Finding a Balance Between Levitt and Levity

Indeed, some companies have expressed concern that the SEC's rules might get in the way of a company's ability to choose the best consultant for a particular project.
"If you believe the audit firm is the best because its insight would provide the most value, you might have a situation where you won't hire them because of the independence rules," says Billie Rawot, vice president and controller of Eaton Corp., an $8 billion manufacturer also based in Cleveland.
Although the rules themselves may not forbid hiring the audit firm in this case, having information about fees paid to the audit firm for consulting work in the public domain might be enough to cause companies not to hire their audit firms for consulting work. Indeed, just the fact that this question comes up with public-company clients could weigh against audit firms' ability to win consulting engagements from their audit clients.
"I think you have to be pretty selective in how you allocate your consulting dollars to your audit firm," says Rawot. Even before these rules went into effect, Eaton Corp. faced situations where it refused to hire its audit firm for specific engagements even though certain members of the management team felt that the audit firm's consulting arm was the better choice. "It was a gray enough area that senior management, which sits on the board, said, 'No, we're not going to use them,'" she says.

How Much Impact?

Although time will tell how the SEC rules affect how companies award consulting work, so far at least, client companies seem to be falling into three distinct categories.

In the first group are those companies that forbade their audit firms to do non-audit work well before the SEC issued its new rules. For those companies, these rules promise to be business as usual.

The second category consists of companies such as CoorsTek, Inc., that will no longer consider their auditors for non-audit consulting work at all because of the SEC rules. CoorsTek, Golden, CO., is a $500 million high-tech manufacturer that was spun off from ACX Technologies, Inc., about 18 months ago and is in the process of cementing its relationship with its audit firm.    
However, thanks to the SEC rules, that audit relationship is unlikely to grow into a consulting relationship. "If we need IT systems implementation help, it's not going to come from our auditor," says Steve Rask, the company's director of finance. "We wouldn't consider them. We will err on the side of being conservative and look to use other providers."

The last group of companies are those that will continue to use their auditors for non-audit work, but carefully monitor that activity with the help of the audit committee. For example, DuPont's audit committee has always played an active role in monitoring the activities of the company's audit firm, from understanding the scope of the audit to evaluating fees for both audit and non-audit work, to monitoring how non-audit work might affect the audit firm's perceived or real independence.

As a result, "I don't think things will change significantly, because we've been very forthright with our audit committee about non-audit activities by our independent public accounting firm [PricewaterhouseCoopers]," says Jessup.
In fact, the merger between Price Waterhouse and Coopers & Lybrand a few years ago caused DuPont to begin disclosing certain non-audit activities in its proxy statement long before the SEC rules went into effect. The reason? DuPont had outsourced its benefits administration to Coopers & Lybrand, which became a significant chunk of fees to be paid to PricewaterhouseCoopers once the merger was complete.
"All of a sudden, we had our independent accountants responsible for that administration work, so we disclosed that in our proxies," says Jessup. "It could have been viewed as a problem, but it wasn't because of the way we manage it."

In fact, the way DuPont managed the situation with its benefits administration work may provide some insight into how other companies will deal with disclosing other types of non-audit work. For DuPont, this meant discussing the non-audit work PwC was doing for the company in some detail, including the nature of the work, the amount of fees involved, the rationale for using the firm, and how the relationship and the work involved might be perceived by someone outside the company in terms of its impact on the audit firm's independence.
Overall, "we have to preplan the work," says Jessup. "Unless we're doing a major acquisition that wasn't envisioned in the original scope of audit that the audit committee approves every year, we'd talk to the chairman in the audit committee at the next meeting" about the work that PwC might be doing for the company.

Perception vs. Reality

While the Big Five accounting firms have repeatedly emphasized that there is no evidence of a link between the failure of public company audits and auditor independence, public companies may find themselves battling perceptions as much as reality. As a result, even though audit firms successfully fought against a proposed requirement from the SEC forbidding auditors to do any non-audit consulting work for their audit clients, these firms may still end up losing business. "As a practical matter, the screen will be a little thinner now," says Jessup. "We would closely scrutinize potential work going forward just because it's a visible item and it's on the radar screen of the audit committee."
Indeed, a company's audit committee may offer unexpected resistance to using the company's audit firm for consulting work. "There's going to be a heightened awareness on the involvement of auditors in non-audit work," says Rawot. "Now that it is in the public domain, an audit committee member might be questioned on some direction that the audit firm might be going in the area of consulting."

Rawot says that some of this may stem from the fact that the required public disclosure does not necessarily reflect the lengthy discussions and scrutiny on these issues that routinely take place within the audit committee. "What you're going to see publicly are bullets with no additional information provided, so I'm not sure what additional insight the public will get," she says. "But I do think there will be heightened concern on the part of the audit committee."

Other companies take an even stronger stand. "We would consider changing external auditors, if we thought we really needed consulting and IT implementation services from our current audit firm," says Rask. While other companies may not take this strong a stand on using their audit firm for non-audit consulting work, just the fact that companies are pausing to consider these issues may be bad news for these companies' audit firms.
"I don't know that the rules place an added burden, but they certainly force us to look wider as we employ consultants," says Bob Demory, a plant supervisor and former director of accounting for Owens Corning, the $5 billion building materials manufacturer in Toledo, OH. "We won't just automatically go to our outside auditors, even though we know their work well. In fact, I see us as being less likely to use our external auditors for consulting roles. I don't know whether they see this as a threat to practice development. We continue to be a good audit client, but our audit firm may not get as much extra work."

"One Firm's Loss"

If the auditor independence rules are some firms' potential losses, they are being viewed by many other firms as potentially major opportunities. After all, companies that previously relied heavily on their audit firm for consulting support may be rethinking that relationship and be looking to establish or expand their relationships with other consulting firms as a result of these rules.
"We have actively sought out relationships with other firms, so when other projects come up, they know our business and can step in and provide us services," says Rask. "We're in a high-growth mode with a lot of projects going on, so we are being proactive to make sure we have the bench strength to handle them."

Even companies such as DuPont, which do not see the rules causing material changes to their interactions with their audit firms, are looking to expand their consulting network. "I think we might be inclined to do some more work with other firms" if they have the necessary capabilities, says Jessup. Moreover, he adds that the company would be cognizant of appearances and investor perception by "making sure that there isn't too much non-audit work with [its audit firm] and that we spread it around a little bit."
"I think companies will tend to look at a variety of firms now that have different services," says Rawot. "Obviously, there are many firms that do high-quality work. I think the advantage is that firms will want your work, and they are not going to be as concerned about not having audit work in addition. I think it used to be that the two kind of went hand-in-hand. And I think, now, firms actually might be more interested in the consulting work than in the audit work."

In fact, as these rules take hold, there could be a 180-degree change in the audit/consulting link for the Big Five firms. In the past, the Big Five often used the audit relationship as a starting point for developing a much broader consulting relationship with their client companies. Now, however, if the audit relationship is seen as a barrier to getting consulting work, the audit relationship may lose some of its luster.
"Having the audit will close one firm out of getting substantial consulting work, and in some respects I'm a little worried about that," says Rawot.
"I have heard of situations where the auditors have been bidding on consulting work and they have turned down the audit to get the consulting work. I think you might see more of that, especially with new and developing companies."

Sidebar:  PowerPoints:

• Nearly six months after the SEC adopted guidelines to more closely regulate auditors, consultancies are still assessing the impact of the rules on a company' willingness to award consulting work to its audit firm.

• By requiring the audit committees to sign off on certain consulting work, there's already a heightened awareness of the involvement of auditors in non-audit work.

• Certain consultants believe a client's audit relationship could eventually become a barrier to getting consulting work.

Sidebar: Levitt's Litmus Test

Former SEC chairman Arthur Levitt sent the following 10 items to consider in a letter to the audit committee chairmen of the top 5,000 public companies to help them determine the appropriateness of a consulting service:

• Whether the service is being performed principally for the audit committee.

• The effects of the service, if any, on audit effectiveness or on the quality and timeliness of the entity's financial reporting process.

• Whether the service would be performed by specialists (e.g., technology specialists) who ordinarily also provide recurring audit support.

• Whether the service would be performed by audit personnel, and if so, whether it would enhance their knowledge of the entity's business and operations.

• Whether the role of those performing the service would be inconsistent with the auditor's role (e.g., whether the service would fill a role where neutrality, impartiality, and auditor skepticism would likely be subverted).

• Whether the audit firm personnel would be assuming a management role or creating a mutual or conflicting interest with management.

• Whether the auditors, in effect, would be "auditing their own numbers."

• Whether the project must be started and completed very quickly.

• Whether the audit firm has unique expertise in the service.

• The size of the fee(s) for the non-audit service(s).