Back to fhe Future: Accounting Firms Are Outgrowing the Audit Market. Again

And then there were four.

Everyone in business remembers Enron. But more people may actually remember Arthur Andersen, arguably the most powerful and well-known of the elite global accounting firms - and Enron's auditor.

As a result of the misstatements found in Enron's books and the aggressive treatment of certain transactions which AA blessed or at least to which they did not raise objections, AA received the dreaded business death penalty. They lost what is politely and somewhat obscurely called the license to operate.

Almost never invoked, but there when governments afraid of angry voters feel they need it, the 'license' is really more of a theoretical construct based on legal interpretations of various statutory and regulatory codicils that could arguably be ignored or reconsidered if anyone wanted to do so.

One upshot of all this was that Arthur Levitt, then Chairman of the US Securities and Exchange Commission decided that the accounting firms' pursuit of consulting work in addition to its traditional audit and tax advisory franchise was a - or, perhaps - the - cause of the Enron debacle, since consulting was a distraction that happened to pay a lot more and was beginning to generate far more revenue for the firms. He felt this violated what he termed 'the sanctity of the audit,' based on his devotion to the memory of his father, who had been an accountant. Anyone who had worked in the industry understood that using the word sanctity in the same breath as the word audit was leaping a figurative chasm of considerable breadth, but he was not to be denied. The firms were forced to sell their consulting businesses.

It is worth noting, as a postscript, that the value of those businesses was, shall we say, open to interpretation. Ernst & Young sold its consulting division to the French firm Cap Gemini for @$11 billion, $9 billion of which CG wrote off several years later. Levitt pursued his notions of sanctity after leaving the SEC by becoming a partner in a private equity firm.

Which brings us to the present day, where the global audit business continues to grow at what might politely be called a 'mature' rate. So, the firms, looking for more robust results are tiptoeing back into the consulting business. The world has changed and the performance of the Chinese accounting industry, among others, has reminded investors that honest audits due perform a useful function. But as the following article points out, chasing growth is what businesses do. JL

The Economist reports:

IT IS hardly news that the “Big Four” accounting firms get bigger nearly every year. But where they are growing says a lot about how they will look like in a decade, and the prospects worry some regulators and lawmakers. On September 19th Deloitte Touche Tohmatsu was the first to report revenues for its 2012 fiscal year, crowing of 8.6% growth, to $31.3 billion. Ernst & Young, PwC and KPMG will soon report their revenues (as private firms the Big Four choose not to report profits).

For all four, Asia is a bright region. Deloitte’s revenue in Asia grew by 16.3% in dollar terms, faster than anywhere else. This was despite long-running worries about dodgy audits of Chinese companies by Western firms. American and Chinese regulators have been rowing over whether America’s accounting watchdog may inspect Deloitte Shanghai’s work. The two sides recently announced that American regulators could visit and observe, but not perform their own inspections.

Yet more important, at all four firms consulting has been growing much faster than the audit business in recent years. In fiscal 2012 Deloitte increased its revenues from consulting by 13.5% and from financial advisory by 15%—compared with just 6.1% for audit and 3.9% for tax and legal services (see chart). Barry Salzberg, Deloitte’s boss, says he expects consulting to continue to grow by double digits, whereas the audit market is mature. Deloitte is adding consulting staff at twice the rate as employees for audits (at the end of May the firm had 193,000 people on its payroll).

If the two businesses continue to grow at the 2012 rate, the firm would do more consulting than auditing by 2017. Some lawmakers already fret that consulting and tax advisory (when the Big Four are explicitly helping companies make money) can be in conflict with auditing (where the firms should take a wary, outside view of the books, in the service of investors not management). Lynn Turner, a former chief accountant at America’s Securities and Exchange Commission, calls the audit firms a “public utility”, but worries that they do not see themselves that way.

In 2002 the Sarbanes-Oxley act limited what kind of non-audit services an American accounting firm can offer to an audit client. But contrary to what many people believe, it did not forbid all of them. In its last full proxy statement before being bought by JPMorgan, Bear Stearns reported paying Deloitte in 2006 not only $20.8m for audit, but $6.3m for other services. The perception that auditors and clients are hand-in-glove, fair or not, is a reason why shareholders of Bear Stearns sued Deloitte along with the defunct bank. (JPMorgan and Deloitte settled in June. Deloitte paid out $20m, denying any wrongdoing.)

The European Commission in Brussels recently proposed taking a meat-axe to the problem. A draft directive provides for the creation of audit-only firms in the European Union. But the legal-affairs committee of the European Parliament does not like the idea. With the EU’s legislative machinery slow and complex, it is impossible to predict the final outcome.

Asked what would happen if people perceived Deloitte as a consulting firm with an audit business rather than the other way round, Mr Salzberg replies: “we’re not going to take our eye off our professional responsibility with respect to either.” The future of the Big Four’s business model may depend on whether lawmakers in Europe and America are convinced that this is possible.