As of last week, Ernst & Young is about halfway through one of the toughest punishments ever doled out by the SEC for auditor misconduct. On April 16, 2004, the Big Four accounting firm was barred from accepting new SEC audit clients for a six-month period.
The ban, which ends in late October, was related to the firm’s business relationship with $2.3 billion enterprise software company PeopleSoft.
During the years 1995 to 1999, Ernst & Young’s tax division worked with PeopleSoft to develop and market a software program to help companies manage payroll and tax-withholding issues. During the same period, E&Y audited Peoplesoft’s financial statements, and the SEC charged the firm with failing to maintain independence.
In the late 1990s, accounting firms were not require to reveal revenues from certain non-audit services, and consulting was a significant profit center for large accounting firms.
Section 202 of The Sarbanes-Oxley Act, effective since December 2003, requires proxy disclosure of fees paid for both audit and non-audit services.
At the time of the ban, Ernst spokesman Charlie Perkins stated, “While the order will prevent us from accepting new public company audits for the next six months, it will not impair our ability to continue to serve our existing public company audit clients, accept new audit work from privately held companies, or to accept non-audit from public companies we do not audit.”
Turner
But former SEC Chief Accountant Lynn Turner disagrees. “The inability to compete for new audits with the other major firms will hurt E&Y financially for some period of time,” he told The Washington Post. “However,” Turner noted, “the reputational damage is probably even greater and might well cause audit committees to wonder if they should retain E&Y for services other than the audit.”
Out Of The Running?
Compliance Week tracks auditor changes every week, so we went back through the data to glean the impact of the E&Y ban.
Since April, for example, about a dozen public companies have moved some—if not all—of their work from one of the Big Four to either Deloitte and Touche, PricewaterhouseCoopers, or KPMG.
Would these same companies have considered E&Y if the firm had not been barred from taking on new audit clients?
According to some, E&Y would indeed have been considered.
When $393.7 million Denbury Resources sought to change accountants, they did consider E&Y. The company switched from using Deloitte and Touche to PricewaterhouseCoopers on June 4.
Allen
According to Mark Allen, vice president and chief accounting officer of the independent oil and gas company, “E&Y had been asked to propose, but they had to decline due to their situation.”
Interestingly, Allen, thinks that the absence of E&Y might have streamlined the selection process. “I don’t know whether or not the outcome would have been different if they had been able to propose, as the audit committee made the selection,” he noted. “It probably made the process easier as there were fewer firms to select from.”
Meritage, a $1.5 billion single-family homebuilder, also moved from one Big Four to another during the E&Y ban. The company dropped KPMG for Deloitte and Touche on June 15.
Seay
According to Larry Seay, Meritage’s chief financial officer and vice president finance, the ban was especially troubling due to the industry expertise that E&Y has in his industry. According to Seay, E&Y audits a significant majority of the publicly traded homebuilders—perhaps 11 of the top 12. Meritage is number 15.
“Obviously, we’d have liked to have considered [Ernst],” he said. “We even considered waiting until they came out of the blackout.”
Ultimately, the company decided to move ahead with another firm. “In the end, our audit committee decided it was best not to wait,” said Seay. “Deloitte audits four of the largest home builders, which puts them in second position after E&Y, so we went with them.”
According to a Government Accountability Office study released last year, E&Y held 60.7 percent of the market for general building contractors. Deloitte had 19.4 percent.
Consolidation And Competition
According to the GAO study, titled “Public Accounting Firms: Mandated Study on Consolidation and Competition,” due to selected industry specialization, the number of auditor choices is often limited to two. In these instances, only two auditors account for over 70 percent of the total assets audited in 2002. As a result, it is hard to find auditors with expertise and staff capacity.
That’s especially true at the smaller firms, including firms like BDO Seidman, McGladrey & Pullen, and others in the “Second Six.”
“The next tier of firms below the Big Four don’t audit a lot of public companies,” notes Seay at Meritage. “We didn’t choose one of them for this reason.”
Even before the E&Y ban, the GAO stated that there is a tight oligopoly in which the top four firms accounted for over 60 percent of the market, and that other firms face high barriers to entry into the market.
The GAO also reported that in 2002 the Big Four audited over 97 percent of all public companies with sales over $250 million.
That means choices are limited.
And the options look particularly sparse if, for example, a company seeks—like Meritage—an industry expert, or desires a firm that does not have a particular competitive relationship.
That lack of competition is a concern that the GAO views as being exacerbated by E&Y’s six-month ban. “When the SEC made its decision about E&Y, they took one of the Big Four out of play, and they took them out at a time when there is a need for more auditing work than ever.”
For Ernst & Young—and for the multinational corporations that need additional options—the countdown until October continues.
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