Burying the past: audit firms have gotten tougher--and board audit committees have, too.

When Isolagen, a Houston-based biotechnology company, recently sought to replace its external auditor with a larger, more national accounting firm, the company's board felt the process needed to be as transparent as possible. Isolagen's chairman, Frank Delape, decided the board's audit committee would take charge of hiring the auditors, as specified by new corporate governance laws.

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What ensued was a competitive bidding process that would have been unheard of at a U.S. public company just three or four years ago. Back then, management teams held a hammerlock on the audit relationship. Audit committees were expected to rubberstamp the accounting decisions of CEOs and CFOs. Now at Isolagen, the audit committee, led by its chairman, Henry Toh, took control. In addition to the time-honored practice of accounting firms paying "site visits" to prospective clients' headquarters, Toh visited the prospective accounting firms, interviewing potential audit team members. Isolagen CFO Jeffrey Tomz helped vet the finalists, but the hiring was clearly being done by the audit committee.

As partners from firms such as Grant Thornton and BDO Seidman pitched their services to Isolagen's board, Delape had a front-row seat on two emerging trends: an increased tendency among outside auditors to question management's accounting decisions and a reluctance to get involved in "strategic" discussions. "It was clear that the firms have internalized this new role of being a detective, rather than just a policeman," Delape says. "Everything is reviewed, everything is questioned--which is healthy." Before, he notes, "your auditor was like another counselor: You might go to the auditors for advice on international situations, interpretations of regulations and questions like, 'What's the best way to amortize or depreciate?' They are less likely to get involved in that now."

For CEOs, it's critical to appreciate this new landscape in corporate accounting. Companies' audit committees now serve as a wedge of sorts between management and accounting firms. "Auditors are learning they have a new boss in the audit committee," says Lynn Turner, who served as chief auditor for former Securities and Exchange Commission Chairman Arthur Levitt and now heads the University of Colorado's Center for Quality Financial Reporting.

The Sarbanes-Oxley Effect

Accounting firms have had much to learn since July 2002, when Congress redefined the regulatory landscape with the passage of the Sarbanes-Oxley Act. It was corporate accounting scandals, of course, that spurred the legislation, namely the implosion of Enron and the disclosure by WorldCom that it had overstated revenues by more than $6 billion. Arthur Andersen, then one of the so-called Big Five accounting firms, served as each company's auditor. Andersen was forced to go out of business after being convicted of obstruction of justice in the Enron scandal. The remaining Big Four--KPMG, Deloitte & Touche, PricewaterhouseCoopers and Ernst & Young--fought to put their stamp on Sarbanes-Oxley, but ultimately failed. Now they must live by the new rules.

Judging by recent headlines, one wonders whether the major accounting firms have learned their lesson. When the dairy giant Parmalat was forced to declare bankruptcy in December, it became apparent that its outside accountants, the Italian branches of Grant Thornton and Deloitte & Touche, had engaged in see-no-evil audits of the struggling conglomerate. KPMG found itself in a dispute with the Internal Revenue Service over sales of allegedly abusive tax shelters to corporations and high-wealth individuals. A PricewaterhouseCoopers audit partner was banned from the profession for life in a settlement with the SEC after being accused of issuing fraudulent audit reports of scandal-tarred Tyco International.

But, these scandals notwithstanding, there is increasing evidence that the Big Four are reforming their act. The firms have placed a premium on managing risk at the highest levels by creating new internal checks and balances. Ernst & Young, for example, has created the position of vice chairman of quality and risk management. "We decided the environment changed and we had to evaluate our processes." says Sue Frieden, who holds that title. "I don't want to say I'm everbody's conscience, because everyone here has to do that for themselves. But we needed to evaluate our risk and manage our risk from an enterprisewide standpoint--issues like how we're training our people, whether we're setting the right tone at the top."

As a sign of auditors' new watchdog role, they're often paying longer and more frequent visits with their clients' top managers. As CEO of Yellow Roadway, a $3-billion trucking company based in Overland Park, Kan., that hired KPMG as its outside auditor, Bill Zollars can attest to the trend. "The communication between the senior audit partner and our CFO was always pretty regular, but now there are a lot more meetings between the audit team and myself," he says. "I'm also meeting more with KPMG's Kansas City management team, not just the audit team."

This focus on nuts-and-bolts testing--a throwback to the audits routinely performed before the explosive growth of consulting in the 1980s and '90s--is the norm at non-Big Four firms as well. Edward Nusbaum, chairman and CEO of Grant Thornton, the fifth-largest accounting firm, says the firms' vigilance can create conflicts between auditors and CEOs. For example, how does a company accurately book revenues so they're not inflated as they were by WorldCom and Enron? To deal with such disputes, Nusbaum says, "auditors must go to management and say, 'Here is what the audit committee wants.' If management has a different opinion, auditors evaluate with the audit committee whether it can be done that way or not. Then you go back to the CEO and say, 'Here are your choices.'"

The prospect of an accounting firm marching in and presenting such stark choices to management is certainly a new phenomenon. It stems from the fact that, under the Sarbanes-Oxley Act, a chief executive must be able to explain exactly how the numbers in his or her company's financial statements are computed. "In some cases in the past, CEOs didn't even read the footnotes to the financial statements," Nusbaum says. "They focused on hitting numbers and achieving results. But now they're also thinking about the quality of the accounting they are using to get to those numbers."

As a sign of tensions under this new climate, more auditing firms are breaking off relationships with clients over accounting disagreements, and vice versa. (See chart, right.) In 2003, such disputes led auditors to drop the following sizable companies, among others, as clients: Calpine, SkyWest, Efunds and Catalina Marketing.

Auditor dismissals and resignations may become even more common this year, says Mark Cheffers, a former PricewaterhouseCoopers auditor who runs AccountingMalpractice.com, a Web site that advises auditors on litigation risk. He predicts there will be growing pressure on CFOs and CEOs to accommodate what the auditors and the audit committee want them to do. "If the auditor goes to the audit committee chair and says, 'I'm not getting cooperation from the CEO,'" Cheffers says, "the head of the committee is going to call the CEO and say, 'Why aren't we getting your cooperation?'"

By having to appeal to two constituencies at once, auditors must keep their diplomatic skills sharp. Dan DiFilippo, head of PwC's governance risk and compliance practice, says that when conflicts erupt, "we sit down with both parties for a constructive conversation. Clearly, there are cases when something is awry, and that's a conversation that doesn't involve everyone." Ultimately, he says, the auditors' first duty is to the committee.

All this detailed testing and looking over management's shoulder has prompted accounting firms to hike their fees. Audit fees climbed 27 percent in the 12 months following the passage of the Sarbanes-Oxley Act.

Although some CEOs bristle at the rising costs, not all of the reaction is negative. Jim Rotherham, CFO of Kintera, a publicly traded San Diego-based software provider that uses Ernst & Young as its auditor, says the higher rates are defensible. The accounting firm has always shown a high level of "professional skepticism," he says, "and we still get the benefit of their business suggestions, even if, due to independence reasons, they can't implement a lot of those suggestions."

Just as they control the process through which companies hire auditors, audit committees also must now review all purchases of non-audit services, such as due diligence on acquisitions. And at most companies, there are plenty of chances to consider these purchases, as the number of audit committee meetings rises. At Kintera, there are eight to 12 meetings a year. Ernst & Young's audit partner and senior manager can contact the audit committee whenever they feel the need to. In addition, there is time set aside for the committee to meet with the auditors without the presence of either the CFO or CEO.

A New Standard on Fraud

At the root of this increased vigilance is a reluctant recognition by accounting firms that their duties now include fraud detection. For years, the auditor's mantra was that the financial statement audit wasn't built to ferret out management fraud. Given the litigation risk that auditors faced in the event of audit failures, that position was understandable. But the ground has shifted under the accounting firms. Last year, the Auditing Standards Board began requiring auditors to evaluate--prior to an audit--where a management team would most likely commit fraud, then tailor their procedures accordingly.

This new fraud-detection standard, together with similar provisions in Sarbanes-Oxley, spells the beginning of the end for what has been known in the accounting industry as the "expectations gap." The term refers to the gap between what auditors have always said they do (attest to the reasonableness of companies' financial statements) and what the public, the media and regulators have always demanded they do (prevent management fraud).

While Isolagen had not decided on an auditor by press time, one thing was certain: Big Four prices were too prohibitive for a company of its size (market capitalization of $200 million). "The biggest firms are pricing for risk," Delape, the chairman, says. "When you have a company like ours, one that is transaction-oriented and involved in capital raising, they view us as more of a risk." With declining non-audit sales margins, a greater fraud-detection role and more onerous internal control auditing duties, it's easy to see why a Big Four firm would want to avoid any risk it could right now.

Auditor Turnover

Resignation rate of Global Seven accounting firms (as percentage of all
public company auditor/client switches)

1998  28%
1999  22%
2000  24%
2001  18%
2002  13%*
2003  31%

*Figures skewed because 1400+ companies fired Arthur Andersen

Source: Public Accounting Report/Audit Analytics.com

ROSE ZGODZINSKI

Mike Brewster is the author of Unaccountable: How the Accounting Profession Forfeited a Public Trust (Wiley, 2003).