Big Five Firms in 2000 and Beyond . An Interview with Stephen G. Butler By James L. Graig Jr. In Brief

'Certified Public Accountant' Is Still in the Vocabulary

Stephen G. Butler, chair and CEO of KPMG LLP and chair of KPMG International, gives his vision of KPMG and the other Big Five firms into the next millennium in an interview with CPA Journal Editor-in-Chief James L. Craig, Jr. Contrary to popular opinion, he sees assurance services as essential to the growth of public accounting. The cost of capital will be lowered for those companies that provide high-quality information, financial and nonfinancial, on which an accounting firm gives appropriate assurances.

The anticipated initial public offering of a portion of his firm's consulting business will provide capital to KPMG LLP, create a vehicle for long-term compensation arrangements to retain and attract professionals, and provide a degree of separation between the consulting practice and the traditional audit and tax practices. Other Big Five firms are also trying to address regulators' concerns that the growth and profitability of nonaudit services threaten the integrity of audit practices. The SEC will be watching, perhaps somewhat anxiously, to make sure that the audit practices of the large firms are in no way compromised.

The future of the accounting profession into the new millennium will be strongly influenced by the Big Five firms. They are major contributors of people and resources to the self-regulatory process. They are also leaders in the development of new professional services. Because they audit most of the largest publicly traded companies, the Big Five firms receive significant attention in the press.

As successful businesses, the Big Five firms face the same pressures and demands of other large businesses. In recent years, they have seized the opportunities presented by the strong market for consulting services and grown this business at double-digit rates. The SEC, however, has raised ongoing concern that the Big Five's attention to consulting may be at the expense of their audit practices.

The Big Five, as most large businesses in periods of growth, need new capital as they enter new ventures and seek to maximize the benefits of technology. But as they explore new sources of capital, they are attempting to address the SEC's concerns about consulting services. Recent reports say that Ernst & Young is selling its consulting practice to a French consulting firm and that Deloitte Consulting has been effectively separated from Deloitte & Touche. PricewaterhouseCoopers recently announced that it is exploring dividing into a number of different businesses with a possible spin-off and public offering. KPMG, the first firm to announce plans to monetize an aspect of its operations, said last year that Cisco Systems is investing $1 billion in its consulting practice and that the firm is planning a public offering of shares for a portion of its consulting business.

CPA Journal Editor-in-Chief James L. Craig, Jr., recently spoke with Stephen G. Butler, chair and CEO of KPMG LLP and chair of KPMG International, about the direction in which KPMG and the Big Five are moving and how they are addressing the business and regulatory concerns that they face.

Reflections on Consulting and Auditing

The CPA Journal: The No. 1 question being posed to the large firms by regulators and the public is whether the huge success and growth of their consulting practices may in part be at the expense of their audit practices. What is your view?

Stephen G. Butler: It starts with a lack of understanding on the part of the SEC of the importance we place on the audit and, for that matter, the traditional tax services segments of our operations. These are large businesses for us. For example, in the United States, our very profitable audit practice produced $1.7 billion in revenues last year. During that time, we also invested more than $40 million in product development for the audit area: enhancing audit tools, expanding the use of technology, and refining our procedures. That sum does not include the huge annual investment we make in staff training for our auditors. We are making these investments as businesspeople, because auditing is a good business. It is a core product.

CPAJ: Why have you been unable to convince the SEC that auditing is not being neglected?

Butler: Perhaps some background will help to understand where we are on this subject. When the SEC first focused on nonaudit services and their possible impact on audit clients, it required disclosure of fees charged to audit clients for those services. After a number of years, that requirement was dropped because it was no longer considered necessary in evaluating auditor independence. I think that because a relatively small proportion of the large firms' consulting services is provided to their audit clients, the disclosures were not revealing troublesome relationships. For example, at KPMG only about 25% of our consulting revenue is derived from audit clients. Reports on consulting fees by members of the SEC Practice Section are consistent with our experience.

The SEC has since refocused its concerns on a macro basis. The staff sees the consulting practices are growing at faster rates than the traditional services and has concluded that they must be more prof- itable. I don't know where they got that idea. But having reached that conclusion, the next step was to think that we must be directing the major thrust of our resources toward consulting at the expense of assurance services. This is absolutely not the case.

We at KPMG, and I think it is true at the other large firms, run the various service lines as distinct businesses. There are different metrics and operating tools that are used to operate each of them. And we provide the resources that are necessary to maintain them all as viable, growing, profitable businesses.

CPAJ: Are the large firms attempting organizational changes that will give assurances to the public that one line of business is not inappropriately influencing another line of business?

Butler: I don't know the details of the other firms. But, for the most part, if you looked at our three major lines of business--assurance services, tax services, and consulting services--you would see a direct correlation between the profitability of those businesses and the compensation of the partners in those businesses. There is very little profit transfer from one business to the other. Some minor shifting may occur because we set compensation based on estimates at the beginning of the year and the actual relative contribution of the business lines can differ.

CPAJ: Would an assurance services partner's compensation in any way be based upon the level of referrals she made to the consulting business?

Butler: Individual partners are compensated relative to the individual goals and objectives that are set for them--we have a performance-based compensation system. For the most part, the goals of an assurance services partner will be set based upon the growth and profitability of the assurance services business.

CPAJ: Is cross-selling part of your strategy for growth?

Butler: KPMG has been in the public accounting business for more than 100 years, during most of which time we have provided audit, tax, and consulting services. The reason we are in those businesses today is because the marketplace wants us there. There is a commonality of skill sets; clients have confidence in our services and the people that deliver them. When making proposals to prospective audit clients, many of the questions that are asked have to do with the complement of skills we bring to the table, not just the question of can we do a great audit. They want to know how else we can help them with their business.

Maintaining Independence

CPAJ: What assurance does the public have, because you are a multifaceted firm offering a variety of services, that your assurance services will not in any way be compromised?

Butler: The business imperative to the audit business and us is to maintain our independence, our integrity, and our reputation. That is the No. 1 economic motivation. The risk of not preserving our reputation in the marketplace is huge. The risk from a litigation standpoint is even greater. The financial penalty is enormous. We have extensive internal monitoring procedures for independence that address all of the independence rules, not just the direct investment aspect. We do not get into situations that would in any way jeopardize our independence and our reputation.

CPAJ: What about putting the assurance services in a separate entity?

Butler: Our discussions and considerations are more the other way--about putting the consulting business in a separate entity. The end result, I think, is basically the same. As was announced last year, we have a three-step strategy in mind: Incorporate the consulting business; sell a minority stake to Cisco Systems for $1 billion; and sell a majority ownership interest through a public offering. KPMG would continue to hold a minority interest, say 20%, in the consulting entity. We have run into some resistance and expression of concern from the SEC staff, which we don't understand and which the SEC staff has not been able to articulate very crisply.

Part of the value of the IPO transaction is that it will provide some separation between the consulting and the core assurance services business. The SEC's concerns, I think, are connected to the appearance of independence, whereas we believe that we have independence in fact.

CPAJ: You are a member of the Independence Standards Board. Do you think the board is making progress?

Butler: It is the intention of the board to develop principle-based standards--as opposed to the detailed rules we have now--on auditor independence. The existing rule-based approach has gotten very cumbersome and has been driven by individual cases. Some rules are archaic.

The most important work product for the ISB is to develop a conceptual framework. We must address the very important question of the role of appearance of independence versus the fact of independence. This is a major fundamental issue for the ISB. The framework is a long-term project. In the meantime, the ISB must address some of the burning issues and develop specific guidance. The alternative firm structures issues, such as those raised by our spin-off, cannot wait for the conceptual framework to be completed.

Once the framework is done, the output of the ISB will pick up considerably.

CPAJ: The ISB is unique in that it has four "public" members--including its chair, William Allen--and four members from the profession--three managing partners of Big Five firms and Barry Melancon, president of the AICPA. Is the board composition working?

Butler: We have not had any situation where the public and professional members have not been able to discuss the issues in an open and frank way. I have not seen any polarization.

The conceptual framework project will, however, have the added benefit of helping the public members understand independence. Those of us that have grown up in the profession know what independence is. But to those without that experience, the concept might not be as clearly understood. The notion of an individual partner reaching an objective, impartial opinion relative to an individual client is foreign to many. The public thinks more in terms of conflicts of interest.

The Future Shape of Assurance Services

CPAJ: What kind of vision do you have for the large firms five years from now?

Butler: They will be dramatically different, because the business world will be dramatically different. The CPA profession has the opportunity to play an expanded role in providing assurances on information well beyond the traditional financial statements, including nonfinancial information and internal controls.

There will be a strong demand for immediate access to relevant, high-quality information. The marketplace rewards those that get good information out quickly. Public companies can't wait until after a quarter closes to know what the results are. The analysts exact a heavy toll on those that miss the estimates. There is a role here for the independent accountant. We need to add value to the quality of information made available both internally and externally.

CPAJ: Will a report be issued or will it be more of a consulting engagement?

Butler: I think it will be an assurance function that revolves around immediate access to information. It might be an opinion that the system can be relied upon to generate the information. KPMG is looking at what the assurance services of the future will be, and we envision a market need along the lines I'm describing.

CPAJ: This makes a great deal of sense. But in the past financial executives have resisted independent auditor involvement in reporting on internal controls and nonfinancial information. Who is going to buy these services?

Butler: There will be demand for these services when it is demonstrated that auditor involvement, by increasing the quality of information, lowers the cost of capital. I believe we will see progressive and forward-looking companies that will engage auditors to validate their procedures and information. The market will reward them in the value of their shares.

CPAJ: Won't this widen the gulf between the services large firms can provide and those that regional and local firms can provide?

Butler: This is an important place for the AICPA to come in and develop services along the lines of WebTrust. The large firms, in my opinion, do not want to see a two-tier profession where the local firm is relegated to a lower-level service. We want the whole profession to move ahead.

CPAJ: In the future, then, assurance services will still be a large part of what firms do, but it may be services of a much different nature?

Butler: We see this as a growth business. The large firms have had double-digit growth in their assurance service practices, and this will continue.

These types of services should help companies and boards allay the SEC's concerns about earnings management and booking adjustments to achieve analysts' projections. Assurance services will demonstrate companies' and boards' commitment to quality financial reporting and the integrity of the securities markets.

Finding and Retaining Talent

CPAJ: Where are you going to find the people you need for growth with the skill sets you need, when we see a decline in the number of people taking the CPA exam and a shortage of people, in general, in the profession?

Butler: The supply of people coming into the profession is less and there are a number of reasons for this that can be remedied. First, we have moved to a five-year education requirement, but without an appropriate adjustment to starting salaries. Some college students are deciding not to commit to the additional time because they do not see the financial benefit. We have to increase starting salaries to what other masters' degrees would attract.

Another factor is the regulatory need to practice in the partnership or CPA owner format. We do not have the wealth accumulation opportunities for our employees that exist in companies that are able to issue stock options. This is a major impediment to attracting and retaining talent. One of the reasons we are seeking to monetize our consulting practice is to create an opportunity for wealth accumulation tied to the business entity's success. To the extent that the investment community wants to have a vibrant auditing profession, it needs to help us change our organizational structures to be able to have the kinds of compensation tools necessary to attract the right kind of people.

CPAJ: Does that mean the stock in KPMG consulting would somehow be used to compensate KPMG auditors?

Butler: No. It does, however, give us a capital base for developing long-term compensation systems that vest over a period of years. As a partnership, we can't do that. We have to distribute all our profits at the end of each year. If, as a result of the spin-off, we have capital to use as long-term compensation, it would provide at least a stopgap for developing the long-term wealth accumulation capabilities we need. An example would be a $200,000 award that would vest over a five-year period.

But, back to the issue of attracting talent to the profession. We need to recreate the belief that existed when I entered the profession that there are attractive career opportunities with substantial financial rewards waiting for those that are successful. We need to recreate that picture in the minds of the young people deciding what they want to be and do.

Building for the Future

CPAJ: What will KPMG look like in the future?

Butler: I expect that KPMG will be on the leading edge of what this profession will be into the next century: understanding the market, doing market research. We need to think about such things as what the movement toward e-commerce will do to the nature and demand for our services. Staying out in front of the market will require capital. We will have to find innovative ways to capitalize our businesses; the capital accounts of partners will not be enough. If we are going to properly serve the public, we have to have access to the capital markets, which will enable us to make the huge investments in technology and attract talent with the right level of compensation. We have the same demands that any successful business would have. We should not be restricted access.

CPAJ: Have you thought about adopting the American Express Tax & Business Services model? That is, run the assurance services through KPMG LLP and operate the rest of the business through a commercial corporation?

Butler: We have chosen to spin off the consulting practice. I think if you spin-off the assurance services practice without capital, that presents real problems as to how growth will be financed and competition met.

CPAJ: Should that concern the SEC? Butler: The SEC wants the firms to invest in their audit practices. I wonder where they think the money will come from.

The International Vision

CPAJ: You also chair KPMG International. What is your thinking on the future of the Big Five at the international level?

Butler: Right now the international firms are basically membership and name licensing organizations. Four are organized as Swiss boreins and one is a cooperative society. One of my major objectives for KPMG, and I am sure it is true of the others, is to create a true global firm, managed on a global basis with a full sharing of profits. We will have to maintain the national organizations for licensing and regulatory reasons, but we can manage on a global basis. That is the path we are on and we hope to get there very quickly. As a first step, we have combined member firms in North and South America, Australia, and New Zealand to form a KPMG Americas body. The national practices in the United Kingdom, Germany, France, and the Netherlands have combined and are operating as the European Anchor Practice.

CPAJ: The SEC has begun to express concern about the quality of international auditing standards, while at the same time it examines the core standards as established by the International Accounting Standards Committee. The large firms in many ways become the international standards setters, do they not, through their international practices?

Butler: We provide uniform standards and U.S. quality auditing practices with regard to international organizations. For organizations that are strictly domestic and prepare their financial statements following the domestic standards, the firms issue audit reports that also conform to the domestic standards. We can't control that because we don't set those standards. American standards are not superimposed, and why should they be? In my opinion, the fundamental international issue is the transparency of accounting standards. That's why we need sound, transparent international accounting standards that become the minimum even at the domestic level.

CPAJ: How is the AICPA Vision Process affecting your strategy for KPMG and KPMG International?

Butler: The Vision Process is very much in keeping with our own vision and strategy as we look at the next 10 years to expansion of services based upon the core values that have made the profession strong and respected. I see the process as being a very positive thing in uniting the whole profession behind a common vision. It is a demonstration of leadership on the part of the AICPA to bring to all firms, no matter how small, managerial thinking and concepts that the large firms are already doing.

The development of WebTrust by the AICPA is an example. KPMG or, for that matter, any one of the Big Five could have developed a service along the same lines. But by having the AICPA develop it, it becomes a CPA service and enhances the perceived value of the CPA designation in the marketplace for all firms. It allows all 330,000 CPAs to offer a service, rather than just one firm. I think that is good for the profession.

CPAJ: KPMG is not a CPA firm? At least it doesn't say so on its letterhead.

Butler: All the partners are CPAs. We are a CPA firm.

CPAJ: Do you sell yourself as a CPA firm?

Butler: Absolutely. One of the reasons we are successful in the consulting business is because it is conducted through a CPA firm. The market attaches great objectivity, quality, and independent thinking to work done by CPA firms.

CPAJ: Are consulting partners partners of the firm? One of the accounting industry newsletters said that non-CPAs owned 34% of the firm.

Butler: Consultants are partners only if they are CPAs. Otherwise they are principals, with no capital account.

CPAJ: When the consulting practice is converted to a public company, will it be part of KPMG?

Butler: It will be a member firm, operating globally. It will be in a separate profit pool--we can't share profits with a public company.

CPAJ: Are other mergers likely among the Big Five firms in the next five years?

Butler: I think that is a real possibility. Mergers will be strategically driven to obtain geographic coverage as we globalize more and more. They will happen because some firms lack full geographic coverage and will combine to solve that.

CPAJ: Will KPMG need to do that?

Butler: As the third largest of the Big Five, we have the right geographic coverage--strong in the major markets of the world.

CPAJ: Steve, thank you for giving us your vision of the large firms into the 21st century. It's all about change and new opportunities.

Butler: We are in an information age revolution. Those that do not think every day about what they need to be doing differently won't survive. *

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