Advice to corporations regarding on-again, off-again mergers of auditing firms: The recent collapse of the proposed union between KPMG Peat Marwick and Ernst & Young may not signal an end to upheaval. As long as auditors face a pressing need to improve their own bottom lines, consolidation remains a tempting proposition.

After downsizing a decade ago to the Big Six, top executives of four firms in the recent merger activity contend that paring the ranks even further is good for clients. They stress economies of scale along with a heightened capacity to deliver integrated consulting services on a global basis with virtually no interruption.

Merits aside, the mergers would have jolted the industry’s pecking order. Arthur Andersen LLP, which had been No. 1 by a wide margin, would have slipped to third place. The combined Ernst & Young LLP and KPMG Peat Marwick LLP threatened to move to the top of the chart. Price Waterhouse LLP and Coopers & Lybrand LLP would have grabbed second place, but can now claim bragging rights to the top slot in the Big Five, with $13.1 billion in revenues.

Much can be said in favor of efficiency and global reach in an era in which large companies are as apt to need auditors in Beijing as in Peoria. To insist, however, that transformations of this magnitude are seamless ignores rocky track records in past mergers and evidence in the current round that some painful dislocation is already occurring. Mergers encumber the choice of outside auditors and impose internal stress that threatens to distract auditors from attention to their clients. Meanwhile, less competition reduces market restraints on firms inclined to increase fees.

Ask Brian Healy, CFO of Computer Language Research Inc., about the disarray the merger between KPMG and Ernst & Young would have triggered. Computer Language, an income tax software developer in Carrollton, Texas, had agreed in 1997 to form a joint venture with Ernst & Young. The purpose was to build and market an international software package, with Computer Language supplying the software development and Ernst & Young the tax expertise.

SHRINKING LIST

Healy’s headaches arose because companies are not allowed to hire business partners as auditors. But in the wake of the mergers, circumstances that rule out Ernst & Young also rule out KPMG. Healy then invited bids from three other firms in the Big Six–all except Arthur Andersen, which is a key competitor in the tax software market.

That short list of candidates quickly evaporated, however. Price Waterhouse bowed out, owing to obligations stemming from the 1995 and 1997 sales of two lines of business to Computer Language. Being in an audit client’s footnotes might not sit well with investors or regulators, Healy says. Coopers, which had declined to bid, would have been knocked out of the running anyway, thanks to its association with Price Waterhouse. For reasons never made clear, Deloitte also turned down the chance to compete for Computer Language’s business.

Suddenly, the Big Six field came down to Arthur Andersen, despite competitive considerations. “What was my alternative? There was nobody but Andersen if we wanted the Big Six,” says Healy. “We were boxed in.”

Venturing outside the accounting industry’s top tier, Healy weighed Grant Thornton LLP’s merits. But Computer Language would have been consigned to Grant Thornton’s manufacturing group. Andersen, at least, had a group composed of auditors accustomed to software companies.

As is often the case, replacing a long-standing auditor ends up improving service and cutting the audit tab. But long term, Healy fears that less competition might have the opposite effect. “I expect we’re going to see a lot of turmoil within the merging accounting firms themselves,” he says.

Considerable internal confusion and strife occurred several years ago when Ernst & Whinney merged with Arthur Young Co.; Deloitte, Haskins & Sells merged with Touche Ross & Co.; and Peat, Marwick Mitchell & Copartners merged with KMG. Organizational consultants note that mergers among big partnerships often force staff to concentrate on internal matters, personnel survival, and office politics, hurting client service.

MANYCONSTRAINTS

At first blush, it is easy to conclude that Computer Language’s problem is a peculiar case. But relationships or engagements other than joint ventures also can constrain the selection process, and competitive circumstances in general can sometimes rule out a particular auditor. “Coca-Cola might not want Pepsi’s auditor,” Healy explains. Litigation, or simple differences of opinion, can have an equally chilling effect.

In mid-1996, Oregon Steel Mills Inc., in Portland, fired Coopers & Lybrand and then sued its former auditor in U.S. District Court for $35 million, claiming that Coopers’s performance was sub-par. Oregon Steel maintains that Coopers reconsidered its own advice, and thus delayed a public offering. Meanwhile, the markets for such securities deteriorated. Coopers denies the charge, and says it followed professional standards in its work. The lawsuit is pending.

“The offering delay cost us a lot of money,” says L. Ray Adams, CFO of Oregon Steel. But just as upsetting, Oregon Steel had selected Price Waterhouse as its new auditor. Now, with the prospect that it will again do business with Coopers because of the merger of Price and Coopers, Adams is somewhat unsettled.

He says that Price has assured him that the new auditing team will continue with Oregon Steel, and “so far it’s doing a fine job.” But Adams frets that the mergers will provide companies with less choice in selecting auditors. “A narrowing of choices is always detrimental,” he says. “Auditing is a required service, and less competition could hurt the companies trying to switch to a new auditor or open the door to audit price hikes.”

A similar problem bedevils Sandra Van Trease, an executive vice president, chief operating officer, and CFO of RightChoice Managed Care Inc., which operates as Alliance Blue Cross Blue Shield, in St. Louis. After using Price Waterhouse as outside auditor for more than a decade, RightChoice elected to put its audit out for bid.

Coopers snared the account because it had top backup staff in health care, insurance, and internal controls, according to Van Trease. The night before Coopers and Price announced their merger plans in September 1997, a Coopers partner phoned Van Tease at home, to assure her that the same audit staff would remain on the RightChoice account.

RightChoice also has been using Ernst & Young as a consultant for a large-scale computer conversion. “Using our outside auditor to consult for this work would be a conflict of interest because the auditor would be doing attest work for its own proj-ect, which isn’t allowed under independence rules,” says Van Trease. Also, use of Ernst as a consultant prevents RightChoice from selecting KPMG as its outside auditor, because of a potential conflict of interest.

So the mergers are limiting “my choices of auditors and consultants,” says Van Trease. “For CFOs, the ability to play one CPA firm’s expertise against another’s will be sharply reduced by the mergers. But this may be offset by the combination and global expertise and cost efficiency resulting from the mergers.” She’s not sure. Nevertheless, she foresees change, which isn’t always comfortable.

Joe Shockley, executive vice president and CFO of BancFirst Corp., a bank holding company in Oklahoma City, says the new merger picture has confused his company. BancFirst had been a Price Waterhouse audit client until Price sold its Oklahoma City practice to Coopers in late 1996. So BancFirst became a Coopers client.

“With the impending merger of Price and Coopers, we wondered if we would wind up as a Price client again,” says Shockley. “But we’ve been assured that we’ll keep the same audit team.” Shockley fears, however, that with the audit partner retiring soon and the possibility of the new firm’s managing partner in Oklahoma City changing, the company’s annual audit fee of more than $100,000 could rise.

Until this year, International Yogurt Co., in Portland, Oregon, had changed auditors every three years by opening the job to bids and selecting the least-expensive bidder. In 1991, the company shifted to Price Waterhouse from Coopers, and three years ago, it hired Grant Thornton for $24,500 annually, notes company CFO W. Douglas Caudell. With fewer auditing firms to choose from, Caudell says it’s now “doubtful” that opening the job to bids “would add value to clients.”

Caudell says the choice of auditor rests with John Hanna, the company’s CEO. And Hanna claims the impending mergers make him wary of changing auditors again. “It’s going to be a confusing picture,” Hanna says. “I’d like to know a lot more about the effect of the mergers before I put the audit out for bids again.

Lee Berton is a financial writer based in New York.

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