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Report to Congressional Addressees: 

United States Government Accountability Office: 

GAO: 

January 2008: 

Audits Of Public Companies: 

Continued Concentration in Audit Market for Large Public Companies Does 
Not Call for Immediate Action: 

Public Companies: 

GAO-08-163: 

GAO Highlights: 

Highlights of GAO-08-163, a report to congressional addressees. 

Why GAO Did This Study: 

GAO has prepared this report under the Comptroller General’s authority 
as part of a continued effort to assist Congress in reviewing 
concentration in the market for public company audits. The small number 
of large international accounting firms performing audits of almost all 
large public companies raises interest in potential effects on 
competition and the choices available to large companies needing an 
auditor. This report examines (1) concentration in the market for 
public company audits, (2) the potential for smaller accounting firms’ 
growth to ease market concentration, and (3) proposals that have been 
offered by others for easing concentration and the barriers facing 
smaller firms in expanding their market shares. 

GAO surveyed a random sample of almost 600 large, medium, and small 
public companies on their experiences with their auditors. GAO also 
interviewed the four largest accounting firms and surveyed all other 
U.S. accounting firms that audit at least one public company. GAO also 
developed an econometric model that analyzed the extent to which 
various factors, including concentration and new auditing requirements, 
affected fee levels. To supplement this work, GAO interviewed market 
participants, including public companies, investors, accounting firms, 
academics, and regulators. 

This report makes no recommendations. 

What GAO Found: 

While the small public company audit market is much less concentrated, 
the four largest accounting firms continue to audit almost all large 
public companies. According to GAO’s survey, 82 percent of large public 
companies—the Fortune 1000—saw their choice of auditor as limited to 
three or fewer firms, and about 60 percent viewed competition in their 
audit market as insufficient. Most small public companies reported 
being satisfied with the auditor choices available to them. 

Figure: Percentage of Companies Audited by Four Largest Accounting 
Firms, by Company Size Percentage: (Number of companies): 

This figure is a bar chart showing percentage of companies audited by 
four largest accounting firms, by company size. The X represents 
company revenue. The Y axis represents percentage (number of 
companies). 

2002: <$100 million: 1,606: 44%; 
2006: <$100 million: 794: 22%. 

2002: $100 million-$500 million: 1,190: 90%; 
2006: $100 million-$500 million: 907: 71%. 

2002: >$500 million-$1 billion: 498: 95%; 
2006: >$500 million-$1 billion: 516: 92%. 

2002: >$1 billion: 1,211: 98%; 
2006: >$1 billion: 1,513: 98%. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

[End of figure] 

Although audit fees rose significantly in recent years, market 
participants attributed these increases to expanding accounting and 
auditing requirements and higher costs for accounting firm personnel. 
GAO’s model also found that factors other than concentration appeared 
to explain audit fee levels. Public company officials generally 
acknowledged that audit quality had increased. Although current 
concentration does not appear to be having a significant adverse 
effect, the loss of another large firm would further reduce large 
companies’ auditor choice and could affect audit fee competitiveness. 

Smaller accounting firms face various challenges in expanding to audit 
more public companies, although most are not interested in these 
clients. As a result, concentration in the audit market for large 
public companies is likely to continue. Large public companies that GAO 
surveyed said that smaller firms lacked the capacity and technical 
expertise they wanted in an auditor. Audit firms that GAO surveyed said 
that adding qualified staff and increasing their name recognition were 
the most significant challenges they faced in expanding their public 
company audit practices. Some have taken steps to increase their 
capacity by joining networks with other firms. 

Academics and business groups have put forth proposals to reduce audit 
market concentration and address challenges facing smaller accounting 
firms, including capping auditors’ liability and creating an office to 
share technical expertise. Market participants raised questions about 
the overall effectiveness, feasibility, and benefit of these proposals, 
and none were widely supported. Given the lack of significant adverse 
effect of concentration in the current environment and that no clear 
consensus exists on how to reduce concentration, no compelling need for 
immediate action appears to exist. 

To view the full product, including the scope and methodology, click on 
[hyperlink, http://www.GAO-08-163]. To view the results of GAO's 
surveys to public companies and accounting firms, click on GAO-08-
164SP. For more information, contact Orice Williams at (202) 512-8678 
or williamso@gao.gov 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

With Continued Audit Market Concentration, Large Public Companies See 
Limited Choices, but No Apparent Significant Effect on Fees: 

Midsize and Smaller Firms Face Challenges Auditing Public Companies, 
and Growth in These Firms Is Unlikely to Ease Concentration in the 
Large Public Company Audit Market: 

Proposals for Addressing Concentration and Increasing Market Share for 
Smaller Auditors Have Significant Disadvantages: 

Agency Comments and Our Evaluation: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Other Issues Related to Concentration in the Audit Market: 

Appendix III: Analysis of Auditor Changes: 

Appendix IV: Trends in Audit Costs and Quality: 

Appendix V: Econometric Analysis of the Effect of Industry 
Concentration on Audit Fees: 

Appendix VI: GAO Contacts and Staff Acknowledgments: 

Tables: 

Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting 
Public Companies and Accounting Firms: 

Table 2: Largest, Midsize, and Smaller Accounting Firm Capacity, 2006: 

Table 3: Disposition of Public Company Sample: 

Table 4: Disposition of Accounting Firms Selected for Survey: 

Table 5: Market Shares of Audit Fees by Accounting Firm Size: 

Table 6: Public Companies Changing Accounting Firms, January 2003 to 
June 2007: 

Table 7: Percentage and Number of Changes Public Companies Made in 
Auditors, by Region: 

Table 8: Descriptive Statistics of the Panel Data Set, 2000-2006: 

Table 9: Hirchman-Herfindahl Indexes by Sector, 2000-2006: 

Table 10: Primary Variables in the Econometric Analysis: 

Table 11: Correlation Matrix, GAO Panel Data Set, Select Variables: 

Table 12: Random-Effects and Fixed-Effects Models Explaining Log of 
Fees: 

Table 13: Fixed Models Explaining Log of Fees, by Market Segments, 2001-
2006: 

Figures: 

Figure 1: Significant Mergers of the 1980s and 1990s: 

Figure 2: Public Companies and Their Auditors, 2002 and 2006: 

Figure 3: Hirschman-Herfindahl Indexes for Public Company Market 
Segments Grouped by Company Revenues: 

Figure 4: Percentage of Midsize and Small Companies That Reported 
Having Three or Fewer Choices for Auditor: 

Figure 5: Percentage of Small and Midsize Companies Reporting They Did 
Not Have Enough Choices for Auditor: 

Figure 6: Changes in Auditors among Small and Midsize Public Companies: 

Figure 7: Percentage of Public Companies Indicating That the Level of 
Audit Market Competition Was Sufficient: 

Figure 8: Firms' Challenges in Auditing Large Public Companies: 

Figure 9: IPOs, 2003-2007: 

Figure 10: Midsize and Smaller Firms' Challenges in Auditing Small and 
Midsize Companies: 

Figure 11: 2006 Market Shares of Each of the Largest Firms Compared to 
Other Firms, as Measured by Audit Fees: 

Figure 12: Hirschman-Herfindahl Indexes, 2000-2006: 

Figure 13: Hirschman-Herfindahl Indexes, Markets Segmented by Industry: 

Figure 14: HHI with Simulated Firm Failure or Merger: 

Abbreviations: 

AICPA: American Institute of Certified Public Accountants: 

AMEX: American Stock Exchange: 

CAQ: Center for Audit Quality: 

CEO: chief executive officer: 

CFO: chief financial officer: 

CPA: certified public accountant: 

DOJ: Department of Justice: 

EDGAR: Electronic Data Gathering, Analysis, and Retrieval system: 

EITF: Emerging Issues Task Force: 

FASB: Financial Accounting Standards Board: 

FTC: Federal Trade Commission: 

GAAP: generally accepted accounting principles: 

GAAS: generally accepted auditing standards: 

GLS: generalized least squares: 

HHIL: Hirschman-Herfindahl Index: 

IOSCO: International Organization of Securities Commissions: 

IPO: initial public offering: 

NAICS: North American Industry Classification System: 

NASBA: National Association of State Boards of Accountancy: 

NYSE: New York Stock Exchange: 

OLS: ordinary least squares: 

OTCBB: Over the Counter Bulletin Board: 

PAR: Public Accounting Report: 

PCAOB: Public Company Accounting Oversight Board: 

SEC: Securities and Exchange Commission: 

United States Government Accountability Office: 

Washington, DC 20548: 

January 9, 2008: 

Congressional Addressees: 

Public and investor confidence in the reliability of financial 
reporting is critical to the effective functioning of the U.S. capital 
markets. Federal securities laws require that a company raising capital 
by issuing securities to the public have an independent public 
accountant perform an audit of the company's financial statements to 
provide reasonable assurance about whether the financial statements are 
fairly presented. Since the 1980s, a small number of large U.S. 
accounting firms have traditionally performed audits for the vast 
majority of the public company market (when measured by the share of 
total audit fees collected). Among the clients of these large firms are 
almost all of the largest U.S. companies.[Footnote 1] The small number 
of large accounting firms performing such audits has decreased as a 
result of mergers and the dissolution of one firm, falling from eight 
in the 1980s to four today.[Footnote 2] These four firms--referred to 
here as the largest firms--have thousands of partners, tens of 
thousands of employees, offices located around the world, and each had 
more than one thousand public company audit clients for 2006.[Footnote 
3] The next four largest accounting firms--referred to here as midsize 
firms--operate nationally, and to some extent, internationally but have 
substantially fewer employees and partners, and each had less than 500 
public company audit clients for 2006.[Footnote 4] All other accounting 
firms--referred to here as smaller firms--audit regional and local 
public companies and have fewer than 100 public company 
clients.[Footnote 5] 

With the audit market concentrated among the four largest firms, 
concerns have been raised about the number of choices that companies 
have when selecting an auditor and the extent of competition in the 
market. In 2003, we conducted a study (mandated by the Sarbanes-Oxley 
Act) on consolidation that had occurred in the accounting profession. 
Our study followed the dissolution of one of the then-five largest 
accounting firms, Arthur Andersen. At that time, we found that although 
audits for large public companies were highly concentrated among the 
largest accounting firms, the market for audit services appeared 
competitive according to various indicators.[Footnote 6] Given that 
several years have passed since the dissolution of Arthur Andersen and 
the passage of the Sarbanes-Oxley Act, which introduced reforms to 
public reporting and auditing, this report provides an update on the 
trends in the market for public company audits that we identified in 
2003 in the market for public company audits.[Footnote 7] Among the 
changes affecting the audit market that have occurred since our last 
report are additional requirements for public companies and auditors to 
assess, report on and attest to companies' internal control practices, 
restrictions intended to ensure the accounting firm's independence that 
limit public companies' ability to use their auditors for certain other 
services, and the creation of a new oversight body for accounting 
firms. 

We prepared this report under the Comptroller General's authority to 
conduct evaluations on his own initiative as part of a continued effort 
to assist Congress in reviewing concentration in the market for public 
company audits. Specifically, this report examines (1) the level of 
concentration in the market for public company audits and the impact of 
this concentration, (2) the potential for increased capacity among 
midsize and smaller accounting firms to ease market concentration, and 
(3) proposals that have been offered by others for easing concentration 
in the market for public company audits and the barriers facing midsize 
and smaller firms in expanding their market share for public company 
audits. 

To address these objectives, we collected data and analyzed changes in 
companies' choice of auditors and in audit fees, computed concentration 
ratios and other measures of concentration. We developed an econometric 
model to evaluate how various factors, including the level of market 
concentration, could explain fees that public companies paid to their 
auditors. To obtain the views of public companies and accounting firms 
on audit competition and challenges, we conducted two surveys. First, 
we surveyed a random sample of 595 of more than 6,000 publicly held 
companies, some of which had recently changed auditors.[Footnote 8] Our 
sample included large public companies (those in the Fortune 1000); 
midsize public companies (those outside the Fortune 1000 with market 
capitalizations--the value of the total outstanding shares of stock-- 
above $75 million); and small companies with less than $75 million in 
market capitalization.[Footnote 9] Our response rate for this survey 
was 73 percent.[Footnote 10] Because our survey was based on a random 
sample of the population, it is subject to sampling errors. The likely 
range of these errors for any survey statistics is no greater than plus 
or minus 12 percentage points, unless otherwise noted. In addition, we 
surveyed representatives of all 434 U.S. accounting firms that audited 
at least 1 public company in 2006 and were registered with the Public 
Company Accounting Oversight Board (PCAOB). Our response rate was 58 
percent.[Footnote 11]Results from our survey of accounting firms are 
limited to those midsize and smaller firms with five or more public 
company clients. Instead of surveying the four largest firms, we 
conducted separate structured interviews with representatives from each 
firm to obtain their views on the issues covered in the survey. This 
report does not contain all the results from the surveys, but the 
surveys themselves and a more complete tabulation of the results can be 
viewed at [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP]. 
We also interviewed staff from the Securities and Exchange Commission 
(SEC), PCAOB, Department of Justice (DOJ); academics; private 
consultants; trade associations; accounting firms; public companies; 
and insurance companies. To obtain information about the strengths and 
weaknesses of various proposals that have been offered to address 
concentration and the challenges that midsize and smaller firms face, 
we also held a roundtable discussion on July 10, 2007, involving 18 
market participants, including representatives of accounting firms, 
public companies, investors, academics, and insurers. For more 
information on our scope and methodology, see appendix I. 

We conducted this performance audit in New York City and Washington, 
D.C., from October 2006 to January 2008 in accordance with generally 
accepted government auditing standards. Those standards require that we 
plan and perform the audit to obtain sufficient, appropriate evidence 
to provide a reasonable basis for our findings and conclusions based on 
our audit objectives. We believe that the evidence obtained provides a 
reasonable basis for our findings and conclusions based on our audit 
objectives. 

Results in Brief: 

Although the market for small public company audits has become much 
less concentrated since 2002, the continuing concentration in the 
market for larger public companies limits these companies' auditor 
choices but does not appear to have significantly affected audit fees. 
According to our analysis, the largest accounting firms audit 98 
percent of the more than 1,500 largest public companies--those with 
annual revenues of more than $1 billion. In contrast, midsize and 
smaller firms audit almost 80 percent of the more than 3,600 smallest 
companies--those with annual revenues of less than $100 million. Larger 
public companies we surveyed indicated that the industry expertise and 
technical capability that they sought in an auditor generally meant 
that their choices were limited to the largest accounting firms. 
According to our survey of a random sample drawn from a population of 
more than 6,000 public companies, almost 60 percent of large companies 
indicated that the number of accounting firms from which they could 
choose was not adequate, although some company officials described 
taking steps to ensure that they would have at least one alternative 
firm they could use under the more restrictive auditor independence 
rules. In contrast, about 75 percent of the smallest public companies 
saw their number of auditor choices as sufficient. While audit fees 
have increased significantly in recent years, many market participants 
that we interviewed attributed fee increases to additional audit work 
and expanded accounting and audit requirements and higher costs to 
hire, train, and retain qualified staff. In addition, the econometric 
model we developed to evaluate the relationship between market 
concentration and audit fees indicated that factors other than 
concentration appeared to explain the recent fee increases. The level 
of market concentration also does not appear to be affecting audit 
quality as many of our survey respondents and those we interviewed said 
that audit quality had improved, which some attributed to the Sarbanes- 
Oxley Act. Although the current level of concentration does not appear 
to be having significant adverse effect, public company officials and 
others we interviewed indicated that a merger or the failure of one of 
the largest firms would further reduce companies' auditor choices and 
could potentially result in higher audit fees and fewer choices. The 
various federal organizations that have a role in overseeing activities 
in the audit market, including SEC, PCAOB, and DOJ, are prepared to 
take various actions to help minimize the disruption to the market if 
further concentration occurred. 

The concentration in the large public company audit market is also 
unlikely to be reduced in the near term by midsize and smaller 
accounting firms because a significant majority is not interested in 
auditing large public companies and those that are interested face 
various challenges in expanding their capability to do so. Over 70 
percent of midsize and smaller accounting firms indicated that they 
were not attempting to obtain large public company clients. 
Approximately 90 percent of large public companies we surveyed cited 
lack of capacity as a reason why they would not consider using midsize 
or smaller firms as their auditor. As a result, many of these firms 
would have to greatly expand their staffing and geographic capabilities 
to serve such companies. However, the most frequent impediment to 
expansion cited by accounting firms responding to our survey was 
difficulty finding staff. Smaller firms also saw their lack of name 
recognition and reputation as preventing them from obtaining more large 
public company clients. Other difficulties that some accounting firms 
cited in obtaining more public company clients included limited access 
to capital and difficulty complying with multiple state licensing 
requirements. Some firms have taken steps to address such challenges, 
such as mergers or joining networks. 

Various proposals by academics and business groups have been put forth 
to reduce the risks of current and further audit market concentration 
and the challenges facing midsize and smaller accounting firms, but 
each proposal also has disadvantages. For example, some have suggested 
that requiring one or more of the largest firms to spin off a portion 
of their operations to create more than four firms with the capacity to 
audit large public companies could ease current concentration. However, 
market participants we spoke with raised concerns that splitting up 
these firms could reduce their economies of scale and the depth of 
expertise that currently allow the largest firms to effectively and 
efficiently audit large companies. Some have also put forth proposals 
to reduce the risk of further concentration that could arise if one of 
the largest firms leaves the market as the result of a large litigation 
judgment or a regulatory action. Proposals to reduce this risk include 
placing caps on auditors' liability and having regulators or others 
take enforcement actions only against responsible partners or employees 
rather than the firm as whole. However, some of the academics and 
others we spoke with saw such liability caps and enforcement 
limitations as potentially reducing the incentives for auditors to 
conduct quality work. Other proposals have been offered to help midsize 
and smaller firms expand their market share, thus potentially easing 
concentration. These proposals include allowing outside ownership of 
these firms in order to provide capital to expand their operations, 
creating a group of accounting and auditing experts to provide needed 
expertise to smaller auditing firms, and establishing a professionwide 
accreditation program to help these firms overcome some of the name 
recognition and reputation challenges they face. However, while each 
action could offer benefits, market participants generally saw these 
proposals as having limited effectiveness, feasibility, and benefit. 

In light of limited evidence that the currently concentrated market for 
large public company audits has created significant adverse impact and 
the general lack of any proposals that were clearly seen as effective 
in addressing the risks of concentration or challenges facing smaller 
firms without serious drawbacks, we found no compelling need to take 
action. As a result, this report does not include any recommendations. 
We provided copies of a draft of this report to SEC, DOJ, PCAOB, and 
the Department of the Treasury. SEC, PCAOB, and DOJ provided technical 
comments, which have been incorporated where appropriate. Treasury had 
no comments. 

Background: 

Following the 1929 stock market crash, legislation was passed that 
required companies seeking to raise funds from the public to provide 
audited financial statements to their investors. 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. Under these federal 
securities laws, public companies are responsible for the preparation 
and content of financial statements that are complete and accurate and 
are presented in conformity with U.S. generally accepted accounting 
principles (GAAP). Financial statements, which disclose a company's 
financial position (balance sheet), stockholders' equity, results of 
operations (income statement), and cash flows, are an essential 
component of the disclosure system on which the U.S. capital and credit 
markets are based. 

Federal securities laws also require that public companies have the 
financial statements they prepare audited by an independent public 
accountant. The independent public accountant's audit is critical to 
the financial reporting process because the audit subjects companies' 
financial statements to scrutiny on behalf of shareholders and 
creditors to whom company management is accountable. The auditor is the 
independent link between management and those who rely on the financial 
statements. The statutory independent audit requirement, in effect, 
grants a franchise to the nation's public accountants, as an audit 
opinion on a public company's financial statements must be secured 
before an issuer of securities can go to market, have the securities 
listed on the nation's stock exchanges, or comply with the reporting 
requirements of the securities laws. 

Having auditors attest to the reliability of financial statements of 
public companies is intended to increase public and investor confidence 
in the fairness of the financial information. 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' audited 
financial statements, which is key to the efficient functioning of the 
markets for public companies' securities, can exist only if reasonable 
investors perceive auditors as independent and expert professionals who 
will conduct thorough audits. In the event that companies are alleged 
to have misled the public or presented falsified financial information, 
the accounting firms that performed those audits are also sometimes 
included in suits brought by investors or actions pursued by 
regulators. 

Accounting Firm Structure: 

Most accounting firms that audit public companies in the United States 
are organized as partnerships. Unlike corporations, which generally 
issue stock to their shareholders in exchange for capital to conduct 
their operations, accounting firms structured as partnerships obtain 
capital from their partners. To conduct an audit of a public company, 
an accounting firm establishes an engagement team that is typically 
headed by a lead audit partner and includes a concurring audit partner, 
audit staff and managers, and, as needed, technical specialists. The 
lead audit partner has responsibility for decision making on 
significant auditing, accounting, and reporting matters that affect the 
financial statements; reviewing the audit work; and maintaining regular 
contact with management and the audit committee. The concurring audit 
partner is responsible for reviewing the audit.[Footnote 12] 

To provide technical assistance to engagement teams, the larger 
accounting firms have national offices staffed with experts in auditing 
and accounting standards. These national offices are made up of 
accounting and auditing technical specialists who assist engagement 
teams by responding to complex questions, researching answers, and 
providing guidance to individual audit teams. These specialists also 
provide guidance to the entire firm on handling issues that arise 
during the course of audits, including evaluating the fair presentation 
of the financial statements. 

Mergers and the Loss of a Major Firm Have Resulted in a National and 
International Market Dominated by Four Large Firms: 

Although the largest 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 the eight largest firms--known as the Big 8--began merging 
with each other. As shown in figure 1, by 2000 various mergers among 
the largest accounting firms had left five large firms that accounted 
for the majority of audit revenues among firms auditing public 
companies. 

Figure 1: Significant Mergers of the 1980s and 1990s: 

This figure is a flowchart illustrating significant mergers of the 
1980s and 1990s. 

[See PDF for image] 

Source: Interviews with the four largest accounting firms and Public 
Accounting Report, 1986-2002. 

[End of figure] 

In 2002, the market consolidated further to 4 large firms after the 
Department of Justice criminally indicted Arthur Andersen on 
obstruction of justice charges stemming from the firm's role as auditor 
of Enron Corporation. The indictment and subsequent conviction of 
Arthur Andersen led to a mass exodus of its partners and staff, as well 
as clients. As a result, the firm was dissolved in 2002.[Footnote 13] 

[See PDF for image] 

[End of figure] 

Statutory Changes Affecting Requirements for Public Companies and Their 
Auditors: 

Public companies and the accounting profession have experienced many 
reporting and auditing changes in recent years. In the aftermath of 
various financial scandals at large public companies such as Enron and 
WorldCom in the early 2000s, new legislation was passed to help restore 
investor confidence in the nation's capital markets.[Footnote 14] The 
Sarbanes-Oxley Act of 2002 (the Act) introduced major reforms to public 
company financial reporting and auditing that were intended to improve 
the accuracy and reliability of financial reporting and enhance 
auditors' independence and audit quality. The reforms include the 
following: 

* Section 404(a) of the Act requires that in each annual financial 
report filed with SEC the management of public companies must (1) state 
its responsibility for establishing and maintaining an adequate 
internal control structure and procedures for financial reporting and 
(2) assess the effectiveness of its internal control structure and 
procedures for financial reporting. 

* Section 404(b) requires that each public company's accounting firm 
must attest to and report on management's assessment of the 
effectiveness of internal control over financial reporting. 

* A separate provision prohibits the company's auditor from providing 
certain nonaudit services, including bookkeeping, appraisal services, 
actuarial services, and internal audit outsourcing services. 

* Another provision requires the mandatory rotation of lead and 
reviewing audit partners after they have provided audit services to a 
particular public company for 5 consecutive years. 

The Act also established the PCAOB as a private-sector nonprofit 
organization subject to SEC oversight. PCAOB's mission is to oversee 
the audits of public companies in order to protect the interests of 
investors and further the public interest in the preparation of 
informative, fair, and independent audit reports. Table 1 shows other 
provisions affecting the corporate governance, auditing, and financial 
reporting of public companies. 

Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting 
Public Companies and Accounting Firms: 

Provision: Section 101: Public Company Accounting Oversight Board; 
Main requirements: Establishes the PCAOB to oversee the audit of public 
companies that are subject to the securities laws. 

Provision: Section 201: Services Outside the Scope of Practice of 
Auditors; 
Main requirements: Registered accounting firms cannot provide certain 
nonaudit services to a public company if the firm also serves as the 
auditor of the financial statements for the public company. Examples of 
prohibited nonaudit services include bookkeeping, appraisal or 
valuation services, internal audit outsourcing services, and management 
functions. 

Provision: Section 301: Public Company Audit Committees; 
Main requirements: Listed company audit committees are responsible for 
the appointment, compensation, and oversight of the registered 
accounting firm, including the resolution of disagreements between the 
registered accounting firm and company management regarding financial 
reporting. Audit committee members must be independent. 

Provision: Section 302: Corporate Responsibility for Financial Reports; 
Main requirements: For each annual and quarterly report filed with SEC, 
the chief executive officer (CEO) and chief financial officer (CFO) 
must certify that they have reviewed the report and, based on their 
knowledge, the report does not contain untrue statements or omissions 
of a material fact resulting in a misleading report and that, based on 
their knowledge, the financial information in the report is presented 
fairly. 

Provision: Section 404: Management Assessment of Internal Controls; 
Main requirements: This section consists of two parts (a and b). First, 
in each annual report filed with SEC, company management must state its 
responsibility for establishing and maintaining an adequate internal 
control structure and procedures for financial reporting, and assess 
the effectiveness of its internal control structure and procedures for 
financial reporting. Second, the registered accounting firm must attest 
to, and report on, management's assessment of the effectiveness of its 
internal control over financial reporting. 

Provision: Section 407: Disclosure of Audit Committee Financial Expert; 
Main requirements: Public companies must disclose in periodic reports 
to SEC whether the audit committee includes at least one member who is 
a financial expert and, if not, the reasons why. 

Source: GAO. 

[End of table] 

The PCAOB has several responsibilities, including: 

* registering public accounting firms that prepare audit reports for 
public companies; 

* establishing auditing, quality control, ethics, independence, and 
other standards relating to the preparation of audit reports for public 
companies; 

* conducting inspections of registered public accounting firms; and: 

* conducting investigations and disciplinary proceedings of registered 
public accounting firms and those associated with such firms. 

Under the Act, SEC was granted oversight and enforcement authority over 
PCAOB and must approve rules proposed by PCAOB for them to become 
effective.[Footnote 15] 

PCAOB is required to annually inspect registered accounting firms that 
provide audit reports for more than 100 issuers and at least 
triennially inspect firms with fewer issuers.[Footnote 16] It conducted 
its first accounting firm inspections during 2003, but these 
inspections were limited in scope and were performed only on the 
largest firms. Since 2004, PCAOB has conducted full scope inspections 
of accounting firms of all sizes. As required in the Sarbanes-Oxley 
Act, PCAOB has issued individual reports to the accounting firms 
explaining issues identified in the inspections and has also issued 
reports covering common observations from their inspection 
process.[Footnote 17] 

The Sarbanes-Oxley Act also mandated that we study (1) the factors 
contributing to the mergers among the largest accounting firms in the 
1980s and 1990s; (2) the implications of consolidation on competition 
and client choice, audit fees, audit quality, and auditor independence; 
(3) the effect of consolidation on capital formation and securities 
markets; and (4) barriers to entry faced by smaller accounting firms in 
competing with the largest firms for large public company audits. In 
2003, we issued our report Public Accounting Firms: Mandated Study on 
Consolidation and Competition (GAO-03-864). We concluded in 2003 that 
the audit market was in the midst of unprecedented change. The market 
had become more highly concentrated, and the largest firms, as well as 
other accounting firms, faced tremendous challenges as they adapted to 
new risks and responsibilities, new independence standards, a new 
business model, and a new oversight structure, among other things. In 
many cases it was unclear what the ultimate outcome of the changes 
would be, and we noted that past findings might not reflect the future 
situation. We also identified several important issues that we believed 
warranted additional attention and study by the appropriate regulatory 
or enforcement agencies, such as the effect of the existing level of 
concentration on audit price and quality. 

Significant Audit and Accounting Standards and Rules Changes Since 
2003: 

Since 2003, significant activity related to management reporting and 
auditing standards has continued to occur. In 2002, 2003, and 2004, SEC 
issued rules and guidance on implementing some of the Sarbanes-Oxley 
Act's provisions. Among these was the requirement that a public 
company's chief executive officer and chief financial officer certify 
in quarterly and annual reports issued after August 29, 2002, that 
their company's financial statements fairly present in material 
respects the company's financial condition (Section 302).[Footnote 18] 
In June 2003, SEC issued final rules to implement Section 404 of the 
Sarbanes-Oxley Act.[Footnote 19] Section 404(a) requires company 
management, in each annual report filed with SEC, to state their 
responsibility for establishing and maintaining an adequate internal 
control structure and procedures for financial reporting and to assess 
the effectiveness of its internal control structure and procedures for 
financial reporting. Section 404(b), which requires the registered 
accounting firm to attest to and report on management's assessment of 
the effectiveness of its internal control over financial reporting was 
implemented later. Public companies whose outstanding stock held by the 
public was valued at $75 million or more--known as accelerated filers-
-were first required to comply with Section 404(a) and (b) for fiscal 
years ending on or after November 15, 2004.[Footnote 20] Public 
companies with stock in public hands valued at less than $75 million-- 
called nonaccelerated filers--were granted several extensions but are 
now expected to comply with these Section 404 requirements over the 
next 2 years--for Section 404(a) in fiscal years ending after December 
15, 2007, and for Section 404(b) in the first annual filing after 
December 15, 2008. 

PCAOB issued its first audit standard on December 17, 2003, which the 
SEC approved on May 14, 2004, and, as of August 2007, has issued a 
total of five audit standards. On July 25, 2007, SEC approved Auditing 
Standard No. 5, An Audit of Internal Control Over Financial Reporting 
That is Integrated with an Audit of Financial Statements, to replace 
Auditing Standard No. 2, An Audit of Internal Control Over Financial 
Reporting Performed in Conjunction with an Audit of Financial 
Statements. According to PCAOB, Auditing Standard No. 2 was more costly 
than expected, and the related effort involved in complying with it 
appeared to be more than was necessary to conduct an effective audit of 
internal controls over financial reporting. Specifically, PCAOB noted 
that auditors were focusing on minutiae that were unlikely to affect 
the financial statements and that audit programs were not tailored to 
small companies. Auditing Standard No. 5, which is expected to address 
some of the cost issues, became effective for audits in fiscal years 
ending on or after November 15, 2007. 

Other accounting and financial reporting standards and requirements 
have been implemented in recent years. Between January 2003 and August 
2007, the Financial Accounting Standards Board (FASB), which issues the 
accounting standards that SEC recognizes as GAAP for public companies, 
issued 11 statements (Nos. 149 through 159) and revised statement 
number 123. These statements cover a range of topics including 
financial instruments, fair value, and pensions. In addition, other 
guidance has been issued by the FASB emerging issues task force (EITF), 
SEC, and other groups. For instance, FASB issued EITF Issue No. 06-6, 
"Debtor's Accounting for a Modification (or Exchange) of Convertible 
Debt Instruments" in November 2006. SEC issued Staff Accounting 
Bulletin Number 108 on September 13, 2006, summarizing the views of the 
staff regarding the process of quantifying financial statement 
misstatements. 

These recent changes to accounting and financial reporting standards 
and guidance add to an already highly complex set of standards and 
rules for public company financial reporting. Currently GAAP consists 
of more than 2,000 separate pronouncements issued in various forms by 
numerous bodies including SEC, FASB, American Institute of Certified 
Public Accountants (AICPA), and others. SEC Chairman Cox has stated 
that "our current system of financial reporting has become 
unnecessarily complex for investors, companies, and the markets 
generally."[Footnote 21] In June 2007, SEC established the SEC Advisory 
Committee on Improvements to Financial Reporting to study the causes of 
complexity and recommend ways to make financial reports clearer and 
more beneficial to investors, reduce costs and unnecessary burdens for 
preparers, and better use advances in technology to enhance all aspects 
of financial reporting. 

With Continued Audit Market Concentration, Large Public Companies See 
Limited Choices, but No Apparent Significant Effect on Fees: 

Despite some reduction since 2002, the overall public company audit 
market has remained highly concentrated. For large public companies, 
the market remains highly concentrated, with the four largest 
accounting firms auditing the financial statements of almost all large 
public companies. However, the audit market for smaller public 
companies has become much less concentrated since 2002. Larger public 
companies indicated that the industry expertise and technical 
capability that they sought in an auditor generally meant that their 
choices were limited to the largest accounting firms in this highly 
concentrated market. Those we spoke to and surveyed had mixed views on 
the extent to which the current level of concentration adversely 
affected choice, audit prices, and audit quality, but most participants 
did not see the current level of concentration as significantly 
affecting these aspects of competition. Although audit fees have 
increased and public companies' opinions of the adequacy of competition 
in the audit market varied, other factors appear to explain the recent 
fee increases. While the current level of concentration does not appear 
to be having significant adverse effect, the loss of another of the 
larger firms would further increase concentration and limit company 
choices and may affect price competition. Regulators overseeing the 
functioning of the audit market could take several actions in response 
to another large audit firm's leaving the market. 

Overall Market for Public Company Audits Remains Highly Concentrated: 

To assess the degree of concentration in a market, we used the 
preferred practice of examining the proportion of each competing 
seller's--in this case accounting firms--share of the overall revenue 
collected. In the case of accounting firms, the revenue measured is the 
total amount of fees these firms collected. Using data from Audit 
Analytics, which collects audit fee information from the filings public 
companies submit to SEC, we found that the largest firms collected 94 
percent of all audit fees paid by public companies in 2006, slightly 
less than the 96 percent they collected in 2002. As a result, the 
overall market continues to represent a tight oligopoly, which is a 
concentrated market in which a small number of firms have large enough 
market share to potentially use their market power, either unilaterally 
or through collusion, to greatly influence price and other business 
practices to their advantage.[Footnote 22] 

A key statistical measure used to assess market concentration and the 
potential for firms to exercise market power is the Hirschman- 
Herfindahl Index (HHI).[Footnote 23] The HHI for a market is calculated 
using the various market shares (in the case of the audit market, 
measured by total audit fees collected) of all the firms competing to 
offer services within that market. In 2006, the HHI for the overall 
market for public company audits was 2,300. According to guidelines 
issued jointly by the Department of Justice (DOJ) and the Federal Trade 
Commission (FTC), an HHI above 1,800 indicates a highly concentrated 
market. Analyzing the audit market by industry and region reveals that 
many industries have similarly highly concentrated audit markets. For 
example, in 2006 the HHI of the audit market in the utilities sector 
was over 3,500. The audit market was also similarly concentrated for 
companies across six major geographic regions of the country.[Footnote 
24] (App. II contains further discussion of overall market 
concentration.) 

In addition to the potential for dominant competitors to use their 
market power to charge uncompetitive prices, highly concentrated 
markets also raise other competitive concerns. For example, firms with 
significant market power have the potential to reduce the quality of 
their products or to cut back on the services they provide because the 
lack of competitive alternatives would limit customers' ability to 
obtain services elsewhere. Similarly, firms that dominate a given 
market may feel less pressure to introduce innovative products and 
services. Finally, a highly concentrated market increases the potential 
for the dominant firms to engage in coordinated actions that can harm 
clients, such as coordinating actions to influence the development of 
standards that raise costs for their customers. However, the presence 
of high market shares does not necessarily mean that anticompetitive 
behavior is occurring. Competition in an oligopoly can also be intense 
and result in a market with competitive prices, innovation, and high- 
quality products. 

Markets with a few large dominant firms can form for natural reasons 
and can also be beneficial. As we reported in 2003, several key factors 
spurred the increased consolidation in the market that resulted from 
the mergers of the eight largest accounting firms in the 1980s and 
1990s.[Footnote 25] For example, as U.S. corporations have increasingly 
expanded into global markets, their need for accounting firms with 
greater global reach also increased. Many public companies have 
developed more complex operations and financial transactions, such as 
the increasing use of derivatives and other financial arrangements, and 
these changes increased the need for auditors with specialized industry-
specific or technical expertise. 

Further, some accounting firms wanted to modernize their operations, 
build their staff capacity, and spread their risk over a broader 
capital base, and large firms can achieve greater economies of scale by 
spreading certain fixed costs, such as staff training, over an expanded 
client base. Therefore, the size of the largest firms may enable them 
to develop sufficient technical expertise and the ability to conduct 
work globally to meet the needs of complex multinational audit clients 
and to do so at a lower cost than could be provided by smaller audit 
firms. Some academic sources have also suggested that the size of the 
largest firms may give them the ability to resist potential pressure 
from large public company clients to reduce or compromise audit 
quality. 

Although Smaller Public Company Market Has Become Less Concentrated, 
Concentration in the Market for Large Companies Persists: 

Although the market is concentrated overall, the degree of market 
concentration, and, thus, the extent to which the largest firms 
dominate, declines with the size of public companies. As shown in 
figure 2, the proportion of large public companies audited by one of 
the largest accounting firms has not changed since 2002. However, the 
proportion of the smallest public companies that used the largest 
auditors fell by half from 2002 to 2006. Specifically, the share of 
public companies with less than $100 million in revenue audited by the 
largest firms decreased from 44 percent to 22 percent over this period. 
As figure 2 shows, smaller accounting firms now serve as auditors for 
many of the companies that had previously used the largest firms. The 
share of companies with revenues between $100 and $500 million that the 
largest firms audited also declined during this period from 90 to 71 
percent. Officials from the largest accounting firms and other market 
participants told us resource constraints in the aftermath of the 
Arthur Andersen collapse and the Sarbanes-Oxley Act led the largest 
firms to resign from auditing some smaller companies or raised their 
audit fees higher than some smaller companies were willing to pay. 

Figure 2: Public Companies and Their Auditors, 2002 and 2006: 

This figure is a bar graph showing public companies and their auditors, 
2002 and 2006. The X axis represents the year, and the Y axis 
represents the percentage. 

2002; 
Smaller firms: 45%; 
Midsize firms: 10%; 
Largest firms: 44%; 
Total companies: 3,617; 
Company revenue: <$100 million. 

2006; 
Smaller firms: 69%; 
Midsize firms: 10%; 
Largest firms: 22%; 
Total companies: 3,643; 
Company revenue: <$100 million. 

2002; 
Smaller firms: 5%; 
Midsize firms: 6%; 
Largest firms: 90%; 
Total companies: 1,329; 
Company revenue: $100 million-$500 million. 

2006; 
Smaller firms: 13%; 
Midsize firms: 16%; 
Largest firms: 71%; 
Total companies: 1,272; 
Company revenue: $100 million-$500 million. 

2002; 
Smaller firms: 3%; 
Midsize firms: 2%; 
Largest firms: 95%; 
Total companies: 522; 
Company revenue: $500 million-$1 billion. 

2006; 
Smaller firms: 2%; 
Midsize firms: 6%; 
Largest firms: 92%; 
Total companies: 522; 
Company revenues: $500 million-$1 billion. 

2002; 
Smaller firms: 1%; 
Midsize firms: 1%; 
Largest firms: 98%; 
Total companies: 1,241; 
Company revenue: >$1 billion. 

2006; 
Smaller firms: 0%; 
Midsize firms: 2%; 
Largest firms: 98%; 
Total companies: 1,544; 
Company revenue: >$1 billion. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

Note: Totals do not always add to 100 percent due to rounding. 

[End of figure] 

As the share of smaller companies audited by the largest firms has 
declined, concentration in the audit market for these companies has 
eased significantly. By grouping public companies by their revenues and 
calculating HHIs for these groupings, we found that while the audit 
market for larger public companies with revenues greater than $500 
million remained highly concentrated, the market for smaller public 
companies with 500 million in revenue or less had become much less 
concentrated.[Footnote 26] As figure 3 shows, between 2002 and 2006 the 
HHI for the audit market for the smallest public companies--those with 
annual revenues of less than $100 million--declined from a level of 
1,400 to about 800. According to DOJ and FTC guidelines, a market with 
an HHI of less than 1000 is considered to be unconcentrated, and no 
competitor would likely have the ability to exert market power. The 
audit market for public companies with revenues between $100 million 
and $500 million also became less concentrated. The HHI for this market 
fell from a 2002 level indicating high concentration to a 2006 level 
indicating only moderate concentration. 

Figure 3: Hirschman-Herfindahl Indexes for Public Company Market 
Segments Grouped by Company Revenues: 

This figure is a bar graph showing Hirschman-Herfindahl indexes for 
public company market segments grouped by company revenues. The X axis 
represents company size by revenue, and the Y axis represents HHI. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

[End of figure] 

In Concentrated Market, Some Companies Perceive Limited Auditor Choice: 

Many of the largest public companies--those in the Fortune 1000--told 
us that they generally found the audit firm attributes they sought only 
in the largest accounting firms, and as a result, many of these 
companies saw their number of auditor choices as insufficient. Midsize 
and small companies were generally more likely than large companies to 
report that they had more than three choices. 

Large Public Companies and Auditor Choices: 

In the current concentrated market, large companies perceived their 
choices as limited, in part because these companies generally said, if 
they had to choose a new auditor, they were not likely to use 
accounting firms smaller than the largest firms.[Footnote 27] Our 
survey of the audit committee chairs of almost 600 public companies 
based in the United States showed that 86 percent of large public 
companies in the Fortune 1000 were not likely to use a midsize 
accounting firm and that none were likely to use a smaller accounting 
firm as a new auditor of record.[Footnote 28] In explaining their 
position, these companies most frequently cited the auditor's ability 
to handle the size and complexity of their company's operations as 
being of great or very great importance (92 percent). In addition, 80 
percent cited the auditor's technical capability with accounting 
principles and auditing standards and 67 percent cited the need for 
industry specialization or expertise as of great or very great 
importance as reasons why they would not consider a midsize or smaller 
auditor. Similarly, in interviews and comments on our survey, some 
company officials noted that they chose the largest firms because they 
believed that these firms had the attributes the company needed, while 
midsize and smaller firms did not. For example, the audit committee 
chair of one large company commented that the company would not choose 
a midsize or smaller auditor because the company's industry was very 
complex, and, therefore, the company needed an auditor with specific 
industry experience. The chief financial officer (CFO) of another large 
public company noted that because of the company's size and 
international operations, the largest firms were the only viable 
options. 

The need to comply with independence standards and other factors can 
further limit the number of choices available to large public companies 
for their auditor of record. As required under the Sarbanes-Oxley Act, 
SEC rules, and auditing standards, a company's auditor must be 
independent. Public companies are prohibited from obtaining audits from 
firms that also provide the company with certain nonaudit services, 
including bookkeeping, design and implementation of financial 
information systems, valuation services, and internal audit outsourcing 
services.[Footnote 29] Ninety-six percent of large companies reported 
that they used one of the largest firms for some nonaudit services, 
potentially further reducing the number of choices for their auditor of 
record if they are precluded from using those firms due to independence 
rules. According to our survey data, 27 percent of large public 
companies that had not switched auditors since 2003 reported that the 
independence restrictions on using certain firms were of at least some 
importance in deciding to retain their current auditor, although only 9 
percent listed these restrictions as of great or very great 
importance.[Footnote 30] 

In interviews, officials from a few large public companies indicated 
that they maintained options while remaining in compliance with 
independence requirements by not using at least one of the largest 
firms for prohibited nonaudit services, in some cases by using smaller 
firms for these services. In this way, they hoped to ensure that they 
would have at least one independent firm to choose if they had to 
change auditors. Some interviewees we spoke with suggested that 
companies using only the largest firms for both audit and nonaudit 
services could be unnecessarily limiting their choices because many 
midsize and smaller firms were capable of handling certain nonaudit 
services. 

A few companies may feel constrained in their choice of auditors for 
other reasons. For example, some companies' desire to avoid using a 
competitor's auditor can reduce the number of choices they have, 
according to several industry participants. However, over 90 percent of 
the large companies that responded to our 2003 survey were willing to 
choose a firm as their auditor regardless of whether that firm also 
audited a competitor.[Footnote 31] Further, some market participants 
and regulators noted that in certain industries, large public companies 
may have more limited choices because one or more of the largest firms 
was not very active in those industries. For example, in 2006 one of 
the largest firms held 77 percent of the market for public company 
audits in the agriculture, forestry, fishing, and hunting industry, 
while another of the largest firms had only a 1 percent market 
share.[Footnote 32] 

Consistent with reporting that they were not likely to use midsize and 
smaller audit firms, large companies also indicated that they had a 
limited number of firms to choose from, and many believed that this 
number was generally insufficient. According to our survey, about 80 
percent of large public companies said that they would have three or 
fewer accounting firms (other than their current auditor of record) to 
choose from if they needed to change primary auditors. The proportion 
of large companies that reported having three or fewer choices was 
about the same for both domestic and multinational companies. 
Furthermore, over half (57 percent) of large public companies stated 
that the number of accounting firms that they could choose among was 
not adequate.[Footnote 33] Forty-three percent of large public 
companies that responded to the survey we conducted for our 2003 report 
indicated that they had insufficient choices for an auditor of record. 

Large public companies' preference for the largest audit firms was 
illustrated by the firms these companies choose when they changed 
auditors. Although some public companies maintain their relationships 
with the same audit firm for many years, there were almost 6,000 
changes in auditors between 2003 and 2007. We analyzed data from Audit 
Analytics and found that 102 large companies had changed auditors 
between January 1, 2003, and June 30, 2007.[Footnote 34] Of the 95 
large companies that were previously audited by one of the largest 
firms, 88 (93 percent) of these companies changed from one of the 
largest auditors to another of the largest auditors. Only seven 
switched to a midsize auditor. The remaining seven large companies that 
changed auditors during this period had been previously audited by a 
midsize or smaller auditor, but switched to one of the largest firms. 
(App. III shows more analysis of the data on auditor changes and the 
reasons these companies reported for changing auditors.) 

Midsize and Small Public Companies and Auditor Choices: 

Although many midsize public companies reported that their choice of 
auditors was limited, smaller companies generally reported having more 
choices than larger companies, if they had to change auditors. For 
example, among midsize companies, 59 percent of multinational and 52 
percent of domestic companies reported that their choices were limited 
to three or fewer firms (fig. 4). In contrast, only about one-third (34 
percent) of small companies indicated that they were restricted to 
three or fewer accounting firms and over 40 percent said that they had 
six or more choices. 

Figure 4: Percentage of Midsize and Small Companies That Reported 
Having Three or Fewer Choices for Auditor: 

This figure is a bar graph showing percentage of midsize and small 
companies that reported having three or fewer choices for auditor. The 
X axis represents percentage, and the Y axis represents midsize 
companies. 

[See PDF for image] 

Source: GAO. 

Note: The estimate for small multinational companies is subject to a 
sampling error of +/-16 percentage points. 

[End of figure] 

Based on our survey, midsize and small public companies were more 
likely than large companies to consider using midsize or smaller 
accounting firms if they had to choose a new auditor. About half (51 
percent) of midsize companies would consider using midsize firms and 16 
percent would consider using smaller firms. Further, 74 percent of 
small public companies would consider using smaller firms. 

In addition, compared with large companies, more midsize and small 
companies were satisfied with the number of choices they had for 
possible auditors. As shown in figure 5, about half of midsize and less 
than a fifth of small companies reported that the number of choices 
they had was not enough. 

Figure 5: Percentage of Small and Midsize Companies Reporting They Did 
Not Have Enough Choices for Auditor: 

This figure represents percentage of small and midsize companies 
reporting they did not have enough choices for auditor. The X axis 
represents percentage, and the Y axis represents midsize companies. 

[See PDF for image] 

Source: GAO. 

Note: The estimate for small multinational companies is subject to a 
sampling error of +/-14 percentage points. 

[End of figure] 

However, about 60 percent of midsize multinational companies reported 
that they would have three or fewer choices if they had to change 
auditors and about half said the number of choices was not enough. 

Our analysis also showed that many midsize and small public companies 
have moved to midsize or smaller auditors. Since 2003, over 1,400 
midsize and small companies that had been audited by one of the largest 
firms have changed auditors. Of these, almost 1,100 (about 74 percent) 
engaged midsize or smaller firms as their new auditors and about 360 
(about 25 percent) chose another one of the largest auditors (fig. 6). 
In contrast, only 13 percent of midsize and small companies that left 
midsize auditors and 3 percent of midsize and small companies that left 
smaller auditors subsequently engaged one of the largest firms. 

Figure 6: Changes in Auditors among Small and Midsize Public Companies: 

This figure is a combination bar chart showing changes in auditors 
among small and midsize public companies. 

Midsize and small companies; 
Former auditor by size: Largest: Moved to largest firms: 25%; 
Former auditor by size: Largest: Moved to midsize firms: 34%; 
Former auditor by size: Largest: Moved to smaller firms: 40%; 
Total number of changes: 1,434. 

Midsize and small companies; 
Former auditor by size: Midsize: Moved to largest firms: 13%; 
Former auditor by size: Midsize: Moved to midsize firms: 13%; 
Former auditor by size: Midsize: Moved to smaller firms: 74%; 
Total number of changes: 341. 

Midsize and small companies; 
Former auditor by size: Smaller: Moved to largest firms: 3%; 
Former auditor by size: Smaller: Moved to midsize firms: 4%; 
Former auditor by size: Smaller: Moved to smaller firms: 93%; 
Total number of changes: 2,373. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

[End of figure] 

Although Opinions on the Impact of Concentration in the Large Public 
Company Market Varied, Other Factors Appeared to Account for Recent Fee 
Increases: 

Opinions varied on the effect of concentration on competition and on 
the sufficiency of competition in the market for public company audits. 
Many of the market participants we interviewed felt that competition 
was quite strong and not significantly affected by concentration. For 
example, representatives of the largest firms told us that they 
competed intensely with each other. Some of the public company 
officials we spoke with also saw the audit market as competitive. For 
example, the audit committee chair of one large public company said 
that although a major competitor was lost when Arthur Andersen 
dissolved, the market had adjusted and was still competitive. However, 
several companies we surveyed commented that, with few firms to choose 
from, the market did not have enough competition. For example, the CFO 
of a midsize company said that consolidation in the market had led to a 
decline of value-added services by auditors and an escalation of audit 
pricing. Another company official that responded to our survey stated 
that the audit market was an oligopoly with little price competition 
and too little concern for service. The CFO for another company 
commented on our survey that something needed to be done to force more 
competition, while a different CFO commented that although more 
competition was desirable, action to break up the largest firms was not 
warranted. 

Based on the results of our survey, 57 percent of public companies 
thought that the level of competition for audit services for their 
company was sufficient. However, while about 70 percent of small 
companies saw the level of competition as adequate, only about 40 
percent of large Fortune 1000 companies shared this view (fig. 7). 
About half of midsize companies saw the level of competition as 
adequate. 

Figure 7: Percentage of Public Companies Indicating That the Level of 
Audit Market Competition Was Sufficient: 

This figure is a bar graph showing percentage of public companies 
indicating that the level of audit market competition was sufficient. 
The X axis represents percentage, and the Y axis represents companies. 

[See PDF for image] 

Note: Of the 6,906 companies in our survey population, 12.6 percent 
were large, 46.5 percent were midsize, and 40.9 percent were small. 

[End of figure] 

Factors Increasing Audit Fees: 

Although highly concentrated markets typically raise concerns about 
price competition, our analysis indicated that other factors appeared 
to explain the increases in audit fees in recent years. Data on audit 
fees paid by public companies show that these fees have increased 
substantially since 2000, a period that included the dissolution of 
Arthur Andersen and the passage of the Sarbanes-Oxley Act. Audit fees 
have risen for companies of all sizes and across industries and 
regions. However, the fee increases, as a percentage of client company 
assets, were most dramatic for smaller companies. Between 2000 and 
2006, median fees as a percent of assets more than quadrupled (a 334 
percent increase) for companies with less than $100 million in revenue, 
more than tripled (a 239 percent increase) for companies with revenue 
between $100 million and $1 billion, and almost tripled (a 190 percent 
increase) for companies with revenue over $1 billion. After these 
increases, median fees were about $111,000 for companies with less than 
$100 million in revenue, $900,000 for companies with revenue between 
$100 million and $1 billion, and $3,156,000 for companies with revenue 
greater than $1 billion. Although audit fees increased significantly on 
average for all sizes of firms, the amount that companies spend on 
audit fees generally remains a small portion of their overall revenues. 

Market participants and others cited various factors that had 
contributed to recent fee increases. The most significant factors that 
staff from the largest firms cited in interviews were the increasing 
complexity of accounting and financial reporting standards and the 
additional requirements of new auditing standards that had increased 
the amount of work involved in audits and the need for technical 
expertise. For example, one of the largest firms noted that the number 
of experts on staff at the firm more than doubled between 2003 and 
2007. Many market participants noted similar factors as impacting fees. 
The largest firms also cited the increased costs of attracting and 
retaining talented staff and specialists. Similarly, midsize and 
smaller firms reported on our survey that the top four factors 
increasing their costs since 2003 were complexity of accounting 
principles and auditing standards, additional requirements of new 
standards, the time and effort necessary to prepare for PCAOB 
inspections, and the costs incurred to hire and train staff. 

In particular, the Sarbanes-Oxley Act, which increased the amount of 
audit work performed at public companies, was frequently cited as one 
of the major factors in the recent fee increases. This legislation 
introduced a number of new requirements for audits of public companies, 
and many market participants told us that the new requirements 
accounted for much of the fee increases since 2002. Representatives 
from some audit firms we spoke to said that section 404 of the act had, 
where implemented, substantially increased their workload and costs for 
implementing new methodologies and staff training. (Section 404 
requires the accounting firm to attest to, and report on, management's 
assessment of the effectiveness of its internal control over financial 
reporting.) In addition, 84 percent of companies reporting that their 
audit fees had increased since 2003 indicated on our survey that the 
audit of internal control over financial reporting was one of the 
reasons for the increase. To date, only larger public companies--which 
SEC calls accelerated filers--have had to comply with the new 
requirements for assessing these internal controls. Smaller public 
companies--those considered nonaccelerated filers--are scheduled to 
fully comply with the new audit requirements in annual filings after 
December 15, 2008, potentially resulting in further increases in these 
companies' audit fees. 

Independence requirements may also have changed the way some firms 
price audits, resulting in rising fees. DOJ officials and others stated 
that audit firms were now less likely to price audits as a loss leader 
in order to sell nonaudit services because of these requirements in the 
Sarbanes-Oxley Act. 

Effects of Concentration on Fee Increases: 

The results of an econometric model we developed to assess the extent 
to which various factors could be influencing audit fees in recent 
years also indicated that factors other than concentration appear to 
explain audit fees.[Footnote 35] Our model analyzes the extent to which 
audit fees paid by public companies appear to be explained by a variety 
of factors that could affect those fees. For example, our model 
included such variables as the concentration within the audit market 
for a particular industry (as measured by HHI), the size of the 
company, whether the company's fiscal year ends during a busy period, 
whether the company completed a Sarbanes-Oxley Section 404 internal 
control audit, the number of times the company changed auditors, and 
other factors that could affect the company's audit fees. Appendix V 
explains our model in detail. 

The results of our model suggested that higher audit market 
concentration across individual industries was not associated with 
higher audit fees. Specifically, our model found that, in general, 
public companies operating in industrial sectors with more concentrated 
audit markets were not paying higher audit fees than companies in 
sectors with less concentrated audit markets. However, for the largest 
companies we found some evidence that audit market concentration within 
an industry did have a very small effect on fees.[Footnote 36] More 
precisely, after isolating the effect of other factors, our model 
results indicated that large companies in industries with audit markets 
that were 10 percent more concentrated than the average industry sector 
(as measured by HHI) paid on average about half a percent more in audit 
fees than other large companies. By comparison, the model results also 
indicated, after controlling for other factors, that companies that 
completed the Sarbanes-Oxley section 404 internal control audit, which 
increased the amount of work done by auditors, paid roughly 45 percent 
more in audit fees than companies that did not complete the internal 
control audit. This finding was consistent with estimates from other 
studies that examined the effect of the implementation of this 
requirement. Although factors other than concentration appeared to 
explain audit fee levels, the available data did not allow us to 
conclude that audit fees were competitive overall or to determine 
whether individual companies were charged competitive fees.[Footnote 
37] 

In addition, the analysis we conducted with our model indicated that 
individual accounting firms appeared to charge higher fees when they 
controlled a large portion of the audit market within a particular 
industry, but this finding did not appear to be the result of 
anticompetitive pricing. Rather, it appeared that these firms may have 
been charging a premium for their industry expertise. We found that the 
price premiums received by accounting firms that collected a large 
share of the revenues from audits conducted within an industry sector 
were similar across all sizes of companies, including those small 
companies that typically have many accounting firms to choose from. 
This suggests that higher fees are more likely the result of these 
firms being able to charge premiums as the result of their industry 
expertise rather than of anticompetitive pricing.[Footnote 38] For 
example, a firm with industry expertise may develop and market audit 
services that are specific to clients in the industry and that provide 
a level of service exceeding that provided by other firms in the same 
industry. If this is the case, the higher fees these firms may charge 
could reflect the specialized service they offer rather than 
anticompetitive pricing. 

Other Potential Effects of Concentration: 

While some market participants expressed concern that concentration in 
the audit market could negatively affect audit quality, others said 
that the quality of audits had improved in recent years. According to 
DOJ and FTC guidance on analyzing market competitiveness, sellers with 
market power may lessen competition on dimensions other than price, 
such as product quality, service, or innovation. However, even in 
highly concentrated markets, including oligopolies, competition among 
sellers may lead to innovation and high-quality products. The effect of 
concentration on audit quality is difficult to measure empirically. 
However, we asked market participants about their views on several 
aspects of audit quality, including the experience and technical 
capability of their accounting firm's partners and staff, the firm's 
ability to efficiently respond to client needs, and its ability and 
willingness to appropriately identify and surface material reporting 
issues in financial reports. Most market participants who commented on 
audit quality in our interviews and many on our survey said that audit 
quality had improved, which some attributed to the Sarbanes-Oxley 
Act.[Footnote 39] However, four others, including some academics, a 
former regulatory official, and an industry consultant with whom we 
spoke, expressed concerns that concentration was affecting the quality 
of audits. For example, one said that that having only four firms in 
the market resulted in low-quality audits that harmed investors. 
Appendix IV provides more information on trends in audit costs and 
quality. 

High concentration may also diminish competition because dominant 
sellers, in this case accounting firms, may be more likely or more able 
to engage in coordinated interaction in ways that can affect auditing 
practices or prices. Some market participants we interviewed expressed 
concern that the prevalence of the largest firms on advisory panels or 
standard-setting bodies enabled them to coordinate actions to influence 
the development of new standards in a way that hampered competition or 
otherwise disadvantaged public company audit clients. However, most 
market participants we spoke to did not express such concerns. 

Further Concentration Could Adversely Affect Audit Fees and Limit 
Choices: 

Although the current level of concentration does not appear to be 
having significant adverse effect, the potential for further 
concentration in the audit market did raise concerns. Further 
concentration could arise as a result of several events. For example, 
audit firms face the risk that civil litigation could result in their 
insolvency or inability to continue operations. Since 1998, audit firms 
may have paid at least ten settlements or awards of $100 million or 
more that have resulted from private litigation.[Footnote 40] In 
addition, a jury recently found BDO Seidman, the sixth-largest 
accounting firm, liable for $521.7 million in damages, although BDO 
Seidman plans to appeal the verdict. Several officials we spoke with 
commented that litigation increases during periods of high market 
volatility. As a result, litigation-related costs to auditors could 
increase in the case of an economic downturn. Officials from the 
largest firms told us that litigation costs have significantly 
increased since 2003. Some officials we interviewed from the largest 
firms and the insurance industry told us that the largest firms do not 
have insurance coverage to protect against the largest claims, both 
because insurance at that level is not available and because of fear 
that having more insurance could induce plaintiffs to seek higher 
awards. However, full information on litigation risk and costs and 
accounting firms' insurance coverage is not publicly available, so we 
could not identify the magnitude of the risk that litigation poses to 
these firms. Some officials we spoke with also suggested that 
litigation could damage a firm's reputation, causing the firm to fail 
if its clients began seeking other firms for their audits. For example, 
according to some academics, Laventhol & Horwath, the seventh-largest 
accounting firm in 1990, declared bankruptcy that year in part due to a 
series of class action lawsuits that resulted in a loss of reputation 
and the firm's inability to attract new work.[Footnote 41] 

Firms also face the risk of failure from federal or state regulatory 
action and criminal prosecution, among other reasons. State Boards of 
Accountancy can revoke accounting firms' licenses to practice in their 
state for violating board rules or for other reasons. Under SEC rules, 
convicted felons shall be suspended from practicing before the SEC, so 
an accounting firm convicted of a felony could not continue to audit 
its SEC-registered clients and would likely fail. Further, an 
indictment for a felony could contribute to a firm's failure if clients 
began leaving in anticipation of a potential conviction. For example, 
many of Arthur Andersen's clients had changed to a different auditor 
even before Arthur Andersen was convicted of obstruction of justice for 
destroying Enron-related documents in 2002. The market for public 
company audits could also become significantly more concentrated if any 
of the existing largest or midsize firms chose to discontinue 
operations for other reasons. Mismanagement of a firm's financial 
obligations could also lead to its bankruptcy. 

As has happened in the past, a merger could also lead to further 
concentration in the market. DOJ and the Federal Trade Commission 
published Horizontal Merger Guidelines for use in determining whether a 
merger is likely substantially to lessen competition. The guidelines 
include steps for assessing whether the merger would significantly 
increase concentration, the potential for any of the firms to exercise 
market power after the merger, and the difficulty of entry into the 
market for new firms. Concerns that DOJ raised about a proposed merger 
of accounting firms in the late 1990s suggest that the agency would be 
less likely to approve any future mergers among the largest accounting 
firms. In 1997, shortly after two of the six largest firms at the time, 
PriceWaterhouse and Coopers & Lybrand, announced their intention to 
merge, two of the other six largest firms, KPMG Peat Marwick and Ernst 
& Young, also announced plans to combine their operations. According to 
the DOJ Antitrust Division's 1999 Annual Report, these two firms 
abandoned their plans to merge after DOJ raised concerns that this 
merger would have "adversely affected competition by reducing the 
already limited number of firms providing auditing services to Fortune 
1000 companies."[Footnote 42] 

The loss of another large accounting firm from the audit market could 
significantly increase the level of concentration. If one of the 
largest firms failed or left the market, concentration would increase 
if many of this firm's public company clients engaged one of the 
remaining three largest audit firms. To illustrate the effect of such 
an event, we simulated the effect of the failure or exit of the 
smallest of the largest firms. To redistribute the clients of this 
firm, we assigned them to other firms in the same proportion as the 
clients of Arthur Andersen were distributed after that firm 
dissolved.[Footnote 43] Under this scenario, the resulting HHI of the 
overall audit market would rise from 2,300 to roughly 3,000, 
substantially above what DOJ considers to be a highly concentrated 
market. The increase in HHI would likely be even greater in the large 
public company market. Higher concentration could increase the risk 
that the remaining large accounting firms would exercise market power 
to raise prices and coordinate their actions among themselves to the 
detriment of their clients. Appendix II contains more information on 
our simulations of the result of the loss of one of the largest firms 
through a failure or a merger. 

Further concentration could have various other negative effects on 
public companies and their investors. While many public companies and 
other market participants indicated that there were enough auditors to 
choose from, further concentration would leave large companies with 
potentially only one or two choices for a new auditor, as our survey 
indicated that 86 percent of large companies would likely only use one 
of the largest auditors if they had to switch auditors. Many 
interviewees said that this would not be enough choices. As in the 
current market, independence rules that prevent companies from using as 
their auditor firms that provide them with certain nonaudit services 
could further limit these choices. Also, companies in specialized 
industries could have fewer choices if some accounting firms do not 
operate in those industries. Many we interviewed also suggested that 
further concentration would reduce competition and potentially increase 
the cost of an audit. 

Further, public company officials stated that changing auditors could 
be costly for the companies involved. According to our survey results, 
44 percent of large companies that had not recently changed auditors 
reported that the burdens of time, effort, and cost were of great or 
very great importance in their decision not to change auditors. In 
addition, only 102 large (Fortune 1000) public company auditor changes 
occurred between January 2003 and June 2007, suggesting that large 
companies preferred to use the same auditor from year to year. If the 
market were further concentrated among three large firms, the affected 
companies would need to change auditors and incur the associated costs. 
Similarly, to the extent the remaining largest firms resigned as 
auditors for smaller clients as they absorbed the failed firm's larger 
clients, these small companies would incur the costs of finding a new 
auditor. Finally, the market disruption caused by a firm failure or 
exit from the market could affect companies' abilities to obtain timely 
audits of their financial statements, reducing the audited financial 
information available to investors. 

Regulators Could Act to Mitigate the Effects of Further Concentration: 

If the number of large accounting firms were to decrease, the 
organizations with oversight responsibility for the public company 
audit market could act to mitigate the effects on the market. The 
organizations that have a role in overseeing aspects of the public 
company audit market include SEC, PCAOB, and DOJ. SEC is responsible 
for protecting investors, maintaining efficient markets, and 
facilitating capital formation and also oversees PCAOB. Similarly, 
PCAOB is responsible for overseeing the auditors of public companies in 
order to protect the interests of investors and further the public 
interest in the preparation of informative, fair, and independent audit 
reports. In the event of the loss of one of the largest firms, the 
agencies' actions could vary according to the facts and circumstances 
of the situation, such as the size of the affected firm, the reason the 
firm left the market, or the degree to which an orderly transition of 
audit services was available. For example, in order to support its 
mission and address temporary market disruptions and difficulties 
companies had in meeting financial reporting deadlines when Arthur 
Andersen was indicted in 2002, SEC issued a number of measures 
providing guidance and regulatory relief to Arthur Andersen's clients. 
This rulemaking provided Arthur Andersen clients with extended 
deadlines to submit audited financial statements and hotline numbers 
for companies and investors to call with questions.[Footnote 44] 
Through the International Organization of Securities Commissions 
(IOSCO), SEC is also working with other securities regulators around 
the world to identify possible actions regulators could consider in 
responding to events affecting the availability of audit services and 
to develop information for regulators to consider in contingency 
planning and crisis management. 

Although it does not have a direct role in addressing the loss of a 
large accounting firm from the market, DOJ would have a role in 
reviewing proposed mergers involving accounting firms. As part of 
ensuring competition in the U.S. economy, the Antitrust Division of DOJ 
is responsible for enforcing antitrust laws. Under DOJ merger 
guidelines, the division would challenge any merger likely to 
substantially lessen competition. DOJ officials explained that action 
on their part would only occur if a merger among current competitors 
was proposed or if an antitrust or criminal case was brought against 
one of the firms. As a result, the division has not been formally 
reviewing trends in the market. When asked whether the Antitrust 
Division might review the competitiveness of the market if one of the 
largest firms exited the market for reasons other than a merger, an 
official stated that the division might analyze the market using 
publicly available information and offer its expertise and advice to 
other regulators. However, the division does not have the authority to 
formally investigate the market or request proprietary information from 
firms or companies in such a situation. 

Midsize and Smaller Firms Face Challenges Auditing Public Companies, 
and Growth in These Firms Is Unlikely to Ease Concentration in the 
Large Public Company Audit Market: 

Growth in the capacity of midsize and smaller audit firms is unlikely 
to reduce concentration in the large company audit market, at least in 
the near term, for two reasons. First, our survey and interviews with 
representatives of these firms suggest that over 70 percent of midsize 
and smaller firms are not interested in expanding their market share by 
adding additional large public company audit clients because they would 
face additional risks and give up existing profitable activities to do 
so. Second, firms that do want to audit large public companies continue 
to face challenges to expanding their public company practices. Chief 
among these challenges are having adequate capacity (e.g., staff and 
geographic coverage) to audit large public companies, acquiring the 
needed technical capability and industry specialization, and developing 
name recognition and a reputation for this kind of work. Similar 
challenges also affect midsize and smaller firms that audit small and 
midsize public companies. Some firms are taking actions to reduce 
certain challenges, such as increasing their geographic reach by 
joining networks and affiliations. But many firms and market 
participants we interviewed also said that the growth of smaller firms 
was unlikely to ease concentration in the market for auditors of large 
public companies. 

Midsize and Smaller Firms Face Several Disincentives and Challenges to 
Entering the Large Public Company Audit Market: 

While most midsize and smaller audit firms expect to grow in the next 
five years, only a small number want to enter or expand their share of 
the large company audit market, in part because they would face 
additional risks and forego currently profitable nonaudit activities to 
do so. According to our survey of the 118 accounting firms with at 
least 5 public company clients, the 4 midsize firms and 79 percent of 
the smaller firms that responded expected to increase the number of 
public companies they audited in the next 5 years.[Footnote 45] 
However, when asked if they would consider expanding their market share 
if they had the opportunity to add acceptable clients, 74 percent of 
both midsize and smaller firms said that they were not interested in 
serving as auditor for additional large public companies.[Footnote 46] 
Some firms and market participants told us that the possibility of 
being sued created a disincentive against entering or expanding in the 
audit market for large companies because the failure of one large 
client could jeopardize the audit firm. Large companies can pose a 
greater financial risk to their auditors than smaller clients. The 
amount shareholders recovered in settlements of class action lawsuits 
against public companies and their auditors tends to increase in 
proportion to the company's market capitalization. Midsize and smaller 
firms also may not be seeking to perform audits of large public 
companies, because they have had new opportunities to provide companies 
of all sizes with nonaudit services, such as consulting, since 2003. 
The Sarbanes-Oxley Act's independence standards prohibit firms from 
providing clients whose financial statements they audit with some of 
the nonaudit services that they were accustomed to providing. As a 
result, many smaller firms have moved into this area. However, 21 
percent of midsize and smaller firms said that they would be willing to 
enter or expand their share of market for auditing large companies, 
given the opportunity and acceptable potential clients, but emphasized 
the challenges they faced in doing so. 

Firm Capacity to Audit Larger Companies: 

According to midsize and smaller firms responding to our survey, their 
capacity to audit large public companies poses the greatest challenge 
to them entering this market and reducing its concentration. According 
to our survey, the firms' capacity is the top reason that large public 
companies give to explain why they would not consider using a midsize 
or smaller firm. Specifically, 92 percent of those companies said that 
the inability of midsize and smaller firms to handle their company's 
size and complexity was of great or very great importance in their 
unwillingness to consider them (fig. 8).[Footnote 47] For example, the 
audit committee chairman of a large technology manufacturing company we 
interviewed said that an auditor smaller than the company's current 
large firm could not audit a business of his company's size. Similarly, 
the audit committee chair for a large automobile manufacturer told us 
that large companies did not consider using midsize firms because those 
firms did not have the number of experienced staff that the firms had. 

Figure 8: Firms' Challenges in Auditing Large Public Companies: 

This figure is a combination of two bar graphs. 

Reasons large public companies are unlikely to use midsize and smaller 
firms; 
Ability to handle size and complexity of company operations: 92%; 
Technical capability with accounting principles and auditing standards: 
80%; 
Industry specialization or expertise: 67%; 
Geographic presence: 66%; 
Reputation or name recognition: 65%; 
Expectations or requirements of share-holders, banks, lenders, or 
underwriters: 54%. 

Reasons midsize and smaller firms interested in auditing large public 
companies cited as impediments to expanding their market share; 
Ability to recruit/retain qualified staff: 58%; 
Complexity of accounting principles and auditing standards: 21%; 
Specialized technical and/or industry expertise: 17%; 
Firm's international reach: 33%; 
Name recognition or reputation with potential clients: 50%; 
Name recognition or credibility with financial markets and investment 
bankers: 54%; 

[See PDF for image] 

Source: GAO. 

[End of figure] 

To meaningfully reduce concentration in the large public company 
market, then, midsize and smaller firms would need to staff audit teams 
that were large enough to serve multiple large public companies. 
However, these firms face challenges recruiting and retaining staff. As 
we reported in 2003, it is not uncommon for an audit of a large 
national or multinational public company to require hundreds of staff, 
and most midsize and smaller firms do not have the staff resources 
necessary to commit hundreds of employees to a single client. As table 
2 illustrates, the largest firms have significantly more capacity, in 
terms of staff and partners than midsize and smaller firms. 

Table 2: Largest, Midsize, and Smaller Accounting Firm Capacity, 2006: 

[See PDF for image] 

Source: Public Accounting Report, 2006-2007. 

[A] Equity partners, including those who do not work on audits. 

[B] Nonequity partners and professionals. 

[C] RSM McGladrey and McGladrey & Pullen are affiliated through an 
alternative practice structure. The number of offices includes those 
for RSM McGladrey, which is a subsidiary of H&R Block and performs tax 
and consulting services and for McGladrey & Pullen, which performs 
audit services. 

[D] Sample of smaller firms that audit at least one public company. 

[End of table] 

To approach the capacity of the largest firms, midsize and smaller 
firms would have to grow substantially. The gap between the largest and 
midsize firms is significant, however. Combined, the four midsize firms 
still have over 2,600 fewer professional staff than the smallest of the 
largest firms, KPMG. The midsize firms also have significantly fewer 
public company clients. But midsize and smaller firms told us that 
obtaining additional staff to expand their audit practices was 
difficult. Specifically, 58 percent of midsize and smaller firms 
responding to our survey that want to audit large public companies said 
that the ability to recruit and retain qualified staff was a great or 
very great impediment to expansion. While the representatives from the 
largest firms told us that they also faced this challenge, one smaller 
firm representative said obtaining sufficient numbers of staff was 
particularly difficult for smaller firms, which have fewer resources 
(salaries and benefits) to use in competing for talent with the largest 
firms, the public companies themselves, and others needing public 
accountants. According to many market participants we interviewed, the 
demand for qualified accountants has increased significantly in recent 
years because accounting firms, including the largest firms, need 
additional staff to conduct the audits of internal controls required in 
section 404 of the Sarbanes-Oxley Act. Firms are not only competing 
with each other for staff, but also with public companies that need 
additional accounting staff to comply with certain requirements of 
Sarbanes-Oxley. In addition, firms are competing with regulators who 
need more staff to oversee the accounting profession. In the face of 
this increased demand, hiring such staff has become more expensive. 

Constraints on midsize and smaller firms' geographic reach also reduced 
the likelihood that the growth of these firms will reduce concentration 
in the large company market. As table 2 shows, midsize and smaller 
firms generally have fewer offices than the largest firms. Accounting 
firm representatives also told us that these firms have a smaller 
presence in foreign countries than the largest firms. According to our 
survey, 66 percent of large companies that would not consider using a 
midsize or smaller firm said that these firms' geographic presence was 
of great or very great importance in explaining their unwillingness to 
do so. Large multinational companies in particular need auditors that 
have a presence in all of the countries in which they operate. While 
many midsize and smaller firms partner with other independent firms to 
expand their geographic reach, a few company officials we interviewed 
said that most of the international networks these firms belong to are 
not extensive enough to meet their companies' needs. In addition, many 
market participants we interviewed were concerned that the quality 
standards, practices, and internal controls of these networks and 
affiliations might be less uniform than those prevailing in the 
international networks of the largest firms. 

Accounting firm representatives we interviewed had mixed views on the 
global capabilities of midsize and smaller firms. In spite of 
companies' views on the importance of firms' abilities to provide 
global services, only one-third of midsize and smaller firms responding 
to our survey that want to audit large public companies said that their 
firms' international reach was a great or very great impediment to 
expansion. For example, one accounting firm official told us that 
midsize firms and affiliations had good global capabilities and global 
operations. However, another accounting firm official told us that the 
global networks used by midsize and smaller firms needed to add 
standardized quality controls in order to improve. 

Technical Capability and Industry Specialization: 

The technical capabilities and specialized industry knowledge of 
midsize and smaller firms that want to enter the large public company 
market can also limit these firms' ability to enter this market and 
reduce its concentration. According to our survey, 80 percent of large 
public companies that would not consider using a midsize or smaller 
firm said that such firms' technical capabilities with accounting 
principles and auditing standards was a great or very great reason why 
they would not do so. One official from a large public company whom we 
interviewed said that accounting firms' technical capabilities 
differentiate the largest and smaller firms and that smaller firms did 
not have the resources to keep up with changing auditing standards and 
increasingly complex accounting rules around the world. Other company 
officials we interviewed also said that technical capabilities were an 
important reason why large and complex companies do not use midsize and 
smaller firms. 

Several representatives of smaller accounting firms also told us that 
their firms had difficulty maintaining their technical capabilities. 
For example, one representative of a smaller firm noted that his firm 
had less depth in terms of technical expertise than larger firms 
especially when it came to complex transactions. Other firms said that 
maintaining technical expertise was time-consuming and costly. Two 
representatives of smaller firms noted that keeping up with new 
standards and guidance from multiple sources was also difficult, 
requiring the firms to revise guidance for their staff as new standards 
were implemented or to purchase costly prepared guidance materials from 
external sources. However, firms see this as less of an issue than do 
their clients. Only 21 percent of accounting firms responding to our 
survey that want to audit large companies said that the complexity of 
accounting principles and auditing standards were a great or very great 
impediment to expansion, compared to 80 percent of clients. 

In addition, having sufficient industry expertise can be challenging 
for firms that want to audit large public companies. According to our 
survey, 67 percent of large public companies that would not consider 
using midsize and smaller firms said that such firms' industry 
specialization or expertise was of great or very great importance in 
their unwillingness to do so. Some large public companies told us that 
they needed this kind of industry expertise in their auditor. For 
example, the audit committee chairman for a large insurance company 
told us that when he chooses an audit firm, industry expertise was the 
most important factor he considered. He said that his company's audit 
firm must have experience with other companies in the insurance 
industry and doubted that midsize or smaller firms could meet these 
requirements. 

Several representatives of smaller accounting firms whom we interviewed 
said that industry expertise was a significant barrier to auditing 
large public companies. For instance, a representative of one smaller 
accounting firm noted that before accepting a new client, her firm was 
very careful to ensure that it has the right expertise to do the audit. 
She said that since the firm's expertise was in distribution and 
manufacturing, the firm would not accept a financial institution 
client. An official from another midsize firm told us that industry 
specialization was important because audits were not commodities. 
Instead, these accounting firms specialized in certain industries and 
had particular areas of expertise. This emphasis on industry expertise 
can limit midsize and smaller firms' ability to expand their businesses 
to serve companies that operate in industries outside of their 
specialty. However, only 17 percent of accounting firms responding to 
our survey that want to audit large companies said that specialized 
technical or industry expertise was a great or very great impediment to 
expansion. 

Accounting Firm Reputation: 

Another major barrier to midsize and smaller firms' ability to obtain 
large company clients is that these auditors do not have the 
reputations the largest firms enjoy. According to our survey, 65 
percent of large companies that would not consider using a midsize or 
smaller firm said that reputation or name recognition were great or 
very great reasons that they were unwilling to do so. In addition, 
company officials told us that they were confident that the largest 
firms could meet their companies' audit needs because these auditors 
had well-established reputations for quality. These officials were less 
familiar with the smaller firms' work and thus were uncertain about the 
ability of such a firm to adequately serve their companies. Market 
participants told us that conducting due diligence on unfamiliar firms 
was time-consuming, in part because information was not readily 
available. Furthermore, although PCAOB has begun inspecting accounting 
firms' audit work, many market participants we interviewed said that 
the information currently available from the PCAOB inspection reports 
was not sufficient to judge a firm's audit capabilities. For example, 
some noted that part of the inspection results were not published, 
inspection reports were not always timely, and PCAOB did not make an 
overall judgment on a firm's quality.[Footnote 48] 

Companies are also responding to their perceptions of investors' 
preferences when they choose one of the largest auditors. According to 
our survey, 54 percent of large companies that would not consider using 
a midsize or smaller firm said that the expectations or requirements of 
shareholders, banks, lenders, or the underwriters that help the company 
raise capital were of great or very great importance in their 
unwillingness to do so. Institutional investors and investment banks 
often use a company's financial statements and audits as the starting 
point in an investment decision and want to have confidence in the 
auditor that reviewed the financial statements. Similarly, 
representatives from an investment bank and an institutional investor 
told us that they preferred auditors with established reputations 
because of a lack of familiarity with capabilities of most midsize and 
smaller firms. One company official we interviewed said that she did 
not know why a larger company would not want to use one of the largest 
firms, given that these firms' name recognition provided underwriters 
with a certain comfort level. In addition, investment bank 
representatives told us that they want companies to use auditors with 
sufficient financial resources to withstand a liability judgment 
against them. For example, if an investment deal falters, the 
investment bank or underwriter may have to assume more of the 
settlement costs if the audit firm cannot bear its share. Furthermore, 
one investor told us that the largest firms' greater financial 
resources made them better able to survive a large client's failure. 

Midsize and smaller firms agree that name recognition and reputation 
pose a challenge to entering the audit market for large companies. 
Fifty percent of accounting firms responding to our survey that want to 
audit large companies said that name recognition or reputation with 
potential clients was a great or very great impediment to expansion. 
Similarly, 54 percent of these firms cited name recognition or 
credibility with financial markets and investment bankers as a great or 
very great impediment to expansion. In addition, some accounting firm 
representatives we interviewed said that midsize and smaller firms have 
had fewer opportunities to compete with the largest firms for large 
companies' business and do not have well-established reputations. 
However, one midsize firm representative noted that reputation should 
become less of an impediment as more companies moved from the largest 
firms to smaller firms and these firms' work became better known. 

An analysis of data on firms that audit initial public offerings (IPOs) 
illustrates investors' preferences for the largest firms in certain 
situations. While midsize and smaller firms' combined share of the IPO 
market has grown progressively, rising from 18 percent to 40 percent 
since 2003, the largest firms have consistently audited the majority of 
IPOs (fig. 9). Staff from some investment firms that underwrite stock 
issuances for public companies told us that in the past they generally 
had expected the companies for which they raised capital to use one of 
the largest firms for IPOs but that now these organizations were more 
willing to accept smaller audit firms. For example, an official from 
one investment firm told us that the firm now generally accepted two of 
the midsize audit firms for IPOs or securities issuances. However, as 
figure 9 shows, most of the companies that went public with a midsize 
or smaller auditor were smaller. In addition, these firms' share of 
IPOs of larger companies (those with revenues greater than $150 
million) rose from none in 2003 to about 13 percent in 2007. 

Figure 9: IPOs, 2003-2007: 

This figure is a combination of two graphs. One graph is a bar graph 
representing largest farms, midsize farms, and smaller farms. It is 
entitled "IPOs by audit firm size." The X axis represents the year, and 
the Y axis represents the percentage. 

The second graph is a line graph, with one line representing revenue 
less than $15 million, one line representing revenue $15-$150 million, 
and another line representing revenue more than $150 million. The X 
axis represents the year, and the Y axis represents the percentage. The 
title of this graph is percentage of companies audited by midsize and 
smaller firms, by company revenue. 

[See PDF for image] 

Source: GAO analysis of IPO data from EDGAR. 

Note: Changes in the business environment and audit market during this 
period make judgments based on year-to-year comparisons difficult. 

[End of figure] 

Midsize and smaller firms responding to our survey indicated that they 
had had mixed experiences assisting clients with IPOs. All of the 
midsize firms and 82 percent of smaller firms responding to our survey 
had assisted new and existing clients with an IPO or subsequent 
securities issuance. However, two of the four midsize firms, as well as 
36 percent of the smaller firms, reported losing clients that wanted 
another firm, often one of the largest firms, to help them prepare for 
an IPO or subsequent securities issuance. 

Similar Challenges Affect Midsize and Smaller Accounting Firms in the 
Market for Small and Midsize Companies: 

Midsize and smaller accounting firms responding to our survey said that 
they faced challenges even in competing in the market for smaller 
public company audits. Our survey respondents in this market generally 
reported that the challenges they faced were significant impediments to 
increasing the number of public companies they served. As shown in 
figure 10, these challenges, such as firms' capacity, global reach, and 
technical capability or expertise, are similar to those facing midsize 
and smaller firms that want to audit large companies. 

Figure 10: Midsize and Smaller Firms' Challenges in Auditing Small and 
Midsize Companies: 

This figure is a bar graph. 

Reason small and midside public companies are unlikely to use midsize 
and smaller firms; 
Ability to handle size and complexity of company operations: 65%; 
Technical capacity with accounting principles and auditing standards: 
57%; 
Industry specialization: 49%; 
Reputation or name recognition: 46%; 
Expectations or requirements of share-holders, banks, lenders, or 
underwriters: 45%; 
Geographical presence: 33%. 

Reasons midsize and smaller firms cited as impediments to auditing 
small and midsize public companies; 
Ability to recruit/retain staff: 65%; 
Complexity of accounting principles and auditing standards: 29%; 
Specialized technical and/or industry expertise: 23%; 
Name recognition or reputation with potential clients: 37%; 
Name recognition or credibility with financial markets and investment 
bankers: 50%; 
Firm's international reach: 29%; 
Firm's national reach: 14%.

[See PDF for image] 

Source: GAO. 

[End of figure] 

To increase their capacity and geographic reach, accounting firms need 
the financial capital to hire new staff or acquire other audit firms, 
but capital constraints and expansion costs pose an impediment to 
growth for some midsize and smaller firms. While this constraint could 
affect firms of all sizes, midsize and smaller firms have fewer 
partners from whom they can obtain capital. Of the midsize and smaller 
firms responding to our survey that focus on smaller companies, 65 
percent said that the costs of hiring and training additional staff 
were a great or very great impediment to expansion. According to an 
accounting firm representative we interviewed, some smaller firms can 
be constrained from raising capital to expand their businesses because 
of the partnership structure, which requires individual partners to 
pool their own assets or assume debt for acquisitions and other growth 
activities, such as hiring new staff. However, one midsize firm 
representative said that raising capital for expansion was not an 
impediment for his firm. 

Smaller firms responding to our survey also told us that complying with 
the many different requirements individual states impose could hinder 
their efforts to audit clients with operations in multiple states. Each 
of the 50 states and 5 U.S. territories have state boards of 
accountancy that have sole authority for establishing licensing 
requirements for certified public accountants in their jurisdictions. 
If a company's business operations extend across state lines, auditors 
may need to get temporary certifications in each of the states where 
they will conduct audit work. These requirements can range in 
complexity and cost among the several states. Some firms we interviewed 
said that complying with multiple state licensing requirements was 
difficult and often expensive. However, only 27 percent of midsize and 
smaller firms responding to our survey that focus on smaller companies 
said that varied state licensing requirements were great or very great 
impediments to expansion. Furthermore, some representatives of 
accounting firms whom we interviewed said that multiple state 
requirements did not stop them from competing for new clients. 

Smaller Audit Firms Are Taking Actions to Expand Their Market Share, 
but Challenges Remain: 

Many midsize and smaller firms have taken steps to reduce the 
challenges that they face and have successfully expanded their share of 
the audit market for small and midsize companies somewhat in recent 
years. In some cases, these firms have expanded their audit practices 
in niches that allow them to use their expertise, rather than 
attempting to serve clients in new industries. Some midsize and smaller 
firms told us that, while having staff with a certain type of expertise 
could be a barrier in trying to serve all types of companies, it did 
not hinder them if they focused on a more select set of industries. 
They said that this approach had allowed them to build their 
reputations in specialty areas, which may enable them to acquire 
progressively larger clients, and grow incrementally. Other firms told 
us that they had expanded their practices through mergers and 
acquisitions, adding new industry expertise, increasing their capacity, 
and extending their geographic reach. Smaller firms that responded to 
our survey generally viewed this approach as effective for increasing 
the number of companies they audited, with 73 percent saying that it 
was at least somewhat effective. Some representatives of midsize firms 
whom we interviewed also said that acquisitions were an effective way 
to expand into regions where they did not already have an office. 

While funding for expanding midsize and smaller accounting firms 
typically came from loans from financial institutions, merging with 
other accounting firms, or the personal resources of the firm's 
partners, a small number of firms are using a different method of 
increasing their access to capital. These firms have established 
alternative practice structures, in which the firm engaged in attest 
services is closely aligned with another organization that performs 
other nonaudit services. One example is where owners of the accounting 
firm sell the nonaudit portion of their practice to a new entity, which 
may be publicly or privately owned. The work the firm previously 
conducted is then essentially divided into two separately controlled 
entities, one of which conducts most of the firm's nonaudit and attest 
work, while the other conducts audits. Owners of the audit firm are 
also employees of the nonaudit entity, and the audit firm generally 
leases employees, office space, equipment, administrative support, and 
other services from this entity. Audit firms gain additional access to 
capital from the initial sale of the nonaudit entity or loans from the 
new entity that they can use for acquisitions and other growth 
activities. However, some firms with alternative practice structures 
told us that getting approval for their organizations from some states 
was challenging and that they were subject to additional scrutiny 
because their uncommon structure raised concerns about 
independence.[Footnote 49] In addition, 63 percent of midsize and 
smaller firms responding to our survey said that alternative practice 
structures would only be slightly or not at all effective in helping 
them increase their market share. 

Finally, according to representatives of two accounting firm networks 
and affiliations of independent firms, these organizations help midsize 
and smaller firms deal with some of the challenges they face. As we 
have seen, some midsize and smaller firms join these networks in order 
to extend their geographic reach. In two cases that we reviewed, we 
found that the structure of these organizations varies widely. One 
organization was described as having a focused mission and high 
standards that member firms must continuously meet, while a 
representative from another said that the organization functioned 
primarily as a vehicle to share best practices and refer business to 
other member firms. All midsize firms and over 60 percent of smaller 
firms responding to our survey belonged to a network or affiliation, 
generally to increase competitiveness with larger firms and extend 
their national and international reach. One network representative we 
spoke to told us that the network's main benefit was its ability to 
serve clients that were expanding, especially internationally, by 
partnering with other firms in the network. In interviews, officials 
from two smaller firms also told us that networks and affiliations 
provided opportunities to serve new clients either by partnering with 
other firms or through referral services. 

Midsize and smaller firms that responded to our survey had mixed views 
about the ability of these networks and affiliations to help increase 
their market share. Some market participants thought that networks' 
value could be limited because, unlike the global networks of the 
largest firms, the member firms of these networks and affiliations did 
not share a common set of methodologies or internal controls. In 
general, the firms in networks wanted to maintain their individuality 
in order to avoid being held liable for another firm's audit work. In 
addition, officials from two smaller firms that are members of a 
network expressed concern that the proposed independence standards of 
the International Federation of Accountants--the global organization 
for the accounting profession that develops international standards on 
ethics, auditing and assurance, education, and public sector accounting 
standards--could present additional challenges for networks because of 
the broad way that the standards define networks.[Footnote 50] 
Officials with the International Federation of Accountants told us that 
the standards were still under consideration and that comments and 
concerns from accounting firms on this issue were still under review. 

While the practices discussed above have helped smaller accounting 
firms to reduce some of the challenges they face, certain barriers are 
likely to persist, particularly in the market for large company audits. 
While focusing on niche markets can deepen a firm's expertise, just as 
mergers, acquisitions, and networks can increase firms' capacity and 
geographic reach, midsize and smaller firms are still much smaller than 
their large firm competitors and have much less experience in the large 
company audit market. Some market participants think that building up 
smaller firms' capacity, experience, and reputation to serve large 
companies is likely to be a long-term process, thus their growth is 
unlikely to ease concentration. 

Proposals for Addressing Concentration and Increasing Market Share for 
Smaller Auditors Have Significant Disadvantages: 

Over the years, academics, industry groups, and other market 
participants have offered a range of proposals that are intended to 
reduce the risks of current and further concentration, or address the 
expansion challenges facing midsize and smaller audit firms. We 
considered a number of these proposals and found that, while each could 
offer certain benefits, each proposal also presents at least some 
significant disadvantages, and market participants generally saw these 
proposals as having limited effectiveness, feasibility, and benefit. 
Since the current level of concentration does not appear to be having 
significant adverse effect, and the proposals we reviewed were 
generally not seen as effective in addressing the risks of 
concentration or challenges facing smaller firms without serious 
drawbacks, we found no compelling need to take action. 

Proposals Others Have Made for Reducing the Risks of the Current Level 
of Concentration Involve Trade-offs: 

Several proposals have been offered to reduce the risks of the current 
level of concentration, including mandatory audit firm rotation, audit 
firm financial statement disclosure, and breaking up the largest firms 
into more firms. 

Mandatory Audit Firm Rotation: 

Some academic and industry sources have suggested that requiring public 
companies to periodically change auditors could reduce the current 
level of concentration. Such mandatory audit firm rotation would limit 
the period of years that an accounting firm could serve as the auditor 
for a particular public company. Our survey results show that companies 
often retain their auditors for long periods of time.[Footnote 51] For 
example, according to our survey results, approximately 40 percent of 
public companies had used their current auditor for at least 5 years, 
and almost a quarter had used their current auditor for at least 10 
years.[Footnote 52] While generally proposed as a means of enhancing 
auditor independence by periodically bringing in a new auditor for a 
"fresh look" at a company's financial statements, mandatory rotation 
could potentially reduce concentration to the extent that it provided 
more opportunities for midsize and smaller firms to compete to provide 
audit services to public companies. 

Although mandatory auditor rotation would increase opportunities to 
compete, it would not increase the number of viable competitors, and 
views on its effectiveness as a means of reducing concentration were 
mixed. For example, 44 percent of midsize and smaller firms responding 
to our survey stated that mandatory rotation would be at least a 
somewhat effective way for their firms to gain more public company 
clients, and 52 percent of respondents thought that it would be only 
slightly or not at all effective.[Footnote 53] One person we 
interviewed noted that mandatory rotation might not be feasible, since 
some companies had very limited choices due in part to the restrictions 
of independence requirements. Another market participant noted that 
mandatory rotation would not necessarily reduce concentration because 
large public companies would likely just rotate to another one of the 
largest firms. In a 2003 report on the potential effects of mandatory 
audit firm rotation, we found similar results.[Footnote 54] Based on 
surveys we conducted for that report, 83 percent of accounting firms 
that audit 10 or more companies and 66 percent of Fortune 1000 public 
companies stated that under mandatory auditor rotation, the market for 
public company audits would either become more concentrated or remain 
about the same. Further, more than half of accounting firms that audit 
10 or more companies felt that mandatory audit firm rotation would 
reduce the number of firms willing and able to compete for public 
company audits. 

In addition, market participants we spoke with raised other concerns 
about mandatory audit firm rotation. Some said that mandatory rotation 
would increase both audit firms' and public companies' costs. In our 
2003 report, we found that many audit firms and large companies 
surveyed believed that mandatory rotation would increase initial year 
audit-related costs by more than 30 percent. For example, we reported 
that audit firms could incur higher marketing costs as they increased 
efforts to acquire or retain clients. With new auditors every few 
years, public companies also would incur higher support costs for 
assisting the new audit firm in understanding the companies' 
operations, systems, and financial reporting practices. Others 
expressed concern that new audit firms would need a period of time to 
become fully familiar with a client's operations. Lacking knowledge, 
and the time that would be required to acquire it, could increase the 
risk of an auditor not detecting financial reporting issues that could 
materially affect the company's financial statements. 

Other recently implemented regulatory changes may have already provided 
at least one of the benefits this proposal is designed to provide. The 
Sarbanes-Oxley Act requires mandatory rotation of lead and reviewing 
audit partners after they have provided audit services to a particular 
public company for five consecutive years. Many market participants we 
interviewed for our 2003 report suggested that this requirement, when 
fully implemented, could achieve some of the independence benefits 
related to a new auditor's having a fresh look at a company's financial 
statements.[Footnote 55] 

Audit Firm Financial Statement Disclosure: 

Another proposal that has been offered would require public company 
auditors to provide financial information that could also be used to 
assess the competitiveness of audit fee levels. Some market 
participants and others advocate requiring accounting firms that audit 
public companies to disclose detailed financial information, such as 
their own revenues and profits. They have noted that providing this 
information could increase the transparency of the market and help 
participants evaluate its profitability, and the information could also 
help market regulators and others evaluate whether firms were charging 
prices above competitive levels. 

Jurisdictions outside the United States have begun requiring audit 
firms to disclose some financial information, but the results have been 
unclear. In the United Kingdom, audit firms are required to file 
financial information. However, because U.K. accounting firms provide 
many services, some find the consolidated financial statement to be of 
limited usefulness in assessing the economics of the firms' audit 
services. As a result, based on the advice of a group of market 
participants, the U.K. Financial Reporting Council recommended that 
audit firms disclose the financial results of their work on statutory 
audits and directly related services, so that "clearer and more 
comparable information on the profitability of audit work" would be 
available.[Footnote 56] In addition, beginning in 2008, audit firms 
that carry out statutory audits in the European Union are required to 
file information on fees charged for audits and other services, as well 
as data on the basis for partners' compensation. 

Most market participants we interviewed on this proposal did not 
believe that requiring audit firms to publicly disclose their financial 
results would be very effective in reducing the risk of anticompetitive 
pricing among the largest accounting firms. Some market participants we 
spoke with indicated that such financial statements would not provide 
useful information for evaluating whether firms were charging fees 
above competitive levels. Others familiar with the accounting 
profession have commented that regulators already had the authority to 
request certain financial information from firms if needed. Therefore, 
this proposal might not have any direct effect on market competition. 

Breaking Up the Largest Firms into More Firms: 

Some academics and former regulators have suggested that requiring one 
or more of the largest firms to spin off a large portion of their 
operations to create more than four firms with the capacity to audit 
large public companies could ease current concentration. Breaking up 
the largest firms would at least temporarily decrease concentration and 
mitigate the adverse effect of one of the firms exiting the market or 
failing. Firms in other markets have been split up in the past--for 
example, Standard Oil and the American Tobacco Company in 1911; 
meatpacking firms in 1920; and AT&T, which owned all regional operating 
telephone companies, in 1984. In some of these cases, some of the 
resulting companies merged in later years after market or technological 
changes. 

Market participants we spoke with expressed concerns about the 
potential adverse effects of forcing the largest firms to divest 
themselves of some of their operations. For example, several indicated 
that splitting the firms could entail significant costs and diminish 
the economies of scale and depth of expertise that currently allow the 
largest firms to audit large public companies with complex technical 
needs and worldwide operations. The result could be increased audit 
costs and decreased quality of audits performed. In the public company 
survey we conducted for our 2003 report on accounting firm 
consolidation we found that 79 percent of survey respondents opposed 
breaking up the largest firms.[Footnote 57] Though a few we interviewed 
thought that this proposal would be effective in reducing 
concentration, those we interviewed on this topic generally agreed that 
it was not very feasible and that it could be complicated, difficult, 
and costly. These adverse results seem especially disruptive in the 
absence of compelling evidence that current levels of concentration 
were causing harm. 

Reducing the Impact or Risk of Litigation Could Prevent Further 
Concentration, but Proposals to Achieve This Goal Have Been Questioned: 

The risk of being sued appears to reduce some audit firms' willingness 
to seek out additional public company clients. We reported in 2003 that 
litigation risk was a barrier for smaller firms seeking to audit larger 
public companies because of the difficulty of managing this risk and of 
obtaining affordable liability insurance.[Footnote 58] In the survey we 
conducted for this report, over half (61 percent) of midsize and 
smaller audit firms reported that liability/tort reform would be at 
least somewhat effective in helping them increase their market share. 
Further, litigation could result in even more market concentration if 
firms that were sued ultimately went out of business. Several proposals 
have been made to reduce the potential for litigation to cause further 
concentration in the market for audit services, including placing caps 
on auditors' liability and targeting enforcement against responsible 
individuals, among others. 

Liability Caps: 

A number of market participants and academics, and a recent report 
commissioned by Senator Charles Schumer and New York City Mayor Michael 
Bloomberg have recently advocated placing caps on auditors' potential 
liability as a means of reducing the risk of litigation that could lead 
to the loss of another large audit firm.[Footnote 59] Liability caps 
would limit the overall amount that an audit firm would have to pay in 
connection with a lawsuit involving the work it performed for one of 
its public company clients. Some of the proposals have suggested caps 
that are fixed across the entire market, while others would base caps 
on the fees the auditor received or the client's market capitalization. 
Some have argued that caps would not only decrease litigation risk but 
would also increase the availability of insurance. Both of these 
developments could reduce the risk of a firm failing because of 
litigation. In addition, some believe liability caps could also lead to 
increased efficiencies if audit firms could reduce the amount of time 
they spent protecting themselves against lawsuits. 

While some market participants thought that capping auditors' liability 
would be beneficial, others pointed out that such caps could have 
negative effects and would not protect firms against all risks that 
could lead to failure. Some of the former regulators and a 
representative of investors we spoke with were concerned that having 
less potential liability would limit the extent to which audit firms 
were held responsible for their work and could lead to lower audit 
quality. Others were concerned that caps would limit investors' ability 
to recoup losses they incurred if an auditor was found to have 
committed fraud. In addition, caps would not reduce the risk that firms 
face from enforcement actions, which could also lead to failure. 
Finally, a few questioned the fairness of capping liability for 
auditors but not for others who faced similar risk, such as public 
companies and investment banks. 

Targeting Enforcement Actions against Responsible Individuals: 

As we have noted, audit firms could also fail as a result of a 
regulatory enforcement action, increasing market concentration. Some 
market participants have suggested that having regulatory or 
enforcement agencies target their efforts against responsible partners 
rather than entire organizations would reduce the risk that an audit 
firm might fail for this reason. DOJ has the authority to take criminal 
enforcement action against individuals, corporations, or partnership 
entities. For example, DOJ indicted Arthur Andersen as a firm for 
obstruction of justice in 2002, but also indicted four current or 
former Ernst & Young partners in 2007 for alleged tax fraud conspiracy 
and other charges related to marketing tax shelters. In 2005, DOJ 
indicted 19 individuals, including 16 former KPMG partners, on charges 
related to marketing fraudulent tax shelters but recently entered into 
a deferred prosecution agreement with the firm itself. As part of the 
agreement, charges would not be brought against KPMG as long as the 
firm followed the terms and conditions of the agreement, which included 
agreeing to pay $456 million in fines, restitution, and 
penalties.[Footnote 60] Advocates of targeting the responsible 
individuals rather than the firm argue that DOJ should consider the 
negative consequences for public companies of further consolidation 
against the benefits of criminal indictment against a firm. DOJ 
guidance states that prosecutors must consider, among other factors, 
whether an indictment would cause "disproportionate harm" to employees 
who have not been proven personally culpable and the effect of 
prosecution on the public in determining whether to charge a firm. DOJ 
officials declined to comment on whether they took the potential 
negative consequences of firm failure into consideration when making 
decisions in the Ernst & Young and KPMG cases or whether they would do 
so in similar cases in the future. 

However, others did not think that the ability of regulatory or 
enforcement agencies to take certain actions against audit firms should 
be limited. Market participants generally agreed that the facts and 
circumstances of each case should determine whether regulatory and 
enforcement agencies should take action against responsible partners or 
firms. One former regulator commented that removing the option of 
taking criminal action against a firm would give those firms safe 
harbor to commit fraud. Further, this proposal would not address the 
risk that firms face from class-action lawsuits, which is thought to be 
a significant portion of firms' total litigation risks: 

Other Proposals to Reduce Auditors' Liability for Alleged Wrongdoing: 

One proposal would seek to reduce the potential for further 
concentration due to the loss of an audit firm by changing how auditors 
attest to the fairness of financial statements. Officials from the six 
largest accounting firms and proponents of this proposal stated in a 
paper on serving global markets that what auditors could reasonably 
uncover in an audit was limited.[Footnote 61] However, the attestation 
that auditors currently make states, "In our opinion, the financial 
statements present fairly, in all material respects, the financial 
position of the company … and the results of its cash flows" which one 
commenter said fails to convey the uncertainty associated with 
financial statements and audits. The accounting firm paper on serving 
global markets states that, in the current environment, company 
managers, investors, and others may have expectations for audits that 
are too high--for example, that an auditor has detected all possible 
fraud in a company's financial statements. Thus, some propose changing 
the format and wording of the auditor's attestation to reflect the 
varying certainty that an auditor can give to different parts of 
financial statements. Some market participants we interviewed believed 
that including more descriptive information in the attestation would be 
helpful, while several others thought such a change would not make a 
difference in firms' liability risk and could make the attestation 
complex and confusing. 

Another proposal, this one involving financial statement insurance, has 
also been suggested as a means of reducing auditors' litigation risk. 
Instead of having companies appoint and pay for their own external 
auditors, this proposal advocates creating financial statement 
insurance that would be provided by insurance companies. This insurance 
would provide coverage for investors in the public company against 
losses suffered as a result of problems with the company's published 
financial statements. Insurance companies, to lower their risk of such 
losses, would then appoint and pay audit firms to attest to the 
accuracy of the financial statements. The auditors' opinions would 
assist the insurance companies in setting future premiums and coverage 
levels. 

Such financial statement insurance may be a way of lowering the risk of 
the loss of another large audit firm because auditors would be agents 
of the insurance companies. Depending on how relevant laws regulating 
financial statement insurance were structured, proponents note that 
liability would generally be shifted to insurers and away from 
auditors. Further, because each policy would be tailored to a 
particular audit engagement, one proponent has argued that more 
insurance than is currently available would be available under this 
proposal, although some risky companies may not be able to obtain it. 
However, most of the market participants we discussed this proposal 
with did not favor it, citing the significant changes it would make to 
the current audit function and federal securities laws and the fact 
that insurance companies themselves might not be interested in insuring 
financial statements in this way or qualified to do so. 

Proposed Actions to Help Reduce the Challenges Facing Smaller Firms 
Would Offer Limited Benefits: 

Various entities have made proposals intended to help smaller firms 
expand their share of the audit market for public companies. These 
include allowing outside ownership, creating a shared experts office, 
standardizing licensing and registration standards, and establishing an 
accounting firm accreditation program. 

Outside Ownership of Accounting Firms: 

Some market participants have suggested that allowing parties other 
than the firm's partners to own or invest in audit firms could increase 
these firms' financial resources and allow them to hire the additional 
staff needed to serve larger companies. According to AICPA, under all 
states' laws, certified public accountants (CPAs) must make up the 
majority ownership of all accounting firms, and other owners must be 
active participants in the firms.[Footnote 62] These requirements were 
intended to preserve audit quality by ensuring auditor independence 
according to one market participant and an industry report. 

Market participants pointed out the potential negative effects of 
allowing outside ownership of accounting firms, and most of the 
accounting firms responding to our survey agreed that being able to 
raise capital from such sources would have little if any effect on 
their ability to expand their market share.[Footnote 63] Opponents of 
extending outside ownership argue that, without CPAs as majority 
owners, external shareholders might make business decisions in a firm's 
economic interests that compromise its independence for purposes of 
performing audits. One report recommending consideration of changing 
outside ownership rules indicated that appropriate safeguards would be 
needed to ensure independence and audit quality. Several of the midsize 
and smaller firms we interviewed said that access to capital did not 
pose a significant impediment to expansion, because firms currently 
raised sufficient capital through traditional channels such as loans 
backed by the partnership and, in some cases, alternative practice 
structures. In fact, 61 percent of midsize and smaller firm survey 
respondents said that increasing their access to capital would be only 
slightly effective or not at all effective in helping them increase the 
number of audit clients they served. Firms told us that the shortage of 
qualified accountants in the labor market rather than limited access to 
capital was their primary impediment to growth. 

Shared Experts Office: 

Creating a shared entity staffed with accounting experts with 
specialized technical and industry expertise to supplement smaller 
firms' technical capabilities for performing public company audits 
could provide midsize and smaller firms with advice on accounting 
standards and audit procedures. A shared experts office could be 
similar in concept to the "national offices" maintained by larger firms 
to provide advice to their staff auditors on complex and emerging 
issues. According to some market participants, smaller audit firms can 
currently obtain assistance through various technical support services 
offered by FASB, AICPA, SEC, and networks or affiliations they may be a 
member of. But some market participants told us that services such as 
those the SEC provides were not heavily used, either because auditors 
and companies feared reprisals if they alerted regulators to potential 
problems they might be facing or because they did not expect a timely 
response.[Footnote 64] 

Market participants we interviewed noted that creating a shared experts 
office that many firms could use would have various advantages and 
disadvantages. Several market participants said a shared experts office 
that provided comprehensive support and guidance on complex accounting 
and auditing issues could be effective, especially if it were 
established within an appropriate organization. However, most did not 
think that establishing such an office would be feasible. Some market 
participants that we interviewed said that a shared office's 
effectiveness would be limited. For instance, one participant noted 
that a shared experts office would lack the "tone at the top" that a 
firm's national office provides. Others noted that staff at an external 
office could find it difficult to obtain all the needed facts from 
firms in order to make an accurate determination. Also, market 
participants said that the shortage of individuals with the required 
expertise could make establishing an external office challenging. 
Finally, some market participants said that such an office would face 
challenges because it could face legal liability if its staff gave out 
erroneous guidance that resulted in criminal or civil litigation. 
Furthermore, other organizations such as AICPA have considered 
establishing similar offices in the past but did not because they could 
not identify ways to overcome these challenges.[Footnote 65] 

Finally, midsize and smaller firms responding to our survey had mixed 
views on the effectiveness of this proposal as a means of expanding the 
number of public companies they could audit. Only 8 percent of midsize 
and smaller firms said that having access to specialized technical and 
industry expertise would be very effective in helping them expand their 
public company client base, and 55 percent said that it would be 
somewhat or moderately effective. 

Uniform Licensing and Registration Standards: 

Easing restrictions that hindered their ability to operate in multiple 
states could potentially increase the ability of smaller accounting 
firms to serve more public company clients. Many accounting firm 
officials and industry groups have said that differences in auditor 
licensing and registration standards across states are costly and make 
operating in multiple jurisdictions burdensome. AICPA and the National 
Association of State Boards of Accountancy (NASBA) have developed the 
Uniform Accountancy Act, a suggested model for state legislation that 
was recently amended to provide a comprehensive system under which CPAs 
would have mobility to practice in more than one state with minimal 
barriers. However, each state will have to implement these changes 
identically to create the uniform system, and some market participants 
we interviewed said that states are unlikely to do so. The AICPA is 
working with NASBA and the state boards of accountancy to develop 
uniform legislation and accountancy rules in each state to eliminate 
some of the barriers that exist for CPAs who perform work across state 
lines. If the current initiative is successful, the regulatory burdens 
associated with licensing will be significantly improved. However, such 
a system is not likely to help reduce concentration because some firms 
we interviewed said that although complying with varying state 
standards was challenging, it did not prevent them from competing for 
new clients or entering new markets. 

Accounting Firm Accreditation: 

Finally, providing more information about the capabilities of midsize 
and smaller firms could make public companies more aware of lesser- 
known firms and potentially increase these companies' willingness to 
consider additional firms as their auditor. Some market participants 
have suggested that establishing an accounting firm accreditation 
program would help establish midsize and smaller firms' reputations by 
providing companies and investors with additional information about 
their audit capabilities. An accreditation program could be similar to 
the programs used for colleges and universities, which use nationally 
recognized accrediting agencies to determine whether institutions meet 
established standards and thus acceptable levels of quality. Accounting 
firm accreditation, whether carried out by a government agency or 
approved private organization, could use a similar approach to certify 
firms as being able to audit certain types of companies. 

Company officials and other market participants told us that having 
additional information about unfamiliar firms could be beneficial. For 
example, investors told us they tended to prefer firms with well- 
established reputations and that conducting due diligence on the 
unknown firms' qualifications required extra work. Several other market 
participants thought that providing additional information about firms 
through an accreditation program could be at least a moderately 
effective and feasible way to establish firms' reputations. One 
accounting firm official thought that having a credible organization 
endorsing firms as qualified to conduct audits for companies of certain 
sizes would help companies make informed decisions and increase their 
choices of auditors. 

However, other market participants raised concerns about the costs and 
burden that accreditation would impose on firms. For example, according 
to Department of Education guidelines universities have to complete an 
in-depth self-evaluation that measures their performance against the 
established standards and undergo on-site evaluations in order to earn 
accreditation. Following accreditation, the accrediting body monitors 
and periodically reevaluates the universities' accreditation status. 
Some participants thought that the burden of this process could 
outweigh any benefits. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Chairman of the SEC, the 
Chairman of the PCAOB, DOJ, and the Department of the Treasury for 
their review and comment. We received technical comments from SEC, 
PCAOB, and DOJ that were incorporated where appropriate. Treasury had 
no comments. 

We are sending copies of this report to interested congressional 
committees and subcommittees; the Chairman, SEC; the Chairman, PCAOB; 
DOJ; and Treasury. We will also make copies available to others on 
request. In addition, the report will be available at no charge on the 
GAO Web site at [hyperlink, http://www.gao.gov]. 

If you have any questions concerning this report, please contact Orice 
M. Williams at (202) 512-8678 or williamso@gao.gov, Jeanette M. Franzel 
at (202) 512-9471 or franzelj@gao.gov, or Thomas J. McCool at (202) 512-
2642 or mccoolt@gao.gov. Contact points for our Offices of 
Congressional Relations and Public Affairs may be found on the last 
page of this report. See appendix VI for a list of other staff who 
contributed to the report. 

Signed by: 

Orice M. Williams: 

Director, Financial Markets and Community Investment: 

Signed by: 

Jeanette M. Franzel: 

Director, Financial Management and Assurance: 

Signed by: 

Thomas J. McCool: 

Director, Center for Economics: 

List of Congressional Addressees: 

The Honorable Christopher J. Dodd: 
Chairman: 
The Honorable Richard C. Shelby: 
Ranking Member: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate: 

The Honorable Richard Durbin: 
Chairman: 
The Honorable Sam Brownback: 
Ranking Member: 
Subcommittee on Financial Services and General Government: 
Committee on Appropriations: 
United States Senate: 

The Honorable John F. Kerry: 
Chairman: 
The Honorable Olympia J. Snowe: 
Ranking Member: 
Committee on Small Business and Entrepreneurship: 
United States Senate: 

The Honorable Barney Frank: 
Chairman: 
The Honorable Spencer Bachus: 
Ranking Member: 
Committee on Financial Services: 
House of Representatives: 

The Honorable Michael K. Conaway: 
House of Representatives: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology: 

This work was conducted under the Comptroller General's authority. Our 
objectives were to study (1) the level of concentration among the 
market for public company audits and the impact of this concentration, 
(2) the potential for increased capacity among midsize and smaller 
accounting firms to ease market concentration, and (3) proposals that 
have been offered by others for easing concentration in the market for 
public company audits and the barriers facing midsize and smaller firms 
in expanding their market share for public company audits. 

We conducted this performance audit in New York City and Washington, 
D.C., from October 2006 to January 2008 in accordance with generally 
accepted government auditing standards. Those standards require that we 
plan and perform the audit to obtain sufficient, appropriate evidence 
to provide a reasonable basis for our findings and conclusions based on 
our audit objectives. We believe that the evidence obtained provides a 
reasonable basis for our findings and conclusions based on our audit 
objectives. 

To determine the level of concentration among the market for public 
company audits and its effect we collected data and calculated our own 
descriptive statistics for analysis. Using audit market data from 
various sources, we analyzed auditor changes and changes in audit fees, 
computed concentration ratios and Hirschman-Herfindahl indexes, and 
conducted trend analyses. We also developed and employed an econometric 
model to analyze the relationship between concentration and fees. 
Appendix V contains more details about this model. To augment these 
data, we interviewed academics, private consultants, trade 
associations, accounting firms, public companies, and Securities and 
Exchange Commission (SEC) and Public Company Accounting Oversight Board 
(PCAOB) officials. We also reviewed relevant academic literature. Most 
of the research studies citied in this report have been published in 
academic journals. These studies were also reviewed by our economists, 
who determined that they did not raise serious methodological concerns 
and were reliable for our limited purpose. However, the inclusion of 
these studies is purely for research purposes and does not imply that 
we deem them definitive. Finally, we surveyed public companies and 
accounting firms about their views on these topics. Our work did not 
include evaluating the quality or viability of the accounting firms 
that perform public company audits. 

To determine the potential for the growth of midsize and smaller firms 
to affect concentration in the market for public company audits we 
reviewed relevant literature and included questions on this topic in 
our survey of public companies and accounting firms. In addition, we 
obtained data on the auditors chosen by initial public offerings (IPO) 
from SEC filings and analyzed this data. We also analyzed data related 
to the size of the largest, midsize, and smaller firms. We assessed the 
reliability of this data and found that it was reasonably sufficient 
for our purposes. We also interviewed representatives of accounting 
firms, public companies, investment banks, institutional investors, 
venture capital firms, and trade associations. 

To determine what proposals have been offered to address further 
concentration and the challenges midsize and smaller firms face we 
reviewed academic literature, as well as government and industry 
papers, and interviewed representatives of accounting firms, public 
companies, and other industry participants. We obtained information 
about the effectiveness, feasibility, and overall benefit of these 
proposals through our survey results and individual and group 
interviews with representatives from accounting firms, public 
companies, investment banks, institutional investors, academics, 
insurance companies, and former SEC officials. We also met with 
officials from SEC, PCAOB, and the Department of Justice (DOJ) to 
obtain their views on the advantages and disadvantages of these 
proposals. We obtained much of this information at a roundtable 
discussion we held on July 10, 2007, that involved 18 market 
participants from across all the sectors mentioned above. The overall 
objectives of the roundtable were to provide an opportunity for the 
participants from different sectors and viewpoints to engage in an in 
depth discussion of the significance of concentration in the market, 
challenges facing midsize and smaller firms, and the strengths and 
weaknesses of proposals previously identified, as well as to identify 
additional proposals. To encourage open and candid input from the 
various parties, we agreed not to attribute any input from either our 
general data collection effort or the roundtable to specific 
organizations or individuals. 

Data Analysis: 

To address the structure of the audit market we computed concentration 
ratios and Hirschman-Herfindahl indexes (HHI) for 2000 to 2006 using 
Audit Analytics, an online market intelligence service maintained by 
Ives Group, Incorporated. Audit Analytics provides, among other things, 
a database of audit fees by company since 2000, along with demographic 
and financial information. We also used the Audit Analytics database to 
analyze changes in the audit fees companies have paid by various size 
categories. Audit Analytics also provides a comprehensive listing of 
all reported auditor changes that includes data on the date of change, 
departing auditor, engaged auditor, nature of the change (dismissal or 
resignation), any going concern flags or other accounting issues, and 
any fee disputes or fee reductions. Using this database, we identified 
5,867 auditor changes from January 2003 through June 30, 2007. For our 
econometric model we also used data on audit opinions (going concern 
opinions), restatements, 404 compliance (internal control), and late 
filers that were also maintained by Ives Group in the Audit Analytics 
database. We used Public Accounting Report (PAR) and other sources for 
the remaining trend and descriptive analyses, including the analyses of 
the top and lower sizes of accounting firms, contained in the report. 

In addition to reviewing the data collection methods and management 
controls over these databases that we conducted for a previous report, 
we assessed the reliability of the current data in other ways. We 
performed several checks to verify the reliability of the Audit 
Analytics databases. For example, we crosschecked random samples from 
each of the Audit Analytics databases with SEC proxy and annual filings 
and other publicly available information. Additionally, we compared our 
HHI calculations based on Audit Analytics data to HHI calculations 
based on 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 also spoke with other users of the Audit Analytics data. 
While we determined that these data were sufficiently reliable for the 
purpose of presenting trends in audit fees and auditor changes, as we 
have previously reported, the descriptive statistics on audit fees 
contained in the report should be viewed in light of a number of data 
challenges. First, the Audit Analytics audit fee database does not 
include fees for companies that did not disclose audit fees paid to 
their independent auditor in an SEC filing.[Footnote 66] Second, some 
companies included in the database--especially small companies--did not 
report complete financial data. We handled missing data by dropping 
companies with incomplete financial data from any analysis involving 
the use of such data. As a result, we are not dealing with the entire 
population included in the Audit Analytics database but rather with a 
large subset. Because of these issues, the results should be viewed as 
estimates of audit fees and market concentration based on a large 
sample rather than precise estimates based on the entire population. 
Moreover, the sample we used to produce the estimates throughout the 
report does not include funds, trusts, nonoperating companies, or 
subsidiaries of another public company. 

For a previous report we performed similar, albeit more limited, tests 
on PAR data, and concluded that they were appropriate for its use in 
this report. However, these data are self-reported by the accounting 
firms, which are not subject to the same reporting and financial 
disclosure requirements as SEC registrants. Moreover, while the data 
are suitable for comparing the largest firms to midsize and smaller 
firms, caution should be used in comparing midsize and smaller firms to 
each other. 

To assess the market for new publicly traded companies we obtained data 
using SEC's Electronic Data Gathering, Analysis and Retrieval (EDGAR) 
system, a database that includes information on registered companies' 
initial public offering (IPO) in the United States. SEC's EDGAR 
database is the primary source for information on IPOs since all 
companies issuing securities that list on the major exchanges, OTC 
Bulletin Board (OTCBB), as well as those that meet certain criteria for 
listing on the Pink Sheets, must register securities with the SEC. In a 
previous report, we crosschecked these data with NASDAQ data on NASDAQ 
IPOs for consistency. For our analysis of size of the companies going 
public and their auditor of record, we dropped companies from our 
analysis that were missing the requisite revenue data in the database. 
We looked at a sample of these companies and concluded that companies 
dropped from our sample are largely companies that used either pro 
forma or partial year revenues in their preliminary filings, or were 
funds, trusts or banks. While funds and trust have been eliminated in 
our empirical work in this report, some publicly traded banks have also 
been excluded in our analysis of IPOs by size. As dropping these 
companies still left a large sample from which we computed the 
descriptive statistics contained in our report, this data limitation is 
minor in the context of this report. 

Survey Data: 

To augment our empirical analysis, we conducted two confidential 
surveys to obtain information from accounting firms and their public 
company clients. First, we surveyed a random sample of 595 publicly 
held companies. We created this population from the Audit Analytics 
database. Our initial population included over 6,900 U.S.-based public 
companies that traded on major exchanges (NYSE, NASDAQ, AMEX, OTCBB), 
excluding foreign filers, funds and trusts, and benefit plans. Our 
sample was allocated across six strata: (1) large companies (Fortune 
1000) that had changed auditors since 2003, (2) medium-size companies 
(greater than $75 million in market capitalization, but not Fortune 
1000) that had changed auditors since 2003, (3) small companies (less 
than $75 million in market capitalization) that had changed auditors 
since 2003, (4) large companies that had not changed auditors since 
2003, (5) medium-size companies that had not changed auditors since 
2003, and (6) small companies that had not changed auditors since 2003. 
The survey included questions related to companies' audit services and 
the selection and engagement of the company's auditor. To develop the 
questionnaire, we consulted with individuals knowledgeable about the 
accounting profession, including representatives of Financial 
Executives International and public companies. We also pretested our 
questionnaire with three public companies of different sizes and 
industries. We directed our survey to the audit committee chair--or 
other member of the audit committee--where available. We obtained names 
and addresses for audit committee members from Audit Analytics. If no 
audit committee information was available, we conducted additional 
research and identified a member of the company's management, typically 
the chief financial officer, as the recipient of the questionnaire. 

We mailed paper questionnaires on May 22, 2007. Those companies not 
completing the questionnaire were sent a replacement questionnaire and 
another reminder letter in June and July. On June 12 and 13, we also 
made phone calls to the corporate headquarters of 210 companies whose 
audit committee chair or other selected informant had not responded in 
an attempt to reach that person to encourage response. After excluding 
29 sampled companies that we found to be ineligible for the population, 
we received 406 usable responses as of August 15, 2007 from the final 
sample of 566 companies, for an overall response rate of 73 percent 
(table 3). Again, the number of responses to individual questions may 
fluctuate, depending on how many respondents answered each question. 

Table 3: Disposition of Public Company Sample: 

Initial population; 
Companies that changed auditor since 2003: Fortune 1000: 80; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of $75 million or greater: 917; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 1,682; 
Companies that have not changed auditor since 2003: Fortune 1000: 792; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 2,295; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 1,140; 
All companies: 6,906. 

Initial sample; 
Companies that changed auditor since 2003: Fortune 1000: 58; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of $75 million or greater: 70; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 124; 
Companies that have not changed auditor since 2003: Fortune 1000: 81; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 178; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 84; 
All companies: 595. 

Ineligibles detected in the sample; 
Companies that changed auditor since 2003: Fortune 1000: 1; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of $75 million or greater: 5; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 14; 
Companies that have not changed auditor since 2003: Fortune 1000: 1; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 4; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 4; 
All companies: 29. 

Final eligible Population; 
Companies that changed auditor since 2003: Fortune 1000: 78; 
Companies that changed auditor since 2003: Non- Fortune 1000, with 
market capitalization of $75 million or greater: 832; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 1,405; 
Companies that have not changed auditor since 2003: Fortune 1000: 778; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 2,228; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 1,061; 
All companies: 6,383. 

Final eligible sample; 
Companies that changed auditor since 2003: Fortune 1000: 57; 
Companies that changed auditor since 2003: Non- Fortune 1000, with 
market capitalization of $75 million or greater: 65; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 110; 
Companies that have not changed auditor since 2003: Fortune 1000: 80; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 174; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 80; 
All companies: 566. 

Usable responses; 
Companies that changed auditor since 2003: Fortune 1000: 42; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of $75 million or greater: 49; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 71; 
Companies that have not changed auditor since 2003: Fortune 1000: 56; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 134; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 54; 
All companies: 406. 

Response rate (number of responses divided by final eligible sample); 
Companies that changed auditor since 2003: Fortune 1000: 74%; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of $75 million or greater: 77%; 
Companies that changed auditor since 2003: Non-Fortune 1000, with 
market capitalization of less than $75 million: 69%; 
Companies that have not changed auditor since 2003: Fortune 1000: 70%; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of $75 million or greater: 78%; 
Companies that have not changed auditor since 2003: Non-Fortune 1000, 
with market capitalization of less than $75 million: 69%; 
All companies: 73%. 

Source: GAO. 

[End of table] 

The public company survey results came from a random sample drawn from 
our population of U.S. publicly traded companies and, thus, could be 
weighted to statistically represent that larger group. We weighted our 
sample to adjust for nonresponse by company size. In our analysis, we 
did detect a small amount of nonresponse bias among small public 
companies traded over the counter. We analyzed the result of this 
nonresponse on selected estimates. We concluded that the nonresponse 
did not affect our findings or conclusions. Unless otherwise noted, the 
margin of error for public company survey results used in the report 
was less than 12 percentage points. 

Second, we surveyed representatives of a take-all sample of the entire 
population--437 midsize and smaller U.S. accounting firms that audited 
at least one public company in 2006 (as identified by information in 
the Audit Analytics database) and were also registered with PCAOB. Each 
of the midsize firms operates nationally and to some extent 
internationally, audits more than 100 public companies, and has around 
$1 billion in revenue or less. The smaller firms audit regional and 
local public companies and have fewer than 100 public company clients. 
We used the survey to obtain firms' views on their plans regarding 
engagements with public companies, participation in associations, 
competition, audit costs and quality, and related issues. We obtained 
name and address information for the executives to be contacted from 
registration applications filed with PCAOB.[Footnote 67] To develop our 
questionnaire, we consulted a number of experts knowledgeable about the 
accounting profession, including representatives of PCAOB. We also 
pretested our questionnaire with one of the four largest firms, a 
midsize firm, and two smaller firms. 

We began our Web-based survey on May 16, 2007, and included all usable 
responses as of August 15, 2007 to produce this report. After we 
removed three firms found to be ineligible for the survey (merged out 
of existence, or without at least one publicly held U.S. client), the 
final eligible population we surveyed was 434 firms. See table 4 for 
the final disposition of our sample, including the subset of firms with 
five or more publicly held clients that we chose to report statistics 
for in this product. 

Table 4: Disposition of Accounting Firms Selected for Survey: 

Initial sample; 
Five or more clients: 181; 
One to four clients: 256; 
Total: 437. 

Ineligibles outside the survey population; 
Five or more clients: 0; 
One to four clients: 3; 
Total: 3. 

Final eligible sample; 
Five or more clients: 181; 
One to four clients: 253; 
Total: 434. 

Refusals; 
Five or more clients: 2; 
One to four clients: 8; 
Total: 10. 

Other nonresponse; 
Five or more clients: 61; 
One to four clients: 112; 
Total: 173. 

Usable responses; 
Five or more clients: 118; 
One to four clients: 133; 
Total: 251. 

Response rate (number of responses divided by final eligible sample); 
Five or more clients: 65%; 
One to four clients: 53%; 
Total: 58%. 

Source: GAO. 

[End of table] 

Those firms not completing the questionnaire were sent up to four 
emails starting on June 1, 2007, and a sample of firms not responding 
were called to attempt to gain their participation on June 13 and 14. A 
paper version of the questionnaire was provided upon request, and firms 
could respond using this questionnaire by fax or mail. 

We received 251 usable responses from these 434 firms, for an overall 
response rate of 58 percent. However, the number of responses to 
individual questions may be fewer than 251, depending on how many 
responding firms were eligible or chose to answer a particular 
question. In addition, we determined during our pretests that many of 
the survey questions were irrelevant for the largest firms, so we 
administered selected survey questions orally to representatives of 
each of the largest firms and conducted indepth individual interviews 
with representatives of each of these firms. That information is 
reported separately from the firm survey results. 

While the accounting firm survey results came from a census of the 
population, we limited our analysis in this report to the 118 
responding firms with 5 or more publicly held clients because the 
response rate of firms with only 1-4 clients was significantly lower 
(53 percent) than for the larger firms (65 percent). Our analysis 
suggested that those small firms responding were different from those 
that did not, in terms of geography and number of clients. We were 
concerned that some small firms did not respond because the prospect of 
more auditing work for publicly held clients did not appeal to them 
and, thus, they found the survey request irrelevant. The small firms 
that responded could have answered the survey questions differently 
than the nonresponding small firms would have. As a result, reporting 
percentages based on responding small firms with one to four clients 
could introduce bias into results if those results were generalized to 
all accounting firms that audited at least one publicly traded company. 

In addition to potential nonresponse bias, there are other practical 
difficulties in conducting any survey that may 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 firms and clients 
with letters, e-mails, and telephone calls to encourage them to respond 
and offer assistance. Before the surveys began, we mailed notification 
letters to both survey samples, encouraging them to respond and asking 
them to correct improper contact information. We also checked and 
edited the survey data and programs used to produce our survey results. 
In addition to the survey statistics cited in this report, all survey 
questions and the frequencies of responses to each question are 
presented in a supplemental product that can be found on our Web site 
at [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP]. 

[End of section] 

Appendix II: Other Issues Related to Concentration in the Audit Market: 

Although having eased slightly recently, the overall market for public 
company audits continues to be highly concentrated among the largest 
accounting firms. In assessing the degree of concentration in a market, 
the standard practice uses the proportion of each competing firm's 
share of the overall revenue collected. By analyzing data from Audit 
Analytics, which collects audit information from the filings public 
companies submit to the Securities and Exchange Commission (SEC), we 
found that the overall extent to which the largest firms dominate the 
amount of total audit fees collected continues to be very high. As 
shown in table 5, 94 percent of the total amount of audit fees paid by 
public companies went to the largest firms in 2006.[Footnote 68] This 
is slightly lower than the 96 percent of audit fees the largest firms 
earned in 2002. As a result, the general market can still be 
characterized as a tight oligopoly, which is a market dominated by a 
small number of sellers with the risk that these firms could greatly 
influence price and other market factors.[Footnote 69] 

Table 5: Market Shares of Audit Fees by Accounting Firm Size: 

Largest; 
2002: 96.2%; 
2004: 96.4%; 
2006: 94.4%. 

Midsize; 
2002: 1.5%; 
2004: 1.7%; 
2006: 2.7%. 

Smaller; 
2002: 2.3%; 
2004: 1.9%; 
2006: 2.9%. 

Source: GAO analysis of Audit Analytics data. 

Note: Data do not include trusts, mutual funds, blank check or 
nonoperating entities. Companies paying audit fees to two different 
auditors in one year are also excluded. 

[End of table] 

The largest firms are significantly larger than their nearest 
competitors. According to data from the Public Accounting Report, which 
collects self-reported financial information from accounting firms, the 
combined audit revenue of the four midsize firms is slightly less than 
one-half the audit revenue of the smallest of the largest 
firms.[Footnote 70] Similarly, as shown in figure 11, the market share 
as measured by audit fees of each of the largest firms individually is 
much larger than the market share of the other groups combined. 

Figure 11: 2006 Market Shares of Each of the Largest Firms Compared to 
Other Firms, as Measured by Audit Fees: 

This figure is a pie chart showing 2006 market shares of each of the 
largest firms compared to other firms, as measured by audit fees. 

PricewaterhouseCoopers: 30.3%; 
Ernst & Young: 23.5%; 
Deloittle $ Touche: 21.2%; 
KPMG: 19.4%; 
Smaller firms: 2.9%; 
Midsize firms: 2.7%. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

Note: Figure does not include trusts, funds, blank check or 
nonoperating entities. Companies paying audit fees to two different 
auditors in one year are also excluded. 

[End of figure] 

Overall Audit Market and Many Specific Industries Are Highly 
Concentrated: 

Another key statistical measure that is used to assess the degree to 
which a market is dominated by relatively few firms also shows that the 
public company audit market is highly concentrated. The Hirschman- 
Herfindahl Index (HHI) is one of the concentration measures used by 
government agencies, such as DOJ and the Federal Trade Commission, to 
aid in the assessment of market structure and potential market power. 
An HHI for a market is calculated using the various market shares of 
the firms competing to offer goods or services within it.[Footnote 71] 
According to merger guidelines issued by DOJ, an HHI below 1,000 
indicates a market that is predisposed to perform competitively and one 
that is unlikely to have adverse competitive effects. An HHI between 
1,000 and 1,800 indicates a moderately concentrated market, while an 
HHI above 1,800 indicates a highly concentrated market. 

As shown in figure 12, the HHI in 2006 for the overall market for 
public company audits--as determined based on the audit fees collected 
by accounting firms auditing public companies--was 2,300, a level 
considered to be significantly concentrated. This represents a slight 
decline since 2002, when the audit market's HHI was around 2,390 after 
it peaked following the dissolution of Arthur Andersen.[Footnote 72] 

Figure 12: Hirschman-Herfindahl Indexes, 2000-2006: 

This figure is a bar chart showing Hirschman-Herfindahl Indexes, 2000-
2006. The X axis represents the year, and the Y axis represents HHI. 

[See PDF for image] 

Note: HHI figures based on total audit fees. 

[End of figure] 

We also found that analyzing the audit market by region and industry 
reveals that many industries were similarly highly concentrated and 
that concentration also exists across six major geographic regions of 
the country.[Footnote 73] We segmented the market into distinct 
economic sector (industry) audits and distinct regional audits. As 
figure 13 illustrates, all industries are above the threshold for 
significant market power and have generally shown some improvement 
since 2002, but some sectors are significantly more concentrated than 
others. A number of these industry-specific markets would not only be 
considered tight oligopolies but would also be considered dominant firm 
markets (one firm holding over 60 percent of the market with no 
significant competitors). For example, Ernst & Young accounts for 77 
percent of all audit fees collected in the agricultural sector while, 
the second largest firm only holds 12 percent of the market. 

Figure 13: Hirschman-Herfindahl Indexes, Markets Segmented by Industry: 

This figure is a dotted chart showing Hirschma-Hergindahl Indexes, 
Market segmented by industry. 

[See PDF for image] 

Source: GAO analysis of Audit Analysis data. 

Notes: Industries defined by two digit North American Industry 
Classification System codes. 

[A] The warehousing sector contains fewer than 15 companies. 

[B] The agriculture sector has fewer than 30 companies. 

[End of figure] 

Similarly, we found regional markets in the United States such the Mid- 
Atlantic and the Midwest to be somewhat more concentrated than the 
Western regions, although all were highly concentrated.[Footnote 74] 

Loss of One of the Largest Firms Would Result in Even Higher 
Concentration: 

In the event of further mergers, acquisitions, or closures of large 
firms, the market would become even more concentrated. To determine the 
effect of further concentration, we simulated the effect of the failure 
or exit of one of the largest firms and the effect of a merger between 
two of the largest firms.[Footnote 75] When simulating the effect of 
the failure or exit of the smallest of the largest firms, we 
distributed the clients of the failed firm among the remaining firms in 
the same proportion as the clients of Arthur Andersen were distributed 
after that firm dissolved. Under this scenario, the resulting HHI of 
the overall audit market would rise from 2,300 to roughly 3,000 which 
is considerably further above what DOJ considers to be a concentrated 
market (fig. 14). Further, figure 14 shows that if we segment the audit 
market by size, that the increase in HHI would be greatest among large 
companies. Higher concentration could increase the risk that the 
remaining large accounting firms could exercise market power to raise 
prices and coordinate their actions among themselves to the detriment 
of their clients. 

Figure 14: HHI with Simulated Firm Failure or Merger: 

This figure is a bar graph showing HHI with simulated firm failure or 
merger. The X axis represents company revenue, and the Y axis 
represents HHI. 

[See PDF for image] 

Source: GAO analysis of Audit Analytics data. 

[End of figure] 

The figure also shows that a merger between two of the largest firms 
could significantly increase concentration for the overall audit 
market. To identify the result of such a merger, we simulated the 
effect of a merger between the two smallest of the largest firms and 
found that HHI for the market as a whole would increase from 2,300 to 
3,124, which is again well above DOJ's threshold for a concentrated 
market and higher than in the case of a firm failure. As with the case 
of a firm failure, segmenting the audit market by size illustrates the 
biggest increase in HHI would occur in the market for large public 
company audits, which according to our simulation would rise from 2,558 
to 3,476 (fig. 14). 

Appendix III: Analysis of Auditor Changes: 

In the last few years, companies that changed their auditor switched to 
a midsize or smaller accounting firm more frequently than to one of the 
largest firms. We analyzed data from the Audit Analytics database of 
over 8,000 auditor changes among companies registered with the 
Securities and Exchange Commission (SEC) and listed on major exchanges 
(NYSE, NASDAQ and AMEX), as well as those traded through other 
exchanges such as OTCBB. Through this analysis, we identified 5,867 
total changes in auditors between January 2003 and June 2007.[Footnote 
76] As shown in table 6, the largest firms lost a net total of 1,149 
clients, while the midsize and smaller firms picked up a net total of 
282 and 867 clients, respectively. 

Table 6: Public Companies Changing Accounting Firms, January 2003 to 
June 2007: 

Accounting firm: Largest: Number of companies leaving largest firms; 
Accounting firm after change: Largest: 561; 
Accounting firm after change: Midsize: 560; 
Accounting firm after change: Smaller: 742; 
Total departures: 1,863. 

Accounting firm: Largest: Average revenue of largest firms' clients; 
Accounting firm after change: Largest: $1,687,884,613; 
Accounting firm after change: Midsize: $170,386,590; 
Accounting firm after change: Smaller: $60,857,991; 
Total departures: [Empty]. 

Accounting firm: Largest: Average audit fee paid by largest firms' 
clients; 
Accounting firm after change: Largest: $2,013,663; 
Accounting firm after change: Midsize: $549,825; 
Accounting firm after change: Smaller: $227,901; 
Total departures: [Empty]. 

Accounting firm: Midsize: Number of companies leaving midsize firms; 
Accounting firm after change: Largest: 52; 
Accounting firm after change: Midsize: 45; 
Accounting firm after change: Smaller: 342; 
Total departures: 439. 

Accounting firm: Midsize: Average revenue of midsize firms' clients; 
Accounting firm after change: Largest: $581,263,262; 
Accounting firm after change: Midsize: $84,047,669; 
Accounting firm after change: Smaller: $34,511,234; 
Total departures: [Empty]. 

Accounting firm: Midsize: Average audit fee paid by midsize firms' 
clients; 
Accounting firm after change: Largest: $820,200; 
Accounting firm after change: Midsize: $300,287; 
Accounting firm after change: Smaller: $151,511; 
Total departures: [Empty]. 

Accounting firm: Smaller: Number of companies leaving smaller firms; 
Accounting firm after change: Largest: 101; 
Accounting firm after change: Midsize: 116; 
Accounting firm after change: Smaller: 3,348; 
Total departures: 3,565. 

Accounting firm: Smaller: Average revenue of smaller firms' clients; 
Accounting firm after change: Largest: $106,434,760; 
Accounting firm after change: Midsize: $40,328,634; 
Accounting firm after change: Smaller: $6,045,755; 
Total departures: [Empty]. 

Accounting firm: Smaller: Average audit fee paid by clients; 
Accounting firm after change: Largest: $431,124; 
Accounting firm after change: Midsize: $213,265; 
Accounting firm after change: Smaller: $52,885; 
Total departures: [Empty]. 

Total gains [A]; 
Accounting firm after change: Largest: $153; 
Accounting firm after change: Midsize: $676; 
Accounting firm after change: Smaller: $1,084; 
Total departures: [Empty]. 

Total losses [B]; 
Accounting firm after change: Largest: ($1,302); 
Accounting firm after change: Midsize: ($394); 
Accounting firm after change: Smaller: ($217); 
Total departures: [Empty]. 

Net gain (loss); 
Accounting firm after change: Largest: ($1,149); 
Accounting firm after change: Midsize: $282; 
Accounting firm after change: Smaller: $867; 
Total departures: [Empty]. 

Source: GAO analysis of Audit Analytics data. 

Notes: Average revenue and average audit fee figures are based only on 
those companies with available relevant financial data. 

[A] Total gains represent the sum of companies that went to that 
particular category of accounting firm (largest, midsize, or smaller) 
from another category. For example, the largest accounting firms gained 
153 companies from 2003 to 2007 (52 from midsize firms and 101 from 
smaller firms). 

[B] Total losses represent the sum of companies that left that 
particular category of accounting firm (largest, midsize, or smaller) 
for another category. For example, large accounting firms lost 1,302 
companies from 2003 to 2007 (560 went to midsize firms and 742 went to 
smaller firms). 

[End of table] 

Table 6 also shows that while midsize and smaller firms gained a larger 
number of clients, the largest firms still retained the clients that, 
on average, have higher revenues and pay larger audit fees than the 
companies that switched to a midsize or smaller firm. Therefore, 
despite the largest firms experiencing a net loss of over one thousand 
clients, most of these were smaller companies with lower revenues and 
audit fees. Companies that changed from one of the largest firms to 
another had average revenues of over $1 billion, while companies that 
changed from one of the largest firms to a smaller firm had average 
revenues of just over $60 million. 

Within these changes, we also found that midsize firms gained clients 
in particular regions and industries. Overall, as shown in table 7, the 
largest firms lost clients in every region of the United States (Mid- 
Atlantic, New England, Southeast, Midwest, Southwest, and West). In 
contrast, the midsize firms experienced net gains in clients in all of 
these regions, especially in the Midwest where they acquired 27 percent 
of the companies that changed auditors. Smaller firms also added 
clients in all regions, most notably in the West, where 329 additional 
companies selected them to serve as the auditor of record. This 
represents 82 percent of the changes made in that region. Incidentally, 
the Western region is also the area in which the largest firms suffered 
their worst losses and the midsize firms generally experienced their 
weakest gains. 

Table 7: Percentage and Number of Changes Public Companies Made in 
Auditors, by Region: 

Engaged Auditor: Largest; 
Percentage of companies changing auditors gained or lost: Mid-Atlantic: 
14.11%; 
(-261); 
Percentage of companies changing auditors gained or lost: New England: 
; 
20.91%; 
(-84); 
Percentage of companies changing auditors gained or lost: Southeast: 
10.44%; 
(-179); 
Percentage of companies changing auditors gained or lost: Midwest: 
19.63%; 
(-152); 
Percentage of companies changing auditors gained or lost: Southwest: 
10.36%; 
(-110); 
Percentage of companies changing auditors gained or lost: West: 9.27%; 
(-360); 
Percentage of companies changing auditors gained or lost: Total: 
12.16%; 
(-1,149). 

Engaged Auditor: Midsize; 
Percentage of companies changing auditors gained or lost: Mid-Atlantic: 
13.49%; 
(75); 
Percentage of companies changing auditors gained or lost: New England: 
13.94%; 
(11); 
Percentage of companies changing auditors gained or lost: Southeast: 
11.38%; 
(49); 
Percentage of companies changing auditors gained or lost: Midwest: 
27.23%; 
(88); 
Percentage of companies changing auditors gained or lost: Southwest: 
11.18%; 
(28); 
Percentage of companies changing auditors gained or lost: West: 8.25%; 
(31); 
Percentage of companies changing auditors gained or lost: Total: 
12.29%; 
(282). 

Engaged Auditor: Smaller; 
Percentage of companies changing auditors gained or lost: Mid-Atlantic: 
72.41%; 
(186); 
Percentage of companies changing auditors gained or lost: New England: 
65.16%; 
(73); 
Percentage of companies changing auditors gained or lost: Southeast: 
78.18%; 
(130); 
Percentage of companies changing auditors gained or lost: Midwest: 
53.15%; 
(64); 
Percentage of companies changing auditors gained or lost: Southwest: 
78.44%; 
(82); 
Percentage of companies changing auditors gained or lost: West: 82.48%; 
(329); 
Percentage of companies changing auditors gained or lost: Total: 
75.54%; 
(867). 

Source: GAO analysis of Audit Analytics data. 

Note: Changes in auditors where region was unknown were excluded. 

[End of table] 

Our analysis of companies that ultimately selected one of the largest 
firms or a midsize firm shows that midsize firms have made inroads into 
certain industry sectors. In sectors in which there were at least 30 
changes, Grant Thornton captured more than 20 percent of the companies 
that switched in mining; certain manufacturing; wholesale trade; 
information; professional, scientific, and technical services; and 
accommodation and food services. BDO Seidman also secured over 20 
percent of the changes in six sectors with at least 30 changes: certain 
manufacturing; wholesale trade; information; professional, scientific, 
and technical services; management of companies and enterprises; and 
administrative, support, and waste management and remediation services. 
Finally, Crowe Chizek was the only firm in the top eight to engage more 
than 20 percent of the finance and insurance companies that switched to 
one of the largest firms or a midsize firm. 

Companies reported a number of different reasons for changing auditors. 
According to our survey results, large companies that recently changed 
auditors frequently reported that they did so to obtain better customer 
service (69 percent). Many large companies also reported changing 
auditors to obtain a better working relationship with their auditor (67 
percent). Others said they changed auditors to obtain lower fees (26 
percent). 

In interviews, representatives of public companies, accounting firms, 
and other market participants attributed many of the midsize and small 
company auditor changes to the aftermath of the Sarbanes-Oxley Act, 
which, among other things, enhanced auditor independence and required 
increased reviews of public companies' internal controls (which 
initially affected larger public companies) and prompted the largest 
firms to focus on providing those services to their large clients. This 
increased workload increased the largest firms' costs and fees and 
necessitated that some smaller public companies expand their options 
and look to midsize or smaller firms. Officials from two of the largest 
firms told us that they did make changes to their client portfolios in 
the period after Sarbanes-Oxley was passed, including resigning as 
auditor of record from some clients for risk or capacity constraint 
reasons. On our survey of the over 400 U.S. accounting firms that audit 
public companies, midsize and smaller accounting firms responding also 
reported resigning as auditor of record for risk mitigation reasons, 
specific issues with the client, or fees being insufficient to cover 
audit costs.[Footnote 77] Midsize and small companies that recently 
changed auditors indicated on our survey that they did so to obtain 
better customer service, a better working relationship with their 
auditor, lower fees or because their auditor resigned. In addition, 
some companies commented that they changed because their auditor was 
too busy and expensive for them or because their auditor wanted to 
focus on larger clients. A few reported, however, that they changed 
auditors because the auditor went out of business or merged with 
another firm.[Footnote 78] 

Appendix IV: Trends in Audit Costs and Quality: 

Various factors likely affected changes in audit fees and audit quality 
since the demise of Enron and Arthur Andersen. According to our data 
analysis, survey, and interviews, audit costs and quality seem to have 
increased in recent years. Additional work associated with new and 
increasingly complex accounting and auditing standards, cost increases 
associated with auditor changes and with acquiring and retaining audit 
staff, new costs associated with regulatory oversight of public company 
audits and other requirements of the Sarbanes-Oxley Act (the Act), and 
some firms' recovering more of their costs have likely contributed to 
increases in audit fees. Similarly, while many of these factors have 
been cited as reasons for why it has been increasingly hard for 
accounting firms to maintain audit quality, market participants 
generally agreed that these changes have contributed to improved audit 
quality. 

Factors Influencing Audit Costs: 

To varying degrees, different factors likely contributed to increased 
audit fees since 2001 including firms' performing additional audit 
work, higher costs commonly associated with auditor changes and with 
acquiring and retaining audit staff, increases associated with the new 
public company audit oversight structure and auditors expanded 
interaction with audit committees, and firms' recovering more of their 
costs through audit fees. Many market participants have noted that the 
number and complexity of requirements associated with accounting and 
auditing standards have contributed to firms performing new and 
additional procedures to help comply with the new requirements and 
reduce audit and litigation risk. Since 2000, public companies and 
their auditor have, where applicable, had to deal with new and expanded 
accounting standards dealing with hedge activities, derivatives, other 
financial instruments, impaired assets, and intangible assets including 
goodwill. In addition, firms have had to deal with new and expanded 
audit standards related to fraud, audit documentation, and fair value 
measurements and disclosures. 

In response to the demise of Arthur Andersen in 2002, more than 1,000 
of its public company audit clients had to find new audit firms. In 
addition, as firms and public companies adjust to market-related 
changes following the 2002 Sarbanes-Oxley Act, auditor change has 
continued. Our analysis of auditor changes found that between 2003 and 
2007 almost 6,000 auditor changes occurred. Echoing our 2003 study of 
audit firm rotation, some market participants we spoke to said that 
changing auditors would increase public company audit-related costs. As 
part of our 2003 study of audit firm rotation, we surveyed large 
(Fortune 1000) public companies and firms that audited more than 10 
public companies and more than 67 percent of companies and firms 
responded that a change in auditor would likely increase firms' initial 
year audit costs and public company audit support costs--taken 
together--by more than 30 percent. In addition, accounting firms we 
have spoken to and surveyed cited increased costs of attracting and 
retaining talented audit staff and specialists. Many of those 
commenting on this factor linked the higher costs of attracting and 
retaining talented staff to the increased capacity-related demands 
facing the firms associated with implementing the Act. 

Also, the Act established a new major audit requirement that has 
significantly expanded the scope of financial audits for public 
companies by requiring, among other things, that their auditor assess 
and report on the effectiveness of their internal control over 
financial reporting (Section 404b). Representatives from all sizes of 
accounting firms we spoke to said that the new audit requirement 
related to internal controls, which generally became effective for the 
2004 audits of the largest public companies, has resulted in a 
substantial increase in their workload and related costs associated 
with additional audit staff and expertise, and audit methodologies. 
Until 2008, auditors for only the largest public companies, those 
considered to be accelerated filers, have had to comply with the new 
internal control audit-related requirements. Firms that audit smaller 
public companies, those considered nonaccelerated filers, are scheduled 
to comply with the new audit requirement with annual filings after 
December 15, 2008. When effective for smaller public companies, the 
requirement is expected to further increase their audit fees. 

The accounting firms that we have spoken to noted that, in addition to 
requiring new internal control work; other requirements of the Act have 
contributed to increased audit costs and the fees charged to public 
companies. The Act established a new regulatory oversight structure for 
firms that audit public companies with the creation of the Public 
Company Accounting Oversight Board (PCAOB). To date, PCAOB has 
established firm registration and inspection programs and has adopted 
auditing standards that Securities and Exchange Commission (SEC) has 
approved that registered firms must follow. Several firms we have 
spoken to since the PCAOB was established noted that they have incurred 
additional costs to support PCAOB-related activities, as well as 
respond to the audit documentation standard and a shorter audit partner 
rotation period mandated by the Act. In addition, since a key provision 
of the Act made public company audit committees responsible for hiring 
the firm and overseeing the audit, some firms we spoke to said they 
have seen a substantial increase in their staffs' interaction with the 
audit committees members, which has added to audit costs. 

A number of firms we spoke to also noted that the Act's stricter 
independence requirements may have contributed to higher audit fees by 
causing some firms to change the way they price their audit service. 
The stricter independence requirements were intended to significantly 
limit the types of nonaudit services firms can sell to their audit 
clients without impairing the firm's independence. Department of 
Justice (DOJ) officials and others we spoke to stated that the 
significant limits on firms' opportunities to sell audit clients 
nonaudit services make them less likely to under price audits as a loss 
leader. To the extent that firms in the past have underpriced their 
audits expecting to sell nonaudit services which are now prohibited, it 
is reasonable to believe that these firms have increased their audit 
fees to cover their audit cost. 

The results of our survey of midsize and smaller firms and our 
discussions with the largest firms generally confirmed the factors that 
have increased the audit cost fees. All four of the largest firms 
reported in interviews that the increasing complexity of accounting and 
auditing standards and the additional requirements of new standards 
were factors having a significant effect on the cost of audits. The 
largest firms and the other firms differed only slightly on other 
factors that have significantly affected audit cost. The largest firms 
noted costs to attract and retain talented staff and costs related to 
litigation as the two other top factors contributing to increased audit 
costs. In addition to the requirements of new standards and the price 
of talent, the other firms cited the time and effort to prepare for the 
PCAOB inspection and the complexity of accounting principles and 
auditing standards as their top factors. 

The results of our survey of the audit committee chairs of over 500 
public companies also show that increases in audit hours and rates 
charged by firms and other factors have led to increased audit fees. 
Public companies that reported increasing audit fees reported that 
changes in the number of hours by the audit engagement team (85 
percent) and senior partners (73 percent), as well as changes in hourly 
rates of the audit team and senior partners (76 percent), led to 
increased audit fees.[Footnote 79] In addition, of those public 
companies reporting that their audit costs had increased since 2003, 84 
percent reported that the additional requirement for an audit of 
internal control over financial reporting was a factor in the increase 
of their audit. 

Factors Influencing Audit Quality: 

While management has the primary responsibility for the quality and 
reliability of a public company's financial statements, the auditor is 
responsible for providing reasonable assurance, through an independent 
audit, about the reliability of the company's financial statements. 
Investors need to know that the financial statements on which they make 
investment decisions are reliable and the independent audit plays a 
vital role in assuring their reliability. In a prior report, we defined 
a quality audit as one conducted, in accordance with applicable 
auditing standards to provide reasonable assurance about whether the 
audited financial statements are presented in accordance with 
applicable accounting principles and are free of material 
misstatements.[Footnote 80] Audit quality is often thought to include 
the experience and technical capability of the auditing firm partners 
and staff, the capability to efficiently respond to a client's needs, 
and the ability and willingness to appropriately identify and surface 
material reporting issues in financial reports. When high quality 
public company audits are performed, management and investors are more 
likely to rely on the financial statements and the financial 
information they contain. 

Audit Oversight: 

For decades, the public accounting profession was, in practice, self- 
regulated, taking responsibility for establishing auditing standards 
and administering a program designed to oversee the activities of 
independent public accounting firms that audit companies whose 
securities are registered with the SEC. While given statutory authority 
for establishing rules governing financial reports for publicly traded 
companies in the 1930s, SEC permitted the accounting profession 
(American Institute of Certified Public Accountants (AICPA)) to set 
auditing standards, subject to SEC's oversight of the standard-setting 
process. Concerns raised with the audits of public companies in the 
1970s focused attention on the need to improve the quality control 
mechanisms used by firms to ensure that professional standards were 
being met. In response, AICPA revised its approach to setting audit 
standards in 1979 by establishing the Auditing Standards Board, which 
was designed to have a more efficient standard-setting process through 
a body composed of representatives from firms of all sizes and 
nonpublic accounting organizations. In 1977, AICPA instituted two 
voluntary peer review programs--one for firms performing audits of 
public companies and one for those performing audits of private 
companies--designed to review the systems of audit quality controls for 
participating firms' audits of companies. Also, in 1977, AICPA created 
the Public Oversight Board to represent the public interest by 
overseeing the audit standards-setting process and the voluntary peer 
review program. 

The purpose of the peer review program AICPA established was to provide 
the public with assurance that a firm performing auditing services for 
companies registered with SEC had an effective quality control system 
that provided reasonable assurance that its audits were in compliance 
with generally accepted auditing standards. According to the AICPA, a 
number of large accounting firms had been using peer reviews to enhance 
audit quality as far back as the early 1960s. In 1988, AICPA made peer 
review mandatory for all member firms performing auditing and 
accounting services. 

To enhance auditor independence, improve audit quality, and restore 
investor confidence in response to the major accountability breakdowns 
at Enron and WorldCom, the Congress, through the enactment of the 
Sarbanes-Oxley Act, replaced the profession's longstanding self- 
regulatory structure for public company audits with an independent 
regulatory structure administered by PCAOB. Among its other 
responsibilities, the Act made PCAOB responsible for establishing 
auditing and other professional standards applicable to the audits of 
public companies by registered firms and inspecting those firms which 
perform public company audits. Since its establishment in 2002, PCAOB 
has designated certain existing auditing and quality control standards 
issued by the Auditing Standards Board through April 2003 as its 
interim standards, while focusing its attention on issuing new and 
modifying certain interim auditing standards. As of September 2007, 
PCAOB has not issued either new or modified quality control standards. 

In addition to its work on standards, PCAOB is responsible, through its 
inspection program, for evaluating the auditor's application of 
existing audit and related requirements standards to promote high 
quality audits.[Footnote 81] The PCAOB inspection program replaced the 
AICPA's peer review program that evaluated firms' public company 
auditing practices.[Footnote 82] 

Views on Audit Quality: 

Many factors can affect audit quality including auditing, accounting, 
and quality control standards; accounting firm inspections; and audit 
staff quality; and the availability of qualified audit staff. In asking 
accounting firms about audit quality, we considered audit quality to 
include the experience and technical capability of the audit firm 
partners and staff as well as the capability to efficiently respond to 
a client's needs and identify and communicate material reporting issues 
in financial reports. All of the largest firms and over 80 percent of 
the midsize and 3 accounting firms responding to our survey said that, 
since 2003, it has been harder to maintain audit quality.[Footnote 83] 
This widely held view likely reflects the significant changes in the 
auditing environment since 2003 and the capacity demands facing the 
profession as audits have become more complex, requirements have 
expanded, and the PCAOB's inspection program has been implemented. 
Together these changes have increased emphasis on audit quality. 
Midsize and smaller accounting firms participating in our survey 
indicated that several factors have made it harder to maintain audit 
quality, with the most significant being the complexity of the 
accounting principles and auditing standards (92 percent), staff 
experience and technical capability with complex accounting principles 
and auditing standards (90 percent), and availability of qualified 
staff (84 percent). The largest firms' views on audit quality were also 
in line with those of the survey respondents. Representatives of all of 
the largest firms indicated that the complexity of the accounting 
principles and auditing standards and staff experience and technical 
capability with complex accounting principles and auditing standards 
have made maintaining audit quality harder. In addition, three of the 
four firms indicated the availability of qualified staff has made 
maintaining audit quality harder. During interviews, some 
representatives of the largest firms noted that they have significantly 
increased the number of staff in their national offices who provide 
technical consultations to the audit teams due to the complexity of the 
accounting principles and auditing standards. Also, during interviews, 
representatives of accounting firms mentioned that they have faced 
stiffer competition in hiring due to companies expanding their 
accounting and internal audit departments, SEC and PCAOB increasing 
their staff, and consulting firms wanting experienced accountants to 
help their clients implement section 404. 

During our interviews, all of the largest firms and in replying to the 
survey, all of the midsize firms who responded, indicated that the 
increased role of the audit committee made maintaining audit quality 
easier. Only 23 percent of the smaller survey respondents shared this 
view.[Footnote 84] Also, half of the largest and midsize firms 
responded that complying with PCAOB inspections made maintaining audit 
quality easier as compared with only 8 percent of the smaller firm 
survey respondents. 

Despite the fact that accounting firms reported it was harder to 
maintain audit quality, market participants we spoke to who commented 
on audit quality generally noted that they thought audit quality had 
improved. Similarly, public companies think several aspects of audit 
quality have increased in recent years. In our survey to public 
companies, we asked about specific aspects of audit quality and how 
those aspects have changed since 2003.[Footnote 85] While companies 
reported that several aspects of quality have remained the same, the 
aspects the public company survey respondents indicated increased most 
significantly were the amount of time spent by audit engagement team 
(77 percent), the addition of audit of internal control over financial 
reporting as required in the Sarbanes-Oxley Act (73 percent), and 
amount of time spent by senior partners and experts (72 percent). 
Company officials and others we interviewed also generally said that 
overall audit quality had increased in recent years. One controller we 
interviewed said that overall audit quality had become lax before the 
Sarbanes-Oxley Act was passed. However, he thinks that quality has 
changed significantly in recent years and auditors are much more 
rigorous. While public companies we surveyed were generally satisfied 
with their auditor of record considering the scope of the audit, the 
fees paid for audit services and the quality they received, several 
respondents commented that the requirements in Sarbanes-Oxley have led 
to significant increases in audit work and fees. Some survey 
respondents also questioned whether these higher costs exceeded the 
benefits of the additional requirements. 

[End of section] 

Appendix V: Econometric Analysis of the Effect of Industry 
Concentration on Audit Fees: 

The current structure of the market for audit services has raised 
concerns about the potential for anticompetitive pricing, especially 
for the largest public company clients. While the classic oligopoly 
theory suggests that prices of goods and services are positively 
associated with market concentration, the modern theory of industrial 
organization makes no clear statement regarding the impact of 
concentration on competition. Therefore, to investigate the 
relationship between concentration and audit fees, we compiled a panel 
data set using Audit Analytics data. The data initially contained 
observations on over 12,000 companies over a seven-year period from 
2000 to 2006 excluding funds, trusts, and nonoperating entities. To 
analyze the relationship as validly as the data constraints allowed, we 
employed various panel data modeling techniques. While the results 
suggest that the increase in audit fees appears largely unrelated to 
supplier concentration, in part because of all the contemporaneous 
changes occurring in the market and other modeling and data 
limitations, these findings should not necessarily be viewed as 
definitive or as proof that that market for audit services is 
competitive. This appendix provides additional information on the 
construction of our database, econometric model, additional descriptive 
statistics and the limitations of the analysis. 

The Panel Data Sample Was Created by Compiling Several Audit Analytics 
Databases: 

To construct the database used to estimate the econometric model we 
compiled audit fee and financial data and additional information on the 
thousands of public companies audited by the largest, midsize, and 
other public accounting firms. Audit Analytics, an online intelligence 
service maintained by Ives Group, Incorporated provides, among other 
things, a database of fees paid by public companies to their auditors 
back to 2000 with demographic and financial information. In addition, 
we added information on these companies using the Late Filer, Internal 
Control, Restatement, Auditor Change and Audit Opinion databases also 
maintained by Audit Analytics. In this manner, we were able to include 
information on the risk and auditing characteristics of the companies 
as additional control variables in the resultant econometric model. 
Moreover, a panel data set, that is data pooled across all companies 
over the 2000 to 2006 period, allowed us to account for variances in 
audit fees across companies and over time as well as use techniques 
that enhance the validity of the parameter estimates. We deleted from 
our sample various entities including funds, plans and trusts, 
subsidiaries with parent data already included in the database, blank 
check and nonoperating entities and duplicate entries. Table 8 reports 
the descriptive statistics on the resultant panel data set. Because 
some companies either did not exist until the later years, merged with 
other companies, went private, entered into bankruptcy, or otherwise 
failed to report at some point over the period, not all the companies 
have the requisite data for each year. Moreover, companies were not 
required to report audit fees until 2001.[Footnote 86] As a result, the 
panel is unbalanced. The public companies clients remaining in our 
sample were used initially to investigate two related questions: 

* When other important factors influencing audit fees are accounted 
for, do companies operating in more concentrated sectors of the economy 
pay higher fees? 

* When other important factors influencing audit fees are accounted 
for, do companies audited by accounting firms with higher market shares 
in a certain sector pay higher fees? 

Table 8: Descriptive Statistics of the Panel Data Set, 2000-2006: 

Dollars in millions. 

Audit fees [A]: Average; 
Dollars in millions: 2000: N=4,440: $0.651; 
Dollars in millions: 2001: N=6,498: $0.707; 
Dollars in millions: 2002: N=8,762: $0.931; 
Dollars in millions: 2003: N=9,817: $1.016; 
Dollars in millions: 2004: N=9,863: $1.431; 
Dollars in millions: 2005: N=9,270: $1.559; 
Dollars in millions: 2006: N=8,559: $1.711. 

Audit fees [A]: Median; 
Dollars in millions: 2000: N=4,440: 0.186; 
Dollars in millions: 2001: N=6,498: 0.187; 
Dollars in millions: 2002: N=8,762: 0.186; 
Dollars in millions: 2003: N=9,817: 0.187; 
Dollars in millions: 2004: N=9,863: 0.243; 
Dollars in millions: 2005: N=9,270: 0.304; 
Dollars in millions: 2006: N=8,559: 0.349. 

Audit fees [A]: Standard deviation; 
Dollars in millions: 2000: N=4,440: 2.134; 
Dollars in millions: 2001: N=6,498: 2.341; 
Dollars in millions: 2002: N=8,762: 3.673; 
Dollars in millions: 2003: N=9,817: 3.671; 
Dollars in millions: 2004: N=9,863: 5.158; 
Dollars in millions: 2005: N=9,270: 5.022; 
Dollars in millions: 2006: N=8,559: 5.395. 

Revenue of firms audited [A]: Average; 
Dollars in millions: 2000: N=4,440: $2,044; 
Dollars in millions: 2001: N=6,498: $1,918; 
Dollars in millions: 2002: N=8,762: $1,888; 
Dollars in millions: 2003: N=9,817: $1,984; 
Dollars in millions: 2004: N=9,863: $2,191; 
Dollars in millions: 2005: N=9,270: $2,292; 
Dollars in millions: 2006: N=8,559: $2,551. 

Revenue of firms audited [A]: Median; 
Dollars in millions: 2000: N=4,440: 130; 
Dollars in millions: 2001: N=6,498: 122; 
Dollars in millions: 2002: N=8,762: 84; 
Dollars in millions: 2003: N=9,817: 70; 
Dollars in millions: 2004: N=9,863: 68; 
Dollars in millions: 2005: N=9,270: 71; 
Dollars in millions: 2006: N=8,559: 80. 

Revenue of firms audited [A]: Standard deviation; 
Dollars in millions: 2000: N=4,440: 10,295; 
Dollars in millions: 2001: N=6,498: 9,209; 
Dollars in millions: 2002: N=8,762: 9,024; 
Dollars in millions: 2003: N=9,817: 9,946; 
Dollars in millions: 2004: N=9,863: 11,444; 
Dollars in millions: 2005: N=9,270: 12,044; 
Dollars in millions: 2006: N=8,559: 13,154. 

Assets of firms audited[A]: Average; 
Dollars in millions: 2000: N=4,440: $5,582; 
Dollars in millions: 2001: N=6,498: $5,070; 
Dollars in millions: 2002: N=8,762: $5,983; 
Dollars in millions: 2003: N=9,817: $6,476; 
Dollars in millions: 2004: N=9,863: $7,244; 
Dollars in millions: 2005: N=9,270: $7,476; 
Dollars in millions: 2006: N=8,559: $8,404. 

Assets of firms audited[A]: Median; 
Dollars in millions: 2000: N=4,440: 312; 
Dollars in millions: 2001: N=6,498: 256; 
Dollars in millions: 2002: N=8,762: 188; 
Dollars in millions: 2003: N=9,817: 156; 
Dollars in millions: 2004: N=9,863: 160; 
Dollars in millions: 2005: N=9,270: 166; 
Dollars in millions: 2006: N=8,559: 190. 

Assets of firms audited[A]: Standard deviation; 
Dollars in millions: 2000: N=4,440: 37,597; 
Dollars in millions: 2001: N=6,498: 38,148; 
Dollars in millions: 2002: N=8,762: 46,492; 
Dollars in millions: 2003: N=9,817: 52,293; 
Dollars in millions: 2004: N=9,863: 62,141; 
Dollars in millions: 2005: N=9,270: 65,008; 
Dollars in millions: 2006: N=8,559: 75,389. 

Median fees (percentage of revenue); 
Dollars in millions: 2000: N=4,440: 0.14%; 
Dollars in millions: 2001: N=6,498: 0.15%; 
Dollars in millions: 2002: N=8,762: 0.22%; 
Dollars in millions: 2003: N=9,817: 0.27%; 
Dollars in millions: 2004: N=9,863: 0.37%; 
Dollars in millions: 2005: N=9,270: 0.39%; 
Dollars in millions: 2006: N=8,559: 0.36%. 

Average fees (percentage of revenue); 
Dollars in millions: 2000: N=4,440: 0.04%; 
Dollars in millions: 2001: N=6,498: 0.04%; 
Dollars in millions: 2002: N=8,762: 0.06%; 
Dollars in millions: 2003: N=9,817: 0.06%; 
Dollars in millions: 2004: N=9,863: 0.08%; 
Dollars in millions: 2005: N=9,270: 0.08%; 
Dollars in millions: 2006: N=8,559: 0.08%. 

Median fees (percentage of assets); 
Dollars in millions: 2000: N=4,440: 0.07%; 
Dollars in millions: 2001: N=6,498: 0.09%; 
Dollars in millions: 2002: N=8,762: 0.14%; 
Dollars in millions: 2003: N=9,817: 0.19%; 
Dollars in millions: 2004: N=9,863: 0.27%; 
Dollars in millions: 2005: N=9,270: 0.31%; 
Dollars in millions: 2006: N=8,559: 0.29%. 

Source: GAO analysis of Audit Analytics data. 

Notes: N is the number of observations in each year that have audit 
fees reported. 

[A] Dollars are converted to real terms using the chain weighted GDP 
price index. Total audit fees include audit and audit-related fees. 

[End of table] 

Our panel data approach investigates industry (economic sector) 
concentration (HHI) from 2000 to 2006 since there is variation in the 
degree of concentration across industries and within industries over 
time. We also investigate variation in audit firm market share of a 
particular industry, and therefore, potential market power, over the 
2000-2006 period as well. Our econometric model is estimated to gauge 
whether or not audit fees can be explained by changes in these 
concentration variables. Sullivan (2007) takes a different approach in 
addressing anticompetitive pricing, using auditor change (switching) 
data from 1988 to 2005 and similarly attributes audit fee increases to 
the new regulatory environment and increased effort on the part of 
auditors rather than anticompetitive behavior.[Footnote 87] Asthana, et 
al. (2004) examines audit fess from 2000 to 2002 and concludes that the 
increase in the fee premium charged by the largest firms was the result 
of decreased competition in the audit market for multinational 
companies due to the exit of Arthur Andersen. However, as Sullivan 
(2007) points out, the authors cannot control for trends in audits fees 
that predate the Arthur Andersen dismantlement.[Footnote 88] 

Econometric Modeling Procedures for Handling Panel Data: 

Panel data provides potential advantages over pure cross sectional and 
pure time series designs and allows us to factor out the time-and space-
invariant components of the data. As a result, panel data are able to 
identify and measure effects that are not detectable in other designs. 
There are two commonly accepted approaches to estimating panel data--
the random-effects model and the fixed-effects model. In the fixed 
effects model individual effects are estimated, in this case, for each 
company to reflect the assumption that special features specific to 
each company--such as audit risk, management style, skill of internal 
auditors or audit committee, or internal control processes-- can be 
captured best with a different, time-invariant intercept for each 
company. In a random effects model, in this context, these individual 
effects are captured through treating the intercept as a random 
variable with a unique error term for each company. While each model 
has its advantages and disadvantages, the random effects model is 
appropriate when we can plausibly assume that the individual effects 
(which are unobserved and unmeasured in the model) are uncorrelated 
with the explanatory variables that are measured and included in the 
model. Otherwise the fixed effects model is preferred, especially as a 
control for omitted variables bias, as it is in this context (see 
discussion below). 

Using panel data--data across companies and over time--the basic model 
takes the form: 

(1) yit = q + Xitb + Zid + eit: 

where y = the dependent variable (audit fees paid by the company to its 
auditor). 

X = a matrix of explanatory variables that varies across time and 
individual companies. These are variables that help capture the 
characteristics of the public company client, the characteristics of 
the auditing industry, the characteristics of the auditor, and the 
characteristics of the audit engagement as well as variables that for 
control the effect of Sarbanes-Oxley. 

Z = a matrix of variables that vary across companies but for each 
individual company are constant across the six years. The variables are 
essentially the variables that indicate the number of auditor changes 
over the period, indicate whether or not a company was a client of 
Arthur Andersen in 2002 as well as regional and industry dummy 
variables. 

q = constant term. 

i = 1, 2, . . ., 12,749 and represents the individual companies in the 
initial panel. 

t = 1, 2, . . ., 6 and represents the number of years (2000-2006). 

As is the typical case with panel data, we have a large number of cross-
sections (public companies) and a relatively small number of time 
periods. Therefore we specify the composite error structure for the 
disturbance term as follows: 

(2) eit = i + hit: 

where i = company-specific error component which captures the 
unobserved heterogeneity across companies (either as a fixed-or random- 
effect). 

E(Xithit) = 0 (there is no correlation between hit and Xit). 

The i is the individual effect which can be treated as either fixed or 
random. The fixed-and random-effect models which take account of the 
repetition inherent in the data and allow us to use the individual 
differences effectively. Correspondingly, if we treat the individual 
effect as zero we can estimate the model using the simple ordinary 
least squares (OLS) procedure. This is a pooled OLS regression model 
where we assume the intercept and slope coefficients are constant 
across time and space and the normal error term (hit) captures 
differences over time and individual companies. However, when the true 
model is random-effects model, pooling the observations in this manner 
using OLS produces biased estimates that are also not efficient when 
compared to the more complex generalized least squares (GLS) procedure 
(outlined below). Moreover, the pooled OLS model is also susceptible to 
omitted variables bias. Likelihood ratio tests strongly rejected the 
pooled OLS model in favor of the fixed-effects and therefore OLS would 
be inappropriate in this regard as well. 

The random effects technique proceeds under the assumption that the 
ignorance about the unobserved differences in audit fees across 
companies is better captured through the disturbance term rather than 
the intercept. The random effects model basically maintains that the 
public companies in the sample have a common mean audit fee 
(represented by the constant term, q) and that the individual 
differences in fees for each company are captured in the error term i 
[Footnote 89]Given the composite nature of the new disturbance term 
which incorporates the individual random effect of each company, the 
appropriate method for producing estimates is GLS.[Footnote 90] 
Feasible GLS derives an estimate of the covariance matrix of the error 
term and uses the information (heteroscedasticity from repeated 
observations of the same crosssection unit) to estimate the 
coefficients in the model. 

The drawback to this approach is that it forces one to make the strong 
assumption that the unobserved random-effects are uncorrelated with the 
explanatory variables in the model E(Xiti) = 0 in addition to the 
standard assumption E(Xithit) = 0). As a result, the random effect 
treatment of the panel data may also produce estimates that suffer from 
the inconsistency due to omitted variables. Therefore, the validity of 
the results would depend more heavily on the control variables included 
in the model to capture differences across companies, unless the 
omitted variables (unobserved heterogeneity across company) are 
uncorrelated with the concentration variables. If this is the case, the 
random-effect model may produce more appropriate estimates than the 
fixed-effects model. In our case, the Hausman test, which formally 
tests whether the omitted variables are correlated with the other 
regressors in the model, clearly rejected the random-effect model in 
favor of the fixed-effects model. Therefore, the results section of 
this appendix focuses primarily the fixed effects models (see below). 

In the case of the fixed effects model, i is estimated uniquely for 
each company as a fixed coefficient to be added to the intercept term. 
In this way, we take into the account the individuality of each company 
(each crosssectional unit) by letting the intercept vary by a fixed 
amount for each company. The benefit of the fixed effects estimator is 
that it is consistent in the presence of omitted variables. Because 
many variables that affect audit fees across companies are difficult to 
measure or could not be obtained this omission could bias the parameter 
estimates. With panel data and a fixed effect specification it is 
possible to obtain consistent estimates of the effect of concentration 
even when there are correlated omitted effects. The differences that 
exist across companies are essentially pulled out and accounted for 
explicitly, allowing for a more valid estimation of the effect of 
industry concentration on company audit fees. Moreover, in many cases 
the fixed effects estimates will still produce consistent estimates 
even when the random effects model is valid. 

Variables Included in the Model: 

SEC disclosure requirements now require companies to disclose audit 
fees paid to the external auditor and that these fees paid be broken 
down into the following categories: (1) audit fees, (2) audit-related 
fees, (3) tax fees, and (4) all other fees.[Footnote 91] Audit-related 
fees can include fees paid to the external auditor for due diligence 
services, internal control reviews or other work that is traditionally 
performed by the independent accountant. The dependent variable in our 
econometric models is total audit fees, which is composed of audit fees 
and audit-related fees. While the results we report below use this 
measure of fees, we also used audit fees (without audit-related fees) 
for each company in some models as a sensitivity test. More 
importantly, because SEC disclosure requirements were not in effect 
during 2000 and for a portion of 2001, some observations are based on 
firm-specific practices for categorizing fees rather than the more 
uniform categorization initiated by SEC regulations. We deal with this 
econometrically by dropping 2000 and 2001 in some specifications for 
sensitivity analysis, and, when these years are included, time fixed- 
effects are used to control for potential difference in the recording 
of audit fees. 

The primary variables of interest are the industry concentration 
variables defined by two-digit North American Industry Classification 
System (NAICS) codes: (1) the share of the market held by a company's 
auditor of record in a given year in a given industry sector (Sharef) 
and (2) the Hirschman-Herfindahl Index (HHI1) for the industry sector 
in which the company operates in a given year. Both concentration 
variables are based on the total audit fees collected. The HHI is 
calculated by summing the squared market shares of all the firms 
auditing public company clients in a given industry. As table 9 
illustrates, the HHI's computed for the various sectors of the economy 
vary across sectors over time. We also interacted the HHI variable with 
measures of company size, to allow for distinct effects for large and 
small companies. We did not include companies operating in the public 
administration sector in our econometric analysis as there were an 
insufficient number of companies to reliably determine concentration. 
Similarly, in some econometric specifications we dropped Agricultural 
and Warehousing companies as the numbers fell below 30 and 15 companies 
respectively in most years. 

Table 9: Hirchman-Herfindahl Indexes by Sector, 2000-2006: 

[See PDF for image] 

Source: GAO analysis of Audit Analytics data. 

Notes: Based on total audit fees collected in industries defined by two 
digit NAICS codes. 

[A] The agriculture sector contains fewer than 30 companies. 

[B] The warehousing sector contains fewer than 15 companies. 

[C] The management of companies and enterprises sector comprises (1) 
establishments that hold the securities of companies and enterprises 
for the purpose of owning a controlling interest or influencing 
management decisions or (2) establishments that administer, oversee, 
and manage establishments of the company and that normally undertake 
the strategic or organizational planning and decision making role of 
the company or enterprise. Not included in any econometric 
specifications. 

[D] Not included in any econometric specifications due to an 
insufficient number of companies. 

[End of table] 

While the HHI variable captures the impact of overall concentration on 
audit fees, the market share variable can capture two distinct types of 
effects. One the one hand, market share can be an indicator of a firm's 
degree of monopoly power and large shares can give substantial market 
power to the firm if there are no significant competitors. On the other 
hand, high market share could result in economies of scale and lower 
costs which are then passed on to clients in the form of lower audit 
fees. In the case of the market for audit services the market share 
variable could also proxy for industry expertise (quality- 
differentiated services), which would justify higher fees. Therefore, a 
positive relationship between market share and audit fees would be 
consistent with both market power and an expertise or quality premium. 
We further explore this with a number of models to determine whether 
individual market power (monopolistic pricing) or industry expertise 
most likely explains the positive relationship we find between market 
share and audit fees (see results section). 

Although, the fixed effect model guards against time invariant omitted 
variables bias, it is always advisable to explore possible causes of 
heterogeneity. We included a number of control variables in an attempt 
to capture the variation in audit fees across companies related to 
audit effort (size), risk factors and complexity. Table 10 includes a 
listing of the various variables included in the econometric models, 
ranging from company size (assets) to indicators of a restatement, a 
going concern opinion, negative earnings, late filings and controls for 
Sarbanes-Oxley (SOX). Sarbanes-Oxley added new costs to the standard 
audit, especially the Section 404 Report on internal controls in 
2004.[Footnote 92] Over the sample there are some companies that 
complete the yearly internal control review beginning in 2004 and other 
that do not. We controlled for this explicitly with a dummy variable, 
as well as an additional dummy if the company was found to have 
inadequate controls. As some of these variables may also be related to 
the concentration variables, controlling for them also enhances the 
internal validity of the parameter estimates. 

Since accounting firms are now prohibited from providing services such 
as financial information system implementation and design, internal 
auditing, and a number of other services, any cross subsidization (or 
low-balling) of the audit that potentially existed in the early years 
(2000 and 2001) is less likely in the later years in our sample. 
Moreover, as indicated above, the sample consists of fees reported 
under the old SEC rules for 2000 and 2001, and fees reported under the 
new rule for 2002 through 2006. As a result, we also included time 
period fixed effects to control for regulatory changes, changes in the 
scope and complexity of audit engagements, changes in the manner in 
which, the audit was priced or audit fees were categorized and 
recorded, and other forces that can be captured by a company-invariant 
(consistent across companies) fixed effect. Collectively the variables 
and techniques help capture the characteristics, of the public company 
client (effect of the amount of effort required by the auditor), of the 
auditing industry (e.g., pricing differences across accounting firms), 
of the auditor (e.g., knowledge advantages due to specialization) and 
of the engagement (e.g., busy season) and help explain the variation in 
audit fees across companies. All appropriate variables were adjusted 
for inflation. 

Table 10: Primary Variables in the Econometric Analysis: 

Variable: TAFEESADJ; 
Description: Total audit and audit-related fees paid by a company to 
its auditor in 2006 dollars. 

Variable: ASSETSADJ; 
Description: Assets of the audited company in 2006 dollars. 

Variable: BIGCO3; 
Description: Indicates whether company has greater than $250 million in 
assets (2006 dollars). 

Variable: BIGCO1; 
Description: Indicates whether company has greater than $1 billion in 
assets (2006 dollars). 

Variable: BIGCO35; 
Description: Indicates whether company has greater than $3.5 billion in 
assets (2006 dollars). 

Variable: HHI1; 
Description: HHI (defined by total audit fees) for a sector defined by 
two-digit NAICS code. 

Variable: SHAREF; 
Description: Percentage of the market (defined by audit fees) held by a 
company's auditor of record. 

Variable: LOSS; 
Description: Indicates whether company experienced a loss in a given 
year. 

Variable: GC; 
Description: Indicates concern about a company's ability to continue as 
a going concern was raised. 

Variable: RESTATDUM; 
Description: Indicates whether a company filed restated financials 
during the year. 

Variable: LATE; 
Description: Indicates whether a company filed a notice of nontimely 
filing during the year. 

Variable: INTERNAL; 
Description: Indicates whether a company completed the Sarbanes-Oxley 
Act Section 404 review. 

Variable: INADEQ; 
Description: Indicates whether companies internal control were found 
inadequate. 

Variable: POSTSOX; 
Description: Indicates audit year occurs after the passage of the 
Sarbanes-Oxley Act. 

Variable: BUSY; 
Description: Indicates whether the company's fiscal year end date 
occurs during the busy season (December). 

Variable: CI (Client Influence)[A]; 
Description: Measured as the fees paid by the company to a given audit 
firm relative to total fees paid by all clients audited by that firm in 
a given industry sector. 

Variable: EXPERT; 
Description: Indicates whether a given firm audits 10 percent or more 
of all company clients audit in a particular industry sector. 

Variable: BIG45; 
Description: Indicates whether a company is audited by one of the 
largest firms in a given year. 

Variable: MID4; 
Description: Indicates whether a company is audited by a midsize firm 
in a given year. 

Variable: SEPARAUDITOR; 
Description: Indicates whether the company paid additional audit-
related fees to a second auditor. 

Variable: AUCH0006; 
Description: Number of auditor switches for a given company over the 
2000-2006 period. 

Variable: AACLIENT2002; 
Description: Indicates whether a company switched from Andersen in 
2002. 

Variable: Firm; 
Description: Audit Firm specific dummy variables for the top eight 
firms. 

Variable: Year; 
Description: Year dummy variables (period-fixed effects). 

Variable: Region; 
Description: Region dummy variables (Canada, Foreign and various 
section of the US). 

Variable: Industry; 
Description: Industry dummy variables (defined by two-digit NAICS 
codes). 

Source: GAO. 

[A] As pointed out in S. Bandyopadhyay and J. Kao, "Market Structure 
and Audit Fees: A Local Analysis," Contemporary Accounting Research, 
vol. 21, issue 3 (fall 2004), one might expect a dominant auditor to 
restrain any pricing behavior when faced with a powerful audit client, 
resulting in a diminished positive relation between auditor market 
concentration and audit fees. We include this variable to control for 
this possibility. Since, in the regressions below it is typically 
positive when it is significant--contrary to theoretical expectation-- 
this variable could be a proxy for complexity. 

[End of table] 

As table 11 shows there is a low degree of correlation between most of 
the explanatory variables in the panel. However, there is a high degree 
of correlation between the market share variable, the dummy indicating 
whether a firm is an industry expert and the dummy variable which 
indicates whether a company is audited by one of the largest accounting 
firms (Big 4/5 dummy variable). In fact, principal components analysis 
suggests the Big 4/5 dummy variable adds very little to a model once 
the market share variable is included.[Footnote 93] As a result the Big 
4/5 is not included in a given model if the market share variable is 
also being estimated. We also drop the expert variable in some 
specifications for sensitivity analysis in lieu of the somewhat high 
correlation with the market share and the interaction variables. It 
should be noted however, the correlation between HHI and market share 
is relatively low. 

Table 11: Correlation Matrix, GAO Panel Data Set, Select Variables: 

1. Log(ASSETSADJ); 
1: 1.00; 
2: [Empty]; 
3: [Empty]; 
4: [Empty]; 
5: [Empty]; 
6: [Empty]; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

2. LOSS; 
1: -0.43; 
2: 1.00; 
3: [Empty]; 
4: [Empty]; 
5: [Empty]; 
6: [Empty]; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

3. GC; 
1: -0.49; 
2: 0.32; 
3: 1.00; 
4: [Empty]; 
5: [Empty]; 
6: [Empty]; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

4. POSTSOX; 
1: -0.03; 
2: -0.05; 
3: 0.07; 
4: 1.00; 
5: [Empty]; 
6: [Empty]; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

5. BUSY; 
1: 0.10; 
2: -0.02; 
3: -0.01; 
4: 0.12; 
5: 1.00; 
6: [Empty]; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

6. CI; 
1: -0.26; 
2: 0.11; 
3: 0.19; 
4: 0.04; 
5: -0.01; 
6: 1.00; 
7: [Empty]; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

7. EXPERT; 
1: 0.53; 
2: -0.16; 
3: -0.31; 
4: -0.08; 
5: 0.01; 
6: -0.36; 
7: 1.00; 
8: [Empty]; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

8. Log (HHI1); 
1: 0.07; 
2: -0.05; 
3: -0.03; 
4: 0.20; 
5: 0.01; 
6: 0.02; 
7: 0.08; 
8: 1.00; 
9: [Empty]; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

9. Log(HHI1)*BIGCO03; 
1: 0.77; 
2: -0.38; 
3: -0.30; 
4: 0.00; 
5: 0.10; 
6: 
-0.21; 
7: 0.40; 
8: 0.06; 
9: 1.00; 
10: [Empty]; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

10. Log(SHAREF); 
1: 0.61; 
2: -0.20; 
3: -0.38; 
4: -0.10; 
5: 0.02; 
6: - 0.45; 
7: 0.88; 
8: 0.09; 
9: 0.44; 
10: 1.00; 
11: [Empty]; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

11. INTERNAL; 
1: 0.29; 
2: -0.17; 
3: -0.18; 
4: 0.24; 
5: 0.11; 
6: -0.09; 
7: 0.18; 
8: 0.01; 
9: 0.28; 
10: 0.22; 
11: 1.00; 
12: [Empty]; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

12. INADEQ; 
1: 0.06; 
2: 0.00; 
3: -0.04; 
4: 0.07; 
5: 0.02; 
6: -0.02; 
7: 0.04; 
8: 0.00; 
9: 0.05; 
10: 0.06; 
11: 0.30; 
12: 1.00; 
13: [Empty]; 
14: [Empty]; 
15: [Empty]. 

13. LATE; 
1: -035; 
2: 0.20; 
3: 0.40; 
4: 0.15; 
5: -0.06; 
6: 0.19; 
7: - 0.29; 
8: -0.01; 
9: -0.24; 
10: -0.33; 
11: -0.05; 
12: 0.12; 
13: 1.00; 
14: [Empty]; 
15: [Empty]. 

14. RESTATDUM; 
1: -0.02; 
2: 0.05; 
3: 0.07; 
4: 0.07; 
5: -0.03; 
6: 0.04; 
7: -0.03; 
8: 0.01; 
9: -0.02; 
10: -0.02; 
11: 0.05; 
12: 0.13; 
13: 0.25; 
14: 1.00; 
15: [Empty]. 

15. BIG45; 
1: 0.56; 
2: -0.17; 
3: -0.32; 
4: -0.11; 
5: 0.02; 
6: -0.38; 
7: 0.94; 
8: 0.10; 
9: 0.43; 
10: 0.92; 
11: 0.18; 
12: 0.04; 
13: -0.31; 
14: - 0.03; 
15: 1.00. 

Source: GAO. 

[End of table] 

Results: 

We ran roughly 100 different models, including several pooled OLS, 
random-effects and fixed-effects models with varied specifications as 
sensitivity tests. Given the number of issues that plague the simple 
OLS model and that formal tests strongly rejected the pooled OLS model 
in favor of fixed-effects, we do not report the pooled OLS results in 
this appendix. Moreover, since the Hausman test overwhelming rejected 
the random-effects in favor of the fixed-effect model, we present the 
results for the random-effects models for comparison only.[Footnote 94] 
Note, also, that the time invariant variables (Zi), such as number of 
auditor changes over the period, and industry and region indicators 
appear in the random-effects model but not in the fixed-effects models 
as these variables are collinear with the unique fixed-effect estimated 
for each company. The random and fixed-effects models run on 2002 
through 2006 data suggest that, in general, companies operating in more 
concentrated industries do not pay higher fees when other important 
drivers of audit fees are included (table 12). Moreover, focusing on 
the fixed-effect results, we found this result to hold even when we 
included 2000 and 2001 in the analysis or if we include only the post 
Sarbanes-Oxley years (2003-2006). In all cases, the HHI is positive but 
statistically insignificant. 

Table 12: Random-Effects and Fixed-Effects Models Explaining Log of 
Fees: 

[See PDF for image]  

Source: GAO. 

Notes: T-statistics are in parentheses. * indicates significance at the 
5 percent level and ** indicates significance at the 1 percent level. 

[A] Whites' stacked covariance matrix was not used. In all other cases 
the covariance matrix was adjusted. 

[B] Adjusted R2 is reported. 

[End of table] 

To explore the differences between different size companies, we also 
interacted the HHI variable with a dummy variable that indicates 
whether a company exceeds $250 million in assets. This variable is both 
positive and significant, indicating that larger firms operating in 
more concentrated industries may pay higher fees, but we note that this 
effect is very small. Because this was an arbitrary definition which 
would include a number of companies considered small by other sources, 
we varied our definition of large using various cut-off values. When we 
defined large as $1 billion or $3.5 billion in assets the results 
remain the same. Consistently the estimates suggest that a 10 percent 
increase in the HHI for large companies results in an increase in audit 
fees around 0.5 percent. Since the dissolution of Andersen initiated an 
increase in the HHI by about 18 percent, the model suggests that the 
result on audit fees for the largest public companies would have been 
less than 1 percent.[Footnote 95] By comparison the estimated effect of 
the 404 internal control requirements resulted in roughly a 45 percent 
increase in audit fees, while issuing a financial restatement is 
associated roughly with an 11 percent increase in fees. However, when 
we ran the models only on companies with assets greater than $250 
million in assets (or any other sub-samples of large companies defined 
by assets) we found no relationship between industry concentration and 
audit fees for these companies. When we defined large by some measures 
we found a negative but statistically insignificant relationship 
between HHI and audit fees. Further, when we ran the model only on 
clients of the largest firms the coefficients on the interaction term 
were either much smaller (substantively insignificant) or statistically 
insignificant. As a result, this finding regarding the price impact for 
larger companies may not be robust and should be interpreted with 
caution. 

Table 13: Fixed Models Explaining Log of Fees, by Market Segments, 2001-
2006: 

[See PDF for image] 

Source: GAO. 

Notes: T-statistics are in parentheses; * indicates significance at the 
5 percent level and ** indicates significance at the 1 percent level. 
Whites' stacked covariance matrix was used in all specifications. 

[A] Adjusted R2 is reported. 

[End of table] 

The models also consistently show that accounting firms holding a 
larger market share of the industry in which the public company 
operates are found to charge higher fees (Sharef is statistically 
significant and positive in each instance) but this leaves open the 
question as to whether the empirical evidence is supportive of 
expertise-quality-differentiated services or anticompetitive pricing. 
Unfortunately, these are extremely difficult issues to address in a 
rigorous and comprehensive manner. Similar to other studies, we 
investigated the audit fee-market share relationship in various large 
and small client segments of the market. We found that market share- 
related price premium also exists in the small client segment of the 
market and these premiums were not statistically different from those 
that existed in the large company segment of the market (table 
13).[Footnote 96] Even when we ran the model on companies with assets 
below 100 million, we still found a statistically significant and 
positive relationship between the auditor's share of the market 
(Sharef) and audit fees. It should be noted that the HHI for this 
sector was well below the critical value of 1,000 in 2006. Therefore, 
the persistence of this positive relationship between market share and 
audit fees in all segments of the market--even those predisposed to 
perform competitively--suggest it is more likely due to industry or 
technical expertise (quality-differentiated service) and in the case of 
the larger firms, brand-name reputation.[Footnote 97] A firm with 
industry expertise may exploit its specialization by developing and 
marketing audit-related services which are specific to clients in the 
industry and provide a higher level of assurance. If this is the case, 
such firms could earn a return on this investment by charging higher 
audit fees than other firms and remain competitive for the most 
relevant opportunities, even at a premium price. It should be noted 
that Oxera (2006), using similar modeling techniques, interpreted this 
association as an indicator of market power in U.K. audit markets but 
did not acknowledge the presence of quality differentiated services and 
industry expertise nor report any further investigation to unpack the 
relationship.[Footnote 98] 

We conducted a number of sensitivity test to examine the robustness of 
our findings. For example, we used the log of audit fees--net of audit- 
related fees--as the dependent variable and obtained similar results. 
To investigate whether multicollinearity was an issue, we ran a number 
of models excluding the potentially collinear variables and obtained 
similar results. We also altered the functional form, using market 
share instead of logged market share, and obtained results which more 
strongly supported our initial results. Because estimated coefficients 
of the fee determinants could differ significantly for the largest and 
other auditors, we also ran the model separately for these two classes 
of firms. To address potential problems of endogeneity we estimated the 
relationships using two-stage least squares. Finally, to investigate 
whether the results were sensitive to unbalanced nature of the data-- 
the number of companies in the sample for each industry differs across 
the years--we estimated the model using sample probability weights, 
where the weights are based on the number of companies in a given 
industry (or alternatively total revenues, fees paid or assets). In our 
case, this amounted to de-meaning the data to obtain the fixed effects 
estimates and then running weighted least squares. Consistently, we 
found no evidence of a positive and significant relationship between 
industry concentration and audit fees. 

While our analysis suggests the increase in audit fees appears largely 
unrelated to supplier concentration, it is difficult to determine the 
extent to which audit pricing is consistent with competitive behavior 
with the available data because of all the contemporaneous changes 
occurring in the market. As a result these results should be 
interpreted with a consideration of a number of limitations. First, 
this is an aggregate analysis and, therefore, does not demonstrate that 
all companies receive a competitive price (local markets may be 
important). Moreover, the absence of evidence of uncompetitive pricing 
does not necessarily imply that we can conclude that the market is 
competitive from a pricing perspective. Second, our results are based 
on one battery of tests focused on industry (economic sector) 
concentration and this does not imply that it is the definitive way to 
examine the effect of concentration on prices. While evidence suggests 
that some sectors have particularly complex audits and sector-specific 
expertise is an important determinant of auditor choice many companies 
are involved in activities that cut across multiple industries raising 
some questions about characterizing industry-specific markets as unique 
audit markets, especially for large firms. Our investigation was 
undertaken because it appeared to be a useful way to consider the 
effect of concentration given the available data. Additional data may 
allow for analysis that may address the issue more completely or more 
validly. Third, although the fixed effect estimator is robust to the 
omission of any relevant time-invariant variables and we have explained 
over 90 percent of the variation in fees, if there are time-varying 
differences that have been omitted, the results could be biased. As 
complexity and inherent risk of the individual client audits could vary 
over time there is some concern that financial variables traditionally 
included in the literature could not be included here (e.g. number of 
subsidiaries, inventory and receivables). However, this threat should 
be balanced against the power of the fixed-effects estimator which may 
capture some of this effect. 

Fourth, our conclusion that quality-differentiation and industry 
expertise most likely better explains market dynamics than monopolistic 
pricing, while standard in the academic literature, critically hinges 
on the smaller company segment actually performing competitively. We, 
like others, have made this assumption based on the low HHI statistics 
computed for that segment of the market and other market indicators 
that suggest competitive pricing for smaller companies. Users of this 
report should note that our tests of individual market power were 
limited and the results should be interpreted in light of this 
limitation. Fifth, potential measurement error in the audit fee 
variable, assuming it is random, would make it more likely that we 
would conclude that a relationship does not exist when indeed it does. 
Given the large amount of the variation in fees we have explained and 
the techniques we have used, this (statistical validity) would not 
appear to be an issue. 

[End of section] 

Appendix VI: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Orice M. Williams, (202) 512-8678 or williamso@gao.gov: 

Jeanette M. Franzel, (202) 512-9471 or franzelj@gao.gov: 

Thomas J. McCool, (202) 512-2642 or mccoolt@gao.gov: 

Staff Acknowledgments: 

In addition to the contacts named above, Cody Goebel and John J. Reilly 
Jr., Assistant Directors; William Bates; Tania Calhoun; Emily Chalmers; 
William R. Chatlos; Bob Dacey; Francis Dymond; Lawrance Evans Jr; 
Kristen Kociolek; Annamarie Lopata; Kimberly McGatlin; Marc Molino; 
Jill M. Naamane; Karen O'Conor; Carl Ramirez; Nicole Riggs; John 
Saylor; Jeremy Schwartz; Estelle Tsay; Richard Vagnoni; Ethan Wozniak; 
and Tory Wudtke also made key contributions to this report. 

[End of section] 

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 whose stock is traded off these 
exchanges--for example, through OTC Bulletin Board (OTCBB), excluding 
funds, trusts, nonoperating companies, or subsidiaries of another 
public company. Large public companies generally include those on the 
Fortune 1000 list, unless otherwise noted. 

[2] The 8 largest firms in the 1980s 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. For the purposes of this report, the largest firms 
include Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and 
PricewaterhouseCoopers LLP. In our 2003 report on consolidation and 
competition, we referred to this group as the "top tier" based on 
revenue and staff size. See GAO, Public Accounting Firms: Mandated 
Study on Consolidation and Competition, GAO-03-864 (Washington, D.C.: 
July 30, 2003). In our mandated study on audit firm rotation, we 
defined Tier 1 as firms with 10 or more public company clients. See 
GAO, Public Accounting Firms: Required Study on the Potential Effects 
of Mandatory Audit Firm Rotation, GAO-04-216 (Washington, D.C.: Nov. 
21, 2003). 

[3] The largest firms each audited more than 1,200 public companies for 
2006 according to Public Accounting Report. These firms are commonly 
referred to as the "Big 4" firms. 

[4] The midsize firms--BDO Seidman LLP, Crowe Chizek & Company LLC, 
Grant Thornton LLP, and McGladrey and Pullen LLP--each audited more 
than 100 but fewer than 425 public companies for 2006 and had around $1 
billion in revenue or less according to Public Accounting Report. 

[5] In addition, a large number of accounting firms have no public 
company clients. 

[6] GAO, Public Accounting Firms: Mandated Study on Consolidation and 
Competition, GAO-03-864 (Washington, D.C.: July 30, 2003). 

[7] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 
(July 30, 2002). 

[8] Our initial population included over 6,900 U.S.-based public 
companies that traded on major exchanges (NYSE, NASDAQ, AMEX, OTCBB). 
Company estimates throughout the report do not include funds, trusts, 
nonoperating companies, or subsidiaries of another public company. 

[9] According to these criteria, approximately 872 companies are large, 
3,212 companies are midsize, and 2,822 companies are small. 

[10] Unless otherwise noted, results from our public company survey are 
representative of and generalized to the larger public company 
population our sample was drawn from. 

[11] Unless otherwise noted, accounting firm survey results do not 
include the responses of the largest firms or firms with four or fewer 
audit clients. Also, data for smaller firms refer to survey respondents 
only and cannot be generalized to all smaller firms because of lower 
response rates for this group. 

[12] SEC Release No. 33-8183, Strengthening the Commission's 
Requirements Regarding Auditor Independence, 68 Fed. Reg. 6006 (Feb. 5, 
2003). 

[13] In May 2005, the Supreme Court reversed the criminal conviction of 
Arthur Andersen. Arthur Andersen LLP v. United States, 544 U.S. 696 
(2005). 

[14] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 
(July 30, 2002). 

[15] Pub. L. No. 107-204, § 107, 116 Stat. 745, 765. 

[16] An issuer is a company that issues or proposes to issue securities 
that are registered under section 12 of the Securities Exchange Act of 
1934 (15 U.S.C. § 78l) or that is required to file reports under 
section 15(d) (15 U.S.C. § 78o(d)), or that files or has filed a 
registration statement that has not yet become effective under the 
Securities Act of 1933 (15 U.S.C. § 77a et seq.) and that it has not 
withdrawn. 

[17] See PCAOB Release No. 2005-023, Report on the Initial 
Implementation of Auditing Standard No. 2, An Audit of Internal Control 
Over Financial Reporting Performed in Conjunction with an Audit of 
Financial Statements (Nov. 30, 2005); PCAOB Release No. 2007-001, 
Observations on Auditors' Implementation of PCAOB Standards Relating to 
Auditors' Responsibilities with Respect to Fraud (Jan. 22, 2007); PCAOB 
Release No. 2007-004, Report on the Second-Year Implementation of 
Auditing Standard No. 2, An Audit of Internal Control over Financial 
Reporting Performed in Conjunction with an Audit of Financial 
Statements (Apr. 18, 2007); and PCAOB Release No. 2007-010, Report on 
the PCAOB's 2004, 2005, and 2006 Inspections of Domestic Triennially 
Inspected Firms (Oct. 22, 2007). 

[18] Section 302 specifically requires an officer to certify that he or 
she has reviewed the report and that, based on his or her knowledge, 
the report does not contain any untrue statement; the certifying 
officers are responsible for internal controls; they have made certain 
disclosures to the audit committee; and, they have indicated any 
significant changes to internal controls subsequent to the date of 
their evaluation. SEC Release No. 33-8124, Certification of Disclosure 
in Companies' Quarterly and Annual Reports, 67 Fed. Reg. 57276 (Sept. 
9, 2002). 

[19] SEC Release No. 33-8238, Management's Report on Internal Control 
Over Financial Reporting and Certification of Disclosure in Exchange 
Act Periodic Reports, 68 Fed. Reg. 36636 (June 18, 2003). 

[20] SEC defines a public company as an accelerated filer if it meets 
two conditions. First, it must have a public float of $75 million or 
more as of the last business day of its most recently completed second 
fiscal quarter. Second, it must have filed at least one annual report 
with the SEC. Initially accelerated filers were required to file for 
years ending after June 15, 2004, but SEC granted an extension to 
November 15, 2004. See SEC Release No. 33-8392, Management's Report on 
Internal Control over Financial Reporting and Certification of 
Disclosure in Exchange Act Periodic Reports, 69 Fed. Reg. 9722 (Mar. 1, 
2004). 

[21] SEC Press Release No. 2007-123. 

[22] A tight oligopoly is generally defined as a market in which four 
providers hold over 60 percent of the market and other firms face 
significant barriers to entry into the market. 

[23] The Hirschman-Herfindahl Index is one of the concentration 
measures that government agencies, including the Department of Justice 
(DOJ) and the Federal Trade Commission, use when assessing 
concentration to enforce U.S. antitrust laws. 

[24] We found that the Mid-Atlantic and Midwest regional audit markets 
were somewhat more concentrated than the western regions, although all 
regional audit markets were highly concentrated. 

[25] GAO-03-864, 12-15. 

[26] Figures do not include a number of companies with missing 
financial data. The category of companies with greater than $1 billion 
in revenue roughly corresponds to the Fortune 1000 list. In 2006, the 
smallest company on the Fortune 1000 list had revenues just over $1.4 
billion. As a result, the $1 billion and over segment shown in the 
figure includes the Fortune 1000, as well as other large companies. 

[27] For the remainder of this report, we define large companies as 
those that are members of the Fortune 1000, midsize companies as those 
that have market capitalization of $75 million or greater but are not 
in the Fortune 1000, and small companies as those with market 
capitalization of less than $75 million. Using this definition, 12.6 
percent of the 6,906 companies in our survey population are large, 46.5 
percent are midsize, and 40.9 percent are small. 

[28] Unless otherwise noted, the margin of error for public company 
survey results was less than 12 percentage points. 

[29] Sections 201 and 2(a)(8) of the Sarbanes-Oxley Act. Nonaudit 
services are any professional services provided to a company by a 
registered public accounting firm, other than those provided to a 
company in connection with an audit or a review of the company's 
financial statements. 

[30] The most common reasons large companies reported for retaining 
their current auditor included satisfaction with their current auditor, 
that auditor's technical expertise compared with other firms, and the 
burden of changing auditors. See [hyperlink, http://www.gao.gov/cgi-
bin/getrpt?GAO-08-164SP] for more detailed survey results. 

[31] The survey for our 2003 report was sent to a random sample of 
Fortune 1000 companies to collect information on their experiences with 
their auditors of record. The response rate for this survey was 64 
percent, but the results were not generalizable to the population of 
large public companies. See GAO, Accounting Firm Consolidation: 
Selected Large Public Company Views on Audit Fees, Quality, 
Independence, and Choice, GAO-03-1158 (Washington, D.C.: Sept. 30, 
2003). 

[32] Appendix II contains more information on concentration by industry 
sector. 

[33] The difference in the percentage of large domestic and large 
multinational companies indicating that the choice of accounting firms 
was inadequate was not significant. 

[34] The data on auditor changes indicate that large companies change 
auditors less frequently than midsize and smaller companies. Between 
2003 and 2006, there were approximately 28 changes per year per 1000 
companies among large companies, 84 changes per year per 1000 companies 
among midsize companies, and 264 changes per year per 1000 companies 
among small companies. 

[35] Our analysis is based on a panel data set compiled for over 12,000 
companies from 2000 through 2006. The panel data set allowed us to 
exploit a number of techniques to increase the validity of the results, 
including estimating "random-effect" and "fixed-effect" model 
specifications. The fixed-effects model helps to control for the 
potentially large number of unmeasured forces that might explain the 
differences in the audit fees paid across public companies. As a 
result, the fixed-effects models were able to account for over 90 
percent of the variation in audit fees. Time period fixed effects were 
added to help control for Sarbanes-Oxley and other factors that have 
impacted the fees paid by all public companies. See appendix V for a 
more complete discussion of our econometric approach, including model 
specification, variables used, data sources, estimation techniques, and 
limitations. 

[36] Appendix V includes the various limitations of our data and the 
model we developed. 

[37] Since price competition is assumed to prevail in the small client 
segment of the audit market because of its low concentration, any 
premium from the effect of market power should be competed away. 
However, premiums that exist due to brand name reputation or quality- 
differentiated services will not be. A number of academic studies on 
publicly traded U.S. firms also explained sizeable premiums for the big 
accounting firms as the result of product differentiation and brand- 
name reputation and not of market power. For a summary see, David Hay, 
W. Robert Knechel, and Norman Wong, "Audit Fees: A Meta-analysis of the 
Effect of Supply and Demand Attributes," Contemporary Accounting 
Research, vol. 23, no. 1 (spring 2006). 

[38] One objective of the Sarbanes-Oxley Act was to improve auditor 
independence and audit quality through stricter limitation on nonaudit 
services, the establishment of the PCAOB and its inspection program, 
and requirements that auditors assess and report on internal controls 
over financial reporting at public companies. 

[39] Six cases were reported in Aon Professional Risks, "Awards/ 
Settlements: Analysis of a Selection of Publicly Known Matters 
Involving Auditors," (Montreal, Canada: March 2006.) Some of the 
reported settlements might not have been approved by the courts, and 
some of the reported awards may have been appealed. Four other cases, 
the Andersen settlement in the Sunbeam case, KPMG settlements involving 
Rite Aid and Lernout & Hauspie, and a PricewaterhouseCoopers settlement 
in the Tyco International case, were widely reported. For these cases, 
see In re Sunbeam Securities Litigation, Case No. 98-8258-CIV- 
Middlebrooks, USDC SDNY, Order Approving Settlement (Nov. 29, 2001); In 
re Rite Aid Securities Litigation, 146 F. Supp. 2d 706 (E.D. Pa. 2001); 
In re Lernout and Hauspie Securities Litigation, Civ. Act. No. 00-CV- 
11589 (PBS), USDC Mass, Order and Final Judgment; In re Tyco Securities 
Litigation, Stipulation of Settlement, MDL Docket 02-1335-PB, Civ. Case 
No. 02-866-PB (July 6, 2007). One research organization examined class 
action securities fraud filings against companies in general and noted 
that new filings, including those that allege specific accounting 
allegations (to the extent they could be identified in complaints and/ 
or press releases), have generally declined since 2004. See Cornerstone 
Research, Securities Class Action Case Filings, 2007 Mid-Year 
Assessment (July 2007) and Cornerstone's previous yearly reports. 

[40] See, for example, Lawrence A. Cunningham, "Too Big to Fail: Moral 
Hazard in Auditing and the Need to Restructure the Industry Before It 
Unravels," 106 Columbia Law Review 1698 (2006). 

[41] Regulators from outside the United States, including those from 
Australia, Canada, and the European Union, had also begun 
investigations of the proposed merger. 

[42] In this simulation, we assumed that surviving firms would keep all 
of their current clients even after picking up clients from the failed 
firm. If some firms would shed clients to midsize or smaller firms as 
they add clients from the failed firm, the effect on concentration 
could be lower. 

[43] SEC Release No. 33-8070, Requirements for Arthur Andersen LLP 
Auditing Clients, 67 Fed. Reg. 13518 (Mar. 22, 2002). 

[44] Accounting firm survey data in this report does not include the 
responses of the largest firms, or firms with four or fewer audit 
clients unless otherwise noted. Also, data for smaller firms refer to 
survey respondents only and cannot be generalized to all smaller firms 
because of low response rates for this group. 

[45] Fifty percent of midsize firms and 75 percent of smaller firms we 
surveyed said that they were not interested in serving as auditor for 
additional large public companies. 

[46] Public company survey statistics are accurate within 12 percentage 
points, unless otherwise noted. 

[47] We did not evaluate PCAOB's inspection program for this report. 

[48] Auditor independence is a frequently cited concern about 
alternative practice structures, and the American Institute of 
Certified Public Accountants (AICPA) has established additional 
independence rules for them to ensure that attest services can be 
performed with objectivity and will protect the public interest. 

[49] The International Ethics Standards Board for Accountants, an 
independent standard-setting body within the International Federation 
of Accountants released an exposure draft, Code of Ethics for 
Professional Accountants, for comment in December 2006. 

[50] Unless otherwise noted, the margin of error for public company 
survey results was less than 12 percentage points. 

[51] Large companies were more likely than small and midsize companies 
to retain their auditor for at least 10 years (47 percent and 20 
percent, respectively). 

[52] Accounting firm survey data in this report does not include the 
responses of the largest firms, or firms with four or fewer audit 
clients unless otherwise noted. Also, data for smaller firms refer to 
survey respondents only and cannot be generalized to all smaller firms 
because of low response rates for this group. 

[53] See GAO, Public Accounting Firms: Required Study on the Potential 
Effects of Mandatory Audit Firm Rotation, GAO-04-216 (Washington, D.C.: 
Nov. 21, 2003). 

[54] The partner rotation requirements went into effect May 6, 2003. 

[55] The Financial Reporting Council oversees the regulatory activities 
of the professional accountancy and actuarial bodies in the United 
Kingdom. In October 2006, the Market Participants Group was established 
to advise the council on possible actions that market participants 
could take to mitigate the risks arising from the characteristics of 
the market for public company audits in the U.K. In October, 2007, the 
group issued a report, titled Choice in the UK Audit Market, Final 
Report of the Market Participants Group, which contains 15 
recommendations to increase auditor choice in the United Kingdom. 

[56] This survey was to a random sample of Fortune 1000 companies on 
their experiences with their auditors of record. See GAO, Accounting 
Firm Consolidation: Selected Large Public Company Views on Audit Fees, 
Quality, Independence, and Choice, GAO-03-1158 (Washington, D.C.: Sept. 
30, 2003). 

[57] GAO-03-864. 

[58] U.S. Senator Charles Schumer and New York City Mayor Michael 
Bloomberg commissioned the management consulting firm McKinsey & 
Company to work with the New York City Economic Development Corporation 
to develop the report Sustaining New York's and the U.S.' Global 
Financial Services Leadership (2006). 

[59] In 2007, charges against 13 of the individuals were dismissed by 
the court, and these dismissals have been appealed by the government. 

[60] Samuel A. DiPiazza and others, Global Capital Markets and The 
Global Economy: A Vision From the CEOs of the International Audit 
Networks (November 2006), available at [hyperlink, 
http://www.globalpublicpolicysymposium.com]. 

[61] According to AICPA and the National Association of State Boards of 
Accountancy (NASBA), all 50 states and the District of Columbia have 
adopted the Uniform Accountancy Act's ownership provisions, which 
require CPAs to be the majority owners of audit firms, or stricter 
ownership provisions. The Uniform Accountancy Act is a model for state 
board legislation developed by the AICPA and NASBA. It is nonbinding, 
and states may adopt it voluntarily, in whole or in part. 

[62] We asked firms for their views on the effectiveness of a list of 
possible measures. Results showed that responses varied on whether the 
following were at least somewhat effective: merger/acquisition (71 
percent); access to specialized technical and industry expertise (63 
percent); liability/tort reform (61 percent); participation in an 
affiliation (56 percent); alternative practice structures (25 percent); 
mandatory audit firm rotation (44 percent); ability to raise capital 
(32 percent); regulatory changes (25 percent). See also GAO-08-164SP 
for detailed survey results. 

[63] We did not evaluate the effectiveness of these programs for this 
report. 

[64] AICPA has several mechanisms to support CPAs and firms that audit 
public companies, including the Accounting and Auditing hotline and the 
Center for Audit Quality (CAQ). AICPA and the largest public accounting 
firms established the CAQ, an autonomous public policy organization 
that is affiliated with AICPA. The CAQ's mission is to foster 
confidence in the audit process. To help fulfill that mission, the CAQ 
provides technical support for public company auditing professionals 
through web casts, conference calls, briefings, and alerts on public 
company auditing developments and practices. 

[65] See appendix V for more details on audit fees and disclosure 
requirements. 

[66] Firms' registration applications are publicly available at 
[hyperlink, http://registrationapplications.pcaobus.org/]. 

[67] Market shares are generally calculated using the dollar value of 
sales - in this case that would correspond to audit fees collected. The 
Federal Trade Commission (FTC) and Department of Justice (DOJ) note 
that measures such as sales, shipments, or production are the best 
indicators of future competitive significance. In the absence of audit 
fees, which were not publicly disclosed until recently, proxies are 
commonly used such as client revenues (sales) or assets. For example, 
see GAO's 2003 report on consolidation (GAO-03-864). 

[68] Markets are considered tight oligopolies if the top four firms' 
share of the market exceeds 60 percent. 

[69] Data on audit revenue from the Public Accounting Report include 
revenue from audits of both public and private companies. Unless 
otherwise noted, market shares and other concentration measures in this 
report are based on audits of public companies only. 

[70] HHI calculated based on Audit Analytics audit fee database by 
summing the squares of the individual market shares of all the firms 
within a given market. For example, a market consisting of five firms 
with market shares of 35 percent, 30 percent, 20 percent, and 10 
percent has an HHI of 2625 (352 + 302 + 202 + 102). The HHI reflects 
both the market shares of the top firms and the composition of the 
market outside of the top firms, whereas the four-firm concentration 
ratio does not. 

[71] A study by London Economics in 2006 for the European Commission 
found that the audit market HHI in the UK and member countries of the 
European Union varied widely but were generally higher than the HHI 
threshold of 2000 used by the European Union as indicating a market 
where a merger could create competitive concerns. See London Economics 
in association with Ralf Ewert, "Study on the Economic Impact of 
Auditors' Liability Regimes," Final Report to EC-DG Internal Market and 
Services (Frankfurt am Main, Germany, September 2006) and Official 
Journal of the European Union, "Guidelines on the assessment of 
horizontal mergers under the Council Regulation on the control of 
concentrations between undertakings," 2004/C31/03 (May 2, 2004). 

[72] This does not imply GAO advocates defining the audit market this 
way, rather this segmentation suggests some differences that might be 
relevant for analyzing choice and other competition-related matters. 
Only if we can define industry-specific markets and regional markets as 
unique audit market sectors of the economy is such a characterization 
appropriate. Evidence suggests that some sectors have particularly 
complex audits and sector-specific expertise is an important 
determinant of auditor choice. This should be viewed in light of the 
fact that many companies are involved in activities that cut across 
multiple industries. 

[73] According to some, local concentration measures may be more 
appropriate than national measures because the availability of 
professional accounting, advertising and law services depends on the 
location of personnel. 

[74] The scenarios are based on simple assumptions and the estimates 
for the increases in the HHI are for illustrative purposes only. 

[75] Foreign companies, benefit plans, pension, health, and welfare 
funds, subsidiaries with parents already included, and fund and trust 
entities are not included in this analysis. 

[76] See [hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP] 
for full results to this survey question. 

[77] We also reviewed the reasons for auditor changes in the Audit 
Analytics auditor change database. Reasons such as independence issues, 
fee reductions, accounting firm merging or exiting the market were also 
cited in these data. 

[78] The results from our public company survey are representative of 
and generalized to the larger public company population our sample was 
drawn from. Unless otherwise noted, the margin of error for public 
company survey results was less than 12 percentage points. 

[79] In our 2003 study on the potential effects of mandatory audit firm 
rotation mandated by the Sarbanes-Oxley Act (GAO-04-216), we defined a 
quality audit as one in which the auditor conducts the audit in 
accordance with Generally Accepted Auditing Standards (GAAS) to provide 
reasonable assurance that the audited financial statements and related 
disclosures are (1) presented in accordance with Generally Accepted 
Accounting Principles (GAAP) and (2) are not materially misstated 
whether due to errors or fraud. This definition assumes that reasonable 
third parties with knowledge of the relevant facts and circumstances 
would have concluded that the audit was conducted in accordance with 
auditing standards and, that within the requirements of those auditing 
standards, the auditor appropriately detected and then dealt with known 
material misstatements by (1) ensuring that appropriate adjustments, 
related disclosures, and other changes were made to the financial 
statements to prevent them from being materially misstated, (2) 
modifying the auditor's opinion on the financial statements if 
appropriate changes or other adjustments were not made, or (3) if 
warranted, resigning as the public company's auditor of record and 
reporting the reasons for the resignation to SEC. 

[80] Section 104(d) (2) of the Sarbanes-Oxley Act. 

[81] The AICPA peer review program is still applicable for PCAOB 
inspected firms' non-SEC issuer audit and accounting practices. 

[82] Accounting firm survey data in this report does not include the 
responses of the largest firms, or firms with four or fewer audit 
clients unless otherwise noted. Also, data for smaller firms refer to 
survey respondents only and cannot be generalized to all smaller firms 
because of low response rates for this group. 

[83] Section 301 of the Sarbanes-Oxley Act requires the audit committee 
to be responsible for hiring, compensating, and overseeing the work of 
the accounting firm. 

[84] The aspects of audit quality we asked about were (1) 
responsiveness to client questions and needs, (2) technical capability 
with accounting principles and auditing standards, (3) amount of time 
spent by audit engagement team, (4) amount of time spent by senior 
partners and experts, (5) appropriate time spent on issues based on 
risk areas, (6) experience and capability of engagement partner, (7) 
experience and capability of engagement staff, (8) addition of audit of 
internal control over financial reporting, and (9) ability/willingness 
to identify and surface material reporting issues. 

[85] The manner in which audit fees are categorized and reported has 
changed since 2000 as well. As discussed below, companies were required 
to report fees paid to their external auditor more uniformly in 2001. 

[86] Mary Sullivan, "Great Migration: How Recent Events Changed the 
Switching Behavior of Top-Tier Audit Clients" (George Washington 
University working paper, Washington, D.C., July 2007). While this 
approach allows for a longer-term look at the audit market, it can only 
investigate whether auditor switching changed as a result of Andersen's 
dismantlement relative to other factors such as the Sarbanes-Oxley Act. 
Auditor switching behavior may reasonably be interpreted as an 
indicator of pricing behavior but it does not directly address whether 
audit fees are higher or lower due to concentration. 

[87] See Sharad Asthana et al, "The Effect of Enron, Andersen, and 
Sarbanes-Oxley on the Market for Audit Services" (SSRN Working Paper, 
June 2004), [hyperlink, http://ssrn.com/abstract=560963]. This is one 
of the reasons we do not attempt a pure interrupted time series design 
using audit fees. Audit fees data were not publicly available until 
recently, and, as a result, our data source did not have fee data prior 
to 2000. Moreover, it would be difficult to reach a valid conclusion 
since the dismantlement of Andersen occurred around the same time as 
the passage of the Sarbanes-Oxley Act. 

[88] The random effects model can be thought of as a regression with a 
random constant term. In other words, it is assumed that the intercept 
is a random outcome variable that is a function of a mean value plus a 
random error. 

[89] Because i is in the composite error for each time period t, the 
error term (eit = i + hit) is serially correlated across time, 
invalidating OLS estimates. 

[90] In November 2000, the SEC adopted a rule requiring public 
companies to disclose audit and audit-related fees paid to their 
outside auditors. These requirements were later expanded to include a 
uniform categorization of fees, among other things. 

[91] Although compliance was not initially anticipated until 2004 for 
large companies or 2005 for smaller companies (before being later 
delayed), it is likely that 2003 fees include some Section 404 
attestation costs in preparation for full compliance. 

[92] Principal components analysis involves a mathematical procedure 
that transforms a number of possibly correlated variables into a small 
number of uncorrelated variables called principal components. The first 
principal component accounts for as much as the variability in the data 
as possible, and each succeeding component accounts for as much as the 
remaining variability as possible. In our case the market share 
variable accounts for 96 percent of the variance in the factor space. 

[93] Additionally, the random effects model allows us to attempt to 
separate out the partial effects of the time invariant variables. 

[94] For individual sectors this result could vary. For example, since 
the dissolution of Arthur Andersen led to an increase in the HHI by 
about 36 percent in the utilities sector, the model suggests the 
resultant impact on audit fees for large companies (with over $1 
billion in assets or revenue) in this sector would have been roughly 
1.8 percent. Either way this is a very small especially when viewed as 
a percentage of large company assets or revenue. 

[95] Since price competition is assumed to prevail in the small client 
segment of the audit market because of its low concentration, any 
premium existing due to the effect of market power should be competed 
away but premiums that exist due to brand name reputation or quality- 
differentiated services will not. 

[96] This interpretation of the premium accruing to larger firms is 
commonplace in the academic literature on audit fees. 

[97] "Competition and Choice in the UK Audit Market," Oxera (April 
2006). 

[98] We ran a model with small and large companies and included a 
variable that allowed us to differentiate the effect of concentration 
from larger companies.When the smallest companies were excluded from 
the analysis, we did not find an effect of concentration on fees for 
the remaining companies. See appendix V for limitations. 

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