Analysis: Conflict of interest fears tax Deloitte

Questions still hang over the future of IT services provider Deloitte Consulting nine months after its parent company, accounting giant Deloitte Touche Tohmatsu, backtracked on plans to separate itself from the consulting unit to avoid potential conflicts of interest.

Deloitte Touche's sudden decision in March to scrap a 14-month old plan to spin off Deloitte Consulting as an independent, privately-held company has put this IT services provider in a difficult position in which challenges outnumber advantages, industry analysts say.

The U.S. government has recently put in place stronger laws and regulations to protect auditor independence and prevent conflicts of interest. Thus, Deloitte Touche's decision not to spin off the consulting group creates concerns for prospective customers and complications for its sales staff. "Deloitte will constantly have to watch its sales force, because there are restrictions on who it can sell to. It will have to be cautious," said Nigel Wallis, an IDC analyst.

Regulatory matters aside, it also doesn't help that Deloitte Consulting seems to be sticking with its core strengths in consulting and systems integration, for which spending has been very timid in the past three years, instead of branching out into the more profitable and fast-growing outsourcing segment, analysts say.

"The outlook for project-based services, such as consulting and SI (systems integration), shows little growth. Thus, firms offering these services will be challenged to grow their revenue," said IDC analyst Stephanie Torto.

The severity of the challenges is such that nine months after the decision, Deloitte Consulting and its parent firm are still struggling to clear the air and get back on track. "The jury is still out. They're still working through this," said Andrew Efstathiou, a Yankee Group analyst. "I do think they're struggling."

The consensus from analysts is that despite the turmoil, Deloitte Consulting retains the skills that have made it an important provider of IT consulting and systems integration services. "The level of expertise and range of capabilities they have coming out of the Deloitte Consulting organization remains pretty much stable," said Andrew Parker, a Forrester Research Inc. analyst.

However, current and future Deloitte Consulting clients and partners are advised to keep a close eye on the situation. Decisions made in 2004 will determine whether the IT services unit can in fact function properly and effectively as part of the parent company or whether it will be sold off to an IT vendor interested in bolstering its IT consulting and systems integration skills, Deloitte Consulting's specialty, analysts say.

"To engage them for extension of projects they've done in the past for the client isn't risky. The real risk would be a large-scale integration project," Efstathiou said.

The original plan

Deloitte Touche announced in February 2002 its intention to separate itself from Deloitte Consulting as a reaction to the scandal energy company Enron Corp. and its independent auditor Arthur Andersen LLP found themselves in. Enron's financial collapse and Dec. 2001 bankruptcy revealed accounting irregularities that put Arthur Andersen in the spotlight, particularly for its dual role of auditor and consultant for Enron.

The scandal resurrected a dormant issue: Isn't it a conflict of interest when an auditing firm, whose job is to objectively review its clients' books, also sells highly lucrative, non-audit consulting services (such as IT services) to those same clients? In the years prior to the Enron scandal, the most lucrative type of non-audit consulting service provided by accounting firms had been IT services.

In this environment, the three of the so-called Big 5 accounting firms that hadn't shed their IT consulting units -- Deloitte Touche, PricewaterhouseCoopers and Andersen Worldwide -- scrambled to do so. They rightly foresaw new U.S. laws and regulations to limit the consulting work they could sell to audit clients. They also sensed concern among their clients over the auditor independence issue.

PricewaterhouseCoopers sold its PwC Consulting to IBM Corp., and Andersen Worldwide sold its IT consulting practices in pieces, before an obstruction of justice conviction on a U.S. federal court mortally wounded the firm.

Deloitte Touche announced its separation intention on Feb. 2, 2002, saying in a statement it wanted "to enable audit clients to continue to use the talents and skills of Deloitte Consulting without raising public concern about auditor independence." James E. Copeland, then the firm's chief executive officer, said in that press release: "We cannot put our clients in the position of having to choose between working with the best auditing professionals and our world-class colleagues from Deloitte Consulting."

But after spending millions in the planned split, choosing a name (Braxton) for Deloitte Consulting and preparing the market, Deloitte Touche did leave its clients in that difficult position. Copeland blamed an uninviting financial scenario for not carrying out the split.

The current plan

Multiple attempts over almost two weeks to obtain comment from Deloitte were unsuccessful. A company spokeswoman said no one was available for interviews due to the end-of-year rush.

However, she sent the IDG News Service a still unpublished article written by a senior partner of Deloitte Touche's U.S. firm that outlines the company's current view of its IT and business advisory services and that is consistent with information some analysts have received from Deloitte Touche.

The article hints at, and briefed analysts outright say, that Deloitte Touche has created a unit to house Deloitte Consulting and Deloitte Touche's non-audit business-consulting services, such as tax and human resources.

Deloitte Touche expects this new unit to allow the company to offer consulting services that extend beyond IT into business areas, analysts say. That way, for example, a company interested in implementing an ERP (enterprise resource planning) application suite would also receive expert advice on its tax strategy. The tax advice might affect the ERP project's design.

To underscore its multidisciplinary ability, Deloitte Touche announced in October a new branding strategy: all units will be referred to as Deloitte, unifying under one brand the audit, business advisory and IT consulting teams.

The challenges

The integration of Deloitte Consulting with Deloitte Touche business advisory teams hasn't been smooth, an analyst said. "It's been quite a transition for Deloitte Consulting. The culture of the two is somewhat different and they're still in an adjustment and integration phase," said IDC's Wallis, who has been briefed by Deloitte Touche in recent months.

Moreover, extending beyond IT services into business advice isn't unique. "Focusing more on business consulting does not provide much competitive differentiation. Many leading IT services firms have a similar approach," said IDC's Torto.

Deloitte Consulting's then chief executive officer resigned days after Deloitte Touche scratched the separation, and analysts say there has been organizational turmoil, leading to staff morale problems. "There were partners and employees that left at or about that time, so there was changeover in client contact in some cases and that created problems," Yankee's Efstathiou said.

While Deloitte Touche celebrates its IT consulting capabilities, analysts warn that it raises red flags for clients concerned about not running afoul of new laws such as the Sarbanes-Oxley Act of 2002 and of strengthened U.S. Securities and Exchange Commission (SEC) rules designed to guard auditor independence. Sarbanes-Oxley and SEC rules allow accounting firms to provide some consulting services under certain conditions to audit clients, but most companies want to play it safe.

"The obvious limitation is Deloitte can't provide advisory services to a company they provide auditing services for unless the client goes through a whole bunch of hoops to say they're not in conflict, and most companies have decided not to do that," Wallis said "If your auditor is Deloitte, you will most likely opt to keep them either as an auditor or a consultant but not both."

That was the case at Longs Drugs Stores Corp., a chain based in Walnut Creek, California, which used Deloitte Consulting for IT work and Deloitte Touche's U.S. firm for auditing. Deloitte Consulting did excellent work for Longs Drugs, including an integrated e-commerce strategy and system, said Brian Kilcourse, Longs Drugs' then chief information officer (CIO) and senior vice president. "I was quite happy with them," he said, citing Deloitte Consulting's deep industry knowledge, willingness to work within Longs Drugs' management framework and willingness to stand behind their work.

But with the Enron/Andersen scandal, Longs Drugs got worried and Deloitte Consulting wasn't chosen for a supply-chain systems integration project it had bid on. "It was the fact that they weren't an independent company that had a lot to do with why they didn't get that bid," said Kilcourse, who retired in Oct. 2002 and is now the senior partner at retail IT strategist BEK Consulting, also in Walnut Creek.

"At the time they were still going back and forth on whether they were going to start Braxton, and while they were doing that we weren't working with them. Our senior executives got quite concerned about the fact that they were also our audit partner," he said.

A Longs Drugs spokeswoman declined to say whether the company is using Deloitte Consulting for IT work currently. She confirmed Deloitte Touche's U.S. firm is still Longs Drugs independent auditor. In an SEC filing in April, Longs Drugs disclosed that it paid Deloitte Consulting US$4.82 million in the fiscal year ended Jan. 31, 2002. In the next fiscal year, ended Jan. 30. 2003, the company paid Deloitte Touche's U.S. firm only $20,000 for non-audit consulting work. The filing doesn't specify whether that money went specifically to Deloitte Consulting, but even if it did, it's a negligible amount compared with the previous fiscal year.

Certain language in Sarbanes-Oxley isn't cut and dry, and the gray areas haven't been tested in court. "The rules have only been recently set out and there are gray spaces. There are definitely deadly sins out there but no one's quite sure what the 10 commandments are. So you have a gap and that's why Deloitte is in a dangerous position. The last thing they want to do is find themselves on the front page of The Wall Street Journal as the new Andersen," IDC's Wallis said.

And it's not only in the U.S. The ripples of Enron have reached international shores, and many countries are proactively enacting legislation and creating regulations along the lines of Sarbanes-Oxley, said Forrester's Parker, who is based in Amsterdam and studies the European market. "It's a worldwide trend among governments to be more stringent about conflict of interest issues," he said.

The limitations of operating from within an accounting firm puts the Deloitte Consulting unit at a disadvantage with most other IT services providers, analysts say. Deloitte Consulting has to present a compelling case to a client which may be more inclined to go with a competitor simply because all things being equal, going with Deloitte can be riskier.

"The new Deloitte consulting and advisory unit has a lot of core strengths but they are in an environment that is difficult for everyone and then they have a few more obstacles than some of their competitors," IDC's Wallis said.

In the coming year, Deloitte Consulting is going to have to market itself aggressively to counter the damage. "This was a transition year for them. They didn't seem to project to the market what their vision of the world was, " IDC's Wallis said. "In 2004 they'll have to make a major marketing push."

If the strategy fails in 2004 and 2005, Deloitte Consulting will become an acquisition target, he said. Hewlett-Packard Co. (HP), which needs to strengthen its IT and business consulting unit and boost its vertical industry focus, would be a logical buyer, he said. "I wouldn't be surprised to see HP and Deloitte form a tighter alliance."

In the meantime, IDC's Torto has this advice for CIOs: "Put the pressure on Deloitte to convince them why they're just as good as these other firms which don't have any restrictions on them."

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