Are Conditions Right for the Next Accounting Scandal?

Will risk-averse corporate audit committees' natural tendencies to engage the biggest accounting firms insure that the current accounting oligopoly will become even stronger?
by James Heskett

Summing Up

Responses to this month's column lead one to conclude that we can expect that more major accounting scandals are in our future. Causes, according to these thoughtful comments, range from the consolidation of the major global accounting firms, the very nature of the shared interests of auditors and audit committees whose mutual survival depends on each other, overly complicated accounting and tax systems, and the nature of the reporting relationships between internal auditors and those responsible for the integrity of their work.

Bill Korn comments, "With the trend of separating audit from consulting, you may have two of the Big Four serving your business, and the other two ... serving your competitor." Edward Hare laments that "conditions have not materially changed ... further scandals are likely."

A range of responses to the dilemma was proposed. They include Hare's call for "a wholesale simplification of our government, accounting, and tax systems," Maria Dell'Oro's suggestion that "the audit committee should have its own staff that follows its own instructions and has no reporting lines to the CEO," and Shann Turnbull's proposal that "a non-Big Four auditor should be retained to [perform tasks such as] ... due diligence."

Until these kinds of things happen, C.J. Cullinane believes that the "deterrent of getting caught is the biggest threat to the present survivors." Mark Alarik, in arguing for the increased use of more narrowly focused professional accounting "boutiques," suggests that "what the industry really needs is more objectivity and innovation—not a larger tribe of 800-pound gorillas." In retrospect, William Rahm wonders "whether the Justice Department should have been more active in reviewing the mergers of the major firms as the industry consolidated over the last fifteen years."

Several responses hinted at the need for audit committees to be more adventurous in their selection of non-Big Four firms to carry out various tasks for the respective organizations. Without incentives to do so, the natural tendency is to opt for the "safe" alternative, particularly in a litigious investing community. What form could these incentives take? Whose responsibility would it be to implement them? How else can what is perceived as a self-reinforcing set of relationships between audit committees and a very small group of firms who serve them be disrupted in useful ways?

What do you think?

Original Article

Consider this scenario: Acme Corp., the large, long-term client of a Big Four accounting firm, asks its accountants to perform due diligence on the books of a company, Zulu Inc., being considered for acquisition. It comes to the attention of the acquirer that for some years Zulu has employed the same accounting firm. Directors at Acme, concerned about having their accountant review the working papers prepared by other employees of the same accounting firm, suggest hiring someone else, even though accountants for both clients insist that proper barriers are maintained within their firm. A search for another Big Four accounting firm is launched by Acme. But upon closer examination, it is found that, for one reason or another, all of the other three Big Four firms have greater conflicts of interest (i.e., representing Acme's arch competitors, etc.) than the one hired to perform due diligence on its own work. The audit committee at Acme, unwilling to entrust the due diligence to a second-tier accounting firm, reluctantly elects not to recommend to management that it switch accountants.

Why has the likelihood of this situation arisen? Consolidation within the "industry" has been underway for the past decade or more. But clearly, the demise of Arthur Andersen didn't help. And at least for those who would claim that the Justice Department played a role in Andersen's demise, the irony is that the Justice Department itself may have contributed to the tightening of an accounting oligopoly that could set the stage for future accounting-related controversies.

Is the hypothetical situation described above more likely to arise periodically in the future than it did in the past? Does it suggest an opportunity for a would-be fifth or sixth entrant to the global elite of accounting firms? Will such an organization, probably already in existence, be able to take advantage of the opportunity? Or will the natural tendency of risk-averse corporate audit committees to engage the biggest accounting firms insure that the oligopoly will become even stronger? Will it require the relaxation of guidelines regarding potential conflicts of interest among accountants? Or will the final answer lie in some other action designed to restore choice among accounting clients facing the prospect of utilizing the services of firms continually "meeting themselves" in one situation after another? What do you think?

    • Edward Hare
    • Director, Strategic Planning, a Fortune 250 manufacturer

    The "accounting scandals" of the recent past are simply the most egregious, and there are any number left to surface. Conditions have not materially changed in that the majority of executives continue to game the system to meet "growth needs" or enhance personal compensation. We have a system that is increasingly run on greed and excess and, until that wanes, further scandals are likely. I've joined a growing number who believe there are few that can be trusted and that a wholesale simplification of our government, accounting and tax systems is long past due to make it more difficult to game the system.

    • Bill Korn
    • Acting CFO, Antenna Software, Inc. and iRail, LLC

    I think the problem is significantly more likely now than when there were eight major firms.

    And with the trend of separating audit from consulting, you may have two of the Big Four serving your business, and the other two are probably serving your competitor.

    American businesses will be better off if three or four of the second-tier firms get anointed to the top ranks.

    • Dr. B. V. Krishnamurthy
    • Executive Vice-President and Professor of Strategy, Alliance Business Academy, Bangalore, India

    The likely scenario is one in which the accounting/audit industry would become even more consolidated with little or no choice for clients.

    This scenario stems from the following:

    1. It is extremely difficult for new entrants to make a significant impact because of the brand loyalties enjoyed by the existing firms. The longer a firm has been in accounting/auditing, the more sacred it is perceived to be.

    2. The service providers and their clients have a vested interest, as their survival depends on each other. Due diligence becomes another buzzword to be used at every seminar or symposium and quickly forgotten thereafter. The relationship between service providers and clients, unfortunate as it might sound, is likely to be in the nature of "You scratch my back and I'll scratch yours."

    3. The threat of substitutes is non-existent. Unless, of course, we are contemplating expert systems that can go through a corporation's accounts and come out with all the anomalies. The paradox here is that since it is the accountants who can provide the inputs for such a system, they are likely to build enough filters to ensure that very uncomfortable questions are never asked.

    All this brings us to a rather discomforting question: Is there no way out at all? I am afraid not.

    Failures are not new to the human race. The tragedy, however, is that very little, if anything at all, is learned from the failures. Public memory is short. Life goes on...till another scandal surfaces, and there is another round of noise. The cycle is repeated with sickening regularity.

    Frugality, honesty, contentment: When these become the cornerstone of our existence, there might yet be some hope.

    • Anonymous

    Use the second-tier firm. When they know they will be competing with the regulars they will probably do a bang-up job. Regardless of who does the work, it does not relieve the board of directors of their own obligation to do as much as they can in their own right.

    • Mark Alarik
    • Managing Principal, Booth Morgan Consulting

    It has become painfully clear that many companies are doing themselves a disservice by continuing to allow the Big Four to dominate. Perhaps the solution will not be found with the addition of two or three more mega-auditing firms. The solution may be found in identifying firms that can augment current auditing practices with additional objectivity, deeper insights, and innovation.

    Here's an example: Nearly 80 percent of the value placed on S&P 500 firms can be attributed to intangible assets. Yet, GAAP and the Big Four ignore intangibles. Share price is largely determined by the market's expectations of future cash flows. For many companies, customers, an intangible asset, determine future cash flows. GAAP is incapable of revealing future cash flows.

    While it's true that the Big Four firms declare the importance of value reporting via intangibles, none of them have this practice in place. Shareholders remain in the dark, and so does management in regard to current corporate health and future value.

    Innovation has been left up to the boutique-sized firms to fill in the gaps in GAAP by discovering better ways to report on the true health and future value of the enterprise. This is why we based our practice solely on a specific area of intangibles we call "Customer Value Governance."

    Your question was well put: "Will such an organization, probably already in existence, be able to take advantage of the opportunity? Or will the natural tendency of risk-averse corporate audit committees to engage the biggest accounting firms insure that the oligopoly will become even stronger?" Perhaps what the industry really needs is more objectivity and innovation—not a larger tribe of 800-pound gorillas.

    I agree with you that companies do need more choice, and perhaps two or three more global firms could be useful. In addition to that, timing has never been more critical in terms of providing companies with greater third-party objectivity and specialists who are developing innovations, such as in auditing intangible assets.

    • Dr. Shann Turnbull (HBS MBA '63)
    • Principal, International Institute for Self-governance

    The hypothetical situation presented by Professor Heskett depends upon the premise that the audit committee of Acme does not trust that their auditor has been carrying out its audits on Zulu in a proper manner and that this would not be revealed with a due diligence investigation by their auditor. If this is the case then Acme should change their auditor whether or not the acquisition goes ahead.

    As Acme does not want any other of the other Big Four audit firms, this would mean trading down to an auditor with lesser standing. However, it could be difficult to justify such a change for a deal that may not proceed because the due diligence investigation proved unsatisfactory or for some other reason. So a non-Big Four auditor should be retained to (a) undertake the due diligence of Zulu and also provide (b) a check on the integrity of the current auditors of Acme. In this way the grounds for Acme not trusting their auditor in regards to point (a) can be checked.

    So the answers to the first and second questions posed by Professor Heskett is yes. The hypothetical situation must become more likely just because the Big Five have become the Big Four. This will provide leverage for other accounting firms to be accepted by clients either because of the reason explained above or because other clients are not quite so conservative as described in the hypothetical situation.

    If Acme uses a non-Big Four audit firm to undertake the due diligence of Zulu and discovers problems in the financials then this will provide grounds for Acme to dismiss its existing audit firm and appoint an auditor who is not one of the Big Four. This possibility provides an incentive for non-Big Four audit firms to be especially zealous in their due diligence investigations. A non-Big Four audit firm could then explain to its new client a way for them to be appointed auditors to provide superior integrity and creditability for shareholders and creditors than by using any of the Big Four firms.

    The non-Big Four audit firm would propose that instead of reporting to an audit committee of directors it would report to a separately constituted shareholder panel that could also include a representative of its prime banker. Such an audit committee panel, watchdog board, or corporate senate would be nominated and approved by shareholders at an annual general meeting. Similar arrangements are found in France, Spain, and even in Russia as reported at

    I used this approach to raise funds for a start-up venture in Australia that had a majority of its investors in the USA. In this way the hegemony of the Big Four audit firms might soon be dissolved as more politically creditable and superior business relationships or developed that eliminate, minimize, or better manage the inherent conflicts that exist in so called "world best practices" in corporate governance.

    • Mario Dell'Oro
    • Owner, Financial Investments Advisory

    As always you hit it on the dot. The underlying conflicts of interest are growing in an exponential manner with the consolidation of the accounting firms. I think that the solution is not one more player to the club. (It could help, but will not solve the problem).

    Most likely there will be different solutions to the problem:

    1. Internal Auditing: Think it is time for the Board to truly assume their responsibilities to the corporation. Therefore the audit committee should have its own staff, that follows its own instructions, and has no reporting lines to the CEO or any member of the management team. If the team that the audit committee builds has the right professionals, and is fully dedicated to protect the corporation from any irregularities, a major change will take place. Board members would not be able to look the other way because they will get first notice of any potential issues.

    2. Due Diligence: This is a slightly different problem where new players will emerge. Knowing the potential conflicts of interest, will the board willingly go with one of the club members, or should it seek the advice of a narrower-focused firm specializing in this particular need when acquiring another firm.

    • C. J. Cullinane

    The problems that have occurred in business (such as Enron and its like) are the result of limited competition and accounting inbreeding. Until competition increases and the accounting field has more players, fear of scandal is the only deterrent to a repeat of the recent past. Competition will appear over time, some very aggressive, some game players, but still competition. Until that happens the deterrent of getting caught is the biggest threat to the present survivors.

    • William Rahm (HBS MBA '04)

    Professor Heskett has made clear the problem that resulted from the Justice Department's elimination of Anderson rather than selective prosecution of individuals. Moreover, this analysis raises the question of whether the Justice Department should have been more active in reviewing the mergers of the major firms as the industry consolidated over the last fifteen years. The only hope is that an audit committee of independents will not have incentives to select one of the four major firms if conflicts arise (i.e., will consider long-term stability over short-term stock price impact).

    • M. Zimmermann
    • Marketing Service Director, BMT of Indiana

    Love some of the comments. Can one part of a whole series of linked processes be declared dominant? More noble? More important? If vision motivates strategy and doing, strategy organizes and guides the doing effort, and doing makes it real...

    Can execution be taught? Teaching can start the education, but not complete it. Cases I learned at Michigan have definitely given me a broader view of the doing possibilities. They helped me take action to finish tasks. But they couldn't cover the full range of real world situations, nor fully convey the power of sweat, fear, teamwork and relationships.

    Can business schools teach execution? As now peopled, probably not well. In my experience, we teach best what we know, have experienced, and do best. What has the typical business school faculty executed in the real world? I recall the old comments: Have you "met a payroll"? Made the "tough" (read "people") decisions?

    • Anne Simmons
    • Managing Partner, Board Advisory Services

    I think that accounting firms have subsidized themselves through consulting services both within consulting affiliates and within the accounting organization. With the demands for separation of consulting and accounting, the diversified multinational accounting firms really will no longer exist. Consequently, the emergence of another "big five" is highly unlikely, as it is not as economically attractive as result of today's circumstances.

    Do I believe that more situations as articulated in your scenario will occur? Yes. With less choice and a continued need for due diligence, companies will have fewer options. However, I believe that smaller, high end, high quality niche players will emerge to augment the shrinking pool of prestigious names.

    Also, considering the landscape today with scandal and issues regarding each of the big four, companies seeking untarnished reputations must look elsewhere.

    • Anonymous

    Remove the auditors' reliance on Letters of Representation. Then auditors will have to audit the facts and not the directors' opinion.