Fractured Fraternity

Oh for the days when auditors were counselors and not pricey overseers.
John GoffSeptember 9, 2005

During the past three decades or so, Patrick Scannell has had countless conversations with accountants. It’s hardly surprising. Scannell, 28 years in corporate finance, has served as CFO at five separate companies, overseen three initial public offerings, and orchestrated one private-market sale. Through it all, Scannell has, to some extent or another, relied on the advice, expertise, and plain good sense of his external auditors.

But Scannell, now at data-warehousing specialist Netezza Corp., in Framingham, Massachusetts, says the environment has become a lot more formal of late. “The consultative advice that auditors had been able to provide in the past has now changed to ‘You tell me what you think the answer is, and I’ll get back to you on that.’ “

The change in tone speaks volumes about the suddenly fractured relationship between line partners and finance executives. Many finance managers complain that their engagement partners are not nearly as engaged as they used to be. This newfound formality (or as one executive calls it, “distancing”) can be traced to the 2002 demise of Arthur Andersen, an implosion that shook the accounting world. More recently, a spate of damaging lawsuits against marquee firms — and a welter of new accounting regulations and independence requirements — have clearly pushed accountants onto the back foot. “We’re a lot more cautious than we used to be,” concedes Russell Wieman of Chicago-based Grant Thornton LLP. “In the past, you may have given [a client] the benefit of the doubt. We won’t necessarily do that now.”

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In fact, some CFOs say dealings with external auditors have become a lot like encounters with the Internal Revenue Service: shrill, chilly, and frustrating as hell. Notes James Wall, CFO at San Francisco–based Core-Mark International Inc.: “Effectively, the audit firms are now working for the government — except for the fee.” Another finance chief, upset over falling service and rising fees, says he’s contemplating bringing in an additional firm to help sort out accounting issues. “Fifteen years ago, we had a partner [in our auditor],” says the executive. “Now, we have an overseer.”

Shakedown Cruise

That, of course, may be exactly what legislators intended when they passed the Sarbanes-Oxley Act in 2002. Among other things, the act gave rise to the Public Company Accounting Oversight Board (PCAOB), a private agency empowered to police the accounting industry. Privately, auditors say they are still not entirely sure how rigidly the board will carry out its mandate.

The uncertainty has been amplified by the regulatory shakedown cruise known in finance circles as “Year One.” Finance executives say the initial year of compliance with Section 404 of Sarbox has done more to sabotage auditor/client goodwill than any other piece of legislation in recent memory. “There was no clarity from the PCAOB or auditors,” says Phil Livingston, a vice chairman at Approva Corp. and an audit-committee member at both Cott Corp. and MSC Software. “The process has audit committee members upset with the entire accounting profession.”

Critics say the PCAOB provided auditors with too little 404 guidance — and too much. Until a May 16 statement from the board, accountants had been left to guess how much advice they could offer clients when assessing internal controls. At the same time, auditors had been bombarded with statements from regulators about what they were not allowed to do. “We kind of felt sorry for them,” says Richard Wehrle, vice president and controller at Alamo Group Inc., a Seguin, Texas, maker of grounds-maintenance machinery. “New bulletins were coming out weekly. Each time we had a meeting, they’d say, ‘Here’s a new guideline.’ “

Partners at accounting firms are taking no chances. “Auditors have reacted with a little bit of fear and a lot of uncertainty,” grants William D. Travis, managing partner of Minneapolis-based accounting firm McGladrey & Pullen LLP. “[They’re wondering,] ‘What stance will the PCAOB take? Will they use a hammer to keep people in line?’ “

Some finance executives say auditor concern about regulatory sanctions has translated into unnecessary 404 precautions. “There was a lot of duplication of work,” claims Dennis Stevens, director of internal audit at Alamo Group. “They were making us do things that were really about protecting them.”

Silent Treatment

Recent Website postings and comment letters echo that sentiment, with CFOs complaining about the documentation required by auditors. It hasn’t helped that outside accountants have apparently gone quiet on clients. Dialogue, once considered the cornerstone of a good auditor/client relationship, has simply ceased.

The lack of input often has CFOs flying blind — leaving them little choice but to interpret complex accounting standards on their own. The silent treatment can be infuriating. “We recently went to our auditor [with a question],” says Leon Level, CFO of Computer Sciences Corp., “and it was like Fear Factor 101. They said, ‘Where’s your white paper?’ ” Eventually, Level went to three of the Big Four firms in search of written advice. He never got any. “I’m the CFO of a major public company,” he bristles, “and I couldn’t get an answer.”

That’s a seismic shift in how auditors deal with clients. “It used to be, ‘Hey guys, here’s an accounting problem; how do we address it?’” recalls David Adante, CFO at landscaping specialist The Davey Tree Expert Co. “Now it’s, ‘Hey guys, we have an accounting problem and here’s how we addressed it. What do you think?’ “

Auditors don’t deny the charge. But they place much of the blame on regulators. “There’s a new sheriff in town,” explains Travis. “So some auditors have acted extremely conservatively and, in some cases, not all that logically.”

Certainly, auditors have tended to err on the side of caution when addressing client inquiries. “The question is, How much assistance can an auditor provide before it’s the auditor’s answer and not the client’s?” asks David Breen, U.S. assurance operational leader at PricewaterhouseCoopers LLP. “At the end of the day, the client must own the answer.”

Finance chiefs agree, but say they wouldn’t mind a little help arriving at the answer. Too many questions can spell trouble, however. What used to pass for normal give-and-take between an auditor and a client might today be construed as a sign of control deficiencies — or worse. “At a certain point, we must draw a line,” says Wayne Kolins, chairman of the board and national assurance director at Chicago-based BDO Seidman LLP. “If a client calls 12 times a day, maybe he’s not competent.”

Don’t Speak

The point is not lost on CFOs, many of whom now seem to be engaging in a form of self-censorship. “You’re kind of showing your hand by asking for advice,” acknowledges one finance chief. “The auditor may think, ‘Maybe they don’t have it together.’” He adds: “It does color things differently.”

So, too, does the tendency for engagement partners to defer client questions to higher-ups at their firms. CFOs say the deferring has become SOP in recent months. “An auditor is no longer capable of making a judgment,” insists Wall. “Any judgment nowadays involves a committee.”

Auditors defend the vetting process. “The complexity of standards leads to more consulting [within a firm],” explains Robert Kueppers, chairman of the executive committee of the Center for Public Company Audit Firms at the American Institute of Certified Public Accountants. “And the stakes for being wrong have gone up.”

Not surprisingly, so has the time it takes for clients to get an answer from their auditors. “Today, it’s a guessing game,” says Wall. “You go to them and say, ‘Here’s the issue; what’s your position?’ Then it goes into this black hole called the national office.”

The jury is still out on whether the constant conferencing will lead to more-reliable financial statements. But the backstopping by national partners isn’t helping finance executives do their jobs. Alamo Group’s Stevens recalls a recent meeting where he questioned his independent auditors about compliance-testing control procedures. “The partner and manager just looked at each other, then said, ‘Um…can we answer that?’ ” he says. “They were unsure what the national office expected them to do.”

Nice Work If You Can Get It

Such indecision galls CFOs, many of whom say they are paying first-class fees for second-rate service. As one finance manager noted in an E-mail to CFO: “Given [that] all remotely ‘material’ items go to national (whom we are not allowed to talk to), how do I explain to my audit committee why we should still pay $570 an hour for a partner?”

Auditors are no doubt familiar with the refrain. John Morrow, a vice president at the AICPA (in which capacity he represents more than 150,000 accountants working at public companies), says flat out, “Everybody’s talking about how outrageous audit fees are getting.”

A recent survey quantifies “outrageous.” According to law firm Foley & Lardner LLP, corporate audit fees shot up an average 61 percent between fiscal 2003 and 2004. While CFOs expected some uptick (due to 404 compliance), many say they were stunned by their accounting fees last year. Says Livingston: “People felt they were being gouged.”

Morrow believes second-year fees for 404 work will probably come in at about 70 percent of first-year fees. But all major firms continue to raise their hourly rates. Field-level or engagement partners now routinely bill $250 per hour for their work, with national partners getting as much as $1,000 per hour.

Auditors don’t apologize for the pricing, insisting that hourly rates reflect higher costs. PwC’s Breen notes that the threat of litigation has forced the top firms to spend more on settlements, insurance, and lawyers. Labor costs have also increased, fueled by a yawning shortage of trained accountants. The AICPA’s Kueppers says clients and regulators — even the PCAOB — are draining the talent pool. “The capacity issue won’t be resolved within the next couple of years,” predicts McGladrey & Pullen’s Travis. “With the shortage, companies should not expect to see declines or even stable [overall] pricing in the near future.”

Because They Can

This prognosis won’t likely thrill finance managers. Davey Tree’s Adante says the company’s audit fees doubled last year. While 404 fees were a big part of that, Adante also points out that the company’s outside auditor increased its hourly rate by 10 percent. “Our audit firm came in and said that its targeted hourly billing rate was $50 more per hour than what we had been paying,” he recalls. “We were pretty much dictated to.”

His comment underscores another reason top-tier firms keep boosting fees: because they can. The value of thorough audits has never been higher. And while perceptions about second-tier firms are changing, many still believe investors are more comfortable with a Big Four imprimatur on a financial statement.

Hence, CFOs at many publicly traded companies seem resigned to sticking with their current auditor — and getting socked with supersized bills. Says Michael McGee, CFO at International Rectifier, in El Segundo, California: “Audit staff and audit partners are subject to the laws of supply and demand.” And right now, McGee adds, “they’re in demand.”

That demand may ease during the second year of 404 compliance, as auditors and their clients get used to the regulatory drill. And some CFOs insist the PCAOB’s May 16 guidance will ease the pressures felt by audit firms. But as BDO Seidman’s Kolins points out, it’s still unclear what constitutes acceptable judgment. “Accountants do not have a free ride on the use of judgment,” he says. “Regulators will determine [what’s appropriate].” He pauses. “It’s still not business as usual as far as advice given to clients.”

Indeed, the AICPA’s Morrow thinks CFOs may just have to get used to a much more formal relationship with their auditors. “It’s a matter of getting used to the new normal,” he says.

Many prefer the old normal. “Before, we had a valued adviser, a valued friend,” laments Wall. “And then all of a sudden, they’re not there. We miss the old guys.”

John Goff is technology editor of CFO.

The Joys of Getting Dumped

Ah, those niggling little signs that a longtime relationship is about to hit the skids. Less talking. More bickering. Squabbles over money.

Take the case of business-data specialist EDGAR Online Inc. Two years ago, Greg Adams, CFO and chief operating officer of the South Norwalk, Connecticut-based business, says he sensed a change in the company’s outside auditors, Big Four firm KPMG LLP. Later, Adams says the auditors informed him that KPMG’s proposed fee for auditing EDGAR Online’s books would be higher in the coming year. “I could see the handwriting on the wall,” recalls Adams. So he dropped KPMG, hiring BDO Seidman LLP in 2003 as EDGAR Online’s independent auditor.

Such bust-ups are not uncommon in Audit Land these days. According to research firm Glass, Lewis & Co., tier-two firms gained 193 new clients in 2004 from Big Four houses. In many cases, however, the pickups were actually smaller businesses that had been thrown over by large auditing firms.

Top firms seem to be doing a lot of that lately. Some clients are being shed because they’re not big fee generators, while others simply pose too great a legal or regulatory risk. Explains David Breen, U.S. assurance operational leader at PricewaterhouseCoopers LLP: “You can hire the best people, give them the best tools, and do inspections. But none of that will overcome the wrong client.”

Overcoming the wrong accountant comes with its own set of problems. Changing independent auditors involves filing an 8-K with the Securities and Exchange Commission, a move that “can affect your share price,” says one CFO. And as William D. Travis, managing senior partner at accounting firm McGladrey & Pullen LLP, notes, “Any time you have to hire a new auditor, there’s a loss of efficiency. And there’s some cost.”

Adams found that out the hard way. When he told KPMG that he’d found a new external auditor, he says the firm informed him that EDGAR Online would have to pay a consent fee for the use of its audits for the previous two years. Adams, who worked at KPMG for 11 years, adds that he failed to convince the partners to lower the price. “We had to absorb that cost for two years,” he says. “They got $40,000 for proofreading.” — J.G.