Score: Common Sense 1; High Priced Auditors 0

There are different ways to get mugged on Wall Street.

Oh, the Wall Street sharpies love seeing the corporate rubes come shuffling in, hat in hand, asking for money and bending over for every fee and outrageous imposition.

But sometimes one of those corporate neophytes turns the tables on banker/auditor/lawyer to do what is ultimately right for its shareholders, customers and employees. It says “no” to outrageous fees. It draws a line in the sand and refuses to back down.

And the hero for all corporate managers who have walked down those dark alleys on Wall Street is Globus Medical, Inc.

KPMG Declines to be Globus’s Auditor

Globus filed a notice with the Securities Exchange Commission (SEC) this week revealing that on April 16, 2015 their auditor, KPMG, orally notified them that they were going to decline to stand for reelection as Globus’s independent registered public accounting firm.

That’s unusual.

Did KPMG find a problem with Globus’s financial statements? No, they did not.

Globus’s financial statements 2014 and 2013 did not contain any adverse opinion or disclaimer of opinion or qualified or modified opinion and were in full compliance with audit scope and accounting principles—according to KPMG.

Were there any disagreements between Globus and KPMG over any accounting principles or practices? No again and KPMG filed a letter with the SEC saying so.

So, what happened?

We think frugal Globus declined to pay the going rate for a big time auditing firm. And KPMG quit.

When Good Auditors Get Fee Crazy

Remember Enron’s auditors—Arthur Anderson? Now defunct. Arthur Anderson earned $25 million in auditing fees and $27 million in consulting fees from Enron in 2000. Did those fees “buy” Arthur Anderson? Well, as Anderson’s staff people were busy shredding several tons of documents and deleting nearly 30, 000 emails and computer files immediately after the SEC announced their investigation, an outside observer might say, “yes.”

Auditors exist in an ethically precarious position. They are paid by the companies they audit, but they represent the public. It’s a situation rife with conflict of interest potential. For this system to work, both company and auditor have to agree on the rules for the greater good—not their own self-interest.

And the system works well. Thousands of companies routinely file their audited financial statements with no hint of an issue.

Those companies that try to use money to influence their auditors—for example offering exorbitantly high fees—raise red flags. Arthur Anderson, for example, charged nearly $52 million in annual fees which, in some way, they must have thought compensated them for cutting corners.

But what does it say when the auditor asks for more money and the company says no?

The Bargaining Power of Top Auditing Firms

To us, it says that one company—Globus—won’t pay more than it thinks is fair.

Four companies audit 43% of all public firms: Ernst & Young, Price Waterhouse, KPMG and Deloitte. The top ten control 60% of the 7, 000 public company audits done each year. KPMG is the third largest with about a 10% market share.

So who’s more influential with investors, KPMG or Globus?

The day the news broke that KPMG was “declining to stand for reelection” Globus’s stock price fell about 2%.

Michael Porter, the Harvard Professor of Management, famously described the bargaining power of suppliers as follows: “Powerful suppliers capture more of the value for themselves by charging higher prices, limiting quality or services, or shifting costs to industry participants. Powerful suppliers, including suppliers of labor, can squeeze profitability out of an industry that is unable to pass on cost increases in its own prices.”

The other problem for a company like Globus that wants to try to bring financial discipline to these fees is that the large auditing firms are not dependent on any single industry for revenues. If they were, they’d be incentivized to protect that specific industry with more reasonable pricing. KPMG and their brethren cover every industry so they have no incentive to support, say, medical device companies.

Then there are switching costs. Globus will pay one way or the other (like seeing its stock price decline) for switching auditors.

The good news for Globus is the auditing services are only modestly differentiated. There is no reason that Crowe Horwath (market share 1.3%), for example, could not do as competent an auditing job as KPMG.

Money, Money, Money

Money, and its ability to influence service providers like auditors or, even doctors, has been the subject of a significant amount of academic research.

And for more than 40 years the research has come to one conclusion:

“At least two dozen studies over the last three decades have conclusively shown that people who expect to receive a reward for completing a task or for doing that task successfully simply do not perform as well as those who expect no reward at all. These studies examined rewards for children and adults, males and females, and included tasks ranging from memorizing facts to creative problem-solving to designing collages. In general, the more cognitive sophistication and open-ended thinking that was required, the worse people performed when working for a reward. Interestingly enough, the researchers themselves were often taken by surprise. They assumed that rewards would produce better work but discovered otherwise.” — Alfie Kohn writing in the Harvard Business Review.

Money doesn’t incentivize people. It can’t alter long term behavior. More money doesn’t make a difference. There are other, more powerful motivators of auditor, doctor, lawyer, teacher performance. The most powerful is the intrinsic value of the work being done.

In final analysis, would the executives of Arthur Anderson rather have the $57 million in fees or their reputation back?

Waste Not, Want Not

There are many stories about Globus’s penny pinching ways. And, frankly, it was refreshing to see the DNA of this firm assert itself with one of the Big Four accounting firms.

(Those must have been interesting phone calls!)

Who will Globus hire to audit its books? Hard to say. But one thing we’re fairly sure about is that the fee structure will be more modest.