Privately held companies report reasons for selecting and switching auditors. (Industry Overview)by Davis, Brian
Recent research shows companies are putting their work out for bid to a greater number of audit firms. At the same time, managing partners are putting more pressure on their fellow partners and managers to increase their batting average in landing audit clients.
Over the last few years, national CPA firms have focused greater attention on acquiring small business clients since there are only a limited number of large client firms available and small firms make up the overwhelming majority of businesses in the U.S.
The fierce competition to win new clients and retain current ones prompted this study of small, private companies. Those seeking to analyze the market place need to consider.
* What criteria do private companies use in selecting audit firms?
* What are the reasons private companies switch audit firms?
To better understand the auditor selection/retention thinking of chief executive officers who are the ultimate decision-makers in small, private companies, we surveyed the INC. 500, the 500 fastest growing, private companies in America.
INC. Magazine selected the 1992 INC. 500 from 21,000 candidates. To gain a spot on the INC. 500, a company must have been independent and privately held. To make the 1992 list, it must have shown at least $100,000 in sales, but no more than $25 million for 1987; and must have shown a sales increase between 1990 and 1991. The final ranking was a function of percentage sales growth from 1987 to 1991.
Because of the population size, sampling was not used in this study. Instead, the researchers attempted to contact the CEOs of all 500 companies. In spite of an exhaustive search, 24 surveys were returned as undeliverable and 251 did not respond or could not be contacted. The original and follow-up mailing yielded a response from 225 CEOs, or 45%. Of the 225 responding CEOs, 74% had engaged an audit firm during the past five years. Over one third (36%) use local audit firms, 42% engage one of the Big Six firms, three percent hire national firms other than the Big Six, and 19% use regional firms.
The questionnaire asked the CEOs to rate the importance of 12 factors relating to their selection of an audit firm. In addition, they were asked to rate the relative importance of 10 factors relating to their switching to another audit firm.
What Criteria Do Private Companies Use in Selecting Audit Firms?
The CEOs of the INC. 500 rated the importance of 12 factors in choosing a new auditing firm. On a seven-point scale, these CEOs rated four of these factors above "4," indicating there is more than one major factor in the critical selection decision. Exhibit 1 lists these 12 factors and their overall average rating.
EXHIBIT 1 FACTORS FOR CHOOSING AUDIT FIRMS
The following survey of INC. 500 CEOs shows results in descending order of importance (6 = great importance; 0 = no importance) of 12 factors as the reasons for selecting a new audit firm.
Personal Relationships. Topping the list of four key factors that are especially pertinent was "personal relationships." CEOs placed considerable importance on the relationships established between the CPA firm's key people and the company's key decision-makers during the course of the proposal process. Confidence in the audit firm is especially important to client companies--particularly during the proposal process. The dialogue and quality of interchanges between audit firm and client ought to be nurtured skillfully during the proposal "courting" stage.
While an important factor, "fees" was not the dominant factor. Fees ranked third behind "technical experitise." Apparently CEOs of small, private companies hold a much broader perspective of selection determinants than many audit firm partners and managers would expect.
Technical and Industry Expertise. The selection factor "quality of technical expertise of the assigned team" came in a close second to the number one factor. Small, growing companies clearly expect the assigned audit team to have excellent technical credentials.
Similarly, "quality of industry expertise of the assigned team," ranked among the top four factors, indicating the importance CEOs place on CPAs understanding their type of business. CEOs indicate an engagement team should have both technical expertise in accounting as well as industry-specific experience.
Other Selection Factors. The "quality of the oral presentation" rated fifth in importance to the CEOs surveyed. This factor, while distant from the four top factors, shows the highest degree of importance among other factors. CPAs must clearly communicate their background and understanding of the firm's needs in the oral presentation.
Although not rated quite as high as the oral presentation (3.66), the quality of the written proposal (3.33) carries some weight in the overall selection process. A clear, concise written proposal is among CEO expectations. Oral and written communication skills must be evident or the proposal will fall flat.
CEOs expect an audit firm to provide additional tax or consulting services to meet their needs, such as planning, budgeting, etc. Having a "broad range of services available" is a message CPAs should communicate in their proposal. "Size of firm" plays a meaningful part to some of the companies surveyed; this factor received a 3.35 ranking.
The next two factors suggest the importance of further cultivating relationships. The recommendation of a CPA firm from an outside person has an impact on the CEO; likewise, some degree of acquaintance between a key player in the CPA firm and a key member of the client company can affect the selection decision.
Rounding out the factors showing a "3" ranking was the "location of the CPA firm's offices." An audit firm engaged by a company needs to be sufficiently close in distance to foster the relationship needed.
Well below all factors was the international resources available within the audit firm selected (1.92). For the INC. 500 firms, this factor simply was not important. Firms trumpeting their international resources need to take particular note of this finding and focus their marketing efforts on more important issues to small, growing companies.
In addition to the 12 factors rated, some CEOs wrote in comments in two areas. One area focused on reciprocity. For instance, a CEO summarized his feelings in this way: "they buy our product and we buy theirs; it's a mutual business relationship."
The other area of note relates to the company's need for a CPA firm with national "brand-name" stature in order to satisfy their lending institution. One CEO commented: "The reason for the audit is that it is required by our bank who also required that we use one of the Big 12 audit firms."
Why Do CEOs of Private firms Switch Auditors?
Of the INC. 500 CEOs responding to the survey, 58% said they had switched audit firms during the last five years. Realizing that a successful CPA practice must retain existing clients as well as win new ones, CEOs of the INC. 500 were also asked to rate the critical factors leading to switching audit firms. Ratings were made on a scale ranging from 0 (no importance) to 6 (great importance). Exhibit 2 lists these 10 factors and the overall average rating on the seven-point scale.
EXHIBIT 2 FACTORS FOR CHANGING AUDIT FIRM
The following survey of INC. 500 CEOs shows results in descending order of importance (6 = great importance; 0 = no importance) of 10 factors as the reasons for changing to another audit firm.
Not Proactive/Not Service Driven. CEOs indicated poor service can be fatal. The No. 1 and No. 2 factors for switching to another auditor centered on the audit firm not being proactive and not being responsive. In other words, the auditor simply made insufficient effort to help the client company address concerns, foresee problems, or take initiative to help the company grow. To further explain these concerns, one CEO commented: "They need to learn my business; we needed ways to save tax dollars. They had no recommendations; there was no tax planning."
Closely aligned with these two service-related factors was "no new ideas," which rated third closely behind responsiveness.
All three of these factors speak to the "take-care-of-the-client" philosophy. Not responding to the client's need in a timely manner or not providing the expertise requested spells trouble with that client. An audit firm must advance ideas to help increase the efficiency or profitability of the client company. For example, some companies need help in reducing expenses, developing policies/procedures, improving planning activities, implementing total quality practices, etc.
Just as the CEOs rated industry expertise important in the selection process, the factor "inadequate understanding of the company's business" ranked fourth among the reasons for non-retention. These four factors were placed higher than fees in the overall rankings of CEO responses.
Fees--Not The Dominant Factor. Because of the competitive environment, a common belief is that companies select new audit firms almost strictly on price. Yet, INC. 500 CEOs rated fees ("fees too high for value of services rendered") as the fifth most important factor in switching audit firms. While the cost of services rendered plays a role in retention, "fees" is not the dominant issue.
Other Factors. Rated sixth and seventh were "inadequate communication between the audit team and company personnel" and "change of personnel on the audit team assigned to the company." These items were of less importance to CEOs, but they are high enough to require attention.
One of the most surprising findings in this survey is the small importance CEOs placed on disputes over accounting treatments arising during audits. This finding is in sharp contrast to the contention that clients routinely switch to buy an unqualified opinion.
Also, the factor "interpersonal clashes between audit team and company personnel" received a low rating. Lastly, the factor "periodic rotation of CPA firm" is a non-issue, as it received only a.98 rating.
Additional reasons for changes written in by CEOs centered around the need for a larger CPA firm. Specifically, some CEOs indicated they needed a national CPA firm with the experience to take their company through a public offering. For example, one CEO wrote: "Our present CPA firm could not sign the SEC tial public offering (IPO) document." Another stated, "We wanted a Big Six firm for the IPO."
Other comments focused on the need for a larger firm with more credibility. One CEO summed up these feelings through this comment: "too small...bank required larger firm, i.e., greater credibility." Another said, "one of the Big Six was selected for recognition of their franchise marketing understanding."
As INC. 500 firms continue to grow, some CEOs feel constrained to utilize a CPA firm with more clout and specialized expertise.
Implications to Practitioners
Fees are not the primary reason for either obtaining or retaining a client. The results of the survey show meeting client needs is the overwhelming issue.
Given the intense competitive environment prevailing to gain new clients and retain present business, practioners need to develop new strategies and provide training to promote client relationships. Furthermore, a bidding audit firm should be skilled in the entire proposal process: truly determining the client's needs; communicating thoughtfully and often during the proposal process; and addressing the client's needs expertly--in person, on paper, and in the formal oral presentation.
Strategies to capitalize on the communication process should include the formation of a proposed audit team with both technical and industry expertise to address the company's needs and to articulate that match during the "courting process." Canned proposals and flashy brochures proclaiming audit firm size and worldwide services will be less effective than proposals that illustrate how the bidding CPA firm can solve the client's real concerns.
Client loyalty simply cannot be taken for granted. Although fees are naturally important, practitioners should spend less partner/manager time numbercrunching to manipulate the audit fee "just a bit lower" on each engagement. Rather, more emphasis should be placed on training managers and staff in cultivating clients, enhancing present relationships, and staying on the cutting edge technically in order to proactively assist a firm in its quest for greater profitability.
Obtaining a new engagement is the culmination of a solid relationship that begins when a practitioner reaches out to a potential client at a social or business function. The practitioner makes headway in that relationship by asking the right questions, to uncover real needs, and by educating the prospective client on how the CPA firm's services can fulfill those needs. Once the relationship results in winning the engagement, the practitioner must not only complete the work as agreed but also be perceived as a problem-solver while continually strengthening the relationship. In this way, more audit engagements can be garnered and fewer active clients lost.
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