Accounting & Tax

Coming: Auditor Cataclysm?

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 RadiganOctober 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.”

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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.

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