Are the Big Four Gouging?
March 1 2005 by Chief Executive
As a licensed certified public accountant and a former auditor at one of the Big Four accounting firms, David A. Smith, CEO of PSS/World Medical, thought he understood a basic axiom of auditing: The more rigorous a company’s financial controls, the less likely that an employee is cooking the books.
That’s why Smith thought that his company’s auditing costs would begin to decline in June 2004, when a major new auditing standard governing public companies was approved by the Securities and Exchange Commission. He figured the fees that PSS/ World Medical’s auditor, KPMG, charged for verifying the company’s internal controls€¦quot;work required under the Sarbanes-Oxley Act€¦quot;would be offset by the fact that the auditors wouldn’t have to do as many traditional audit tasks at the medical supply company’s 50 distribution centers.
But Smith and his fellow executives at the $1.35 billion company, based in Jacksonville, Fla., were in for a surprise. During discussions about the audit with KPMG partners in January, they learned that the firm’s auditors had spent more hours€¦quot;not fewer€¦quot;doing the traditional financial statement audit. Smith projects that PSS/World Medical’s total audit costs for fiscal 2005 will be double those of the previous year. “If you are going to attest to our internal controls, and you say we can rely on them, then shouldn’t we see a reduction in fees associated with the substantive testing?” says Smith, who once worked at Coopers & Lybrand, a precursor to PricewaterhouseCoopers. “We haven’t seen any of that. It’s a gouging.”
KPMG, like the rest of the Big Four firms, does not publicly comment on its work with individual clients.
The explosive rise of Big Four audit fees appears to be one of the many unintended consequences of Sarbanes-Oxley, one that has CEOs like Smith shaking their heads in bafflement, resignation and, in more than a few cases, outright anger. Regardless of size, geographic location and industry, public companies are facing skyrocketing accounting fees€¦quot;and management teams can do little about it. As Smith says of KPMG: “We’re going to push back on fees, but I don’t have much power to improve their performance because they know we can’t switch; it’s too much of a pain.”
Nearly three years after passage of the most far-reaching corporate governance legislation in U.S. history€¦quot;driven by accounting scandals at Enron and WorldCom€¦quot;the world’s biggest auditing firms are realizing large increases in revenue. The surge in business is being enjoyed particularly by the Big Four, which in addition to KPMG includes PricewaterhouseCoopers, Deloitte Touche and Ernst & Young. A recent survey by the Corporate Executive Board, a consulting firm, found that the Big Four raised their audit fees during 2004 by an average of between 78 percent and 134 percent.
Leaders at some of the Big Four firms say rising auditing costs are the result of market forces and that CEOs, of all people, should understand. “Fees are market-driven€¦quot;based on competition, our costs, our efforts and the cost of recruiting the best people,” says Bob Lipstein, a KPMG partner who heads the firm’s Sarbanes-Oxley Section 404 services. How would Lipstein respond to chief executives who decry the current situation? “CEOs,” he says, “have to start getting value out of the information that’s coming out of the controls work.” Another basic reality, say the auditors, is that the government forced Arthur Andersen out of business because of its role at Enron and that dramatically reduced competition in the marketplace.
The rise in audit fees is a sensitive issue for the Big Four. Two of the firms, Deloitte and Ernst & Young, declined requests to be interviewed for this article.
The Big Four’s revenues are likely to climb even faster in 2005, as the firms attest to their clients’ compliance with Section 404 of Sarbox, which requires public companies to certify to the SEC that their financial controls are sound. In a July 2004 survey of 224 public companies with average revenues of $2.5 billion, conducted by the trade association Financial Executives International (FEI), executives predicted a 40 percent increase in the total fees their companies would be charged by external auditors. Recent interviews with several CEOs and third-party experts found that many of them expect even higher rates of growth for auditing costs.
That’s because the Financial Executives survey was done prior to the July 2004 release of the final version of the Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 2, a broad, open-ended directive regarding Section 404-related audits. Among the increased responsibilities auditors face under the standard is a mandate to evaluate all financial controls designed to prevent material fraud. As public companies scramble to include their internal controls certifications in their annual reports to the SEC, auditors are spending enormous amounts of time applying the new standard. Colleen Sayther, president and CEO of FEI, estimates that average total fee increases from 2003 to 2004 will be somewhere between 100 and 200 percent.
One issue is whether the Big Four had adequate time to prepare for all these changes. They say they didn’t, but not everyone agrees. Lynn Turner, former chief accountant at the SEC under Arthur Levitt, the agency chairman who famously battled the accounting industry in the late 1990s, says the firms had more than 18 months between the passage of Sarbanes-Oxley and the release of Standard No. 2 to prepare a new audit. “They didn’t do it,” says Turner, now managing director of the analytical research firm Glass, Lewis & Co. and chairman of the audit committee at Sun Microsystems. “Now, you have a bunch of auditors getting on-the-job internal controls training, which is asinine.”
There is a good reason why the enormous number of hours auditors spend examining internal controls is not translating into efficiencies in the financial statement audit, says Turner. In the past, he argues, auditors simply weren’t doing a good job on financial statement audits, much less looking at internal controls. Now, partners and managers at the Big Four are struggling to improve both kinds of audits and keep regulators happy. “Today, the audit firms are realizing that someone is coming in to see [their work], and the PCAOB can take away a partner’s license,” Turner says. “So they better do the basic audit right, as well as the internal control audit.”
In addition to the soaring costs, another problem public companies face is their auditors’ inability to accurately predict how many hours will be involved. Bill Zollars, CEO of Yellow Roadway, a $3 billion trucking company based in Overland Park, Kan., ran into this issue with KPMG. First, it was difficult for his management team to obtain a forecast of the hours KPMG would need to complete its 2004 audit, because the accounting firm was reluctant to make any forecast before Standard No. 2 was released. The number of hours KPMG eventually projected turned out to be too low by roughly half. “It’s hard to tell what value you’re getting for all that money spent, and it was hard to tell how much effort on their part was required,” says Zollars. “Nobody likes surprises. And I think a lot of companies are surprised at how much it costs.” KPMG declined to comment on its work for Yellow Trucking.
The amount of money that companies are spending to comply with Section 404, in particular, is eye-popping. Yellow Roadway, for example, has spent about $7 million in audit and related consulting fees to meet the new requirements, and approximately double that amount on internal expenses related to Section 404 compliance. On average, public companies spent more than $3.1 million last year on 404 compliance, according to Financial Executives International. That figure was driven up by the fact that companies with revenues of $5 billion or more spent $8 million on average. (See chart, page 22.) To be sure, says Zollars, “it’s not all the accounting firms’ fault. The law has been a lot more invasive than it was probably intended to be.”
How did it reach this point? Recent shocks to the accounting industry have prompted the firms to try to squeeze fees out of lucrative clients while jettisoning risky and nonprofitable ones. First, Andersen’s demise in 2002 threw thousands of public companies onto the auditing market, stretching the auditing staffs of the Big Four perilously thin and driving up hourly rates. Then, the passage of Sarbanes-Oxley barred accounting firms from providing most consulting services to their audit clients, eliminating a big revenue stream for the firms and placing a premium on audit fees. Now looms the specter of the PCAOB, which conducts annual inspections of all the major accounting firms and wields unprecedented power to discipline them.
After the results of the first PCAOB inspections of the Big Four were made public last August, the scope of audit work related to internal controls skyrocketed, according to Sayther of Financial Executives International. “The inspection reports were not that flattering,” she says, “and when the Big Four realized they were going to be second-guessed every step of the way, the scope of the work basically quadrupled.”
Some CEOs believe the power of the oversight board, together with the risks of doing a bad audit€¦quot;embodied by the implosion of Andersen€¦quot;has forced the Big Four into a highly expensive conservativeness. “One of the few firms was put out of business, so they’re running scared,” says Donald Nigbor, chairman of the board of Benchmark Electronics, a $1.8 billion manufacturer in Angleton, Tex.
Audit Fees: Art or Science?
What’s especially maddening about audit fees for many companies is that the accounting firms sometimes seem to employ as much art as science in setting their fees. Projected annual fees depend on the complexity of a company’s accounting and are rarely fixed, meaning that if auditors spot a weakness or an extra process to check, they go ahead and do it and bill for it later.
Jeff Rodek, chairman of the Santa Clara, Calif., software maker Hyperion, likens the effort to comply with Section 404 to “running the high hurdles in the dark.” Steep audit fees, he says, is one of those hurdles. “We expected fees to go up,” Rodek says, “but the initial request was more than we expected. You have higher fees, less choice and switching auditors implies that something is wrong.” Rodek believes that his company’s audit fees will be 50 percent higher than they were last year.
According to several CEOs, the Big Four are factoring the risk of a wayward audit into their fees. Al Fasola, chairman of RCN, a Princeton, N.J.-based telecommunications company that recently parted ways with PricewaterhouseCoopers to go to a second-tier firm, estimated that what the Big Four calls “practice protection,” or insurance and legal costs, comes to about $250,000 per partner. That’s a substantial percentage of the annual revenues that the average partner brings in.
In fairness, pricing for risk has long been part of the audit. The $25 million in audit fees that Enron paid Arthur Andersen in 2000 was the second highest among public companies that year, even more than the $23.9 million that General Electric paid KPMG. “On the face of it, there was no way that you could say Enron should cost more to audit than GE, which had something like 45 major subsidiaries,” says Mark Cheffers, a former PwC auditor who runs AccountingMalpractice.com, a Web site that advises auditors on litigation risk. “The fact is that Andersen knew Enron was a risk and charged accordingly.” Former SEC Chairman Arthur Levitt believes it’s only fair for risk to be a key pricing factor. “The CEOs are grousing,” Levitt says, “but we’re asking auditors to do a lot more than they used to. Before, internal controls were an afterthought. Now, they are front and center.”
While the Accounting Oversight Board plays a direct watchdog role over the Big Four, other regulators are also keeping a close eye. New York Stock Exchange CEO John Thain, speaking at Chief Executive’s CEO summit in Palm Beach, Fla., in December, noted the lack of choice for large public companies when it came to purchasing audit services. “Part of the reason that accounting firms have had carte blanche,” Thain said, “is that there are basically only four of them, and they’re employed by every single company that has to do this. And they simply have the ability to charge high amounts.”
The SEC’s chief accountant, Don Nicolaisen, said at an accounting conference in late January in New York that he was hearing complaints from companies accusing their auditors of performing time-consuming, duplicative tasks. Nicolaisen went on to wonder aloud about whether Auditing Standard No. 2 was being implemented in a manner “more costly than it needs to be.”
Maurice Taylor, CEO of Titan International, certainly thinks so. Taylor says of the PricewaterhouseCoopers auditors assigned to the Quincy, Ill.-based manufacturer: “These aren’t auditors, these are kids. They are trying to read the law, but they don’t know what they’re doing.”
PricewaterhouseCoopers Vice Chairman John O’Connor defends his firm’s ability to audit internal controls. “I think next year you’ll see more of an integrated audit,” O’Connor says. “It was hard to do it this year when Standard No. 2 came out so late, and there was not a lot of interpretive guidance.”
Despite the prestige of a Big Four audit, no firms have a stranglehold on the auditing business at the largest U.S. companies. Partly because of the Big Four’s tarnished reputation in light of the accounting scandals, a national or even a regional firm is now a viable option for many companies. In fact, second- and third-tier accounting firms are seeing significant increases in business. According to the research firm Audit Analytics, in two-thirds of the cases in which a Big Four firm and its client parted ways between from January through August 2004, it was the client that broke off the relationship.
The issue may be one of quality as well as cost. “Over the long term, our fees are probably a little less than the Big Four’s,” says Ed Nusbaum, CEO of Grant Thornton, a leading second-tier firm. “But the Big Four’s real problem isn’t that their fees are going up. It’s that their fees are going up and their service is getting worse.” RCN’s Fasola believes a company is “better off” being a high-priority client of a second-tier firm than a low-priority client of a Big Four firm.
Pricing for Risk
What’s more, for a truly global audit€¦quot;and that’s what most major companies need€¦quot;the international reach of the Big Four is a must. The bad news is that it appears fees won’t be going down anytime soon. “The rates will likely have some increases, based on our cost increases,” says O’Connor.
While the Big Four talk of becoming more efficient as they get up to speed on internal controls, some observers remain skeptical. “The Big Four love Sarbanes-Oxley,” says Ron Baker, author of Firm of the Future, a book that argues that accounting and law firms should bill not by the hour but by the value they add. Baker suggests that the public auditing franchise be taken away from CPAs to trigger greater competition and, in turn, lower prices.
But for the foreseeable future, that isn’t going to happen. The PCAOB, which sets audit standards in the United States, and the International Auditing and Assurance Standards Board, which sets standards for the rest of the world, appear committed to maintaining exacting audit standards, meaning upward pressure on fees.
From the point of view of overall public policy, the question is whether the cost and time involved in complying with ever-tightening standards is making boards more conservative and risk-averse, and therefore acting as a constraint on the ability of chief executives to take risks and increase sales. A majority of CEOs probably believe that the answer to that question is, “Of course.” But unless they can communicate that message to Washington, without sounding like cry babies, there’s little on the horizon but even more auditor hours, higher audit fees and greater CEO frustration.
Mike Brewster is author of Unaccountable: How the Accounting Profession Forfeited a Public Trust (Wiley & Sons, 2003).
On the AuditingWars
Lynn Turner, an industry insider, offers a historical perspective.
Lynn Turner has been involved in the accounting industry for nearly 30 years. He recently served as point man for SEC Chairman Arthur Levitt’s battle to stop accounting firms from selling consulting services to their audit clients. Today, he is managing director of the analytical research firm Glass, Lewis & Co. and chairman of the audit committee at Sun Microsystems. Excerpts from an interview with Chief Executive:
On the ability of the Big Four to audit internal controls: “When I joined the profession in July of 1976, we did a lot of testing on internal controls. The belief was, if controls are working the way they should, it gives you great confidence that the numbers are good. Today, many Big Four partners have never had to audit internal controls. That fell out of vogue in the early 1980s.”
On the competition that drove down audit fees in the 1980s and ’90s: “When the firms were forced to go to competitive bidding in the 1970s, corporations did a fantastic job of playing one firm off another from then on. The firms had to reduce hours to lower fees, and that meant an audit that wasn’t as good.”
On the impact of Sarbanes-Oxley: “There are a number of institutions, as a result of their SOX work, that have found controls weaknesses. A lot of companies haven’t had the right controls in place, and for the first time in years, they’re being forced to invest in the finance function.”
On the value of an audit: “People need to realize this is a very important function of the capital markets. It’s worth a lot more than the 99 bucks an hour companies were paying for a long time.”