulting business to Hitachi few years ago gave the company cash to expand... University of Delaware's Charles Elson says if any of Second Six were to jump to Big Four, Thornton is most likely candidate. But Nusbaum tells CFO.com that firm will stick to middle-market focus.
McGladrey & Pullen
Headquarters: Minneapolis
International Affiliation: RSM
Total Sales Audited: $4.7 billion
Total Clients Audited: 95
Average Sales per Client ($ Millions): $49.6 million
Offices: National
Strengths: Financial institutions, manufacturing, wholesale distribution, government, nonprofit, healthcare construction, agriculture.
Skinny: McGladrey sold its tax and consulting business to H&R Block in late 1990s, creating an entity called RSM. Bowman says it's an unusual arrangement — one where McGladrey partners are Block employees, but own the auditing practice itself... To date, effort to cross-sell services between McGladrey and Block has produced mixed results.
Crowe Chizek
Headquarters: South Bend, Indiana
International Affiliation: Horwath International
Total Sales Audited: $3.7 billion
Total Clients Audited: 82
Average Sales per Client: $45.1 million
Strengths: Banking, automobile dealerships.
Skinny: Crowe Chizek was one of first accountancies to get into information technology consulting. Firm still owns U.K.-based subsidiary that sells software to banks... Bowman says Crowe Chizek has a more "collegial atmosphere than other firms. There's more of a balance in the compensation among partners." Setup has its plus and minuses. Few, if any, Crowe Chizek partners make seven-figure incomes. On the other hand, there's little reason for any partners at low end of the pay scale to feel envious... Company maintains offices in Indiana, Florida, Illinois, Kentucky, Michigan, Ohio, and Tennessee.
BKD
Headquarters: Springfield, Missouri
International Affiliation: Moores Rowland
Total Sales Audited: $1.2 billion
Total Clients Audited: 40
Average Sales per Client: $29.7 million
Strengths: Healthcare, banking
Skinny: Bowman on BKD: "(They) like to say that they are the major player in the heartland of America." But he says firm's looking to acquire $20 million or so firm in Chicago to beef up presence. Currently, BKD more established in border states, with headquarters in Missouri and offices in Kentucky, Tennessee, and Arkansas. Firm does have operations in Colorado, Indiana.
Moss Adams
Headquarters: Seattle
International Affiliation: Moores Rowland
Total Sales Audited: $843 million
Total Clients Audited: 32
Average Sales per Client: $26.3 million
Strengths: High-tech, apparel finance, forestry, recording-industry royalty compliance
Skinny: Largest independent auditing firm based on the West Coast, with branch offices in Los Angeles and San Francisco... Bowman says Moss Adams, Crowe Chizek, and BKD all well-positioned for the future. He adds they face difficult task of "providing challenges for their personnel to show them a career path, while not exceeding management's ability to manage the firms." A nifty trick, if you can pull it off.
Can software prevent future Enrons?
Peter Krass, CFO Magazine
November 1, 2002
New developments in computer software could lead financial executives and accountants to completely change the way they conduct corporate audits. The question is whether that would be a good thing — and whether it could prevent the next Enron.
So-called continuous-auditing software promises to transform the process of financial auditing by changing it from an archival activity that is performed at the end of a month, quarter, or year to a process that could be done on a continuous, nonstop basis. The promise is that this type of system could catch — and stop — illegal financial transactions before any damage is done.
But critics of such software say it blurs the line between auditing and monitoring. That's a line, they say, that few companies — or their independent auditors — wish to cross. Worse, in their view, is the idea — put forward by some proponents of continuous-auditing software — that the software could actually shut down an entire transactional system whenever it detected a major transgression. That, they fear, wouldn't just cross the line, it would obliterate it.
Welcome the Auditbot
Even if auditing software were pushed to this limit, could it stop the next Enron or WorldCom? Probably not, say experts. As Don Schulman, leader of the global financial-management solutions practice at PricewaterhouseCoopers Consulting, puts it: "The CEO who wants to cheat and lie can take [a transaction] out of the system and tell the CFO to change it."
For all that, the basic idea behind continuous-auditing software, sometimes known as "auditbot" technology, is fairly simple: A piece of software runs in concert with standard financial-application suites such as those offered by SAP, Oracle, and PeopleSoft, monitoring each transaction conducted by the suite and watching for violations of the company's rules and practices. (These rules are programmed in beforehand by the company's internal audit group or an outside auditor.) If and when the software detects a violation, it issues a warning report or an alert to top management.
Such auditbots are built around a kind of software known as a rule-based system. In contrast to most software, which represents information in a relatively static way, a rule-based system constantly compares one data type with others, using the programmer's classic "if-then" formulation. For example, a standard computer system for determining the day of the week would simply store calendar information, in effect saying, "Today is Monday and tomorrow is Tuesday." But for the same task, a rule-based system would compare days, saying, in effect, "If today is Monday, then tomorrow is Tuesday." In an accounting situation, a rule-based system could formulate: "If an invoice is paid in full, then book the payment as revenue."
Much of the early work on continuous-auditing software was done in the telecom industry, which, not coincidentally, was one of the first to have real-time electronic records of all its transactions — in this case, telephone calls — on hand. One of these early projects was undertaken at Bell Labs (now AT&T Laboratories) in the mid-1980s and led by a pioneer in the field, Miklos Vasarhelyi, today a professor of accounting and information systems at Rutgers University. The system, called CPAS (Continuous Process Auditing System), was tested over a four-year period but was never implemented. One reason, says Vasarhelyi, was that it raised hackles among other departments. "Our detractors within the company said, 'This is not auditing, it's monitoring,'" he recounts. His take? "Auditing is supervision."
Still, that debate hasn't prevented other companies from testing auditbots. They include those that conduct large numbers of real-time transactions, mainly financial-services companies such as Citibank, Schwab, and PayPal, says Vasarhelyi. "With online, real-time technology, it is possible to get very close to the transaction, take a global view of it, and pick up an understanding of things that are not cricket," he explains.
Ifs, Ands, or Bots
While independent auditors say they're interested in applying auditbots to their clients' systems, to date it has been internal audit departments, not outsiders, that have taken the first steps. The reason is mostly a matter of trust. "Quite rightly, companies don't want to put things on their computers they don't fully understand the implications of," says John Fogarty, director of audit methodology, policy, and procedures at Deloitte & Touche. "They want to consider how [auditbot software] would interact with their other systems, and they want to consider the security issues. It's not a casual thing." Instead, independent auditors are turning to Web-based tools as the next step in automating corporate audits.
Another barrier to the widespread adoption of auditbots is the mind-numbing complexity of enterprise applications — and the fact that multinational, multicompany corporations rarely standardize on a single version of a single suite. "ERP [enterprise resource planning] software is a misnomer, because these systems are not really enterprisewide," says Fogarty. "As a result, automated techniques can be applied to some systems, but not really to all."
Critics of auditbots argue that auditing can never be totally automated, and will always require human intervention. "You can't audit a company in real time, because judgments and estimates are involved, and human beings make those after the fact," insists Brian Kinman, head of PricewaterhouseCoopers's enterprise risk-management practice.
Adds Frank Gori, global director of assurance services at Ernst & Young: "Technology tools are only tools. The most important element in the auditing process is your people bringing skepticism to the table to ensure quality."
Even Vasarhelyi admits that auditbots are unlikely to usher in an era of flawless financial reporting. In the first place, it's relatively easy for bad guys to keep one step ahead of the software, much the way computer-virus makers engage in a kind of arms race with computer-security experts. By the time the security gurus have figured out how to detect and disable the latest virus, the evil virus-makers have unleashed new ones. A similar arms race could erupt between corporate crooks and auditbot developers. And even if the software triumphed, says Vasarhelyi with a sigh, "if management is really crooked, they'll do something [else] anyway."
Audit.com
While the widespread use of auditbots is still a blue-sky dream, in the here and now, independent auditors are increasingly relying on Web-based software.
Ernst & Young, for one, supplies its teams with a Web-based portfolio of audit tools called EY/NexGen. Currently in what the firm labels "early adoption mode," NexGen helps multinational teams collaborate by providing a suite of Web-based software tools that let team members share documents and communicate with one another.
NexGen also lets a project manager bring in subject-matter experts from around the world on an as-needed basis, explains Frank Gori, E&Y's global director of assurance services. "Anyone with user access and a password can engage in the review or creation of work papers in real time," he says. NexGen also provides online-collaboration software that lets professionals working on an audit project conduct virtual meetings over the Internet.
After some 18 months in development and testing, NexGen is being rolled out to E&Y's Business Risk Services Group and selected clients. It augments, but probably won't replace, the firm's standard desktop auditing tool, called EY/AWS 1.5 (AWS stands for Auditor's Work Station); small clients — those without multinational operations — simply don't need the benefits NexGen offers. "For a small client with, say, $20 million in revenue, using a tool like NexGen is like bringing a howitzer to the table," says Gori.
Similarly, Deloitte & Touche uses two Web-based audit systems. The first, known as ACL Web, is based on a commercial application from ACL Services Ltd., though it has been customized for Deloitte's auditors. ACL Web addresses a key barrier to automated auditing: incompatible data formats. To help Deloitte auditors get a client's data into a single format, ACL Web acts as a kind of self-help kiosk, providing lists of questions and terminology so auditors can work with a client's IT department. The Web-based tool also provides preprogrammed tests that auditors can apply to the data, rather than have to create new tools on the fly, explains John Fogarty, Deloitte's director of audit methodology, policy, and procedures.
Deloitte's second Web-based system is somewhat experimental. Developed with software vendor Intacct Corp., it takes the entire automated-audit process one step further by actually embedding the audit system into the accounting system. Among other benefits, this eliminates the need to reformat financial data before it can be audited. Although the current product is suitable only for small and midsize accounting firms, that could change, says Fogarty: "We developed it as something we might use in our own practice." Nothing blue-sky about that.
It's no surprise that audit bills have gotten a whole lot bigger.
Alix Stuart, CFO Magazine
October 1, 2002
Better usually means more expensive. So it's no surprise that audit bills have gotten a whole lot bigger, thanks to a raft of new projects — such as internal control certifications — that the Sarbanes-Oxley Act of 2002 handed to auditors.
"Audit committees are asking us to do more work, visit more locations, and get involved with different types of issues," says Dennis Nally, PricewaterhouseCoopers's U.S. chairman and senior partner. "That translates into more audit fees."
Overall, prices at the Big Four are likely to rise between 15 and 25 percent this year, according to industry experts — and that's just "tranche one," says Greg Weaver, national managing partner at Deloitte & Touche. "We will probably see another increase next year."
Some say audit firms will also be forced to raise per-hour fees to make up what they'll lose on consulting. "The only alternative will be to increase audit fees," says Jay Nisberg of Jay Nisberg & Associates, a consultancy for audit firms.
Auditors don't see it that way. Instead, they say a client's risk factors will make the big difference in price. "We really didn't differentiate [on risk] as much as we should have in the past," says Weaver. Deloitte is currently culling its portfolio to drop companies that are too risky, he says. "We'll be more like a bank that's lending a company money."
Then there is the contention that the small oligopoly of four firms will have more power to raise prices. The comptroller general will complete a study on the effects of consolidation in the accounting industry, including pricing, by next July. "I wouldn't be at all surprised if the SEC steps in and tells the audit firms what prices they can charge," says Nisberg.
One way for small and midsize businesses to save money: Switch to a local auditing firm. Their fees are some 35 to 40 percent lower than the Big Four's, according to Bowman's Accounting Report editor Arthur Bowman. While there hasn't been a massive exodus to smaller firms yet, that could change. Bowman estimates their fees will increase only 3 to 16 percent.
Smaller Is Cheaper
Companies moving from Big Five to smaller audit firms.
| Year | Number of companies* | % of all auditor changes |
| 1999 | 18 | 2 |
| 2000 | 48 | 4 |
| 2001 | 26 | 2.2 |
| 2002** | 39 | 2 |
*Firms with over $100 million in revenues or assets
**As of September 4, 2002
Source: Auditor-Trak
Not certain how your finance department stacks up? Here are ten markers of mediocrity.
Marie Leone, CFO.com | US
February 20, 2003
You can't benchmark the performance of one finance department against another, says Blythe McGarvie, CFO of the Paris and New York-based BIC Group. The same numbers, she argues, are handled by different companies in too many differently nuanced ways for direct comparisons to be practical. Many finance chiefs, consultants, and academics are willing to make those comparisons — but they disagree on where to draw the lines.
McGarvie and the others we interviewed for this article, however, all agree on several indications that do provide a certain measure of a finance department's effectiveness. (Within this article, "finance department" refers to all those areas over which the CFO holds sway.)
Steer clear of these treacherous areas, and you have no guarantee of success; run afoul of them, on the other hand, and your finance department simply cannot be considered among the best. Your company and your career may fare poorly as well.
1. Slow Closes
A properly skilled staff should produce a complete financial statement within ten days of the quarter's end, says Miles Stover of Crossroads LLC in Irvine, California. Seven days, he adds, should be long enough to produce a preliminary "flash" report suitable for internal distribution.
Stover, who's been an interim CFO on behalf of Crossroads at multibillion-dollar conglomerates and at tiny private concerns, grants an exception for companies with annual revenues under $50 million — but even for these companies, he maintains, the quicker the better.
Dave Peralta, CFO of software provider Arbortext in Ann Arbor, Michigan, doesn't hold to such a strict rule of thumb, but he agrees that "the longer it takes to close, the more inefficient the department becomes." Tasks tend to expand to fill the available time unless the finance chief has the discipline to fix a date, then push the department to meet it.
Efficiency aside, why else should you concern yourself about a leisurely close? It can be a sign that policies may need some tweaking — say, because closings are held up by laggard invoices that trickle in on the last day of the month. There's a simple remedy for that one: Move up the deadline to earlier in the month to give your staff some breathing room.
Sometimes, of course, appropriate policies and procedures are in place, but they're being ignored by employees outside your department. "That's when the CFO needs to put in some calls to get things back on track," offers Peralta. (For more on the efforts of CFOs to close the books more quickly, see "Virtual Close: Not So Fast.")
Now there's slow, and there's very slow — it's not simply a process problem when the close is a full quarter behind. Witness power producer Mirant, which filed its 10-Q for the period ending June 30 on November 7, and pharmaceutical giant Bristol-Myers Squibb, which plans to file its third-quarter 10-Q in February 2003.
"If this was just a process problem," says James Owers, a finance professor at the J. Mack College of Business at Georgia State, management might have felt compelled "to bring in a new cast of characters in the CFO function." Owers notes that these tardy filings indicate wider problems — restatements coupled with investigations by federal regulators, in the cases of Mirant and Bristol-Myers Squibb.
2. Outrageous Audit Fees
Insiders and outsiders have different opinions about whether high fees spell trouble for the finance department. Kris Onken, CFO of Logitech International, a manufacturer of personal digital devices based in Fremont, California, maintains that rising audit fees are often an indication that a company's business is becoming increasingly complex. At a previous employer, she saw audit fees jump 25 percent while the company worked through growing pains.
Daniel Weinfurter, president of Parson Consulting in Chicago, counters that high fees, including those for non-audit services, can be traced to an underperforming finance department that requires an abnormal amount of "cleanup." Weinfurter, whose Chicago-based firm specializes in ferreting out corporate finance problems, warns executives to keep tabs on the fix-it bills for such things as slow shipments, bloated inventory, out-of-control receivables, and big write-offs for items that should have been handled earlier in the reporting cycle.
Paying a CPA $500 per hour to correct general-ledger mistakes is throwing money away, adds Miles Stover. Accounting errors should be corrected in-house by a staffer who makes $60 per hour. (Another option, many firms have found, is to have their outside audits performed by one of the many "Second-Tier Audit Firms.")
3. High DSO
Days sales outstanding (DSO) — the average time taken by a company to collect payment from its customers — can be calculated using figures from the 10-Qs or 10-Ks of a public company. When DSO rises, it also appears on the radar screens of company shareholders.
Daniel Weinfurter says an increase in DSO usually stems from a lapse in the accounts receivable process. Collection calls, for example, might not begin until 30 days after the past-due date. A related headache manifests itself as high customer adjustments, which can lead to higher DSO as well as hinder the usefulness of forecasts.
Although the CFOs we spoke with consider such adjustments to be "business as usual," all agree that when the number of adjustments creeps up month after month, something's amiss. Perhaps it's simply a warning of sloppy quality control on the assembly line, but faulty control procedures in the finance department are more common and more directly controllable.
There's no rule of thumb for DSO, mainly because industries vary greatly in the speed with which they collect. Tracking your receivables aging pattern is one useful yardstick; even better would be to compare your company's DSO with that of its peers. (To keep tabs on DSO and many other metrics, most publicly traded U.S. companies can compare themselves with their peers by entering company tickers in the CFO PeerMetrix interactive scorecards.)
4. Multiple Payments
Are your vendors seeing double? When they bill you once and you pay them twice, you may ensure that your company's credit is stellar, but it's not great for cash flow. Kris Onken remembers when, as a newly hired controller for a previous employer, three different vendors notified her of double payments. "I can only imagine how many more were out there that never reported it," she laments.
Your accounts-payable system is probably not to blame. Most standard accounts-payable software incorporates a safeguard that matches up each check with an invoice. Even off-the-shelf small-business software that retails for under $100 usually has that invoice-matching feature.
"Double payments, or slow payments, often have their origins in operations," observes Dave Peralta, and to some degree the finance department must rely on the diligence and discipline of the operating units. Bill Hurley, practice director at Parson Consulting, notes that new, sophisticated procurement systems have added another layer of complexity to the payment process. True, these trading systems may standardize the information gathered from vendors — but if an accounts payable employee runs into a snag while negotiating four or five software filters, an exception can take weeks to resolve.
Whether double-payment problems begin with poor compliance by operating units or with haywire procurement systems, the buck stops with the finance department. (That's a big reason so many companies are "Working on the Chain.")
5. Earnings Restatements
According to the U.S. General Accounting Office, during the past five years 10 percent of all publicly traded companies restated their earnings because of accounting irregularities. About 250 companies, the GAO estimates, will restate by the end of this year, far more than the 92 companies that restated in 1997.
Most restatements aren't a harbinger of fraud, simply the result of common accounting errors or oversight. Parson's Weinfurter maintains, in fact, that two-thirds of all restatements are caused by trip-ups related to revenue recognition. A restatement usually won't bring a company to its knees, adds Logitech's Onken, but "it's still a black eye." (Or is it a knockout punch? In a poll conducted for our special report "CFOs: The New Patsies?," more than 60 percent of respondents thought that an earnings restatement was the biggest threat to a CFO's career.)
Many errors that might lead to a restatement are caught by internal audits and corrected. When they slip by, says Professor Owers, it's a strong signal that the accounting and financial functions are having a problem with accounting judgments.
6. Manual Entries
The sole proprietor of John's Coffee Shop can automate his books for $80 with an off-the-shelf software package. Not only will he free himself from manual entries, his accountant tells him that he'll be able to shore up his financial controls.
For larger companies, however, ridding the finance department of manual entries and stand-alone spreadsheets is proving to be a Herculean task (think "Augean stables").
Parson's Hurley says that 99 percent of his clients — these are Fortune 500 firms, mind you — still work with spreadsheets or disparate financial systems. Only the Fortune 50, claims Hurley, are really breaking away from their reliance on spreadsheets, since only these companies have the resources to connect far-flung systems with middleware and to wean employees from spreadsheets by retraining them.
Spreadsheets are still handy for running "what if" scenarios as well as budgeting and forecasting exercises. But when the subject is financial controls, notes Crossroads' Stover, relying on stand-alone spreadsheets instead of financial systems "violates the audit trail." More opportunities exist for mistakes — or wrongdoing — and widespread use of spreadsheets means that a company's financial-database history is useless.
Balance sheets and income statements, Stover maintains, should be posted within a systems environment. (For more, see "Core Values," our ERP buyer's guide.)
7. Lack of Transparency
Accounting is a straightforward science, says Arbortext's Peralta, and transparency is a non-negotiable item for both internal and external reporting.
From an internal perspective, the department must respond to questions with timely and logical answers. When the mechanisms that deliver reports are too confusing, or when the systems that should be running routine reports are spitting out incorrect or incomplete information, that inefficiency should raise a red flag.
Deal with it promptly: While poor report generation creates an unproductive finance department, it also hamstrings business units that depend on updated financial data. When operating units don't get the information they need to support their management and planning decisions, they're not likely to keep quiet.
As for external reporting, Professor Owers gives straightforward advice: Meet disclosure requirements and do it quickly. He praises broadband services and products purveyor Scientific Atlantic for management's quick announcement about the financial impact of the bankruptcy filing of Adelphia Communications, a 20-year customer of Scientific Atlantic. Footnotes, Owers counsels, should follow the spirit and not just the letter of the law. (Easily said — but faced with tough new reporting requirements, many CFOs are having difficulties with "The Fear of All Sums.")
8. Dubious Structures
First, and most dubious: If your internal audit team reports to the CFO, you would be hard-pressed to find an executive, regulator, or Sunday-morning talk-show pundit who did not bristle at the potential conflict of interest.
Every CFO we interviewed for this article insists that this line of report is a grievous governance deficiency that's wide open for exploitation. (The flip side, as exposed by our article "There's a Monster in Finance," is that the newfound power and independence of internal auditors poses its own threat for finance chiefs.)
Then there's the case of the company whose treasurer and controller each reported their own cash number — different numbers, that is. (Apparently the discrepancy stemmed from an inflated cash sum reported by the treasurer, who ignored the float on the cash balance.)
It turns out, says Michael Feder, a partner in the Chicago office of turnaround firm AlixPartners, that the two executives were aggressively competing for face time with the CEO and CFO. A little competition is fine, but it should never trump a clear delineation of duties.
Another crack in the structural foundation is improper division of duties. For example, internal audit rules usually require that the employee that receives checks doesn't post them, and that the employee who prepares checks doesn't sign them.
Finance chiefs agree that its often impossible for very small companies to separate the administration of payables, receivables, and bank-statement reconciliation among three different people. For companies of more than 100 employees, however, it should be mandatory.
9. Overly Cozy with Sales
At its root, this is a problem of revenue recognition, and of training the sales department about just how serious an issue this can be. Just last week, Computer Associates landed back in the headlines over new allegations that it had shifted revenue from quarter to quarter, a practice that could violate generally accepted accounting principles (GAAP).
Accountants from Logitech International, declares CFO Kris Onken, are routinely sent out into the field "to put the fear of God into the sales staff." ("Routinely" used to mean about twice a year, but since Sarbanes-Oxley it's been four times in four months.) Onken insists that the finance department is responsible for educating the salesforce about when to book revenue — "but there can be no doubt who is boss."
What's on the syllabus? It's a refresher course in revenue recognition rules, for new and existing employees, including "what if" scenarios and a question-and-answer period. In addition to the sales and marketing staffs, Onken's team trains other supply-chain workers such as order-entry and shipping employees.
Sales employees should understand the nuances of different contracts, and other supply-chain workers should have at least some familiarity with them. For example, one Logitech agreement states that the company will ship products to a customer warehouse, but the inventory title is not transferred until the customer actually pulls products from the warehouse — so revenue cannot be recognized until that time.
In a good organization, say many CFOs, the sales and marketing departments should be aggressive about order flow, and the accounting department should lend a helping hand when it can do so appropriately. But when "lending a hand" leads to postponing sales problems — or even straying from GAAP — a company might pass "second-rate" and drop to the bottom of the barrel. (For more, see RevenueRecognition.com.)
10. Staff Turnover
Where there's churn, there's trouble, says Stover, and it's usually associated with burnout or poor management. Accountants are precise by nature, adds Onken, and the CFO has to cater to that part of their personality.
Procedures that aren't sharply defined, processes with too much wiggle room, moving targets for deadlines, inadequate staffing, systems that don't support job functions — all are incentives for employees to walk.
Some CFOs believe that substandard transaction systems are the most common cause of dissatisfaction in the finance department. Accountants detest the idea of manually extracting numbers from a system that should deliver them automatically.
Bill Hurley looks instead to procedural breakdowns as a major cause of discontent. The practice leader for Parson Consulting points a finger at departments that wait until the last day of the month to run the numbers, instead of updating receivables, payables, inventory, and cost of goods sold on a daily or weekly basis.
No one likes to "do the big cleanup" — especially when it's the one thing that seems to arrive on schedule, month after month. (For more on best practices and motivating employees, see "What Works: Building a Strong Finance Team.")
The best reason to keep staff turnover low might be to help communication flow more freely within the finance department. When your finance professionals and other staffers are unhappy or untrusting, word of potential problems may not reach your ears until it's too late.
A CFO survey suggests that recently passed rules for auditors may be a wise idea.
Andrew Osterland, CFO Magazine
September 1, 2002
Remember back last summer, when Harvey Pitt vowed to run a kinder, gentler Securities and Exchange Commission than his predecessor, Arthur Levitt?
With Enron and all that has come after, last summer might as well be a lifetime ago. The audit firms are finding little sympathy at the SEC or even on Capitol Hill these days. On July 24, a Senate-House conference committee agreed upon the most sweeping changes to securities law, corporate governance, and the regulation of auditors since the Securities Exchange Act of 1934. Not even the legendary lobbyists for the big auditors could water down Sen. Paul Sarbanes's (D-Md.) bill in conference committee. Meanwhile, Pitt, who has had to recuse himself from more than a few SEC investigations in the past year because of his former ties to business, has been fighting to hold on to his post. Since the calls for his resignation started, he has been sounding less kind and gentle by the day.
Pitt's problems mark the end of an era. The Sarbanes-Oxley Act, which passed both the House and the Senate by huge majorities and was signed into law on July 30, is intended to fundamentally change the relations between public corporations and their auditors. It will place new restrictions on the services that auditors can provide for their clients, and it will establish an independent board to oversee the industry for the first time in its history.
Congress isn't the only purveyor of new regulations affecting auditors. The New York Stock Exchange will prohibit auditors of listed companies from serving on the boards of clients for five years. Meanwhile, Nasdaq-listed companies will be prohibited from hiring former auditors at all levels for three years. "No one could have imagined all the changes that have happened and are still happening in the industry," says Ed Nussbaum, CEO of Grant Thornton LLP, which, with $342 million in revenues last year, will be the sixth-largest audit firm in the country after Arthur Andersen officially ceases operations on August 31. "It's mind-boggling."
The ultimate responsibility for financial statements may lie with corporate managers, but by any measure, the audit firms have failed miserably in their role as financial watchdogs. And with their profession about to undergo a major overhaul, they have been a very quiet voice in the reform debate. "There's a void of leadership in the audit industry," says Michael H. Sutton, a former chief accountant at the SEC who testified in the Sarbanes hearings. "The firms are all in defensive mode."
For corporate executives, that defensive mode already means tougher, more-expensive audits and less wiggle room when it comes to the interpretation of accounting rules. "If anything, [the auditors] have become overly conservative," says David Banks, head of corporate communications at First Data Corp. The Sarbanes Act is no immediate cure for a deeply shaken market, but it may go a long way toward fostering a more independent and adversarial role for auditors of public companies. "It's a very different environment from nine months ago," says Nussbaum. "Instead of focusing on whittling down our fees, senior executives and audit committees are challenging us to make sure we're doing an adequate job."
An Auditor by Any Other Name
In the past two decades, the accounting firms have ventured far beyond their humble roots. While they have always provided some degree of nonaudit services to clients, the opportunities for new business have exploded in the past 20 years. With the spread of information technology, the biggest auditors became designers and implementers of IT systems. They expanded their tax, legal, and investment advisory services, and branched out into all manner of management consulting work. Since SEC auditor-independence rules enacted in November 2000 began requiring firms to disclose their sources of revenue, the magnitude of the industry's transformation has become apparent. A survey conducted by the Investor Responsibility Research Center found that 72 percent of the $5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for nonaudit services.
In his seven and a half years as SEC chairman, Levitt tirelessly pushed the issue of auditor independence, arguing that corporate audits were being compromised by the firms' growing reliance on other sources of revenue. Indeed, in the broader offering of professional services by the audit firms, the actual audit has arguably become a loss leader to land more lucrative consulting contracts. "Some firms used to refer to audits as a commodity," says Nussbaum. "No one believes that now."
The American Institute of Certified Public Accountants (AICPA) has long argued that no evidence exists that the provision of consulting services has ever resulted in a tainted audit, but there is certainly an apparent conflict of interest. "Independence in appearance is as important as in fact," says Charles Mulford, an accounting professor at the Georgia Institute of Technology. "Even if there's a wall between the consultants who might design and implement a system and those who audit the statements, appearances matter."
The Sarbanes Act lists eight distinct services that firms will no longer be allowed to provide to their audit clients, and it gives the new oversight panel the authority to prohibit other services as it sees fit. It also requires that corporate audit committees preapprove all services provided by auditors to the company.
Investors have already been attempting to reduce the ties between public companies and their auditors this proxy season, says Ann Yerger, a director of research at the Council of Institutional Investors. A handful of shareholder proposals to eliminate all nonaudit service contracts with auditors made it onto corporate proxies this spring. Several were withdrawn after discussions with management yielded a compromise, but a few, including proposals at Walt Disney and Motorola, drew shareholder support in the range of 40 percent.
At Motorola, the Sheet Metal Workers National Pension Fund proposed that the company sever all nonaudit service contracts with its auditor, KPMG. Last year, Motorola paid the firm $19 million — only $4.1 million of which was for audit work. Thanks to a large IT implementation, the audit fees paid to KPMG in 2000 were only $3.9 million of a total bill of $62.3 million. Motorola spokesman Scott Wyman says the company had already committed to discontinuing IT consulting, internal audit, and financial transaction-structuring contracts with its auditor prior to the March 29 shareholder vote. It may have to further curtail its business with KPMG in the coming year.
Many companies are paying extra attention to their relationships with auditors these days. Beth Farbacher, senior vice president and general auditor for Pittsburgh-based health insurer Highmark, says that all internal proposals to use the company's auditor, PricewaterhouseCoopers, for nonaudit work have to be cleared with her first. "I'm sensitive to any engagement that presents a conflict of interest in fact or appearance — particularly in the financials or systems area," says Farbacher, who reports directly to the audit committee of Highmark's board of directors. In some cases — actuarial services, for example — Farbacher says the auditor has a base of knowledge that gives it an advantage over other providers. "It puts them in a position to make better assumptions or to poke holes in our assumptions," she says. The new restrictions in the reform bill, however, will likely force Farbacher to find another firm to perform Highmark's actuarial work.
Joe Martin, CFO of Fairchild Semiconductor, has to choose a new provider of internal audit services for his South Portland, Maine-based company. His auditor, KPMG, has performed the function up until now. "I have no problem with the new rules. We've seen it coming for a couple of years," says Martin, who has also hired KPMG for such other services as human resources management and appraisal work. He has recently been interviewing alternative providers. "It's been convenient to do one-stop shopping [with KPMG]," says Martin. "Now it's just going to be a little less convenient."
A notable exception to the new service restrictions is tax work — the assumption being that issues of tax are so intertwined with accounting and financial reporting that separating the two could jeopardize the quality of audits. Other nonaudit services, however, are also essential to the audit work, says PricewaterhouseCoopers global CEO Samuel DiPiazza Jr. "To perform good audits, we need more skills than just forensic accounting," he asserts. Specifically, DiPiazza suggests that general accounting skills, tax planning, risk management, and security analysis are all vital competencies for auditors to possess. "All these elements are embedded in the financial statements. If we legislate against providing these services, we could end up with poorer audits," he warns.
The new restrictions on the provision of nonaudit services don't resolve all conflicts of interest. The fact that clients foot the bill for their audits and can readily take their business elsewhere creates a basic conflict to begin with. But the new ground rules will at least reduce the appearance of conflicts of interest. "If we're going to rebuild trust in financial reporting, these things are needed," says Professor Mulford.
Bringing the Watchdogs to Heel
When Congress gave the task of setting accounting standards to the newly created SEC in 1934, it left the job of overseeing auditing standards and individual firms to the accounting profession. For the past 65 years, the job has been performed by the AICPA and its predecessor organization.
Industry self-regulation, however, has often meant no regulation. The recently dissolved Public Oversight Board, established by the AICPA to monitor the conduct of auditors and funded by the industry, had little power to enforce standards and discipline wayward audit firms. When it did examine audit failures and factors that may have compromised auditor independence, the industry simply threatened to cut off its funding. "The profession has resisted meaningful self-regulation for decades," says Sutton.
The successor to the old POB, the Public Company Accounting Oversight Board will be funded by mandatory fees from public companies and will operate under the oversight of the SEC. It is charged with establishing audit, independence, and ethical standards for auditors; investigating auditor conduct; and imposing penalties.
Formerly, auditors under investigation by the AICPA oversight board could simply refuse to participate. The new board will have the same subpoena powers as the SEC to bring auditors to the table. But its effectiveness will depend largely on the aggressiveness of the members chosen by the SEC to serve on it. Of the five members, only two can be current or former accountants.
While the industry begrudgingly accepts that an oversight panel with teeth is now a political reality, there are reservations about its role in setting standards for audit processes. Up until now, the job has been performed by the Audit Standards Board of the AICPA. The industry trade group, which declined requests for an interview, has argued that this task should remain in the hands of industry practitioners. "We firmly believe that standard-setting is better done by individuals who have an in-depth, current, and comprehensive understanding of auditing," wrote James Castellano and Barry Melancon, the two senior executives at the AICPA. This sentiment is echoed by others in the profession. "Auditing standards should be established by accountants, not by regulators and lawyers," says Nussbaum. "When standard-setting becomes a political event, it changes depending on what's popular, and that's not good for standards."
The reforms being imposed on the accounting profession by politicians and regulators may have auditors gnashing their teeth, but the long-term results may not be entirely negative from their point of view. "Enron and WorldCom have done a lot to strengthen auditors' hands," says Mulford. Corporate executives are now realizing that the credibility of their financial disclosures can be more important than the financials themselves. That should result in less pressure on auditors from executives trying to make their numbers. It also may improve the compensation auditors receive to conduct their work.
Nussbaum has already noticed the difference. In an effort to improve its ability to detect fraud, Grant Thornton has been increasing the number of procedures it performs to confirm receivables with customers and verify liabilities with vendors and other outside parties. And despite the weak economy, companies are accepting the increased expense from the added work. "I think our clients understand that if they want strong audits from reputable firms, the costs are going to go up," says Nussbaum. "It's one of the silver linings to this situation."
Second-Guessing GAAP
Of the parade of participants in the Enron hearings, none generated more outrage than the document-shredding Andersen auditors. Greed and corruption may be no more acceptable in corporate executives than in anyone else, but the auditors have borne a particularly large share of the public opprobrium from Enron and other corporate accounting scandals.
PwC's DiPiazza admits that the audit industry shares much of the blame for the loss of confidence in the capital markets. "Accounting firms must never forget that their work serves the interests of shareholders, not just the company that writes the check," he wrote in his recently published book, Building Public Trust: The Future of Corporate Reporting. He believes, however, that the reform debate has to shift to broader considerations of corporate reporting rather than just the failings of auditors. "If we're going to move toward a new auditing framework, we need to consider all the pieces of the puzzle," says DiPiazza.
U.S. generally accepted accounting principles, long considered the best and most accounting standards in the world, may be the most important piece of that puzzle. Growing numbers of financial accounting experts believe that GAAP itself may be part of the problem. As financial transactions have become more complicated, so too has the accounting for them. "Over the last 10 years, U.S. GAAP has evolved into complex detailed rules that encourage financial engineering rather than transparency," says DiPiazza. The highly politicized nature of the standards-setting process, wherein businesses lobby politicians to exert pressure on the Financial Accounting Standards Board, is a large part of the problem. New funding sources for FASB independent of the audit industry may improve the situation, but the legacy of the process is thousands of pages of rules riddled with exceptions for specific situations and opportunities to use aggressive assumptions. GAAP has enabled companies to comply with the accounting standards and yet violate basic principles of transparency and risk disclosure.
Given the ground rules, auditors are not wholly to blame for helping finance chiefs negotiate their way through them. But the situation has fostered a culture of gamesmanship in which auditors help their clients engineer transactions to achieve their accounting objectives. Enron is a case in point. Andersen received millions of dollars for helping to structure Enron's labyrinthine network of off-balance-sheet entities. It clearly bears responsibility for not investigating what transactions the company was conducting in the entities more thoroughly, but at the end of the day, accounting rules may not have been broken.
The solution, says DiPiazza, is principles. Rather than focusing on whether or not the accounting complies with rules, executives and auditors should be evaluating whether or not it portrays the underlying economics of a transaction. "It's a lot harder for me to bend a principle than to bend a rule," says DiPiazza. He believes the International Accounting Standards movement, which relies more on a principles-based framework, can provide momentum for a similar approach in the United States. Of course, regulators may not be inclined to rely on the good judgment of auditors at this point, but integrity and adherence to principles are the only things that will restore confidence in the audit community and in financial disclosures. "The auditors have to be willing to take a position on principle," says Sutton.
The give-and-take between public companies and their auditors in the reporting of financial results won't disappear with the passage of a reform package. Accounting involves interpretation, and judgment will continue to play a part in how financial results are presented. "We want to be as transparent as possible, but we also want to help investors see our performance," says Banks of First Data. The two objectives will always create points of contention with auditors. "We have arguments about a lot of things. Some we win, some we lose," he says.
More than likely, the arguments will be a lot more vigorous going forward.
Andrew Osterland is a senior editor at CFO.
A Beautiful Friendship
The CFO Survey of Auditor-Client Relationships
For the second in a series of four surveys on corporate finance practices, CFO E-mailed questionnaires to 2,750 senior finance executives about their relations with their external auditors. Fifty-two percent of the 170 respondents carried the title of CFO or finance director, and 51 percent worked for public companies. All but two of the companies had their financial statements audited by certified public accountants.
The survey respondents represent a broad cross-section of industries and company sizes. The most-represented industries were financial services (11 percent) and health care (10 percent). Two-thirds of respondents worked at companies with less than $1 billion in revenue, 15 percent at companies with revenue of $1 billion to $3 billion, and 18 percent at companies with revenue of more than $3 billion.
The next two surveys will focus on investment-banking relationships and corporate-governance issues.
1. Has your auditor challenged any of your accounting practices during the past 12 months?
2. What part of your financial statements did this involve? (Based on 62 respondents who have been challenged. Total exceeds 100% due to multiple responses.)
3. What was the result? (Based on 62 respondents who have been challenged.)
4. Have you switched audit firms for any reason in the past three years?
What was the reason?
A majority of those that switched were former clients of Arthur Andersen LLP. Other common reasons for switching included mergers, price concerns, and mistakes by the former auditor. A few respondents cited the practice of regularly rotating auditors.
5. Have you hired your external auditor to perform internal audit as well?
6. Have you bought consulting services during the past three years?
7. In what area? Please check all that apply. (Based on 154 respondents who bought consulting. Total exceeds 100% due to multiple responses.)
8. Have you bought these services from the same firm that performs your external audit?
9. Did you work for your current external audit firm prior to joining your company?
10. Have you hired staff from your current external audit firm during the past three years?
11. Have you ceased any of the following practices during the past six months: (a) hiring enternal auditor to perform internal audit? (b) purchasing consulting services from external auditor? (c) hiring staff from external auditor?
Which one(s)? (Total exceeds 100% due to multiple responses.)
12. Do you plan to cease any of the practices referred to above during the next 12 months?
13. Do you think audit firms should be banned from providing consulting services to clients?
14. Do you think auditors should be barred from going to work for clients for a specified period?
15. Do you think companies should rotate audit firms on a regular basis?
International Turf Wars
The new corporate governance rules and auditor oversight prescriptions in the Sarbanes-Oxley Act will apply to all companies that file financial statements with the Securities and Exchange Commission as well as all firms that audit those statements. Not surprisingly, the rest of the world — with Europe leading the way — is not pleased with the extension of U.S. regulatory reach to any company that has shares listed on a U.S. exchange. "Forcing the U.S. solution on the rest of the world is not acceptable," Mike Rake, the international chairman of KPMG, told the Financial Times. Adds Samuel DiPiazza Jr., global CEO of PricewaterhouseCoopers: "It could start a regulatory war, and audit firms might withdraw from servicing U.S. companies abroad." Others have suggested that the regulatory reforms will make the U.S. markets a far less desirable place to raise capital.
Frederik Bolkestein, the EU commissioner in charge of financial regulation, says that the EU and its members are already taking steps to improve corporate-governance rules and to tighten market supervision. They do not need U.S. regulators to do the job for them, he adds.
At issue is the reach of not only the SEC but also the new board created by Congress to oversee the auditors. With the large audit firms set up as limited partnerships, auditors outside the United States are accustomed to operating under local rules and regulatory frameworks. The oversight board will have the responsibility of creating audit standards, investigating audit-firm conduct, and disciplining the firms if necessary. "I think it has been demonstrated that the U.S. does not have the right answers to all these problems," says Rake.
Looks like regulatory reform could be one more issue for the old world and the new to argue about. —A.O.
Signing on the Dotted Line
The pressure on auditors to sign off on aggressive accounting practices by corporate managers was immense during the 1990s bull market. One tactic that the Securities and Exchange Commission hopes will help reduce some of that pressure is to force senior executives to swear by their financial statements. The CEOs and CFOs of 947 companies with revenues of more than $1.2 billion will have to sign a written statement under oath certifying that their company's most recent 10-K filing, and any 10-Qs or 8-K filings since the year-end report, are complete and accurate. For most companies (those with December fiscal year-ends), the deadline was August 14. And with the passage of the Sarbanes-Oxley Act, all public companies will eventually have to certify their statements.
The SEC's order is being embraced by many corporate managers. "It goes with the territory," says Joe Martin, CFO of Fairchild Semiconductor. "It will make us all more cognizant of our responsibilities to shareholders." Other companies, many not on the list of 947, have also announced that they will certify their financial filings. "People want the markets to hear that they are standing behind their financial statements," says Dixie L. Johnson, a partner at Fried Frank Harris Shriver & Jacobson. She is advising senior-executive clients to keep a file on all their efforts to review the financial statements, including attestations from people within and outside the company as well as a record of meetings and discussions they have had as part of their due diligence. "The quality of the review they undertake will correlate with the quality of their defense if they're ever charged," says Johnson.
Not every C-level executive is keen on the new order. Sun Microsystems CEO Scott McNealy reportedly complained that it will force him to spend too much time slogging through financial statements rather than generating new business. Those executives who do not certify their financial statements, whether because their companies are in bankruptcy or undergoing a period of restructuring, must supply reasons for not doing so. Of course, CEOs and CFOs already sign off on financial statements, and are potentially liable for misrepresentations therein to shareholders. Under the Sarbanes Act, executives who "willfully" certify statements they know to be false can now be criminally charged with perjury or making false statements to the U.S. government, and can face jail terms of up to 20 years and fines of up to $5 million.
That could also take some heat off auditors. —A.O.
To restore investor trust, many companies are disclosing more information, according to a CFO survey. But it may not be enough.
Ronald Fink, CFO Magazine
August 1, 2002
There's no telling exactly what will dispel the crisis of confidence dogging the markets for corporate equity and debt. The crisis only deepened in June when WorldCom, the former high-flying telecommunications company, disclosed that it had overstated its cash flow for the previous five quarters by almost $4 billion. With the S&P 500 and Nasdaq Composite indices dropping to five-year lows, the stakes for CFOs obviously are huge. But CFOs themselves surely can extinguish doubt by improving their financial reporting practices and, at least in some cases, by frankly acknowledging the need for improvement in the first place.
Some companies are taking steps in that direction, however haltingly. Among them are Cisco Systems, General Electric, IBM, Krispy Kreme, Priceline.com, and Sears, Roebuck. And a new survey of senior financial executives at publicly traded companies by CFO magazine points to others. Almost 60 percent say they have disclosed more information to investors during the past 3 months, and a similar proportion plans to disclose more during the next 12 months. On the other hand, the remaining 40 percent saw no need to disclose more.
However, the survey also suggests that many companies must do much more. Over half (54 percent) of the 141 respondents say they report pro forma results in quarterly earnings releases, but 18 percent of those that use pro forma don't reconcile those results to U.S. generally accepted accounting principles (GAAP), even though the Securities and Exchange Commission has advised companies to do so. Even more troubling, 17 percent of all respondents report being pressured to misrepresent their results by their companies' CEOs during the past five years.
Of all respondents, 5 percent say their reporting practices have violated GAAP. Those abuses most often involve reserves and revenue recognition.
How likely is it that the offending companies will clean up their acts? Both our survey results and anecdotal evidence suggest that companies are changing their practices so reluctantly that they risk undercutting whatever trust such moves might regenerate.
Under Suspicion
The need for improvement, and for acknowledging it, seems indisputable. Although the economy shows signs of recovery, the capital markets continue to labor under a cloud of suspicion, much of it directed at the integrity of corporate financial statements.
Some CFOs concede that they have a responsibility to help restore trust. "Because of Enron, companies are really held to a higher standard in terms of what they're reporting," says Randy Casstevens, CFO of Krispy Kreme Doughnuts Inc., a doughnut retailer and franchiser based in Winston-Salem, North Carolina. "We want to do whatever we can to increase public confidence in us."
A big question, however, is whether companies are capable of that in the absence of new rules and regulations. Says Casstevens: "It will take a combination" of action in the private and public arenas to restore confidence.
The CFO survey of corporate financial reporting suggests that other financial executives are resisting the kind of change that might go some ways toward alleviating investor suspicion. Of the respondents to our survey who take debt off the balance sheet through special-purpose entities (SPEs), almost 80 percent say they have no plans to consolidate any of it. And that's so despite the fact that almost 42 percent guarantee the investments of outside investors in such deals. Under existing accounting rules, the assets of SPEs must be consolidated when outside investors' stakes are protected in that fashion.
Slow to Change
Resistance is also clear in individual cases. Consider IBM Corp. Although criticized for years for counting gains on asset sales as reductions in its overhead, artificially inflating its reported profit margins, the company fought tooth and nail to continue the practice. According to press reports, it even resisted demands from the SEC to cease and desist. The company finally acquiesced in the 10-K it issued last spring, excluding one-time gains from SG&A costs and reporting them on a separate line on its income statement. That change, along with the exclusion of intellectual property income from R&D expense, revealed that the company's actual overhead costs in 2000 were $17.5 billion, 12 percent higher than the $15.6 billion it reported in its previous 10-K.
IBM's CFO, John Joyce, told Business Week magazine that the changes would better display the company's financial strength. Others suggest that Big Blue has belatedly come to appreciate the virtues of transparency, which, all things being equal, should reduce its cost of capital. "They got religion," says Charles Mulford, an accounting professor at Georgia Institute of Technology. Yet IBM's change of heart looks to have been coerced — hardly the sort of conversion likely to impress skeptics.
Another company that has improved its reporting practices is Priceline.com. Analysts credit the online travel discounter with making it easier to compare the pro forma results it reports in press releases with its results according to U.S. GAAP. As recently as last year, for instance, David Kathman of Chicago-based Morningstar says he had to hunt for the information necessary to compare Priceline's results under GAAP with its pro forma numbers, to which the company called investors' attention in the first few lines of its earnings press release. In contrast, the data needed to come up with GAAP-based numbers, says Kathman, "was buried in a table." But now Priceline's GAAP-based numbers are given almost equal prominence.
Company spokesman Brian Ek rejects the notion that the company has changed its reporting practices in any way. "We'd like to take credit for improvement," says Ek, but he contends there hasn't been any. "We've always reconciled pro forma results to GAAP," he says.
Maybe. Yet in the first few lines of text of Priceline's Q1 2001 earnings release, the company stated that it had a pro forma loss of 3 cents a share, before restructuring and special charges. Only in the table that followed did the company show what those items were. In the release for Q1 2002, however, the company reported its pro forma and GAAP earnings, both of which happened to be 2 cents, within a few sentences of each other.
Of course, Priceline has less reason to make the comparison between pro forma and GAAP results difficult, now that the Internet bubble has burst and the company has managed to move into the black according to generally accepted accounting principles as well as its own. "They've gotten a lot better now that they see themselves as a niche player in the travel market instead of an E-commerce giant," says Kathman. "And their GAAP earnings are the same as pro forma."
Synthetic Choices
Some companies simply won't budge. Symantec Corp., a maker of Internet security technology, is one of a number of companies that have continued to use synthetic leases to keep real estate financing off their balance sheets, despite the hue and cry that has arisen over such devices in the wake of Enron. The company defends its practices by pointing out that the arrangements meet existing accounting rules. Indeed, the Financial Accounting Standards Board has yet to finalize a proposed change with regard to SPEs, including those involving synthetic leases. The new rule would make it much harder, if not impossible, to make use of such arrangements when they involve SPEs.
Synthetic leases that don't involve SPEs, like Symantec's, wouldn't be affected by that change. But most lenders have to get a regulatory exemption to offer such leases without the use of SPEs, and only a handful have done so. While the debt reflected by Cupertino, California-based Symantec's synthetic leases is indeed kept off the balance sheet, the amounts involved appear on the balance sheet under "restricted cash."
And Symantec CFO Greg Myers sees no need to revisit its use of off-balance-sheet financing in light of Enron. "I don't think you try to alter a solid financial transaction because there's been fraudulent and criminal activity at another company," he says.
But the distinction Myers draws is largely beside the point, notes Krispy Kreme's Casstevens, because after Enron, the legitimacy of off-balance-sheet financing depends less on rules than on public perception. "We don't want to be the judge of that [legitimacy]," says Casstevens. "It depends on what the public thinks."
For that reason, Krispy Kreme has unwound a non-SPE synthetic lease that was slated to finance a new mixing plant in Illinois, and will instead carry some $33 million to $35 million of the debt on its balance sheet. And its confidence-building moves haven't stopped there.
Cisco Systems Inc. has also decided to abandon its use of synthetic leases no matter what comes of FASB's proposal, announcing last March that it would unwind all the leases it has used to finance its San Jose, California, headquarters and several manufacturing facilities in California and New England. In so doing, Cisco will consolidate roughly $1.6 billion in real estate assets by the end of the current fiscal year, adding some fat to its famously lean balance sheet.
Yet in today's climate, Cisco has concluded that it's better to have investors see a bigger balance sheet than suspect that it's hiding debt. "This should remove any concern that investors may have about off-balance-sheet financing," says company spokeswoman Terry Anderson.
In some cases, at least, investors seem so eager for greater transparency that they're willing to ignore the decrease in reported returns on capital that stem from bigger balance sheets. For instance, when Sears, Roebuck and Co. returned $8 billion in credit card receivables from an SPE to its balance sheet, in early 2001, the move was partly to blame for slashing the company's reported return on assets from 3.6 percent in 2000 to 1.6 percent last year. Even so, Sears's stock has soared by almost 70 percent since the change, more than doubling the gains seen by its peers.
Krispy Kreme, for its part, doesn't expect to be penalized for having more debt on its balance sheet, says CFO Casstevens. After all, he notes, the company's plans for a synthetic lease were fully disclosed. And while few investors might once have disregarded its off-balance-sheet treatment and considered the facility Krispy Kreme's, Casstevens says that, post-Enron, that's no longer likely. Today, he says, "more investors understand that nothing has changed" when assets are moved off the balance sheet through such arrangements.
Coming Clean
Indeed, more investors can now be expected to disregard any accounting change that has no bearing on a company's financial condition. Needless to say, IBM's income-statement changes concerning one-time gains have nothing to do with its fundamentals. When all is said and done, IBM's nonfinance debt level remains a relatively insignificant 7 percent of total capital. And the company's cash flow grew a healthy 10 percent last year, even after discounting changes in working capital. So long as any stock repurchases, which IBM typically makes when its share price falls, are funded out of free cash flow and are not large enough to weaken its equity base, credit analysts are likely to approve.
"We realize IBM has been caught performing some sleight-of-hand with nonrecurring items," wrote Carol Levenson, an analyst for New York advisory firm Gimme Credit, in a recent report. But Levenson noted that she was satisfied that this legerdemain "will come out in the wash of the cash flow statement."
On the other hand, additional disclosures that may at first glance seem trivial, such as additional footnote detail, can reveal important information about a company's financial condition. Witness what General Electric has brought to light through added disclosure.
Granted, the company has made significant changes in the wake of Enron, not in its accounting but in its funding practices. For starters, its finance subsidiary, GE Capital, has increased its backup lines from a relatively paltry 30 percent of short-term debt to somewhere between 50 percent and 60 percent. (Standard corporate practice among lower-rated companies is 100 percent.) The company also is decreasing its dependence on commercial paper — which, at $117 billion at the end of 2001, amounted to roughly 67 percent of its total funding — to no more than 35 percent by the end of 2002, and has issued some $58 billion in longer-term debt so far this year with that goal in mind.
These moves have reassured some analysts that GE remains deserving of a triple-A credit rating. As GE CFO Keith Sherin recently told us, "We want a triple-A rating, and we don't want to have investor concerns about liquidity."
But skepticism about GE lingers. Toronto-based credit-rating agency Dominion Bond Rating Service figures that if all of GE Capital's off-balance-sheet securitizations were added back to the debt it consolidates, the finance subsidiary's leverage ratio would rise from 13.5 times tangible assets to closer to 16 (as of year-end 2001). And even with its longer footnotes, "it's still difficult to fully understand GE Capital's operations," Gimme Credit's Kathy Shanley recently wrote. As a result, the credit analyst added, "it is entirely fair for investors to keep the heat turned up."
It may be small consolation to GE, but our survey suggests that other companies will also be sweating for some time.
Ronald Fink is a deputy editor of CFO.
No More Holes?
While unwinding a synthetic lease for a $35 million mixing plant, doughnut retailer Krispy Kreme Doughnuts Inc. has plugged other gaps in its disclosure and governance. For starters, the company has added new detail to its footnotes concerning loan guarantees to franchisees. Previously, the amounts involved were reported only in the aggregate. But in its fiscal year 2002 annual report, Krispy Kreme's footnotes specify the amounts of each guarantee.
Why not go a step further and put them on the balance sheet? CFO Randy Casstevens explains that different treatment is called for because the company's obligations are much less certain under the loan guarantees than they were under the synthetic lease. Whereas Krispy Kreme would have been required to take action at the end of the lease's term by refinancing or purchasing the facility, it has to make good on its loan guarantees only if the franchisees cannot meet their financial obligations. And while he says Krispy Kreme must analyze that likelihood on a quarterly basis, performance is by no means a foregone conclusion. As a result, says Casstevens, "there's a smaller likelihood that you'll have to perform under the terms of the guarantee."
The company has also taken other steps to improve its governance practices. To eliminate potential conflicts of interest, it has abandoned an arrangement that allowed some 30 managers and the company's shareholders to invest in franchisees. Also, Krispy Kreme has agreed to start reporting insider stock transactions on its Web site within two business days, established a governance committee, and decided to seek two more independent directors for its 11-member board, thus providing a majority of seven independent directors.
Casstevens concedes that it is difficult to draw any definitive connection between these efforts to improve governance and disclosure practices and the performance of the company's stock. But, he insists, "we aren't doing it to get kudos, we're doing it because we felt it was the right thing to do."
Yet in the current environment, doing the right thing can't hurt. —R.F.
Better Numbers?
The CFO survey of corporate financial reporting.
This past June, CFO magazine E-mailed a questionnaire on financial reporting practices to some 3,000 senior financial executives, drawn randomly from our circulation list. We received 180 responses, 141 from executives at publicly traded companies, the majority with annual revenues exceeding $1 billion. The results below are based on the responses from the public companies.
The sample is too small for drawing definitive conclusions about the financial reporting practices of America's 17,000 public companies. Nevertheless, the results are suggestive and even surprising. For example, 42 percent of the companies in the survey that use special-purpose entities (SPEs) to keep debt off their balance sheets guarantee or otherwise protect the investment of third parties in those SPEs — precisely the practice that led to Enron's downfall.
This is the first in a series of surveys on corporate finance. In coming issues, we will be asking CFOs about practices in auditing, investment banking, and corporate governance.
1. What is your title?
2. What were your company's (or business unit's) approximate revenues for the most recently completed fiscal year?
3. Have you disclosed more information in your financial statements during the past three months?
4. Where did such additional disclosure take place? (Based on those who answered "yes" to question 3.)
5. Will you disclose more information during the next 12 months?
6. Where will such additional disclosure take place? (Based on those who answered "yes" to question 5.)
7. What percentage of your debt or other liabilities is not reflected on your balance sheet?
8. Do you use special-purpose entities to achieve that result? (Based on those who did not answer "none" to question 7.)
9. Do you guarantee or otherwise protect the investment of third parties in such entities? (Based on those who did not answer "none" to question 7.)
10. How much of your off-balance-sheet debt would you have to consolidate if, as expected, FASB increased the minimum level of investment required by a third party from 3 percent to as much as 10 percent? (Based only on those who did not answer "none" to question 7.)
11. Do you report pro forma results in your quarterly earnings press releases?
12. What items do you typically exclude from EPS as calculated under U.S. GAAP? (Based only on those who answered "yes" to question 11. Check all that apply.)
13. Do you reconcile your pro forma results to U.S. GAAP? (Based only on those who answered "yes" to question 11.)
14. Will you continue to use pro forma results in your quarterly releases during the next 12 months? (Based only on those who answered "yes" to question 11.)
15. How often have you felt pressure from your company's CEO to misrepresent its financial results during the past five years?
16. How often have you engaged in aggressive accounting practices during the past five years?
17. How often have your accounting practices violated U.S. GAAP during the past five years?
(Total exceeds 100% due to rounding.)
18. What did such practices involve? (Check all that apply.)
Survey shows that auditors mostly fail to uncover bookkeeping irregularities, and often fail to warn about clients headed for Chapter 11.
Stephen Taub, CFO.com | US
July 12, 2002
Sunbeam. Enron. WorldCom.
What do these three companies have in common? Well, beyond the stain of accounting scandals, the three corporations were all clients of auditing firm Arthur Andersen.
That, of course, has led critics to charge that Andersen auditors were either in cahoots with these companies or incompetent. But was Andersen really that much worse at spotting bookkeeping irregularities than other large accounting firms?
Not necessarily. As a group, it seems top-tier accounting firms have been uniformly lousy at uncovering accounting irregularities. Or at least, that's the upshot of a new study put out by Weiss Ratings, entitled "The Worsening Crisis of Confidence on Wall Street: The Role of Auditing Firms."
In the survey, Weiss found that auditing firms gave a clean bill of health to fully 94 percent of the public companies that were subsequently cited for accounting irregularities. The survey group included 33 publicly traded companies that reported bookkeeping errors.
The bad math cost shareholders dearly, too. The companies in the survey dropped from a total peak market value of $1.8 trillion to only $527 billion. That implies an aggregate loss to shareholders of almost $1.3 trillion.
Andersen audited 11 of the 33 companies in the survey; PricewaterhouseCoopers, 7; Deloitte & Touche and KPMG, 5 apiece; Ernst & Young, 4; and Tullis Taylor, 1.
Of the Big Five firms, PricewaterhouseCoopers came out best in the study. PwC issued a "going concern" warning on two of the seven companies it audited. Remarkably, that made PwC the only one of the six firms that actually issued going concerns for any of the 33 companies cited for accounting irregularities.
"The first and most important line of defense for investors is manned by the nation's auditing firms," says Martin Weiss, chairman of Weiss Ratings. "Unfortunately, the accounting industry has overwhelmingly failed in its responsibility to deliver independent oversight to corporate financial statements."
Equally worrisome, Weiss Ratings found that 42 percent of the 228 companies that subsequently filed for bankruptcy between January 1, 2001 and June 30, 2002, were given a clean bill of health by their auditors. "Going concern" warnings were issued on 58 percent of the companies.
The Big Five firms audited 194 of the 228 companies that went bust, while smaller accounting firms audited the remaining 34. Weiss found a dramatic difference in performance by each of the auditing firms in alerting shareholders to bottom-line problems.
Ernst & Young was the best at alerting investors about impending corporate implosions. E&Y correctly issued warnings on 65 percent of the 46 firms it audited that later went bankrupt. PwC issued warnings on 63 percent of its 38 audit clients that went bust.
Interestingly, however, a group of second-tier accounting firms in the study correctly issued warnings on 59 percent of the 34 companies they audited. That put those smaller firms ahead of the rest of the Big Five. Andersen, for example, issued warnings on 56 percent of the 48 companies it audited that eventually declared bankruptcy. Deloitte & Touche offered warnings for 56 percent of its clients that later filed for Chapter 11. Conversely, KPMG only issued warnings on 42 percent of the firm's 28 audit clients that ultimately went broke.
Overall, PricewaterhouseCoopers had the best track record among the Big Five in alerting shareholders to potential problems. For instance, PwC's going-concern warnings were issued further in advance of the bankruptcy filings. On average, PwC warned 245 days before failure, compared to a global average of 209 days, according to Weiss.
Not surprisingly, Weiss found that when auditors issued their reports soon before a company filed for Chapter 11 (within three months), they were able to see a company's weaknesses more clearly. In that scenario, auditors correctly warned of problems in 91 percent of the cases.
By contrast, when auditors issued their reports long before the Chapter 11 filing (between nine and 12 months ahead of time) it was more difficult to detect any weaknesses, and they correctly warned of problems in only 38 percent of the cases.
Weiss issues safety ratings on more than 15,000 financial institutions, including securities brokers, banks, insurers, and HMOs. Weiss also rates the risk-adjusted performance of more than 11,000 mutual funds and more than 9,000 stocks.
(Editor's note: Weiss receives no compensation from the companies it rates. Revenues are derived strictly from sales of its products to consumers, businesses, and libraries.)
Internal auditors look to declare their independence from CFOs. This may not be a good thing for finance chiefs.
David M. Katz, CFO.com | US
July 2, 2002
The latest rash of high-profile accounting scandals is adding fuel to the debate over reporting relationships in the finance department.
No longer satisfied with financial audits controlled exclusively by senior corporate executives and accounting firms, regulators and institutional investors are now insisting that publicly traded companies reorder some of those reporting relationships.
Under a recent proposal by a New York Stock Exchange (NYSE) committee, for example, board audit committees would have more power over external auditors. Among the audit-committee powers being championed: sole hiring and firing authority over a company's independent auditor.
Internal auditors, who until recently have typically slaved away in anonymity, focusing mostly on broad corporate controls and risk-management programs, are also being asked to take on added responsibility. But in the wake of Enron, Xerox, and WorldCom, internal auditors at some large companies — JC Penney, for instance — have begun playing key roles in setting audit-committee agendas. "I write the agenda for the audit-committee meeting," says Howard Johnson, senior vice president and director of auditing at Penney.
At other corporations, internal auditors have been asked to pore over financial statements, assuring the soundness of the numbers — or ferreting out mistakes. Indeed, management at WorldCom claims that internal auditor Cynthia Cooper uncovered the accounting ploys that ultimately forced the company to lower its stated earnings for 2001 by $3 billion.
Remarkably, WorldCom management says Cooper and Glyn Smith, another member of the internal audit staff, directly contacted the chairman of the board's audit committee, Max Bobbitt, to discuss what they had found. Bobbitt later had Cooper and Smith interview David Myers, then WorldCom's controller, about the company's treatment of payments to third-party vendors as expenses.
Some finance chiefs see internal audits as something of a sniff test for overly sophisticated accounting schemes. "If a corporation is engaging in activities beyond the understanding of the internal audit department, that's a warning sign," says Richard Marsh, CFO of FirstEnergy Corp., an Akron-based utility holding company. "If there's that kind of a disconnect, it really weakens the control function."
Edison Discovers the Audit
To beef up the function, reform advocates (among them, William Bishop of the Institute of Internal Auditors; David Richards, director of FirstEnergy's internal auditing department and immediate past chairman of the IIA; and Dorothy Heyl, senior trial counsel for the Securities and Exchange Commission) say internal auditors must have direct links to audit committees. That way, they can report concerns without fear of reprisal from their bosses.
Of course, some companies have always allowed the head of internal audit a private audience with the audit committee. Members of the NYSE's corporate accountability and listing standards committee think that the practice should be universal. In a June 6 report to the exchange's board, the committee said internal auditors should meet separately with the audit committee at least every quarter.
And the SEC is forcing those relationships on some companies. In a settlement this past May, the SEC ordered Edison Schools Inc., based in New York, to improve its financial controls by creating an internal audit department. Edison Schools also agreed to promptly hire an internal audit director, who would periodically report to the audit committee. In its order, the SEC found that Edison, a for-profit manager of public schools, violated federal record-keeping laws by, among other things, failing to properly accelerate its recognition of losses relating to agreements with certain school districts.
But the SEC also found that the company did not have "an adequate accounting system to bill [school] districts," and that its inability to address the system's weaknesses stemmed from its lack of an internal auditor. "We found the lack of an effective audit function to be a problem [at Edison]," says the SEC's Heyl.
Edison does have a CFO, Adam Feild, as well as a fairly famous chairman, Benno Schmidt Jr., the former president of Yale University. But company management adhered to the SEC's request to hire an internal audit director by June 14.
The company hired an Edison employee to direct the newly created internal audit department before the deadline, according to Adam Tucker, vice president of communications and advocacy for the company. "To maintain the independence of the internal auditing role, the Edison internal audit director reports directly to the audit committee of the board of directors of Edison Schools, and not to senior management," says Tucker.
Function at the Junction
At most large public companies, however, the issue isn't whether there is an internal auditor, but who the auditor's boss should be. It's one thing for regulators and investors to say the internal audit department should get its general marching orders from the board audit committee, but internal auditors usually report to the CFO.
The most popular solution, according to the IIA, is to provide auditing executives with two masters: the audit committee for policy-making and a senior corporate executive — usually the CEO — for more-routine work.
On "functional" matters (general direction and policy-making), about half of the internal audit executives report directly to audit committees, according to a recent survey conducted by the IIA. But in more than a quarter of the 42 companies that responded to the question, top internal auditors report to either the CEO or the CFO on functional matters.
When it comes to more-routine tasks, chief audit executives (CAEs) most often report to senior finance executives. At almost half of the 74 companies responding to another question on the IIA survey, the CFO (42 percent) or the controller (5 percent) signs off on the budget and performance of the CAE. Just 2 percent of the respondents said they report to the board on budget and performance matters.
Some reformers believe internal auditors should report to the board more often. They argue that otherwise CFOs and controllers can exert pressure on internal auditors to rubber-stamp finance-department numbers.
They Walk the Line
Then again, some internal auditing chiefs like reporting to CFOs, as long as they have complete, private access to the audit committee. For one thing, finance chiefs tend to be more accessible than CEOs. For another, they are generally more savvy about auditing minutiae, says David Richards.
Although Richards preaches the institute's gospel of separation of finance and internal auditing at FirstEnergy, he reports to Richard Marsh, the company's finance chief. Both Richards and Marsh say they have a collaborative relationship, working hand-in-hand to bring major internal audit issues to the audit committee.
Richards says he has easy access to FirstEnergy's audit committee, which is responsible for hiring and firing the top internal audit executive and approving the department's annual plan. Marsh and members of the audit committee have encouraged him to call committee members if anything questionable crops up, adds Richards.
Beyond a change in the reporting lines for CAEs, observers say a move to more-intense checking of company financials would be a substantial shift in duties for many audit teams. For years, those teams have focused just on keeping information systems and operations running smoothly, says the IIA's Bishop.
After all, most internal auditors aren't CPAs. Before the current accounting scandals, internal auditors largely steered clear of such complicated financial maneuverings as off-balance-sheet accounting, third-party investment vehicles, and derivatives accounting. Some internal auditing executives still feel they shouldn't get involved in auditing those processes. "Should the internal auditing function be plowing the same ground [as independent auditors]?" asks Richards. "My own view is that it's a waste of corporate resources."
Togetherness
Still, internal audit teams at a number of big companies are working much more closely with their independent audit firms. In that regard, Howard Johnson, Penney's chief internal auditing executive, took it as a vote of confidence when Allen Questrom, the company's chairman, said at a meeting of the company's senior managers early this year that the retailer was counting on its internal auditors to make sure its numbers are right.
Until recently, Penney's internal auditors had given KPMG, the company's external auditor, a wide berth. "We didn't spend a lot of time with them," grants Johnson. "We're doing more of that now, however."
One for-instance: Penney's internal auditors are providing their external counterparts with timelier operations data than the accountants normally work with, says Johnson. His 80-member internal audit team now supplies KPMG with up-to-date figures on the markdown of company inventory as soon as it gets them.
"KPMG would have the prior history, but we are out there auditing the stores," adds Johnson. Penney's internal auditors are also taking a closer look at company disclosures of special-purpose entities and travel expenses.
Reporting on day-to-day department matters to Charles Lotter, Penney's general counsel, secretary, and executive vice president, Johnson takes his general direction from the audit committee. But he also works for the committee itself, writing the agendas for its meetings after consulting with members and company officials. Although he says he has "a great relationship" with the company's CFO, Robert Cavanaugh, Johnson notes that it is not a reporting relationship.
Then again, that's just fine with the Penney internal audit chief. These days, he says, "being separate from the finance organization is a very good thing."
WorldCom internal auditor Glyn Smith thinks finance and operations executives shouldn't be the overseers of internal auditors.
David M. Katz, CFO.com | US
July 16, 2002
In the wake of the Senate's historic vote to put corporate wrong-doers behind bars for up to ten years, a suggestion to change the reporting line of internal auditors seems sort of minor.
The suggestion tends to carry a lot more weight, though, when it comes from an internal auditor who helped uncover the biggest accounting error — perhaps the biggest accounting fraud — in U.S. corporate history.
Glyn Smith, a senior manager in WorldCom's internal audit department, worked closely with Cynthia Cooper, the vice president of audit, in the investigation of that company's capital expenditures and capital accounts. The duo's probing eventually unearthed the telco's treatment of line charges as capital investments. As a result of their work, WorldCom was forced to increase its previously stated expenses for 2001 by $3.01 billion and increase expenses for the first quarter of 2002 by $800 million.
In an exclusive interview with CFO.com late last week, however, the WorldCom employee voiced strong general views about the need for internal auditors to pursue their work without ties to finance executives or heads of operating units.
Indeed, by Smith's lights, an internal auditor's primary allegiance should be to the audit committee of the board of directors. "In the post-Enron, post-Andersen environment," he says, "internal audit really needs to function independently of either the CEO or the CFO."
At the Center of the WorldCom
According to sworn public documents filed by WorldCom, the telco's internal audit team seems to have demonstrated why such a setup may be preferable.
On June 11, after Cooper discussed her investigation with then-CFO Scott Sullivan, Sullivan asked the head of WorldCom's audit team to delay their review. But Cooper and Smith pressed on with the audit.
The next day, the two internal auditors called Max Bobbitt, the chairman of the audit committee, to discuss "questionable transfers" the company made during 2001 and the first quarter of 2002, according to the sworn statement. The two auditors apparently discovered that the company had begun accounting for its line costs (payments for network services and the use of third-party facilities) as capital expenditures — and not as expenses.
That treatment was out of whack with industry practice. It also didn't jibe with GAAP.
The WorldCom SEC filing indicates that, during the call to the audit committee chairman, Smith himself told Bobbitt about the key points Scott Sullivan made in his discussion with colleague Cooper. The points included the CFO's request for a delay of the audit review, and his claim that the capitalization issues would be cleared up in the second quarter of 2002.
Along with Cooper, Smith also interviewed WorldCom senior vice president and controller David Myers (who later resigned without severance). In addition, Smith attended the June 20 audit committee meeting where the expense transfers were described, according to the company's sworn statement.
On June 26, WorldCom management announced the discovery of the expense transfers, along with the firing of Sullivan. The telco's management also noted that the company would be forced to restate its earnings for the time in question.
All in all, company management believed the improper bookkeeping would trim nearly $4 billion from WorldCom's previously reported EBITDA (over a five-quarter period). Without the line-charge transfers, WorldCom would have actually reported a net loss in 2001 and the first quarter of 2002, not a net profit.
Wake Up the Audit Committee
Given current Congressional investigations into WorldCom's accounting, and the specter of shareholder and lender lawsuits, Smith understandably refuses to talk about any aspect of WorldCom's current predicament. And he says his ideas about internal audit independence do not stem from his experiences at the troubled telco.
But the WorldCom auditor says that, in general, audit committees need to learn more about accounting — and should frequently freshen their perspectives. He also believes board audit committees should be equipped to take firmer control over both internal and external audits.
Toward that end, Smith believes audit committee members should be required to take at least 32 hours of continuing professional education courses in auditing and corporate governance a year. Such courses would help committee members "get enough color, enough background on the audit function to be able to ask intelligent questions, to be able to have a better understanding than most do now," Smith asserts.
In addition, Smith says, directors often sit on audit committees for six years or more. That tenure can create problems, with long-timers apt to apply a rubber-stamp to audits. Therefore, Smith thinks audit committee terms should be limited to around three years.
Besides boosting alertness, regular audit committee shakeups would supply internal auditors with a changing group of bosses. That, in turn, would provide many inside auditors with more independence than they have today, according to Smith.
Fuzzy, Gray
Unlike many internal auditors, Smith is a C.P.A. He is also a certified internal auditor. While currently a member of the corporate world, Smith worked for seven years at Haddox, Reid, Burkes, and Calhoun, a public accounting firm in Jackson, Mississippi.
Smith left the small accountancy in 1997 to take an internal auditing job at giant SkyTel Communications. In 1999 SkyTel merged with what was then MCI WorldCom.
Smith readily concedes that most chief audit executives get their general marching orders and policy direction from board audit committees. But he says they tend to be managed on a day-to-day basis by CFOs. Typically, things like audit team budgets and auditor performance appraisals are handled by a company's finance department.
But the WorldCom internal auditor believes such a setup can lead to problems. He says in some cases, an internal auditor can become too beholden to finance or operations.
If that occurs, the definition of "administrative" can easily get blurred by politics and turf wars. At that point, an audit team may wind up as a de facto unit of the finance department, thus threatening the integrity of a company's internal financial controls.
Smith provides the hypothetical example of a vice president of internal audit whose bonus will be set by the CFO on April 1. In the course of a review he's completing before that date, however, the auditor concludes that the company's reserve for receivables is too low.
The auditor is then faced with a thorny decision: include the subject of receivable set-asides in his report and he risks incurring the wrath of the finance chief. But exclude the subject and he might betray his responsibility to board and the owners of the company.
Complicating the matter: Determining the proper reserve is almost always a judgment call. "When you estimate an allowance, it's not an objective decision," notes Smith. "It's not a black-and-white thing."
The small matter of the bonus only widens the gray zone. "What happens more often than not is that that administrative line is crossed," says Smith, "and there is a little more [operational] control in determining what can and can't be audited."
Hole-Poking
Not exactly an ideal scenario for sound risk management. But Smith is quick to point out that finance chiefs and CEOs should have some input in determining the scope of a company's internal accounting investigations.
But he goes on to warn that auditors often tread a fine line in deciding what to do with that input. "If you get to a point where you're giving their input more weight than anybody else's," argues Smith, "then I think you've impaired your objectivity and your independence."
To avoid conflicts, Smith predicts that some companies will begin to install a senior vice president of risk management or governance to oversee the audit department. Besides approving the work of internal auditors, such an executive could supervise areas like disaster recovery, commercial insurance buying, and ethics.
The real oversight power, however, should rest with the members of the audit committee. They should be "driving the internal audit plan and giving direction to the internal audit department," says Smith.
That's rarely the case, says the WorldCom internal auditor. What's more, board audit committees should be questioning their external auditors more closely than they do, he believes.
In that effort, audit committees may begin to look to inside auditors for help. "Maybe one of the things the audit committee does is to say, 'Hey, Mr. External Auditor, I would like you to sit down with our internal auditors and walk them through your work papers, your procedures on accounts receivable. Let them shoot holes through your procedures and see what you did.' "
Based on recent developments, it seems Smith and Cooper are pretty good at shooting holes through procedures.
Survey reveals rating for auditors lags far behind marks for other service providers. Corporate clients say value, not values, the problem.
Stephen Taub, CFO.com | US
April 12, 2002
Accountants take note: Businesses using outside auditors give your profession an overall grade that is close to failing.
This is the result of an April 2002 survey of companies that purchase outside accounting services, conducted by NFO WorldGroup, a provider of research-based marketing information and counsel.
Using its self-described NFO TRI*M Index, a relationship and reputation management tool, auditors received a score of 61. NFO says that is equivalent to a D. By comparison, general B2B service providers rated an 80 with customers — which is the equivalent of a B. Top-performing businesses with the strongest relationships fall in the range of 90 to 100, which is like receiving an A. There is no curve.
"This low rating is reflected in client evaluation of auditor performance," according to NFO. Only 55 percent of the respondents ranked overall performance of their auditor as excellent or very good, compared with the 70 percent to 75 percent typically seen in the professional services, said NFO.
In addition, only 55 percent of respondents said they definitely or probably would recommend their auditors to business colleagues. That compares with 75 percent to 80 percent for the professional-services category.
"These weak scores should be a clear warning bell that the accounting profession has serious, fundamental client relationship problems that are different from the issues dominating the headlines about Andersen and Enron," says Shubhra Ramchandani, stakeholder management practice leader for North America at NFO, who heads up the TRI*M study. "The problem isn't integrity — it is value. Most clients rate their outside accountants' business ethics very highly, but what they question is the performance and value of the services they receive."
According to the survey's results, the respondents gave high performance marks to auditors with regard to:
"We're seeing a clear demand that auditors get back to basics, to shore up their core competencies and concentrate on delivering fundamental value to their corporate clients," adds Ramchandani. "The accounting industry has concentrated on expanding its portfolio of services, such as consulting and international support. But these do not appear to be what is motivating clients to continue their current external auditor relationships. The crisis of competence will continue to affect the accounting industry long after the big headline controversies become old news."
Do companies prefer using the same provider for both auditing and consulting? The jury is still out, according to the survey. About a third of the respondents would recommend using their current outside auditor for nonauditing services to their company, while 27 percent would not and 42 percent were unsure or undecided.
No surprise, then, that 50 percent of the companies surveyed said they are currently using auditing and consulting from the same vendor.
The scores are based on NFO's recent survey of top managers and executives with responsibility for managing auditing and consulting relationships with outside accountants. The results of the survey were compared with NFO's database comprising results from more than 1,500 studies and 2.6 million interviews across all business sectors.
Recent corporate meltdowns are putting internal auditors under greater pressure. Will the latest auditing software ease their pain?
Adam Lincoln, CFO Europe Magazine
April 1, 2002
It's not surprising that Anton Bouwer, Brussels-based consulting manager of ACL Europe, says the collapse of Enron has been good for business. ACL, which started as a small Canadian software house in the 1970s, has become the world's largest provider of software applications for corporate auditing. Today, ACL's products are used by internal and external auditors alike, and handle everything from data analysis and compliance monitoring to network security assessment and forensic accounting.
Yet, as Bouwer notes, long before Enron — and other less spectacular corporate nosedives — forced auditors into the spotlight, many of them were already ramping up their use of software tools to help them do their jobs. "Internal auditors are under pressure to play an even greater role in strengthening internal control and governance by providing their companies with wider, deeper data analysis on a regular basis," observes Bouwer.
This, in turn, has dramatically changed the types of software auditors reach for. "Auditors need to spend quality time on solving exceptions, rather than finding them," asserts Bouwer, adding that this allows them to go beyond routine policing and take on more value-adding responsibilities, including risk management.
The question is: Do current auditing tools meet the taxing demands of their users? Charles Le Grand, director of technology practices for the Florida-based Institute of Internal Auditors (IIA), an international professional organization, believes they do. As evidence he cites the results of the seventh annual software survey of nearly 600 internal auditors worldwide, which was conducted last summer by Internal Auditor, a magazine published by the IIA. The survey revealed that respondents were generally happy with the quality of the software tools they have at their disposal, particularly applications designed specifically for auditing professionals. These include software from ACL and CaseWare, as well as propietary programs.
The results are not overly surprising. These days, most audit programs are Web-enabled. Hence, auditors can now access, read, analyze and manipulate data files drawn from all sorts of sources, including legacy mainframe systems. They can then present that information in a user-friendly format for workers in other departments. That's a big time-saver.
What's more, the latest versions of audit software is a whole lot easier to use then earlier releases. "Ten years ago, using audit software meant a lot of programming," says Ulrich Hahn, a member of the corporate audit team of Alcatel, the French telecoms-equipment supplier, which has installed ACL's software across its entire global operation. "Now, you just point and click. The benefit of that cannot be underestimated."
Vim Vendors
The job of an auditor is getting tougher in at least one respect, however. Software selection is a lot trickier than it used to be. According to the IIA survey, companies often implement a combination of home-grown applications and off-the-shelf packages. Thus, an auditor might use one tool to extract data and another to present the data over the corporate network. Further, an auditor's toolbox now includes software used by other departments. "Increasingly, auditors are using the same types of tools as IT professionals," notes Le Grand.
In fact, one of the most striking changes to take place within internal auditing departments is the growing use of applications that fall under the banner of business intelligence. A number of vendors specializing in business intelligence are now pushing their offerings into the auditing arena. The pushers include Business Objects, SAS Institute, Coda, Hyperion, Crystal Decisions, Cognos, and Adaytum.
All of these companies maintain that their products complement those that internal auditors use. "Our products weren't designed with audit specifically in mind, but the principles are the same — getting the right data in front of the right people at the right time," says Donald MacCormick, a product manager at Crystal Decisions (formerly Seagate Software), which makes browser-enabled enterprise-reporting products. "It would be a natural thing for an internal auditor to write a report with Crystal and share it over the Web with external auditors."
Some ERP vendors also see a place for their products in auditing departments. Brian Gregory, a former internal auditor and now a marketing director for Oracle's E-business unit, trumpets the virtues of Daily Business Close (DBC). Launched in February as a rebranded version of Oracle's latest E-business suite, DBC lets auditors access up-to-the-minute performance reports from various parts of a company. "It supports the need for companies to monitor adherence to key performance indicators on a regular and, increasingly, real-time, basis," explains Gregory. "The term 'dashboard' is overused, but that's what it is."
Despite the growing choice of tools, however, many companies cling to the tried-and-tested. The IIA's survey found 21 percent of businesses continue to rely on spreadsheet software to extract and analyse data. The comfort factor seems to have much to do with this — along with costs. Indeed, cost is one of the main reasons auditors hang on to their old spreadsheets.
But makers of auditing software contend that any auditor using a spreadsheet is missing a trick. "As with other office suite tools, there's a tendency to think of spreadsheets as free," says Pamela Eichhorst, a marketing manager for Hyperion, which specializes in business analysis software. As Eichhorst sees it, companies often underestimate the maintenance cost and training needed with spreadsheets, while overestimating the quality of information found in them. "They just keep rolling it out," she says.
They also keep rolling out in-house software. The IIA survey revealed that home-grown audit solutions are becoming increasingly popular. In fact, the overall proportion of corporations developing their own programs internally has nearly doubled over the past over the past year or so, notes the IIA.
Non-Stop Audit
This is not to say that audit software, whether off-the-shelf or inernally built, is perfect. Many auditors say it can be difficult keeping current with software upgrades in other departments. Noted the IIA study: "Remarks concerning the audit staff's ability to 'effectively audit the auditee's changing technology environment' were far more common than those relating to software within the audit department itself."
Sticker shock is another concern. While the size and scope of internal audit departments can vary enormously, ACL reckons that its large corporate clients — that is, those with 100 or more auditors — invest initially on average of $80,000 in audit technologies, with $20,000 being spent annually for additional tools, consulting and training.
Still, the IIA notes that most of the auditors in its survey said they plan to increase their software usage over the next three to five years. The area that will receive the most investment is data extraction and analysis, along with network security assessment.
That doesn't surprise Le Grand of the IIA. "Auditors have been using software for data analysis and other sorts of auditing for a long time," he says. "But now we're finding that auditors are able to get much closer to the source of a problem and move towards continuous auditing using real-time information."
And this is just the beginning, he says. He believes demand for timely, accurate data is sure to escalate as other parts of the company begin working in real time. Adds Oracle's Gregory: "In previous decades, when labor was cheaper, auditors would spend a long time sifting through data. Companies just don't have that luxury anymore."
Former Andersen employees are finding sympathy, employment.
Alix Stuart, CFO Magazine
January 1, 2003
Only a year ago, Arthur Andersen LLP still looked like it had a chance. Despite threats by the Department of Justice and rumors that major audit clients like Delta Air Lines and News Corp. were jumping ship, the venerable 89-year-old firm seemed as unlikely to sink as the Titanic. "We will survive," intoned then-CEO Joseph Berardino at a late-January press conference. "People know us. People respect us."
The "us" quickly dissolved when Justice Department convictions forced the firm to give up its auditing licenses over the summer, leaving companies around the world scrambling for new auditors while a skeleton crew at Andersen juggled the inevitable lawsuits. Perhaps the saddest aspect of the whole debacle, though, has been its impact on Andersen's respectable employees as they try to move into new jobs.
Overall, about half of Andersen's 26,000 U.S. employees were swept into deals with other firms, including some 750 partners and 7,000 staff members who joined other Big Four accounting firms. Hundreds of others are finding out what it's like to work at a start-up, with ex-Andersen partners heading up new specialty practices like Avail Consulting in Houston or Chicago-based Huron Consulting and hiring scores of former associates.
One former partner, Scott Taub, is on the other side of the table as deputy chief accountant for the Securities and Exchange Commission. A few others became CFOs, most notably Melvin Dick, the partner once in charge of the WorldCom account; he became retailer Coldwater Creek's finance chief in early June.
But many ex-Andersen employees are unaccounted for. "A lot of people clipped out of there because they didn't want to be associated with the past," says Allan D. Koltin, president and CEO of the Practice Development Institute. While some have set up Web sites (Andersenalumni.com and Andersenalumni.net, for example) to help foster links among alumni, no comprehensive, updated database of the firm's erstwhile staff seems to exist. Traditionally, each office kept its own alumni records, according to former employees, and few were concerned with updating them in the haste to shut down.
In general, employers are more than willing to look past Andersen's unfortunate finish when making hiring decisions. "There's no taint," says Gordon Grand, head of Russell Reynolds Associates's financial officers practice. "On the contrary, people feel very, very badly for them." Adds Christina Robinson, a Houston-based executive recruiter for ProStaff Finance & Accounting: "Even people who worked on the Enron account have had tremendous success finding new work."
Atlanta-based Atlantic American Corp., a holding company for four insurance companies, lavishly detailed former Andersen partner John Sample's various insurance industry assignments in an April 2002 press release announcing his hire as CFO. Sample, who had spent his entire career at Andersen, had worked with Atlantic through 1999. As a result, "there are few people who know more about Atlantic American, its business, and its people, than John," said CEO Hilton Howell.
ChoicePoint Inc., Ernst & Young LLP, and Ilex Oncology Inc. made similar disclosures when they hired former Andersen partners to fill their CFO positions. "I have no problem with the Andersen association," says Brian Rye, an Ilex analyst at Raymond James. "What would have given me greater pause was if they'd gotten someone completely outside the industry."
John Bednarski, a litigation-services specialist, says his eight years with Andersen weren't even an issue when he looked for jobs last spring. And since he's joined Detroit-based consulting firm AlixPartners, about one-third of the office's new hires have been former Andersen employees, with more likely to come. "You had to be an intelligent, fairly affable person to get hired at Andersen, and certainly to survive there," says Bednarski. "As we're growing, that's the kind of people we're looking for." Personally, he says he's in better shape post-breakup, with "essentially the same job" he had at Andersen but at a 40 percent higher salary and half the commute time.
Ego Shocks
Still, the transitions haven't all been easy. "We were twice as big as the next-biggest accounting firm in Houston, and you don't get that way without being good," says Warren White, who logged 171/2 years with Andersen before cofounding valuation-services firm Avail Consulting LLC this past July. Now, he says, many of his former colleagues who have gone on to other firms are getting "ego shocks" when they are asked to adapt to a new culture. "They're happy to have a job, but some of them feel somewhat like second-class citizens." That Andersen partners auditing the clients they have brought with them often get double-checked and shadowed by incumbent partners doesn't help matters, says Koltin. "Even when it's not intentional, there's the implication that somehow the Andersen partner might not be as trustworthy."
Even Sample says his new job has taken some getting used to, even though he has known most of his new colleagues for years. Andersen "was a highly charged, very demanding atmosphere," he says, with as many as 1,300 people in the Atlanta office. Now, at the much-smaller Atlantic, "I find myself involved in a lot more of the nuisance issues, things that at Andersen someone else would have dealt with."
With the illusion of lifetime employment now gone for former Andersen partners, and new restrictions on the types of consulting services big accounting firms can provide, Koltin and others say the job transitions aren't over yet.
Meanwhile, former CEO Berardino has struck out on a new career path of his own: the lecture circuit. With several big speeches under his belt in 2002, including one at the American Institute of Certified Public Accountants's annual leadership conference this past November, he's slated to cap off another conference, sponsored by The Advisory Board this month in Las Vegas entitled "Winning Is Everything."
Alix Nyberg is a staff writer at CFO.
Crash Landings?
U.S. hires of some former Andersen employees.
Source: The companies
BearingPoint (formerly KPMG consulting): 1,575
Deloitte & Touche: 2,500
Ernst & Young: 2,300
Grant Thornton: 500
KPMG: 2,200
PricewaterhouseCoopers: 660
Protiviti (subsidiary of Robert Half): 760
With a welter of new reporting requirements coming, controller skills are suddenly a hot commodity.
Alix Stuart, CFO Magazine
December 1, 2002
Three years ago, Greg Cowan was promoted from controller to CFO at professional staffing firm CDI Corp., making the leap that so many accounting professionals dream of: from keeping the books to helping set business strategy. But in November he took what looked like a step back, swapping his CFO title for a newly created role as chief accounting officer.
Cowan, a former auditor, will focus on financial and operating controls, essentially "looking at where we are today and where we've been historically." New CFO Jay Stuart, who had previously worked with the CEO and has been consulting with the firm for the past year, will oversee financial operations and focus on the future. "It's difficult to explain this role in a traditional sense," says Cowan, "but you could think of it as taking the CFO charter and putting two financial people on it."
President and CEO Roger H. Ballou, who in concert with the company's audit committee created the CAO slot in part in response to requirements associated with the Sarbanes-Oxley Act of 2002 and new stock-exchange rules, is enthusiastic about putting Cowan's controller skills to work in the new position. "This is a very powerful job that is going to help us be a better company... with a dramatically enhanced focus on control," he says. While the company has a corporate controller to handle day-to-day issues, Cowan will oversee policy development and all policy-compliance functions, including overhauling internal and external audit processes and reporting to the audit committee.
He will also be "learning from historical financial performance" in order to improve profitability, says Ballou. But best of all, he will enable the new CFO to focus on strategy without getting into trouble. "When you look at the new responsibilities that are being required here [as a result of Sarbanes-Oxley and stock exchange rules], there is a risk that if you don't specifically delineate roles, you could dilute the ability of your CFO to help you with forward-looking growth, and acquisitions," says Ballou. "I'd be shocked if other companies don't move the same way."
Controllers: Not Remote
There's no question that accounting skills are back in vogue for CFOs, given the massive amounts of work associated with the new disclosure and governance rules flooding out of the Securities and Exchange Commission and the stock exchanges. In sharp contrast to two years ago, executive recruiters say that a CPA degree is one of the top attributes on their clients' CFO wish list these days, with experience in initial public offerings and mergers and acquisitions lagging far behind.
Controllers are getting much more exposure, as keepers of the financial statements that nearly every other executive in a company must now sign. Along with CDI, several companies, including BMC Software, Euronet Worldwide, and Galaxy Nutritional Foods, have recently announced that they are shuffling current CFOs' responsibilities in order to deal more effectively with those requirements. But many experts are skeptical about how long the new emphasis on accounting skills will remain popular, and they warn that playing up those skills may backfire for CFOs when they go looking for their next job.
Put in Cowan's situation, "I would resist [the change], because there are lots of companies that still want a strategic, externally focused CFO," says Peter Crist, vice chairman of Korn/Ferry International and a director of Wintrust Financial Co. He is sympathetic to the increased accounting workload, noting that three-quarters of a recent Wintrust board meeting was taken up by the CFO's report on responses to Sarbanes-Oxley. But, "the challenge is managing it, not succumbing to being sequestered in [an accounting-oriented] role," he says.
"I think that CFOs are clearly expected to continue to assume the mantle of strategic business partner," agrees E. Peter McLean, vice chairman and head of Spencer Stuart's CFO recruitment practice. He notes that 47 percent of the current Fortune 500 CFOs have MBAs, and only 25 percent of those have CPAs. "The trend is away from CFOs being technical experts; rather, you're asked to be a good selector of people. You have to be someone who can challenge and motivate a team of experts."
Title Match
For the sake of one's résumé, it may make more sense to retain the CFO title and try to delegate some functions such as human resources or IT to others, says Walt Williams, a partner at retained executive search firm Battalia Winston International. But Williams does agree that in the current climate, number crunching has moved to the fore. "I would expect CFOs who have taken on broader duties to be refocusing on the financial side," he says. "I don't think that such a focus weakens the position if a larger percentage of his or her time is spent on these [accounting] issues."
Accounting experience may be the ticket to bigger career changes, such as an industry switch. After holding the CFO title for a total of 11 years at two companies, Thomas Livengood left funeral-home operator Carriage Services on good terms in August and became corporate controller at Reliant Resources, a retail and wholesale energy provider that has been under regulatory scrutiny for accounting restatements it made earlier this year. "I was looking for an opportunity to get back into the sector," says Livengood, who spent much of his earlier career in the energy industry.
While he reports to CFO Mark Jacobs, a former investment banker who had joined the company a month earlier, Livengood says the two have "complementary skill sets." The company redefined the controller role when Livengood joined, aggregating previously disparate accounting functions under him. And given Reliant's recent spin-off from its parent company, more than $5 billion worth of debt maturing within the next nine months, and SEC investigations to respond to, Livengood says he's got plenty to keep him busy.
Thanks to Sarbanes-Oxley, he notes, "I think all executives have been sent back to the books, even CEOs."
Tips for Staying on Top
Some useful career advice for CFOs grappling with the demands for tighter accounting.
Make sure you have outstanding outside counsel — you must have access to people who are smarter than you and are spending every waking moment watching for what's coming out of Washington and the exchanges." —Peter Crist, vice chairman, Korn/Ferry International
When facing an internal shake-up, negotiate a mutually acceptable title while you're deciding what to do. If you accept a lower title, it doesn't do your résumé a whole lot of good." —Pam Lassiter, executive consultant and principal, Lassiter Consulting
Hire a great controller." —E. Peter McLean, vice chairman and head of Spencer Stuart's CFO recruitment practice
Are some sell-side analysts circulating a list of companies whose CFOs have close ties to the big accounting firms?
Marie Leone, CFO.com | US
June 5, 2002
If history teaches one thing, it's that people rarely learn anything from history.
How else can you explain the existence of a corporate list that appears to be currently circulating among some sell-side analysts in New York and London? According to sources, the common denominator of the companies on the list: All employ CFOs who have close ties to Big Five accounting firms.
That's right, a kind of blacklist of Big Five-trained CFOs. The possibility that such a list exists conjures Kinescope memories of the witch hunts conducted by the House Un-American Activities Committee — and Sen. Joseph McCarthy. And while CFO.com was not able to obtain a copy of the list, several sources vouch for it existence. They also say the same sell-side analysts are also circulating a list of companies that engage in numerous off-balance-sheet transactions.
If Enron Corp. weren't in Chapter 11, it would no doubt be on both lists. In fact, Barry Bregman, managing partner of search firm Heindrick & Struggles's CFO practice, believes the finance chief blacklist is a "knee-jerk" reaction to the spectacular demise of the giant Houston trading company.
Indeed, following the collapse of Enron in October, the reputation of Enron's auditor, Arthur Andersen, took a beating — particularly since so many finance staffers at Enron came from Andersen, including former chief accounting officer Richard Causey.
Other less-than-inspiring audits by Andersen — most recently at the Arizona Baptist Foundation — have not helped to restore AA's good name in the eyes of the public.
And given the recent parade of corporate restatements, shareholder lawsuits, and missed earnings, the taint from "Accountinggate" may well be spreading to other Big Five accountancies (Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers). In fact Barry Honig, president of executive search firm Riskon Inc., says finance staff candidates with strong Big Five ties can expect heightened scrutiny during interviews.
Such scapegoating of the Big Five accounting firms does not sit well with James Drury. Drury, principal of executive search firm James Drury Partners, is outraged that top accountancies are being blamed for aggressive corporate bookkeeping. By Drury's lights, senior management teams and Wall Street — and their fixation on quarterly earnings — are behind the creative accounting employed by some companies.
To Drury, the idea of heaping abuse on auditing firms in general seems ludicrous. "It's hard to imagine," he says, "that a blacklist of Big Five-trained executives would taint career searches."
Farm Team
It would shorten the list of candidates for finance jobs, that's for sure. Thousands — if not tens of thousands — of corporate finance executives cut their teeth at Big Five accounting firms.
Many CFOs, in fact, view audit firms as a sort of development system — farm teams, if you will — for the finance function. But if CEOs come to believe that sell-side analysts may lower their ratings on companies employing Big-Five trained CFOs, such a development system will likely be shot.
So far, that has not happened. Heidrick & Struggles's Bregman says that, from what he can tell, CEOs and board members still value Big Five training and experience.
Other executive recruitment specialists seem to back that up. Eric Archer, president of Spherion Professional Recruiting Group, asserts that accountants from Big Five firms are talented people with a good skill sets — and therefore remain attractive hires.
He does expect that former Enron and Andersen employees will have to live with a short-term career bump, however. But he doesn't believe prospective employers will discount salary offers to ex-Arthur Andersen auditors — despite the steady stream of former Andersen partners and staffers now flooding the market.
The Auditors and the Audited
If some headhunters say they haven't noticed a dramatic change in the types of CFOs getting hired since Enron's collapse, they do report some shifts in hiring practices.
According to Archer, a number of companies are now shying away from hiring finance executives directly from their independent audit teams. As CFO.com reported in "When Accountants Switch Sides," some critics and lawmakers believe such a practice creates an overly cozy relationship between finance staff employees and external accountants. In some cases, they say it can lead to shoddy financial oversight — or worse, fraud.
Eliminating possible conflicts of interest between auditors and audited won't be easy. Sherlyn Farrell, CEO at RGL Forensic Accountants and Consultants, thinks mandatory rotation of independent auditors could go a long way to erase the perception of impropriety between auditing firms and clients.
But Farrell concedes that a constant switching of auditors will mean more work for finance departments. Why? Because they'll have to slog through a learning curve with a new auditor every few years, explains Farrell.
And while most executive recruiters are put off by the idea of a Big Five blacklist, some do see the value of a list identifying companies with numerous off-balance sheet transactions. In fact, they say a finance chief who has set up or managed special purpose entities for a current employer may find it tougher lining up a future employer.
"I'd be cautious if a CFO candidate came from a main-line business that engaged in complicated financials," warns Drury. "Company officers and board members are more likely to debate how vulnerable the company becomes by hiring that kind of candidate."
Crib Sheet Required?
Robert Denney agrees. "Off-balance-sheet transactions would definitely send up a red flag for me," says Denny, a long-time corporate board member and principal of marketing consultancy Robert Denney Associates. He says asking management the "nasty questions" is part of the board's due diligence responsibility.
Many of those questions, he says, are aimed at top finance executives. Denney thinks senior finance managers should know more about a company than the company CEO. "The corporate finance team should know where every dollar of income comes from," he states, "and where every dollar of expense goes."
Moreover, Denney insists CFOs better have an economic rationale for removing assets from the balance sheet.
In fact, one audit firm practice leader told CFO.com privately that he is more concerned analysts have put together a list of companies with off-balance transactions than a list of CFOs with Big Five pedigrees. The purported list — essentially, a collection of companies with complicated financial statements — is said to include basic metrics that analysts can check off when analyzing publicly traded businesses.
Asks the practice leader, "Does the investment community really need a crib sheet to remind them that they must look into the fundamentals of corporate finance?"
Is it time for the SEC to prohibit corporations from offering jobs to their external auditors?
Craig Schneider, CFO.com | US
April 3, 2002
Following the collapse of Enron in October, scores of lawmakers and regulators started looking into the tangled relationship between Enron and the company's lead audit team from accountancy Arthur Andersen. In a number of cases, the inquiries have focused on Andersen's role as both independent auditor for Enron and a provider of consulting services to the Houston trading company. The premise of some of the inquiries: Andersen auditors may not have been overly eager to put the kibosh on fee-generating deals proposed by Andersen consultants.
The $62 billion bankruptcy in Texas has led many legislators to call for new rules prohibiting corporations from buying consulting services from their independent audit firms. But in the rush to wall off accountants from consultants, lawmakers and regulators appear to be ignoring another possible conflict of interest between auditors and their customers. The conflict? Auditors sometimes find themselves working with clients who used to work for them.
CFOs know the scenario only too well. A management team hires an independent audit firm. Over the course of a year, that audit team works closely with members of the company's management team, going over the books and such. In turn, the company's management team gets to know — and feel comfortable with — members of that audit team. Eventually, the company's management offers a member of that audit team a job — usually on the company's finance staff. Often, the original accounting firm stays on as the company's independent auditor. Says Ed Durkin, director of specialty programs at the United Brotherhood of Carpenters and Joiners of America, "It's very common to have senior people within the corporations who were formerly employed at the audit firms that the companies still use."
This cozy relationship, critics charge, can lead to trouble. Case in point: Richard Causey, former chief accounting officer at Enron, who joined the company after working as a senior manager at Arthur Andersen in Houston. While at Andersen, Causey worked on the Enron account.
Admittedly, it's difficult to assess what role (if any) Causey played in Enron's descent into bankruptcy. He was, however, chief accounting officer at the company, and as such, was probably responsible for keeping close track of Enron's books. In that job, it seems likely he would have worked with Andersen employees in developing and implementing accounting procedures, policies and strategies at Enron. But in a report released in February, a special investigative committee of Enron's board of directors seemed less than thrilled with some of Causey's decisions: "[Causey] presided over and participated in a series of accounting judgements that, based on the accounting advice we have received, went well beyond the aggressive."
The chief accounting officer's connection to Enron's auditor was not lost on members of the committee. In its report, the committee noted, "The fact that these judgements were, in most if not all cases, made with the concurrence of Andersen is a significant, though not entirely exonerating, fact."
Take My Auditor, Please!
While cause-and-effect is hard to prove, it's easy to see how an audit team might be less than objective when dealing with a colleague-turned-client.
Roger Barton, a partner at Barton Barton & Plotkin, believes even the best financial processes can be circumvented when corporate managers have close ties to their auditors. He says his law firm has recently taken on a rash of cases that involve allegations of embezzlement by CFOs and controllers. "Even if the company has the internal controls that it should have," he says, "the auditing firm doesn't pick up on the defalcations or improper acts. And most times, the reason for that is that there is a cozy relationship between the controller or the CFO and the outside auditing firm."
The relationship gets even cozier when a company's management continually hires finance employees from its audit firm. Until 1997, for example, every CFO and chief accounting officer hired by Waste Management worked previously at Arthur Andersen — Waste Management's independent auditor. All told, 14 former Andersen employees went to work for the Houston-based waste treatment and disposal company during the '90s. According to the SEC, most of the former Andersen auditors took jobs in key financial and accounting positions at the waste treatment and disposal company.
Last week, the SEC filed a lawsuit against five former managers at Waste Management, claiming the executives perpetrated "an egregious accounting fraud." Three of the five executives named in the suit worked in Waste Management's finance department (one was the company CFO). In a statement, the SEC was also highly critical of Waste Management's auditor Andersen. The commission noted that the "defendants were aided in their fraud by the company's long-time auditor Arthur Andersen LLP, which repeatedly issued unqualified audit reports on the company's materially false and misleading annual financial statements." The previous employer of the three former executives named in the SEC suit? Andersen. According to the SEC, two of the finance staffers listed in the suit worked on the Waste Management account while at Andersen.
Concerned that these kinds of close ties between accountants and corporates can lead to mistakes in judgement — or worse — one attorney has started counseling clients to show restraint in hiring audit team members. Martin Lipton, a partner at the law firm of Wachtell, Lipton, Rosen & Katz, recently advised the firm's corporate clients to refrain from hiring key members of the accountant's team "for at least three years after the individual last worked on the company's account." He adds, "At no time should a significant number of the company's finance and accounting staff be former employees of the account."
Shareholder activists are also encouraging the accounting industry to rethink the auditor/client relationship. Some activists believe corporations should be required to rotate their independent auditors. And in February, the Council of Institutional Investors asked the accounting industry to impose cooling-off periods before audit firm employees can go to work for audit clients.
So far, that hasn't happened. The Independence Standards Board's Standard No. 3 ("Employment with Audit Clients") offers safeguards to protect against the impairment of auditor independence, but does not recommend a cooling-off period. The American Institute of Certified Public Accountants has also issued guidelines for any company that does offer a job to a member of its existing audit team. And in November 2000, the SEC approved its revisions on auditor independence guidance — but did not endorse a cooling-off period.
It remains to be seen whether the commission will revisit auditor employment concepts like auditor rotation and cooling-off periods. Sue Coffey, AICPA vice president of self regulation and the SEC practice section, says that in the wake of the Enron collapse, the auditor employment issue is "on the periphery."
Managers at many audit firms would probably like to keep it there, too. The reality is, for a great many accountants, corporate audit work is their entree into the corporate world. For these future C-level executives, a cooling-off period would place a sizeable roadblock in their career paths. The SEC noted this problem when it issued its revised auditor independence guidance. "We have determined that a cooling-off period unnecessarily restricts the employment opportunities of former professionals," the commission stated, "and we have decided not to adopt a cooling-off provision."
Such a provision might have cost Jon Gacek a shot at becoming CFO. In the mid-'90s, Gacek worked as an auditor at PricewaterhouseCoopers. Then, in 1997, Gacek took at finance chief job at software vendor Advanced Digital Information Corp. (ADIC) — one of his clients at PwC. In fact, Gacek, was hired by the software maker right before the start of an audit.
By Gacek's lights, concerns about auditor independence should be focused squarely on auditors, not the audited. "The rules need to impact the firms, not the companies, and not the partners therefore leaving the firms," he insists. "My view is we have a relationship with our auditor, but it's their job to manage their independence, not mine."
Under the Influence
It appears auditors think they're managing their independence just fine. A number of accounting firms have examined the issue of auditors who go to work for clients. "Most firms have policies that exceed requirements," claims Edward Coulson, national director of independence at Ernst & Young. "I personally don't think there should be — or would be — a need for change."
At least one other Big Five senior executive appears to agree with Coulson. In a SEC-sponsored panel examining auditor oversight, Deloitte & Touche CEO James Copeland noted: "I believe most of the proposals will take us backwards rather than forwards. We need to be careful with ideas like mandatory auditor rotation, and examine why it now makes sense when so many groups previously studied the issue and consistently concluded it was wrong."
Nevertheless, two legislators appear undeterred by industry resistance to auditor employment restrictions. Senator Christopher Dodd (D-Conn.) and Sen. Jon Corzine (D-N.J.) recently proposed a bill that would in part ban any accounting firm from providing a public audit for a company whose controller or chief financial officer had worked for the firm in the previous two years.
The SEC did not go nearly that far when it issued its guidance on auditor independence. According to the commission's guidelines, an auditor's independence is not compromised if the auditor does not influence a company's operations or financial policies, does not have a capital balance in the firm, or does not have a financial arrangement with the company, other than a fully funded, fixed-payment retirement account.
Under the SEC's framework, when a auditor is approached by a client — and is considering a job offer — the auditor should pull out of the engagement. If the auditor accepts the offer, the accounting firm is advised to review the auditor's work to ensure that there is an appropriate level of skepticism in the audit. Also, the firm should reassess whether its audit procedures need to be changed, or for that matter, whether members of the audit team need to be replaced.
But industry watchers assert that SEC guidance and industry self-regulation may not be enough. They argue that an auditor who goes to work for a client may be able to exercise undue influence over the remaining audit team. If several members of an audit team go to work for the same company, critics claim it tends to create an old-boy network between auditor and client.
Industry watchers also point out that an accountant-turned-finance staffer has great familiarity with a firm's audit process. That knowledge could enable a former auditor to help a new employer game the system — or even circumvent audits completely. "As someone who has supervised the audit, he knows what the procedures are," asserts Roy Van Brunt, a forensic accountant with Ten Eyck Associates who once worked with the SEC on the auditor independence issue. "So it becomes somewhat easier for him to hide something — at least in theory."
Farm System
Paul Free puts considerable stock in that theory. Free, corporate controller at Delphi Automotive Systems Corp., avoids hiring auditors from the company's independent auditor (Deloitte & Touche) when filling positions on Delphi's finance staff.
Ironically, Free himself was a partner at Deloitte before joining Delphi, although he was not engaged in the company's audit. Nevertheless, Deloitte and Free have put in a policy prohibiting the Delphi CFO from hiring Deloitte auditors at the managerial level — even ones that aren't working on the Delphi account. The company's audit committee, Free says, reviews his new hires on an annual basis "to make sure that my actions are consistent with my policy."
Free grants that the policy, while probably best for shareholders, does make it somewhat tougher to staff the finance department at Delphi. "It's unfortunate in some respects," he explains, "because the management people who do [audit] Delphi know a tremendous amount about us. They're learning curve would be less steep than someone who doesn't."
In fact, some CFOs see their audit firms as something akin to a farm system. Robert Ryan, CFO of Medtronic Inc., says the company does hire members from its independent audit team — but only for lower-level positions. He says he can then train them to move up at the company. "This, for us, is an opportunity to develop future leaders for the company," says Robert Ryan, "You're better off to hire three or four, get them acclimated to the company, and then you have the bench strength to send them out."
Some shareholders activists concede new auditor employment laws could make it tougher for companies to find qualified finance employees. And union man Durkin say's he not exactly certain what can be done to stem auditor/client abuses. "We're not quite sure how you grapple with it," grants Durkin, who is still in early-stage negotiations about employment relationships with audit committees. "Disclosure may begin to address those concerns."
Human Beings Are Complicated
Possibly. Some shareholder activists suggest that if a CFO has worked for an audit firm within the last five years, that information should be noted in the audit committee's report.
One company has already taken that tack. Last week, IndyMac Bancorp named Scott Keys to the CFO post. Keys came from IndyMac's audit firm, Ernst & Young. In announcing the hire, management at the company noted that, "while Ernst & Young has been IndyMac's auditors since June 2001, Mr. Keys was not a part of IndyMac's year-end audit team."
It remains to be seen if that sort of voluntary disclosure catches on at other publicly traded corporations. The fact is, many corporate managers value their long-term — and close — relationships with their audit firms. UAL, the parent company of United Airlines, employed Andersen as its independent auditor for nearly 67 years. As Richard Roe, partner in the law firm Proskauer Rose LLP, notes: "You have human relationships. But you could have those [close relationships] because the CFO has been the CFO and the audit partner has been the audit partner for years."
Moreover, some CFOs say new auditor employment requirements could also be gotten around. "You can't determine everything with rules," argues Medtronic's Ryan. "You need to have good reputable people with good judgement."
Even some lawyers admit that laws may not be the answer. Notes Neil Lang, partner with Sutherland Asbill & Brennan: "I don't know how you regulate someone's state of mind."
You can't. You can't stop people from conducting insider trading, either, but there are still laws against it. Lawmakers in Washington, feeling pressure from the public outrage over the Enron scandal, may well push through some sort of auditor employment legislation. Such legislation could forever change the nature of the auditor/client relationship, and the careers of countless accountants.
That prospect may cheer shareholders, but it probably won't thrill many accountants. "It's up to an individual company who they hire," insists E&Y's Coulson. "Presumably they hire people based on competence and knowledge, as opposed to some evil motivation that helps them perpetrate some fraud."