Deloitte & Touche resisted splitting with its consulting arm, and now the multibillion-dollar segment has inspired other audit firms to rebuild theirs
Four years ago, the partners of Deloitte & Touche did something radical: They kept the firm in one piece. The Big 4 accounting firm had spent more than a year calculating how it would sever its large consulting practice from its audit and tax group. It was the only one of the big firms that hadn't already done so, and pressure inside and outside the firm was high for them to split.
Outside, concerns raged that consulting had compromised the integrity of the audit. The Sarbanes-Oxley Act had already prohibited firms from selling a number of consulting services to audit clients, chief among them the multiyear IT system integrations that had been their cash cow. Big lawsuits accusing the firms of bias at Enron and a long list of other meltdowns added to the drumbeat. For Deloitte Consulting to survive, all signs seemed to point to separation.
But Deloitte had waited too long. Arthur Andersen had already collapsed under the weight of its Enron woes, and the lenders Deloitte relied on to finance its planned management-led leveraged buyout were demanding big premiums and collateral, too. Audit-client defections meant consulting revenue was dropping, and potentially might not be enough to cover the deal costs. So on Mar. 31, 2003, with little alternative, the firm scrapped the idea.
Sometimes it's better to be lucky. In the years since the aborted breakup, Deloitte's consulting business has taken off. Consultants have more than made up for their losses at audit clients by selling to the three-quarters of public companies the firm doesn't audit. Private equity firms and their companies are big clients, too. Strong need for consulting on Sarbanes-Oxley compliance, risk, forensic investigations, and outsourcing has helped fuel demand. So has the mergers-and-acquisitions boom. Today, consulting is Deloitte's second-largest business in the U.S., a $3 billion segment that accounted for more than one-third of the U.S. firm's 2006 revenue. "In a strange kind of way, we're very fortunate," says Barry Salzberg, chief executive of Deloitte & Touche USA. "By serendipity we ended up with a strategy that is unique."
Worldwide, consulting is an even bigger business for Deloitte, making up 45% of its $20 billion in global revenue. In 2006, it totaled $8.9 billion, according to Peterborough (N.H.)-based Kennedy Information. And it hasn't taken long for the other audit firms to do the math, and quickly rebuild their own consulting arms. KPMG Worldwide last year sold $5.3 billion of consulting, a 12% jump from the year before; PricewaterhouseCoopers (PwC) $3.7 billion, up 20%; and Ernst & Young $2.4 billion, a 2% increase. "It's a huge growth industry, and a big margin business," says Clark Beecher, a professional-services executive search consultant at Houston-based Magellan International. Beecher estimates demand for consultants who do the work the Big 4 specialize in is now 15 times the supply. "It's the old mentality again. You sell everything you can."
That, of course, is exactly what got the firms in trouble the last time. Critics say that the resurgence of consulting within these firms is raising concerns once again that consulting could grow so big that it becomes hard for audit firms to keep the proper focus on the audit part of the business. "The real issue that's going to be posed is, have you learned your lesson or is this going to turn out badly again?" says Tom Rodenhauser, vice-president of Kennedy Information's consulting division.
Lynn Turner, former chief accountant of the Securities & Exchange Commission, notes that ensuring auditors don't overstep the bounds of what's allowed falls ultimately to each company's audit committee. But those committees are not always as attuned to independence issues as they might be. As evidence, Turner cites recent examples of companies where auditors were partly paid on a contingent-fee basis. Such fees are a no-no under U.S. regulatory rules, but the audit committees hadn't caught it.
A series of SEC and private lawsuits accusing the firms of independence violations in the 1990s and early 2000s continue to fuel concerns. Most recently, PwC paid $2.3 million to settle Justice Dept. allegations of kickbacks and undisclosed conflicts of interest in government contracts, though they did not admit wrongdoing and denied kickbacks. Those contracts were handled by the consulting group PwC spun off in 2002. On Aug. 13 and 14, a Florida jury came in with two verdicts of $521 million combined against BDO Seidman, the sixth-largest audit firm. That case included accusations of conflicts of interest in BDO's audits of factoring firm E.S. Bankest, based on a BDO affiliate's consulting work at the company. The firm is appealing.
Benefiting from Compliance
Given these criticisms—and others involving Enron, WorldCom, Adelphia, Tyco (TYC), et al, it's more than a little surprising that the very dangers those meltdowns highlighted are what's driving much of the demand for Big 4 non-audit services today. Mark Goodburn, head of KPMG's advisory business, says forensic investigations and anti-money-laundering concerns are among the businesses that have grown his practice to 30% of the firm's U.S. revenue. "The risk awareness has been changed forever," says Goodburn.
M&A deals that used to be done on the CEO's handshake now take months of financial due diligence. Even credit markets are finally demanding tough financial reviews of debt. High turnover among chief financial officers, combined with increasing responsibility in that role, has provided a steady stream of customers in need of help.
At Deloitte, partners say consultants are far more intertwined with the rest of the business than ever before, starting with their wallets. The SEC outlawed the practice of paying auditors based on non-audit work. So now Deloitte has one big pool of profit that auditors, tax experts, and consultants all share. Audit partners can still refer business to their consulting counterparts, but they only benefit in a broad sense, no longer directly. "Teaming became our mantra," says Salzberg. James Quigley, chief executive of the global firm, Deloitte Touche Tohmatsu, says the U.S. firm's array of services makes it "a category of one."
A 200-Person Assignment
Rival audit firms aren't conceding that point, but Deloitte is cross-selling pretty vigorously these days. One example: A large project the firm did for test and measurement company Agilent Technologies (A) in 2005 and 2006. Agilent, then a $7 billion hodgepodge of businesses Hewlett-Packard (HPQ) had spun off, wanted to split up, and eventually sold off its semiconductor business to private equity firm Kohlberg Kravis Roberts (KKR) and spun off another business, Verigy (VRGY).
Deloitte was the main adviser on all three deals, and put a team of 200 different people on the assignment. Auditors advised on how to set up the IPO financials, consultants helped design the proper supply chain for a smaller Verigy, and tax strategists worked to lower the tax bill for the remaining Agilent business. In the course of the work, Deloitte ran into just one independence issue. The firm had been running some of the systems KKR was buying, and since Deloitte audits the private equity giant, it had to off-load those duties before the deal closed. Other than that, says Agilent CFO Adrian Dillon, there was "never an issue."
To ensure it stays that way, Deloitte has a firm-wide training program for all professionals, and everyone has to attest each year, around the time of their birthday, that they have not provided forbidden services. The firm has changed its accounting system as well. It won't allow someone to start a project at all without first asserting the lead partner at that company has O.K.'d it. (Any new engagement requires an accounting number.)
The lead partner is particularly pivotal, because he or she knows all the business the firm is doing at the client and is in the best position to flag any potential issues. Deloitte has created a team that randomly audits its own engagements to ensure compliance as well. Thanks to Sarbanes-Oxley, the services with the clearest potential for conflict of interest have been outlawed. And though there remains potential for tension within the firm if one practice is growing faster than another, Deloitte purposefully no longer calculates the individual profitability of its audits or consulting in an attempt to foster team spirit.
It's not easy to know for certain how well any of the firms' systems are working. The Public Company Accounting Oversight Board (PCAOB), created by the Sarbanes-Oxley Act to monitor audit quality, does check whether auditors are providing any of the explicitly prohibited services. But the PCAOB does not publicly disclose their findings. At Deloitte, small issues may have been raised, Salzberg says, but the firm, he asserts, has yet to lose a single client over an independence issue.