Incorporated: 1989
NAIC: 541211 Offices of Certified Public Accountants
SIC: 8721 Accounting, Auditing & Bookkeeping
Ernst & Young is the fourth largest public accounting firm in the world. The firm was formed in 1989 when the third largest accounting firm at the time, Ernst & Whinney (based in Cleveland, Ohio), merged with the sixth largest firm, Arthur Young (headquartered in New York), forming what, at the time, was the world's largest accounting firm. As of 1999 Ernst & Young stood as one of the "Big Five" accounting firms that dominated the accounting business. A private partnership, Ernst & Young was owned by its senior partners. Ernst & Young provided auditing services primarily to the world's largest corporations. In addition, it specialized in tax advice for multinational firms. In recent years, the firm increasingly moved into the business of management consulting, providing guidance to clients in such areas as risk management, mergers and acquisitions, and recent trends in worker-management relations. Other service areas included consulting on information technology and legal services.
The roots of Ernst & Young can be traced back well over 100 years to the formation of the auditing business and the development of generally accepted accounting practices, rules that became increasingly necessary with the rise of the multinational corporation and the intrusion of complicated taxes into private business. Prior to the 1989 merger, each of the two firms had enjoyed rich histories. Both rose from very small beginnings by capitalizing on the enterprise potential of accounting in its early years. Pioneer Arthur Young founded and headed the original Arthur Young firm back in 1895 in Kansas City after breaking from an earlier union of the firm of Stuart and Young in Chicago. In 1896 Young formed the firm of Arthur Young and Company with his brother Stanley, but by 1906 Young had completely terminated his unsatisfactory partnership with Stuart. Arthur Young and Company flourished for many years, slowly developing its reputation as "old reliable" for auditing, adding more and more partners throughout the years.
The other half of the marriage, Ernst & Whinney, can be traced back to 1906, when Ernst & Ernst was founded in Cleveland, Ohio, as a partnership between Alwin C. Ernst and his older brother, Theodore C. Ernst. The firm took on its first additional partners in 1910 and from there the family tree expanded by immense and unforeseen proportions. By 1913, when income taxes began to be levied in the United States, the need for accountants swelled dramatically. By the 1980s the firm had become one of the largest members of the Big Eight. In one of its more publicized actions, Ernst & Whinney's audit paved the way for the 1979 government bailout of the Chrysler Corporation.
Meanwhile, the Arthur Young firm endured a rocky decade in the 1980s. Long known for its reliable auditing practice and a clean, conservative interpretation of tax law, the company image was tarnished by events of the 1980s, many in the area of the national savings and loan scandal. For instance, Arthur Young was sued for $560 million for allegedly allowing Western Savings Association of Dallas to overstate its net worth by more than $400 million. In 1988 the Bank of England sued Arthur Young and collected $44 million after a bank that Young audited collapsed.
In contrast to the struggles of Arthur Young prior to the merger, Ernst & Whinney's business had thrived, with its management consulting practice growing faster than its audit and tax practice. In fact, at the time of the merger, consulting fees accounted for 24 percent of Ernst & Whinney's revenues, whereas only 17 percent of Arthur Young's revenues came from consulting.
In general, both firms thought that a merger represented a comparative advantage for each. Although both had heavy hitters for clients, Arthur Young's clients were mostly investment banks and high-tech firms on the East and West Coasts, while Ernst & Whinney had more healthcare and manufacturing industry clients concentrated in the Midwest and South. Internationally, Arthur Young had more clients in Europe, while Ernst & Whinney had established a presence in the Pacific Rim countries. Arthur Young's clients included American Express, Mobil, and Texas Instruments, while Ernst & Whinney had BankAmerica, Time, Inc., and Eli Lilly.
Although touted as a merger, the evidence suggests that the 1989 transaction that created the firm Ernst & Young was, in fact, an acquisition in disguise, with the stronger Ernst & Whinney swallowing up the floundering Arthur Young practice. Arthur Young had established a strong reputation over many years, although it was generally seen as a cautious and stodgy practice. But by the 1980s, after much of its traditional audit practice started to collapse and massive leveraged buyouts became an increasingly common practice in the business world, Arthur Young had difficulty competing in the cutthroat environment of the accounting arena.
Historically, the accounting business has seen increasing numbers of partners concentrated in a decreasing number of firms. In this respect, the birth of Ernst & Young in 1989 was the natural outcome of the cycle of competition that breeds concentration and expansion, thus leading to further rounds of competition. But for over half a century previous to the creation of Ernst & Young, eight firms had dominated the accounting business. The elite group was dubbed the "Big Eight" by Fortune magazine.
Following two major mergers in the 1980s (the Ernst & Young deal and the merger the same year between Deloitte, Haskins & Sells and Touche Ross), the Big Eight became the Big Six. All of the Big Six were private partnerships, meaning that all were owned by the firm's senior executives, which also meant that none of the firms were required to report their profits.
The Ernst & Young merger created a firm with 6,100 partners and two chief executive officers, Ray Groves from Ernst & Whinney and William Gladstone from Arthur Young. The newly formed firm had world revenues in 1989 of $4.27 billion, and its total sales eclipsed that established by a merger in 1987 of Peat Marwick and KMG Main Hurdman.
The actual merger in 1989 was essentially viewed as a smart competitive move, although some observers thought the merger might be difficult due to perceived differences in management styles, with Ernst & Whinney governed from the top and Arthur Young favoring a more decentralized management system. At the time of the merger Ernst & Whinney had 1,276 partners and 14,739 total personnel in 118 U.S. offices as well as 3,159 partners and 35,600 total personnel in 89 countries. The smaller Arthur Young had 829 U.S.-based partners and 10,652 total U.S. personnel in 93 offices; worldwide they had 2,900 partners and 33,000 total personnel in 74 countries.
There was a conflict at the time of the merger over each firm's "cola" clients. A conflict of interest existed in that PepsiCo had been an Arthur Young client since 1965, while Coca-Cola had been an Ernst & Whinney client since 1924. Coca-Cola forced the firm to dump PepsiCo, as Ernst & Young noted that Coca-Cola had been a client for a longer time and that Coke's annual audit fee was $14 million, a much higher figure than Pepsi's $8.8 million audit fee.
In one of its first business decisions following the merger, Ernst & Young began to move into computer-aided software engineering. This step reflected Ernst & Young's diversification into management systems and strategic planning services for businesses. Under the general heading of Development Effectiveness, these services capped a string of moves into computer-aided software engineering. The general thrust of the project incorporated management consulting, Total Quality Management, and process innovation. The process innovation services were sold worldwide, primarily to the insurance and banking industries.
However, as the newly formed firm faced the 1990s, it was steeped in the controversy surrounding the crisis of the savings and loan industry. Ernst & Young's audits of 23 failed savings and loans were investigated by the Office of Thrift Supervision (OTS) under a subpoena issued in June 1991. OTS was formed by the federal government to recover losses from accounting firms that should have discovered improprieties during S&L audits and to impose fines on auditors for violations of accounting rules. Some of the thrifts that Ernst & Young audited included Charles Keating's failed Lincoln Savings & Loan (Irvine, California), Silverado Banking (Denver, Colorado), Vernon Savings & Loan (Vernon, Texas), and Western Federal Savings & Loan (Dallas, Texas), all of which experienced total losses of over $5.5 billion. The OTS subpoena required that Ernst & Young surrender one million documents from its work for the 23 failed S&Ls.
Several judgments were rendered against Ernst & Young in connection with the investigation. In July 1992, for instance, the firm paid a fine of $1.66 million to settle accusations that it helped Charles H. Keating, Jr., deceive the federal government about the health of his failing S&L. Moreover, former Ernst & Young partner Jack D. Atchison's license was suspended for four years by the accounting board of Arizona. He was accused of helping persuade five U.S. senators to intervene with federal regulators on Keating's behalf. In connection with this settlement, Ernst & Young paid $63 million to settle charges of wrongdoing in the Keating affair. Ernst & Young did not admit guilt, however, and the claim was paid largely by insurance. In total, some $204 million in fines were paid in this civil suit.
In another settlement, Ernst & Young paid $400 million to the federal government in compliance with a federal ruling against the company. The settlement secured recovery of losses attributable to audit failures. In addition, the settlement avoided huge litigation costs and assured that future audits of insured institutions would be conducted according to the highest professional standards. With potential claims that could have mounted to an estimated $1 billion, the ruling relieved Ernst & Young of concerns regarding future penalties involving S&L auditing improprieties. Ernst & Young also agreed to change its accounting practices and ensure that its partners meet federal guidelines for working with federally insured financial institutions. Some of Ernst & Young's partners were barred from doing such work and changes in banking laws required accounting firms to be legally responsible for sharing with regulators reports prepared for bank management.
Despite these troubles, Ernst & Young defied the rumors that it would fold. To eliminate overlap created by the merger and to reduce its payroll expenses, the firm cut its staff in 1991 and eliminated many partner positions. Although revenues had fallen slightly in the late 1980s, by the early 1990s revenues were modestly but steadily rising. Sales from Ernst & Young's risk management and actuarial services group rose 7.4 percent from 1990 to 1991, from $9.5 million to $10.2 million. Overall revenues rose from $5 billion in 1990 to $5.4 billion in 1991 and $5.7 billion in 1992.
The company garnered an increasing number of clients, and their involvement in such large projects as municipal insurance and environmental risk management consulting continued to grow. Revenues in risk management consulting went from $10.3 million in 1991 to $10.9 million in 1992. This increase reflected a growing market for these kinds of services. Moreover, major restructuring was taking place in hospitals and in the healthcare industry in general, creating a need for consultants. The traditional Ernst & Young mainstay, auditing, still fared quite well in the new firm's early years. By 1992, in fact, Ernst & Young performed the most audits of large publicly held multinational companies. It audited 3,231 companies with a total value audited of $10.228 trillion (based on asset figures for financial companies and sales for all other firms audited).
Ernst & Young's costly legal battles encouraged several changes in the mid-1990s. First, the firm hired a new general legal counsel, Kathryn Oberly, who reputedly made keeping costs down a higher priority than battling on principle. Second, the firm stepped up its expansion into consulting, an area much less fraught with legal responsibilities and their concomitant lawsuits than auditing. In addition to increasing its consulting in risk management, the company moved into information software products.
Ernst & Young also entered new business areas in the mid-1990s by developing alliances and by acquiring smaller companies. In 1996 the firm forged an alliance with Tata Consulting, headquartered in India. The same year, its alliance with ISD/Shaw gave the firm an entree into banking industry consulting. The firm moved into the petroleum and petrochemical consulting business in 1996 when it purchased Wright Kellen & Co. Ernst & Young created a new subsidiary with the Houston-based company, which they named Ernst & Young Wright Killen.
In 1997 Ernst & Young forged an agreement to merge with KPMG International, another Big Six accounting firm. The agreement came only weeks after the announcement of a merger between Price Waterhouse and Coopers & Lybrand, which would have created the world's biggest accounting firm, with $12 billion in revenues and a staff of 135,000. However, the Ernst & Young-KPMG International merger overshadowed that, with combined revenues of $16 billion and 160,000 people. According to Ernst & Young, the deal was designed to satisfy multinational clients who wanted an auditor and consultant with offices in every city in which the client had offices. In addition, the merger would have limited the risk of a liability suit severely damaging earnings and would have made greater economies of scale for developing new products or services.
Combining the two huge companies presented a formidable task, particularly because they were intense competitors. Between 1991 and 1997 KPMG had lost approximately 60 of its auditing clients in the United States to Ernst & Young. A larger problem than overcoming historic rivalries, however, was gaining regulatory approval. The Ernst & Young-KPMG International merger and the Price Waterhouse-Coopers & Lybrand merger would have furthered the consolidation of the major accounting firms into the Big Four, an outcome disturbing to many industry analysts. Along with fears that the relative lack of choice would encourage a rise in prices, there were fears among clients that the combined firms would make company secrets vulnerable to rivals using the same firm.
Citing the high cost of pursuing the merger and the uncertain regulatory outcome, Ernst & Young suggested in early 1998 that the two firms abandon their merger plans. Some analysts thought that the money and attention required to integrate the firms, at a time when all Big Six firms were expanding rapidly, also discouraged the merger.
Ernst & Young experienced substantial growth in 1997, despite being hit by a $4 billion lawsuit alleging the firm mishandled the restructuring of Merry-Go-Round Enterprises in 1993. Overall revenues rose from $7.8 billion in 1996 to $9.1 billion in 1997. A substantial amount of this growth was fueled by a 30 percent surge in tax advice revenues and an 18 percent increase in worldwide tax revenues, an area in which Ernst & Young led the Big Six. The firm also boosted its efficiency in 1997, raising its revenue per employee ten percent that year, to $238,360. Revenues continued to rise spectacularly in 1998, reaching $10.9 billion, a jump of almost 20 percent.
The Big Five, as they were called with the completion of the Price Waterhouse-Coopers & Lybrand merger in 1998, continued to diversify their services in the late 1990s. Revenues from consulting on tax issues, personnel, management, property, and personal finance swamped revenues from auditing for Ernst & Young. In 1999 the firm had plans to add a worldwide law practice to its stable of services. Ernst & Young already had associated law practices in several countries by the end of the century and planned to build a global staff of 4,000 by the year 2005.
Further Reading
"Bean-Counters Unite," Economist, October 25, 1997, pp. 67-68.
Berton, Lee, "Arthur Young, and Ernst Firm Plan to Merge," Wall Street Journal, May 19, 1989.
Burton, J. C., ed., Arthur Young and the Business He Founded, New York: Arthur Young & Company, 1948.
Cannon, Phillippa, "Ernst & Young Tax Breaks $2 Billion Barrier," International Tax Review, February 1998, p. 9.
"Entrepreneurial Services: Ernst & Young's Territory," Emerson's Professional Services Review, November 1991.
"E&W, AY, DH&S, and TR Financial Data Creates Public Stir," Emerson's Professional Services Review, March, 1990.
"E&Y: The Masters of Total Quality Management," Emerson's Professional Services Review, March 1992.
Ernst & Ernst: A History of the Firm, Cleveland: Ernst & Ernst, 1960.
"Ernst & Young: Driving for Specialization and Service Integration Leadership," Emerson's Professional Services Review, March 1990.
"Ernst & Young Settles Lincoln Savings Case," New York Times, July 15, 1992.
"Finance and Economics: Disciplinary Measures," Economist, March 6, 1999, pp. 68-69.
Jones, Edgar, Accountancy and the British Economy 1840-1980: The Evolution of Ernst & Whinney, London: B.T. Batsford, Ltd., 1981.
Labaton, Stephen, "$400 Million Bargain for Ernst," New York Times, November 25, 1992.
Law, Donald M., "Business Tycoon Arthur Young Loved Life in Aiken at Crossways," Aiken Standard, April 19, 1987.
Moskowitz, Milton, et al., Everybody's Business: A Field Guide to the 400 Leading Companies in America, New York: Doubleday, 1990.
Stevens, Mark, The Accounting Wars, New York: Macmillan, 1985.
------, The Big Eight, New York: Macmillan, 1981.
------, The Big Six: The Selling Out of America's Top Accounting Firms, New York: Simon & Schuster, 1991.
Willis, Clint, "How Winners Do It," Forbes, August 24, 1998, pp. 88-92.
— John A. Sarich; Updated by Susan Windisch Brown
