Governance: Tough questions for top firms

I bought a new mobile phone recently. Well, I say ‘bought’, but they actually gave it to me. They were, however, reluctant to allow me to leave their premises until I signed a contract agreeing to pay Orange £35 each month for all my calls and text messages for the next year. I guess you don’t make money by giving away free phones.

When you think about it, the business models for mobile phone providers and the larger accounting firms are not dissimilar.

Traditionally, accounting firms have made their money by offering relatively cheap audit services as a springboard for more lucrative non-audit services such as tax and corporate advisory work.

And it’s not difficult to see why this model has worked so well. After all, the legal and regulatory requirement for companies to be audited has existed for over 100 years. When you’ve built up a relationship and gained the trust of a company’s directors over many years, it’s not particularly difficult to convince the company that your audit firm is best placed to deliver that piece of tax-planning work – even for an accountant.

The problem now is that following the fallout from Enron, WorldCom, Tyco and so on, the business model for the larger accounting firms, and particularly the Big Four, is fundamentally flawed. In the aftermath of these corporate scandals, the reaction of regulators around the world in prohibiting the provision of certain non-audit services to audit clients was relatively swift.

On 30 July 2002 President Bush signed the Sarbanes-Oxley Act. It highlighted eight services that were deemed ‘unlawful’ if provided to a publicly held company by its auditor. They were bookkeeping; information systems design and implementation; appraisals or valuation services; actuarial services; internal audits; management and human resources services; broker/dealer and investment banking services; and last, but by no means least, legal or expert services related to audit services.

In addition, Sarbanes-Oxley required all other non-audit services, such as tax services, to be pre-approved by the company’s audit committee, and these services are now disclosed to investors in periodic reports.

Other countries across the world also reacted, with accounting bodies in Australia, New Zealand and elsewhere quick to issue similar regulations and guidance. In the UK, ICAEW guidance and the recommendations contained in reports from Derek Higgs, Sir Robert Smith and Patricia Hewitt have also discussed, if not dealt with, the issue.

It now seems, on reflection, that we needn’t have bothered going to all the trouble and expense of producing these regulations and commissioning these reports, because shareholders now increasingly act for the regulators.

They have picked up the regulators ‘stick’ and are now wielding it to demand compliance with the highest standards of corporate governance.

CalPERS, otherwise known as the California Public Employees’ Retirement System, is the third-biggest pension fund in the world. With $166bn (£91.7bn) under management, it has an ownership interest in more than 3,000 companies in its US equity investment portfolio.

On 20 April 2004 CalPERS issued a press release stating that it intended to withhold its vote for all audit committee members for approximately 2,700 companies (90% of their stock holdings) because these members agreed to allow their company’s auditor to perform non-audit services.

We are talking here about some of the biggest companies in the world.

The pension fund’s position is very clear: it believes that corporate auditors being compensated for work outside their normal audit duties raises potential conflicts of interest, and potentially questionable audits.

In its press release, CalPERS notes that its campaign to restore auditor independence is not about individual directors or performance. It is about shareowners’ ability to trust the integrity of the financial statements upon which investors rely to determine the value of a corporation.

The campaign of CalPERS is not a lone one, and many predict larger institutional shareholders and investors across the world will start making similar demands for their particular investments. And why shouldn’t they?

American Express has certainly got the message. In return for CalPERS changing its proxy vote for its audit committee members, Amex promised never to engage its auditor (currently Ernst & Young) to perform non-audit services in the future.

CalPERS argued the benefit of this was that the auditor will no longer have a conflict and shareowners will not have to question the integrity and independence of the audit. Somehow, I doubt Ernst & Young will see any ‘benefit’ in Amex’s decision. In fact it’s far more likely to be distraught.

From once being the Big Four’s ‘bread and butter’, the audit division has fast become the embarrassing uncle. You know, the one nobody really likes but turns up to every party without fail and makes all the other guests uncomfortable.

Surely the answer is to cut the audit practices adrift and get on with making some real money, free of any conflicts? This would probably have happened some time ago had audit partners not historically held such dominant numbers on Big Four boards.

It has been understandably difficult to persuade an audit partner to go their own way and lose the most profitable part of their business. When it does happen, and it will in some form, you can bet the price of your audit will increase significantly.

After all, you don’t make any money by giving away free phones.

• Travis Taylor, a founding partner of Gravitas Partners LLP, an independent specialist valuation practice based in London