TCS Daily

Shredder for Hire

By Stephen W. Stanton - February 21, 2003 12:00 AM

Auditors have taken a beating lately, with good reason. A few guardians of the investor class collaborated with crooked executives in the world's largest accounting scandals. Why would a few rogue auditors gamble so recklessly with the livelihoods of 85,000 hard-working employees? Why would a handful of unethical opportunists risk the entire accounting profession's well-earned reputation for integrity?

According to the most popular theory, these auditors had consulting on the brain. Perhaps Arthur Andersen did not confront Enron about its questionable accounting because its managers feared losing consulting contracts worth $23 million annually. If this theory is correct, we need only to separate the consultants from the auditors. Problem solved.

Then again, nothing in the accounting world is so simple. There is more to the problem than just consulting. To figure out why a good auditor would go bad, follow the money trail. What's in it for him?

A lot of money, that's what. The compensation structure of American audit firms creates perverse incentives and compromises auditor independence, regardless of any consulting contracts. The capital structure encourages shortsighted decision-making and excessive risk-taking. As a result, unethical partners can reap windfalls by cutting corners and pushing the envelope.

It is a testament to the profession that there have been so few audit failures in spite of such powerful temptations. Each of the Big Four partnerships has more than a thousand partners. It only takes a few to cause big problems. Yet for generations, CPA's have demonstrated the discipline, integrity, and professionalism necessary to effectively manage the ethical challenges of public accountancy and build a laudable record of success. Enron was the exception, not the rule. Still, it is useful to examine the underlying structure of accounting firms to understand the nature of the conflicts they face.

Partnerships, Not Corporations

Accounting firms are partnerships, not corporations. That subtle difference has profound implications. Each share of a corporation receives equal preference in dividend payments, and vested stockholders cannot have their shares taken from them. However, in a partnership, successful partners are allocated a disproportionate share of profits. Conversely, partners that fail to meet the standards watch their checks get smaller. If they continue to falter, they are unceremoniously ejected from the partnership. The process is similar to the feudal system, under which the king judged how well each vassal managed his fief primarily on the amount of taxes paid to the king.

In a pre-Enron interview with CPA Journal, Stephen G. Butler, chairman of KPMG International, pointed out that audit partner reviews are "based upon the growth and profitability of the assurance services business." In other words, audit partners are not really concerned about losing consulting clients. They are, however, desperately afraid of losing their audit clients.

Mr. Butler did not mention the hierarchy of partner compensation at most firms. The largest component of a partner's income is based on profits generated by clients for which he is personally responsible. Next in importance is the profitability of the specific practice, separately rewarding audit and consulting divisions. The least significant component of a partner's compensation relates to the results of the firm as a whole.

There are two unintended consequences of this hierarchy. First, it creates an unhealthy zero-sum competition for clients within the firm. For example, even a small audit by Big Five standards represents six-figure annual fees.

That is a drop in the bucket for a multi-billion dollar practice. But it can be a windfall for an individual partner. PricewaterhouseCoopers alone has 9,400 partners, each representing a separate profit center. Often, their fiercest competitors are their own partners.

This competition also discourages partners from providing clients with the best resources a firm has to offer. When an auditor seeks input from an in-house expert on a particular issue, the lead partner must "share fees" with the specialist. He must choose between providing world-class service and receiving a world-class paycheck.

The compensation structure also creates economic dependence on individual clients, especially among the largest CPA firms. Small firms often have as many as a dozen small audit clients per partner. The loss of any particular client is not a financial disaster. In contrast, the multinational clients of the Big Four firms require several partners per audit. If such a client were to switch audit firms, responsible partners at the old firm face irrelevance and potential dismissal. To avoid such a fate, some partners are willing to placate client management and push the envelope.

Even below partner level, the compensation structure creates an ethical house of cards. Most firms maintain a considerable compensation gap between the best-paid managers and least-paid partners. When a manager makes partner, his income often makes a quantum leap of more than 50 percent. For many aspiring partners, such a large reward justifies significant risks.

Managers and partners are judged on their net fees and "recovery." Although net fees are an objective measure, recovery is easily manipulated. Every pay period, employees fill out detailed time sheets. Each hour spent on a client engagement is multiplied by the employee's full billing rate and the total amount automatically becomes an account receivable. Managers then try to collect this sum from each client.

However, many clients negotiate a fixed fee for their annual audits. As auditors put in their time, hourly billings will often exceed the fixed fee. In addition, some clients that pay by the hour balk at the $200 price tag for professionals fresh out of college. In both cases, a manager must discount the firm's standard fees to keep the client happy. However, partners frown upon large discounts from customary rates. Partners want to recover as much of the full billing rates as possible, hence the term "recovery." A 15 percent discount equates to an 85 percent recovery.

To increase recovery and get a bigger paycheck, auditors can either cut corners or play ball. They assign inexperienced personnel with low billing rates to critical duties or skip some time-consuming audit procedures altogether. Just as when a night watchman falls asleep on the job, these shortcuts will usually go undetected. If the day of reckoning ever comes, the original partners on the account may have long since retired as rich men and women. Auditors can also boost recovery on the revenue side by collaborating with aggressive clients willing to pay for the results they want to see. (Such as keeping partnerships with debt in excess of a billion dollars off balance sheet.)

At the very root of the compensation problem is the shortsightedness of the capital structure. In public companies, executives receive most of their compensation in the form of stock. They have a strong incentive to maximize the value of the firm. However, An accounting partner's equity stake is illiquid, and can only be sold at a steep discount to other partners. How steep? The divorce papers of Ernst & Young CFO Norbert Becker indicate that his capital account of $1.1 million had a fair value of $24.9 million, a sum he cannot ever hope to collect under current laws.

Partners are clearly in it for their paychecks, not capital gains. Their compensation comes out of current year cash flow. To maximize cash flow, partners are reluctant to make important capital investments. Some of these investments can greatly enhance annual audit quality, such as software implementation that would automate error-prone manual procedures. But such costly projects only make sense if amortized over several years. The hit to current year cash flow is too much for some partners to bear, and many auditors rely on outdated processes.

So to recap the compensation structure of the world's largest accounting firms:

  • Auditor salaries are based on the profitability of their client engagements, not audit quality.

  • Many supposedly independent auditors have only one client, suggesting clear economic dependence.

  • Even within a firm, audit partners compete for client fees, and the compensation system discourages use of internal specialists when thorny issues arise.

  • The economic rewards of becoming a partner provide strong incentives for managers to cut corners and manipulate recovery figures.

  • All salaries and profits are paid out of current year cash flows, encouraging short-term thinking and unhealthy risk taking.

In a nutshell, there are many incentives for a rogue auditor to certify misleading financials.

What to Do?

Legislators will no doubt want to address the inherent conflicts of Big Four compensation schemes. While there may be better ways to manage the profession's inherent conflicts of interest, they cannot be legislated away completely. In fact, the kinks in the current system are an unintended consequence of longstanding legal restrictions on CPA firm ownership.

Today's regulatory proposals may actually exacerbate the problem. For example, rotating auditors on an account annually would decrease conflicts. On the other hand, reassigned partners would lack a deep understanding of their clients' history and business models. We would be trading away expertise for independence.

There are good reasons there were so few audit failures before the late '90s bubble. First, the vast majority of auditors demonstrate impeccable integrity. It is easy to forget the proud history of the profession during a down-market witch-hunt.

In addition, most accountants take a longer view, guarding against fellow partners that would foolishly risk a firm's reputation. If an audit firm's integrity comes into question, client stakeholders will demand immediate change. If the firm resists, the clients walk. maintained an extensive Andersen Defection Directory to keep track of clients that fled shortly after its improprieties were discovered. Client investors, boards of directors, lenders, suppliers, customers, and employees all demanded new auditors.

The mainstream media did not get the whole story. They identified the problem, a lack of auditor independence. They identified only one cause, consulting. If they were right, then the problem has already been largely solved. Deloitte and PWC were the last of the Big Five to divest their major consulting units.

A quick audit of the auditors proves that there are still powerful incentives for good accountants to do bad things. Follow the money trail. Fortunately, they should keep out of trouble if we keep an eye on them. To paraphrase Jefferson, the price of capitalism is eternal vigilance.

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