Deloitte Restates its case After Enron, the accounting profession is under fire. To find out what it's like on the frontlines, FORTUNE dropped in on one of the Final Four.
(FORTUNE Magazine) – Jim Copeland, CEO of Deloitte & Touche, knows exactly when he realized that Enron was going to be unlike any other accounting scandal. It was the shredding. As the news that employees in Arthur Andersen's Houston office had destroyed thousands of Enron-related documents scrolled across a TV news ticker one afternoon in early January, Copeland's stomach turned. He knew instinctively that the focus of all the public outrage, the government investigations, and the breathless media coverage would shift to Andersen and, by extension, to the rest of the accounting profession. He knew that none of the Big Five would emerge unscathed. And he knew right then that Deloitte's long-term strategy--a global partnership offering multinationals one-stop shopping for accounting, tax, risk management, consulting, and, outside the U.S., legal work--might well be doomed.
The following month proved him right. Both Congress and the media seized on the fact that Enron had paid Andersen $25 million in audit fees and $23 million for other consulting work. To do away with that perceived conflict, legislators started calling for a complete separation of auditing from consulting. More important, corporate boards started asking whether they should continue to buy consulting services from their accounting firms and risk a possible hit in the stock market as a result. Those issues were weighing heavily on Copeland one Thursday evening in early February, when the 57-year-old former Georgia State point guard eased his lanky frame downstairs from his office on the 36th floor of the firm's Manhattan headquarters to visit Manoj Singh, head of Deloitte Consulting's American operations. Copeland told Singh that the day was approaching when "you're going to come to me and say that we have to separate consulting from the rest of business. I hate it, but I think it's unavoidable." One week earlier PricewaterhouseCoopers and Andersen had said they would stop selling technology-consulting services to audit clients. Ernst & Young had already sold its consulting business to Cap Gemini, and KPMG had spun off KPMG Consulting in an initial public offering. Deloitte stood alone as the only Big Five firm that had not announced major changes to its business post-Enron.
That night Singh told Copeland it wasn't time to shift strategy. But the next morning he appeared unexpectedly in Copeland's office. Singh had just learned that a big audit client was backing out of a contract to use Deloitte Consulting for a multimillion-dollar restructuring and cost-reduction study. The client was concerned about the perception of a conflict. Copeland nodded sadly and picked up the phone. He dialed Douglas McCracken, the head of Deloitte Consulting worldwide, and William Parrett, the managing partner for Deloitte's American accounting, tax, and related services. That afternoon the four men--Copeland, McCracken, Singh, and Parrett--locked themselves in a conference room for five hours. They emerged, Copeland recalls, with tears in their eyes. They began working the phones, hosting marathon conference calls with partners around the world. The message was simple: The one-firm model was dead. Deloitte & Touche would reluctantly separate from Deloitte Consulting.
This traumatic decision was just the beginning of a period of gut-wrenching uncertainty for the firm. In the weeks to come, Deloitte would find itself in merger discussions with a desperate Arthur Andersen. It would then find itself working with the SEC on plans to avoid a major disruption to the capital markets after Andersen was indicted and its clients started bailing. Finally, Deloitte would find itself locked in an epic struggle with Congress and other critics over the future of the accounting profession itself. Not to mention, of course, that it was trying to decide the shape of Deloitte to come.
In the midst of this tumult, Deloitte granted FORTUNE an up-close look at its operations. In part, the firm was eager to demonstrate that it was not Arthur Andersen. It believes it has a better auditing record than any of the other large accounting shops, and while that claim is difficult to verify, it is true that few of the jaw-dropping accounting scandals of recent memory have occurred on Deloitte's watch. (The most notable exception is the failure of the Canadian entertainment company Livent.) But the firm also wanted to make its case that some of the proposals to limit the consulting services that accounting firms can provide audit clients are misguided. After more than a month spent interviewing scores of Deloitte's current and former auditors, consultants, and tax gurus, as well as its clients and outside accounting experts, the portrait that emerges is of a firm where pride and commitment to quality mingle with bitterness and resentment that another company's mistakes have forced it to make decisions its partners never wanted to contemplate.
Deloitte's Seattle offices are as tastefully non-descript as one would want any accountant's offices to be. There are warrens of cubicles that auditors use when they aren't out in the field, and the windows of the partners' offices offer commanding views of Lake Washington and, weather permitting, Mount Rainier.
Arriving here in the heart of accounting's busy season--the first quarter of each year, when companies file both audited year-end financials and tax returns--it's difficult to get young auditors to consider the long-term implications of the latest rash of financial scandals. They're swamped, and they're confident that the firm's leaders will do the right things.
But Deloitte's older partners are happy to talk, especially about something that irks them as much as the fact that because of Andersen's Enron debacle, Deloitte must now divide itself. Listen to Jim Flaherty, leader of the team that audits Microsoft. He has spent 33 years with the firm. He cut his teeth auditing Midwestern banks and Chrysler, where he worked shoulder to shoulder with Lee Iacocca's financiers to help pull the company out of bankruptcy. Flaherty is friends with many Deloitte Consulting partners, including the unit's CEO, McCracken, whom he has known since their days together in Detroit. "I'm sorry to see it happen," he says of the separation. "I've worked with consultants my whole career."
Flaherty doesn't conceal his anger toward former SEC Chairman Arthur Levitt, who fought to limit the kinds of consulting that accountants could do when he was in office, and who has emerged as a loud and public critic of the industry post-Enron. Flaherty accuses Levitt of deliberately misleading the public into thinking that there is a conflict between auditing and consulting. He even says the SEC twisted its definitions of audit and nonaudit fees to inflate the revenues accounting firms seemed to be getting for consulting. "It's arrogance," he fumes, citing a particularly nettlesome example, "to say that an audit done under government mandate in another country isn't an audit fee." Levitt told FORTUNE that his record speaks for itself.
Deloitte staffers can be forgiven for lashing out. Put simply, they're all a little shell-shocked. Deloitte was having a rotten year even before Enron. The recessionary slowdown in IT spending hit consulting especially hard, forcing the firm to lay off close to a thousand employees. Expenses were cut back. Then there was Sept. 11. More than 3,000 Deloitte employees worked in the World Financial Center, right next door to the Twin Towers. And while all but one--a 24-year-old consultant who was visiting a client in the World Trade Center--survived, Deloitte had to accommodate the displaced workers in other offices, including its now overcrowded headquarters in midtown Manhattan. Then came Enron.
It all adds up to one of the most challenging periods in the firm's history--a history that parallels the rise of modern accounting. William Welch Deloitte, an Englishman of French extraction, started auditing the books of railway companies in 19th-century London. In 1893 he opened offices in the U.S. and soon after began policing the accounts at a burgeoning soap and candle business called Procter & Gamble (still a Deloitte client). Today's Deloitte Touche Tohmatsu, as the firm is known globally, is the product of two major mergers, the first with Haskin & Sells in 1924 and the second 65 years later with Touche Ross. The second largest of the Big Five, behind PricewaterhouseCoopers, Deloitte has 6,400 partners and 88,000 employees worldwide. Its revenues were $12.4 billion last year, of which about $3.5 billion came from Deloitte Consulting.
Among the Big Five, Deloitte is known as a collegial place, in contrast to, say, Andersen, which acquired a reputation as being cutthroat and arrogant. Also, says accounting industry consultant Arthur Bowman, "Deloitte has had a reputation for audit expertise and the quality of their work." But being viewed as conservative hasn't always been a good thing, adds Bowman: "They were thought of as stodgy, stuck in the old ways and not willing to get with the new ones." When Ken Lay merged Houston Natural Gas with InterNorth to form Enron in 1984, he dropped Deloitte as its auditor. Michael Pieri, HNG's chief financial officer at the time, recently told Newsweek that Deloitte was "not as creative and imaginative as Ken wanted them to be."
So to many partners it's a big, albeit pleasant, surprise that Deloitte's reputation as the "auditor's auditor" is suddenly a selling point. Brian Gallagher, a 15-year Deloitte veteran in Boston who specializes in investment firms, remembers that until recently many companies saw audits as commodities. As long as an audit carried the imprimatur of one of the Big Five, price mattered more than quality. Some of the Big Five were only too happy to cater to that perception, and used audits as loss leaders to gain entree to clients so that they could sell more profitable consulting services. Deloitte, Gallagher says, never played this game--often to its detriment. "It would be frustrating," Gallagher says. "We'd lose out to another firm because of price, and I would have a follow-up meeting and ask them just how it was that our bids could be that far apart. But the market didn't seem to care about anything else." Times have certainly changed. Last month Delta Airlines picked Deloitte to be its auditor after deciding to drop Andersen--despite the fact that Deloitte was one of the highest bidders.
Deloitte's audit record--which has few major restatements--ought to speak for itself. But judging audit quality can be tricky. Bob Garland, the Deloitte partner in charge of what the firm calls "the A's" (assurance, accounting, and advisory services), concedes that even he's not entirely certain the firm's methods are better than anyone else's. "If you're asking if we're lucky or smart, the answer is, I don't know. Probably a little of both," he says.
Still, it is clear that Deloitte has made several smart moves in the past five years. For one, while other firms have reduced the documentation they require for audits, Deloitte has actually added procedures. Then there's the firm's compensation system, which is designed to eliminate potential conflicts of interest. Partners are evaluated on client satisfaction and are not assigned revenue targets. Auditors are not rewarded for selling consulting. Deloitte Consulting has a separate profit-pool from the accountants. And in 1999, Deloitte did away with a short-lived bonus program that provided $5,000 "synergy payments" for auditors who referred clients to Deloitte Consulting. Perhaps most important, top accountant Parrett encourages audit partners to stand up to clients trying to employ dubious accounting. "If a partner ever decides to resign from an account because the client wants to do something we don't want to be associated with, he's celebrated, not chastised," he says. Lynnette Frank, a 33-year-old audit senior manager in the Seattle office, says it is not uncommon to wrangle with clients over an accounting decision. Among other duties, Frank helps direct the eight-person team that "counts the beans at Starbucks," as a humorous Deloitte advertising campaign once put it. "I get more respect when I disagree with a client," she says. While her relationship with Starbucks has been cordial, in other instances, "I've had a CFO in my face before, but I stood my ground, and he accepted it."
Given all the years they've spent building up their one-firm model, it's not surprising that Deloitte executives can cite any number of reasons their pending divorce is a disaster. They often start with the claim that audits from an accounting-only firm will get worse, not better. Parrett, whose first leadership experience was directing a high-school drill team, compares the modern auditor's role to that of an orchestra conductor, whose skill lies more in harmonizing the efforts of talented performers than in playing music himself. Auditors need technical expertise, be it in financial derivatives or the workings of advanced computer systems, to understand the books of today's complicated businesses. Those technical experts, he argues, won't stay with a firm if they can't do cutting-edge work--and audit support is hardly cutting edge. "You'll get less and less qualified people doing work in more-complex companies. That's a formula for disaster," he says.
In truth, however, there is little evidence that this breakup will prove calamitous. Deloitte consultants do brief auditors on the ways in which big IT installations affect a client's business. But the auditors can get these briefings from whoever installs the computers, be it Deloitte Consulting or IBM. Lynn Turner, the former chief accountant of the SEC who clashed frequently with the Big Five, points to a study the SEC published in May 2000 that found that only 17% of companies used their auditors for IT consulting. "I didn't hear the Big Five say the other 83% of audits were lousy," Turner quips. And Deloitte's own Garland acknowledges that spinning off Deloitte Consulting will probably do little to degrade the firm's auditing capabilities.
In fact, Deloitte's consultants are surprisingly optimistic about flying solo. Consulting shares only 15% of its clients with audit--and that's a loose definition of the word "shares." For instance, Michael de Maar, a Consulting partner who specializes in health care, admits that until he was introduced to him recently, he wouldn't have recognized the Deloitte auditor of one of his longtime clients if he had collided with him in the street. "I have no reason to ever talk to the guy," de Maar says. The two halves of Deloitte's business have had separate profit pools and management structures since 1996. In other words, it may be a shotgun divorce, but the couple have been sleeping in separate beds for some time.
The spinoff will actually provide Deloitte Consulting with new opportunities. Currently the firm occupies the middle ground between high-end strategy firms such as McKinsey and the Boston Consulting Group and heavy-duty tech implementers such as EDS. "We have great ideas, but we can also implement those ideas," McCracken says. "There aren't many consulting firms that can do that well." But because of auditor-independence rules, there are several things Deloitte Consulting can't do now. One is "transformational business outsourcing." In these deals a consulting firm not only agrees to design and install a client's business process--such as an inventory-management system--but actually operates it as well. Freestanding consulting companies like Accenture have moved heavily into this booming area in the past year, in part because it provides a sizable annuity business that can help them weather economic downturns, says Michele Cantara, a consulting industry analyst with the Gartner Group. "This area could be as big as the entire rest of our consulting business," says top Americas consultant Singh, who adds that he wants Deloitte Consulting to offer the "whole enchilada" in terms of types of service. Deloitte could also begin taking equity stakes in clients or offering services on a contingency basis, two more things it is barred from doing under current rules.
As with any divorce, the details of the separation are of great concern to both parties. A task force made up of both consultants and auditors is trying to deliver a set of recommendations ahead of its May deadline. The firm has already had to quell rumors circulating among its staff that McCracken agreed to sell the consulting side to a large tech consulting company during a meeting at the Super Bowl (McCracken wasn't even at the game). A sale or an IPO are possibilities, but most people at Deloitte are strongly in favor of a private partnership. The only concern is whether the firm will be able to raise enough capital to compete with companies such as Accenture and KPMG Consulting, which had the good luck to build substantial war chests through tech-boom-era IPOs. Also yet to be determined is whether the consulting partners will have to make any kind of payment to the accounting partners and whether the new firm will be allowed to keep the Deloitte name.
Whatever the shape of the separation, CEO Copeland will run the $9 billion accounting business, and that's what he's focused on these days. Copeland did pursue merger discussions with Andersen, at the behest of Andersen CEO Joseph Berardino. But Deloitte was never satisfied that it would be isolated from Andersen's legal risks, and a broad deal fell through. "We decided that there was no way to do a global transaction without running more risk than we are willing to run," Copeland says. Instead, Deloitte will probably pick up bits and pieces of Andersen. As of press time, Deloitte had won 13 former Andersen audit clients. It also signed deals to acquire Andersen's British and Spanish businesses, and parts of its U.S. tax practice, which consists of some 600 partners and thousands of employees. But even that deal may get hung up by Andersen's legal woes. Several insurers that are plaintiffs in the civil suits over Enron's collapse have filed for an injunction to block the acquisition.
Copeland has also been working to ensure that the nation's financial system itself doesn't get hit too hard. He's huddled with the SEC to develop contingency plans to handle the financial reports of Andersen's 2,300 audit clients in the event the firm collapses entirely. He's also been pushing his idea for creating a board of financial experts that would report on major corporate failures the way the National Transportation Safety Board reports on airline crashes. "That way you don't have to worry if the process is going to become politicized," he says. Copeland's idea has won plaudits from some legislators but no concrete political support yet.
The Deloitte CEO is also organizing lobbying efforts against further limits on the kinds of work accounting firms can perform. He is convinced that these restrictions will make audits worse. Spend any length of time talking about this with Copeland and it becomes obvious that he's pessimistic about the immediate future. "I wish I did believe this would all go away, but I don't," he says. "And I don't think it will stop. There is a real chance here for people who don't know what they are dealing with to come to a conclusion that will make audits less effective and the profession less viable." Indeed, proposals to turn accounting firms into audit-only shops--such as legislation introduced by Senators Chris Dodd (D-Conn.) and Jon Corzine (D-N.J.)--could well hurt Deloitte, by robbing the firm of the technical experts who, in Parrett's orchestra analogy, are the principal soloists.
In Seattle, for example, Jim Flaherty's Microsoft audit team leans heavily on Tom Scrivener, a 30-year-old senior manager in Deloitte's global markets group. He's a derivatives whiz. The section of the Generally Accepted Accounting Principles that deals with these complex financial instruments runs to over 800 pages; Scrivener knows it backward and forward. He's so good that when Deloitte was hired to assist the special committee of Enron's board looking into the company's restatement, his bosses put him on the team charged with sorting out the web of swap transactions that underpinned many of the company's complex off-balance-sheet partnerships. Scrivener devotes part of his time to the Microsoft audit and spends the rest of it assisting clients in structuring transactions. He says that this improves his ability as an auditor. "We have to work as hard as we can to keep up with the Wharton and Harvard grads at the investment banks who come up with this stuff," says Scrivener, an alum of the University of California at Santa Barbara. It's the consulting that keeps him interested in his job. "If you take away everything but the basic audit," he says, "I wouldn't stick around."
That is Copeland's nightmare, and it's one of the things that's fueling anxiety for the workers on the ground, who are waiting to see which accounting industry reforms are enacted. Sheryl Hildebrand, who heads the Enterprise Risk Services (ERS) practice for the Northwest, admits she's nervous. Her team of IT and internal auditors help companies test and strengthen controls over financial and operational systems. ERS straddles the gap between consulting and auditing but is located in the accounting part of Deloitte. So Hildebrand knows ERS could be vulnerable if accounting firms are forced to severely limit the scope of their services. She says she was surprised by the firm's decision to spin off Deloitte Consulting, and now she doesn't know what to expect. So when her group meets to discuss this topic, she plans on bringing a Magic 8-Ball. "That way we might be able to get some answers," she jokes. That's about as predictable as the once-staid world of accounting has become these days. No one knows what the future of the profession will look like. The best answer anyone can give is the same one you might get from the wise old 8-Ball: Ask again later.