|By Tessoni, Daniel|
Nearly one decade ago, most of the large accounting firms divested their advisory services business. The divestitures were motivated not only by business and management reasons, but by regulatory pressures as well. In particular, regulators were concerned that audit quality could suffer if advisory services threatened auditor independence. As a result of the divestitures and the adoption of the Sarbanes-Oxley Act of 2002 (SOX), advisory services revenue represented only a small share of accounting firms' revenues circa 2007. In recent years, however, advisory services revenue has risen again, renewing concerns of its potential effects on audit quality. But auditor independence is no longer viewed as the primary threat to audit quality; instead, concerns revolve around the audit firm's culture and the quality of the resources allocated to advisory versus assurance services. The following is an examination of the rise and fall - and rise again - of advisory services within public accounting firms.
Advisory services revenue grew rapidly at public accounting firms during the late 1990s; yet, by the early 2000s, all but one of the then-Big Five had spun off or sold these business lines. Three factors drove these divestitures: 1) internal management tensions because ci the fester revenue growth and perceived higher margins of advisory services as compared to assurance services; 2) the opportunity to unlock higher values and raise capital through sales to publicly traded corporations or via an initial public offering (IPO); and 3) the pressure applied, and regulations adopted, by policymakers aimed at ensuring auditor independence.
Beginning in the early 2000s, advisory services revenue shrank due to divestitures and the adoption of SOX. At the same time, assurance services revenue soared as SOX fueled rapid increases in the demand for assurance services from clients. As a result, advisory services played a diminished role in accounting firms beginning in the early 2000s to about 2007. Since 2007, however, advisory services have represented a rising share of revenue for accounting firms, triggering renewed concerns.
Over the years, observers have raised management and policy concerns about the role that advisory services play in the accounting industry.
Recently, however, advisory sendees have again become important to accounting firms. These firms have found ways to sell advisory services to clients for which they are not the primary auditor. This rebirth of advisory services has generated renewed policy and management concerns. A Treasury report (Final Report of the
The fact that the Big Four are delivering value for their advisory services clients is indisputable. The markets clearly recognize their prowess as consultants. In an
Prior Round of Divestitures
Around 2000, all of the then-Big Five, with the exception of Deloitte, divested their advisory services practices. The divestitures were driven by one or more of the factors described earlier: management tension, opportunity for unlocking value, and pressure from regulators. Each of the Big Five's experiences is described below.
Arthur Andersen. Management tension caused the breakup at Andersen Worldwide, foe parent company of Arthur Andersen (AA), and
PricewaterhouseCoopers. A similar story unfolded at PricewaterhouseCoopers (PwQ, where the primary reason for the divestiture appeared to be pressure from the
Deloitte. The sole member of the Big Five not to "successfully" divest its advisory practice was Deloitte. Deloitte' s attempt to divest through a managementled buyout fell through in
The Big Four accounting firms have reentered the advisory services market by targeting non-audit clients. In addition, they are able to offer nonprohibited advisory sendees to audit clients with advanced audit committee approval under SOX section 201(a). The current barrier to entry now appears to be lower for accounting firms. The significant brand recognition and recruiting strength of the Big Four provide them access to large clients and qualified advisory services candidates. As the growth in advisory services accelerates, will regulatory pressure force the public accounting firms to replay the divestitures of the early 2000s?
At the present time, the advisory business is thriving among the Big Four, with revenues exceeding
The Increasing Role of Advisory
Services in Recent Years: Understanding the Trend
The authors' analysis shows mat advisory services revenue has grown since 2007, both in absolute terms and also as a share of total revenue for public accounting firms. The data are compiled from surveys published by Accounting Today in its annual 'Top 100 Accounting Firms" from 1996 to 2010. The survey instrument requests firms to provide data on their net U.S. revenues and their fee split as a percentage of total revenue. Total revenues (U.S. public and private clients) are disaggregated into three components: assurance, tax, and the remainder as advisory. Starting with the 2002 'Top 100 Accounting Firms," a fourth revenue component, "other," was added, including elements such as financial planning, litigation support and valuation work, payroll, and benefit plan administration. To provide consistency over time, advisory services are defined as "other" and "management advisory services."
Exhibit 1 shows the changes in advisory services revenue for the Big Four from 1996 to 2010. During the late 1990s and early 2000s, advisory services revenue increased rapidly for all of mese firms. Advisory services revenue men dropped significantly for three of the Big Four, due to the aforementioned divestitures. And even in the case of Deloitte, which did not divest, revenue declined beginning in 2001. From 2005 onwards, advisory services revenue began to increase again for most of these firms. In 2010, advisory services revenue, as a percentage of total revenue, accounted for a significant share of Big Four revenues: 19% for PwC, 26% for E&Y, 28% for
In the early 2000s, the assurance business took center stage while the advisory business declined. As discussed earlier, most of the Big Four divested their advisory businesses and SOX increased demand for audit services. From 2003 to 2005, in spite of the drop in advisory services revenue, increases in assurance services revenue more man made up the difference, resulting in overall revenue increases for all of the firms. Assurance services revenue increases were driven by increases in liability risks for auditors and clients alike, as well as increases in engagement hours. With the passage of SOX and the implementation of SOX section 404, assurance revenues soared. Due to SOX section 404 compliance, audit fees nearly doubled from 2003 to 2004, and remained high in 2005, according to several studies (e.g., a
From 2006 to 2007, several factors-including a backlash from clients over high engagement fees - impacted assurance revenues of the Big Four (Freeman, "Who's Going to Fund the Next Steve Jobs?"
During this same 2006-2007 period, most of the non-compete agreements on advisory services expired. Thus, as assurance revenues started to stagnate or decline, audit firms had a strong motivation to make up those revenues through other business lines; thus, managers recultivated advisory services. Deloitte's success in maintaining and growing its advisory services, even with the strong regulatory constraints in place, provided a blueprint for the other firms to resuscitate their advisory services. The years following 2007 clearly indicate mat advisory services are on the rise.
Since 2008, advisory sendees revenues have continued to grow for the Big Four, while assurance services revenues have stagnated. Based on this rapid growth, it seems clear mat firms are focusing their growth strategy on advisory services. For example, advisory services revenue for PwC grew as a share of total revenue from 14% to 19% between 2008 and 2010, and Deloitte's advisory services grew from 34% to 45%.
The 1996-2010 timeframe can be divided into four periods. The first period, in the late 1990s, was one of rapid growth in advisory services. The second period, 2000-2005, was characterized by divestitures in advisory services coupled with a post-SOX boom in auditing services. The third period, 2006-2007, saw stagnation in audit revenues and an opportunity to reconsider advisory services. The final period, since 2007, has seen a full-blown rebirth of advisory services.
Exhibit 2 takes a big picture look at revenue components of the Big Four. The three primary components of revenues for audit firms are assurance, advisory, and tax, and each has taken a different path over the 1996-2010 timeframe. Assurance services revenues were
A Closer Look at Each of the Big Four
PricewaterhouseCoopers. PwC's advisory business accounted for 40% of its revenues in 1996. PwC sold its advisory arm to IBM in
Deloitte. Deloitte is the outlier among the Big Four because it never divested its advisory services business. Its overall revenue increased more than threefold, from
Policy and Management Concerns: Framing the Debate
Policymakers were especially concerned about the outsized role advisory services were playing at the large accounting firms during the late 1990s and early 2000s. In particular, they questioned whether auditors could be independent if a large share of a firm's revenue - and an even larger share of its profits - came from its non-assurance work. Could a client use the leverage of advisory business to impair the objectivity of the audit and threaten auditor independence? Policymakers promulgated increasingly stringent regulations, culminating in SOX, which prohibited primary auditors from performing a wide range of non-assurance services.
Title II of SOX says in very clear language mat "it shall be unlawful for a registered public accounting firm (and any associated person of that firm, to the extent determined appropriate by the Commission) that performs for any issuer any audit required by this title ... to provide to mat issuer, contemporaneously with the audit, any nonaudit service," including nine prohibited advisory services activities. The justification for limiting advisory work performed by the primary auditor was to ensure that auditors were bom independent in fact and in appearance with respect to their audit clients. According to an analysis of fees paid to primary auditors in the Audit Analytics database, auditors served as both auditor and consultant to 90% of their public clients before the passage of SOX. For clients who received both auditing and advisory services, advisory services accounted for 65% of total revenue. As a result of SOX, at least until 2006, audit firms appeared to refocus their efforts on assurance services and deemphasized their advisory services. In recent years, advisory services accounted for only 10% of total revenue from clients where the auditor provides both audit and advisory services. Thus, as expected from SOX compliance, advisory revenue from audit clients is relatively low.
The criticism mat was leveled at auditors regarding independence softened after SOX was implemented. SOX was successful at enforcing audit independence at the primary auditor level, but now a new issue - audit quality - has risen. Auditors are not constrained from providing advisory services to non-audit clients, and the large firms have increased mese services. The Big Four rank among the top 10 consulting firms, reflecting their ability to successfully deliver those services (Gartner Dataquest Research Note G00200370,
As noted above, concerns about the growth in non-audit services have been expressed by others recently (Wyatt 2004, ACAP 2008, Hermanson 2009). The cochairs of the ACAP committee expressed the following concern in their statement in the beginning of the report:
The rate of growth for non-audit services, especially advisory services offered to nonaudit clients, now exceeds the rate of growth for audit services. We realize mat the allocation of investment dollars and professional talent is in many cases interchangeable, and that some auditing firms are working a delicate balance in allocating resources amongst their various practices. As Co-Chairs of this Committee, we strongly believe that the audit practice should always be the highest priority.
Hermanson, who served on the
Audit quality has clearly become the central focus of the debate. Building on Wyatt's discussion of advisory services and audit firm culture (2004), Hermanson (2009) described five negative effects of advisory services on audit firm culture. First, the culture of the firm might no longer be consistent with accounting professionalism Second, the reason for the firm's existence - audit- might become diluted by advisory work. Third, the "identity of the client" might shift from the investing public (audit realm) to company managers (advisory realm). Fourth, as evidenced in the pre-divestiture environment by Andersen and others, internal management tensions might arise. Auditors and consultants might expend considerable effort arriving at an agreement about compensation and profit sharing, based on the perception that advisory services are often a higher margin business. Such internal squabbles might take energy away from providing high-quahty auditing services. Auditors might feel pressure to cut costs on their audits in order to make their margins and profits more comparable to those of the consultants. Finally, the reward system within the firm might focus too much on revenue and profit generation, and not enough on technical ability and accounting professionalism.
The authors are concerned that audit quality might be impaired as firms refocus on advisory services. Specifically, how will this affect the focus of CPA firm employees and clients - for example, when it comes to resource allocation, will audit or advisory services gamer the larger share of the most qualified talent in the firm? As advisory services expand, it's very likely that the competition for high-quahty performers will increase. There are several reasons for believing that top accounting graduates might choose advisory over the assurance arm, including higher compensation, better opportunities for advancement, more potential clients, declining revenues in the assurance segment, and a broader range of work experience to place on a resume. Of course, even if the Big Four were not actively providing advisory services, top students might choose to work for an advisory-only firm Finally, high-quality candidates might be more likely to shy away from auditing, given the riskier audit environment and their greater individual liability exposure.
The route to a partnership and what follows differs for an advisory partner, versus an assurance partner; the legal and financial risks from SOX and the PCAOB are greater in the assurance field. Some audit firms also extract financial penalties from audit partners for errors in judgment. This could contribute to assurance personnel constantly second-guessing their work and looking over their shoulder, creating an uncomfortable work environment.
In addition, the authors question how auditors will view prospective clients: as a potential audit client, or an advisory client? If advisory services are more profitable, will auditors only become the client's primary auditor when the probability of doing advisory work is low? Reviewing ads in the popular press, the authors note that marketing ads appear to focus on the overall firm, or individually on tax and advisory services, but rarely on assurance services. It would appear that the large firms are leading with their non-assurance services in targeting potential clients. The constraints placed by the PCAOB have increased the risk profile of audit engagements and of auditors, whereas such burdens and oversight are not apparent in the advisory arena.
A Public Discussion
Advisory services have once again become a significant share of the Big Four's overall revenues. Observers of the auditing profession have expressed renewed concerns about the adverse effects this may have on audit quality. While auditor independence does not appear to be threatened, other concerns have been raised about firms' allocation of key resources, especially talent The data show very clearly that advisory services have been growing, and given that assurance revenues have remained relatively flat, the profession ought to begin a public discussion on the role of advisory services and its possible impact on audit quality. Paraphrasing E&Y CEO
The lucrative nature of advisory services has been, and likely will continue to be, a major draw for accounting firms. In the early 2000s, when the role of advisory services was last debated within the profession, prominent observers predicted that it would play a significant role at audit firms.
Wyatt (2004) discussed the cultural changes that have occurred within the large accounting firms - which might still dominate the firm culture - since the last round of advisory services growth. Since the 1960s, firms' culture started to change from an emphasis on professionals with technical skills, experience, and knowledge about diverse accounting issues to an emphasis on growing revenues, profitability, and hiring staff without accounting degrees. Success in generating high-margin advisory fees offered consultants an increasing voice in firm management that slowly started to change the culture of the firms. Specifically, Wyatt stated that pleasing the client and doing what was necessary to retain the client reached a prominence unseen prior to the rise of the successful advisory services arms. A cultural shift was occurring within the accounting firms, and the recent return of firms to advisory services may indicate that SOX did not reverse the behaviors and culture that once existed.
A change is observable in the structure of the large accounting firms' revenue streams. Clearly, advisory services are becoming a more important source of revenue for the Big Four. The authors believe that this raises legitimate concerns about the possible impact on the quality of audits performed by these firms. These concerns are unlikely to go away. It would thus be beneficial for the accounting profession to publicly recognize these concerns - and to develop a framework for addressing them.
|Copyright:||(c) 2012 New York State Society of Certified Public Accountants|