Cover Story: Dealing With the Rifts At Accounti ng Firms: As internal schisms and other pressures reshape the accounting industry, breakups among the conflict-riddled Big Five seem inevitable.

Ernst & Young’s decision to sell most of its management consulting business to the Cap Gemini Group for $10.7 billion, announced in February, is one Big Five accounting firm’s response to the winds of change buffeting the profession. The deal is one example of the seismic shifts in the U.S. in what has come to be known as the professional services industry. But as much as it exemplifies an emerging breakup trend among the conflict-riddled Big Five, it is also the largest merger to date executed by companies like Paris-based Cap Gemini that are embracing a convergence strategy linking management consulting with information technology expertise. Internal schisms and pressures from clients and regulators are reshaping what had been the staid accounting industry to the extent that many participants expect to see a totally changed landscape in as little as five years. Prof. Kent St. Pierre, chairman of the accounting department at the University of Delaware, said that one result could be further reduction in the ranks of the Big Five to only three firms. Driving the structural changes is the growth of the consulting side of the business. Traditionally, accountants performed three basic functions: tax work, audits, and assurance. But these operations have been basically flat. By the ’90s, management consulting and information technology advice were the firms’ growth engines. As planned, they were growing faster and throwing off more revenue than the “core” accounting functions. However elegant the growth strategy, it has run afoul of culture clashes, resulting in turmoil as the consultants at some firms became restive and pressed for independence because they felt encumbered by the governmental and professional organization rules that govern the audit side. By selling off the majority of its consulting practice, Ernst & Young sidestepped growing concern on the part of regulators about mixing the auditing and tax operations with consulting activities. Other members of Big Five and smaller accounting firms as well have reacted to pressure from their consulting colleagues by considering a variety of restructuring schemes. Strife-torn Arthur Andersen has developed a structure that separates the two sides; PricewaterhouseCoopers is planning a similar division; and KPMG Peat Marwick has proposed splitting off its consulting practice with Cisco Systems Inc. as a partner. Arthur Andersen Worldwide, whose consulting arm is Andersen Consulting, is suffering through the most visible airing of tensions between audit-side partners and consulting partners. Although Andersen has been divided into two companies – Andersen Consulting and the “core” businesses, called Arthur Andersen Inc. – the split didn’t provide the complete independence that the consulting side wants. “Andersen Consulting was way ahead of the other majors. It saw the natural progression of going into everything from computers to human resources,” St. Pierre said. That hasn’t yet satisfied the consultants. As a result of continued dueling between the two sides of the firm, an arbitration process is underway in Chicago, home of Arthur Andersen Worldwide, to decide the future of the firm. “They will separate, it’s just a question of setting the price. Basically, the consulting side is suing for its freedom,” said Rick Telberg, an editor at Accounting Today, a trade paper. The desire of the consulting side to seek out increased opportunities is a prime mover in the industry’s push for restructuring. “In general, the consulting side of the Big Five firms provides about 45% to 50% of the revenue and it is growing much faster than the audit side,” Telberg said. As a result, the consulting arms of these firms want the freedom to chase opportunities without the restrictions and conflict-of-interest limits that are a given on the audit side. Put more simply, consulting is not a regulated business; the audit and tax practice is. The basic conflict of interest that Big Five firms grapple with, although not the only one, grows out of how firms react to the rule that says that the firm that audits a client company’s books doesn’t provide consulting advice, and vice versa. The accounting profession is governed by a combination of state rules, American Institute of Certified Public Accountants (AICPA) guidelines, internal standards at firms, and, where applicable, Securities and Exchange Commission (SEC) rules for public companies. “If Andersen audits a client, it doesn’t do consulting work for them,” St. Pierre said. But he acknowledges there is room for interpretation in this rule. “The AICPA is in turmoil over some of these issues. There is an old guard and a new guard developing.” He said the new guard is pushing the theory that perhaps you can build in enough safeguards so that the prohibition between the two kinds of work need not be absolute. The old guard believes no wall is strong enough to prevent absolute conflict or the perception of potential conflict. The temptation to work on both sides of the divide arises, however, because, according to Telberg, once you do an audit, you see into the guts of a client’s business. Auditors can see many remedies and potential improvements that, in some cases, are begging to be implemented. This places accounting firm employees in a position to recommend courses of action. Sometimes these auditors co-exist with personnel within their firms that provide the needed business and consulting services. The range of these potential assignments extends from computer and telecommunications consulting to human resources services, and even to getting paper clips at a cheaper price through purchasing efficiencies. Pressure to keep the audit and consulting activities separate comes from government regulators and from some parts of the accounting profession. Interestingly, one place it doesn’t come from is the client base. “Auditor independence is not a business issue. It is a political one,” Telberg said. He added that clients want the quickest, cheapest audit. Regulators, however, are charged with protecting the integrity of the markets, and that means audits that are untainted by any potential self-interest on the part of the accountants, Telberg said. In addition to the temptation to work both sides of the fence, i.e., auditing and giving advice, the Big Five and smaller firms also risk running afoul of regulators when they own stock in their clients. PricewaterhouseCoopers was hit by an SEC censure in January when the agency reported that nearly half of the firm’s partners – 1,301 out of a total of 2,698 – had at least one independence violation. Almost half of the reported violations involved direct investments by the PWC professionals in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32% of reported violations, or 2,565 instances, involved holdings of a client’s stock or stock options. SEC Chief Accountant Lynn E. Turner said, “This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence.” The firm has set up a computerized tracking system since the SEC’s action. Similar conflicts are thought to exist at other accounting firms, some of which are also under investigation by authorities. A third type of conflict of interest that is fueling industry restructuring is concern voiced by the SEC in late March that accounting firms are violating conflict of interest laws by designing corporate tax shelters for audit clients. The SEC is especially focusing on cases in which accounting firms are providing tax shelter consulting on a contingency-fee basis. The regulators’ concern is the loss of independence if an accounting firm’s payment is a percentage of the tax savings that its advice creates. Another dicey regulatory issue is how cozy auditors can get with law firms. Press reports have linked Ernst &Young with plans to create what some are calling a “captive” law firm. While state laws and the bar’s ethics rules prohibit non-lawyers from owning or controlling law firms, there are a number of linkages among Big Five firms and law firms. While many CPA firms employ lawyers, they are usually used in an advisory mode to help clients but are not practicing law. By the same token, there are many strategic alliances between law firms and accounting firms. If a Big Five firm were to go directly into the business of providing legal services in the U.S., the enterprise could run into regulatory problems. “The role of the lawyer and the auditor shouldn’t co-exist, that much is agreed upon,” Telberg said. He noted that professional services practitioners in the U.S. are looking at a proposed deal that could involve lawyers from Atlanta’s King & Spalding who might jump to Ernst & Young and plant the seeds for an in-house law firm. In Europe, there is less emphasis on separating the two functions. Indeed, Telberg said PricewaterhouseCoopers is the one of the largest law firms in France and Spain. While the outcome of the push by accounting firms into legal work in the U.S. isn’t clear, it does represent another revenue opportunity that some Big Five members may eventually tap into. As the Big Five try to chart their future, it is obvious that in some areas, regulators are driving policy; in others, the rapid growth of the consulting side of the business is making current structures unwieldy. And while some of these conflicts are intramural in the sense that they are strictly tied to the audit side, and may not impact on whatever structure evolves for the consulting practice, they point to the ongoing recasting of job descriptions on both sides of these firms. The professional services industry, then, is in a state of flux, to say the least. Add to the internal debates and reassessments of the roles of various sectors within the profession the impact of the Internet, and the rate of change hits at warp speed. The Internet poses challenges for the Big Five both externally and internally. Externally, the majority of the consulting work being done by the firms is Internet-related. Donald C. Spitzer, national partner in charge of financial strategies at KPMG, said that about 95% of the firm’s consulting work is tied into e-commerce and Internet issues. Internally, the numerous defections by accounting and consulting executives from these partnerships to Internet companies comprise a huge talent drain. Andersen Consulting lost its CEO George Shaheen last year to Internet grocery start-up WebVan Group Inc. Among the company’s 65,000 employees, there was increased concern that if they didn’t make the jump to Internet businesses, they would be missing an enriching opportunity. Andersen Consulting did not return a phone call seeking comment. But it isn’t as if Andersen or any other Big Five firm is the only poster child for problems with retaining talent or for casting about for new structures. Before looking at the Ernst & Young/Cap Gemini deal in depth, consider recent moves by other Big Five members. First is Andersen Consulting’s response to the industry-wide talent drain, while the restructuring initiatives at PricewaterhouseCoopers and KPMG also are part of the mix. Andersen Consulting said in March that it will launch a major new initiative to attract and reward high-performing employees. Among other actions, Andersen Consulting will invest $200 million in e-commerce-related companies on behalf of the employees. It said it intends to subsequently continue to invest another $100 million each year. The wealth created by these investments will be distributed to employees as “eUnits” – a unique and proprietary form of compensation that harnesses the value of the electronic economy. Joe Forehand, Andersen Consulting’s managing partner and CEO, also outlined other new opportunities for employees, including extended access to the firm’s partnership ranks. The result will be a doubling of the partnership (more than 1,000 new partners) in most parts of the world this year. PricewaterhouseCoopers said in February that it is planning to disaggregate its business into two or more separate operating units. Under the proposed restructuring plan, the organization’s audit and business advisory services along with its tax practice will remain as PricewaterhouseCoopers. Its management consulting, business process outsourcing, and human resources consulting practices and certain corporate finance activities will be developed into one or more separate businesses. KPMG said in January that it will incorporate its KPMG Consulting unit. Both consulting and audit practices are still under a single management. The newly incorporated entity, already a leading provider of Internet integration services globally, will be 80.1% owned by KPMG and its partners, and 19.9% owned by Cisco Systems Inc., which in August 1999 agreed to invest $1 billion in KPMG. The involvement of Cisco with KPMG is not an isolated hookup. It is part of the convergence trend of management consultants and information technology, taken a step further with the involvement of an information technology manufacturer. Cisco has a joint venture with Cap Gemini, announced just after the Ernst & Young deal. It includes a $835 million investment by the networking company. Cisco also has hookups with consultants at International Business Machines Corp. and Electronic Data Systems Corp. In a related move, Microsoft Crop. and Andersen Consulting announced a $1 billion alliance in March to start a 5,000-employee tech services company that will help Internet companies running Microsoft products. The new company will be called Avanade and will be based in Seattle. It will be about 50/50 owned by the two companies and is planning to do an IPO as soon as possible. The other member of the Big Five, Deloitte Touche Tohmatsu, whose consulting arm is Deloitte Consulting, instituted a new global structure about a year ago. “Increasingly, our clients are thinking and acting globally. To keep pace with them, we must become even more flexible, nimble, responsive, and global. The changes we have approved take us a long way toward that destination. Implementing them requires fundamental changes on our part, but this implementation is nothing less than the key to success of DTT in the 21st Century,” said Deloitte CEO James E. Copeland Jr. In most professional services industry reorganizations m&a professionals will be staying with the core organizations. At KPMG, Spitzer said the recently announced incorporation of the consulting practice will have little effect on his m&a staffers, who will remain on the audit side of the organization. “Our priority will remain getting the deal done, and getting it done right.” He said that KPMG dealmakers pay special attention to postmerger integration issues while providing the whole range of m&a advisory services from “soup to nuts.” CEO Terry Ozan of Ernst & Young Consulting said that the m&a staff will not be part of the spun-off consulting operations. This will apparently hold true for the other firms as well. The sale of Ernst & Young’s consulting business, however, most clearly embodies the splintering of the traditional accounting firms and the coming-together of management consultants and information technology consultants. While the deal has to pass regulatory muster in the U.S. and in Europe, the synergies that the companies hope to achieve are clear. The agreement calls for the two companies to combine their consulting and information technology services. Cap Gemini will acquire almost all of the Ernst & Young Consulting business, with a headcount of approximately 18,000 and 1999 revenues of around 3.5 billion euros (roughly $3.5 billion U.S.). Cap Gemini will issue shares in exchange for the Ernst & Young Consulting businesses. Getting the deal to the finish line was complicated. First of all, the completion of the transaction was subject to a vote of Ernst & Young partners. A qualified majority of all Ernst & Young partners and specific majority of 75% of the consulting partners were needed to clear the deal. These votes took place in April on a country-by-country basis. Subsequently, Cap Gemini shareholders were to be called on to approve the terms and conditions of the transaction at a meeting to take place by the end of June. If all Ernst & Young Consulting entities participate in the transaction, Cap Gemini will issue a maximum of 43.5 million new shares and pay 375 million euros in cash (roughly $375 million U.S.). Subject to market conditions, up to a maximum of 50% of Cap Gemini’s newly issued shares will be sold by April 1, 2001, of which a minimum of 25% upon closing will be used to cover certain tax, pension, and other liabilities of the Ernst & Young partners. The remaining shares will be subject to retention and forfeiture agreements over five years, and any disposals will based on an orderly marketing agreement. Ernst & Young’s Ozan said that his organization’s integration experience gained 11 years ago when the former Arthur Young merged with Ernst & Co. will help the integration process as the consulting practice is absorbed by Cap Gemini. One benefit of the merger that he sees is the doubling of the channels to the marketplace that each firm will gain. “We can now use their channels to gain new accounts, while they will be able to bring their capacities to the service of our existing accounts. Plus, no doubt, we can help them land new clients.” For Cap Gemini, the deal gives the Paris-based company an additional 20,000 staff to its 40,000 employees worldwide and would almost double revenue from 4.3 billion euros to 8 billion euros. It will also greatly increase its geographic scope, giving it more heft in North America and Germany. Analysts have described the pact as moving Cap Gemini from the Chief Information Officer’s (CIO) office to the CEO’s office. But Cap Gemini’s vice chairman of the executive board, Geoff Unwin, said it will increase the company presence in the CEO offices at client companies. “The deal gives us the ability to compete with the pure players on the technology side but with the added strength and reach of the Ernst & Young consulting operations.” Unwin says that it makes Cap Gemini a truly global company and moves its business mix toward higher-valued services. He added that for Ernst &Young a major benefit is the capital that the publicly traded Cap Gem brings to the deal. “One of the problems with a partnership is that it doesn’t have a capital structure, but going forward we can use our capital to attack problems with our Ernst & Young partners,” Unwin said. The reaction from European analysts generally has been favorable. “The deal gives Cap Gemini access to a higher level of management and the higher you go, the more valuable your offering should be,” said Matt Hoen, an information technology analyst at ABN AMRO Holding NV in Amsterdam. Hoen added that the biggest risk that the companies face could be cultural issues between the Cap Gemini consultants and the Ernst & Young employees. “It could be that the Ernst & Young personnel, who are management consultant types, will have difficulty accepting the Cap Gemini technology consultants as equals,” he said. “They could have the attitude that while they provide strategic advice, the Cap Gemini information technology consultants are mere wire-pullers’ who only coordinate computer systems.” Richard Sabine, who follows the accounting industry for French broker CCF Securities in Paris, said that one of the deal’s biggest risks is the disparity between the wages of the Ernst & Young consultants and the Cap Gemini consultants. “You have to find a way to equalize the payouts to both groups,” he remarked. “Of course, if the deal increases operating margins, it will benefit both groups.” Sabine noted that the deal will help Cap Gemini reinforce its position in e-business, an area in which, perhaps ironically, the Ernst & Young consultants are perceived to be further advanced than the French information technology consultants. He also said that while the Ernst & Young/Cap Gemini hookup is by far the largest deal in the sector, it is only the latest of a number of deals whose rationale rests on the convergence of management consulting companies and information technology firms. “We are going to see the Big Five take another form,” Ernst & Young’s Ozan said. “Consulting operations will be split from the audit side. In this connected economy, the web of relationships becomes quite complex, but we will still need teamwork and alliances to create new business opportunities.” According to some observers, the rapid changes and breakups could produce some additional casualties in the consulting field because of the loss of the growth opportunities consulting provided. “The audit side has been outdistanced by the rapid growth of the consulting side. It wouldn’t surprise me if the Big Five shrank to the Big Three in a few years,” St. Pierre of the University of Delaware reiterated.