Early last year, Bob Brannon called KPMG, his accounting firm, to schedule an external review. Brannon, the co-CEO of Associated Packaging in Gallatin, Tenn., thought he had a great relationship with his auditors. KPMG had signed off on the company's books for the past 20 years, and Brannon himself had worked at one point for Peat Marwick, one of KPMG's predecessor companies.

So the response Brannon received shocked him. "They said to me, 'Do you really need us?'” he recalls. "I said to them, 'You are firing us?'”

Brannon's company is hardly the only private company to be dumped by an accountant lately. The Sarbanes-Oxley Act—specifically, SOX's Regulation 404, which requires a slew of new internal controls for public companies—is to blame. The new law is adding dramatically to the length and complexity of the standard corporate audit, creating a mountain of new work for accountants and prompting a manpower shortage for the entire industry. Public companies with $25 million or less in revenue expect outside consultants such as auditors to bill them for 846 labor hours, on average, in order to comply with SOX, according to Financial Executives International, a trade organization based in Florham Park, N.J. (See "The Curse of SOX,” below.) Although the law applies only to public companies, a recent survey by PricewaterhouseCoopers shows that some 30% of growing private companies are implementing parts of the new regulations, as well.

The resulting staffing woes are widespread, from large markets on the East and West Coast to smaller markets like Tennessee, where Brannon's company, which sells packaging equipment such as shrink-wrap machinery, is based. But the problem is particularly acute at the Big Four accounting firms. Earlier this year, PricewaterhouseCoopers imported 1,000 auditors from abroad.

The surge in auditing business has led accounting firms to raise prices. It has also led them to purge companies from their client lists. Private companies are dumped in favor of public companies, and firms that end their fiscal year on December 31 find that their CPAs are especially discriminating.

"In many cases, it is simply a question of resources,” says Chuck Landes, vice president of the professional standards group at the American Institute of Certified Public Accountants, the national group that sets professional standards for CPAs. "Firms have to step back and say, 'We can't do all of the work, we can't get to everything.'”

Ignored by the Big Four

Last fall, when the Securities and Exchange Commission convened a roundtable discussion on the effects of new auditing rules on smaller public companies, the accountant shortage dominated the conversation. William Balhoff, a Baton Rouge accountant, recalls that the executives, accountants, and policymakers who were present all agreed that, in his words, "the Big Four are essentially pricing themselves in a way that they don't want to do” private-company work. Seeing an opportunity, Balhoff's firm, Postlethwaite & Netterville, now audits only privately held companies.

The Big Four—Deloitte, Ernst & Young, KPMG, and PwC—are the surviving half of the Big Eight that existed in the 1980s. When consolidation first swept through the industry in the mid-1990s, no one worried. But when Arthur Andersen collapsed following its Enron-related indictment in March 2002, some people in and around the accounting world began to think that there were too few firms left. When The Wall Street Journal reported this June that KPMG might be indicted over illegal tax shelters, the prospect of having just three major firms shook the industry. (A KPMG indictment now seems unlikely.)

As the number of firms has shrunk and the workload has increased dramatically, the Big Four have happily jacked up their rates. Fees charged by external auditors to public companies have jumped 58% over the last year, according to Financial Executives International. In dollar terms, public companies with less than $25 million in revenue were spending an average of $863,120 on Section 404 compliance, the survey found.

Companies that face an important transition like an impending IPO often pay even more. Zach Nelson, CEO of the San Mateo, Calif.-based business software maker NetSuite, has seen his accounting bill from Deloitte increase tenfold, from $100,000 last year to $1 million this year. NetSuite had $33 million in sales in 2004. "We had heard the horror stories so we were prepared,” Nelson says. "It is the cost of doing business now.”

For some, that cost is simply too high. "We have had companies that were talking about going public,” says Balhoff, "but they don't talk about it as much anymore because of the cost.”

A Problem That Will Persist

Sadly, accounting firms will likely face a labor shortage for years to come. The war on terrorism and corporate scandals are partly to blame. Both have prompted government employers to beef up their CPA staffs, according to Ira Solomon, head of the University of Illinois Urbana-Champaign's accountancy department, one of the largest in the country in terms of enrollment. The FBI and the Department of Homeland Security have hired CPAs to investigate the way terror networks are funded, and the SEC has hired accountants to work on its high-profile corporate fraud cases. CPAs are also in high demand to work internally at big corporations, Solomon notes. All of that adds up to stiffer recruiting competition for the Big Four.

The large accounting firms have historically lived with abysmal turnover, which further complicates matters now that there's a major talent war at hand. Then there's the fact that all of that new work is fairly tedious. "People are working hard and long hours and a lot of the SOX work is not particularly interesting,” Solomon says. "People have described it as mind-numbing. My fear is that we haven't seen anything yet. We may see unprecedented levels of turnover.”

There is some light at the end of the tunnel: Undergraduate accounting programs report the most robust enrollment since 2001. Still, the market is so overheated that even fresh-faced graduates with accounting degrees are hot commodities these days. According to financial services staffing firm Robert Half International, starting salaries at large accounting firms hit $41,750 this year, a 13.4% increase over 2004.

Smaller Accounting Firms Rise Up

So what are entrepreneurial companies to do? Many private companies are discovering that there are benefits to losing a well-heeled auditor. The tier of firms below the largest accounting companies is moving aggressively to fill the vacuum left by bigger players. "We have picked up some clients that have been cut by the Big Four firms,” says Bruce Webb, the national director of auditing for Bloomington, Minn., firm McGladrey & Pullen. "These are companies that would have in the past felt that they should go with a Big Four audit firm.” 

Ken Stillwell, CEO of Milestone Group, a consulting firm based in Arlington, Va., that specializes in government contract work, is among the growth-company executives who have turned to this segment of the market. "We didn't want to compete with the big companies, so we purposely chose a firm that specialized in our industry and didn't do work for public companies,” he says. "That was our way around it.”

At Associated Packaging, Brannon also chose not to seek another large accounting firm to replace KPMG. Instead, he turned to local and regional accountants to bid on his business. Associated, which brings in annual revenue of $75 million, used to spend $20,000 with KPMG. His new CPA firm offered a better deal. Brannon spent half of what he spent last year on this year's external review. (A spokesman for KPMG declined to comment for this article.)

In the end, even though Associated's transition to a new external auditor was smooth and the company ended up saving money, Brannon and the company's management team couldn't help but feel rejected. "It hurt just a little bit,” says Mike Boyette, Associated Packaging's CFO.

Sidebar: The Curse of SOX

Public and private companies are finding that complying with SOX, particularly Section 404, is expensive.

Cost to private companies

$138,000 35%
average annual cost as a result of voluntary compliance with SOX companies that say outside auditors asked them to adopt SOX reforms
34% 52%
average increase in audit costs as a result of voluntary compliance with SOX companies that say board members asked them to adopt SOX reforms
28% 78%
companies that say the costs of compliance outweigh the benefits companies that adopted SOX reforms on their own initiative

Cost to public companies *

846 $52,500
average number of external consulting hours expected for SOX compliance average expected additional fee for SOX annual auditor attestation
1,150 $170,000
average number of internal people hours expected for SOX compliance average expected cost for SOX-related external consulting, software, and other charges

Amy Gunderson can be e-mailed at amygunderson@yahoo.com. Additional research by Matthew Phan.