Accounting: Bloodied but Rich
Just three months ago, the Big Five accounting firms seemed to be on the ropes. Arthur Andersen LLP was starting to disintegrate. Capitol Hill rang with calls to overhaul the firms and clean up their conflict-ridden practices. Corporate clients even stopped buying consulting services from their auditors for fear of the Enron taint. Making partner in a Big Five firm looked like a pretty lousy career move.
What a different picture now. Andersen is a goner. But the Final Four--PricewaterhouseCoopers, Deloitte & Touche, Ernst & Young, and KPMG--are emerging as winners. They're keeping most of their non-audit businesses, notably tax consulting, human resources management, actuarial work, and merger and acquisition advice. Best of all, the new demand for high-quality auditing services post-Enron has given a shot in the arm to the unglamorous business that the firms once claimed couldn't stand alone.
What happened? Andersen--now on trial for destroying documents from its Enron Corp. audits--has taken the fall for the profession's failures. Its collapse created a vacuum in the audit market that the survivors rushed to fill. And legislation that would have forced the firms to focus just on auditing has lost some steam, thanks to the Bush Administration's indifference and heavy lobbying from the still-influential CPAs.
The result: The firms that will emerge from the Enron shakeout won't lack for profits or opportunities. Ironically, much of their growth will come from their traditional businesses--audits and tax services--and not consulting. That's all the more appealing since Andersen's virtual disappearance. The buyers of Andersen regional offices "have grabbed up market share at 50 cents on the dollar," says Allan D. Koltin, CEO of Practice Development Institute Inc., a Chicago marketing consultant for accounting firms. The Big Five's revenues from tax and audit businesses rose 12.3% last year, while those from info-tech and other consulting fell 1.9%, according to data the firms provided to Public Accounting Report newsletter.
The firms have claimed for years that they needed consulting to grow and attract the best talent. Instead they have actually been weaning themselves from these businesses for some time. Their biggest, most controversial moneymaker during the tech boom--installing and tuning up financial information systems--has been in decline since Y2K spending dried up. That's why Ernst & Young and KPMG sold their tech consulting arms, and Andersen and Deloitte are looking for buyers. The No. 1 firm, PWC, has shed business valuation and human resources consulting and will spin off its $5.9 billion IT shop later this summer. But "we'll still have a $14 billion global business in audit, tax, and other advisory services," says Dennis M. Nally, PWC's senior U.S. partner. Even in their shrunken state, "the Big Four look to be a darned good investment over the next five years," says Koltin.
Profits, too, should be healthy--if the firms get their pricing right. In an exhaustive 2000 study of the accounting industry's economics, Yale School of Management accounting professor Rick Antle concluded that auditing is more profitable than consulting. While audits consume a great deal of partners' time, audit engagements can last years. And Enron's failure has inspired directors and shareholders to demand more from their auditors. Some board panels are even instituting quarterly meetings with their auditors, adding billable hours. "The audit side of the business is a steady, reliable cash cow," says Lynn E. Turner, director of the Center for Quality Financial Reporting at Colorado State University.
James E. Copeland Jr., CEO of Deloitte & Touche, believes that audit demand will grow rapidly in Asia, Latin America, Central Europe, and Russia. Nally says the Securities & Exchange Commission's push for more corporate disclosure will produce new measures of company and industry performance, such as indexes of customer loyalty or product quality--that will all need to be audited.
Given the doldrums in corporate technology spending, the Big Five were willing early this year to make some concessions to reformers. But only to a point: They couldn't accept proposals from Washington requiring companies to change auditors every five years or so. And they very much wanted to continue advising public audit clients on acquisitions, pension plans, and personnel management.
So far, the industry's powerful lobby--fueled by decades of hefty campaign contributions--has headed off all attempts to crimp those businesses. The House-passed accounting reform bill, backed by the GOP and President Bush, would essentially keep the current system, under which audit committees and the SEC decide whether consulting deals compromise an auditor's integrity. A rival bill backed by Senate Banking Committee Chairman Paul S. Sarbanes (D-Md.) would impose stricter limits, but it's stalled in committee until at least June. To gain the Republican votes needed to pass his bill in an election year, Sarbanes will have to ease up on the firms. Unless new laws restrict their business, the Final Four will continue to offer such fast-growing services as tax planning, deal advice, and company valuations. They hope to expand their current work checking out computer security systems.
The CPAs aren't entirely in the clear, though. A fresh wave of accounting scandals could revive Washington's zeal for reform. And almost a dozen states, led by California, are considering bills that would block CPAs from consulting in a range of areas for audit clients.
The firms also must thread their way through legal minefields. The SEC has acknowledged that it's investigating two of the Final Four. KPMG allegedly failed to catch more than $3 billion in revenue-boosting maneuvers at Xerox Corp. And the SEC says Ernst & Young compromised its independence by selling software in a joint venture with an audit client. Both firms have denied any wrongdoing. Enraged shareholders are also likely to bring more cases against auditors who failed to detect or halt financial shenanigans. "Next to asbestos manufacturing, auditing is about the worst business to be in from a liability standpoint," grouses Copeland of Deloitte & Touche.
True, the glare of the Enron spotlight hasn't done much for the image of the profession. And assimilating the Andersen partners and managing their liabilities is likely to be a challenge for the survivors. Even without sweeping legislation, "we still have a couple of years of turmoil ahead, for clients, for partners, and for the firms," says Arthur W. Bowman, editor of Bowman's Accounting Report, an industry newsletter. But don't shed any tears for the profession. When it comes to the bottom line, the Final Four accounting firms will have little to fear.
By Mike McNamee in Washington, with Joseph Weber in Chicago