Investors used to view a company's appointment of new auditors with suspicion. Did it signal a disagreement between management and the old accountants that could cast doubt on the integrity of the financial statements? Companies never admitted as much, but investors learned to be skeptical; to some, a change in auditor sent a clear signal: sell.

The Sarbanes-Oxley Act is erasing that stigma. That's partially because new Securities and Exchange Commission rules have required companies to be more careful about the types of projects assigned to their auditors, in some cases forcing them to make changes to leverage their accounting firms. In Jan. 2003, the Securities and Exchange Commission adopted rules promulgated by Section 201 of SOX that listed nine non-audit services that, if provided by the accounting firm, would impair the firm's independence (see box at right).

In addition, SOX 201 requires that certain partners on the audit engagement team rotate after no more than five or seven consecutive years. This also has forced companies to make changes.

But perhaps the greatest change agent has been the internal control provisions of Section 404. The additional time and manpower needed to complete audits—and the increasingly risk-averse outlook of the Big 4—has caused many smaller companies to be dropped or overlooked by their auditors. The Big Four accounting firms, who audit more than 90 percent of all SEC registered companies, simply haven't been able to handle the increased workload.

Dennis

"The big firms had a lot heaped on them by the 404 process; their SEC practice has effectively doubled overnight," says Leroy Dennis, executive vice president of audit and assurance services at RSM McGladrey. "We are hearing comments from middle market and smaller companies that the service levels they had experienced in the past were not there."

As Compliance Week has covered in the past (see Related Coverage in box above, right), this dynamic has prompted smaller companies to look beyond the Big 4.

TOP TEN

Largest Accounting Firms

"The Big 4"

Revenue

Deloitte & Touche

$6.9 billion

Ernst & Young

$5.5 billion

PricewaterhouseCoopers

$5.2 billion

KPMG

$4.1 billion

Subtotal

$21.7 billion

"The Second 6"

Revenue

RSM McGladrey

$1.0 billion

Grant Thornton

$634 million

CBiz/Mayer Hoffman McCann

$373 million

BDO Seidman

$365 million

Crowe Group

$286 million

BKD

$230 million

Subtotal

$2.9 billion

Source: H&R Block. Revenue data from Accounting Today “2005 Top 100 Firms” and H&R Block analysis. RSM McGladrey revenue includes revenues of RSM McGladrey, American Express Tax & Business Services, and McGladrey & Pullen.

The "Second 6" tier of accounting firms (see box at right) in particular have benefited from the overflow work.

BDO Seidman, for example, has added a net 35 public company audit clients in 2005 through the end of September. That includes 65 new clients and 30 "outplaced" clients (i.e. from which BDO resigned or was dismissed), says Leland Graul, national director of the firm's SEC practice.

According to Graul, BDO grabbed a net 39 public companies for the whole of 2004; those figures count only the primary audit, not benefit plans and other work.

Hercules Inc., a $2 billion chemical manufacturer based in Wilmington, Del., caused a stir in April when it appointed BDO Seidman to replace PricewaterhouseCoopers. That severed a 75-year relationship with PwC and its predecessors dating from Hercules' earliest days as a public company.

Aanonsen

Fred Aanonsen, vice president and controller at Hercules, says the initial Section 404 review contributed to the audit committee's decision to bid out the work. "Things that had not in the past been documented in our control environment were all documented," he explains, "What better time to go and take a look at our audit?"

Hercules invited proposals from the Big Four, plus BDO and Grant Thornton. It gave the firms access to a data room and offered interviews with senior officers. Management, the chairman of Hercules' audit committee and its non-executive board chairman attended oral presentations, as well. Aanonsen believes audit committee involvement is critical, because its members make the final decision. "We asked the firms to look at our footprint, where we are located, and then where they are located. With BDO that lined up very well," he says, "BDO did a very good job of demonstrating both to the audit committee and management that they had the ability to handle this account."

The transition has gone smoothly, according to Aanonsen. "Having the SOX documentation in place has helped a lot," he says. "They don't have to ask us a lot of questions because we gave them access to that material."

Safety Not An Option

Ueltschy

In Hercules, BDO snared a company much larger than its typical client, an experience shared by other second tier accounting firms. Rick Ueltschy, an executive at Crowe Chizek and Co., notes that his firm's newest public company clients tend to exceed the average size of its existing clients. He sees many private companies migrating to smaller audit firms, too. "We are now doing work for several private equity groups that not too long ago would have only considered using the Big Four," he says.

These episodes run counter to the findings of a SOX-mandated study of audit-firm consolidation, published by the U.S. General Accounting Office in July 2003 (see box below, left). The study found that smaller accounting firms faced "significant barriers to entry" into the large public company audit market, but many billion-dollar companies are clearly migrating to the "Second 6" tier of firms.

In time, that could erode the Big Four's stranglehold on large company audits, and audits of companies that go public. Ueltschy believes self-interest drives a clear preference among underwriters for a Big Four name. "If the IPO blows up, they have the biggest possible ally," he says. "It's like it used to be with computer equipment: if you bought IBM you had done the safe thing."

STUDY

GOA Analysis Still Relevant?

The increase in audit work for the "Second 6" tier of accounting firms runs counter to the conclusions of a July 2003 GAO study. The analysis, officially called "Public Accounting Firms: Mandated Study on Consolidation and

Competition," found that "smaller accounting firms faced significant barriers to entry—including lack of staff, industry and technical expertise, capital

formation, global reach, and reputation—into the large public company audit market." An excerpt from the study is below:

...Finally, we found that smaller accounting firms faced significant barriers to

entry into the audit market for large national and multinational public

companies. First, smaller firms generally lack the staff, technical expertise,

and global reach to audit large and complex national and multinational

public companies. In this regard, the large public companies that

responded to our survey to date indicated that smaller firms lacked the

requisite capacity to audit their operations. For example, based on the

average number of partners and nonpartner professional staff

internationally, the Big 4 had almost three times as many partners and over

five times as many nonpartner professional staff as the average for the next

three largest firms. We also employed the previously cited economic model

by simulating mergers among smaller firms in order to assess whether, in a

purely price-competitive environment, such mergers could lead to viable

competitors to the Big 4 for large national and multinational clients. We

found that, in general, any new firm resulting from such mergers would still

lack the resources necessary to compete, to any significant degree, with the

Big 4 for larger clients. Second, capital market participants are familiar

with the Big 4 and are hesitant to recommend that companies use firms

with whom they are not familiar. Third, many of the eight largest firms

below the Big 4 with whom we spoke said that litigation risks and

insurance costs associated with auditing a large public company made

growth into the large public company market less attractive than other

growth opportunities. Fourth, raising the amount of capital to build the

infrastructure necessary to audit large multinational companies is difficult,

in part because the partnership structure of accounting firms limits these

firms’ ability to raise outside capital. Finally, certain state laws make it

difficult for firms to expand nationally. For example, firms face the burden

and additional expense of obtaining state licenses for staff across the

country. As a result of these barriers, we observe that market forces are not

likely to result in the expansion of the current Big 4. However, it is unclear

what, if anything, can be done to address these issues.

Source

Public Accounting Firms: Mandated Study on Consolidation and Competition (GAO, Jul. 2003)

Related Coverage

Q&A With Grant Thornton CEO Edward Nusbaum, Conducted Shortly After Above GAO Study Was Published (Aug. 2003)

But safety isn't always an option for middle market companies looking for an auditor today, largely because the Big 4 firms may not want the business. Astec Industries, a $504.6 million construction equipment manufacturer in Chattanooga, Tenn., found that out the hard way. In September 2004, Ernst & Young resigned as Astec's auditor. "With Sarbanes-Oxley and other factors, the market got so tight for accounting people that Ernst & Young had to start making choices," says David Silvious, Astec's corporate controller, "They had to determine who they wanted to continue on as clients—we didn't make that cut."

The decision left the company scrambling. E&Y had audited Astec for years from its local office; it is the only Big Four firm to maintain a presence in Chattanooga. "We hated to lose the relationship and all the knowledge they had gathered over the years," says Silvious. "They had some folks that were long term players who had developed a significant amount of knowledge about our company."

Astec invited proposals from several firms, including two Big 4 firms. One fell at the first hurdle—it did not respond in time. The other came close, but in the end Grant Thornton won the business. "When GT came in, we got a good feeling about them immediately," Silvious recalls. "They seemed very professional and they guaranteed they would have the staff to do the job. That was huge for us because we were in a crunch." GT's knowledge of manufacturing was helpful as well. "Inventory is our largest asset and if you don't understand cost accounting the rest of it doesn't matter," says Silvious.

Under intense time pressure, the transition went as well as the circumstances permitted. GT took over the Sarbanes-Oxley review of internal controls as well as the audit. Astec had already started its SOX 404 review under E&Y's auspices, but, as Silvious points out, every audit firm looks at Sarbanes-Oxley a little differently. "We weren't using the format and approach GT would normally use, but they adapted to what we had already done so we wouldn't have to reinvent the wheel on our end," he says. For 2005, Astec is revamping its procedures to conform to GT's practice.

The pressures that led to Hercules' choice and Astec's predicament will only worsen if the SEC extends the reach of Section 404 to smaller companies. (In September, the Commission extended the compliance date for non-accelerated filers for another 12 months; those companies would begin to be required to comply with the Section 404 requirements for its first fiscal year ending on or after July 15, 2007). Yet even if smaller audit firms continue to gain market share, the Big 4 will likely not become a Big 5 or Big 8 through organic growth; the gulf between KPMG, the smallest Big Four firm, and the rest is too vast (see box above, right, for financial data).

In addition, a hypothetical combination of the smallest firms may not represent a credible alternative anyway. "I don't think just adding the firms together does it," says Dennis at RSM McGladrey. "You haven't necessarily added people who can serve Fortune 100 companies."

Graul

Although companies the size of Astec or Hercules have no shortage of choices for their auditors, it's a different story for the largest of multinational corporations. "The number of people who have to be there just to do the inventory observation for GM far exceeds our capacity ever to serve them," BDO's Graul says, "We just couldn't do it; we'd have to shut down everybody else."

RSM McGladrey's Leroy Dennis echoes that sentiment. "If GM came to us and said we're not happy with our auditors we'd say we're not the right firm," he says.

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