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Report to the Senate Committee on Banking, Housing, and Urban Affairs
and the House Committee on Financial Services:
July 2003:
Public Accounting Firms:
Mandated Study on Consolidation and Competition:
GAO-03-864:
GAO Highlights:
Highlights of GAO-03-864, a report to the Senate Committee on Banking,
Housing, and Urban Affairs and the House Committee on Financial
Services
Why GAO Did This Study:
The audit market for large public companies is an oligopoly, with the
largest firms auditing the vast majority of public companies and
smaller firms facing significant barriers to entry into the market.
Mergers among the largest firms in the 1980s and 1990s and the
dissolution of Arthur Andersen in 2002 significantly increased
concentration among the largest firms, known as the “Big 4.” These
four firms currently audit over 78 percent of all U.S. public
companies and 99 percent of all public company sales. This
consolidation and the resulting concentration have raised a number of
concerns. To address them, the Sarbanes-Oxley Act of 2002 mandated
that GAO study:
* the factors contributing to the mergers;
* the implications of consolidation on competition and client choice,
audit fees, audit quality, and auditor independence;
* the impact of consolidation on capital formation and securities
markets; and barriers to entry faced by smaller accounting firms in
competing with the largest firms for large public company audits.
What GAO Found:
Domestically and globally, there are only a few large firms capable of
auditing large public companies, domestically and globally, which
raises potential choice, price, quality, and concentration risk
concernsface a. A cAs shown below one measure of market concentration
common concentration measure used in antitrust analysis, the Hirschman-
Herfindahl Index (HHI) (HHI), indicates that the largest firms have
the potential for significant significant market power following a
mergers among the largest firms in the 1990s and the dissolution of
Arthur Andersen in 2002 (see fig. below). Although GAO found no
evidence of impaired that competition to date had been impaired in the
past, the significant changes that have occurred in the profession may
have raise potential implications for competition and public company
choice, especially in certain industries, in the future.
Existing research on audit fees did not conclusively identify a direct
correlation with consolidation. GAO found that fees have started to
increase, and most experts expect the trend to continue as the audit
environment continues to responds to recent and ongoing changes in the
audit market. Research on quality and independence diodes not link
these factors audit quality and auditor independence to consolidation
and in generally, wais inconclusive. Likewise, GAOI was unable to draw
clear linkages between consolidation and capital formation but did
observe potential impacts for some smaller companies seeking to raise
capital. However, given the unprecedented changes occurring in the
audit market, GAO observes that past behavior may not be indicative of
future behavior, and these potential implications may warrant
additional study in the future, including preventing further
consolidation and maintaining competition.
Finally, GAO found that smaller accounting firms faced significant
barriers to entry— including lack of staff, industry and technical
expertise, capital formation, global reach, and reputation—to entry
into the large public company audit market. Major barriers are lack of
global reach, staff resources, industry and technical expertise,
reputation, and capital As a result, market forces are not likely to
result in the expansion of the current Big 4. Furthermore, certain
factors and conditions could cause a further reduction in the number
of major accounting firms.
www.gao.gov/cgi-bin/getrpt?GAO-03-864.
To view the full product, including the scope and methodology, click
on the link above. For more information, contact Davi M. D'Agostino
(202) 512-8678 or d'agostinod@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Several Key Factors Spurred Consolidation in the 1980s and 1990s:
Audit Market Has Become More Highly Concentrated, Leaving Large Public
Companies with Few Choices:
Linking Consolidation to Audit Price, Quality, and Auditor Independence
Is Difficult:
Consolidation Appears to Have Had Little Effect on Capital Formation
or Securities Markets to Date, and Future Implications Are Unclear:
Smaller Accounting Firms Face Numerous Barriers to Entry into the Top
Tier:
Observations:
Agency Comments and Our Evaluation:
Appendixes:
Appendix I: Scope and Methodology:
Identifying the Factors for Consolidation:
Impact of Consolidation on Competition, Auditor Choices, Audit Fees,
and Audit Quality and Auditor Independence:
Data Analysis Used a Variety of Sources:
We Used the Doogar and Easley (1998) Model of Audit Market Structure to
Assess Concentration in a Purely Price Competitive Framework:
Impact of Consolidation on Capital Formation and Securities Market:
Identifying Barriers to Entry:
Appendix II: GAO Surveys of Public Accounting Firms and Fortune 1000
Public Companies:
Appendix III: Arthur Andersen Case Study:
Background:
Most Andersen Clients Switched to a Big 4 Firm:
Largest Clients Switched to Big 4 Firms:
Thirteen Percent of Former Andersen Clients Switched to Non-Big 4
Firms:
Former Andersen Clients by Industry Sectors:
Appendix IV: Analysis of Big 4 Firms’ Specialization by Industry
Sector:
Limitations of SIC Analysis:
Industry Specialization Can Limit Public Company Choice:
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Acknowledgments:
Glossary:
Tables:
Table 1: Twenty-five Largest Accounting Firms by Total Revenue,
Partners, and Staff Resources (U.S. Operations), 2002:
Table 2: List of Selected Tight Oligopolies, as of 1996:
Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms
(U.S. Operations), 1988 and 2002:
Table 4: Largest U.S. Accounting Firms (Global Operations), 2002:
Table 5: Simulation One--Market Shares, Actual and Simulated with
Various Switching Costs, 2002:
Table 6: Simulation Two--Market Shares, Actual and Simulated by Client
Assets, 2002:
Table 7: Simulation Three--Market Shares, Merger Analysis with Various
Efficiency Assumptions, 2002:
Table 8: Former Andersen Public Company Clients (Actual and Percentage)
Categorized by Assets, Big 4, and Other Firms, as of December 2002:
Table 9: Former Andersen Public Company Clients (Number and Percentage)
Categorized by Assets and Big 4 Firm, as of December 31, 2002:
Table 10: Former Andersen Clients Hired by Other Firms, as of December
31, 2002:
Table 11: New Firms for Former Andersen Clients by SIC Code, as of
December 31, 2002:
Table 12: Description of Selected SIC Groups:
Table 13: Industries in Which the Big 4 Have a Significant Presence
(10 percent or More):
Table 14: Industries in Which the Big 4 Have a Significant Presence
(25 percent or more):
Figures:
Figure 1: Accounting Firm Services as a Percentage of Revenue,
1975, 1987-2002:
Figure 2: Significant Mergers of the 1980s and 1990s:
Figure 3: Hirschman-Herfindahl Indexes, 1988-2002:
Figure 4: Hirschman-Herfindahl Indexes (Based on Number of Clients),
2002:
Figure 5: Percentage of Public Company Audit Market (by Total
Sales Audited), 1988, 1997, and 2002:
Figure 6: Percentage of Public Company Audit Market (by Number
of Clients), 1988, 1997, and 2002:
Figure 7: Percentage of Assets Audited in Selected Industries, 1997
and 2002:
Figure 8: Changes in Audit Fees (Actual), 1984-2000:
Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of
Total Sales Audited, 1988-2001:
Figure 10: Where Andersen’s Public Company Clients Went,
2001-2002:
Figure 11: New Firms for Former Andersen Public Company Clients,
2001- 2002:
Figure 12: Average Assets of Former Andersen Pubic Company
Clients by New Firm, 2001-2002:
Figure 13: Percentages of Assets Audited by the Big 4 in Selected
Industries, 1997 and 2002:
Figure 14: Percentages of Assets Audited in Industries Potentially
Impacted by the PriceWaterhouseCoopers Merger and Dissolution of
Andersen, 1997 and 2002:
[End of section]
Abbreviations:
AA: Arthur Andersen LLP:
AICPA: American Institute of Certified Public Accountants:
Amex: American Stock Exchange:
AY: Arthur Young LLP:
CEO: chief executive officer:
CL: Coopers & Lybrand LLP:
DHS: Deloitte Haskins & Sells LLP:
DOJ: Department of Justice:
DT: Deloitte & Touche LLP:
EW: Ernst & Whinney LLP:
EY: Ernst & Young LLP:
FTC: Federal Trade Commission:
GAAP: generally accepted accounting principles:
GAAS: generally accepted auditing standards:
HHI: Hirschman-Herfindahl Index:
KPMG: KPMG (or KPMG Peat Marwick prior to February 1995):
NYSE: New York Stock Exchange:
PAR: Public Accounting Report:
PCAOB: Public Company Accounting Oversight Board:
PW: Price Waterhouse LLP:
PWC: PricewaterhouseCoopers LLP:
SEC: Securities and Exchange Commission:
SECPS: SEC Practice Section of AICPA:
SIC: Standard Industry Classification:
TR: Touche Ross LLP:
UAA: Uniform Accountancy Act:
Letter July 30, 2003:
The Honorable Richard C. Shelby
Chairman
The Honorable Paul S. Sarbanes
Ranking Minority Member
Committee on Banking, Housing, and Urban Affairs
United States Senate:
The Honorable Michael G. Oxley
Chairman
The Honorable Barney Frank
Ranking Minority Member
Committee on Financial Services
House of Representatives:
There are hundreds of public accounting firms that audit public
companies in the United States. However, a small number of very large
firms have traditionally provided audit and attest services for the
majority of public companies, particularly large national and
multinational companies.[Footnote 1] The number of firms widely
considered capable of providing audit services to large national and
multinational companies decreased from eight ("the Big 8") in the 1980s
to four ("the Big 4") today.[Footnote 2] The reduction was the result
of mergers involving six of the top eight firms since the late 1980s
and the abrupt dissolution of Arthur Andersen LLP (Andersen) in 2002.
The Big 4 firms are substantially larger than the other U.S. or
international accounting firms, each with thousands of partners, tens
of thousands of employees, offices located around the world, and annual
revenues in the billions of dollars. These four firms currently audit
over 78 percent of all U.S. public companies and 99 percent of public
company annual sales. Internationally, the Big 4 dominate the market
for audit services.
Big 8 mergers and Andersen's sudden dissolution have prompted
heightened concerns about concentration among the largest accounting
firms and the potential effect on competition and various other
factors. As a result, Congress mandated in the Sarbanes-Oxley Act of
2002 that we study these issues.[Footnote 3] Specifically, we were
asked to study (1) the factors leading to the mergers among the largest
public accounting firms in the 1980s and 1990s; (2) the impact of
consolidation on competition, including the availability of auditor
choices for large national and multinational public companies; (3) the
impact of consolidation on the cost, quality, and independence of audit
services; (4) the impact of consolidation on capital formation and
securities markets; and (5) the barriers to entry faced by smaller
firms in competing with the largest firms for large national and
multinational public company clients.
To evaluate the factors contributing to consolidation among the largest
firms, we interviewed current and former partners of large public
accounting firms involved in past mergers and Department of Justice
(DOJ) and Federal Trade Commission (FTC) officials. However, we did not
review any antitrust analyses conducted by DOJ specific to the proposed
mergers of the 1980s and 1990s. According to DOJ officials, most of the
firm documents had been returned to the relevant parties, and other
documents were viewed as "predecisional" by DOJ. While GAO's statute
provides us with access to predecisional information absent a
certification by the President or the Director of the Office of
Management and Budget, we were more interested in the reasons for the
mergers than DOJ's analysis in approving the mergers. Therefore, we
used other sources to obtain the necessary information for this report.
We also collected information from and coordinated with the Securities
and Exchange Commission (SEC) and its counterparts from the other six
members (Canada, France, Germany, Italy, Japan, and the United Kingdom)
of the Group of Seven nations as required in the mandate. To evaluate
the impact of consolidation on competition and auditor choice, audit
fees, and audit quality and auditor independence, we consulted with
academics, researchers, U.S. and foreign regulators, and trade
associations and collected data and descriptive statistics for
analysis. We also employed a simple model of pure price competition, in
which clients choose auditors based on price, ignoring factors such as
quality or reputation, to assess whether the current high degree of
concentration in the market for audit services is necessarily
inconsistent with a purely price competitive setting. Additionally, as
of July 11, 2003, we had received 47 responses to a survey of the 97
largest accounting firms--those with at least 10 corporate clients
registered with SEC--on their views of accounting firm consolidation
and its potential implications. This report also includes responses
from 148 of 250 randomly sampled, Fortune 1000 public companies on
their experiences with their auditor of record and their views on the
potential implications of consolidation. We plan to issue a subsequent
report in September 2003 on client responses received through July 30,
2003. Lastly, we interviewed a judgmental sample of 20 chairs of audit
committees for Fortune 1000 companies to obtain their views on
consolidation and competition. To address the issue of the impact of
consolidation and concentration on capital formation and securities
markets, we interviewed representatives from institutional investors,
investment banks, self-regulatory organizations, and credit rating
agencies, among others, and we consulted with academics and reviewed
relevant literature. To identify any barriers to competition faced by
accounting firms, we reviewed existing state and federal requirements
and interviewed knowledgeable officials. We also employed the
previously cited economic model by simulating mergers among smaller
firms in order to assess whether, in a purely price competitive
environment, such mergers could lead to viable competitors to the Big 4
for large national and multinational clients. We also obtained
information from the American Institute of Certified Public Accountants
(AICPA).[Footnote 4] Appendix I contains a full description of our
scope and methodology.
We conducted our work in Chicago, Illinois, New York, New York, and
Washington, D.C., between October 2002 and July 2003.
Results in Brief:
According to officials involved in mergers among Big 8 firms,
consolidation of the largest public accounting firms was driven by many
factors but primarily by the need and desire to (1) keep pace with the
growing size and global reach of the public companies the firms served,
(2) achieve greater economies of scale as they modernized operations
and other technological capabilities, and (3) expand industry-specific
and technical expertise. Mergers with compatible firms--usually other
Big 8 firms--were the quickest way to fill gaps in geographic coverage,
expand global reach, and build industry-specific expertise. Moreover,
mergers provided firms an opportunity to rapidly increase their capital
bases to spread risk and create greater economies of scale as they
modernized operations, particularly information technology and
training systems. Lastly, some firms merged to maintain their size
relative to larger competitors and to maintain their position among the
top tier.
While the market for audit services to public companies has become
increasingly concentrated--with significant barriers to entry into the
market for audit services for large public companies in particular--and
the largest accounting firms (domestically and globally) have
increasingly had the potential to exercise significant market power, we
found no empirical evidence that competition in the audit services
market has been impaired to date. However, given the dissolution of
Andersen and other significant changes in accounting firm operations,
it is unclear whether the Big 4 will exercise any increased market
power. To assess whether the current high degree of concentration in
the market for audit services is necessarily inconsistent with a price-
competitive setting, we employed a simple model of pure price
competition in which clients choose auditors based on price.[Footnote
5] The model's simulation results were very similar to the prevailing
actual market shares, a result suggesting that the observed high degree
of concentration to date is not necessarily inconsistent with a price-
competitive environment. The most observable impact of consolidation
appears to be on the limited number of auditor alternatives for large
national and multinational companies that require firms with extensive
staff resources, industry-specific and technical expertise, geographic
coverage, and international reputation. In many cases, the auditor
alternatives are further limited due to potential conflicts of
interest, Sarbanes-Oxley requirements, including independence rules,
or the need for industry-specific expertise--all of which may serve to
effectively reduce the number of eligible alternatives to three or in
many cases fewer.[Footnote 6] Given the unprecedented changes occurring
in the audit market and potential competitive implications, these
issues raise concerns about further consolidation and lack of viable
alternatives in certain industries.
Isolating the impact of consolidation on audit fees, audit quality, and
auditor independence is difficult, given the significant changes that
have occurred and are occurring in the accounting profession.
Researchers using small samples of aggregate billings of companies and
other proxies for audit fees (such as average audit revenues) found
consolidation did not appear to affect audit fees, which generally
remained flat or decreased slightly between 1989 and the mid-1990s
(inflation adjusted). However, since the late 1990s, audit fees appear
to have increased, in part due to the changing audit environment and
increased client expectations. Concerning the impact of consolidation
on audit quality or auditor independence, we found no research linking
changes to consolidation; instead, the research attempted to measure
changes in audit quality and auditor independence in general. The
existing research and accounting experts we consulted had mixed views
on both audit quality and auditor independence. Given the numerous
ongoing changes in the market, past behavior may not be indicative of
the future and, therefore, we observe that these and other factors may
warrant attention given the potential price, quality, and concentration
risk implications.
We found no evidence to suggest that consolidation among the firms had
directly impacted capital formation or the securities markets, nor did
we find research that directly addressed how consolidation might affect
capital formation or the securities markets. Given the important
assurance role the auditor plays in the capital markets by attesting to
the fairness of the financial information presented by company
management, market participants often expect public companies to use
one of the Big 4. While this expectation or preference is less likely
to impact large national and multinational public companies,
consolidation may have consequences for smaller, less established
companies. For example, to the extent that the Big 4 evaluate the
profitability and risk of auditing companies, they might become more
selective about retaining their smaller, potentially less-profitable or
higher risk audit clients. In turn, these smaller companies might face
increasing costs of capital if investors were to react adversely to
their not using a Big 4 auditor.
Finally, we found that smaller accounting firms faced significant
barriers to entry into the audit market for large national and
multinational public companies. First, smaller firms generally lack the
staff, technical expertise, and global reach to audit large and complex
national and multinational public companies. In this regard, the large
public companies that responded to our survey to date indicated that
smaller firms lacked the requisite capacity to audit their operations.
For example, based on the average number of partners and nonpartner
professional staff internationally, the Big 4 had almost three times as
many partners and over five times as many nonpartner professional staff
as the average for the next three largest firms. We also employed the
previously cited economic model by simulating mergers among smaller
firms in order to assess whether, in a purely price-competitive
environment, such mergers could lead to viable competitors to the Big 4
for large national and multinational clients. We found that, in
general, any new firm resulting from such mergers would still lack the
resources necessary to compete, to any significant degree, with the Big
4 for larger clients. Second, capital market participants are familiar
with the Big 4 and are hesitant to recommend that companies use firms
with whom they are not familiar. Third, many of the eight largest firms
below the Big 4 with whom we spoke said that litigation risks and
insurance costs associated with auditing a large public company made
growth into the large public company market less attractive than other
growth opportunities. Fourth, raising the amount of capital to build
the infrastructure necessary to audit large multinational companies is
difficult, in part because the partnership structure of accounting
firms limits these firms' ability to raise outside capital. Finally,
certain state laws make it difficult for firms to expand nationally.
For example, firms face the burden and additional expense of obtaining
state licenses for staff across the country. As a result of these
barriers, we observe that market forces are not likely to result in the
expansion of the current Big 4. However, it is unclear what, if
anything, can be done to address these issues.
This report makes no recommendations. We provided copies of a draft of
this report to SEC, DOJ, the Public Company Accounting Oversight Board
(PCAOB), and AICPA. DOJ provided additional information on the extent
to which coordination with antitrust officials and consideration of the
competitive implications of the Andersen criminal indictment occurred.
As a result, we clarified the language provided in the final report.
SEC, DOJ, and AICPA provided technical comments, which have been
incorporated where appropriate. PCAOB had no comments.
Background:
For over 70 years, the public accounting profession, through its
independent audit function, has played a critical role in financial
reporting and disclosure, which supports the effective functioning of
U.S. capital markets. Over this period, the accounting profession and
the accounting firms have undergone significant changes, including
changes in the scope of services provided in response to the changing
needs of their clients. Following significant mergers among the Big 8
in the 1980s and 1990s and the dissolution of Arthur Andersen in 2002,
market share among the accounting firms became more concentrated and
dominated by the Big 4.
Full Disclosure Critical for Market Confidence:
The Securities Act of 1933 and the Securities Exchange Act of 1934
established the principle of full disclosure, which requires that
public companies provide full and accurate information to the investing
public. Moreover, these federal securities laws require that public
companies have their financial statements audited by an independent
public accountant. While officers and directors of a public company are
responsible for the preparation and content of financial statements
that fully and accurately reflect the company's financial condition and
the results of its operations, public accounting firms, which function
as independent external auditors, provide an additional safeguard. The
external auditor is responsible for auditing the financial statements
in accordance with generally accepted auditing standards to provide
reasonable assurance that a company's financial statements are fairly
presented in all material respects in accordance with generally
accepted accounting principles.
Public and investor confidence in the fairness of financial reporting
is critical to the effective functioning of U.S. capital markets.
Auditors attest to the reliability of financial statements of public
companies. Moreover, investors and other users of financial statements
expect auditors to bring integrity, independence, objectivity, and
professional competence to the financial reporting process and to
prevent the issuance of misleading financial statements. The resulting
sense of confidence in companies' financial statements, which is key to
the efficient functioning of the markets for public companies'
securities, can only exist if reasonable investors perceive auditors as
independent and expert professionals who will conduct thorough audits.
Repeal of Ban on Advertising and Solicitation Created More Competitive
Environment:
For many decades, public accountants, like members of other
professions, could not advertise, solicit clients, or participate in a
competitive bidding process for clients. These restrictions were set by
AICPA, which directed the professional code of conduct for its members,
and the state accountancy boards for the 50 states, District of
Columbia, Guam, Puerto Rico, and U.S. Virgin Islands.[Footnote 7]
Beginning in the 1970s, FTC, DOJ, and individual professionals began to
challenge the legality of these restrictions through various court
actions. As a result of these challenges, AICPA and state boards
adopted new rules that targeted only false, misleading, or deceptive
advertising; liberalized restrictions on solicitation; and changed bans
on competitive bidding. While large public companies generally did not
switch auditors based on price competition, increased competition and
solicitations served as incentives for incumbent firms to continually
offer competitive fees to retain their clients.
Expansion and Contraction of Management Consulting Services Raised
Concerns about Auditor Independence:
Historically, accounting firms offered a broad range of services to
their clients. In addition to traditional services such as audit and
attest services and tax services, firms also offered consulting
services in areas such as information technology. As figure 1
illustrates, over the past several decades, the provision of management
consulting services increased substantially. For example, in 1975, on
average, management consulting services comprised 11 percent of the Big
8's total revenues, ranging from 5 percent to 16 percent by firm. By
1998, revenues from management consulting services increased to an
average of 45 percent, ranging from 34 to 70 percent of the Big 5's
revenues for that year.[Footnote 8] However, by 2000, firms had begun
to sell or divest portions of their consulting business and average
revenue from management consulting services had decreased to about 30
percent of the Big 5's total revenues.
Figure 1: Accounting Firm Services as a Percentage of Revenue, 1975,
1987-2002:
[See PDF for image]
Note: The information included in the subcommittee report was based on
1975 data.
[End of figure]
Although all of the Big 4 firms continue to offer certain consulting
services, three of the Big 4 have sold or divested portions of their
consulting businesses. PricewaterhouseCoopers' consulting practice was
sold to International Business Machines Corp; KPMG's consulting
practice became BearingPoint; and Ernst & Young sold its practice to
Cap Gemini Group S.A. While it has contemplated doing so, Deloitte &
Touche has not divested its management consulting practice.
The increase in the provision of management consulting and other
nonaudit services contributed to growing regulatory and public concern
about auditor independence. Although auditor independence standards
have always required that the accounting firm be independent both in
fact and in appearance, concern over auditor independence is a long-
standing and continuing issue for accounting firms. During the late
1970s, when consulting services represented only a small portion of the
Big 8's revenue, a congressional study noted that an auditor's ability
to remain independent was diminished when the firm provided both
consulting and audit services to the same client.[Footnote 9] A number
of subsequent studies resulted in various actions taken by both the
accounting firms and SEC to enhance the real and perceived independence
of auditors. By 2000, SEC proposed to amend its rules on auditor
independence because of the growing concern that the increase in
nonaudit services had impaired auditor independence. The rules that
were promulgated in 2001 amended SEC's existing rules regarding auditor
independence and identified certain nonaudit services that in some
instances may impair the auditor's independence, among other things.
The amendments also required most public companies to disclose in their
annual financial statements certain information about nonaudit services
provided by their auditor. Following the implementation of the
Sarbanes-Oxley Act in 2002, SEC issued new independence rules in March
2003.[Footnote 10] The new rules placed additional limitations on
management consulting and other nonaudit services that firms could
provide to their audit clients.
Big 8 Mergers and Andersen Dissolution Brought about the Big 4:
Although U.S. accounting firms have used mergers and acquisitions to
help build their businesses and expand nationally and internationally
since the early part of the twentieth century, in the late 1980s Big 8
firms began to merge with one another. As shown in figure 2, the first
such merger in 1987 between Peat Marwick Mitchell, one of the Big 8,
and KMG Main Hurdman, a non-Big 8 U.S. affiliate of the European firm,
Klynveld Main Goerdeler, resulted in the creation of KPMG Peat
Marwick.[Footnote 11] Because of the extensive network Klynveld Main
Goerdeler had in Europe, which none of the other Big 8 had, the merged
firm became the largest accounting firm worldwide and the second
largest U.S. firm until 1989. In 1989, six of the Big 8 firms explored
merging. In June 1989, the first merger among the Big 8 involved
fourth-ranked Ernst & Whinney and sixth-ranked Arthur Young to form
Ernst & Young. The resulting firm became the largest firm nationally
(and internationally). In August 1989, seventh-ranked Deloitte Haskins
& Sells and eighth-ranked Touche Ross merged to form Deloitte & Touche.
The resulting firm became the third largest firm nationally (and
internationally). A proposed merger between Andersen and Price
Waterhouse was called off in September 1989.
Figure 2: Significant Mergers of the 1980s and 1990s:
[See PDF for image]
Note: Firms are ranked by total U.S. revenue.
[End of figure]
In 1997, four firms proposed additional mergers. The first two were
Price Waterhouse and Coopers & Lybrand. Soon thereafter, the leaders of
Ernst & Young and KPMG Peat Marwick announced a proposal to merge their
two firms. DOJ and the European Commission of the European Union
initiated studies of both merger requests. However, Ernst & Young and
KPMG Peat Marwick subsequently withdrew their proposal. In 1998, sixth-
ranked Price Waterhouse merged with fifth-ranked Coopers & Lybrand to
become the second-ranked firm, PricewaterhouseCoopers.
To evaluate these mergers, DOJ, as indicated in its Merger Guidelines,
used various measures to determine whether the mergers were likely to
create or enhance market power and should, therefore, be challenged.
DOJ assessed whether the merger would result in a concentrated market,
increase the likelihood of adverse competitive effects, and whether
entry of other competitors into the market would be timely, likely, and
sufficient "to deter or counteract the competitive effects of concern."
DOJ then evaluated whether the mergers would result in efficiency gains
that could not be achieved by other means and whether one of the
parties to the merger would be likely to fail and exit the market if
the transaction was not approved.
Finally, the market consolidated to the Big 4 in 2002. The criminal
indictment of fourth-ranked Andersen for obstruction of justice
stemming from its role as auditor of Enron Corporation led to a mass
exodus of Andersen partners and staff as well as clients. Andersen was
dissolved in 2002.
Several Key Factors Spurred Consolidation in the 1980s and 1990s:
Any one or a combination of several key factors were cited by the Big 4
and others as spurring the mergers of the Big 8 in the 1980s and 1990s-
-notably the immense growth of U.S. businesses internationally, desire
for greater economies of scale, and need and desire to build or expand
industry-specific and technical expertise, among others. First, the
trend toward corporate globalization led to an increased demand for
accounting firms with greater global reach. Second, some firms wanted
to achieve greater economies of scale as they modernized their
operations and built staff capacity and to spread risk over a broader
capital base. Third, some firms wanted to build industry-specific or
technical expertise as the operations of their clients became
increasingly complex and diversified. Finally, some firms merged to
increase or maintain their market share and maintain their market
position among the top tier.
Globalization of Clients Prompted Need for Greater Global Reach:
According to representatives of the Big 4 firms, globalization was a
driving force behind the mergers of the 1980s and 1990s. As their
clients expanded their operations around the world, the top-tier firms
felt pressure to expand as well as to provide service to their clients.
The trend toward corporate globalization, which continues today, was
spurred in part by the lowering of trade barriers. Moreover, by the
mid-1990s, the overall economic environment was changing dramatically
as technological and telecommunications advances changed the way
businesses operated. As a result, large U.S. companies operated
worldwide and more foreign-based companies entered U.S. markets.
Although all of the Big 8 had offices in certain countries, they did
not have extensive networks that enabled them to provide comprehensive
services to large multinational clients. Some of the smaller Big 8
firms had difficulty attracting and retaining strong foreign
affiliates. Mergers with compatible firms were the quickest way to fill
gaps in geographic coverage. For instance, in the 1980s, Ernst &
Whinney had an established network in the Pacific Rim countries while
Arthur Young did not. Likewise, Price Waterhouse had a network in South
America while Coopers & Lybrand's network was in Europe.
In addition to expanding their reach and staff capacity, firms believed
that they needed to establish global networks to stay abreast of
country-specific generally accepted accounting principles and
regulations. Globalization also had raised a number of tax issues that
required firms to have networks able to accommodate clients with
operations in a growing number of countries. To have successful global
networks, the Big 8 needed affiliations with prominent foreign firms.
Growing Complexity of Client Operations Prompted Need for Greater
Industry-Specific and Technical Expertise:
In addition to responding to globalization, representatives of the
firms told us that some of the mergers served to increase their
industry-specific and technical expertise and expand and build
management-consulting operations to better serve the complex needs of
their rapidly evolving clients. Each of the Big 8 firms had different
strengths and industry specializations. Through mergers, firms were
able to build expertise across more industries and diversify their
operations. For example, the Ernst & Whinney and Arthur Young merger
brought together two firms that specialized in healthcare and
technology, respectively. Similarly, the Price Waterhouse and Coopers &
Lybrand merger brought together two firms that dominated the market for
audit services in the energy and gas and telecommunications industries,
respectively.
In addition, firm officials said that some of the mergers of the 1980s
and 1990s were spurred by the need and desire to build or expand
management consulting services, which, as discussed previously, were
becoming a larger percentage of revenue. Officials also said that the
mergers allowed them to achieve economies of scope by offering a
broader range of services to clients.[Footnote 12] As firms merged,
they were able to create synergies and offer their clients extensive
services beyond traditional audit and attest services such as tax
consulting, internal audit, and information systems support. In order
to remain competitive, some firms merged to build upon different
operating strengths such as consulting services versus auditing. For
example, the Deloitte Haskins & Sells and Touche Ross merger brought
together a firm with substantial audit and tax consulting operations
and a firm with a strong management consulting business.
In the same era, some firm officials said that they had to build their
technical expertise in areas such as derivatives and other complex
financial arrangements used by their clients. Firms also needed to
build their expertise to address a series of changes to the U.S. tax
code and the regulatory requirements faced by their clients in other
countries. Strengthening a firm's technical expertise was critical,
because some firms believed that clients were increasingly selecting
their auditors based on specialized expertise and geographic coverage.
Firms began to provide technological support and services to clients
that were modernizing their operations.
Mergers Enabled Firms to Achieve Greater Economies of Scale:
Like public companies, the accounting firms were undergoing dramatic
technological change and innovation in the 1980s and 1990s. According
to firm officials, firms were beginning to transition to computer-based
accounting systems and develop new auditing approaches that required a
considerable capital commitment. By expanding their capital base
through mergers, firms planned to create economies of scale by
spreading infrastructure costs from modernizing across a broader
capital base. Some firm officials said that mergers were critical to
the firms' modernization because, unlike their clients, accounting
firms could not raise new capital by issuing securities. Because of
their prevailing partnership structures, the firms' capital bases were
largely dependent upon partner-generated capital.
In addition to economies of scale, firm officials said that they also
expected that mergers would increase overall staff capacity and result
in more efficient delivery of services and more effective allocation of
resources in order to better respond to market demands. The broader
capital bases also allowed firms to invest substantial resources in
staff training and development. Big 4 representatives said that staff
training and development were critical in attracting and retaining
quality staff necessary to offer services demanded by clients. Firm
officials said that they also expected that economies of scale would
improve operational efficiencies and offset declining profit margins as
competition increased.
Mergers Helped Firms Increase Market Share and Maintain Market
Position:
Many accounting firms also merged to maintain or increase their market
share in order to hold their market position among top-tier firms.
Furthermore, some firms believed that some of their foreign affiliates
would change affiliations if they perceived that greater advantages in
seeking and retaining client business could be obtained through
affiliation with a larger firm. The mergers of the 1980s resulted in a
growing disparity in size between the largest and smallest of the Big
8. Big 4 representatives told us that merging was a practical
alternative to trying to build the business through internal growth.
For example, when seventh-ranked Deloitte Haskins & Sells and eighth-
ranked Touche Ross merged, they became the third-ranked firm. The
creation of Deloitte & Touche resulted in Coopers & Lybrand being the
second smallest of the top tier until it merged with the smallest top-
tier firm, Price Waterhouse, in 1998 to become PricewaterhouseCoopers,
the second-largest firm.
Audit Market Has Become More Highly Concentrated, Leaving Large Public
Companies with Few Choices:
Since 1988, the audit market has become increasingly concentrated,
especially in the market for large national and multinational company
audits, leaving these companies with fewer choices. The 1989 and 1998
mergers led to significant increases in certain key concentration
measures typically used by DOJ and FTC to evaluate potential mergers
for antitrust concerns. These measures indicate highly concentrated
markets in which the Big 4 have the potential to exercise significant
market power. In addition to using concentration measures, we employed
a simple model of pure price competition to assess whether the current
high degree of concentration in the market for audit services was
necessarily inconsistent with a purely price-competitive setting.
Regardless of the ability of the firms to exercise market power or not,
consolidation has limited the number of choices of accounting firms for
large national and multinational companies that require firms with
requisite staff resources, industry-specific and technical expertise,
extensive geographic coverage, and international reputation. In some
cases, the choices would be further limited due to conflicts of
interest, independence rules, and industry specialization.
Large Public Company Audit Market is a Tight Oligopoly:
By any measure, the large public company audit market is a tight
oligopoly, which is defined as the top four firms accounting for more
than 60 percent of the market and other firms facing significant
barriers to entry into the market. In the large public company audit
market, the Big 4 now audit over 97 percent of all public companies
with sales over $250 million, and other firms face significant barriers
to entry into the market. As table 1 illustrates, when comparing the
top 25 firms on the basis of total revenues, partners, and staff
resources, the Big 4 do not have any smaller-firm competitors, a
situation that has given rise to renewed concerns about a possible lack
of effective competition in the market for large company audit
services.
Table 1: Twenty-five Largest Accounting Firms by Total Revenue,
Partners, and Staff Resources (U.S. Operations), 2002:
Firm: Deloitte & Touche; Total revenue (dollars in millions): $5,900;
Audit and attest revenue (dollars in millions): $2,124; Tax revenue
(dollars in millions): $1,239; MCS revenue (dollars in millions):
$2,006; Professional Staff: 19,835; Partners: 2,618;
Total staff: 22,453; Offices: 81.
Firm: Ernst & Young; Total revenue (dollars in millions): 4,515; Audit
and attest revenue (dollars in millions): 2,664; Tax revenue (dollars
in millions): 1,716; MCS revenue (dollars in millions): 0;
Professional Staff: 15,078; Partners: 2,118; Total staff:
17,196; Offices: 86.
Firm: PricewaterhouseCoopers; Total revenue (dollars in millions):
4,256; Audit and attest revenue (dollars in millions): 2,596; Tax
revenue (dollars in millions): 979; MCS revenue (dollars in
millions): 0; Professional Staff: 16,774; Partners:
2,027; Total staff: 18,801; Offices: 113.
Firm: KPMG; Total revenue (dollars in millions): 3,200; Audit and
attest revenue (dollars in millions): 2,016; Tax revenue (dollars in
millions): 1,184; MCS revenue (dollars in millions): 0;
Professional Staff: 10,967; Partners: 1,535; Total staff:
12,502; Offices: 122.
Firm: Grant Thornton; Total revenue (dollars in millions): 400; Audit
and attest revenue (dollars in millions): 200; Tax revenue (dollars
in millions): 136; MCS revenue (dollars in millions): 64;
Professional Staff: 2,068; Partners: 312; Total staff:
2,380; Offices: 51.
Firm: BDO Seidman; Total revenue (dollars in millions): 353; Audit and
attest revenue (dollars in millions): 145; Tax revenue (dollars in
millions): 145; MCS revenue (dollars in millions): 64;
Professional Staff: 1,229; Partners: 281; Total staff:
1,510; Offices: 37.
Firm: BKD; Total revenue (dollars in millions): 211; Audit and attest
revenue (dollars in millions): 93; Tax revenue (dollars in millions):
65; MCS revenue (dollars in millions): 53; Professional Staff:
972; Partners: 193; Total staff: 1,165; Offices: 26.
Firm: Crowe, Chizek and Co; Total revenue (dollars in millions): 205;
Audit and attest revenue (dollars in millions): 45; Tax revenue
(dollars in millions): 37; MCS revenue (dollars in millions): 88;
Professional Staff: 936; Partners: 101; Total staff:
1,037; Offices: 12.
Firm: McGladrey & Pullen; Total revenue (dollars in millions): 203;
Audit and attest revenue (dollars in millions): 187; Tax revenue
(dollars in millions): 16; MCS revenue (dollars in millions): 0;
Professional Staff: 1,894; Partners: 475; Total staff:
2,369; Offices: 86.
Firm: Moss Adams; Total revenue (dollars in millions): 163; Audit and
attest revenue (dollars in millions): 64; Tax revenue (dollars in
millions): 62; MCS revenue (dollars in millions): 37;
Professional Staff: 758; Partners: 179; Total staff: 937;
Offices: 25.
Firm: Plante & Moran; Total revenue (dollars in millions): 161; Audit
and attest revenue (dollars in millions): 79; Tax revenue (dollars in
millions): 45; MCS revenue (dollars in millions): 37;
Professional Staff: 714; Partners: 161; Total staff: 875;
Offices: 15.
Firm: Clifton Gunderson; Total revenue (dollars in millions): 137;
Audit and attest revenue (dollars in millions): 55; Tax revenue
(dollars in millions): 36; MCS revenue (dollars in millions): 48;
Professional Staff: 850; Partners: 140; Total staff:
990; Offices: 39.
Firm: Virchow, Krause & Co; Total revenue (dollars in millions): 96;
Audit and attest revenue (dollars in millions): 35; Tax revenue
(dollars in millions): 32; MCS revenue (dollars in millions): 21;
Professional Staff: 536; Partners: 60; Total staff:
596; Offices: 11.
Firm: Larson Allen; Total revenue (dollars in millions): 79; Audit and
attest revenue (dollars in millions): 27; Tax revenue (dollars in
millions): 21; MCS revenue (dollars in millions): 23;
Professional Staff: 401; Partners: 73; Total staff: 474;
Offices: 8.
Firm: Richard A. Eisner & Co; Total revenue (dollars in millions): 69;
Audit and attest revenue (dollars in millions): 30; Tax revenue
(dollars in millions): 20; MCS revenue (dollars in millions): 18;
Professional Staff: 280; Partners: 70; Total staff:
350; Offices: 3.
Firm: Eide Bailly; Total revenue (dollars in millions): 62; Audit and
attest revenue (dollars in millions): 25; Tax revenue (dollars in
millions): 11; MCS revenue (dollars in millions): 13;
Professional Staff: 464; Partners: 59; Total staff: 523;
Offices: 13.
Firm: J.H. Cohn; Total revenue (dollars in millions): 60; Audit and
attest revenue (dollars in millions): 30; Tax revenue (dollars in
millions): 16; MCS revenue (dollars in millions): 4;
Professional Staff: 193; Partners: 58; Total staff: 251;
Offices: 8.
Firm: Reznick Fedder & Silverman; Total revenue (dollars in millions):
58; Audit and attest revenue (dollars in millions): 33; Tax revenue
(dollars in millions): 18; MCS revenue (dollars in millions): 8;
Professional Staff: 350; Partners: 32; Total staff:
382; Offices: 4.
Firm: Cherry, Bekaert & Holland; Total revenue (dollars in millions):
54; Audit and attest revenue (dollars in millions): 26; Tax revenue
(dollars in millions): 19; MCS revenue (dollars in millions): 6;
Professional Staff: 363; Partners: 45; Total staff:
408; Offices: 23.
Firm: Berdon; Total revenue (dollars in millions): 54; Audit and attest
revenue (dollars in millions): 20; Tax revenue (dollars in millions):
19; MCS revenue (dollars in millions): 14; Professional Staff:
289; Partners: 38; Total staff: 327; Offices: 2.
Firm: Wipfli Ullrich Bertelson; Total revenue (dollars in millions):
52; Audit and attest revenue (dollars in millions): 27; Tax revenue
(dollars in millions): 16; MCS revenue (dollars in millions): 8;
Professional Staff: 335; Partners: 62; Total staff:
397; Offices: 16.
Firm: M.R.Weiser & Co; Total revenue (dollars in millions): 51; Audit
and attest revenue (dollars in millions): 29; Tax revenue (dollars in
millions): 18; MCS revenue (dollars in millions): 4;
Professional Staff: 248; Partners: 32; Total staff: 280;
Offices: 3.
Firm: Rothstein, Kass & Co; Total revenue (dollars in millions): 50;
Audit and attest revenue (dollars in millions): 39; Tax revenue
(dollars in millions): 11; MCS revenue (dollars in millions): 1;
Professional Staff: 303; Partners: 16; Total staff:
319; Offices: 4.
Firm: Goodman & Co; Total revenue (dollars in millions): 49; Audit and
attest revenue (dollars in millions): 26; Tax revenue (dollars in
millions): 22; MCS revenue (dollars in millions): 1;
Professional Staff: 450; Partners: 69; Total staff: 519;
Offices: 9.
Firm: Schenck Business Solutions; Total revenue (dollars in millions):
48; Audit and attest revenue (dollars in millions): 16; Tax revenue
(dollars in millions): 16; MCS revenue (dollars in millions): 7;
Professional Staff: 267; Partners: 41; Total staff:
308; Offices: 12.
Sources: Public Accounting Report, 2002-2003.
Notes: Revenues from audit and attest, tax, and management consulting
services (MCS) may not equal total revenues due to rounding or
exclusion of certain nontraditional services offered by firm. Companies
are ranked in Public Accounting Report by revenues. Figures are self-
reported by the audit firms. Note that Deloitte & Touche's relative
ranking reflects the fact that it is the only one of the Big 4 with
revenues from MSC.
[End of table]
The Big 4 accounting firms dominate internationally as well, with over
$47 billion in total global net revenues for 2002, according to a
February 2003 edition of Public Accounting Report. Moreover,
information provided by officials from foreign regulators suggests that
the national markets for audit services to large public companies in
the other countries tend to be as highly concentrated as they are in
the United States, with the Big 4 accounting firms auditing a vast
majority of these large public company clients. For example, according
to regulatory officials the Big 4 audited over 80 percent of all public
companies in Japan and at least 90 percent of all listed companies in
the Netherlands in 2002, while the Big 4 firms were the auditors for
virtually all major listed companies in the United Kingdom. According
to Italian regulators, in 2001 the Big 5 audited over 80 percent of
listed companies in Italy.
Moreover, concentration measures, such as the Hirschman-Herfindahl
Index (HHI), which are used by DOJ and FTC to aid in the interpretation
of market concentration data, raise potential concerns about the level
of competition among accounting firms when calculated using recent
data.[Footnote 13] As figure 3 illustrates, following the merger of
Price Waterhouse and Coopers & Lybrand and the dissolution of Andersen,
the market consisted of firms with the potential for significant market
power. As a general rule, an HHI below 1,000 indicates a market
predisposed to perform competitively and one that is unlikely to have
adverse competitive effects. Conversely, an HHI above 1,800 indicates a
highly concentrated market in which firms have the potential for
significant market power--the ability to profitably maintain prices
above competitive levels for a significant period of time. Sellers with
market power may also lessen competition on dimensions other than price
such as product quality, service, or innovation. In addition to using
concentration measures, DOJ considers barriers to entry and other
competitive factors such as coordinated interaction among firms,
conditions conducive to establishing coordination among firms, firm-
specific price increases, alternative and differentiated products,
changing market conditions, and the ability of rival sellers to replace
lost competition. As figure 3 also shows, the criminal indictment of
Andersen and subsequent dissolution resulted in the HHI increasing to
2,566, well above the threshold for significant market power. It is
unclear whether and to what extent the Antitrust Division was consulted
and to what extent DOJ's Antitrust Division had input into the decision
to criminally indict Andersen.
Figure 3: Hirschman-Herfindahl Indexes, 1988-2002:
[See PDF for image]
[End of figure]
In 2002, we found that the most significant concentration among
accounting firms was in the large public company market segment. As
figure 4 shows, although consistently above 1,000, HHIs (based on
number of clients) for firms auditing public companies with total sales
between $1 million and $100 million are all below the 1,800 threshold.
However, HHIs for companies with sales over $100 million are
consistently above the 1,800 threshold, indicating the potential for
significant market power in the market for larger company audits.
Figure 4: Hirschman-Herfindahl Indexes (Based on Number of Clients),
2002:
[See PDF for image]
[End of figure]
Analysis of the four-firm concentration ratio also indicates that
concentration among the top four accounting firms has increased
significantly since 1988.[Footnote 14] As shown in figure 5, in 1988
the top four firms (Price Waterhouse, Andersen, Coopers & Lybrand, and
KPMG) audited 63 percent of total public company sales. The next four
firms (Ernst & Whinney, Arthur Young, Deloitte Haskins & Sells, and
Touche Ross) were significant competitors, auditing 35 percent of total
public company sales. Also shown in figure 5, by 1997 the top four
firms audited 71 percent of public company total sales, with two major
competitors (Coopers & Lybrand and KPMG) auditing an additional 28
percent. Finally, by 2002, the top four firms audited 99 percent of
public company total sales with no significant competitors (see fig.
5).
Figure 5: Percentage of Public Company Audit Market (by Total Sales
Audited), 1988, 1997, and 2002:
[See PDF for image]
[End of figure]
Likewise, the four-firm concentration ratio based on the total number
of public company clients increased from 51 percent in 1988 to 65
percent in 1997 and to 78 percent in 2002 (see fig. 6).[Footnote 15]
Not surprisingly, the larger public company segment of the market is
even more concentrated than the overall market. For example, the Big 4
audit roughly 97 percent of all public companies with sales between
$250 million and $5 billion and almost all public companies with sales
greater than $5 billion.
Figure 6: Percentage of Public Company Audit Market (by Number of
Clients), 1988, 1997, and 2002:
[See PDF for image]
[End of figure]
Effective competition does not require pure competitive conditions;
however, a tight oligopoly raises concerns because the firms may
exercise market power, and the concentrated structure of the market
makes successful collusion, overt or tacit, easier.[Footnote 16] In
terms of market concentration, the audit market does not differ from
numerous other markets in the United States that are also characterized
by high degrees of concentration (see table 2). Although the resulting
structures are similar, the factors contributing to the market
structures and the competitive environments may be fundamentally
different.
Table 2: List of Selected Tight Oligopolies, as of 1996:
Market: Cereals; Leading companies: Kellogg, General Mills, General
Foods.
Market: Beer; Leading companies: Anheuser-Busch, Miller, Coors.
Market: Airlines; Leading companies: American, United, Northwest,
Delta, USAir.
Market: Garbage disposal; Leading companies: Waste-Management,
Browning-Ferris.
Market: Automobiles; Leading companies: General Motors, Ford, Chrysler,
Toyota.
Market: Locomotives; Leading companies: General Electric, General
Motors.
Market: Carbonated drinks; Leading companies: Coca-Cola, PepsiCo.
Market: Recordings; Leading companies: Warner, Sony, BMG, Polygram,
EMI, MCA.
Market: Express delivery; Leading companies: Federal Express, UPS,
Airborne Freight.
Market: Soaps and detergents; Leading companies: Procter & Gamble,
Colgate, Lever.
Market: Meat packing; Leading companies: Iowa Beef Packers, Cargill,
ConAgra.
Market: Automobile rentals; Leading companies: Hertz (Ford), Avis,
Budget (Ford), Alamo, National (GM).
Market: Athletic shoes; Leading companies: Nike, Reebok, Adidas.
Market: Toys; Leading companies: Mattel, Hasbro.
Source: W. Shepherd, The Economics of Industrial Organization, 4TH ed.
(London: Prentice-Hall, 1997).
Notes: This list includes a variety of tight oligopolies, and it does
not attempt to compare or infer similarities aside from market
concentration. It includes leading companies from the U.S. market
perspective. The companies in certain markets may have also changed
since 1996.
[End of table]
Consolidation Does Not Appear to Have Impaired Price Competition to
Date:
Despite the high degree of concentration among accounting firms, with
four firms auditing more than 78 percent of all public companies and 99
percent of all public company sales, we found no evidence that price
competition to date has been impaired. As indicated in table 2, much of
the economy is concentrated, but U.S. markets are generally considered
quite competitive. Thus, market concentration data can overstate the
significance of a tight oligopoly on competition. While concentration
ratios and HHI are good indicators of market structure, these measures
only indicate the potential for oligopolistic collusion or the exercise
of market power. As market structure has historically been thought to
influence market conduct and economic performance, there is concern
that a tight oligopoly in the audit market might have resulted in
detrimental effects on both purchasers of audit services and users of
audited financial statements.
We employed a simple model of pure price competition to assess whether
the high degree of concentration in the market for audit services was
necessarily inconsistent with a price-competitive setting. The model is
designed to simulate a market driven by pure price competition, in
which clients choose auditors on price--neither quality nor reputation,
for example, is a factor. The model's simulation results suggest that a
market driven solely by price competition could also result in a high
degree of market concentration. We found that the model simulated
market shares that were close to the actual market shares of the Big 4,
which are thought to be driven by a number of other factors including
quality, reputation, and global reach.(See app. I for a detailed
discussion of the model, results, and limitations.) Specifically, the
model predicted that the Big 4 would audit 64 percent of companies in
the sampled market, compared with the Big 4 actual market share of 62.2
percent in 2002 for the companies included in the simulation.[Footnote
17] Moreover, the model predicted that the Big 4 would audit 96.3
percent of companies in the sample with assets greater than $250
million, compared with the 97 percent of these companies actually
audited by the Big 4 in 2002. While evidence to date does not appear to
indicate that competition in the market for audit services has been
impaired, the increased degree of concentration coupled with the
recently imposed restrictions on the provision of nonaudit services by
incumbent auditors to their audit clients could increase the potential
for collusive behavior or the exercise of market power.
Large Public Companies Have Limited Number of Accounting Firm Choices:
The most observable impact of consolidation among accounting firms
appeared to be the limited number of auditor choices for most large
national and multinational public companies if they voluntarily
switched auditors or were required to do so, such as through mandatory
firm rotation. Of the public companies responding to our survey to
date, 88 percent (130 of 147) said that they would not consider using a
smaller (non-Big 4) firm for audit and attest services. See appendix II
for survey questionnaires and responses. In addition, our analysis of
1,085 former Andersen clients that changed auditors between October
2001 and December 2002 suggested that public companies (especially
large companies) overwhelmingly preferred the Big 4. Only one large
public company with assets over $5 billion that was audited by Andersen
switched to a smaller firm. See appendix III for a detailed analysis.
For most large public companies, the maximum number of choices has gone
from eight in 1988 to four in 2003. According to our preliminary survey
results, a large majority (94 percent or 137 of 145) of public
companies that responded to our survey to date said that they had three
or fewer alternatives were they to switch accounting firms. All 20 of
the audit chairpersons with whom we spoke believed that they had three
or fewer alternatives. Of the companies responding to our survey, 42
percent (61 of 147) said that they did not have enough options for
audit and attest services. However, when asked whether steps should be
taken to increase the number of available choices, results revealed
that 76 percent (54 of 71) of public companies responding to our survey
to date said they would strongly favor or somewhat favor letting market
forces operate without government intervention.
We also found that client choices could be even further limited due to
potential conflicts of interest, the new independence rules, and
industry specialization by the firms--all of which may further reduce
the number of available alternatives to fewer than three. First, the
Big 4 tend to specialize in particular industries and, as our
preliminary survey results indicated, public companies that responded
often preferred firms with established records of industry-specific
expertise, which could further reduce a company's number of viable
choices.[Footnote 18] For example, 80 percent (118 of 148) of the
public companies responding to our survey to date said industry
specialization or expertise would be of great or very great importance
to them if they had to choose a new auditor.[Footnote 19] When asked
why they would not consider an alternative to the Big 4, 91 percent
(117 of 129) of public companies responding to date cited technical
skills or knowledge of their industry as a reason of great or very
great importance.
As figure 7 shows, in selected industries, specialization can often
limit the number of firm choices to two--in each case, two firms
accounted for well over 70 percent of the total assets audited in each
industry in 2002. As a result, it might be difficult for a large
company to find a firm with the requisite industry-specific expertise
and staff capacity. Figure 7 also shows the impact of the Price
Waterhouse and Coopers & Lybrand merger and dissolution of Andersen on
industry specialization and associated client choice. While two firms
also dominated the four selected industries in 1997, this concentration
became much more pronounced by 2002, as illustrated in figure 7. See
appendix IV for a detailed discussion of industry specialization and
further industry-specific examples and limitations of this type of
analysis.
Figure 7: Percentage of Assets Audited in Selected Industries, 1997 and
2002:
[See PDF for image]
[End of figure]
Industry specialization, as captured by a relatively high market share
of client assets or client sales in a given industry, may also be
indicative of a firm's dominance in that industry on a different level.
As a hypothetical example, consider a highly concentrated industry,
with several very large companies and numerous smaller companies, in
which a single accounting firm audits a significant portion of the
industry assets. This firm's interpretation of accounting standards
specific to the industry could become the prevailing standard practice
in that industry due to the firm's dominant role. If, subsequently,
these interpretations were found to be inappropriate (by some
influential external third party, for example), the firm as well as the
companies audited by that firm could be exposed to heightened liability
risk, which could potentially have a severe negative impact on that
industry as a whole as well as the firm.
Finally, the new independence rules established under the Sarbanes-
Oxley Act of 2002, which limit the nonaudit services firms can provide
to their audit clients, may also serve to reduce the number of auditor
choices for some large public companies. As a hypothetical example,
suppose that a large multinational petroleum company that used one Big
4 firm for its audit and attest services and another Big 4 firm for its
outsourced internal audit function wanted to hire a new accounting firm
because its board of directors decided that the company should change
auditors every 7 years. In this case, this company would appear to have
two remaining alternatives if it believed that only the Big 4 had the
global reach and staff resources necessary to audit its operations.
However, one of the remaining two Big 4 firms did not enter a bid
because its market niche in this industry was small companies.
Consequently, this company would be left with one realistic
alternative. Although hypothetical, this scenario spotlights another
concern that focuses on the potential exercise of market power, as it
is highly probable the remaining firm would be aware of its competitive
position. Conceivably, there are other scenarios and circumstances in
which such a company would have no viable alternatives for its global
audit and attest needs.
Linking Consolidation to Audit Price, Quality, and Auditor Independence
Is Difficult:
We found little empirical evidence to link past consolidation to
changes in audit fees, quality, and auditor independence. Given the
significant changes that have occurred in the accounting profession
since the mid-1980s, we were also unable to isolate the impact of
consolidation from other factors. However, researchers (relying on
analyses based on aggregate billings of small samples of companies or
proxies for audit fees, such as average audit revenues) generally found
that audit fees remained flat or increased slightly since 1989.
Additionally, although not focused on consolidation, a variety of
studies have attempted to measure overall changes in audit quality and
auditor independence. The results varied, and we spoke with numerous
accounting experts who offered varying views about changes in quality
and independence. Like audit fees, a variety of factors, such as the
increasing importance of management consulting services provided to
clients, make attributing any changes, real or perceived, to any one of
the factors difficult.
Research on Changes in Audit Fees Used a Variety of Measures but Did
Not Conclusively Determine Effects from Consolidation:
Existing research indicated that audit fees (measured in different
ways) generally remained flat or decreased slightly from the late 1980s
through the mid-1990s but have been increasing since the late 1990s
(inflation adjusted). However, we were unable to isolate the effects of
consolidation and competition from the numerous other changes that have
affected accounting firms and how they conduct business. These changes
included evolving audit scope, the growth of management consulting
services, technological developments, and evolving audit standards and
legal reforms that altered audit firms' litigation exposure.Given
potential changes in the scope of the audit, only the public accounting
firms themselves can accurately determine whether hourly audit fees
have increased or decreased since 1989. In general, the scope of an
audit is a function of client complexity and risk.
Although there are very little data on changes in audit fees over time
and existing studies used a variety of approaches to measure audit
fees, two recent academic studies are widely cited. One used a proxy
measure for the audit fee (Ivancevich and Zardkoohi) and the other was
based on actual
fees charged to a small sample of companies (Menon and
Williams).[Footnote 20] For the period following the mergers of the
late 1980s, both studies found that audit fees declined through the mid
1990s. Using audit revenues per accounting firm divided by the dollar
value of assets audited as a proxy for the audit fee, Ivancevich and
Zardkoohi found that "fees" fell for both the merged firms (Ernst &
Young and Deloitte & Touche) and the remaining Big 6 accounting firms
from 1989 through 1996.[Footnote 21] Similarly, Menon and Williams
found that the average real audit fee per client declined from $3.4
million in 1989 to $2.8 million in 1997, the year Price Waterhouse and
Coopers & Lybrand announced their proposed merger. Moreover, although
the results were limited due to the small sample size used in the
regression analysis, the study did not find any evidence that the Big 6
mergers resulted in a permanent increase in fees.
In addition, as figure 8 illustrates, the periodic survey of actual
audit fees of about 130 companies conducted by Manufacturers Alliance
also found a similar downward trend in audit fees per $100 of public
company revenues in 1989 (and earlier) through 1995.[Footnote 22] In
1995, the Private Securities Litigation Reform Act was enacted, which
limited the liability exposure of accounting firms, among others.
However, the survey revealed a slight increase from 1995 through 1999
for U.S. and foreign companies. Figure 8 shows that U.S. companies also
paid lower fees than their foreign counterparts over the survey period.
Separately, using net average audit revenues for the top tier as a
percentage of total sales audited as a proxy for audit fees, we found
that audit fees declined slightly from 1989 through 1995 and increased
from 1995 through 2001 (see fig. 9). However, no determination can be
made as to whether consolidation negatively or positively impacted
audit fees in either case.
Figure 8: Changes in Audit Fees (Actual), 1984-2000:
[See PDF for image]
Note: This graph depicts the average fees for audit services paid by
companies as a percentage of the average total revenue of the
companies. Given that this fee analysis is based on a small sample of
public companies and the results incorporate changing revenue
classifications and refinements in the underlying survey questions, the
results should be viewed in the context of those companies surveyed and
not the market overall.
[End of figure]
Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of
Total Sales Audited, 1988-2001:
[See PDF for image]
Note: This graph depicts average audit revenue for the top-tier
accounting firms as a percentage of the average total sales audited by
the accounting firms. This estimate is used for trend analysis and
should be viewed as only a rough proxy for the audit fee in part
because the firms' revenues include clients other than public
companies. See appendix I for details.
[End of figure]
Although audit fees are generally a relatively small percentage of a
public company's revenue, recent evidence suggests audit fees have
increased significantly since 2000 and there are indications they may
increase further in the future.[Footnote 23] Some experts believe that
during the 1980s and 1990s audit services became "loss leaders" in
order for accounting firms to gain entry into other more lucrative
professional service markets, primarily management consulting
services.[Footnote 24] Therefore, evidence of flat audit fees since
1989 and the relatively small percentage of company revenue in 2000 may
reveal little about the possible market power produced by having fewer
firms. Likewise, historical fees (especially certain proxy measures of
audit fees) reveal little about the potential for noncompetitive
pricing in the future given the new independence rules and evolving
business model.
According to one source, average audit fees for Standard & Poor's 500
companies increased 27 percent in 2002 due primarily to new
requirements and changing audit practices in the wake of recent
accounting scandals.[Footnote 25] Moreover, many market participants,
experts, and academics with whom we consulted believe prices will
increase further due to the implementation of the Sarbanes-Oxley
requirements and related changes in the scope of certain audit services
and possible changes in auditing standards. Because of these important
changes and the potential for market power, it would be difficult to
isolate the portion of any price increase resulting from noncompetitive
behavior.
Likewise, nearly all accounting firms that responded to our survey said
that both costs and fees have increased over the past decade, but that
costs have increased more: 24 firms (51 percent) said their costs have
"greatly" increased, and another 22 firms (47 percent) said that costs
have "moderately" increased. However, when asked about the fees they
charge, only 12 of the 47 firms (26 percent) responded that the fees
they charge have greatly increased while another 33 firms (70 percent)
said that their fees had moderately increased. When public companies
were asked about fees, 93 percent (137 of 147) of the public companies
that responded to our survey to date said that audit fees had somewhat
or greatly increased over the past decade and 48 percent (70 of 147)
said that consolidation had a great or moderate upward influence on
those fees. Some companies indicated that most of this increase has
occurred in the last few years.
Linking Consolidation to Audit Quality and Auditor Independence Is
Difficult:
Although we identified no research directly studying the impact of
consolidation among the accounting firms on audit quality or auditor
independence, we did find limited research that attempted to measure
general changes in audit quality and auditor independence, and we
explored these issues with market participants and researchers. We
found that theoretical and empirical research on both issues to date
present mixed and inconclusive results as, in general, measurement
issues made it difficult to assess changes in audit quality or auditor
independence.
Research Offers Competing Theories on Factors Influencing Audit Quality
and Auditor Independence:
Audit quality and auditor independence are, in general, difficult to
observe or measure. Theory suggests that auditor independence and audit
quality are inextricably linked, with auditor independence being an
integral component of audit quality. One widely cited academic study
defined auditor independence as the probability that an auditor would
report a discovered problem in a company's financial reports while
another widely cited academic study defined audit quality as the joint
probability that an auditor would discover a problem in a company's
financial reports and, further, that the auditor would report the
problem.[Footnote 26]
Research offers competing theories that address how competition among
firms, auditor tenure, and accounting firm size--all factors that could
be influenced directly by consolidation--might impact auditor
independence and, thus, audit quality.[Footnote 27] For example, some
research hypothesized that increased competition could have a negative
effect, as a client's opportunities and incentives to replace an
incumbent auditor might increase for reasons ranging from minimizing
audit fees to a desire for a more compliant auditor. However, other
research hypothesized that increased competition could reduce the
probability that some accounting firms could exercise disproportionate
influence over the establishment of accounting principles and policies.
Likewise, auditor tenure might also have a positive or negative impact.
Some research hypothesized that an auditor that served a given client
for a longer period of time may be more valuable to that client due to
its deeper familiarity with and deeper insight into the client's
operations, which would allow the auditor to become less dependent on
the client for information about the client's operations. However,
other research hypothesized that increased tenure could result in
complacency, lack of innovation, less rigorous audit procedures, and a
reflexive confidence in the client. Some research hypothesized that an
accounting firm's size might also have an impact, as a larger firm
might become less dependent on a given client than a smaller firm.
Academic research suggests that larger auditors will perform higher
quality audits and there are many studies employing proxies for audit
quality that frequently report results consistent with such a notion.
However, given its unobservable nature, there does not appear to be
definitive evidence confirming the existence of differential audit
quality between the Big 4 accounting firms and other auditors. Some
researchers have dismissed the notion of differential audit quality,
while others have questioned the assumption that the larger firms
provide higher quality audits.[Footnote 28] Some experts with whom we
consulted asserted that there was a quality differential, while others
were not convinced of this. One academic told us that the question of
differential audit quality was difficult to answer, since large
accounting firms generally handle most large company audits. This
individual also suggested that smaller accounting firms could provide
the same audit quality as larger accounting firms, provided that these
smaller firms only accepted clients within their expertise and service
potential.
Studies Often Use Restatements, Going-Concern Opinions, and Earnings
Management to Measure Audit Quality and Auditor Independence:
Audit quality is not generally measurable and tends only to be made
public when a company experiences financial difficulties and its
investors have a reason to question it.[Footnote 29] Studies addressing
audit quality and auditor independence have typically focused on
financial statement restatements, going-concern opinions, and earnings
management or manipulation.[Footnote 30]
Financial statement restatements due to accounting improprieties have
been used by some as a measure of audit quality.[Footnote 31] By this
measure, there is some evidence suggesting that audit quality may have
declined over the 1990s, as several recent studies have found that
financial statement restatements due to accounting irregularities have
been increasing, and those by larger companies have been increasing as
well.[Footnote 32] As larger companies typically employ larger
accounting firms, which have been perceived historically by some as
providing higher quality audits, this trend toward larger company
financial statement restatements may heighten concerns about
potentially pervasive declining audit quality. In addition, in some
recent high-profile restatement cases it appeared that the auditors
identified problems but failed to ensure that management appropriately
addressed their concerns, raising questions about auditor independence.
Another measure that has been employed by researchers to gauge audit
quality is whether an auditor issues a going-concern opinion warning
investors prior to a company's bankruptcy filing.[Footnote 33] One
study found that during the 1990s accounting firms issued fewer going-
concern audit opinions to financially stressed companies prior to
bankruptcy.[Footnote 34] This study found that auditors were less
likely to issue going-concern opinions in 1996-1997 than in 1992-1993,
and again less likely to issue such opinions in 1999-2000 than in 1996-
1997. Moreover, another study that analyzed going-concern opinions
found that accounting firms failed to warn of nearly half of the 228
bankruptcies identified from January 2001 through June 2002, despite
the fact that nearly 9 out of 10 of these companies displayed at least
two indicators of financial stress.[Footnote 35] However, numerous
prior studies also found that approximately half of all companies
filing for bankruptcy in selected periods prior to the 1990s did not
have prior going-concern opinions in their immediately preceding
financial statements either.[Footnote 36] Another study focusing on
going-concern opinions over a relatively short, recent time period
examined whether there was an association between nonaudit fees and
auditor independence, but it found no significant association between
the two using auditors' propensity to issue going-concern opinions.
[Footnote 37] This study's findings were consistent
with market-based institutional incentives dominating expected
benefits from auditors compromising their independence.
Corporate earnings reported in companies' annual filings (to which
auditors attest fairness) can be an important factor in investors'
investment decisions, and can be used by corporate boards and
institutional investors in assessing company performance and management
quality, and in structuring loans and other contractual arrangements.
As such, they can have an impact on securities prices and managers'
compensation, among other things. Earnings management or manipulation
(captured by, for example, managers' propensity to meet earnings
targets) is another measure that has been used by researchers to
capture audit quality, although in this case an auditor's influence on
its clients' earnings characteristics is likely to be less direct and
there can be more significant measurement problems.[Footnote 38] While
there has been growing anecdotal and empirical evidence of earnings
management, research using this measure to determine whether audit
quality or auditor independence was impaired yielded mixed results. For
example, while one recent study suggested that nonaudit fees impair the
credibility of financial reports, another cast doubt on its results,
and another found evidence consistent with auditors increasing their
independence in response to greater financial dependence (that is, for
larger clients).[Footnote 39]
Despite Contrasting Views on Audit Quality, Experts and Professionals
Did Not View Consolidation as Cause:
Existing research on audit quality and auditor independence presents
inconclusive results, suffers from problematic measurement issues, and
generally does not consider or compare these factors over extended time
periods. Many academics and other accounting experts we contacted
indicated that they believed audit quality had declined since 1989.
However, others, including small accounting firms and large company
clients that responded to our survey to date, believed that audit
quality had not decreased. For example, 43 percent (63 of 147) of
public companies that responded believed the overall quality had gotten
much or somewhat better over the past decade, while 18 percent (27 of
147) felt it had gotten much or somewhat worse. Of the public companies
that responded to our survey to date, 60 percent (88 of 147) indicated
that their auditor had become much more or somewhat more independent
over the last decade. However, some accounting firms acknowledged that
achieving auditor independence was difficult: 10 percent (14 of the
147) accounting firms that responded to our survey said that it had
become much or somewhat harder to maintain independence at the firm
level in the past decade and 19 percent (9 of the 47) indicated that it
had become much more difficult or somewhat harder to maintain
independence at the individual partner level over the past decade.
Even if audit quality or auditor independence has been affected, it
would be difficult to determine any direct link to consolidation among
accounting firms because of numerous other structural changes that
occurred both within and outside of the audit market. When we asked our
survey respondents how consolidation influenced the quality of audit
services they received, 64 percent (94 of 147) of the public companies
responding to date and 95 percent (41 of 43) of accounting firms said
that consolidation had little or no effect. However, some academics we
contacted believed that consolidation might have indirectly influenced
audit quality during the 1990s, with some suggesting, for example, that
concentration among a few firms enabled the largest accounting firms to
exercise greater influence over the audit standard setting process and
regulatory requirements.
Academics and Other Experts Said Other Factors Affected Audit Quality
and Auditor Independence:
In general, many of the people with whom we spoke--representing
academia, the profession, regulators, and large public companies--
believed that other factors could potentially have had a greater effect
on audit quality than consolidation. According to knowledgeable
individuals with whom we spoke, a variety of factors may have had a
more direct impact on audit quality and auditor independence than
consolidation. For example, they cited the removal of restrictions
against advertising and direct solicitation of clients, the increased
relative importance of management consulting services to accounting
firms, legal reforms, changing auditing standards, and a lack of
emphasis on the quality of the audit by clients and some capital market
participants.
Several individuals who were knowledgeable about accounting firm
history suggested that when advertising and direct solicitation of
other firms' clients began to be permitted in the 1970s, the resulting
competitive pressure on audit prices led accounting firms to look for
ways to reduce the scope of the audit, resulting in a decline in audit
quality. Many of the experts with whom we consulted also suggested that
the entry of accounting firms into more lucrative management consulting
services led to conflict-of-interest issues that compromised the
integrity and quality of the audit service.
Other sources noted that, as a result of several legal reforms during
the 1990s, it became more difficult and less worthwhile for private
plaintiffs to assert civil claims against auditors and audit quality
may also have suffered.[Footnote 40] This view was supported by a study
that concluded that accounting firms were less likely to warn investors
about financially troubled companies following the litigation reforms
of the 1990s.[Footnote 41]
Consolidation Appears to Have Had Little Effect on Capital Formation
or Securities Markets to Date, and Future Implications Are Unclear:
Although accounting firms play an important role in capital formation
and the efficient functioning of securities markets, we found no
evidence to suggest that consolidation among accounting firms has had
an impact on either of these to date. Moreover, we were unable to find
research directly addressing how consolidation among accounting firms
might affect capital formation or the securities markets in the future.
Capital formation and the securities markets are driven by a number of
interacting factors, including interest rates, risk, and supply and
demand. Isolating any impact of consolidation among accounting firms on
capital formation or the securities markets is difficult because of the
complex interaction among factors that may influence the capital
formation process, and we were unable to do so. Moreover, most capital
market participants and other experts with whom we spoke were either
unsure or did not believe that consolidation had any directly
discernible impact on capital formation or the securities markets. Some
said that the broader issues facing accounting firms, such as the
recent accounting-related scandals involving Enron and WorldCom, might
have affected the capital markets by reducing investor confidence, but
that these were not necessarily linked to consolidation.
The informational role played by accounting firms is key to reducing
the disparity in information between a company's management and capital
market participants regarding the company's financial condition, thus
enhancing resource allocation. Consequently, to the extent that
consolidation might affect audit quality, especially the perception of
audit quality, the cost and allocation of capital could be affected.
For example, a perceived decline in audit quality for a given company
might lead the capital markets to view that company's financial
statements with increased skepticism, potentially increasing the
company's cost of capital as well as altering the capital allocation
decisions of capital market participants.[Footnote 42] The liability to
which accounting firms are subject also creates a form of "insurance"
to investors through an auditor's assurance role, which provides
investors with a claim on an accounting firm in the event of an audit
failure.[Footnote 43] To the extent that consolidation increased the
capital bases of some accounting firms, investors might view this as
potentially increasing loss recovery in the event of an audit failure
involving those firms. However, it is unclear whether there has been or
would be any impact on investor behavior, either positive or negative,
due to the increased capital base of some firms.
Although there appears to be no direct effect from consolidation of the
Big 8 on the capital markets to date, some capital market participants
and anecdotal evidence suggested that investment bankers and
institutional investors, both of whom are integral to the capital
formation process, often prefer that public companies use the Big 4 to
audit their financial statements.[Footnote 44] Although such a
preference does not appear to represent much of a constraint to large
national and multinational companies, it could have an impact on other,
smaller companies accessing the capital markets, as a company's use of
a less well-known accounting firm might create added uncertainty on the
part of investors and could possibly lead to delays in accessing new
capital. For example, some research indicated that there was less
initial public offering underpricing for companies that used Big 8 or
larger accounting firms, as opposed to those that engaged smaller
accounting firms.[Footnote 45] According to firm officials, as larger
accounting firms reevaluate their portfolio of clients, some smaller
public companies may no longer be able to engage the Big 4 or other
large accounting firms with whom capital market participants are more
familiar. Thus, partially as a result of a market with fewer accounting
firms able or willing to provide audit services to larger public
companies, some smaller companies could be hindered in their ability to
raise capital.
Because the audit market has become more concentrated, the Big 4 have
been increasing their focus on gaining the audit contracts of larger
public companies. In the process, the Big 4 shed some of their clients,
particularly smaller ones, which they viewed as not profitable or as
posing unacceptable risks to their firms. Likewise, smaller firms said
that they have undergone similar risk assessment and client retention
processes, and they have also shed some clients that no longer
satisfied their client criteria. Moreover, the possible reduction in
the number of accounting firms willing to audit public companies in the
wake of the passage of Sarbanes-Oxley could further impact the
availability and cost of capital for some smaller companies,
particularly companies for whom the accounting firms may doubt the
profitability of the audit engagements. As noted earlier, familiarity
with an accounting firm on the part of capital market participants
could lead to easier, less expensive access to the capital markets.
Smaller Accounting Firms Face Numerous Barriers to Entry into the Top
Tier:
Unlike the Big 4, which have established global operations and
infrastructure, smaller accounting firms face considerable barriers to
entry, such as the lack of capacity and capital limitations, when
competing for the audits of large national and multinational public
companies. First, smaller firms generally lack the staff resources,
technical expertise, and global reach to audit large multinational
companies. Second, public companies and markets appear to prefer the
Big 4 because of their established reputation. Third, the increased
litigation risk and insurance costs associated with auditing public
companies generally create disincentives for smaller firms to actively
compete for large public company clients. Fourth, raising the capital
to expand their existing infrastructure to compete with the Big 4,
which already have such operations in place, is also a challenge, in
part because of the partnership structure of accounting firms. Finally,
certain state laws, such as state licensing requirements, make it
harder for smaller firms that lack a national presence to compete. The
firms with whom we spoke, including the Big 4, all told us that they
did not foresee any of the other accounting firms being able to grow to
compete with the Big 4 for large national and multinational public
company clients in the near future.
Smaller Firms Generally Lack Staff Resources, Technical Expertise, and
Global Reach to Audit Large Public Companies:
Perhaps the most difficult challenge facing smaller firms is the lack
of staff resources, technical expertise, and global reach necessary to
audit most large national and multinational companies and their often
complex operations. Moreover, 91 percent (117 of 129) of public
companies responding to our survey who would not consider using a non-
Big 4 firm as their auditor said that the capacity of the firm was of
great or very great importance in their unwillingness to do
so.[Footnote 46] Large multinational companies are generally more
complex to audit and require more auditors with greater experience and
training. The complexity of a public company audit depends on many
factors, such as the number of markets in which the company competes,
the size of the company, the nature of the company's business, the
variety of revenue streams it has, and organizational changes. It is
not uncommon for an audit of a large national or multinational public
company to require hundreds of staff.
Most smaller firms lack the staff resources necessary to commit
hundreds of employees to a single client, which limits smaller firms'
ability to compete with the Big 4 for large audit clients. Yet, without
having large clients, it is difficult to build the capacity needed to
attract large clients. Even with global networks and affiliations, the
capacity gap between the fourth-and fifth-ranked firms is significant.
For example, the smallest Big 4 firm in terms of 2002 partners and
nonpartner professional staff from U.S. operations, KPMG, is over five
times the size of the fifth-largest firm, Grant Thornton. As table 3
illustrates, the gap between the top tier and the next tier has grown
significantly since 1988. This gap spans revenue, number of partners,
professional staff size, offices, and number of SEC clients. The result
is a dual market structure--one market where the Big 4 compete with
several smaller accounting firms for medium and small public companies
and another market where essentially only the Big 4 compete for the
largest public company clients.[Footnote 47]
Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms
(U.S. Operations), 1988 and 2002:
[See PDF for image]
Source: Public Accounting Report, 1989 and 2003.
Notes: The next tier includes Laventhol & Horwath, Grant Thornton, BDO
Seidman, and McGladrey & Pullen in 1988 (based on the next four largest
ranked firms by total public company sales audited); for 2002,
Laventhol & Horwath is replaced by Crowe, Chizek and Company. Average
real revenue figures have been adjusted for inflation. Gap figures may
not sum due to rounding.
[End of table]
Although firms of all sizes expressed some difficulty attracting staff
with specialized audit or industry-specific expertise, smaller firms
said that this was particularly difficult. Further, some smaller firms
told us that they had difficulty keeping talented employees, especially
those with sought-after expertise, from leaving for jobs with the Big
4. The Big 4 can afford to more highly compensate employees and also
offer a wider range of opportunities than smaller firms. Moreover, the
public companies that responded to our survey to date ranked industry
specialization or expertise as the third most important consideration
in selecting an auditor. Some company officials also said that they
preferred a firm to have a "critical mass" or depth of staff with the
requisite expertise and knowledge, which generally required a firm of a
certain size.
In addition to smaller firms having staff resource and technical
expertise constraints, some public companies said that their auditor
had to have sufficient global reach to audit their international
operations. Without extensive global networks, most smaller firms face
significant challenges in competing for large multinational clients. As
table 4 illustrates, the disparity in capacity between the Big 4 and
the next three largest firms' global operations was even more dramatic
than the comparison between their U.S. operations. For example, on
average, the Big 4 had over 75,000 nonpartner professional staff and
over 6,600 partners compared to the next three largest firms with over
14,000 nonpartner professional staff and around 2,200 partners.
Table 4: Largest U.S. Accounting Firms (Global Operations), 2002:
Accounting firms: Big 4: PricewaterhouseCoopers; Revenue: (dollars in
thousands): Big 4: $13,782; Partners: Big 4: 7,020; Professional staff
(nonpartner): Big 4: 97,109.
Accounting firms: Big 4: Deloitte & Touche; Revenue: (dollars in
thousands): Big 4: 12,500; Partners: Big 4: 6,714; Professional staff
(nonpartner): Big 4: 73,810.
Accounting firms: Big 4: KPMG; Revenue: (dollars in thousands): Big 4:
10,720; Partners: Big 4: 6,600; Professional staff (nonpartner): Big 4:
69,100.
Accounting firms: Big 4: Ernst & Young; Revenue: (dollars in
thousands): Big 4: 10,124; Partners: Big 4: 6,131; Professional staff
(nonpartner): Big 4: 60,713.
Accounting firms: Next tier.
Accounting firms: BDO Seidman; Revenue: (dollars in thousands):
2,395; Partners: 2,182; Professional staff (nonpartner):
16,078.
Accounting firms: Grant Thornton; Revenue: (dollars in
thousands): 1,840; Partners: 2,256; Professional staff
(nonpartner): 14,019.
Accounting firms: McGladrey & Pullen; Revenue: (dollars in
thousands): 1,829; Partners: 2,245; Professional staff
(nonpartner): 12,775.
Source: Public Accounting Report, 2003.
Notes: This table is limited to U.S.-based firms with global
operations. Some foreign firms may have operations comparable to
smaller U.S. firms.
[End of table]
While some of the smaller firms have international operations, we found
that some public companies and others were either unaware that they had
such operations or were uncertain of the degree of cohesive service
that these smaller firms could provide through their global
affiliations. The various national practices of any given Big 4 firm
are separate and independent legal entities, but they often share
common resources, support systems, audit procedures, and quality and
internal control structures. Market participants said that the
affiliates of smaller firms, in contrast, tended to have lower degrees
of commonality. Rather than a tight network, they described smaller
firms' international affiliations as associations or cooperatives in
which there was less sharing of resources and internal control systems.
In addition, they said that quality standards, practices and procedures
might be less uniform between smaller firm affiliates, which raised
concerns for multinational public companies.
Smaller Firms Lack Global Reputation:
Smaller firms face a challenge to establish recognition and credibility
among large national and multinational public companies and, as
discussed previously, capital market participants. One reason capital
market participants often prefer a Big 4 auditor is because of their
higher level of familiarity with the Big 4. For example, some large
public companies said that some of the smaller accounting firms could
provide audit services to certain large national public companies,
depending on the complexity of the companies' operations. These
individuals added, however, that boards of directors of these companies
might not consider this option. Others said that despite recent
accounting scandals involving the Big 4, many capital market
participants continued to expect the use of the Big 4 for audit
services. Thus, companies seeking to establish themselves as worthy
investments may continue to engage one of the Big 4 to increase their
credibility to investors. Eighty-two percent (121 of 148) of the public
companies that responded to our survey indicated that reputation or
name recognition was of great or very great importance to them in
choosing an auditor. This was the second-most-cited factor, exceeded
only by quality.
Increased Litigation Risk and Insurance Costs Make Large Company Audit
Market Less Attractive Than Other Options:
Increased litigation risk presents another barrier for smaller firms
seeking to audit larger public companies as they face difficulties
managing this risk and obtaining affordable insurance. Like many of the
challenges faced by smaller firms, this is a challenge for all firms.
However, assuming that smaller firms were able to purchase additional
insurance to cover the new risk exposure, most smaller firms lacked the
size needed to achieve economies of scale to spread their litigation
risk and insurance costs across a larger capital base. According to 83
percent of firms (38 of the 46) that responded to our survey,
litigation and insurance factors have had a great or moderate upward
influence on their costs, which they indicated have increased
significantly.[Footnote 48] Specifically, some of the firms with whom
we spoke said that their deductibles and premiums have increased
substantially and coverage had become more limited. Given the recent
high-profile accounting scandals and escalating litigation involving
accounting firms, some firms said that insurance companies saw
increased risk and uncertainty from insuring firms that audited public
companies. As a result, some of the smaller firms with whom we spoke
said they had or were considering limiting their practices to nonpublic
clients. Others said that the greater risk associated with auditing
large public companies was a key factor in their decisions not to
attempt to expand their existing operations in the public company audit
market.
Finally, many of the largest non-Big 4 firms said that they had ample
opportunities for growth in the mid-sized public company segment of the
public company audit market and in the private company audit market. In
addition, smaller firms said that they could attract large companies as
clients for other audit-related and nonaudit services such as forensic
audits, management consulting services, and internal audits. In their
efforts to maximize profits, these smaller firms said they were
targeting market segments in which they were best positioned to
compete, which generally did not include the large public company audit
market.
Raising Capital for Growth Is Difficult:
Access to capital is another critical element to an accounting firm's
ability to generate the capacity needed to establish the network and
infrastructure to audit large multinational companies. Several firms
cited the lack of capital as one of the greatest barriers to growth and
the ability to serve larger clients. They said that the partnership
structure of most public accounting firms was one factor that limited
the ability of all firms to raise capital but posed a particular
challenge for smaller firms. Under a partnership structure, accounting
firms are unable to raise capital through the public markets. To expand
their operations, accounting firms must look to other options, such as
borrowing from financial institutions, merging with other accounting
firms, growing the business without merging, or tapping the personal
resources of their partners and employees. Raising capital through
borrowing may be difficult because accounting firms as professional
service organizations may lack the collateral needed to secure loans.
While mergers provide a way for firms to grow and expand their capital
base, the smaller firms with whom we spoke indicated that they were not
interested in merging with other similarly sized firms. Some firms said
that they did not see the economic benefits or business advantages of
doing so while others said that they wanted to maintain their unique
identity.
We also employed the Doogar and Easley (1998) model by simulating
mergers among smaller firms in order to assess whether, in a purely
price competitive environment, such mergers could lead to viable
competitors to the Big 4 for large national and multinational clients.
In particular, we merged the five largest firms below the Big 4 in
terms of the number of partners (Grant Thornton, BDO Seidman, Baid
Kurtz & Dobson, McGladrey & Pullen, and Moss Adams) and simulated the
market to see if the newly merged firm could attract public companies
(of any size) away from the Big 4. We first assumed that the newly
merged firm would become as efficient as the Big 4, as measured by the
staff-to-partner ratio. Under this best-case scenario, we projected
this firm's market share would be 11.2 percent, compared with the five
firms' actual collective 2002 market share of 8.6 percent, indicating a
2.6 percentage-point gain in market share. However, when we assumed
lesser efficiency gains, the merged firm's projected market share
ranged from 4.5 percent (no efficiency gains) to 6.4 percent (some
efficiency gains), indicating that the merged firm's market share would
be lower than their collective market share (see app. II). Even
ignoring many real world considerations, such as reputation and global
reach, these results illustrated the difficulty faced to date by any
potential competitor to the Big 4 firms in the market for large public
company audits.
State Requirements Pose Obstacles for Smaller Firms in Particular:
While all accounting firms must comply with state requirements such as
licensing, smaller firms that lack an existing infrastructure of
national offices face increased costs and burden to establish
geographic coverage needed for auditing most large public companies.
All 50 states, the District of Columbia, Guam, Puerto Rico, and the
U.S. Virgin Islands have laws governing the licensing of certified
public accountants, including requirements for education, examination,
and experience.
While each jurisdiction restricts the use of the title "certified
public accountant" to individuals who are registered as such with the
state regulatory authority, the other licensure requirements are not
uniform. State boards have been working toward a more uniform system
based on the Uniform Accountancy Act (UAA), which is a model licensing
law for state regulation within the accounting profession. The UAA
seeks adoption of the idea of "substantial equivalency" with regard to
education, examinations, and experience, so that states recognize each
other's certification as "substantially equivalent" to their own.
According to National Association of State Boards of Accountancy and
AICPA officials, fewer than half (23) of the jurisdictions had agreed
to the equivalency practice as of July 1, 2003.
Some firms expressed concerns that potential state and federal
duplication of oversight could pose more of a burden for smaller firms
than the Big 4 and might induce some smaller firms to stop auditing
public companies altogether. Specifically, to mirror the federal
oversight structure, most states (37) implemented statutorily required
peer reviews for firms registered in the state. Until 2002, these
requirements were generally consistent with the peer review process
conducted by AICPA's SEC Practice Section.[Footnote 49] However,
Sarbanes-Oxley created PCAOB to establish auditing standards and
oversee firms' compliance with those standards. Unlike the old peer
review that focused on a firm's overall operations, PCAOB plans to
conduct inspections of a firm's public company practice. Whether this
inspection will be sufficient to satisfy the peer review requirements
under state law or whether firms with private clients would have to be
subject to both state-and federal-level reviews is unclear at this
time.
Observations:
The audit market is in the midst of unprecedented change and evolution.
It has become more highly concentrated, and the Big 4, as well as all
accounting firms, face tremendous challenges as they adapt to new risks
and responsibilities, new independence standards, a new business model,
and a new oversight structure, among other things. In many cases it is
unclear what the ultimate outcome will be and our findings about past
behavior may not reflect what the situation will be in the future.
Therefore, we have identified several important issues that we believe
warrant additional attention and study by the appropriate regulatory or
enforcement agencies at some point. First, agencies could evaluate and
monitor the effect of the existing level of concentration on price and
quality to see if there are any changes in the firms' ability to
exercise market power. This is especially important as the firms move
to a new business model with management consulting becoming a less
significant source of revenue. Second, the issue of what, if anything,
can or should be done to prevent further consolidation of the Big 4
warrants consideration. Such an analysis could determine the possible
impact of increased concentration through the voluntary or involuntary
exit of one of the current Big 4 firms. If the effects were seen as
detrimental, regulatory and enforcement agencies could evaluate the
types of actions that could be taken to mitigate the impact or develop
contingency plans to deal with the impact of further consolidation.
Part of this analysis would be to evaluate the pros and cons of various
forms of government intervention to maintain competition or mitigate
the effects of market power. Third, it is important that regulators and
enforcement agencies continue to balance the firms' and the
individuals' responsibilities when problems are uncovered and to target
sanctions accordingly. For example, when appropriate, hold partners and
employees rather than the entire firm accountable and consider the
implications of possible sanctions on the audit market. However, it is
equally important that concerns about the firms' viability be balanced
against the firms' believing they are "too few to fail" and the ensuing
moral hazard such a belief creates. Fourth, Big 4 market share
concentration, particularly in key industries, may warrant ongoing and
additional analysis, including evaluating ways to increase accounting
firm competition in certain industries by limiting market shares.
Finally, it is unclear what can be done to address existing barriers to
entry into the large public company market. However, it may be useful
to evaluate whether addressing these barriers could prevent further
concentration in the top tier. Part of this evaluation could include
determining whether there are acceptable ways to hold partners
personally liable while reasonably limiting the firms' exposure, but at
the same time increasing the firms' ability to raise capital.
Agency Comments and Our Evaluation:
We provided copies of a draft of this report to SEC, DOJ, PCAOB, and
AICPA for their comment. We obtained oral comments from DOJ officials
from the Antitrust and Criminal Divisions, who provided additional
information on the extent to which coordination with antitrust
officials and consideration of the competitive implications of the
Andersen criminal indictment occurred. As a result, we clarified the
language provided in this report. SEC, DOJ, and AICPA provided
technical comments, which have been incorporated into this report where
appropriate. PCAOB had no comments.
We are sending copies of this report to the Chairman and Ranking
Minority Member of the House Committee on Energy and Commerce. We are
also sending copies of this report to the Chairman of SEC, the Attorney
General, the Chairman of PCAOB, and other interested parties. This
report will also be available at no cost on GAO's Internet homepage at
http//www.gao.gov.
This report was prepared under the direction of Orice M. Williams,
Assistant Director. Please contact her or me at (202) 512-8678 if you
or your staff have any questions concerning this work. Key contributors
are acknowledged in appendix V.
Davi M. D'Agostino
Director, Financial Markets and Community Investment:
Signed by Davi M. D'Agostino:
[End of section]
Appendixes:
Appendix I: Scope and Methodology:
As mandated by Section 701 of the Sarbanes-Oxley Act of 2002 (P.L. 107-
204) and as agreed with your staff, our objectives were to study (1)
the factors leading to the mergers among the largest public accounting
firms in the 1980s and 1990s; (2) the impact of consolidation on
competition, including the availability of auditor choices for large
national and multinational public companies; (3) the impact of
consolidation on the cost, quality, and independence of audit services;
(4) the impact of consolidation on capital formation and securities
markets; and (5) the barriers to entry faced by smaller firms in
competing with the largest firms for large national and multinational
public company clients.
We conducted our work in Chicago, Illinois, New York, New York, and
Washington, D.C., from October 2002 through July 2003.
Identifying the Factors for Consolidation:
To identify the factors contributing to consolidation among accounting
firms, we interviewed past and current partners of public accounting
firms involved in Big 8 mergers, and officials from the Department of
Justice (DOJ) and Federal Trade Commission (FTC). Specifically, we
conducted in-depth interviews with senior partners of the Big 4 firms
and, to the extent possible, the former partners, chairmen, and chief
executive officers (CEO) of the Big 8 who were instrumental in their
firms' decisions to consolidate. We asked these officials to recount in
detail their firms' histories of consolidation and their views on the
impetus for merging. We also conducted interviews with senior DOJ
officials about the studies and investigations they had undertaken to
determine whether the mergers would raise antitrust issues. We did not,
however, review any of the antitrust analyses conducted by DOJ specific
to any of the proposed mergers during the 1980s and 1990s. We requested
DOJ's antitrust analysis and related documentation from the mergers
among the largest firms in 1987 and 1997. According to DOJ officials,
most of the firm documents had been returned to the relevant parties,
and other documents were viewed as "predecisional" by DOJ. While GAO's
statute provides us with access to predecisional information absent a
certification by the President or the Director of the Office of
Management and Budget, we were more interested in the reasons for the
mergers than DOJ's analysis in approving the mergers. Therefore, we
used other sources to obtain the necessary information for this report.
To the extent possible, we obtained copies of public decisions made by
FTC in the 1970s and 1980s concerning the ability to advertise by
professional service firms, including the accounting firms. As directed
by the mandate, we coordinated with the Securities and Exchange
Commission (SEC) and SEC's counterparts from the Group of Seven nations
(Canada, France, Germany, Italy, Japan, United Kingdom, and United
States). To do this, we met with the representatives of the appropriate
regulatory agencies under the auspices of the International
Organization of Securities Commissions and obtained additional
information relevant to their countries. We also conducted a literature
review of existing studies on the history of the accounting profession
and consolidation.
Impact of Consolidation on Competition, Auditor Choices, Audit Fees,
and Audit Quality and Auditor Independence:
To evaluate the impact of consolidation on competition, auditor
choices, audit fees, and audit quality and auditor independence, we
consulted with academics and other researchers, U.S. and foreign
regulators, and trade associations, and we reviewed relevant academic
literature. Most of the research studies cited in this report have been
published in highly regarded, refereed academic journals. These studies
were also reviewed by GAO's economists, who determined that they did
not raise serious methodological concerns. However, the inclusion of
these studies is purely for research purposes and does not imply that
we deem them definitive. We sent out 26 structured questionnaires
regarding the impact of consolidation on choice, price, and quality to
a cross section of academics and other experts (with backgrounds in
accounting, securities, and industrial organization) and received 14
responses. We also collected data and calculated our own descriptive
statistics for analysis. Using audit market data from various sources,
we computed concentration ratios and Hirschman-Herfindahl indexes and
conducted trend analyses and tests of statistical independence. We also
employed a simple model of pure price competition, in which clients
choose auditors based on price, ignoring factors such as quality or
reputation, to assess whether the current high degree of concentration
in the market for audit services is necessarily inconsistent with a
purely price competitive setting. To augment our empirical findings, we
conducted two surveys. Finally, we interviewed a judgmental sample of
20 chairpersons of audit committees of Fortune 1000 companies to obtain
their views on consolidation and competition.
Data Analysis Used a Variety of Sources:
To address the structure of the audit market we computed concentration
ratios and Hirschman-Herfindahl indexes for 1988 to 2002 using the Who
Audits America database, a directory of public companies with detailed
information for each company, including the auditor of record,
maintained by Spencer Phelps of Data Financial Press. We used Public
Accounting Report (PAR) and other sources for the remaining trend and
descriptive analyses, including the analyses of the top and lower tiers
of accounting firms, contained in the report.[Footnote 50] Data on
audit fees were obtained from a variety of academic and other sources,
including Manufacturers Alliance. The proxy for audit fees that we
constructed was based on numerous issues of PAR and Who Audits America.
Given the data used and the manner in which our proxy was constructed,
this should be considered to be a rough proxy and is used for
illustrative trend analysis in this report. To verify the reliability
of these data sources, we performed several checks to test the
completeness and accuracy of the data. Random samples of the Who Audits
America database were crosschecked with SEC proxy filings and other
publicly available information. Descriptive statistics calculated
using the database were also compared with similar statistics from
published research. Moreover, Professors Doogar and Easley (see next
section for fuller discussion), who worked with us on the modeling
component of the study, compared random samples from Compustat, Dow-
Jones Disclosure, and Who Audits America and found no discrepancies.
Because of the lag in updating some of the financial information, the
results should be viewed as estimates useful for describing market
concentration. We performed similar, albeit more limited, tests on PAR
data. However, these data are self-reported by the accounting firms and
it should be noted that the firms are not subject to the same reporting
and financial disclosure requirements as SEC registrants.
We Used the Doogar and Easley (1998) Model of Audit Market Structure to
Assess Concentration in a Purely Price Competitive Framework:
We also employed a simple model of pure price competition, in which
clients choose auditors based on price, ignoring factors such as
quality or reputation, to assess whether the current high degree of
concentration in the market for audit services is necessarily
inconsistent with a price-competitive setting.[Footnote 51] We worked
with Professor Rajib Doogar, University of Illinois at Urbana-
Champaign, and Professor Robert Easley, University of Notre Dame, to
expand and update their 1998 model using 2002 data. Our sample
consisted of 5,448 companies listed on the American Stock Exchange,
NASDAQ, and New York Stock Exchange, and other companies with stock
traded on other over-the-counter markets identified from Who Audits
America. To ensure consistency with Doogar and Easley (1998), we
limited the market studied to only industrial companies. The
information on accounting firms, such as number of partners and staff,
was obtained from PAR. Professors Doogar and Easley performed the
simulations.
To determine whether the tight oligopoly in the audit market in 2002
could be explained with a model of pure price competition, we ran three
market simulations. In the first simulation, we allowed the firms to
compete for clients to determine market share in a simulated price-
competitive market. For the second simulation, we assigned companies to
their current auditor and simulated the market to see if the accounting
firms could defend their market share in a purely price-competitive
market. Finally, we combined several smaller firms to see if they could
successfully compete with the Big 4 for larger clients. In each
simulation, the computer-generated market mimicked a process of pure
price competition in which firms bid for each client, based on the
short-term cost of performing the audit.
Model Assumptions:
The model makes several principal assumptions. First, the model assumes
that firms produce audits with a constant returns-to-scale technology
using a fixed number of partners and a variable number of
staff.[Footnote 52] Second, it assumes that firms seek to minimize cost
(maximize profits), which determines each firm's optimal staff-to-
partner, or leverage, ratio. Third, the model assumes that firms
compete in a market characterized by perfect price competition--firms
bid their incremental costs for audits and clients choose auditors
solely on price so that firm expertise, quality, and reputation, among
other things, are not considered. In the model, firms with lower
leverage ratios are more efficient and can therefore bid lower prices
for audit engagements than less efficient firms, and thus clients will
gravitate to more efficient accounting firms. Because data on partners
and staff published by PAR are reported at the consolidated level for
the entire accounting firm, not just the audit division, some error may
be introduced into the measure of leverage. In this model and
simulation framework, a client's size is captured by the natural
logarithm (log) of its total assets, which has been shown to be a good
predictor of audit hours and thus audit effort. The model ignores all
client characteristics that may influence audit fees but not "out-of-
pocket" costs of audit production. Liability and litigation costs are
assumed to be zero.
Although our survey responses revealed that other factors such as
expertise, global reach, and reputation play an important role in
selecting an accounting firm, it is notable that a simple model, which
does not take these factors into consideration, is able to simulate
actual market shares that currently exist. Our work shows how publicly
available data and the Doogar and Easley (1998) model can be combined
to address important audit market concentration issues that are not
easily addressed, especially given limited data on audit fees.
Simulation One:
A short-run equilibrium is obtained when accounting firms compete on
price until every client seeking an auditor is satisfied (that is, it
has received the lowest price possible).[Footnote 53] After all clients
have been assigned to an auditor, the incumbent firm charges its client
a fee equal to the second-lowest bid. The results are then generated
based on various assumed levels of switching costs (the cost of
changing auditors). As table 5 illustrates, the model of price
competition was able to closely predict the actual 2002 market shares,
regardless of the level of switching cost assumed. Of the 5,448
industrial companies, the Big 4 audited 68 percent of the log of
assets:
in 2002, and the model of price competition consistently predicted that
this tier of firms would audit 68 percent or more of the
total.[Footnote 54] In fact, collectively the Big 4 firms are predicted
to audit 1-2 percent more than the actual percentage audited, depending
on the cost of switching auditors. As table 5 also illustrates, we
found that if switching costs are prohibitively expensive (20 percent
or above) companies will not switch auditors and price competition will
have no impact on the Big 4's market share.
Table 5: Simulation One--Market Shares, Actual and Simulated with
Various Switching Costs, 2002:
Accounting firms: Deloitte & Touche; Actual market: share: (percent):
14.94; Switching cost (percent): 25: 14.94; Switching cost
(percent): 20: 14.94; Switching cost (percent): 15: 15.58; Switching
cost (percent): 10: 17.24; Switching cost (percent): 5: 19.09;
Switching cost (percent): 0: 22.00.
Accounting firms: Ernst & Young; Actual market: share: (percent):
19.73; Switching cost (percent): 25: 19.73; Switching cost
(percent): 20: 19.73; Switching cost (percent): 15: 19.73; Switching
cost (percent): 10: 19.73; Switching cost (percent): 5: 18.78;
Switching cost (percent): 0: 14.90.
Accounting firms: PricewaterhouseCoopers; Actual market: share:
(percent): 18.98; Switching cost (percent): 25: 18.98;
Switching cost (percent): 20: 18.98; Switching cost (percent): 15:
18.98; Switching cost (percent): 10: 18.98; Switching cost (percent):
5: 19.15; Switching cost (percent): 0: 22.37.
Accounting firms: KPMG; Actual market: share: (percent): 14.38;
Switching cost (percent): 25: 14.38; Switching cost (percent):
20: 14.38; Switching cost (percent): 15: 14.38; Switching cost
(percent): 10: 14.38; Switching cost (percent): 5: 13.76; Switching
cost (percent): 0: 10.91.
Accounting firms: McGladrey & Pullen; Actual market: share: (percent):
0.82; Switching cost (percent): 25: 0.82; Switching cost
(percent): 20: 0.82; Switching cost (percent): 15: 0.84; Switching cost
(percent): 10: 0.88; Switching cost (percent): 5: 0.93; Switching cost
(percent): 0: 1.01.
Accounting firms: Grant Thornton; Actual market: share: (percent):
4.21; Switching cost (percent): 25: 4.21; Switching cost
(percent): 20: 4.21; Switching cost (percent): 15: 3.93; Switching cost
(percent): 10: 2.95; Switching cost (percent): 5: 2.25; Switching cost
(percent): 0: 1.81.
Accounting firms: BDO Seidman; Actual market: share: (percent): 3.13;
Switching cost (percent): 25: 1.72; Switching cost (percent):
20: 1.42; Switching cost (percent): 15: 1.14; Switching cost (percent):
10: 0.96; Switching cost (percent): 5: 0.79; Switching cost (percent):
0: 0.69.
Accounting firms: BKD; Actual market: share: (percent): 0.10;
Switching cost (percent): 25: 0.40; Switching cost (percent): 20: 0.46;
Switching cost (percent): 15: 0.48; Switching cost (percent): 10: 0.52;
Switching cost (percent): 5: 0.55; Switching cost (percent): 0: 0.61.
Accounting firms: Moss Adams; Actual market: share: (percent): 0.30;
Switching cost (percent): 25: 0.30; Switching cost (percent):
20: 0.33; Switching cost (percent): 15: 0.35; Switching cost (percent):
10: 0.36; Switching cost (percent): 5: 0.38; Switching cost (percent):
0: 0.42.
Accounting firms: Plante & Moran; Actual market: share: (percent):
0.14; Switching cost (percent): 25: 0.28; Switching cost
(percent): 20: 0.31; Switching cost (percent): 15: 0.32; Switching cost
(percent): 10: 0.35; Switching cost (percent): 5: 0.38; Switching cost
(percent): 0: 0.40.
Accounting firms: Clifton Gunderson; Actual market: share: (percent):
0.01; Switching cost (percent): 25: 0.41; Switching cost
(percent): 20: 0.46; Switching cost (percent): 15: 0.49; Switching cost
(percent): 10: 0.54; Switching cost (percent): 5: 0.59; Switching cost
(percent): 0: 0.66.
Accounting firms: Crowe, Chizek and Co; Actual market: share:
(percent): 0.15; Switching cost (percent): 25: 0.78; Switching
cost (percent): 20: 0.95; Switching cost (percent): 15: 1.08; Switching
cost (percent): 10: 1.23; Switching cost (percent): 5: 1.37; Switching
cost (percent): 0: 1.64.
Accounting firms: Richard A. Eisner & Co; Actual market: share:
(percent): 0.37; Switching cost (percent): 25: 0.35; Switching
cost (percent): 20: 0.28; Switching cost (percent): 15: 0.23; Switching
cost (percent): 10: 0.20; Switching cost (percent): 5: 0.17; Switching
cost (percent): 0: 0.15.
Accounting firms: Goodman & Co; Actual market: share: (percent): 0.04;
Switching cost (percent): 25: 0.23; Switching cost (percent):
20: 0.26; Switching cost (percent): 15: 0.28; Switching cost (percent):
10: 0.31; Switching cost (percent): 5: 0.34; Switching cost (percent):
0: 0.38.
Accounting firms: Wipfli Ullrich Bertelson; Actual market: share:
(percent): 0.02; Switching cost (percent): 25: 0.14; Switching
cost (percent): 20: 0.16; Switching cost (percent): 15: 0.18; Switching
cost (percent): 10: 0.19; Switching cost (percent): 5: 0.21; Switching
cost (percent): 0: 0.23.
Accounting firms: Virchow, Krause & Co; Actual market: share:
(percent): 0.13; Switching cost (percent): 25: 0.42; Switching
cost (percent): 20: 0.49; Switching cost (percent): 15: 0.58; Switching
cost (percent): 10: 0.64; Switching cost (percent): 5: 0.72; Switching
cost (percent): 0: 0.85.
Accounting firms: Eide Bailly; Actual market: share: (percent): 0.02;
Switching cost (percent): 25: 0.29; Switching cost (percent):
20: 0.34; Switching cost (percent): 15: 0.38; Switching cost (percent):
10: 0.43; Switching cost (percent): 5: 0.47; Switching cost (percent):
0: 0.56.
Accounting firms: J.H. Cohn; Actual market: share: (percent): 0.24;
Switching cost (percent): 25: 0.19; Switching cost (percent):
20: 0.17; Switching cost (percent): 15: 0.14; Switching cost (percent):
10: 0.12; Switching cost (percent): 5: 0.11; Switching cost (percent):
0: 0.09.
Accounting firms: Parente Randolph; Actual market: share: (percent):
0.03; Switching cost (percent): 25: 0.10; Switching cost
(percent): 20: 0.11; Switching cost (percent): 15: 0.12; Switching cost
(percent): 10: 0.12; Switching cost (percent): 5: 0.12; Switching cost
(percent): 0: 0.14.
Source: Doogar and Easley (1998). The simulations were conducted by R.
Doogar, University of Illinois, and R. Easley, University of Notre
Dame.
Notes: Market share is based on the log of total company assets.
Partner-to-staff (leverage) ratios for two outliers (small regional
firms) were replaced with the market average. The simulated market
shares vary depending on the assumed switching costs, which range from
no costs associated with switching to a 25 percent increase in costs
associated with switching.
[End of table]
Simulation Two:
In the second market simulation, we assigned clients to their current
auditor and simulated the market to see if the accounting firms could
defend their market share in a purely competitive market. As table 6
shows, the model predicted that the Big 4 would audit 64.0 percent of
the total market, compared with the Big 4 actual market share of 62.2
in 2002. Moreover, the model predicted that the Big 4 would audit 96.3
percent of companies in the sample with assets greater than $250
million compared
with the 97.0 percent actually audited by the Big 4 in 2002.
Additionally, Doogar and Easley (1998) found that the model of pure
price competition could explain the pattern of market shares in 1995.
Table 6: Simulation Two--Market Shares, Actual and Simulated by Client
Assets, 2002:
Accounting firms: Panel A: Actual number of clients (2002):
Accounting firms: Big 4; Accounting firms: Panel A: Actual number of
clients (2002): 271; Client asset class (millions): $1,000-5,000: Panel
A: Actual number of clients (2002): 489; Client asset class (millions):
$500-1,000: Panel A: Actual number of clients (2002): 353; Client asset
class (millions): $250-500: Panel A: Actual number of clients (2002):
394; Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 493; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 353; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 336; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 697; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 3,386; Total (percent): Panel A:
Actual number of clients (2002): 62.2%.
Accounting firms: Middle 15; Accounting firms: Panel A: Actual number
of clients (2002): 1; Client asset class (millions): $1,000-5,000:
Panel A: Actual number of clients (2002): 8; Client asset class
(millions): $500-1,000: Panel A: Actual number of clients (2002): 8;
Client asset class (millions): $250-500: Panel A: Actual number of
clients (2002): 15; Client asset class (millions): $100-250: Panel A:
Actual number of clients (2002): 50; Client asset class (millions):
$50-100: Panel A: Actual number of clients (2002): 51; Client asset
class (millions): $25-50: Panel A: Actual number of clients (2002): 86;
Client asset class (millions): Less than $25: Panel A: Actual number of
clients (2002): 343; Client asset class (millions): Total (number):
Panel A: Actual number of clients (2002): 562; Total (percent): Panel
A: Actual number of clients (2002): 10.3.
Accounting firms: Fringe 754; Accounting firms: Panel A: Actual number
of clients (2002): 0; Client asset class (millions): $1,000-5,000:
Panel A: Actual number of clients (2002): 4; Client asset class
(millions): $500-1,000: Panel A: Actual number of clients (2002): 2;
Client asset class (millions): $250-500: Panel A: Actual number of
clients (2002): 8; Client asset class (millions): $100-250: Panel A:
Actual number of clients (2002): 28; Client asset class (millions):
$50-100: Panel A: Actual number of clients (2002): 42; Client asset
class (millions): $25-50: Panel A: Actual number of clients (2002): 91;
Client asset class (millions): Less than $25: Panel A: Actual number of
clients (2002): 1,325; Client asset class (millions): Total (number):
Panel A: Actual number of clients (2002): 1,500; Total (percent): Panel
A: Actual number of clients (2002): 27.5.
Accounting firms: Total; Accounting firms: Panel A: Actual number of
clients (2002): 272; Client asset class (millions): $1,000-5,000: Panel
A: Actual number of clients (2002): 501; Client asset class (millions):
$500-1,000: Panel A: Actual number of clients (2002): 363; Client asset
class (millions): $250-500: Panel A: Actual number of clients (2002):
417; Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 571; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 446; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 513; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 2,365; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 5,448; Total (percent): Panel A:
Actual number of clients (2002): 100.0.
Accounting firms: Panel B: Simulated number of clients (2002):
Accounting firms: Big 4; Accounting firms: Panel A: Actual number of
clients (2002): 265; Client asset class (millions): $1,000-5,000: Panel
A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: Simulated
number of clients (2002): 482; Client asset class (millions): $500-
1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: Panel
B: Simulated number of clients (2002): 353; Client asset class
(millions): $250-500: Panel A: Actual number of clients (2002): 395;
Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 515; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 376; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 368; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 731; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 3,485; Total (percent): Panel A:
Actual number of clients (2002): 64.0%.
Accounting firms: Middle 15; Accounting firms: Panel A: Actual number
of clients (2002): 6; Client asset class (millions): $1,000-5,000:
Panel A: Actual number of clients (2002): 489: 8: 4: 501: Panel B:
Simulated number of clients (2002): 12; Client asset class (millions):
$500-1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363:
Panel B: Simulated number of clients (2002): 7; Client asset class
(millions): $250-500: Panel A: Actual number of clients (2002): 12;
Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 34; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 30; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 65; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 386; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 552; Total (percent): Panel A: Actual
number of clients (2002): 10.1.
Accounting firms: Fringe 754; Accounting firms: Panel A: Actual number
of clients (2002): 1; Client asset class (millions): $1,000-5,000:
Panel A: Actual number of clients (2002): 489: 8: 4: 501: Panel B:
Simulated number of clients (2002): 7; Client asset class (millions):
$500-1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363:
Panel B: Simulated number of clients (2002): 3; Client asset class
(millions): $250-500: Panel A: Actual number of clients (2002): 10;
Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 22; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 40; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 80; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 1,248; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 1,411; Total (percent): Panel A:
Actual number of clients (2002): 25.9.
Accounting firms: Total; Accounting firms: Panel A: Actual number of
clients (2002): 272; Client asset class (millions): $1,000-5,000: Panel
A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: Simulated
number of clients (2002): 501; Client asset class (millions): $500-
1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: Panel
B: Simulated number of clients (2002): 363; Client asset class
(millions): $250-500: Panel A: Actual number of clients (2002): 417;
Client asset class (millions): $100-250: Panel A: Actual number of
clients (2002): 571; Client asset class (millions): $50-100: Panel A:
Actual number of clients (2002): 446; Client asset class (millions):
$25-50: Panel A: Actual number of clients (2002): 513; Client asset
class (millions): Less than $25: Panel A: Actual number of clients
(2002): 2,365; Client asset class (millions): Total (number): Panel A:
Actual number of clients (2002): 5,448; Total (percent): Panel A:
Actual number of clients (2002): 100.0.
Source: Doogar and Easley (1998). The simulations were conducted by R.
Doogar, University of Illinois, and R. Easley, University of Notre
Dame.
Notes: For Simulation Two, companies were placed in one of eight asset
classes, depending on size: (1) assets greater than $5 billion, (2)
assets between $1 and $5 billion, (3) assets between $500 million and
$1 billion, (4) assets between $250 million and $500 million, (5)
assets between $100 million and $250 million, (6) assets between $50
million and $100 million, (7) assets between $25 million and $50
million, and (8) assets less than $25 million. Market share is based on
total number of clients. Partner-to-staff (leverage) ratios for two
outliers (small regional firms) were replaced with the market average.
[End of table]
Simulation Three:
Finally, we merged the five largest firms below the Big 4 in terms of
the number of partners (capacity)--Grant Thornton, BDO Seidman, Baid
Kurtz & Dobson, McGladrey & Pullen, and Moss Adams--and simulated the
market to see if the newly merged firm could successfully win clients
from the Big 4 (see table 7). Measured by the log of assets, these
firms collectively audited 8.6 percent of the actual market in 2002.
However, when we simulated the market to begin the process, the model
predicted these firms would collectively audit only 4.5 percent of the
market, while the Big 4 would audit 70.1 percent. When we simulated the
merger of the:
five firms and assumed no efficiency gains would result, the merged
firm's market share declined slightly. When modest efficiency gains
were permitted, the merged firm gained market share, to 6.4 percent,
and was able to attract a few of the Big 4's larger clients. Finally,
in the best-case scenario in which we allowed the newly merged firm to
become as efficient as the Big 4 (strong efficiency gains), the market
share increased to 11.2 percent, and both the Big 4 and remaining
accounting firms lost market share to the merged firm. However, since
the five firms actually audited 8.6 percent of the market in 2002
collectively, the simulated mergers only resulted in a market share
increase of 2.6 percentage points in the best-case scenario.
Table 7: Simulation Three--Market Shares, Merger Analysis with Various
Efficiency Assumptions, 2002:
Efficiency assumption: No merger:
Efficiency assumption: Simulated 2002; Simulated market shares: Merged:
firms (percent): No merger: 4.5%; Simulated market shares: Remaining
10: No merger: 5.1%; Simulated market shares: No merger: 70.1%;
Simulated market shares: Other firms (percent): No merger: 20.2%.
Efficiency assumption: Merger:
Efficiency assumption: No efficiency gains; Simulated market shares:
Merged: firms (percent): No merger: 4.2; Simulated market shares:
Remaining 10: No merger: 5.2; Simulated market shares: No merger: 70.4;
Simulated market shares: Other firms (percent): No merger: 20.2.
Efficiency assumption: Some efficiency gains; Simulated market shares:
Merged: firms (percent): No merger: 6.4; Simulated market shares:
Remaining 10: No merger: 5.0; Simulated market shares: No merger: 68.9;
Simulated market shares: Other firms (percent): No merger: 19.7.
Efficiency assumption: Strong efficiency gains; Simulated market
shares: Merged: firms (percent): No merger: 11.2; Simulated market
shares: Remaining 10: No merger: 4.8; Simulated market shares: No
merger: 65.4; Simulated market shares: Other firms (percent): No
merger: 18.7.
Source: Doogar and Easley (1998). The simulations were conducted by R.
Doogar, University of Illinois, and R. Easley, University of Notre
Dame.
Notes: Market share is based on the log of total company assets.
Partner-to-staff (leverage) ratios for two outliers (small regional
firms) were replaced with the market average.
[End of table]
Survey Data:
To augment our empirical analysis, we conducted two sample surveys to
get information from the largest accounting firms and their clients.
First, we surveyed representatives of each of the 97 largest accounting
firms--those with 10 or more corporate clients that are registered with
SEC--about their experience consolidating with other firms, their views
on consolidation's effects on competition, and what they thought were
the potential implications of consolidation for auditor choice, audit
fees, audit quality, and auditor independence within their industry. We
identified the 97 firms and obtained name and address information for
the executive to be contacted primarily from the membership list of the
American Institute of Certified Public Accountants' (AICPA) SEC
Practice Section. To develop our questionnaire, we consulted a number
of experts at SEC, AICPA, and others knowledgeable about the accounting
profession. We also pretested our questionnaire with two of the Big 4
firms, four other firms among the largest 97, and two small firms. We
began our Web-based survey on May 23, 2003, and included all usable
responses as of July 11, 2003, to produce this report. One of the 97
firms was found to be ineligible for the survey because the answers of
another responding firm comprised the activity of the former, so the
final population surveyed was 96 firms. We received 47 usable responses
from these 96 firms, for an overall response rate of 49 percent.
However, the number of responses to individual questions may be fewer
than 47, depending on how many responding firms were eligible to or
chose to answer a particular question.
Second, we surveyed a random sample of 250 of the 960 largest publicly
held companies. We created this population from the 2003 list of the
Fortune 1000 companies produced by Fortune, a division of Time, Inc.,
after removing 40 private firms from this list. We mailed a paper
questionnaire to the chief financial officers, or other executives
performing that role, requesting their views on the services they
received from their auditor of record, the effects of consolidation on
competition among accounting firms, and its potential implications. To
develop this questionnaire, we consulted with AICPA and SEC and
pretested with six large public companies from a variety of industries.
The survey began on May 6, 2003. We removed one company that had gone
out of business, and received 148 usable responses as of July 11, 2003,
from the final sample of 249 companies, for an overall response rate of
59 percent. Again, the number of responses to individual questions may
fluctuate, depending on how many respondents answered each question. We
plan to issue a subsequent report in September 2003 on client responses
received through July 30, 2003.
While the public company survey results came from a random sample drawn
from the population of Fortune 1000 companies and thus could be
weighted to statistically represent that larger group, we are reporting
totals and percentages only for those companies (and accounting firms)
actually returning questionnaires. Since the small number of
respondents to both surveys at the time of publication could
significantly differ in their answers from the answers nonrespondents
might have given had they participated, it is particularly risky to
project the results of our survey to not only the nonrespondents, but
also to the part of the public company population we did not sample.
There are other practical difficulties in conducting any survey that
may also contribute to errors in survey results. For example,
differences in how a question is interpreted or the sources of
information available to respondents can introduce unwanted variability
into the survey results. We included steps in both the data collection
and data analysis stages to minimize such errors. In addition to the
questionnaire testing and development measures mentioned above, we
followed up with the sample firms and clients with e-mails and
telephone calls to encourage them to respond and offer assistance. We
also checked and edited the survey data and programs used to produce
our survey results.
Finally, we conducted structured interviews with a judgmental sample of
20 chairs of audit committees for Fortune 1000 companies to obtain
their views on audit services, consolidation, and competition within
the audit market. Our selection criteria included geographic location,
the company's industry, and the chairperson's availability. The audit
chairpersons whom we interviewed all had a background in business and
most had been or were currently serving as CEOs of a Fortune 1000
company. On average, the chairpersons we interviewed served on over two
boards in addition to the board on which they sat for purposes of the
interview. On average, they served as chairpersons of the audit
committee for just over 2 years, served as a member on the audit
committee for over 5 years, and served on that Fortune 1000 company's
board of directors for over 7 years.
Impact of Consolidation on Capital Formation and Securities Markets:
To address the issue of the impact of consolidation and concentration
among large accounting firms on capital formation and securities
markets, we interviewed representatives from accounting firms,
investment banks, institutional investors, SEC, self-regulatory
organizations, credit agencies, and retail investors, among others. We
also consulted with numerous academics and reviewed relevant economic
literature.
Identifying Barriers to Entry:
To identify the barriers to entry that accounting firms face in the
public company audit market, we discussed competition and competitive
barriers with representatives of a cross section of public accounting
firms, large public companies, various government agencies, the
accounting profession and trade associations, institutional investors,
securities underwriters, self-regulatory organizations, credit rating
agencies, and other knowledgeable officials. We obtained information
from the National Association of State Boards of Accountancy and AICPA.
We also reviewed existing state and federal requirements. Finally, we
used the Doogar and Easley (1998) model to roughly assess whether
mergers between non-Big 4 firms could potentially increase the number
of accounting firms capable of auditing large national and
multinational companies.
[End of section]
Appendix II: GAO Surveys of Public Accounting Firms and Fortune 1000
Public Companies:
[See PDF for image]
[End of figure]
Appendix III: Arthur Andersen Case Study:
Background:
In 2001, Arthur Andersen LLP (Andersen) was the fourth-largest public
accounting firm in the United States, with global net revenues of over
$9 billion. On March 7, 2002, Andersen was indicted by a federal grand
jury and charged with obstructing justice for destroying evidence
relevant to investigations into the 2001 financial collapse of Enron.
At the time of its indictment, Andersen performed audit and attest
services for about 2,400 public companies in the United States,
including many of the largest public companies in the world. In
addition, Andersen served private companies and provided additional
professional services such as tax and consulting services.
This appendix is an analysis of 1,085 former Andersen public company
clients that switched to a new public accounting firm between October
1, 2001, and December 31, 2002.[Footnote 55]In addition to identifying
the new public accounting firms of the former Andersen clients, we
determined which firms attracted the largest clients and how many
Andersen clients switched to non-Big 4 firms.[Footnote 56]
Most Andersen Clients Switched to a Big 4 Firm:
Between October 2001 and December 2002, 1,085 public companies audited
by Andersen switched to a new auditor of record. As figure 10
illustrates, of the 1,085 companies reviewed, 938 switched to one of
the Big 4 (87 percent), and 147 switched to a non-Big 4 firm (13
percent). Among the Big 4, Ernst & Young attracted the largest number
of former Andersen clients, followed by KPMG, Deloitte & Touche, and
PricewaterhouseCoopers (see fig. 11). Of the former Andersen clients
who switched to a non-Big 4 firm, 45 switched to Grant Thornton (4
percent) and 23 switched to BDO Seidman (2 percent).
Figure 10: Where Andersen's Public Company Clients Went, 2001-2002:
[See PDF for image]
Note: Numbers are rounded and adjusted to equal 100.
[End of figure]
Figure 11: New Firms for Former Andersen Public Company Clients, 2001-
2002:
[See PDF for image]
Note: Percentages are rounded and adjusted to equal 100.
[End of figure]
Largest Clients Switched to Big 4 Firms:
We found that almost all former Andersen clients with total assets
above $5 billion switched to a Big 4 firm. The one exception, Global
Crossing, switched to Grant Thornton. We found that the Big 4 audited
approximately 98 percent of the total assets of the 1,085 former
Andersen clients that switched auditors between October 1, 2001, and
December 31, 2002. As illustrated in figure 12, PricewaterhouseCoopers,
although attracting the smallest number of Andersen clients (159),
tended to attract the largest clients based on average total company
asset size ($3.9 billion). Comparatively, former Andersen clients that
switched to Deloitte & Touche and KPMG averaged total assets of $3.0
billion and $2.4 billion, respectively. In addition, Ernst & Young,
although attracting the largest number of Andersen clients, tended to
attract smaller clients based on average total company asset size ($1.5
billion).
Figure 12: Average Assets of Former Andersen Pubic Company Clients by
New Firm, 2001-2002:
[See PDF for image]
[End of figure]
We also analyzed former Andersen clients by asset size and determined
how many of its clients switched to Big 4 versus other firms. As table
8 illustrates, the vast majority of the largest former Andersen clients
switched to one of the Big 4 firms. With the exception of the smallest
asset class, 90 percent or more of the former Andersen clients switched
to one of the Big 4 firms.
Table 8: Former Andersen Public Company Clients (Actual and Percentage)
Categorized by Assets, Big 4, and Other Firms, as of December 2002:
Accounting firm: Actual public company clients:
Accounting firm: Big 4; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 85; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 180; Asset ranges (millions):
$1,000-500: Actual public company clients: 111; Asset ranges
(millions): $500-100: Actual public company clients: 291; Asset ranges
(millions): Less than $100: Actual public company clients: 271; Asset
ranges (millions): Total: Actual public company clients: 938.
Accounting firm: Other; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 1; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 5; Asset ranges (millions):
$1,000-500: Actual public company clients: 5; Asset ranges (millions):
$500-100: Actual public company clients: 26; Asset ranges (millions):
Less than $100: Actual public company clients: 110; Asset ranges
(millions): Total: Actual public company clients: 147.
Accounting firm: Total; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 86; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 185; Asset ranges (millions):
$1,000-500: Actual public company clients: 116; Asset ranges
(millions): $500-100: Actual public company clients: 317; Asset ranges
(millions): Less than $100: Actual public company clients: 381; Asset
ranges (millions): Total: Actual public company clients: 1,085.
Accounting firm: Percentage of public company clients:
Accounting firm: Big 4; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 99%; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 97%; Asset ranges (millions):
$1,000-500: Actual public company clients: 96%; Asset ranges
(millions): $500-100: Actual public company clients: 92%; Asset ranges
(millions): Less than $100: Actual public company clients: 71%; Asset
ranges (millions): Total: Actual public company clients: 87%.
Accounting firm: Other; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 1; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 3; Asset ranges (millions):
$1,000-500: Actual public company clients: 4; Asset ranges (millions):
$500-100: Actual public company clients: 8; Asset ranges (millions):
Less than $100: Actual public company clients: 29; Asset ranges
(millions): Total: Actual public company clients: 13.
Accounting firm: Total; Asset ranges (millions): Greater than $5,000:
Actual public company clients: 100; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 100; Asset ranges (millions):
$1,000-500: Actual public company clients: 100; Asset ranges
(millions): $500-100: Actual public company clients: 100; Asset ranges
(millions): Less than $100: Actual public company clients: 100; Asset
ranges (millions): Total: Actual public company clients: 100.
Source: Who Audits America, 2001-2002.
[End of table]
We also looked at the movement of former Andersen clients to the Big 4
firms within the asset range groups. As table 9 shows, KPMG was hired
by the highest percentage of former Andersen clients in both the
largest and smallest asset groups, while Ernst & Young was hired by the
highest percentage of former Andersen clients with assets between $100
million and $5 billion.
Table 9: Former Andersen Public Company Clients (Number and Percentage)
Categorized by Assets and Big 4 Firm, as of December 31, 2002:
[See PDF for image]
Source: Who Audits America, 2001-2002.
Notes: Deloitte & Touche (DT), Ernst & Young (EY), KPMG, and
PricewaterhouseCoopers (PwC). Percentages may not sum to 100 due to
rounding.
[End of table]
Thirteen Percent of Former Andersen Clients Switched to Non-Big 4
Firms:
Of the former Andersen clients, 147 (13 percent) switched to a non-Big
4 firm. Of the 147 firms, 31 percent switched to Grant Thornton and 16
percent switched to BDO Seidman (fig. 11). The average asset size of a
company that switched to a non-Big 4 firm was $309 million, which is
approximately $2.2 billion less than the average asset size of a
company that switched to a Big 4 firm. As table 10 illustrates, the
average asset size of a company that switched to Grant Thornton was
$644 million, and the average asset size of a company that switched to
BDO Seidman was $54 million. The 147 public company clients that did
not engage a Big 4 firm switched to one of 52 non-Big 4 firms.
Table 10: Former Andersen Clients Hired by Other Firms, as of December
31, 2002:
Accounting firm: Big 4; Number of former Andersen clients: 938;
Percentage of total clients: 87%; Average assets (millions): $2,508.
Accounting firm: Grant Thornton; Number of former Andersen clients: 45;
Percentage of total clients: 4; Average assets (millions): 644.
Accounting firm: BDO Seidman; Number of former Andersen clients: 23;
Percentage of total clients: 2; Average assets (millions): 54.
Accounting firm: Other; Number of former Andersen clients: 79;
Percentage of total clients: 7; Average assets (millions): 193.
Accounting firm: Total; Number of former Andersen clients: 1,085;
Percentage of total clients: 100; Average assets (millions): 2,210.
Source: Who Audits America, 2001-2002.
[End of table]
Former Andersen Clients by Industry Sectors:
Of the 1,085 former Andersen clients, we were able to classify 926
companies into 56 different industry sectors.[Footnote 57] We observed
that former Andersen clients in 22 industry sectors stayed with a Big 4
firm, while former Andersen clients in 34 industry sectors switched to
a non-Big 4 firm. Within some industries certain accounting firms were
hired more often than others. For example, Ernst & Young attracted
former Andersen clients in more industry sectors overall than any other
firm (49 of the 56 industry sectors). We also observed that within 16
industries KPMG attracted more former Andersen clients than other firms
(see table 11).
It is important to review this analysis in the context of its
limitations. Specifically, defining markets by SIC codes can exaggerate
the level of concentration because, like the audit market, a few large
companies dominate many industry sectors (see table 2). To mitigate the
potential for bias, we limited our analysis to the 2-digit SIC codes
rather than the 4-digit codes. There are additional methodological
issues with defining markets by SIC codes. First, the audited
companies' lines of business, not the business of the accounting firms,
defines the markets. Second, some companies that could be included in a
particular industry are not included because no SIC code identifier was
provided in the database that we used. Moreover, assignment of a
company to a particular SIC code sometimes involves judgment, which may
create bias.
Table 11: New Firms for Former Andersen Clients by SIC Code, as of
December 31, 2002:
[See PDF for image]
Source: Who Audits America, 2002.
Note: The Big 4 are Deloitte & Touche (DT); Ernst & Young (EY); KPMG;
and PricewaterhouseCoopers (PwC).
[End of table]
[End of section]
Appendix IV: Analysis of Big 4 Firms' Specialization by Industry
Sector:
The concentration that exists across accounting firms that audit public
companies is even more pronounced in certain industry sectors. For
example, in certain industry sectors, two firms audit over 70 percent
of the assets. Because public companies generally prefer auditors with
established records of industry expertise and requisite capacity, their
viable choices are even more limited than the Big 4. This appendix
provides additional descriptive statistics on selected industries in
the U.S. economy using U.S. Standard Industry Classification (SIC)
codes--numerical codes designed by the federal government to create
uniform descriptions of business establishments.[Footnote 58]
Limitations of SIC Analysis:
The purpose of this analysis is to illustrate that certain firms
dominate particular industries or groups, and companies may consider
only these firms as having the requisite expertise to provide audit and
attest services for their operations. However, it is important to
review this analysis in the context of its limitations. Specifically,
defining markets by SIC codes can exaggerate the level of concentration
because, like the audit market, a few large companies dominate many
industry sectors (see table 2). For example, in the petroleum industry,
we were able to identify only 25 publicly listed companies in 2002, 20
of which were audited by the Big 4. Because PricewaterhouseCoopers and
Ernst & Young audit the six largest companies, they audit 95 percent of
the assets in this industry. To mitigate the potential for bias, we
limited our analysis to the 2-digit SIC codes rather than the more
specific 4-digit codes.
There are additional methodological issues with defining markets by SIC
codes. First, the audited companies' lines of business, not the
business of the accounting firms, defines the markets. Second, some
companies that could be included in a particular industry are not
included because no SIC code identifier was provided in the database
that we used. Moreover, assignment of a company to a particular SIC
code sometimes involves judgment, which may create bias. Finally, the
methodology assumes different accounting firms are in separate markets
and cannot easily move from auditing one type of industry to another.
The total assets data come from the 1997 and 2002 editions of Who
Audits America, which has detailed information on public companies,
including current and former auditor and SIC code.[Footnote 59] Because
some companies are not classifiable establishments, others do not list
SIC codes because they operate in many lines of business, or the
necessary information might have been missing in some cases, the data
only include companies that had a 4-digit, 3-digit or 2-digit SIC code
in the 1997 and 2002 versions of the database (8,724 companies in 1997
and 9,569 companies in 2002). All SIC codes were converted to 2-digit
codes (major group) for analysis. Table 12 lists and defines each SIC
major economic group analyzed here and in the body of the report. In
computing concentration ratios for each accoounting firm in the various
industry groups, we used total assets audited. However, the results
generally are not sensitive to the use of a different measure (such as
total sales).
Table 12: Description of Selected SIC Groups:
Major group (SIC code): 10; Description: Metal mining; This major group
includes establishments primarily engaged in mining, developing mines,
or exploring for metallic minerals (ores). This major group also
includes all ore dressing and beneficiating operations, whether
performed at mills operated in conjunction with the mines served or at
mills, such as custom mills, operated separately.
Major group (SIC code): 13; Description: Oil and gas extraction; This
major group includes establishments primarily engaged in (1) producing
crude petroleum and natural gas, (2) extracting oil from oil sands and
oil shale, (3) producing natural gasoline and cycle condensate, and (4)
producing gas and hydrocarbon liquids from coal at the mine site.
Major group (SIC code): 15; Description: General building contractors;
This major group includes general contractors and operative builders
primarily engaged in the construction of residential, farm, industrial,
commercial, or other buildings. General building contractors who
combine a special trade with the contracting are included in this major
group.
Major group (SIC code): 24; Description: Lumber and wood products; This
major group includes establishments engaged in cutting timber and
pulpwood; merchant sawmills, lath mills, shingle mills, cooperage stock
mills, planting mills, and plywood mills and veneer mills engaged in
producing lumber and wood basic materials; and establishments engaged
in manufacturing finished articles made entirely or mainly of wood or
related materials.
Major group (SIC code): 25; Description: Furniture and fixtures; This
major group includes establishments engaged in manufacturing household,
office, public building, and restaurant furniture; and office and store
fixtures.
Major group (SIC code): 26; Description: Paper and allied products;
This major group includes establishments primarily engaged in the
manufacture of pulps from wood and other cellulose fibers, and from
rags; the manufacture of paper and paperboard; and the manufacture of
paper and paperboard into converted products, such as paper coated off
the paper machine, paper bags, paper boxes, and envelopes.
Major group (SIC code): 27; Description: Printing and publishing; This
major group includes establishments engaged in printing by one or more
common processes, such as letterpress; lithography (including offset),
gravure, or screen; and those establishments that perform services for
the printing trade, such as bookbinding and platemaking. This major
group also includes establishments engaged in publishing newspapers,
books, and periodicals, regardless of whether they do their own
printing.
Major group (SIC code): 28; Description: Chemicals and allied products;
This major group includes establishments producing basic chemicals, and
establishments manufacturing products by predominantly chemical
processes. Establishments classified in this major group manufacture
three general classes of products: (1) basic chemicals, such as acids,
salts, and organic chemicals; (2) chemical products to be used in
further manufacture, such as synthetic fibers, plastics materials, dry
colors, and pigments; and (3) finished chemical products to be used for
ultimate consumption, such as drugs, cosmetics, and soaps; or to be
used as materials or supplies in other industries, such as paints,
fertilizers, and explosives.
Major group (SIC code): 29; Description: Petroleum and coal products;
This major group includes establishments primarily engaged in petroleum
refining, manufacturing paving and roofing materials, and compounding
lubricating oils and greases from purchased materials.
Major group (SIC code): 33; Description: Primary metal industries; This
major group includes establishments engaged in smelting and refining
ferrous and nonferrous metals from ore, pig, or scrap; in rolling,
drawing, and alloying metals; in manufacturing castings and other basic
metal products; and in manufacturing nails, spikes, and insulated wire
and cable.
Major group (SIC code): 34; Description: Fabricated metal products;
This major group includes establishments engaged in fabricating ferrous
and nonferrous metal products, such as metal cans, tinware, handtools,
cutlery, general hardware, nonelectric heating apparatus, fabricated
structural metal products, metal forgings, metal stampings, ordnance
(except vehicles and guided missiles), and a variety of metal and wire
products, not elsewhere classified.
Major group (SIC code): 35; Description: Industrial and commercial
machinery and computer equipment (Industry machinery and equipment);
This major group includes establishments engaged in manufacturing
industrial and commercial machinery and equipment and computers.
Included are the manufacture of engines and turbines; farm and garden
machinery; construction, mining, and oil field machinery; elevators and
conveying equipment; hoists, cranes, monorails, and industrial trucks
and tractors; metalworking machinery; special industry machinery;
general industrial machinery; computer and peripheral equipment and
office machinery; and refrigeration and service industry machinery.
Machines powered by built-in or detachable motors ordinarily are
included in this major group, with the exception of electrical
household appliances. Power-driven handtools are included in this major
group, whether electric or otherwise driven.
Major group (SIC code): 37; Description: Transportation equipment; This
major group includes establishments engaged in manufacturing equipment
for transportation of passengers and cargo by land, air, and water.
Important products produced by establishments classified in this major
group include motor vehicles, aircraft, guided missiles and space
vehicles, ships, boats, railroad equipment, and miscellaneous
transportation equipment, such as motorcycles, bicycles, and
snowmobiles. Establishments primarily engaged in manufacturing
equipment used for moving materials on farms; in mines and on
construction sites; in individual plants; in airports; or on other
locations off the highway are classified in Major Group 35.
Major group (SIC code): 42; Description: Trucking and warehouse; This
major group includes establishments furnishing local or long-distance
trucking or transfer services, or those engaged in the storage of farm
products, furniture and other household goods, or commercial goods of
any nature.
Major group (SIC code): 44; Description: Water transportation; This
major group includes establishments engaged in freight and passenger
transportation on the open seas or inland waters, and establishments
furnishing such incidental services as towing, and canal operation.
This major group also includes excursion boats, sight-seeing boats, and
water taxis.
Major group (SIC code): 45; Description: Transportation by air; This
major group includes establishments engaged in furnishing domestic and
foreign transportation by air and also those operating airports and
flying fields and furnishing terminal services including air courier
services and air passenger carriers.
Major group (SIC code): 48; Description: Communications; This major
group includes establishments furnishing point-to-point communications
services, whether intended to be received aurally or visually; and
radio and television broadcasting. This major group also includes
establishments primarily engaged in providing paging and beeper
services and those engaged in leasing telephone lines or other methods
of telephone transmission, such as optical fiber lines and microwave or
satellite facilities, and reselling the use of such methods to others.
Major group (SIC code): 49; Description: Electric, gas, and sanitary
services This major group includes establishments engaged in the
generation, transmission, and/or distribution of electricity or gas or
steam. Such establishments may be combinations of any of the above
three services and also include other types of services, such as
transportation, communications, and refrigeration. Water and
irrigation systems, and sanitary systems engaged in the collection and
disposal of garbage, sewage, and other wastes by means of destroying or
processing materials, are also included.
Major group (SIC code): 60; Description: Depository institutions; This
major group includes institutions that are engaged in deposit banking
or closely related functions, including fiduciary activities.
Major group (SIC code): 61; Description: Nondepository institutions;
This major group includes establishments engaged in extending credit in
the form of loans, but not engaged in deposit banking.
Major group (SIC code): 62; Description: Security and commodity
brokers; This major group includes establishments engaged in the
underwriting, purchase, sale, or brokerage of securities and other
financial contracts on their own account or for the account of others;
and exchanges, exchange clearinghouses, and other services allied with
the exchange of securities and commodities.
Major group (SIC code): 67; Description: Holding and other investment
offices (holding and other investment companies); This major group
includes investment trusts, investment companies, holding companies,
and miscellaneous investment offices.
Major group (SIC code): 70; Description: Hotels and other lodging
places; This major group includes commercial and noncommercial
establishments engaged in furnishing lodging, or lodging and meals, and
camping space and camping facilities.
Major group (SIC code): 73; Description: Business services; This major
group includes establishments primarily engaged in rendering services,
not elsewhere classified, to business establishments on a contract or
fee basis, such as advertising, credit reporting, collection of claims,
mailing, reproduction, stenographic, news syndicates, computer
programming, photocopying, duplicating, data processing, services to
buildings, and help supply services.
Major group (SIC code): 80; Description: Health services; This major
group includes establishments primarily engaged in furnishing medical,
surgical, and other health services to persons. Establishments of
associations or groups, such as Health Maintenance Organizations,
primarily engaged in providing medical or other health services to
members are included; but those, which limit their services to the
provision of insurance against hospitalization or medical costs, are
classified in Insurance, Major Group 63.
Source: U.S. Bureau of Census, http://www.census.gov/epcd/www/
naicstab.htm (7/20/2003) and U.S. Department of Labor, http://
www.osha.gov/oshstants/oshstats.(7/20/2003):
[End of table]
Industry Specialization Can Limit Public Company Choice:
As figure 13 shows, in selected industries specialization can often
limit the number of auditor choices to two--in each case, two auditors
account for over 70 percent of the total assets audited in 2002.As a
result, it might be difficult for a large company to find an auditor
with the requisite industry expertise and staff capacity.[Footnote 60]
Figure 13 also shows that while a few firms dominated certain
industries in 1997 before the merger of Price Waterhouse and Coopers &
Lybrand and dissolution of Arthur Andersen, there were fewer industries
where two firms accounted for more than 70 percent of the total sales
audited; and in most cases, at least one of the remaining Big 6 firms
audited a significant share (greater than 10 percent) of the industry.
Figure 13: Percentages of Assets Audited by the Big 4 in Selected
Industries, 1997 and 2002:
[See PDF for image]
[End of figure]
The dissolution of Andersen in 2002 and the merger of Price Waterhouse
and Coopers & Lybrand in 1998 appear to have impacted many industries,
including those in the primary metals, general building contractors,
furniture and fixtures, petroleum and coal products, transportation by
air, and electric, gas, and sanitary services groups included in figure
13. Moreover, figure 14 shows the remaining major economic groups with
20 or more companies for which Andersen audited roughly 25 percent or
more of the total assets in the industry or Price Waterhouse and
Coopers & Lybrand both had significant presence in 1997. As the figure
indicates, in many of these sectors Ernst & Young and Deloitte & Touche
acquired significant market share by 2002. Because the Big 4 firms have
increased their presence in these industries formerly dominated by
Andersen or Price Waterhouse and Coopers & Lybrand, the number of firms
with industry expertise appears to have remained unchanged in most
cases. The mergers between Price Waterhouse and Coopers & Lybrand did
not impact choice in most industries because the firms generally
dominated different industries as figure 13 and figure 14 show. This
highlights that one of the factors contributing to the mergers was the
desire to increase industry expertise. However, there are some
industries (petroleum and coal products, communications, primary
metals, and fabricated metals among others) that may have experienced a
reduction in the number of viable alternatives for companies that
consider industry expertise important when choosing an auditor.
Figure 14: Percentages of Assets Audited in Industries Potentially
Impacted by the PriceWaterhouseCoopers Merger and Dissolution of
Andersen, 1997 and 2002:
[See PDF for image]
[End of figure]
Table 13 provides a list of industries defined by 2-digit SIC codes
with 25 or more companies and also indicates where each of the Big 4
firms audit at least 10 percent of the total industry assets. As the
table illustrates, there are very few industries where all four of the
top-tier firms have a major presence. In many industries, only two or
three of the Big 4 firms audit 10 percent or more of the total assets
in an industry. Of the 49 industries represented, less than one-third
(16) have a significant presence (10 percent or more) of all four
firms. Moreover, as table 14 illustrates, if the threshold is increased
to 25 percent or more of total assets audited, then almost all (48 of
49) of the industries have a significant presence of only one or two
firms.
Table 13: Industries in Which the Big 4 Have a Significant Presence (10
percent or More):
[See PDF for image]
Source: Who Audits America, 2002.
Note: We have arbitrarily defined significant presence as auditing 10
percent or more of the total assets within an industry.
[End of table]
Table 14: Industries in Which the Big 4 Have a Significant Presence (25
percent or more):
SIC code: 10; Economic group: Primary metals; Firms with 25 percent of
more of the industry: DT: No; Firms with 25 percent of more of the
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG:
No; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 13; Economic group: Oil and gas extraction; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 15; Economic group: General building contractors; Firms with
25 percent of more of the industry: DT: No; Firms with 25 percent
of more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: No.
SIC code: 17; Economic group: Special trade contractors; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: Yes; Firms with 25 percent of more of the industry:
KPMG: No; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 20; Economic group: Food and kindred products; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 22; Economic group: Textile mill products; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 23; Economic group: Apparel and other textile products; Firms
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent
of more of the industry: EY: No; Firms with 25 percent of more of
the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 24; Economic group: Lumber and wood products; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: 4; Firms with 25 percent of more of the
industry: KPMG: 4; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 25; Economic group: Furniture and fixtures; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: 4.
SIC code: 26; Economic group: Paper and allied products; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: No.
SIC code: 27; Economic group: Printing and publishing; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 28; Economic group: Chemicals and allied products; Firms with
25 percent of more of the industry: DT: Yes; Firms with 25 percent of
more of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 29; Economic group: Petroleum and coal products; Firms with
25 percent of more of the industry: DT: No; Firms with 25 percent
of more of the industry: EY: No; Firms with 25 percent of more of
the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 30; Economic group: Rubber and miscellaneous plastics; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: Yes; Firms with 25 percent of more
of the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 31; Economic group: Leather and leather products; Firms with
25 percent of more of the industry: DT: No; Firms with 25 percent
of more of the industry: EY: No; Firms with 25 percent of more of
the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 32; Economic group: Stone, clay, and glass products; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: Yes; Firms with 25 percent of more
of the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: No.
SIC code: 33; Economic group: Primary metal industries; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 34; Economic group: Fabricated metal products; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 35; Economic group: Industrial machinery and equipment; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: No; Firms with 25 percent of
more of the industry: KPMG: Yes; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 36; Economic group: Electronic and other electric equipment;
Firms with 25 percent of more of the industry: DT: No; Firms with
25 percent of more of the industry: EY: Yes; Firms with 25 percent of
more of the industry: KPMG: No; Firms with 25 percent of more of
the industry: PwC: Yes.
SIC code: 37; Economic group: Transportation equipment; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 38; Economic group: Instruments and related products; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: No; Firms with 25 percent of
more of the industry: KPMG: No; Firms with 25 percent of more of
the industry: PwC: Yes.
SIC code: 39; Economic group: Miscellaneous manufacturing industries;
Firms with 25 percent of more of the industry: DT: No; Firms with
25 percent of more of the industry: EY: Yes; Firms with 25 percent of
more of the industry: KPMG: No; Firms with 25 percent of more of
the industry: PwC: No.
SIC code: 42; Economic group: Trucking and warehousing; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 45; Economic group: Transportation by air; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: Yes; Firms with 25 percent of more of the industry:
KPMG: Yes; Firms with 25 percent of more of the industry: PwC: No.
SIC code: 48; Economic group: Communications; Firms with 25 percent of
more of the industry: DT: No; Firms with 25 percent of more of the
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG:
[Empty]; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 49; Economic group: Electric, gas, and sanitary services;
Firms with 25 percent of more of the industry: DT: Yes; Firms with 25
percent of more of the industry: EY: No; Firms with 25 percent of
more of the industry: KPMG: No; Firms with 25 percent of more of
the industry: PwC: No.
SIC code: 50; Economic group: Wholesale trade - durable goods; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: Yes; Firms with 25 percent of more
of the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: Yes.
SIC code: 51; Economic group: Wholesale trade - nondurable goods; Firms
with 25 percent of more of the industry: DT: No; Firms with 25
percent of more of the industry: EY: Yes; Firms with 25 percent of more
of the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: No.
SIC code: 53; Economic group: General merchandise stores; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: Yes; Firms with 25 percent of more of the industry:
KPMG: No; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 54; Economic group: Food stores; Firms with 25 percent of
more of the industry: DT: Yes; Firms with 25 percent of more of the
industry: EY: No; Firms with 25 percent of more of the industry:
KPMG: No; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 56; Economic group: Apparel and accessory stores; Firms with
25 percent of more of the industry: DT: Yes; Firms with 25 percent of
more of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: No.
SIC code: 57; Economic group: Furniture and homefurnishing stores;
Firms with 25 percent of more of the industry: DT: No; Firms with
25 percent of more of the industry: EY: Yes; Firms with 25 percent of
more of the industry: KPMG: Yes; Firms with 25 percent of more of the
industry: PwC: No.
SIC code: 58; Economic group: Eating and drinking places; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 59; Economic group: Miscellaneous retail; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: Yes; Firms with 25 percent of more of the industry:
KPMG: No; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 60; Economic group: Depository institutions; Firms with 25
percent of more of the industry: DT: No; Firms with 25 percent of
more of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC:
4.
SIC code: 61; Economic group: Nondepository institutions; Firms with 25
percent of more of the industry: DT: Yes; Firms with 25 percent of more
of the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC:
No.
SIC code: 62; Economic group: Security and commodity brokers; Firms
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent
of more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: No.
SIC code: 63; Economic group: Insurance carriers; Firms with 25 percent
of more of the industry: DT: Yes; Firms with 25 percent of more of the
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG:
[Empty]; Firms with 25 percent of more of the industry: PwC: No.
SIC code: 64; Economic group: Insurance agents, brokers, and service;
Firms with 25 percent of more of the industry: DT: No; Firms with
25 percent of more of the industry: EY: No; Firms with 25 percent
of more of the industry: KPMG: No; Firms with 25 percent of more
of the industry: PwC: Yes.
SIC code: 65; Economic group: Real estate; Firms with 25 percent of
more of the industry: DT: Yes; Firms with 25 percent of more of the
industry: EY: No; Firms with 25 percent of more of the industry:
KPMG: Yes; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 67; Economic group: Holding and other investment offices;
Firms with 25 percent of more of the industry: DT: Yes; Firms with 25
percent of more of the industry: EY: Yes; Firms with 25 percent of more
of the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: No.
SIC code: 70; Economic group: Hotels and other lodging places; Firms
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent
of more of the industry: EY: Yes; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: No.
SIC code: 72; Economic group: Personal services; Firms with 25 percent
of more of the industry: DT: Yes; Firms with 25 percent of more of the
industry: EY: No; Firms with 25 percent of more of the industry:
KPMG: No; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 73; Economic group: Business services; Firms with 25 percent
of more of the industry: DT: No; Firms with 25 percent of more of
the industry: EY: No; Firms with 25 percent of more of the
industry: KPMG: No; Firms with 25 percent of more of the industry:
PwC: Yes.
SIC code: 78; Economic group: Motion pictures; Firms with 25 percent of
more of the industry: DT: No; Firms with 25 percent of more of the
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG:
[Empty]; Firms with 25 percent of more of the industry: PwC: Yes.
SIC code: 79; Economic group: Amusement and recreation services; Firms
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent
of more of the industry: EY: No; Firms with 25 percent of more of
the industry: KPMG: No; Firms with 25 percent of more of the
industry: PwC: No.
SIC code: 80; Economic group: Health services; Firms with 25 percent of
more of the industry: DT: No; Firms with 25 percent of more of the
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG:
4; Firms with 25 percent of more of the industry: PwC: No.
SIC code: 87; Economic group: Engineering and management services;
Firms with 25 percent of more of the industry: DT: No; Firms with
25 percent of more of the industry: EY: Yes; Firms with 25 percent of
more of the industry: KPMG: No; Firms with 25 percent of more of
the industry: PwC: No.
Source: Who Audits America.
Note: We have arbitrarily defined significant presence as auditing 25
percent or more of the total assets within an industry.
[End of table]
[End of section]
Appendix V: GAO Contacts and Staff Acknowledgments:
GAO Contacts:
Davi M. D'Agostino, (202) 512-8678
Orice M. Williams, (202) 512-8678:
Acknowledgments:
In addition to those individuals named above, Martha Chow, Edda
Emmanuelli-Perez, Lawrance Evans, Jr., Marc Molino, Michelle Pannor,
Carl Ramirez, Barbara Roesmann, Derald Seid, Jared Stankosky, Paul
Thompson, Richard Vagnoni, and Walter Vance made key contributions to
this report.
[End of section]
Glossary:
Antitrust:
The general process of preventing monopoly practices or breaking up
monopolies that restrict competition. The term antitrust derives from
the common use of the trust organizational structure in the late 1800s
and early 1900s to monopolize markets.
Federal antitrust laws:
A series of federal laws intended to maintain competition and prevent
businesses from getting a monopoly or unfairly obtaining or exerting
market power. The first of these, the Sherman Antitrust Act, was passed
in 1890. Two others, the Clayton Act and the Federal Trade Commission
Act, were enacted in 1914. These laws impose restrictions on business
ownership, control, mergers, pricing, and how businesses go about
competing (or cooperating) with each other.
Audit and attest services:
Services provided for professional examination and verification of a
company's accounting documents and supporting data for the purpose of
rendering an opinion on the fairness with which they present, in all
material respects, the financial position, results of operations, and
its cash flows, and conformity with generally accepted accounting
principles.
Audit fee:
Fee paid by a company to an audit accounting firm for the professional
examination and verification of its accounting documents and supporting
data.
Auditor, auditor of record, and public accounting firm:
Generally refers to an independent public accounting firm registered
with SEC that performs audits and reviews of public company financial
statements and prepares attestation reports filed with SEC. In the
future, these public accounting firms must be registered with Public
Company Accounting Oversight Board (PCAOB) as required by the Sarbanes-
Oxley Act of 2002.
Auditor independence:
The idea that the auditor of record is exclusively concerned with
examination and verification of a company's accounting documents and
supporting data without bias or conflicts of interest. Professional
auditing standards require an auditor to be independent and avoid
situations that may lead others to doubt its independence, referred to
as being independent in fact as well as in appearance. Auditor
independence is an important factor in establishing the credibility of
the audit opinion.
Audit market:
The organized exchange of audit and attest services between buyers and
sellers within a specific geographic area and during a given period of
time.
Barriers to entry:
Institutional, governmental, technological, or economic factors that
limit the flow of new entrants into profitable markets. Possible
barriers to entry may include resources, patents and copyrights or
technical expertise, reputation, litigation and insurance risks, and
start-up costs. Barriers to entry are a key reason for market power. In
particular, monopoly and oligopoly often owe their market power to
assorted barriers to entry.
Bottom line loss:
Occurs when gross sales minus taxes, interest, depreciation, and other
expenses are negative. Also called negative net earnings, income, or
profit.
Capital formation:
The transfer of savings from households and governments to the business
sector, resulting in increased output and economic expansion. The
transfer of funds to businesses for investment can occur through
financial intermediaries such as banks or through financial markets
such as the stock market. (For the purpose of this report, we focus on
public capital markets.):
Competition:
In general, the actions of two or more rivals in pursuit of the same
objective. In the context of markets, the specific objective is selling
or buying goods. Competition tends to come in two varieties --
competition among the few, which is a market with a small number of
sellers (or buyers), such that each seller (or buyer) has some degree
of market control, and competition among the many, which is a market
with so many buyers and sellers that none is able to influence the
market price or quantity exchanged.
Concentration ratio:
The proportion of total output in an industry that is produced by a
given number of the largest firms in the industry. The two most common
concentration ratios are for the four largest firms and the eight
largest firms. The four-firm concentration ratio is the proportion of
total output produced by the four largest firms in the industry and the
eight-firm concentration ratio is the proportion of total output
produced by the eight largest firms in the industry:
Due diligence:
The process of investigation performed by investors, accountants and
other market participants into the details of a potential investment,
such as an examination of operations and management and the
verification of material facts. Obtaining a comment letter written by
independent accountants to an underwriter is part of that underwriter's
due diligence.
Economies of scale:
Declining long-run average costs that occur as a firm increases all
inputs and expands its scale of production, realized through
operational efficiencies. Economies of scale can be accomplished
because as production increases, the cost of producing each additional
unit falls.
Economies of scope:
Declining long-run average costs that occur due to changes in the mix
of output between two or more products. This refers to the potential
cost savings from joint production - even if the products are not
directly related to each other. Economies of scope are also said to
exist if it is less costly for one firm to produce two separate
products than for two specialized firms to produce them separately.
Hirschman-Herfindahl Index (HHI):
A measure of concentration of the production in an industry that is
calculated as the sum of the squares of market shares for each firm.
This is an alternative method of summarizing the degree to which an
industry is oligopolistic and the relative concentration of market
power held by the largest firms in the industry. The HHI gives a better
indication of the relative market power of the largest firms than can
be found with the four-firm and eight-firm concentration ratios.
Going-concern opinion:
Opinion that expresses substantial doubt about whether or not a company
will continue to operate for 1 year beyond the financial statement date
or go out of business and liquidate its assets. Indicated when there
are substantial doubts about whether the company will be able to
generate and/or raise enough resources to stay operational.
Industry:
A collection of firms that produce similar products sold in the same
market. The concept of industry is most often used synonymously with
market in most microeconomic analysis.
Loss Leader:
The term loss leader implies that the firms bid unrealistically low
fees ("low-balling") to obtain a new client. Once the new client is
secured, the low audit fee, which alone may not be adequate to cover
the cost of an audit and provide the firm with a reasonable margin, is
offset by additional fees generated from other services, such as
management consulting and tax.
Market:
The organized exchange of commodities (goods, services, or resources)
between buyers and sellers within a specific geographic area and during
a given period of time.
Market power:
The power to profitably maintain prices above competitive levels for a
significant amount of time. More generally, if it is the ability of
sellers to exert influence over the price or quantity of a good,
service, or commodity exchanged in a market. Market power depends on
the number of competitors.
Market structure:
The manner in which a market is organized, based largely on the number
of firms in the industry. The four basic market structure models are
perfect competition, monopoly, monopolistic competition, and
oligopoly. The primary difference between each is the number of firms
on the supply side of a market. Both perfect competition and
monopolistic competition have a large number of relatively small firms
selling output. Oligopoly has a small number of relatively large firms.
Monopoly has a single firm.
Peer review:
A part of the accounting profession's former self-regulatory system
whereby accounting firms reviewed other firm's quality control systems
for
compliance with standards and membership requirements. The Sarbanes-
Oxley Act of 2002 significantly overhauled the oversight and regulation
of the accounting profession. Among other things, it established the
Public Company Accounting Oversight Board to oversee the audit of
public companies, including registering public accounting firms,
establishing standards, and conducting compliance inspections,
investigations, and disciplinary proceedings.
Predatory pricing:
The process in which a firm with market power reduces prices below
average total cost with the goal of forcing competitors into
bankruptcy. This practice is most commonly undertaken by oligopolistic
firms seeking to expand their market shares and gain greater market
control. Antitrust laws have outlawed predatory pricing, but this
practice can be difficult to prove.
Publicly listed companies (public companies):
A company which has issued securities (through an offering) that are
traded on the open market. Used synonymously with public company. For
the purposes of this report public companies include companies listed
on the New York Stock Exchange, American Stock Exchange, NASDAQ or
traded on other over-the-counter markets such as Pink Sheets.
Retained earnings:
Earnings not paid out as dividends but instead reinvested in the core
business or used to pay off debt. Also called earned surplus,
accumulated earnings, or unappropriated profit.
Tight oligopoly:
An oligopolistic market structure where the four firms hold over 60
percent of the market. A loose oligopoly is a market structure with 8-
15 firms and a four-firm concentration ratio below 40 percent.
Working capital:
Current assets minus current liabilities. Working capital measures how
much in liquid assets a company has available to build its business.
The number can be positive or negative, depending on how much debt the
company is carrying. In general, companies that have a lot of working
capital will be more successful since they can expand and improve their
operations.
(250104):
FOOTNOTES
[1] For the purpose of this report, public companies are defined as
those that are listed on the American Stock Exchange (Amex), NASDAQ, or
the New York Stock Exchange (NYSE), or with stock traded on other over-
the-counter markets such as Pink Sheets. Large public companies
generally include those with over $1 billion in annual revenue unless
otherwise noted.
[2] For the purpose of this report, we refer to the Big 8 and Big 4
firms as the "top tier," based on total revenue and staff size. The Big
8 were Arthur Andersen LLP, Arthur Young LLP, Coopers & Lybrand LLP,
Deloitte Haskins & Sells LLP, Ernst & Whinney LLP, Peat Marwick
Mitchell LLP, Price Waterhouse LLP, and Touche Ross LLP. The Big 4 are
Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and
PricewaterhouseCoopers LLP. Any reference to "smaller firms" includes
any of the other more than 700 firms that audit public companies. When
we present firm rankings, we do so based on annual total revenues in
the United States unless otherwise noted.
[3] Pub. L. No. 107-204 § 701 (2002), the Sarbanes-Oxley Act
significantly overhauled the oversight and regulation of the accounting
profession. Its purpose was to strengthen corporate governance
requirements and improve transparency and accountability, among other
things.
[4] Historically, the accounting profession maintained a voluntary,
self-regulatory system through AICPA that included setting professional
standards, monitoring compliance with professional standards,
disciplining members for improper acts and substandard performance, and
conducting oversight of the industry. The Sarbanes-Oxley Act
established the Public Company Accounting Oversight Board to oversee
the audit of public companies, including registering public accounting
firms; establishing audit standards; and conducting compliance
inspections, investigations, and disciplinary proceedings.
[5] R. Doogar and R. Easley, "Concentration without Differentiation: A
New Look at the Determinants of Audit Market Concentration," Journal of
Accounting and Economics, vol. 25 (1998): 235-253. The Doogar and
Easley model is premised on the assumption of pure price competition,
in which clients choose auditors solely based on price, ignoring
factors such as quality or reputation. In this framework, audit clients
will gravitate to larger and more efficient audit firms, where
efficiency is defined by the partner-to-staff, or leverage, ratio.
Companies with lower leverage ratios are more efficient and can
therefore bid lower prices for audit engagements.
[6] Sarbanes-Oxley requires that SEC enact independence rules, which
address areas such as prohibited nonaudit services, audit partner
rotation, and conflicts of interest.
[7] State boards of accountancy, operating under the authority of
individual state laws, adopt rules that govern licensing for practice
in their jurisdiction, including educational and experience
qualifications, continuing professional education requirements, and
the manner and use of the title "certified public accountant."
[8] The Big 5 were Andersen, Deloitte & Touche, Ernst & Young, KPMG,
and PricewaterhouseCoopers.
[9] Senate Subcommittee on Reports, Accounting and Management,
Committee on Government Operations, The Accounting Establishment, 95TH
Congr.,1ST Sess., March 31, 1977. This study is commonly known as the
Metcalf Report.
[10] Pub. L. 107-204, Title II § 201-§206 and 17 CFR Parts 210 and 240,
Final Rule: Revision of the Commission's Auditor Independence
Requirements.
[11] KPMG Peat Marwick is now known as KPMG.
[12] The term, "economies of scope," refers to the notion that a
producer's average total cost of production decreases as a result of
increasing the number of different goods it produces.
[13] The HHI is calculated by summing the squared individual market
shares of all accounting firms (public company clients). For example, a
market consisting of four firms with market shares of 35 percent, 30
percent, 20 percent, and 10 percent has an HHI of 2,625 (352+ 3022
2020+ 102). The HHI reflects both the distribution of the market shares
among top firms and the composition of the market outside of the top
firms. We have computed concentration ratios and the HHI based on
summary tables included in Who Audits America for the relevant years.
[14] For this measure, the top four firms are determined by the
percentage of total sales audited. The four-firm concentration ratio is
the aggregate sales audited by the top four firms as a percentage of
total sales audited. We have computed concentration ratios based on
summary tables included in Who Audits America for the relevant years.
These summary tables omit certain small auditors that audit small
public companies not listed on Amex, NASDAQ, or NYSE.
[15] Market shares are generally calculated using the dollar value of
sales as we have done in the text above and as shown in figure 5. FTC
and DOJ note that measures such as sales, shipments, or production are
the best indicators of future competitive significance. Nevertheless,
we have also computed concentration ratios based on the number of
clients for descriptive purposes.
[16] Collusion refers to a usually secret agreement among competing
firms (mostly oligopolistic firms) in an industry to control the
market, raise the market price, and otherwise act like a monopoly.
While overt collusion involves an explicit formal agreement among the
firms, under tacit collusion each firm seems to be acting independently
with no explicit agreement, perhaps each responding to the same market
conditions, but ultimately the result is the same as it is under an
explicit agreement.
[17] The simulation is based on 5,448 industrial companies and their
auditors. According to data obtained from Who Audits America, the Big 4
audited 62.2 percent of these companies. In this simulation, we
assigned clients to their current auditor and simulated the market to
see if the accounting firms could defend their market share in a purely
competitive market. In an alternative simulation, we initiated the
process without assigning clients to a particular firm and allowed
accounting firms to compete for each client. The results were
consistent with the above analysis; in fact, the Big 4 were predicted
to audit 1-2 percent more of the 5,448 industrial clients than the
actual percentage audited, depending on the cost of switching auditors
(see app. I for complete results).
[18] Historically, firm consolidation in particular industries was
often driven by the fact that a few largre companies dominated certain
industries. Accounting firm "industry specialization" can be captured
by a firm's relatively high market share, in terms of client assets or
cllient sales, in a given industry. The observation that a few
accounting firms audit the vast majority of company assets in a given
industry does not necessarily indicate that they audit many companies
in that industry--in fact, these few "specialists" may audit only a few
very large companies. While firms that are not considered to be
specialists in a given indusry may audit a large number of smaller
companies, they may not have the requisite excess staff capacity or
technical expertise necessary to handle the larger clients in that
industry, which is implied by the term specialization. Industries
conducive to specialization would tend to preclude other firms from
easily entering the market and challenging specialist firms' market
share.
[19] Industry specialization or expertise ranked third in importance
behind quality of services offered (99 percent) and reputation or name
recognition (82 percent).
[20] S. Invancevich and A. Zardkoohi, "An Exploratory Analysis of the
1989 Accounting Firm Megamergers," Accounting Horizons, vol. 14, no. 4
(2000): 155-136. K. Menon and D. Williams, "Long-Term Trends in Audit
Fes," Auditing: A Journal of Practice and Theory, vol. 20, no. 1
(2001): 115-136. The samples included cllients of Big 6 audit firms
that voluntarily disclosed audit fee data in SEC filings (between 68
and 90 companies for each year). The fee data have been adjusted for
inflation.
[21] In 1997, the Big 6 were Arthur Andersen, Coopers & Lybrand,
Deloitte & Touche, Ernst & Young, KPMG, and Price Waterhouse. For Ernst
& Young and Deloitte & Touche, the researchers found the average audit
price fell from $503.6 to $441.84 per million dollars of assets
audited. The "fees" for the remaining Big 6 fell from $441.28 to $378.4
per million dollars of assets audited in 1989-1996.
[22] Manufacturers Alliance/MAPI, Survey on Outside Audit Fees, 2000.
Manufacturers Alliance provides executive education and business
research services.
[23] According to an SEC report, in 2000 audit fees for the Fortune
1000 public companies were.03 percent of company revenue on average.
Securities and Exchange Commission, Office of the Chief Accountant,
"Independence Rule Proxy Disclosures: Independent Accountants Fees,"
(2001).
[24] The term loss leader implies that the firms bid unrealistically
low fees ("low-balling") to obtain a new client. Once the new client is
secured, the low audit fee, which alone may not be adequate to cover
the cost of an audit and provide the firm with a reasonable margin, is
offset by additional fees generated from other services, such as
management consulting and tax.
[25] L. Kimmel and S. Vazquez, "The Increased Financial and Non-
Financial Cost of Staying Public," Foley & Lardner, Attorneys at Law
(2003).
[26] These definitions are commonly used in the academic literature,
reflecting the assessment of capital market participants, and are
consistent with those used in the professional literature that describe
audit quality in terms of audit risk. This definition of auditor
independence is provided in L. DeAngelo, "Auditor Independence, 'Low
Balling,' and Disclosure Regulation," Journal of Accounting and
Economics, vol. 3 (1981): 113-127. This definition of audit quality is
provided in L. DeAngelo, "Auditor Size and Audit Quality," Journal of
Accounting and Economics, vol. 3 (1981): 183-199.
[27] Concern over auditor independence has typically centered on the
provision of nonaudit services to a company by its incumbent auditor, a
concern based on the assumption that an auditor is willing to sacrifice
its independence in exchange for retaining a client that may pay large
fees for nonaudit services. Historically, some have argued that the
provision of nonaudit services to an audit client can impair auditor
independence by creating an economic bond between an auditor and its
client. Other researchers note that an economic bond could result from
large audit fees, too, and, especially, that auditors also have market-
based institutional incentives to act independently and remain
independent of their public company clients. Numerous academic studies
suggest that auditors face an expected cost for compromising their
independence, namely loss of reputation and litigation costs, which is
corroborated by historical evidence.
[28] For example, the notion of differential audit quality is dismissed
in American Institute of Certified Public Accountants, The Commission
on Auditors' Responsibilities: Report, Conclusions, and
Recommendations, New York: AICPA (1978): 111. However, Weiss Ratings
Inc., "The Worsening Crisis of Confidence on Wall Street: The Role of
Auditing Firms," 2002, reported that smaller accounting firms issued a
higher percentage of going-concern warnings on their clients that
subsequently went bankrupt than did four of the five largest firms,
from January 2001 through June 2002.
[29] In such a framework, capturing differential audit quality is
particularly elusive: If no problem were found in a given company's
financial reports, it is not necessarily the case that the
corresponding audit was of high quality.
[30] These studies generally approached the issues from the perspective
of capital market participants. Another avenue through which
researchers have attempted to assess audit quality was the analysis of
data on litigation involving auditors. However, auditor litigation data
suffer from more serious measurement issues. For example, see Z.
Palmrose, "An Analysis of Auditor Litigation and Audit Service
Quality," The Accounting Review, vol. 63, no. 1 (1988): 55-73.
[31] Financial statement restatements can be triggered for a variety of
reasons, including evolving interpretations of existing accounting
standards, and are not necessarily the result of audit failures.
[32] For example, see Huron Consulting Group, "An Analysis of
Restatement Matters: Rules, Errors, Ethics," Internet-Based Report,
2003; U.S. General Accounting Office, Financial Statement Restatements:
Trends, Market Impacts, Regulatory Responses, and Remaining Challenges,
GAO-03-138 (Washington, D.C.: October 2002); and M. Wu, "Earnings
Restatements: A Capital Market Perspective," Working Paper, New York
University, 2002. These studies reported restatements based on when
they were announced or reported rather than the periods affected by the
restatements. Some restatements announced in the late 1990s could be
the result of heightened SEC activity designed to curb earnings
manipulation, and the marked decline in the stock market beginning in
2000 may have also contributed to the discovery of many reporting
improprieties that had previously gone undiscovered during the stock
market expansion.
[33] A going-concern opinion indicates substantial doubt in the audited
report regarding the ability of a company to continue as a "going
concern." Academic research has noted that there are two types of
misclassification in the context of going-concern opinions: (1) a
company receives a going-concern opinion but subsequently remains
viable or (2) a company enters bankruptcy but did not receive a prior
going-concern opinion. The latter is the focus of the studies to which
we refer. It is important to note that, technically, neither type of
misclassification is a reporting error from the perspective of
professional auditing standards, but capital market participants do not
necessarily share this view, as they can be impacted by both.
[34] M. Geiger and K. Raghunandan, "Going-Concern Opinions in the 'New'
Legal Environment," Accounting Horizons, vol. 16, no. 1 (2002): 17-26.
The authors define a company as "financially stressed" if it exhibits
at least one of the following features: (1) negative working capital,
(2) negative retained earnings, or (3) a bottom-line loss. (See
Glossary for definitions.)
[35] Weiss Ratings (2002) also found that accounting firms almost
universally failed to warn the public of accounting irregularities over
this period. Of the 33 instances of accounting irregularities
investigated, in only two cases did an accounting firm issue warnings
about the companies involved. Because it examined a relatively brief
period, this study does not weigh in on whether the propensity to warn
investors has increased or decreased over time, however.
[36] Additional references are provided in K. Raghunandan and K. Rama,
"Audit Reports for Companies in Financial Distress: Before and After
SAS No. 59," Auditing: A Journal of Practice and Theory, vol. 14, no. 1
(1995): 50-63.
[37] M. DeFond, K. Raghunandan, and R. Subramanyam, "Do Non-Audit
Service Fees Impair Auditor Independence? Evidence from Going Concern
Audit Opinions," Journal of Accounting Research, vol. 40, no. 4 (2002):
1247-1274.
[38] It is also possible that auditors providing nonaudit services to
their audit clients are more tolerant of earnings management but draw
the line at compromising the integrity of the audit opinion.
[39] R. Frankel, M. Johnson, and K. Nelson, "The Relation between
Auditors' Fees for Nonaudit Services and Earnings Management," The
Accounting Review, vol. 77 (2002): 71-105; W. Kinney, Jr., and R.
Libby, "Discussion of 'The Relation between Auditors' Fees for Nonaudit
Services and Earnings Management,'" The Accounting Review, vol. 77
(2002): 107-114; and J. Reynolds and J. Francis, "'Does Size Matter?
The Influence of Large Clients on Office-Level Auditor Reporting
Decisions," Journal of Accounting and Economics, vol. 30 (2001): 375-
400.
[40] For example, in 1994 the U.S. Supreme Court held that the federal
securities laws do not provide a private cause of action for aiding and
abetting securities fraud. Central Bank of Denver v. First Interstate
Bank of Denver, 511 U.S. 164 (1994). The Private Securities Litigation
Reform Act made it more difficult for a plaintiff suing a company and
its auditor to collect damages from the accounting firm. In 1998
Congress passed the Securities Litigation Uniform Standards Act of
1998, Pub. L. No. 105-353, which restricted class actions and certain
consolidated actions that make specific allegations involving the
purchase or sale of a security.
[41] Geiger and Raghunandan (2002).
[42] A recent study of some of Andersen's public company clients
reported that their stock prices were adversely impacted by Andersen's
admission to shredding documents, providing some empirical evidence of
the capital market impact resulting from an auditor's loss of
reputation and the subsequent concerns about the quality of its audits
in general. See P. Chaney and K. Philipich, "Shredded Reputation: The
Cost of Audit Failure," Journal of Accounting Research, vol. 40, no. 4
(2002): 1221-1245.
[43] For example, see R. Dye, "Auditing Standards, Legal Liability, and
Auditor Wealth," Journal of Political Economy, vol. 101, no. 5 (1993):
887-914.
[44] Some capital market participants suggested that the litigation
risk faced by underwriters was a primary reason why underwriters
generally prefer that their public company clients engage Big 4
accounting firms for audit services in their securities offering
processes. The Securities Act of 1933 assigned certain responsibilities
to the auditor and underwriter in connection with their participation
in a securities offering, and both may be held liable in the event of a
material misstatement or omission in the offering documents. To
discharge its "due diligence" responsibilities (the process of
investigation into the details of a potential investment, such as an
examination of operations and management and the verification of
material facts), an underwriter must demonstrate that it has reviewed
an issuer's financial information. In performing its due diligence, the
underwriter relies on the expertise of professional auditors to review
certain financial information and to provide "comfort letters" (an
independent auditor's letter, required in securities underwriting
agreements, to assure that information in the registration statement
and prospectus is correctly prepared and that no material changes have
occurred since their preparation) evidencing any reviews. Given its
liability risk, an underwriter may prefer that a client in the
securities offering process engage a Big 4 accounting firm, which has a
larger capital base than any non-Big 4 firm, to more effectively
redistribute this risk. Underwriters also prefer the Big 4 because they
may have more experience with the capital formation process, more
capacity to meet deadlines, and can provide more assistance throughout
the process.
[45] Initial public offering underpricing generally refers to the
difference between the offering price and the market clearing price at
issuance of a company's security, which can be translated directly into
the initial market-adjusted return earned by a market participant who
buys the security at its offering price and sells it at its first-day
closing price. For example, see M. Willenborg, "Empirical Analysis of
the Economic Demand for Auditing in the Initial Public Offerings
Market," Journal of Accounting Research, vol. 37, no. 1 (1999): 225-
238, and R. Beatty, "Auditor Reputation and the Pricing of Initial
Public Offerings," The Accounting Review, vol. 64, no. 4 (1989): 693-
709.
[46] Two of the three most frequently cited reasons given for not
considering a non-Big 4 firm were capacity of the firm (117 of 129
respondents) and technical skills/knowledge (117 of 129 respondents).
[47] This discussion of markets is limited to the public company audit
market and associated competition. Public accounting firms actually
compete in a variety of niche markets, such as the audit market for
small public companies, nonprofit companies, private companies, and
governmental agencies.
[48] The other two most-cited factors having an upward influence on
costs were changing accounting principles and standards/complexity of
audits (47 of 47) and price of talent or training (43 of 47).
[49] The AICPA's SEC Practice Section (SECPS) was a part of the former
self-regulatory system. SECPS was overseen by the Public Oversight
Board (POB), which represented the public interest on all matters
affecting public confidence in the integrity of the audit process.
SECPS required AICPA member accounting firms to subject their
professional practices to peer review and oversight by POB and SEC.
[50] Top-tier firms would include the Big 8 in 1988 and the Big 4 in
2002. Likewise, the next-tier firms would include Grant Thornton, BDO
Seidman, BKD, Crowe, Chizek and Co., McGladrey & Pullen, Moss Adams,
Plante & Moran and Clifton Gunderson in 2002.
[51] R. Doogar and R. Easley, "Concentration without Differentiation: A
New Look at the Determinants of Audit Market Concentration," Journal of
Accounting and Economics, vol. 25 (1998): 235-253.
[52] This assumption implies that the model's results are not driven by
economies of scale.
[53] In the "short run," each accounting firm's size, as captured by
the number of partners, is fixed. The algorithm allows companies to
switch auditors whenever they can find a lower price, and clients who
gain the most from a change are allowed to switch first. As long as
there is a dissatisfied client, the model resigns the client,
recalculates costs for all clients, and looks to identify any newly
dissatisfied clients. This process is repeated until equilibrium is
reached.
[54] While the Big 4 audited over 95 percent of the total assets of
these industrial companies, they audited 68 percent of the log of total
assets.
[55] The data we analyzed are from Who Audits America, 2001-2002. We
tracked the companies that left Andersen, beginning with the last
quarter of 2001 because some companies began leaving Andersen once the
firm came under suspicion.
[56] We also administered a survey to a random sample of 250 Fortune
1000 public companies, of which 148 companies responded, and 34 of the
148 respondents were former Andersen clients. We found that half of the
34 former Andersen clients switched to the new firm of the former
Andersen partner who was in charge of their audit.
[57] One hundred fifty-nine companies that did not have SIC codes
reported in Who Audits America were excluded from this analysis.
[58] SIC codes are arranged in a very structured, hierarchical manner;
and for the purposes of this report, we have focused on the 2-digit SIC
code; the first digit designates a major Economic Division, such as
agriculture or manufacturing; the second digit designates an Economic
Major Group, such as crop production.
[59] To test the reliability of this database, we preformed various
checks on random samples of the data, compared results we obtained
using the data to published work in the area and relied on previous
academic research, which verified the completeness and accuracy of the
data. For example R. Doogar and R. Easley, "Concentration without
Differentiation: A New Look at the Determinants of Audit Market
Concentration," Journal of Accounting and Economics, vol. 25 (1998):
235-253, compared auditor information contained in the Compustat, Dow-
Jones Disclosure and Who Audits America and found no discrepancies. The
data issues are also discussed in appendix I.
[60] This assumes that a firm does not have sufficient expertise and
staff resources if it audits only a small share of industry assets
(defined here by major economic group).
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