I. KPMG: How Many Firms?

BACKGROUND

How many major accounting firms are needed to provide companies sufficient choice? Because of their scale, expertise, and international presence, the world's largest corporations have traditionally relied on the largest accounting firms to conduct their audits. As late as 1988, the "Big Eight" firms (Arthur Andersen & Co.,Arthur Young & Company,Coopers & Lybrand, Deloitte Haskins & Sells, Ernst & Whinney,KPMG, Price Waterhouse & Co., andTouche Ross & Co.) dominated the market for audit services. In 1989, mergers between Ernst & Whinney and Arthur Young (to form Ernst & Young) and Deloitte Haskins & Sells and Touche Ross (to form Deloitte & Touche, now Deloitte) reduced choices to six providers. The merger of Price Waterhouse and Coopers & Lybrand in 1998 asPricewaterhouseCoopers(PwC) limited them to five.

Although a company's options with respect to the choice of an independent auditor were reduced by almost 50 percent, not until the Justice Department's dissolution of Arthur Andersen in 2002 were concerns raised about the lack of choices in the market for audit services and its impact on the competitiveness of the industry. (Arthur Andersen's verdict was overturned by the Supreme Court in 2005, but its partners and personnel had pursued other employment opportunities.)

The gulf between the Big Four and the remaining accounting firms can be best illustrated by comparing KPMG (the smallest of the Big Four, in terms of revenues) withRSM(formerlyMcGladrey)the fifth-largest accounting firm. In 2015, KPMG's U.S. revenues from audit and assurance services totaled $6.9 billion, compared to $1.6 billion at McGladrey.Viewed from a consumer's standpoint, in 2015, Big Four firms audited all but one of theFortune100 companies (Energy Transfer) and all but four of theFortune500 companies (Energy Transfer,Henry Schein, Inc., Icahn Enterprises, andNGL Energy Partners).

In addition to a smaller set of large accounting firms, public companies are constrained by provisions of the Sarbanes-Oxley Act. In an effort to enhance auditor independence, Sarbanes-Oxley prohibits auditors from providing various types of nonaudit services to their audit clients. This prohibition was in response to the large shift of accounting firm revenues from primarily audit revenues to revenues for other services.²For example, in 1975, the percentage of total revenues from the Big Eight firms derived from audit services ranged from 62 percent (Touche Ross & Co.) to 76 percent (Price Waterhouse & Co.); in 2000, this same percentage ranged from 31 percent (Deloitte & Touche) to 45 percent (KPMG).³

As a result of Sarbanes-Oxley, public companies have engaged other Big Four firms for nonaudit services. As just one example, at one time, the Big Four firms providedWabtec Corp.auditing (Ernst & Young), internal control testing (Deloitte & Touche), acquisitions advising (KPMG), and tax services (PricewaterhouseCoopers). If Wabtec decided to change auditors yet retain a Big Four firm, it would need to consider the effect of these services on the independence of its new auditor. A survey by J.D. Power & Associates of the 400 companies with more than $1 billion in revenue revealed that 55 percent of these companies are using more than one Big Four firm to provide various types of services (including audit services).⁴

The bottom line is that two independent developments (a smaller number of international accounting firms and Sarbanes-Oxley's limitations on the nonaudit services that can be provided by a company's auditors) have significantly impacted companies' choices of auditors. This dilemma can be best reflected by the experiences of two large organizations.

First, in 2005,Intel Corp.considered proposals for its audit engagement from all four firms. It retained Ernst & Young, which has audited Intel's financial statements for more than 30 years. This decision was largely driven by the nonaudit service provided to Intel by the other Big Fourfirms. Cary Klafter, Intel's corporate secretary, noted that "because there are only a limited number of large multinational audit firms that do the kind of work that we need, if we were to switch audit firms, all sorts of dominos would fall."⁵

Second, whenFannie Maedismissed KPMG as its auditor in the wake of an accounting scandal, its choices for a successor were slim: Deloitte & Touche had been advising the federal government in its probe of Fannie Mae, Ernst & Young had been providing consulting services to Fannie Mae's audit committee responding to the probes related to the scandal, and PricewaterhouseCoopers auditedFreddie Mac, a major competitor.⁶

Could something happen to limit companies' choices even further?

THE PROBLEM

From 1996 through 2002, KPMG received $124 million in tax consulting fees from promoting tax shelters that allowed individuals and corporations to improperly avoid more than $1.4 billion in federal taxes.⁷E-mail messages obtained and released by the Internal Revenue Service indicated that KPMG officials were aware that the tax shelters were questionable.

As one example, a shelter referred to asbond-linked issue premium structures (BLIPS)created $5 billion in tax losses for investors. Under this shelter, clients would purchase foreign currency from offshore banks with funds borrowed from those same banks only to sell the currency back to the same bank a few months later. These investments were presented to the Internal Revenue Service as seven-year investments.⁸Other shelters in question carried similar names such asFLIP, OPIS, andSOS.

THE OUTCOME

On August 26, 2005, KPMG admitted to criminal tax fraud and agreed to a payment of $456 million in penalties (an average of $300,000 per KPMG partner); the government agreed to deferred adjudication and, in January 2007, dismissed all criminal charges against the firm. Subsequently, Judge Lewis Kaplan of the U.S. District Court for the Southern District of New York dismissed indictments against 13 of 16 former KPMG partners and, on December 18, 2008, two of the remaining three partners were convicted on multiple counts of tax evasion. (The remaining partner was acquitted.)⁹

In the midst of this activity, federal prosecutors indicted four current and former partners of Ernst & Young on similar charges. The shelters designed and sold by these partners brought Ernst & Young $120 million in fees. Those familiar with the matter do not expect that the firm itself will face criminal charges in this matter¹⁰; however, on May 8, 2009, four current and former E&Y executives were convicted.

THE ISSUE

KPMG has avoided the fate of Arthur Andersen: dissolution. However, the KPMG case has raised numerous questions about the future of the accounting profession if the small number of international accounting firms should become even smaller. For example, the Securities and Exchange Commission discussed various actions to assist companies in changing auditors if KPMG was indicted, including allowing companies to seek waivers to the stricter independence rules on a case-by-case basis and allowing KPMG to continue to perform audits if it were indicted. An unidentified SEC official indicated that "we have scenarios in place for any eventuality that could come out of this."¹¹In addition, prior to the settlement, Deloitte & Touche, Ernst & Young, and PricewaterhouseCoopers reportedly requested that their partners not solicit current KPMG clients.¹²

1.Provide us a very high-level summary of the Issues in the Case Study (Think who, what, where, and when.) (Keep it brief).

2.What are the big four accounting firms? Have there always been four? If not- when did they become four- provide us a very brief history to becoming the big four.(Focus on the merger history.)