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Industry Analysis: U.S. Return Preparation and Consulting

Posted on Nov. 23, 2020
[Editor's Note:

This article originally appeared in the November 23, 2020, issue of Tax Notes Federal.

]

Sammie Parsley is a senior accountant at Carr, Riggs & Ingram LLC and a part-time doctoral student resident at the University of Missouri, St. Louis, where his research focuses on taxation and behavioral accounting.

In this article, Parsley examines the return preparation and tax consulting segment of the top 20 U.S. public accounting firms (excluding the Big Four) using a strategic framework combined with personal experience and interviews with individuals from two leading firms.

Accounting is often referred to as the universal language of business, and the accounting profession has for many years displayed the highest standards for providing attest, financial, tax, and accounting services. The public accounting industry in the United States has a long and rich history dating back to the late 19th century, when the profession was set in motion by the Industrial Revolution. The salience of accounting services to both microeconomic and macroeconomic systems has stimulated high demand in recent decades. Public accounting continues to see significant demand as a result of today’s increasingly complex business environment. This article analyzes the tax preparation and tax consulting segment of the top 20 U.S. public accounting firms (excluding the Big Four) using a strategic framework combined with personal experience and interviews with individuals from two leading public accounting firms. This analysis will be of interest to accounting researchers who explore regulation and industry trends. CPAs in public practice can also benefit from this analysis through an increased understanding of the underpinnings of industry competition and the causes of profitability.

The Industry

The U.S. accounting profession emerged in the late 1800s, with New York recognizing the title of Certified Public Accountant in 1896. The public accounting industry now offers a variety of services that can be broken down into three broad categories: assurance services, tax services, and consulting services. Public accounting firms can be divided by size into four tiers: (1) the Big Four; (2) the next 120 firms by revenue; (3) other firms with more than 10 American Institute of CPAs members; and (4) the approximately 45,000 smaller firms.1 The focus of this analysis will be on the tax practices at the top 20 (non-Big Four) U.S. public accounting firms as identified by an annual survey.2 Buyers, suppliers, substitutes, and entry barriers within this focus group will be identified. Excluding the Big Four provides a group of firms that follow a similar strategy within the public accounting industry, therefore providing increased external validity.

The North American Industry Classification System (NAICS) is a system that categorizes businesses according to primary business activity using a five- or six-digit code. The following analysis will focus on CPA firms with an NAICS code of 541211, which falls within the “Professional, Scientific, and Technical Services” sector. This industry includes accounting firms certified to audit the accounting records of public and private organizations and to attest to compliance with generally accepted accounting principles. CPA firms may provide one or more of the following services: (1) audit; (2) designating accounting systems; (3) financial statement preparation; (4) developing budgets; and (5) providing advice on accounting matters. These firms may also provide related services such as bookkeeping, tax return preparation, and payroll processing.

The federal income tax went into effect with the passage of the Tariff Act of 1909. With this legislation, corporations conducting business in the United States were subject to a tax of 1 percent on profits exceeding $5,000. Although initially controversial, the Supreme Court validated the legality of the corporate income tax two years later.3 The federal individual income tax came to fruition with passage of the Revenue Act of 1913. During this time, individual states began to levy corporate and individual taxes, beginning with Wisconsin in 1911. Since that time, there have been several changes to U.S. tax policy, which have provided both challenges and opportunities for public accounting firms. Before the introduction of tax legislation, many companies had not maintained adequate financial records. Consequently, the Revenue Act of 1913 would lead to many company executives gaining an understanding of the concept of depreciation, as it was beneficial for income tax purposes.4 Demand for income tax return preparation was created, and the public accounting profession answered the call.

Table 1. NAICS Code 541211: 2017 Data by Enterprise Employment Size

Employment Size

Number of Firms

Total Employment

Annual Payroll ($1,000)

Preliminary Receipts ($1,000)

Less than 5

36,507

61,916

$3,061,625

$9,017,646

5-9

10,058

65,856

$3,271,133

$7,709,869

10-19

4,270

55,912

$3,361,195

$7,252,089

20-99

2,023

74,130

$5,578,637

$11,432,927

100-499

242

39,679

$3,360,926

$7,402,992

500 or more

67

206,338

$20,313,181

$59,945,311

Total

53,167

503,831

$38,946,697

$102,760,834

Source: Census Bureau, “2017 SUSB Annual Data Tables by Establishment Industry” (Mar. 2020).

There have been several major reforms to the U.S. tax code throughout the years. Arguably the most significant of these overhauls (before the recent Tax Cuts and Jobs Act) was the passing of the Tax Reform Act of 1986. One of the objectives of TRA 1986 was to promote the increased fairness of corporate taxation by decreasing the top rate and introducing a corporate alternative minimum tax.5 Tax policies created by the act would influence the business structure for decades, and the complexities added to the code generated increased demand for CPAs.

With the enactment of the TCJA in 2017 came the most substantial reform of the tax code since TRA 1986 and the greatest overhaul of international tax provisions since the early 1960s.6 Under prior policy, business owners generally obtained the most favorable tax outcomes by forming passthrough entities, such as partnerships and S corporations.7 The sweeping changes under the TCJA have prompted many individual and business taxpayers to seek out the professional expertise of CPAs.

Method

This analysis was created through a triangulated methodological approach that consisted of qualitative research techniques comprising individual interviews, the collection and analysis of quantitative industry data from a contemporary survey, and a systematic analytical framework following Michael E. Porter’s “five forces.”8 Triangulation involves performing more than just one technique in a study and is a good choice to examine a topic from different angles.9 Data was collected between February and April 2020. Partly because of parsimony, personal observations from 14 years of professional experience in both public and private accounting are combined with archival data collection techniques from multiple databases.

Further, face-to-face semi-structured interviews were conducted with one senior manager and one partner representing two regional U.S. public accounting firms. The semi-structured approach was used because it allows the interviewee the opportunity to provide important insights during the conversation while previously prepared questions provide the structure and direction of the conversation. Questions asked were open-ended to gain high-quality comments and sufficient data. Participants were encouraged to speak freely, and interviews lasted approximately 45 minutes. A focused interview format helped minimize the methodological threat of reflexivity created by the conversational nature of the interviews.10 Both interviewees were selected using a theoretical sampling approach of senior managers and partners employed in large public accounting firms. The subjects possessed over 45 years of cumulative industry experience. A concept-driven approach, theoretical sampling allows researchers to explore problems from various angles while keeping an open mind for discovery of solutions and enhanced discussion.11

Analysis

The focus of this analysis is on the top 20 U.S. tax firms exclusive of the Big Four. Omission of the Big Four firms provides a strategic group within the industry on which comparisons can be made; results can be generalized, thus strengthening external validity. All the firms included in this analysis provide services that involve tax planning, preparation, reporting, and consulting. These services can be offered to both audit and non-audit clients. Tax preparation and consulting services are driven by client demand and revolve around meeting tight deadlines. Observations in recent years reveal numerous mergers and acquisitions occurring within this mid-tier group as firms seek scale economies.

Stakeholders have much to benefit from in this focused analysis. Management teams of top 20 firms can gain an increased understanding of the industry, which can help them formulate future corporate strategy. Industry percipience paves the way for structured and profitable growth with increased productivity as a byproduct. Threats and opportunities can be identified, allowing firms to focus their resources in the most efficient ways. Staff employees can enjoy increased benefits in the form of increased overall job satisfaction. Firm clients can reap benefits indirectly through improved efficiencies within their service provider and higher-quality products can be delivered to clients at affordable pricing.

Threat of New Entrants

For the Big Four, the threat of new entrants is low. The threat is quite high for the smallest segment of firms in Table 1, as starting a small CPA firm requires relatively little initial capital. Barriers to entry into the top 20 market fall between those of the Big Four and the smallest tier of firms, but remain significant. The threats are a function of existing barriers to entry and retaliation from incumbents.12 High barriers to entry and harsh reactions from extant firms can serve as an effective deterrent to potential industry newcomers. Descriptive statistics can be found in tables 2 and 3.

Table 2. 2020 Top U.S. Tax Firms (excluding Big Four)

 

Number

Minimum

Maximum

Mean

Standard Deviation

Tax revenue

20

120.62

858.64

258.26

185.27

Total revenue

20

174.00

2,436.37

789.80

594.26

Offices

20

13.00

120.00

41.90

28.88

Employees

20

620.00

10,882.00

3,618.20

2,677.11

Source: “The Top 100 Firms and Regional Leaders,” Accounting Today (Mar. 2020).

Note: Revenue minimum, maximum, and mean stated in millions.

Table 3. 2019 Top U.S. Tax Firms (excluding Big Four)

 

Number

Minimum

Maximum

Mean

Standard Deviation

Tax revenue

19

103.55

771.02

239.71

172.02

Total revenue

19

150.00

2,141.72

730.56

544.81

Offices

19

10.00

110.00

41.00

27.91

Employees

19

580.00

9,670.00

3,427.16

2,503.40

Source: “The 2019 Top 100 Firms: Top Tax Firms,” Accounting Today (Mar. 2019).

Note: Revenue minimum, maximum, and mean stated in millions.

Costs of entry include initial capital, which is obviously high for this industry segment. Also, a credentialed and competent workforce is necessary to address the complex business needs of more financially sophisticated clients. Finally, the top 20 firm sector produces economies of scale, thus reducing the threat of new entrants by forcing newcomers to enter the market at a larger scale. That market position can be the result of vertical and horizontal integration, which achieves cost advantages. On the other hand, the tax component of the service offerings is somewhat commoditized as the cost of switching tax services providers is relatively low. This factor increases the threat of new entrants ceteris paribus, as clients would incur limited financial consequences for switching service providers.

Perhaps the most important entry barrier to the public accounting industry is product differentiation.13 As a partner of a leading midsize public accounting firm observed, “Getting in is easy; it’s finding the clientele base” that proves challenging. Firms strive to create differentiation when providing a service such as tax preparation and consulting, which can be commoditized by buyers. Product differentiation can result in increased customer loyalty, long-standing client and provider history, and brand awareness. Successful CPA firms seeking differentiation must create a benefit that is in excess of the cost of switching.14 Taken together, these factors create a medium entry threat to this strategic group.

Firms within this focus group can strive to cultivate client relationships via trust-inducing skills and personal friendships. Senior leaders should recognize and embrace that trending skills, such as statistical analysis and data analytics, can bring differentiated value propositions to their client base. Relationships built on trust through demonstrated expertise and continuous integrity can put the firm in a role of a strategic business partner rather than a mere service provider.

Threat of Substitutes

The threat of substitution is quite high at the small firm level. Competition can come from several sources. First, the client can choose to file their own tax returns using commercially available software in conjunction with past returns prepared by the CPA. Second, non-CPA credentialed providers attempt to underprice small CPA firms. The threat of substitutes is less for the top 20 firm sector when compared with its smaller counterparts. Companies are required to file tax and informational returns, and these returns can be complex. Therefore, those services can be viewed by potential buyers as being nearly identical.

Offices of CPAs possess skill and expertise in this area via a tradition of hiring high-quality staff, training staff, and continuous learning experiences. As a result, the target client base of firms within this strategic group would view the choice to seek out the services of a smaller CPA firm as risky, as smaller firms may not possess access to resources to service more economically and financially sophisticated clients. Smaller firms could see an increased threat from substitutes in the form of online tax preparation aides such as TurboTax and IRS Free File. However, the typical client of this focus group would likely require more robust tax services than could be found in off-the-shelf software packages. Also, these larger clients often require service in the form of consultations and planning throughout the year.

Bargaining Power of Buyers

Clients of CPA firms can exercise influence by driving down fees, bargaining for increased services or quality, and pitting firms against one another in competitive rivalry. This buyer power results from somewhat commoditized products or services. The good news for the firms’ bargaining position is that the buyers must garner services to meet federal, state, and local laws. The downside is that there are a multitude of firms able and willing to provide those services. This issue is mitigated in the public accounting industry by product and service differentiation. Firm leaders can create differentiated services by customizing their standardized offerings (such as tax return preparation and consulting) to individual clients. Expertise in statistical analysis can create value by offering deeper insight into problems experienced by the client base.

Also, as mentioned earlier, the cost of switching firms for tax services is relatively low, resulting in increased buyer advantage. Cloud computing has led to increased client mobility, making it easier and less costly for clients to switch providers. Industry incumbents can alter buyer power by the careful selection of clients to protect positive-sum outcomes.

Bargaining Power of Suppliers

Conditions determining the bargaining power of suppliers not only change, but can also be out of a firm’s control.15 Powerful industry suppliers can exert influence that limits the profitability of a firm. Because this analysis excludes Big Four firms, many of the corporate juggernaut clients serviced by the Big Four are also excluded as suppliers. Consequently, the clients of this focus group may be unable to exert as much influence as some larger corporate giants.

The labor force is a supplier as well. Public accounting inherently deals with an ever-changing knowledge base. Clients with a complex financial makeup require highly skilled professionals to address their business needs. Millennials are being onboarded as new hires while many baby boomers are retiring. When asked about alternative work arrangements and millennial employees, a senior manager at a top 20 firm observed, “Firms have had to adapt, and adapt quickly. You don’t have to get all the hours in one sitting.”

Many other employment options exist for CPAs as well. Private industry, governmental entities, and nonprofit organizations all seek to retain CPAs, which is a contributing factor to the high turnover found in public accounting. Offshoring of tax processing tasks has reduced the bargaining power of the labor market in recent years. However, accountants possessing skills in areas such as data and statistical analysis, problem solving, and critical thinking are likely to retain their bargaining power. Overall, the threat of supplier bargaining power is medium.

Public accounting firms depend on a wide array of supplier groups for inputs. Examples of suppliers in this focus group include employees, technology providers, landlords, trade associations, and lenders and creditors.

Rivalry Intensity

The intensity of the rivalry among the firms in this analysis is a result of the aforementioned factors. These firms will be diversified, offering a wide range of services to their clients. A stagnant client base, however, can create slow industry growth in which CPA firms seek to acquire additional market share by mergers and acquisitions. For the most part, mid-tier firms compete among themselves for small to mid-market business. Occasionally, these firms also find16 themselves competing against Big Four firms that have achieved economies of scale. The more rivalry that exists among competing firms, the less attractive the industry is to potential new entrants. The result of this is high rivalry intensity within the industry.

Future Change

The COVID-19 pandemic has been a tremendous disrupter for public accounting firms. The outbreak’s effect has been felt during the industry’s peak busy season. Clients and other stakeholders need top-quality, reliable, and timely data now more than ever. Public accounting firms have had to reassess staffing. Consequently, countless employees found themselves working from home or in other alternative work arrangements, many for the first time. More CPA firms will be considering alternative work arrangements as viable long-term options for employees. Digital communication methods through applications such as Skype, Slack, or Zoom have been increasingly used to communicate with telecommuting staff and clients. CPA firms will likely be dealing with both the financial and nonfinancial effects of the coronavirus pandemic for a prolonged period.

Although automation remains relatively nascent in the accounting industry, it is increasingly being used in tax preparation and consulting. Many tasks that once took a lengthy period now require much less time because of automated processes. This trend will not likely change in the near future. With “Industry 4.0” at hand, an increasing number of once manually arduous tasks are being automated. As automation increases, tax preparation itself may slowly phase out, but tax consulting services could increase. Public accounting firms that prosper in the 21st century will be those that anticipate change, effectively manage it, and capitalize on the opportunities presented by change.

Conclusion

Academic researchers could design future longitudinal studies to examine industry changes caused by increased automation. Another avenue for potential academic research given the threats discussed earlier would be assessing the change in the workforce dynamic in public accounting firms from the onboarding of millennial employees. Business school curriculums can be revamped to include more statistical and data analysis in coursework.

Some takeaways can be gleaned by assessing each of the threats discussed in this article. Public accounting firms can continue to exercise innovative techniques by providing more value-added services to clients and developing closer working relationships. Firms should consider using technology to strengthen existing service offerings. Perhaps more important than any specific technical knowledge is the ability to leverage innovations to become strategic partners with clients. Promote the consulting portfolio of services offered. Develop corporate policies to retain top talent. Public accounting firms invest a lot of time and money to train employees. Jobs can be restructured and enriched in a way that promotes retention among the firm’s top performers. Although the tax preparation industry now seems stable, top 20 firms can use this analysis to develop a long-term course for success.

FOOTNOTES

1 Government Accountability Office, “Public Accounting Firms: Mandated Study on Consolidation and Competition,” Report to the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services (July 2003).

2  The Top 100 Firms and Regional Leaders,” Accounting Today (Mar. 2020).

3 Li Liu, “Income Taxation and Business Incorporation: Evidence From the Early Twentieth Century,” 67(2) Nat’l Tax J. 387-418 (2014).

4 Stephen A. Zeff, “How the U.S. Accounting Profession Got Where It Is Today: Part I,” 17(3) Acct. Horizons 189-205 (2003).

5 Ross Jennings, Connie D. Weaver, and William J. Mayew, “The Extent of Implicit Taxes at the Corporate Level and the Effect of TRA86,” 29(4) Contemp. Acct Res. 1021-1059 (2012).

6 Andrew B. Lyon and William A. McBride, “Assessing U.S. Global Tax Competitiveness After Tax Reform,” 71(4) Nat’l Tax J. 751-788 (2018).

7 Bradley T. Borden, “Income-Based Effective Tax Rates and Choice-of-Entity Considerations Under the 2017 Tax Act,” 71(4) Nat’l Tax J. 613-634 (2018).

8 Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (1980).

9 Michael David Meyers, Qualitative Research in Business and Management (2013).

10 Robert K. Yin, Case Study Research and Applications: Designs and Methods (2018).

11 Juliet Corbin and Anselm Strauss, Basics of Qualitative Research (2015).

12 Porter, supra note 8.

13 Id.

14 Id.

15 Id.

16 Id.

END FOOTNOTES

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