The Fires That Won't Go Out The Big Four accounting firms have been fighting off one public-relations crisis after another. There's a good reason: They keep starting them.
By Janice Revell Reporter Associate Doris Burke

(FORTUNE Magazine) – The timing could hardly have been worse. PricewaterhouseCoopers, the nation's largest accounting firm, had just finished rolling out a series of full-page newspaper advertisements--bearing catchy titles like PRINCIPLES HAVE NO LOOPHOLES and INTEGRITY IS STILL A PERSONAL RESPONSIBILITY--aimed at restoring the firm's battered public image. But instead of basking in the warm afterglow of its multimillion-dollar marketing campaign, PwC became the subject of bruising headlines like SEC PUNISHES PRICEWATERHOUSE PARTNER and PENSION FUND TARGETS AUDITOR. During one week in August, the SEC barred two PwC partners (one had already left the firm) who had overseen the audits of scandal-plagued MicroStrategy and Tyco International from auditing the financial statements of publicly traded companies. Not exactly a great chance for PwC's marketing staff to "stay on message."

While PwC may be the current poster child for bad behavior in the accounting industry, its three other rivals in the Big Four--KPMG, Ernst & Young, and Deloitte & Touche--continue to be dogged by a seemingly unending string of controversies. To recap the latest news: A former E&Y audit partner has been arrested on federal obstruction of justice charges that allege he destroyed documents related to the audit of a now-defunct consumer loan company. The SEC is going after KPMG and four of its partners for failing to detect a $3 billion accounting fraud at Xerox. Deloitte & Touche, meanwhile, is being sued by former audit client Adelphia Communications, which has alleged that the accounting firm failed to notice that the company's founders were looting billions of dollars. Were that not embarrassing enough, three of the acronymic auditors (PwC, KPMG, and E&Y) have been accused of fraudulently overbilling clients by hundreds of millions of dollars for travel-related expenses. (In each of these cases, the firms and individuals charged deny any wrongdoing.) And two of the Big Four now face a virtual tsunami of litigation from wealthy clients--many of whom were top executives of audit clients--who bought into complex, and possibly unlawful, tax shelters.

Hold on a second: Wasn't this supposed to be the Awakening for the nation's leading audit firms, a time when a sobered-up industry welcomed back the gospel of honest number crunching? The collapse of Enron and the stunningly quick demise of its auditor, Arthur Andersen (a member of what was once the Big Five) ushered in a new era of accountability for accountants. It wasn't just PR, of course; it was law. The Sarbanes-Oxley Act mandated tough new accounting and corporate governance standards for executives, boards, and auditors. And everybody, from CEOs to newly minted CPAs, got the message. Or so it seemed.

True, only a year has passed since the passage of Sarbanes-Oxley--not much time for an industry to reinvent itself. And to be sure, some of the cases now making news are actually pre-Enron in origin. But neither of those excuses is enough to explain why the Big Four--which together audit a staggering 78% of the nation's 15,000 publicly traded companies--continue to careen from one humiliating headline to the next. The ultimate reason, say many observers, is quite simple: They haven't gotten the message. "Has the world totally changed in accounting? The short answer is no," says Ashish Nanda, a Harvard Business School professor who has written extensively about the accounting industry.

What hasn't changed, for starters, is the omnipresent potential for conflicts of interest among auditors--this, as you'll recall, was supposed to be the root of all evil when it came to accounting scandals. That's not to say that this cause-and-effect relationship was always so apparent. For much of the 1980s and 1990s, in fact, the major accounting firms were performing audits alongside non-audit services, such as consulting on information technology, tax planning, and human-resources issues, and few people batted an eye. But then the balance shifted. To lure in that extremely lucrative consulting work, the newly labeled "professional services" firms began low-balling the prices on their old-fashioned audits (even to the point of taking a loss, say some experts). That inevitably led to cutting corners, says Thomas Weirich, a Central Michigan University accounting professor who autopsied dozens of audit failures for the Public Oversight Board, which until recently was the accounting industry's regulator. Investigative techniques like checking all manual overrides to a company's computerized accounting system--which are classic red flags for fraud--fell by the wayside.

Audit partners, meanwhile, were soon receiving bonuses for securing this extra work for the firm. Suddenly, bean-counting CPAs were making real money. "The huge jump in compensation was one of the problems," says Charles Bowsher, a former Andersen partner, U.S. Comptroller General, and head of the Public Oversight Board. By 1999, when nearly half of the Big Five's revenues came from consulting fees, the extent of that problem became clear. Critics, led by former SEC chairman Arthur Levitt, argued that auditors were shrinking away from making tough calls on their client's aggressive accounting practices for fear of losing the higher-margin consulting business. The scandals at Waste Management and Rite Aid gave the first whiff of a dangerous conflict of interest. And then came Enron, when whiff turned to stench.

Sarbanes-Oxley was supposed to fix that, banning auditors outright from providing a number of services to their audit clients, including internal audit work and investment-banking advice. But did it? The large accounting firms can and do still offer consulting services for their audit clients on everything from tax planning to litigation support to executive-compensation practices. "The common misconception is that they don't do any consulting anymore," says Jonathan Hamilton, editor of Public Accounting Report. "That's not true. They've just called it other things."

The mother lode of these "other" fees comes from tax consulting, which observers estimate accounts for anywhere between 30% and 40% of the Big Four's overall revenue in the United States--much of that from audit clients. For instance, in 2002, General Electric paid auditor KPMG $21.2 million for tax services alone; Caterpillar shelled out $17.4 million to PwC. (Even tax preparer H&R Block paid auditor PwC some $600,000 for tax advice!) Those tax and consulting fees can easily outstrip the revenues the firms bring in from the audits of financial statements. Amazingly, E&Y brought in $5.8 million in 2000 for tax-shelter advice to just two top executives of audit client Sprint--more than it got for verifying the financial statements of the entire company. (E&Y says it has since disbanded the group that came up with high-net-worth tax services.) And the firm reportedly got some $4 million from scandal-battered health-care provider HealthSouth for doing "pristine audits"--which involved such grave tasks as looking for toilet-seat stains in the company's health-care facilities, inspecting the liners on trash cans, and making sure magazines were in order in the waiting rooms. Again, that was considerably more than E&Y received for auditing the company's financial statements.

But instead of worrying that consulting services might compromise the objectivity of their financial sleuths, the major accounting firms argue that nonaudit services actually make them better auditors. "I think in order to perform a high-quality audit you need to have a set of skills that mirrors the complexity of the business enterprise you're trying to audit," says James Quigley, CEO of Deloitte's U.S. operations and the only chief executive among the Big Four firms who agreed to be interviewed for this story.

Levitt sees it differently. "I think that any kind of consulting in this environment makes the audit look at least in question," he says. That was also the conclusion reached by the respected former Federal Reserve chairman, Paul Volcker, who in 2002 was brought in by Andersen to help restore its shattered image and stay afloat. Volcker's simple solution? Provide audit clients with audit services and practically nothing else.

Andersen never got the chance to try this pared-down business model; the Justice Department essentially put it out of business first. The question is, Could the remaining big firms even make money following Volcker's suggestion, going back to the old-fangled business of scouring corporate ledgers? "In today's world, the answer is yes," says Harvard's Nanda. "The commoditization of auditing has totally stopped." The low-balling is gone. Sarbanes-Oxley gives audit committees, not company managers, the responsibility of hiring auditors.

And in this post-Enron environment, nervous corporate directors are willing to pay whatever it takes to ensure that financial audits are as comprehensive as they should be. Hamilton of the Public Accounting Report estimates that audit fees will rise by 50% this year alone. While much of the increase is due to additional testing required by Sarbanes-Oxley, industry experts say the margins have also greatly improved. Ron Mano, a CPA and accounting professor at Weber State University in Utah, is not surprised. "The accounting profession has been crying all along that we can't make money on auditing. That's nuts!" he says. "We have the single best franchise in the world: Our clients have to buy our services every year, they're the biggest companies in the world, and nobody else can offer them. How much better can it get?"

Much better, in fact. Because the accounting firms don't have to give up their tax and consulting services at all. The danger comes only when they hawk them to audit clients! You'd think the Big Four would embrace this modest self-regulation (after all, they could pick up lost business from each other). But they don't.

Nor, for that matter, are industry leaders racing to eliminate another, and potentially more dangerous, conflict of interest: that auditors stay too long--and get too close--to the companies they audit. Sarbanes-Oxley is supposed to resolve that dilemma by limiting the amount of time senior audit partners can spend on any given client engagement to five consecutive years. What's more, the newly formed Public Company Accounting Oversight Board (along with the SEC) is now charged with enforcing accounting-industry standards and will randomly inspect the work of auditors.

"If you're the audit partner and know that a PCAOB inspector might select your engagement and review the judgments you've made, don't you think that's going to influence your thinking?" asks Deloitte's Quigley, rhetorically. And even without this incentive, he adds, Deloitte's auditors have enough integrity to do the right thing.

That may be, but the recent scandal-filled headlines have made doubters of many. Even with the new regulations and oversight board, the same firm can continue to do a company's audit ad infinitum, so the pressure remains for any single audit partner not to rock the boat with a client that generates millions in fees for the firm. The most effective system of checks and balances, many experts say, is to bring a completely different firm into the audit every few years. If Arthur Andersen had known that a new auditor was going to take over on Enron, the firm might have been more aggressive in its oversight, contends John Biggs, a former chairman and chief executive of TIAA-CREF, a $262 billion pension fund that rotates its auditor every seven years. Earlier this year a special commission established by the Conference Board, including Biggs, Volcker, Levitt, and former Secretary of Commerce Peter G. Peterson, recommended that audit committees should "carefully consider rotation of audit firms" in those cases in which the outside auditor had been employed for ten years or more.

As logical as that may sound, the Big Four are once again defiant. Auditors need time, they insist, to thoroughly understand a company, its finances, even its culture. They claim that the riskiest audits are those that occur within the first year or two of the arrival of a new auditor. What they don't mention is that virtually all of the marquee accounting scandals in recent years--including Waste Management, Enron, WorldCom, Tyco, Adelphia, HealthSouth, and Xerox--happened on the watch of auditors who had been on the job for at least a decade. In the case of HealthSouth, for instance, the SEC charged that former executives had used their intimate knowledge of the procedures done by longtime auditor Ernst & Young to perpetrate their $2.5 billion fraud.

Certainly, the major accounting firms didn't seem too concerned about their status as "new auditors" when they were feasting on the remains of the Andersen carcass. "I'm sure that not one of them went into an audit committee meeting and said, 'Don't consider us because we don't know anything about the company,'" scoffs ex-regulator Bowsher. In fact, it took PwC only a few weeks to raise questions about the books of mortgage giant and former Andersen client Freddie Mac--arguably one of the most financially complex companies in the world--that eventually resulted in the restatement of three years' worth of earnings.

Surely that's evidence that when the Big Four put their minds to it, they can do bang-up audits. Now it's time to see if they're truly serious about doing them. Most agree that writing more laws restricting auditing firms isn't the answer. "We've had a pretty strong dose of regulation with Sarbanes-Oxley," says Levitt. "I'd prefer to take the risk with a strengthened audit committee."

But ultimately the auditing firms have to step up and end these conflicts of interest on their own. "You've seen full-page ads taken about how we're going to do more quality work and be more independent," says Bowsher. "But you haven't seen any CEO of one of the Big Four firms come out and take a leadership position."