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Report to the Senate Committee on Banking, Housing, and Urban Affairs 
and the House Committee on Financial Services:

July 2003:

Public Accounting Firms:

Mandated Study on Consolidation and Competition:

GAO-03-864:

GAO Highlights:

Highlights of GAO-03-864, a report to the Senate Committee on Banking, 
Housing, and Urban Affairs and the House Committee on Financial 
Services

Why GAO Did This Study:

The audit market for large public companies is an oligopoly, with the 
largest firms auditing the vast majority of public companies and 
smaller firms facing significant barriers to entry into the market. 
Mergers among the largest firms in the 1980s and 1990s and the 
dissolution of Arthur Andersen in 2002 significantly increased 
concentration among the largest firms, known as the Big 4. These 
four firms currently audit over 78 percent of all U.S. public 
companies and 99 percent of all public company sales. This 
consolidation and the resulting concentration have raised a number of 
concerns. To address them, the Sarbanes-Oxley Act of 2002 mandated 
that GAO study: 

* the factors contributing to the mergers; 

* the implications of consolidation on competition and client choice, 
audit fees, audit quality, and auditor independence; 

* the impact of consolidation on capital formation and securities 
markets; and barriers to entry faced by smaller accounting firms in 
competing with the largest firms for large public company audits. 

What GAO Found:

Domestically and globally, there are only a few large firms capable of 
auditing large public companies, domestically and globally, which 
raises potential choice, price, quality, and concentration risk 
concernsface a. A cAs shown below one measure of market concentration 
common concentration measure used in antitrust analysis, the Hirschman-
Herfindahl Index (HHI) (HHI), indicates that the largest firms have 
the potential for significant significant market power following a 
mergers among the largest firms in the 1990s and the dissolution of 
Arthur Andersen in 2002 (see fig. below). Although GAO found no 
evidence of impaired that competition to date had been impaired in the 
past, the significant changes that have occurred in the profession may 
have raise potential implications for competition and public company 
choice, especially in certain industries, in the future. 

Existing research on audit fees did not conclusively identify a direct 
correlation with consolidation. GAO found that fees have started to 
increase, and most experts expect the trend to continue as the audit 
environment continues to responds to recent and ongoing changes in the 
audit market. Research on quality and independence diodes not link 
these factors audit quality and auditor independence to consolidation 
and in generally, wais inconclusive. Likewise, GAOI was unable to draw 
clear linkages between consolidation and capital formation but did 
observe potential impacts for some smaller companies seeking to raise 
capital. However, given the unprecedented changes occurring in the 
audit market, GAO observes that past behavior may not be indicative of 
future behavior, and these potential implications may warrant 
additional study in the future, including preventing further 
consolidation and maintaining competition.

Finally, GAO found that smaller accounting firms faced significant 
barriers to entry including lack of staff, industry and technical 
expertise, capital formation, global reach, and reputationto entry 
into the large public company audit market. Major barriers are lack of 
global reach, staff resources, industry and technical expertise, 
reputation, and capital As a result, market forces are not likely to 
result in the expansion of the current Big 4. Furthermore, certain 
factors and conditions could cause a further reduction in the number 
of major accounting firms.

www.gao.gov/cgi-bin/getrpt?GAO-03-864.

To view the full product, including the scope and methodology, click 
on the link above. For more information, contact Davi M. D'Agostino 
(202) 512-8678 or d'agostinod@gao.gov.

[End of section]

Contents:

Letter:

Results in Brief:

Background:

Several Key Factors Spurred Consolidation in the 1980s and 1990s:

Audit Market Has Become More Highly Concentrated, Leaving Large Public 
Companies with Few Choices:

Linking Consolidation to Audit Price, Quality, and Auditor Independence 
Is Difficult:

Consolidation Appears to Have Had Little Effect on Capital Formation 
or Securities Markets to Date, and Future Implications Are Unclear:

Smaller Accounting Firms Face Numerous Barriers to Entry into the Top 
Tier:

Observations:

Agency Comments and Our Evaluation:

Appendixes:

Appendix I: Scope and Methodology: 

Identifying the Factors for Consolidation:

Impact of Consolidation on Competition, Auditor Choices, Audit Fees, 
and Audit Quality and Auditor Independence:

Data Analysis Used a Variety of Sources:

We Used the Doogar and Easley (1998) Model of Audit Market Structure to 
Assess Concentration in a Purely Price Competitive Framework:

Impact of Consolidation on Capital Formation and Securities Market:

Identifying Barriers to Entry:

Appendix II: GAO Surveys of Public Accounting Firms and Fortune 1000
Public Companies: 

Appendix III: Arthur Andersen Case Study: 

Background:

Most Andersen Clients Switched to a Big 4 Firm:

Largest Clients Switched to Big 4 Firms:

Thirteen Percent of Former Andersen Clients Switched to Non-Big 4 
Firms:

Former Andersen Clients by Industry Sectors:

Appendix IV: Analysis of Big 4 Firms Specialization by Industry 
Sector: 

Limitations of SIC Analysis:

Industry Specialization Can Limit Public Company Choice:

Appendix V: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Acknowledgments:

Glossary:

Tables:

Table 1: Twenty-five Largest Accounting Firms by Total Revenue, 
Partners, and Staff Resources (U.S. Operations), 2002:

Table 2: List of Selected Tight Oligopolies, as of 1996:

Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms 
(U.S. Operations), 1988 and 2002:

Table 4: Largest U.S. Accounting Firms (Global Operations), 2002:

Table 5: Simulation One--Market Shares, Actual and Simulated with 
Various Switching Costs, 2002:

Table 6: Simulation Two--Market Shares, Actual and Simulated by Client 
Assets, 2002:

Table 7: Simulation Three--Market Shares, Merger Analysis with Various 
Efficiency Assumptions, 2002:

Table 8: Former Andersen Public Company Clients (Actual and Percentage) 
Categorized by Assets, Big 4, and Other Firms, as of December 2002:

Table 9: Former Andersen Public Company Clients (Number and Percentage) 
Categorized by Assets and Big 4 Firm, as of December 31, 2002:

Table 10: Former Andersen Clients Hired by Other Firms, as of December 
31, 2002:

Table 11: New Firms for Former Andersen Clients by SIC Code, as of 
December 31, 2002:

Table 12: Description of Selected SIC Groups:

Table 13: Industries in Which the Big 4 Have a Significant Presence 
(10 percent or More):

Table 14: Industries in Which the Big 4 Have a Significant Presence 
(25 percent or more):

Figures:

Figure 1: Accounting Firm Services as a Percentage of Revenue,
1975, 1987-2002: 

Figure 2: Significant Mergers of the 1980s and 1990s: 

Figure 3: Hirschman-Herfindahl Indexes, 1988-2002:

Figure 4: Hirschman-Herfindahl Indexes (Based on Number of Clients), 
2002:

Figure 5: Percentage of Public Company Audit Market (by Total
Sales Audited), 1988, 1997, and 2002: 

Figure 6: Percentage of Public Company Audit Market (by Number
of Clients), 1988, 1997, and 2002: 

Figure 7: Percentage of Assets Audited in Selected Industries, 1997
and 2002: 

Figure 8: Changes in Audit Fees (Actual), 1984-2000: 

Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of
Total Sales Audited, 1988-2001: 

Figure 10: Where Andersens Public Company Clients Went,
2001-2002: 

Figure 11: New Firms for Former Andersen Public Company Clients,
2001- 2002: 

Figure 12: Average Assets of Former Andersen Pubic Company
Clients by New Firm, 2001-2002: 

Figure 13: Percentages of Assets Audited by the Big 4 in Selected
Industries, 1997 and 2002: 

Figure 14: Percentages of Assets Audited in Industries Potentially
Impacted by the PriceWaterhouseCoopers Merger and Dissolution of 
Andersen, 1997 and 2002: 

[End of section]

Abbreviations:

AA: Arthur Andersen LLP:

AICPA: American Institute of Certified Public Accountants:

Amex: American Stock Exchange:

AY: Arthur Young LLP:

CEO: chief executive officer:

CL: Coopers & Lybrand LLP:

DHS: Deloitte Haskins & Sells LLP:

DOJ: Department of Justice:

DT: Deloitte & Touche LLP:

EW: Ernst & Whinney LLP:

EY: Ernst & Young LLP:

FTC: Federal Trade Commission:

GAAP: generally accepted accounting principles:

GAAS: generally accepted auditing standards:

HHI: Hirschman-Herfindahl Index:

KPMG: KPMG (or KPMG Peat Marwick prior to February 1995):

NYSE: New York Stock Exchange:

PAR: Public Accounting Report:

PCAOB: Public Company Accounting Oversight Board:

PW: Price Waterhouse LLP:

PWC: PricewaterhouseCoopers LLP:

SEC: Securities and Exchange Commission:

SECPS: SEC Practice Section of AICPA:

SIC: Standard Industry Classification:

TR: Touche Ross LLP:

UAA: Uniform Accountancy Act: 

Letter July 30, 2003:

The Honorable Richard C. Shelby 
Chairman 
The Honorable Paul S. Sarbanes 
Ranking Minority Member 
Committee on Banking, Housing, and Urban Affairs 
United States Senate:

The Honorable Michael G. Oxley 
Chairman 
The Honorable Barney Frank 
Ranking Minority Member 
Committee on Financial Services 
House of Representatives:

There are hundreds of public accounting firms that audit public 
companies in the United States. However, a small number of very large 
firms have traditionally provided audit and attest services for the 
majority of public companies, particularly large national and 
multinational companies.[Footnote 1] The number of firms widely 
considered capable of providing audit services to large national and 
multinational companies decreased from eight ("the Big 8") in the 1980s 
to four ("the Big 4") today.[Footnote 2] The reduction was the result 
of mergers involving six of the top eight firms since the late 1980s 
and the abrupt dissolution of Arthur Andersen LLP (Andersen) in 2002. 
The Big 4 firms are substantially larger than the other U.S. or 
international accounting firms, each with thousands of partners, tens 
of thousands of employees, offices located around the world, and annual 
revenues in the billions of dollars. These four firms currently audit 
over 78 percent of all U.S. public companies and 99 percent of public 
company annual sales. Internationally, the Big 4 dominate the market 
for audit services.

Big 8 mergers and Andersen's sudden dissolution have prompted 
heightened concerns about concentration among the largest accounting 
firms and the potential effect on competition and various other 
factors. As a result, Congress mandated in the Sarbanes-Oxley Act of 
2002 that we study these issues.[Footnote 3] Specifically, we were 
asked to study (1) the factors leading to the mergers among the largest 
public accounting firms in the 1980s and 1990s; (2) the impact of 
consolidation on competition, including the availability of auditor 
choices for large national and multinational public companies; (3) the 
impact of consolidation on the cost, quality, and independence of audit 
services; (4) the impact of consolidation on capital formation and 
securities markets; and (5) the barriers to entry faced by smaller 
firms in competing with the largest firms for large national and 
multinational public company clients.

To evaluate the factors contributing to consolidation among the largest 
firms, we interviewed current and former partners of large public 
accounting firms involved in past mergers and Department of Justice 
(DOJ) and Federal Trade Commission (FTC) officials. However, we did not 
review any antitrust analyses conducted by DOJ specific to the proposed 
mergers of the 1980s and 1990s. According to DOJ officials, most of the 
firm documents had been returned to the relevant parties, and other 
documents were viewed as "predecisional" by DOJ. While GAO's statute 
provides us with access to predecisional information absent a 
certification by the President or the Director of the Office of 
Management and Budget, we were more interested in the reasons for the 
mergers than DOJ's analysis in approving the mergers. Therefore, we 
used other sources to obtain the necessary information for this report. 
We also collected information from and coordinated with the Securities 
and Exchange Commission (SEC) and its counterparts from the other six 
members (Canada, France, Germany, Italy, Japan, and the United Kingdom) 
of the Group of Seven nations as required in the mandate. To evaluate 
the impact of consolidation on competition and auditor choice, audit 
fees, and audit quality and auditor independence, we consulted with 
academics, researchers, U.S. and foreign regulators, and trade 
associations and collected data and descriptive statistics for 
analysis. We also employed a simple model of pure price competition, in 
which clients choose auditors based on price, ignoring factors such as 
quality or reputation, to assess whether the current high degree of 
concentration in the market for audit services is necessarily 
inconsistent with a purely price competitive setting. Additionally, as 
of July 11, 2003, we had received 47 responses to a survey of the 97 
largest accounting firms--those with at least 10 corporate clients 
registered with SEC--on their views of accounting firm consolidation 
and its potential implications. This report also includes responses 
from 148 of 250 randomly sampled, Fortune 1000 public companies on 
their experiences with their auditor of record and their views on the 
potential implications of consolidation. We plan to issue a subsequent 
report in September 2003 on client responses received through July 30, 
2003. Lastly, we interviewed a judgmental sample of 20 chairs of audit 
committees for Fortune 1000 companies to obtain their views on 
consolidation and competition. To address the issue of the impact of 
consolidation and concentration on capital formation and securities 
markets, we interviewed representatives from institutional investors, 
investment banks, self-regulatory organizations, and credit rating 
agencies, among others, and we consulted with academics and reviewed 
relevant literature. To identify any barriers to competition faced by 
accounting firms, we reviewed existing state and federal requirements 
and interviewed knowledgeable officials. We also employed the 
previously cited economic model by simulating mergers among smaller 
firms in order to assess whether, in a purely price competitive 
environment, such mergers could lead to viable competitors to the Big 4 
for large national and multinational clients. We also obtained 
information from the American Institute of Certified Public Accountants 
(AICPA).[Footnote 4] Appendix I contains a full description of our 
scope and methodology.

We conducted our work in Chicago, Illinois, New York, New York, and 
Washington, D.C., between October 2002 and July 2003.

Results in Brief:

According to officials involved in mergers among Big 8 firms, 
consolidation of the largest public accounting firms was driven by many 
factors but primarily by the need and desire to (1) keep pace with the 
growing size and global reach of the public companies the firms served, 
(2) achieve greater economies of scale as they modernized operations 
and other technological capabilities, and (3) expand industry-specific 
and technical expertise. Mergers with compatible firms--usually other 
Big 8 firms--were the quickest way to fill gaps in geographic coverage, 
expand global reach, and build industry-specific expertise. Moreover, 
mergers provided firms an opportunity to rapidly increase their capital 
bases to spread risk and create greater economies of scale as they 
modernized operations, particularly information technology and 
training systems. Lastly, some firms merged to maintain their size 
relative to larger competitors and to maintain their position among the 
top tier.

While the market for audit services to public companies has become 
increasingly concentrated--with significant barriers to entry into the 
market for audit services for large public companies in particular--and 
the largest accounting firms (domestically and globally) have 
increasingly had the potential to exercise significant market power, we 
found no empirical evidence that competition in the audit services 
market has been impaired to date. However, given the dissolution of 
Andersen and other significant changes in accounting firm operations, 
it is unclear whether the Big 4 will exercise any increased market 
power. To assess whether the current high degree of concentration in 
the market for audit services is necessarily inconsistent with a price-
competitive setting, we employed a simple model of pure price 
competition in which clients choose auditors based on price.[Footnote 
5] The model's simulation results were very similar to the prevailing 
actual market shares, a result suggesting that the observed high degree 
of concentration to date is not necessarily inconsistent with a price-
competitive environment. The most observable impact of consolidation 
appears to be on the limited number of auditor alternatives for large 
national and multinational companies that require firms with extensive 
staff resources, industry-specific and technical expertise, geographic 
coverage, and international reputation. In many cases, the auditor 
alternatives are further limited due to potential conflicts of 
interest, Sarbanes-Oxley requirements, including independence rules, 
or the need for industry-specific expertise--all of which may serve to 
effectively reduce the number of eligible alternatives to three or in 
many cases fewer.[Footnote 6] Given the unprecedented changes occurring 
in the audit market and potential competitive implications, these 
issues raise concerns about further consolidation and lack of viable 
alternatives in certain industries.

Isolating the impact of consolidation on audit fees, audit quality, and 
auditor independence is difficult, given the significant changes that 
have occurred and are occurring in the accounting profession. 
Researchers using small samples of aggregate billings of companies and 
other proxies for audit fees (such as average audit revenues) found 
consolidation did not appear to affect audit fees, which generally 
remained flat or decreased slightly between 1989 and the mid-1990s 
(inflation adjusted). However, since the late 1990s, audit fees appear 
to have increased, in part due to the changing audit environment and 
increased client expectations. Concerning the impact of consolidation 
on audit quality or auditor independence, we found no research linking 
changes to consolidation; instead, the research attempted to measure 
changes in audit quality and auditor independence in general. The 
existing research and accounting experts we consulted had mixed views 
on both audit quality and auditor independence. Given the numerous 
ongoing changes in the market, past behavior may not be indicative of 
the future and, therefore, we observe that these and other factors may 
warrant attention given the potential price, quality, and concentration 
risk implications.

We found no evidence to suggest that consolidation among the firms had 
directly impacted capital formation or the securities markets, nor did 
we find research that directly addressed how consolidation might affect 
capital formation or the securities markets. Given the important 
assurance role the auditor plays in the capital markets by attesting to 
the fairness of the financial information presented by company 
management, market participants often expect public companies to use 
one of the Big 4. While this expectation or preference is less likely 
to impact large national and multinational public companies, 
consolidation may have consequences for smaller, less established 
companies. For example, to the extent that the Big 4 evaluate the 
profitability and risk of auditing companies, they might become more 
selective about retaining their smaller, potentially less-profitable or 
higher risk audit clients. In turn, these smaller companies might face 
increasing costs of capital if investors were to react adversely to 
their not using a Big 4 auditor.

Finally, we found that smaller accounting firms faced significant 
barriers to entry into the audit market for large national and 
multinational public companies. First, smaller firms generally lack the 
staff, technical expertise, and global reach to audit large and complex 
national and multinational public companies. In this regard, the large 
public companies that responded to our survey to date indicated that 
smaller firms lacked the requisite capacity to audit their operations. 
For example, based on the average number of partners and nonpartner 
professional staff internationally, the Big 4 had almost three times as 
many partners and over five times as many nonpartner professional staff 
as the average for the next three largest firms. We also employed the 
previously cited economic model by simulating mergers among smaller 
firms in order to assess whether, in a purely price-competitive 
environment, such mergers could lead to viable competitors to the Big 4 
for large national and multinational clients. We found that, in 
general, any new firm resulting from such mergers would still lack the 
resources necessary to compete, to any significant degree, with the Big 
4 for larger clients. Second, capital market participants are familiar 
with the Big 4 and are hesitant to recommend that companies use firms 
with whom they are not familiar. Third, many of the eight largest firms 
below the Big 4 with whom we spoke said that litigation risks and 
insurance costs associated with auditing a large public company made 
growth into the large public company market less attractive than other 
growth opportunities. Fourth, raising the amount of capital to build 
the infrastructure necessary to audit large multinational companies is 
difficult, in part because the partnership structure of accounting 
firms limits these firms' ability to raise outside capital. Finally, 
certain state laws make it difficult for firms to expand nationally. 
For example, firms face the burden and additional expense of obtaining 
state licenses for staff across the country. As a result of these 
barriers, we observe that market forces are not likely to result in the 
expansion of the current Big 4. However, it is unclear what, if 
anything, can be done to address these issues.

This report makes no recommendations. We provided copies of a draft of 
this report to SEC, DOJ, the Public Company Accounting Oversight Board 
(PCAOB), and AICPA. DOJ provided additional information on the extent 
to which coordination with antitrust officials and consideration of the 
competitive implications of the Andersen criminal indictment occurred. 
As a result, we clarified the language provided in the final report. 
SEC, DOJ, and AICPA provided technical comments, which have been 
incorporated where appropriate. PCAOB had no comments.

Background:

For over 70 years, the public accounting profession, through its 
independent audit function, has played a critical role in financial 
reporting and disclosure, which supports the effective functioning of 
U.S. capital markets. Over this period, the accounting profession and 
the accounting firms have undergone significant changes, including 
changes in the scope of services provided in response to the changing 
needs of their clients. Following significant mergers among the Big 8 
in the 1980s and 1990s and the dissolution of Arthur Andersen in 2002, 
market share among the accounting firms became more concentrated and 
dominated by the Big 4.

Full Disclosure Critical for Market Confidence:

The Securities Act of 1933 and the Securities Exchange Act of 1934 
established the principle of full disclosure, which requires that 
public companies provide full and accurate information to the investing 
public. Moreover, these federal securities laws require that public 
companies have their financial statements audited by an independent 
public accountant. While officers and directors of a public company are 
responsible for the preparation and content of financial statements 
that fully and accurately reflect the company's financial condition and 
the results of its operations, public accounting firms, which function 
as independent external auditors, provide an additional safeguard. The 
external auditor is responsible for auditing the financial statements 
in accordance with generally accepted auditing standards to provide 
reasonable assurance that a company's financial statements are fairly 
presented in all material respects in accordance with generally 
accepted accounting principles.

Public and investor confidence in the fairness of financial reporting 
is critical to the effective functioning of U.S. capital markets. 
Auditors attest to the reliability of financial statements of public 
companies. Moreover, investors and other users of financial statements 
expect auditors to bring integrity, independence, objectivity, and 
professional competence to the financial reporting process and to 
prevent the issuance of misleading financial statements. The resulting 
sense of confidence in companies' financial statements, which is key to 
the efficient functioning of the markets for public companies' 
securities, can only exist if reasonable investors perceive auditors as 
independent and expert professionals who will conduct thorough audits.

Repeal of Ban on Advertising and Solicitation Created More Competitive 
Environment:

For many decades, public accountants, like members of other 
professions, could not advertise, solicit clients, or participate in a 
competitive bidding process for clients. These restrictions were set by 
AICPA, which directed the professional code of conduct for its members, 
and the state accountancy boards for the 50 states, District of 
Columbia, Guam, Puerto Rico, and U.S. Virgin Islands.[Footnote 7] 
Beginning in the 1970s, FTC, DOJ, and individual professionals began to 
challenge the legality of these restrictions through various court 
actions. As a result of these challenges, AICPA and state boards 
adopted new rules that targeted only false, misleading, or deceptive 
advertising; liberalized restrictions on solicitation; and changed bans 
on competitive bidding. While large public companies generally did not 
switch auditors based on price competition, increased competition and 
solicitations served as incentives for incumbent firms to continually 
offer competitive fees to retain their clients.

Expansion and Contraction of Management Consulting Services Raised 
Concerns about Auditor Independence:

Historically, accounting firms offered a broad range of services to 
their clients. In addition to traditional services such as audit and 
attest services and tax services, firms also offered consulting 
services in areas such as information technology. As figure 1 
illustrates, over the past several decades, the provision of management 
consulting services increased substantially. For example, in 1975, on 
average, management consulting services comprised 11 percent of the Big 
8's total revenues, ranging from 5 percent to 16 percent by firm. By 
1998, revenues from management consulting services increased to an 
average of 45 percent, ranging from 34 to 70 percent of the Big 5's 
revenues for that year.[Footnote 8] However, by 2000, firms had begun 
to sell or divest portions of their consulting business and average 
revenue from management consulting services had decreased to about 30 
percent of the Big 5's total revenues.

Figure 1: Accounting Firm Services as a Percentage of Revenue, 1975, 
1987-2002:

[See PDF for image]

Note: The information included in the subcommittee report was based on 
1975 data.

[End of figure]

Although all of the Big 4 firms continue to offer certain consulting 
services, three of the Big 4 have sold or divested portions of their 
consulting businesses. PricewaterhouseCoopers' consulting practice was 
sold to International Business Machines Corp; KPMG's consulting 
practice became BearingPoint; and Ernst & Young sold its practice to 
Cap Gemini Group S.A. While it has contemplated doing so, Deloitte & 
Touche has not divested its management consulting practice.

The increase in the provision of management consulting and other 
nonaudit services contributed to growing regulatory and public concern 
about auditor independence. Although auditor independence standards 
have always required that the accounting firm be independent both in 
fact and in appearance, concern over auditor independence is a long-
standing and continuing issue for accounting firms. During the late 
1970s, when consulting services represented only a small portion of the 
Big 8's revenue, a congressional study noted that an auditor's ability 
to remain independent was diminished when the firm provided both 
consulting and audit services to the same client.[Footnote 9] A number 
of subsequent studies resulted in various actions taken by both the 
accounting firms and SEC to enhance the real and perceived independence 
of auditors. By 2000, SEC proposed to amend its rules on auditor 
independence because of the growing concern that the increase in 
nonaudit services had impaired auditor independence. The rules that 
were promulgated in 2001 amended SEC's existing rules regarding auditor 
independence and identified certain nonaudit services that in some 
instances may impair the auditor's independence, among other things. 
The amendments also required most public companies to disclose in their 
annual financial statements certain information about nonaudit services 
provided by their auditor. Following the implementation of the 
Sarbanes-Oxley Act in 2002, SEC issued new independence rules in March 
2003.[Footnote 10] The new rules placed additional limitations on 
management consulting and other nonaudit services that firms could 
provide to their audit clients.

Big 8 Mergers and Andersen Dissolution Brought about the Big 4:

Although U.S. accounting firms have used mergers and acquisitions to 
help build their businesses and expand nationally and internationally 
since the early part of the twentieth century, in the late 1980s Big 8 
firms began to merge with one another. As shown in figure 2, the first 
such merger in 1987 between Peat Marwick Mitchell, one of the Big 8, 
and KMG Main Hurdman, a non-Big 8 U.S. affiliate of the European firm, 
Klynveld Main Goerdeler, resulted in the creation of KPMG Peat 
Marwick.[Footnote 11] Because of the extensive network Klynveld Main 
Goerdeler had in Europe, which none of the other Big 8 had, the merged 
firm became the largest accounting firm worldwide and the second 
largest U.S. firm until 1989. In 1989, six of the Big 8 firms explored 
merging. In June 1989, the first merger among the Big 8 involved 
fourth-ranked Ernst & Whinney and sixth-ranked Arthur Young to form 
Ernst & Young. The resulting firm became the largest firm nationally 
(and internationally). In August 1989, seventh-ranked Deloitte Haskins 
& Sells and eighth-ranked Touche Ross merged to form Deloitte & Touche. 
The resulting firm became the third largest firm nationally (and 
internationally). A proposed merger between Andersen and Price 
Waterhouse was called off in September 1989.

Figure 2: Significant Mergers of the 1980s and 1990s:

[See PDF for image]

Note: Firms are ranked by total U.S. revenue.

[End of figure]

In 1997, four firms proposed additional mergers. The first two were 
Price Waterhouse and Coopers & Lybrand. Soon thereafter, the leaders of 
Ernst & Young and KPMG Peat Marwick announced a proposal to merge their 
two firms. DOJ and the European Commission of the European Union 
initiated studies of both merger requests. However, Ernst & Young and 
KPMG Peat Marwick subsequently withdrew their proposal. In 1998, sixth-
ranked Price Waterhouse merged with fifth-ranked Coopers & Lybrand to 
become the second-ranked firm, PricewaterhouseCoopers.

To evaluate these mergers, DOJ, as indicated in its Merger Guidelines, 
used various measures to determine whether the mergers were likely to 
create or enhance market power and should, therefore, be challenged. 
DOJ assessed whether the merger would result in a concentrated market, 
increase the likelihood of adverse competitive effects, and whether 
entry of other competitors into the market would be timely, likely, and 
sufficient "to deter or counteract the competitive effects of concern." 
DOJ then evaluated whether the mergers would result in efficiency gains 
that could not be achieved by other means and whether one of the 
parties to the merger would be likely to fail and exit the market if 
the transaction was not approved.

Finally, the market consolidated to the Big 4 in 2002. The criminal 
indictment of fourth-ranked Andersen for obstruction of justice 
stemming from its role as auditor of Enron Corporation led to a mass 
exodus of Andersen partners and staff as well as clients. Andersen was 
dissolved in 2002.

Several Key Factors Spurred Consolidation in the 1980s and 1990s:

Any one or a combination of several key factors were cited by the Big 4 
and others as spurring the mergers of the Big 8 in the 1980s and 1990s-
-notably the immense growth of U.S. businesses internationally, desire 
for greater economies of scale, and need and desire to build or expand 
industry-specific and technical expertise, among others. First, the 
trend toward corporate globalization led to an increased demand for 
accounting firms with greater global reach. Second, some firms wanted 
to achieve greater economies of scale as they modernized their 
operations and built staff capacity and to spread risk over a broader 
capital base. Third, some firms wanted to build industry-specific or 
technical expertise as the operations of their clients became 
increasingly complex and diversified. Finally, some firms merged to 
increase or maintain their market share and maintain their market 
position among the top tier.

Globalization of Clients Prompted Need for Greater Global Reach:

According to representatives of the Big 4 firms, globalization was a 
driving force behind the mergers of the 1980s and 1990s. As their 
clients expanded their operations around the world, the top-tier firms 
felt pressure to expand as well as to provide service to their clients. 
The trend toward corporate globalization, which continues today, was 
spurred in part by the lowering of trade barriers. Moreover, by the 
mid-1990s, the overall economic environment was changing dramatically 
as technological and telecommunications advances changed the way 
businesses operated. As a result, large U.S. companies operated 
worldwide and more foreign-based companies entered U.S. markets. 
Although all of the Big 8 had offices in certain countries, they did 
not have extensive networks that enabled them to provide comprehensive 
services to large multinational clients. Some of the smaller Big 8 
firms had difficulty attracting and retaining strong foreign 
affiliates. Mergers with compatible firms were the quickest way to fill 
gaps in geographic coverage. For instance, in the 1980s, Ernst & 
Whinney had an established network in the Pacific Rim countries while 
Arthur Young did not. Likewise, Price Waterhouse had a network in South 
America while Coopers & Lybrand's network was in Europe.

In addition to expanding their reach and staff capacity, firms believed 
that they needed to establish global networks to stay abreast of 
country-specific generally accepted accounting principles and 
regulations. Globalization also had raised a number of tax issues that 
required firms to have networks able to accommodate clients with 
operations in a growing number of countries. To have successful global 
networks, the Big 8 needed affiliations with prominent foreign firms.

Growing Complexity of Client Operations Prompted Need for Greater 
Industry-Specific and Technical Expertise:

In addition to responding to globalization, representatives of the 
firms told us that some of the mergers served to increase their 
industry-specific and technical expertise and expand and build 
management-consulting operations to better serve the complex needs of 
their rapidly evolving clients. Each of the Big 8 firms had different 
strengths and industry specializations. Through mergers, firms were 
able to build expertise across more industries and diversify their 
operations. For example, the Ernst & Whinney and Arthur Young merger 
brought together two firms that specialized in healthcare and 
technology, respectively. Similarly, the Price Waterhouse and Coopers & 
Lybrand merger brought together two firms that dominated the market for 
audit services in the energy and gas and telecommunications industries, 
respectively.

In addition, firm officials said that some of the mergers of the 1980s 
and 1990s were spurred by the need and desire to build or expand 
management consulting services, which, as discussed previously, were 
becoming a larger percentage of revenue. Officials also said that the 
mergers allowed them to achieve economies of scope by offering a 
broader range of services to clients.[Footnote 12] As firms merged, 
they were able to create synergies and offer their clients extensive 
services beyond traditional audit and attest services such as tax 
consulting, internal audit, and information systems support. In order 
to remain competitive, some firms merged to build upon different 
operating strengths such as consulting services versus auditing. For 
example, the Deloitte Haskins & Sells and Touche Ross merger brought 
together a firm with substantial audit and tax consulting operations 
and a firm with a strong management consulting business.

In the same era, some firm officials said that they had to build their 
technical expertise in areas such as derivatives and other complex 
financial arrangements used by their clients. Firms also needed to 
build their expertise to address a series of changes to the U.S. tax 
code and the regulatory requirements faced by their clients in other 
countries. Strengthening a firm's technical expertise was critical, 
because some firms believed that clients were increasingly selecting 
their auditors based on specialized expertise and geographic coverage. 
Firms began to provide technological support and services to clients 
that were modernizing their operations.

Mergers Enabled Firms to Achieve Greater Economies of Scale:

Like public companies, the accounting firms were undergoing dramatic 
technological change and innovation in the 1980s and 1990s. According 
to firm officials, firms were beginning to transition to computer-based 
accounting systems and develop new auditing approaches that required a 
considerable capital commitment. By expanding their capital base 
through mergers, firms planned to create economies of scale by 
spreading infrastructure costs from modernizing across a broader 
capital base. Some firm officials said that mergers were critical to 
the firms' modernization because, unlike their clients, accounting 
firms could not raise new capital by issuing securities. Because of 
their prevailing partnership structures, the firms' capital bases were 
largely dependent upon partner-generated capital.

In addition to economies of scale, firm officials said that they also 
expected that mergers would increase overall staff capacity and result 
in more efficient delivery of services and more effective allocation of 
resources in order to better respond to market demands. The broader 
capital bases also allowed firms to invest substantial resources in 
staff training and development. Big 4 representatives said that staff 
training and development were critical in attracting and retaining 
quality staff necessary to offer services demanded by clients. Firm 
officials said that they also expected that economies of scale would 
improve operational efficiencies and offset declining profit margins as 
competition increased.

Mergers Helped Firms Increase Market Share and Maintain Market 
Position:

Many accounting firms also merged to maintain or increase their market 
share in order to hold their market position among top-tier firms. 
Furthermore, some firms believed that some of their foreign affiliates 
would change affiliations if they perceived that greater advantages in 
seeking and retaining client business could be obtained through 
affiliation with a larger firm. The mergers of the 1980s resulted in a 
growing disparity in size between the largest and smallest of the Big 
8. Big 4 representatives told us that merging was a practical 
alternative to trying to build the business through internal growth. 
For example, when seventh-ranked Deloitte Haskins & Sells and eighth-
ranked Touche Ross merged, they became the third-ranked firm. The 
creation of Deloitte & Touche resulted in Coopers & Lybrand being the 
second smallest of the top tier until it merged with the smallest top-
tier firm, Price Waterhouse, in 1998 to become PricewaterhouseCoopers, 
the second-largest firm.

Audit Market Has Become More Highly Concentrated, Leaving Large Public 
Companies with Few Choices:

Since 1988, the audit market has become increasingly concentrated, 
especially in the market for large national and multinational company 
audits, leaving these companies with fewer choices. The 1989 and 1998 
mergers led to significant increases in certain key concentration 
measures typically used by DOJ and FTC to evaluate potential mergers 
for antitrust concerns. These measures indicate highly concentrated 
markets in which the Big 4 have the potential to exercise significant 
market power. In addition to using concentration measures, we employed 
a simple model of pure price competition to assess whether the current 
high degree of concentration in the market for audit services was 
necessarily inconsistent with a purely price-competitive setting. 
Regardless of the ability of the firms to exercise market power or not, 
consolidation has limited the number of choices of accounting firms for 
large national and multinational companies that require firms with 
requisite staff resources, industry-specific and technical expertise, 
extensive geographic coverage, and international reputation. In some 
cases, the choices would be further limited due to conflicts of 
interest, independence rules, and industry specialization.

Large Public Company Audit Market is a Tight Oligopoly:

By any measure, the large public company audit market is a tight 
oligopoly, which is defined as the top four firms accounting for more 
than 60 percent of the market and other firms facing significant 
barriers to entry into the market. In the large public company audit 
market, the Big 4 now audit over 97 percent of all public companies 
with sales over $250 million, and other firms face significant barriers 
to entry into the market. As table 1 illustrates, when comparing the 
top 25 firms on the basis of total revenues, partners, and staff 
resources, the Big 4 do not have any smaller-firm competitors, a 
situation that has given rise to renewed concerns about a possible lack 
of effective competition in the market for large company audit 
services.

Table 1: Twenty-five Largest Accounting Firms by Total Revenue, 
Partners, and Staff Resources (U.S. Operations), 2002:

Firm: Deloitte & Touche; Total revenue (dollars in millions): $5,900; 
Audit and attest revenue (dollars in millions): $2,124; Tax revenue 
(dollars in millions): $1,239; MCS revenue (dollars in millions): 
$2,006; Professional Staff: 19,835; Partners: 2,618; 
Total staff: 22,453; Offices: 81.

Firm: Ernst & Young; Total revenue (dollars in millions): 4,515; Audit 
and attest revenue (dollars in millions): 2,664; Tax revenue (dollars 
in millions): 1,716; MCS revenue (dollars in millions): 0; 
Professional Staff: 15,078; Partners: 2,118; Total staff: 
17,196; Offices: 86.

Firm: PricewaterhouseCoopers; Total revenue (dollars in millions): 
4,256; Audit and attest revenue (dollars in millions): 2,596; Tax 
revenue (dollars in millions): 979; MCS revenue (dollars in 
millions): 0; Professional Staff: 16,774; Partners: 
2,027; Total staff: 18,801; Offices: 113.

Firm: KPMG; Total revenue (dollars in millions): 3,200; Audit and 
attest revenue (dollars in millions): 2,016; Tax revenue (dollars in 
millions): 1,184; MCS revenue (dollars in millions): 0; 
Professional Staff: 10,967; Partners: 1,535; Total staff: 
12,502; Offices: 122.

Firm: Grant Thornton; Total revenue (dollars in millions): 400; Audit 
and attest revenue (dollars in millions): 200; Tax revenue (dollars 
in millions): 136; MCS revenue (dollars in millions): 64; 
Professional Staff: 2,068; Partners: 312; Total staff: 
2,380; Offices: 51.

Firm: BDO Seidman; Total revenue (dollars in millions): 353; Audit and 
attest revenue (dollars in millions): 145; Tax revenue (dollars in 
millions): 145; MCS revenue (dollars in millions): 64; 
Professional Staff: 1,229; Partners: 281; Total staff: 
1,510; Offices: 37.

Firm: BKD; Total revenue (dollars in millions): 211; Audit and attest 
revenue (dollars in millions): 93; Tax revenue (dollars in millions): 
65; MCS revenue (dollars in millions): 53; Professional Staff: 
972; Partners: 193; Total staff: 1,165; Offices: 26.

Firm: Crowe, Chizek and Co; Total revenue (dollars in millions): 205; 
Audit and attest revenue (dollars in millions): 45; Tax revenue 
(dollars in millions): 37; MCS revenue (dollars in millions): 88; 
Professional Staff: 936; Partners: 101; Total staff: 
1,037; Offices: 12.

Firm: McGladrey & Pullen; Total revenue (dollars in millions): 203; 
Audit and attest revenue (dollars in millions): 187; Tax revenue 
(dollars in millions): 16; MCS revenue (dollars in millions): 0; 
Professional Staff: 1,894; Partners: 475; Total staff: 
2,369; Offices: 86.

Firm: Moss Adams; Total revenue (dollars in millions): 163; Audit and 
attest revenue (dollars in millions): 64; Tax revenue (dollars in 
millions): 62; MCS revenue (dollars in millions): 37; 
Professional Staff: 758; Partners: 179; Total staff: 937; 
Offices: 25.

Firm: Plante & Moran; Total revenue (dollars in millions): 161; Audit 
and attest revenue (dollars in millions): 79; Tax revenue (dollars in 
millions): 45; MCS revenue (dollars in millions): 37; 
Professional Staff: 714; Partners: 161; Total staff: 875; 
Offices: 15.

Firm: Clifton Gunderson; Total revenue (dollars in millions): 137; 
Audit and attest revenue (dollars in millions): 55; Tax revenue 
(dollars in millions): 36; MCS revenue (dollars in millions): 48; 
Professional Staff: 850; Partners: 140; Total staff: 
990; Offices: 39.

Firm: Virchow, Krause & Co; Total revenue (dollars in millions): 96; 
Audit and attest revenue (dollars in millions): 35; Tax revenue 
(dollars in millions): 32; MCS revenue (dollars in millions): 21; 
Professional Staff: 536; Partners: 60; Total staff: 
596; Offices: 11.

Firm: Larson Allen; Total revenue (dollars in millions): 79; Audit and 
attest revenue (dollars in millions): 27; Tax revenue (dollars in 
millions): 21; MCS revenue (dollars in millions): 23; 
Professional Staff: 401; Partners: 73; Total staff: 474; 
Offices: 8.

Firm: Richard A. Eisner & Co; Total revenue (dollars in millions): 69; 
Audit and attest revenue (dollars in millions): 30; Tax revenue 
(dollars in millions): 20; MCS revenue (dollars in millions): 18; 
Professional Staff: 280; Partners: 70; Total staff: 
350; Offices: 3.

Firm: Eide Bailly; Total revenue (dollars in millions): 62; Audit and 
attest revenue (dollars in millions): 25; Tax revenue (dollars in 
millions): 11; MCS revenue (dollars in millions): 13; 
Professional Staff: 464; Partners: 59; Total staff: 523; 
Offices: 13.

Firm: J.H. Cohn; Total revenue (dollars in millions): 60; Audit and 
attest revenue (dollars in millions): 30; Tax revenue (dollars in 
millions): 16; MCS revenue (dollars in millions): 4; 
Professional Staff: 193; Partners: 58; Total staff: 251; 
Offices: 8.

Firm: Reznick Fedder & Silverman; Total revenue (dollars in millions): 
58; Audit and attest revenue (dollars in millions): 33; Tax revenue 
(dollars in millions): 18; MCS revenue (dollars in millions): 8; 
Professional Staff: 350; Partners: 32; Total staff: 
382; Offices: 4.

Firm: Cherry, Bekaert & Holland; Total revenue (dollars in millions): 
54; Audit and attest revenue (dollars in millions): 26; Tax revenue 
(dollars in millions): 19; MCS revenue (dollars in millions): 6; 
Professional Staff: 363; Partners: 45; Total staff: 
408; Offices: 23.

Firm: Berdon; Total revenue (dollars in millions): 54; Audit and attest 
revenue (dollars in millions): 20; Tax revenue (dollars in millions): 
19; MCS revenue (dollars in millions): 14; Professional Staff: 
289; Partners: 38; Total staff: 327; Offices: 2.

Firm: Wipfli Ullrich Bertelson; Total revenue (dollars in millions): 
52; Audit and attest revenue (dollars in millions): 27; Tax revenue 
(dollars in millions): 16; MCS revenue (dollars in millions): 8; 
Professional Staff: 335; Partners: 62; Total staff: 
397; Offices: 16.

Firm: M.R.Weiser & Co; Total revenue (dollars in millions): 51; Audit 
and attest revenue (dollars in millions): 29; Tax revenue (dollars in 
millions): 18; MCS revenue (dollars in millions): 4; 
Professional Staff: 248; Partners: 32; Total staff: 280; 
Offices: 3.

Firm: Rothstein, Kass & Co; Total revenue (dollars in millions): 50; 
Audit and attest revenue (dollars in millions): 39; Tax revenue 
(dollars in millions): 11; MCS revenue (dollars in millions): 1; 
Professional Staff: 303; Partners: 16; Total staff: 
319; Offices: 4.

Firm: Goodman & Co; Total revenue (dollars in millions): 49; Audit and 
attest revenue (dollars in millions): 26; Tax revenue (dollars in 
millions): 22; MCS revenue (dollars in millions): 1; 
Professional Staff: 450; Partners: 69; Total staff: 519; 
Offices: 9.

Firm: Schenck Business Solutions; Total revenue (dollars in millions): 
48; Audit and attest revenue (dollars in millions): 16; Tax revenue 
(dollars in millions): 16; MCS revenue (dollars in millions): 7; 
Professional Staff: 267; Partners: 41; Total staff: 
308; Offices: 12.

Sources: Public Accounting Report, 2002-2003.

Notes: Revenues from audit and attest, tax, and management consulting 
services (MCS) may not equal total revenues due to rounding or 
exclusion of certain nontraditional services offered by firm. Companies 
are ranked in Public Accounting Report by revenues. Figures are self-
reported by the audit firms. Note that Deloitte & Touche's relative 
ranking reflects the fact that it is the only one of the Big 4 with 
revenues from MSC.

[End of table]

The Big 4 accounting firms dominate internationally as well, with over 
$47 billion in total global net revenues for 2002, according to a 
February 2003 edition of Public Accounting Report. Moreover, 
information provided by officials from foreign regulators suggests that 
the national markets for audit services to large public companies in 
the other countries tend to be as highly concentrated as they are in 
the United States, with the Big 4 accounting firms auditing a vast 
majority of these large public company clients. For example, according 
to regulatory officials the Big 4 audited over 80 percent of all public 
companies in Japan and at least 90 percent of all listed companies in 
the Netherlands in 2002, while the Big 4 firms were the auditors for 
virtually all major listed companies in the United Kingdom. According 
to Italian regulators, in 2001 the Big 5 audited over 80 percent of 
listed companies in Italy.

Moreover, concentration measures, such as the Hirschman-Herfindahl 
Index (HHI), which are used by DOJ and FTC to aid in the interpretation 
of market concentration data, raise potential concerns about the level 
of competition among accounting firms when calculated using recent 
data.[Footnote 13] As figure 3 illustrates, following the merger of 
Price Waterhouse and Coopers & Lybrand and the dissolution of Andersen, 
the market consisted of firms with the potential for significant market 
power. As a general rule, an HHI below 1,000 indicates a market 
predisposed to perform competitively and one that is unlikely to have 
adverse competitive effects. Conversely, an HHI above 1,800 indicates a 
highly concentrated market in which firms have the potential for 
significant market power--the ability to profitably maintain prices 
above competitive levels for a significant period of time. Sellers with 
market power may also lessen competition on dimensions other than price 
such as product quality, service, or innovation. In addition to using 
concentration measures, DOJ considers barriers to entry and other 
competitive factors such as coordinated interaction among firms, 
conditions conducive to establishing coordination among firms, firm-
specific price increases, alternative and differentiated products, 
changing market conditions, and the ability of rival sellers to replace 
lost competition. As figure 3 also shows, the criminal indictment of 
Andersen and subsequent dissolution resulted in the HHI increasing to 
2,566, well above the threshold for significant market power. It is 
unclear whether and to what extent the Antitrust Division was consulted 
and to what extent DOJ's Antitrust Division had input into the decision 
to criminally indict Andersen.

Figure 3: Hirschman-Herfindahl Indexes, 1988-2002:

[See PDF for image]

[End of figure]

In 2002, we found that the most significant concentration among 
accounting firms was in the large public company market segment. As 
figure 4 shows, although consistently above 1,000, HHIs (based on 
number of clients) for firms auditing public companies with total sales 
between $1 million and $100 million are all below the 1,800 threshold. 
However, HHIs for companies with sales over $100 million are 
consistently above the 1,800 threshold, indicating the potential for 
significant market power in the market for larger company audits.

Figure 4: Hirschman-Herfindahl Indexes (Based on Number of Clients), 
2002:

[See PDF for image]

[End of figure]

Analysis of the four-firm concentration ratio also indicates that 
concentration among the top four accounting firms has increased 
significantly since 1988.[Footnote 14] As shown in figure 5, in 1988 
the top four firms (Price Waterhouse, Andersen, Coopers & Lybrand, and 
KPMG) audited 63 percent of total public company sales. The next four 
firms (Ernst & Whinney, Arthur Young, Deloitte Haskins & Sells, and 
Touche Ross) were significant competitors, auditing 35 percent of total 
public company sales. Also shown in figure 5, by 1997 the top four 
firms audited 71 percent of public company total sales, with two major 
competitors (Coopers & Lybrand and KPMG) auditing an additional 28 
percent. Finally, by 2002, the top four firms audited 99 percent of 
public company total sales with no significant competitors (see fig. 
5).

Figure 5: Percentage of Public Company Audit Market (by Total Sales 
Audited), 1988, 1997, and 2002:

[See PDF for image]

[End of figure]

Likewise, the four-firm concentration ratio based on the total number 
of public company clients increased from 51 percent in 1988 to 65 
percent in 1997 and to 78 percent in 2002 (see fig. 6).[Footnote 15] 
Not surprisingly, the larger public company segment of the market is 
even more concentrated than the overall market. For example, the Big 4 
audit roughly 97 percent of all public companies with sales between 
$250 million and $5 billion and almost all public companies with sales 
greater than $5 billion.

Figure 6: Percentage of Public Company Audit Market (by Number of 
Clients), 1988, 1997, and 2002:

[See PDF for image]

[End of figure]

Effective competition does not require pure competitive conditions; 
however, a tight oligopoly raises concerns because the firms may 
exercise market power, and the concentrated structure of the market 
makes successful collusion, overt or tacit, easier.[Footnote 16] In 
terms of market concentration, the audit market does not differ from 
numerous other markets in the United States that are also characterized 
by high degrees of concentration (see table 2). Although the resulting 
structures are similar, the factors contributing to the market 
structures and the competitive environments may be fundamentally 
different.

Table 2: List of Selected Tight Oligopolies, as of 1996:

Market: Cereals; Leading companies: Kellogg, General Mills, General 
Foods.

Market: Beer; Leading companies: Anheuser-Busch, Miller, Coors.

Market: Airlines; Leading companies: American, United, Northwest, 
Delta, USAir.

Market: Garbage disposal; Leading companies: Waste-Management, 
Browning-Ferris.

Market: Automobiles; Leading companies: General Motors, Ford, Chrysler, 
Toyota.

Market: Locomotives; Leading companies: General Electric, General 
Motors.

Market: Carbonated drinks; Leading companies: Coca-Cola, PepsiCo.

Market: Recordings; Leading companies: Warner, Sony, BMG, Polygram, 
EMI, MCA.

Market: Express delivery; Leading companies: Federal Express, UPS, 
Airborne Freight.

Market: Soaps and detergents; Leading companies: Procter & Gamble, 
Colgate, Lever.

Market: Meat packing; Leading companies: Iowa Beef Packers, Cargill, 
ConAgra.

Market: Automobile rentals; Leading companies: Hertz (Ford), Avis, 
Budget (Ford), Alamo, National (GM).

Market: Athletic shoes; Leading companies: Nike, Reebok, Adidas.

Market: Toys; Leading companies: Mattel, Hasbro.

Source: W. Shepherd, The Economics of Industrial Organization, 4TH ed. 
(London: Prentice-Hall, 1997).

Notes: This list includes a variety of tight oligopolies, and it does 
not attempt to compare or infer similarities aside from market 
concentration. It includes leading companies from the U.S. market 
perspective. The companies in certain markets may have also changed 
since 1996.

[End of table]

Consolidation Does Not Appear to Have Impaired Price Competition to 
Date:

Despite the high degree of concentration among accounting firms, with 
four firms auditing more than 78 percent of all public companies and 99 
percent of all public company sales, we found no evidence that price 
competition to date has been impaired. As indicated in table 2, much of 
the economy is concentrated, but U.S. markets are generally considered 
quite competitive. Thus, market concentration data can overstate the 
significance of a tight oligopoly on competition. While concentration 
ratios and HHI are good indicators of market structure, these measures 
only indicate the potential for oligopolistic collusion or the exercise 
of market power. As market structure has historically been thought to 
influence market conduct and economic performance, there is concern 
that a tight oligopoly in the audit market might have resulted in 
detrimental effects on both purchasers of audit services and users of 
audited financial statements.

We employed a simple model of pure price competition to assess whether 
the high degree of concentration in the market for audit services was 
necessarily inconsistent with a price-competitive setting. The model is 
designed to simulate a market driven by pure price competition, in 
which clients choose auditors on price--neither quality nor reputation, 
for example, is a factor. The model's simulation results suggest that a 
market driven solely by price competition could also result in a high 
degree of market concentration. We found that the model simulated 
market shares that were close to the actual market shares of the Big 4, 
which are thought to be driven by a number of other factors including 
quality, reputation, and global reach.(See app. I for a detailed 
discussion of the model, results, and limitations.) Specifically, the 
model predicted that the Big 4 would audit 64 percent of companies in 
the sampled market, compared with the Big 4 actual market share of 62.2 
percent in 2002 for the companies included in the simulation.[Footnote 
17] Moreover, the model predicted that the Big 4 would audit 96.3 
percent of companies in the sample with assets greater than $250 
million, compared with the 97 percent of these companies actually 
audited by the Big 4 in 2002. While evidence to date does not appear to 
indicate that competition in the market for audit services has been 
impaired, the increased degree of concentration coupled with the 
recently imposed restrictions on the provision of nonaudit services by 
incumbent auditors to their audit clients could increase the potential 
for collusive behavior or the exercise of market power.

Large Public Companies Have Limited Number of Accounting Firm Choices:

The most observable impact of consolidation among accounting firms 
appeared to be the limited number of auditor choices for most large 
national and multinational public companies if they voluntarily 
switched auditors or were required to do so, such as through mandatory 
firm rotation. Of the public companies responding to our survey to 
date, 88 percent (130 of 147) said that they would not consider using a 
smaller (non-Big 4) firm for audit and attest services. See appendix II 
for survey questionnaires and responses. In addition, our analysis of 
1,085 former Andersen clients that changed auditors between October 
2001 and December 2002 suggested that public companies (especially 
large companies) overwhelmingly preferred the Big 4. Only one large 
public company with assets over $5 billion that was audited by Andersen 
switched to a smaller firm. See appendix III for a detailed analysis.

For most large public companies, the maximum number of choices has gone 
from eight in 1988 to four in 2003. According to our preliminary survey 
results, a large majority (94 percent or 137 of 145) of public 
companies that responded to our survey to date said that they had three 
or fewer alternatives were they to switch accounting firms. All 20 of 
the audit chairpersons with whom we spoke believed that they had three 
or fewer alternatives. Of the companies responding to our survey, 42 
percent (61 of 147) said that they did not have enough options for 
audit and attest services. However, when asked whether steps should be 
taken to increase the number of available choices, results revealed 
that 76 percent (54 of 71) of public companies responding to our survey 
to date said they would strongly favor or somewhat favor letting market 
forces operate without government intervention.

We also found that client choices could be even further limited due to 
potential conflicts of interest, the new independence rules, and 
industry specialization by the firms--all of which may further reduce 
the number of available alternatives to fewer than three. First, the 
Big 4 tend to specialize in particular industries and, as our 
preliminary survey results indicated, public companies that responded 
often preferred firms with established records of industry-specific 
expertise, which could further reduce a company's number of viable 
choices.[Footnote 18] For example, 80 percent (118 of 148) of the 
public companies responding to our survey to date said industry 
specialization or expertise would be of great or very great importance 
to them if they had to choose a new auditor.[Footnote 19] When asked 
why they would not consider an alternative to the Big 4, 91 percent 
(117 of 129) of public companies responding to date cited technical 
skills or knowledge of their industry as a reason of great or very 
great importance.

As figure 7 shows, in selected industries, specialization can often 
limit the number of firm choices to two--in each case, two firms 
accounted for well over 70 percent of the total assets audited in each 
industry in 2002. As a result, it might be difficult for a large 
company to find a firm with the requisite industry-specific expertise 
and staff capacity. Figure 7 also shows the impact of the Price 
Waterhouse and Coopers & Lybrand merger and dissolution of Andersen on 
industry specialization and associated client choice. While two firms 
also dominated the four selected industries in 1997, this concentration 
became much more pronounced by 2002, as illustrated in figure 7. See 
appendix IV for a detailed discussion of industry specialization and 
further industry-specific examples and limitations of this type of 
analysis.

Figure 7: Percentage of Assets Audited in Selected Industries, 1997 and 
2002:

[See PDF for image]

[End of figure]

Industry specialization, as captured by a relatively high market share 
of client assets or client sales in a given industry, may also be 
indicative of a firm's dominance in that industry on a different level. 
As a hypothetical example, consider a highly concentrated industry, 
with several very large companies and numerous smaller companies, in 
which a single accounting firm audits a significant portion of the 
industry assets. This firm's interpretation of accounting standards 
specific to the industry could become the prevailing standard practice 
in that industry due to the firm's dominant role. If, subsequently, 
these interpretations were found to be inappropriate (by some 
influential external third party, for example), the firm as well as the 
companies audited by that firm could be exposed to heightened liability 
risk, which could potentially have a severe negative impact on that 
industry as a whole as well as the firm.

Finally, the new independence rules established under the Sarbanes-
Oxley Act of 2002, which limit the nonaudit services firms can provide 
to their audit clients, may also serve to reduce the number of auditor 
choices for some large public companies. As a hypothetical example, 
suppose that a large multinational petroleum company that used one Big 
4 firm for its audit and attest services and another Big 4 firm for its 
outsourced internal audit function wanted to hire a new accounting firm 
because its board of directors decided that the company should change 
auditors every 7 years. In this case, this company would appear to have 
two remaining alternatives if it believed that only the Big 4 had the 
global reach and staff resources necessary to audit its operations. 
However, one of the remaining two Big 4 firms did not enter a bid 
because its market niche in this industry was small companies. 
Consequently, this company would be left with one realistic 
alternative. Although hypothetical, this scenario spotlights another 
concern that focuses on the potential exercise of market power, as it 
is highly probable the remaining firm would be aware of its competitive 
position. Conceivably, there are other scenarios and circumstances in 
which such a company would have no viable alternatives for its global 
audit and attest needs.

Linking Consolidation to Audit Price, Quality, and Auditor Independence 
Is Difficult:

We found little empirical evidence to link past consolidation to 
changes in audit fees, quality, and auditor independence. Given the 
significant changes that have occurred in the accounting profession 
since the mid-1980s, we were also unable to isolate the impact of 
consolidation from other factors. However, researchers (relying on 
analyses based on aggregate billings of small samples of companies or 
proxies for audit fees, such as average audit revenues) generally found 
that audit fees remained flat or increased slightly since 1989. 
Additionally, although not focused on consolidation, a variety of 
studies have attempted to measure overall changes in audit quality and 
auditor independence. The results varied, and we spoke with numerous 
accounting experts who offered varying views about changes in quality 
and independence. Like audit fees, a variety of factors, such as the 
increasing importance of management consulting services provided to 
clients, make attributing any changes, real or perceived, to any one of 
the factors difficult.

Research on Changes in Audit Fees Used a Variety of Measures but Did 
Not Conclusively Determine Effects from Consolidation:

Existing research indicated that audit fees (measured in different 
ways) generally remained flat or decreased slightly from the late 1980s 
through the mid-1990s but have been increasing since the late 1990s 
(inflation adjusted). However, we were unable to isolate the effects of 
consolidation and competition from the numerous other changes that have 
affected accounting firms and how they conduct business. These changes 
included evolving audit scope, the growth of management consulting 
services, technological developments, and evolving audit standards and 
legal reforms that altered audit firms' litigation exposure.Given 
potential changes in the scope of the audit, only the public accounting 
firms themselves can accurately determine whether hourly audit fees 
have increased or decreased since 1989. In general, the scope of an 
audit is a function of client complexity and risk.

Although there are very little data on changes in audit fees over time 
and existing studies used a variety of approaches to measure audit 
fees, two recent academic studies are widely cited. One used a proxy 
measure for the audit fee (Ivancevich and Zardkoohi) and the other was 
based on actual 
fees charged to a small sample of companies (Menon and 
Williams).[Footnote 20] For the period following the mergers of the 
late 1980s, both studies found that audit fees declined through the mid 
1990s. Using audit revenues per accounting firm divided by the dollar 
value of assets audited as a proxy for the audit fee, Ivancevich and 
Zardkoohi found that "fees" fell for both the merged firms (Ernst & 
Young and Deloitte & Touche) and the remaining Big 6 accounting firms 
from 1989 through 1996.[Footnote 21] Similarly, Menon and Williams 
found that the average real audit fee per client declined from $3.4 
million in 1989 to $2.8 million in 1997, the year Price Waterhouse and 
Coopers & Lybrand announced their proposed merger. Moreover, although 
the results were limited due to the small sample size used in the 
regression analysis, the study did not find any evidence that the Big 6 
mergers resulted in a permanent increase in fees.

In addition, as figure 8 illustrates, the periodic survey of actual 
audit fees of about 130 companies conducted by Manufacturers Alliance 
also found a similar downward trend in audit fees per $100 of public 
company revenues in 1989 (and earlier) through 1995.[Footnote 22] In 
1995, the Private Securities Litigation Reform Act was enacted, which 
limited the liability exposure of accounting firms, among others. 
However, the survey revealed a slight increase from 1995 through 1999 
for U.S. and foreign companies. Figure 8 shows that U.S. companies also 
paid lower fees than their foreign counterparts over the survey period. 
Separately, using net average audit revenues for the top tier as a 
percentage of total sales audited as a proxy for audit fees, we found 
that audit fees declined slightly from 1989 through 1995 and increased 
from 1995 through 2001 (see fig. 9). However, no determination can be 
made as to whether consolidation negatively or positively impacted 
audit fees in either case.

Figure 8: Changes in Audit Fees (Actual), 1984-2000:

[See PDF for image]

Note: This graph depicts the average fees for audit services paid by 
companies as a percentage of the average total revenue of the 
companies. Given that this fee analysis is based on a small sample of 
public companies and the results incorporate changing revenue 
classifications and refinements in the underlying survey questions, the 
results should be viewed in the context of those companies surveyed and 
not the market overall.

[End of figure]

Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of 
Total Sales Audited, 1988-2001:

[See PDF for image]

Note: This graph depicts average audit revenue for the top-tier 
accounting firms as a percentage of the average total sales audited by 
the accounting firms. This estimate is used for trend analysis and 
should be viewed as only a rough proxy for the audit fee in part 
because the firms' revenues include clients other than public 
companies. See appendix I for details.

[End of figure]

Although audit fees are generally a relatively small percentage of a 
public company's revenue, recent evidence suggests audit fees have 
increased significantly since 2000 and there are indications they may 
increase further in the future.[Footnote 23] Some experts believe that 
during the 1980s and 1990s audit services became "loss leaders" in 
order for accounting firms to gain entry into other more lucrative 
professional service markets, primarily management consulting 
services.[Footnote 24] Therefore, evidence of flat audit fees since 
1989 and the relatively small percentage of company revenue in 2000 may 
reveal little about the possible market power produced by having fewer 
firms. Likewise, historical fees (especially certain proxy measures of 
audit fees) reveal little about the potential for noncompetitive 
pricing in the future given the new independence rules and evolving 
business model.

According to one source, average audit fees for Standard & Poor's 500 
companies increased 27 percent in 2002 due primarily to new 
requirements and changing audit practices in the wake of recent 
accounting scandals.[Footnote 25] Moreover, many market participants, 
experts, and academics with whom we consulted believe prices will 
increase further due to the implementation of the Sarbanes-Oxley 
requirements and related changes in the scope of certain audit services 
and possible changes in auditing standards. Because of these important 
changes and the potential for market power, it would be difficult to 
isolate the portion of any price increase resulting from noncompetitive 
behavior.

Likewise, nearly all accounting firms that responded to our survey said 
that both costs and fees have increased over the past decade, but that 
costs have increased more: 24 firms (51 percent) said their costs have 
"greatly" increased, and another 22 firms (47 percent) said that costs 
have "moderately" increased. However, when asked about the fees they 
charge, only 12 of the 47 firms (26 percent) responded that the fees 
they charge have greatly increased while another 33 firms (70 percent) 
said that their fees had moderately increased. When public companies 
were asked about fees, 93 percent (137 of 147) of the public companies 
that responded to our survey to date said that audit fees had somewhat 
or greatly increased over the past decade and 48 percent (70 of 147) 
said that consolidation had a great or moderate upward influence on 
those fees. Some companies indicated that most of this increase has 
occurred in the last few years.

Linking Consolidation to Audit Quality and Auditor Independence Is 
Difficult:

Although we identified no research directly studying the impact of 
consolidation among the accounting firms on audit quality or auditor 
independence, we did find limited research that attempted to measure 
general changes in audit quality and auditor independence, and we 
explored these issues with market participants and researchers. We 
found that theoretical and empirical research on both issues to date 
present mixed and inconclusive results as, in general, measurement 
issues made it difficult to assess changes in audit quality or auditor 
independence.

Research Offers Competing Theories on Factors Influencing Audit Quality 
and Auditor Independence:

Audit quality and auditor independence are, in general, difficult to 
observe or measure. Theory suggests that auditor independence and audit 
quality are inextricably linked, with auditor independence being an 
integral component of audit quality. One widely cited academic study 
defined auditor independence as the probability that an auditor would 
report a discovered problem in a company's financial reports while 
another widely cited academic study defined audit quality as the joint 
probability that an auditor would discover a problem in a company's 
financial reports and, further, that the auditor would report the 
problem.[Footnote 26]

Research offers competing theories that address how competition among 
firms, auditor tenure, and accounting firm size--all factors that could 
be influenced directly by consolidation--might impact auditor 
independence and, thus, audit quality.[Footnote 27] For example, some 
research hypothesized that increased competition could have a negative 
effect, as a client's opportunities and incentives to replace an 
incumbent auditor might increase for reasons ranging from minimizing 
audit fees to a desire for a more compliant auditor. However, other 
research hypothesized that increased competition could reduce the 
probability that some accounting firms could exercise disproportionate 
influence over the establishment of accounting principles and policies. 
Likewise, auditor tenure might also have a positive or negative impact. 
Some research hypothesized that an auditor that served a given client 
for a longer period of time may be more valuable to that client due to 
its deeper familiarity with and deeper insight into the client's 
operations, which would allow the auditor to become less dependent on 
the client for information about the client's operations. However, 
other research hypothesized that increased tenure could result in 
complacency, lack of innovation, less rigorous audit procedures, and a 
reflexive confidence in the client. Some research hypothesized that an 
accounting firm's size might also have an impact, as a larger firm 
might become less dependent on a given client than a smaller firm.

Academic research suggests that larger auditors will perform higher 
quality audits and there are many studies employing proxies for audit 
quality that frequently report results consistent with such a notion. 
However, given its unobservable nature, there does not appear to be 
definitive evidence confirming the existence of differential audit 
quality between the Big 4 accounting firms and other auditors. Some 
researchers have dismissed the notion of differential audit quality, 
while others have questioned the assumption that the larger firms 
provide higher quality audits.[Footnote 28] Some experts with whom we 
consulted asserted that there was a quality differential, while others 
were not convinced of this. One academic told us that the question of 
differential audit quality was difficult to answer, since large 
accounting firms generally handle most large company audits. This 
individual also suggested that smaller accounting firms could provide 
the same audit quality as larger accounting firms, provided that these 
smaller firms only accepted clients within their expertise and service 
potential.

Studies Often Use Restatements, Going-Concern Opinions, and Earnings 
Management to Measure Audit Quality and Auditor Independence:

Audit quality is not generally measurable and tends only to be made 
public when a company experiences financial difficulties and its 
investors have a reason to question it.[Footnote 29] Studies addressing 
audit quality and auditor independence have typically focused on 
financial statement restatements, going-concern opinions, and earnings 
management or manipulation.[Footnote 30]

Financial statement restatements due to accounting improprieties have 
been used by some as a measure of audit quality.[Footnote 31] By this 
measure, there is some evidence suggesting that audit quality may have 
declined over the 1990s, as several recent studies have found that 
financial statement restatements due to accounting irregularities have 
been increasing, and those by larger companies have been increasing as 
well.[Footnote 32] As larger companies typically employ larger 
accounting firms, which have been perceived historically by some as 
providing higher quality audits, this trend toward larger company 
financial statement restatements may heighten concerns about 
potentially pervasive declining audit quality. In addition, in some 
recent high-profile restatement cases it appeared that the auditors 
identified problems but failed to ensure that management appropriately 
addressed their concerns, raising questions about auditor independence.

Another measure that has been employed by researchers to gauge audit 
quality is whether an auditor issues a going-concern opinion warning 
investors prior to a company's bankruptcy filing.[Footnote 33] One 
study found that during the 1990s accounting firms issued fewer going-
concern audit opinions to financially stressed companies prior to 
bankruptcy.[Footnote 34] This study found that auditors were less 
likely to issue going-concern opinions in 1996-1997 than in 1992-1993, 
and again less likely to issue such opinions in 1999-2000 than in 1996-
1997. Moreover, another study that analyzed going-concern opinions 
found that accounting firms failed to warn of nearly half of the 228 
bankruptcies identified from January 2001 through June 2002, despite 
the fact that nearly 9 out of 10 of these companies displayed at least 
two indicators of financial stress.[Footnote 35] However, numerous 
prior studies also found that approximately half of all companies 
filing for bankruptcy in selected periods prior to the 1990s did not 
have prior going-concern opinions in their immediately preceding 
financial statements either.[Footnote 36] Another study focusing on 
going-concern opinions over a relatively short, recent time period 
examined whether there was an association between nonaudit fees and 
auditor independence, but it found no significant association between 
the two using auditors' propensity to issue going-concern opinions.
[Footnote 37] This study's findings were consistent 
with market-based institutional incentives dominating expected 
benefits from auditors compromising their independence.

Corporate earnings reported in companies' annual filings (to which 
auditors attest fairness) can be an important factor in investors' 
investment decisions, and can be used by corporate boards and 
institutional investors in assessing company performance and management 
quality, and in structuring loans and other contractual arrangements. 
As such, they can have an impact on securities prices and managers' 
compensation, among other things. Earnings management or manipulation 
(captured by, for example, managers' propensity to meet earnings 
targets) is another measure that has been used by researchers to 
capture audit quality, although in this case an auditor's influence on 
its clients' earnings characteristics is likely to be less direct and 
there can be more significant measurement problems.[Footnote 38] While 
there has been growing anecdotal and empirical evidence of earnings 
management, research using this measure to determine whether audit 
quality or auditor independence was impaired yielded mixed results. For 
example, while one recent study suggested that nonaudit fees impair the 
credibility of financial reports, another cast doubt on its results, 
and another found evidence consistent with auditors increasing their 
independence in response to greater financial dependence (that is, for 
larger clients).[Footnote 39]

Despite Contrasting Views on Audit Quality, Experts and Professionals 
Did Not View Consolidation as Cause:

Existing research on audit quality and auditor independence presents 
inconclusive results, suffers from problematic measurement issues, and 
generally does not consider or compare these factors over extended time 
periods. Many academics and other accounting experts we contacted 
indicated that they believed audit quality had declined since 1989. 
However, others, including small accounting firms and large company 
clients that responded to our survey to date, believed that audit 
quality had not decreased. For example, 43 percent (63 of 147) of 
public companies that responded believed the overall quality had gotten 
much or somewhat better over the past decade, while 18 percent (27 of 
147) felt it had gotten much or somewhat worse. Of the public companies 
that responded to our survey to date, 60 percent (88 of 147) indicated 
that their auditor had become much more or somewhat more independent 
over the last decade. However, some accounting firms acknowledged that 
achieving auditor independence was difficult: 10 percent (14 of the 
147) accounting firms that responded to our survey said that it had 
become much or somewhat harder to maintain independence at the firm 
level in the past decade and 19 percent (9 of the 47) indicated that it 
had become much more difficult or somewhat harder to maintain 
independence at the individual partner level over the past decade.

Even if audit quality or auditor independence has been affected, it 
would be difficult to determine any direct link to consolidation among 
accounting firms because of numerous other structural changes that 
occurred both within and outside of the audit market. When we asked our 
survey respondents how consolidation influenced the quality of audit 
services they received, 64 percent (94 of 147) of the public companies 
responding to date and 95 percent (41 of 43) of accounting firms said 
that consolidation had little or no effect. However, some academics we 
contacted believed that consolidation might have indirectly influenced 
audit quality during the 1990s, with some suggesting, for example, that 
concentration among a few firms enabled the largest accounting firms to 
exercise greater influence over the audit standard setting process and 
regulatory requirements.

Academics and Other Experts Said Other Factors Affected Audit Quality 
and Auditor Independence:

In general, many of the people with whom we spoke--representing 
academia, the profession, regulators, and large public companies--
believed that other factors could potentially have had a greater effect 
on audit quality than consolidation. According to knowledgeable 
individuals with whom we spoke, a variety of factors may have had a 
more direct impact on audit quality and auditor independence than 
consolidation. For example, they cited the removal of restrictions 
against advertising and direct solicitation of clients, the increased 
relative importance of management consulting services to accounting 
firms, legal reforms, changing auditing standards, and a lack of 
emphasis on the quality of the audit by clients and some capital market 
participants.

Several individuals who were knowledgeable about accounting firm 
history suggested that when advertising and direct solicitation of 
other firms' clients began to be permitted in the 1970s, the resulting 
competitive pressure on audit prices led accounting firms to look for 
ways to reduce the scope of the audit, resulting in a decline in audit 
quality. Many of the experts with whom we consulted also suggested that 
the entry of accounting firms into more lucrative management consulting 
services led to conflict-of-interest issues that compromised the 
integrity and quality of the audit service.

Other sources noted that, as a result of several legal reforms during 
the 1990s, it became more difficult and less worthwhile for private 
plaintiffs to assert civil claims against auditors and audit quality 
may also have suffered.[Footnote 40] This view was supported by a study 
that concluded that accounting firms were less likely to warn investors 
about financially troubled companies following the litigation reforms 
of the 1990s.[Footnote 41]

Consolidation Appears to Have Had Little Effect on Capital Formation 
or Securities Markets to Date, and Future Implications Are Unclear:

Although accounting firms play an important role in capital formation 
and the efficient functioning of securities markets, we found no 
evidence to suggest that consolidation among accounting firms has had 
an impact on either of these to date. Moreover, we were unable to find 
research directly addressing how consolidation among accounting firms 
might affect capital formation or the securities markets in the future.

Capital formation and the securities markets are driven by a number of 
interacting factors, including interest rates, risk, and supply and 
demand. Isolating any impact of consolidation among accounting firms on 
capital formation or the securities markets is difficult because of the 
complex interaction among factors that may influence the capital 
formation process, and we were unable to do so. Moreover, most capital 
market participants and other experts with whom we spoke were either 
unsure or did not believe that consolidation had any directly 
discernible impact on capital formation or the securities markets. Some 
said that the broader issues facing accounting firms, such as the 
recent accounting-related scandals involving Enron and WorldCom, might 
have affected the capital markets by reducing investor confidence, but 
that these were not necessarily linked to consolidation.

The informational role played by accounting firms is key to reducing 
the disparity in information between a company's management and capital 
market participants regarding the company's financial condition, thus 
enhancing resource allocation. Consequently, to the extent that 
consolidation might affect audit quality, especially the perception of 
audit quality, the cost and allocation of capital could be affected. 
For example, a perceived decline in audit quality for a given company 
might lead the capital markets to view that company's financial 
statements with increased skepticism, potentially increasing the 
company's cost of capital as well as altering the capital allocation 
decisions of capital market participants.[Footnote 42] The liability to 
which accounting firms are subject also creates a form of "insurance" 
to investors through an auditor's assurance role, which provides 
investors with a claim on an accounting firm in the event of an audit 
failure.[Footnote 43] To the extent that consolidation increased the 
capital bases of some accounting firms, investors might view this as 
potentially increasing loss recovery in the event of an audit failure 
involving those firms. However, it is unclear whether there has been or 
would be any impact on investor behavior, either positive or negative, 
due to the increased capital base of some firms.

Although there appears to be no direct effect from consolidation of the 
Big 8 on the capital markets to date, some capital market participants 
and anecdotal evidence suggested that investment bankers and 
institutional investors, both of whom are integral to the capital 
formation process, often prefer that public companies use the Big 4 to 
audit their financial statements.[Footnote 44] Although such a 
preference does not appear to represent much of a constraint to large 
national and multinational companies, it could have an impact on other, 
smaller companies accessing the capital markets, as a company's use of 
a less well-known accounting firm might create added uncertainty on the 
part of investors and could possibly lead to delays in accessing new 
capital. For example, some research indicated that there was less 
initial public offering underpricing for companies that used Big 8 or 
larger accounting firms, as opposed to those that engaged smaller 
accounting firms.[Footnote 45] According to firm officials, as larger 
accounting firms reevaluate their portfolio of clients, some smaller 
public companies may no longer be able to engage the Big 4 or other 
large accounting firms with whom capital market participants are more 
familiar. Thus, partially as a result of a market with fewer accounting 
firms able or willing to provide audit services to larger public 
companies, some smaller companies could be hindered in their ability to 
raise capital.

Because the audit market has become more concentrated, the Big 4 have 
been increasing their focus on gaining the audit contracts of larger 
public companies. In the process, the Big 4 shed some of their clients, 
particularly smaller ones, which they viewed as not profitable or as 
posing unacceptable risks to their firms. Likewise, smaller firms said 
that they have undergone similar risk assessment and client retention 
processes, and they have also shed some clients that no longer 
satisfied their client criteria. Moreover, the possible reduction in 
the number of accounting firms willing to audit public companies in the 
wake of the passage of Sarbanes-Oxley could further impact the 
availability and cost of capital for some smaller companies, 
particularly companies for whom the accounting firms may doubt the 
profitability of the audit engagements. As noted earlier, familiarity 
with an accounting firm on the part of capital market participants 
could lead to easier, less expensive access to the capital markets.

Smaller Accounting Firms Face Numerous Barriers to Entry into the Top 
Tier:

Unlike the Big 4, which have established global operations and 
infrastructure, smaller accounting firms face considerable barriers to 
entry, such as the lack of capacity and capital limitations, when 
competing for the audits of large national and multinational public 
companies. First, smaller firms generally lack the staff resources, 
technical expertise, and global reach to audit large multinational 
companies. Second, public companies and markets appear to prefer the 
Big 4 because of their established reputation. Third, the increased 
litigation risk and insurance costs associated with auditing public 
companies generally create disincentives for smaller firms to actively 
compete for large public company clients. Fourth, raising the capital 
to expand their existing infrastructure to compete with the Big 4, 
which already have such operations in place, is also a challenge, in 
part because of the partnership structure of accounting firms. Finally, 
certain state laws, such as state licensing requirements, make it 
harder for smaller firms that lack a national presence to compete. The 
firms with whom we spoke, including the Big 4, all told us that they 
did not foresee any of the other accounting firms being able to grow to 
compete with the Big 4 for large national and multinational public 
company clients in the near future.

Smaller Firms Generally Lack Staff Resources, Technical Expertise, and 
Global Reach to Audit Large Public Companies:

Perhaps the most difficult challenge facing smaller firms is the lack 
of staff resources, technical expertise, and global reach necessary to 
audit most large national and multinational companies and their often 
complex operations. Moreover, 91 percent (117 of 129) of public 
companies responding to our survey who would not consider using a non-
Big 4 firm as their auditor said that the capacity of the firm was of 
great or very great importance in their unwillingness to do 
so.[Footnote 46] Large multinational companies are generally more 
complex to audit and require more auditors with greater experience and 
training. The complexity of a public company audit depends on many 
factors, such as the number of markets in which the company competes, 
the size of the company, the nature of the company's business, the 
variety of revenue streams it has, and organizational changes. It is 
not uncommon for an audit of a large national or multinational public 
company to require hundreds of staff.

Most smaller firms lack the staff resources necessary to commit 
hundreds of employees to a single client, which limits smaller firms' 
ability to compete with the Big 4 for large audit clients. Yet, without 
having large clients, it is difficult to build the capacity needed to 
attract large clients. Even with global networks and affiliations, the 
capacity gap between the fourth-and fifth-ranked firms is significant. 
For example, the smallest Big 4 firm in terms of 2002 partners and 
nonpartner professional staff from U.S. operations, KPMG, is over five 
times the size of the fifth-largest firm, Grant Thornton. As table 3 
illustrates, the gap between the top tier and the next tier has grown 
significantly since 1988. This gap spans revenue, number of partners, 
professional staff size, offices, and number of SEC clients. The result 
is a dual market structure--one market where the Big 4 compete with 
several smaller accounting firms for medium and small public companies 
and another market where essentially only the Big 4 compete for the 
largest public company clients.[Footnote 47]

Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms 
(U.S. Operations), 1988 and 2002:

[See PDF for image]

Source: Public Accounting Report, 1989 and 2003.

Notes: The next tier includes Laventhol & Horwath, Grant Thornton, BDO 
Seidman, and McGladrey & Pullen in 1988 (based on the next four largest 
ranked firms by total public company sales audited); for 2002, 
Laventhol & Horwath is replaced by Crowe, Chizek and Company. Average 
real revenue figures have been adjusted for inflation. Gap figures may 
not sum due to rounding.

[End of table]

Although firms of all sizes expressed some difficulty attracting staff 
with specialized audit or industry-specific expertise, smaller firms 
said that this was particularly difficult. Further, some smaller firms 
told us that they had difficulty keeping talented employees, especially 
those with sought-after expertise, from leaving for jobs with the Big 
4. The Big 4 can afford to more highly compensate employees and also 
offer a wider range of opportunities than smaller firms. Moreover, the 
public companies that responded to our survey to date ranked industry 
specialization or expertise as the third most important consideration 
in selecting an auditor. Some company officials also said that they 
preferred a firm to have a "critical mass" or depth of staff with the 
requisite expertise and knowledge, which generally required a firm of a 
certain size.

In addition to smaller firms having staff resource and technical 
expertise constraints, some public companies said that their auditor 
had to have sufficient global reach to audit their international 
operations. Without extensive global networks, most smaller firms face 
significant challenges in competing for large multinational clients. As 
table 4 illustrates, the disparity in capacity between the Big 4 and 
the next three largest firms' global operations was even more dramatic 
than the comparison between their U.S. operations. For example, on 
average, the Big 4 had over 75,000 nonpartner professional staff and 
over 6,600 partners compared to the next three largest firms with over 
14,000 nonpartner professional staff and around 2,200 partners.

Table 4: Largest U.S. Accounting Firms (Global Operations), 2002:

Accounting firms: Big 4: PricewaterhouseCoopers; Revenue: (dollars in 
thousands): Big 4: $13,782; Partners: Big 4: 7,020; Professional staff 
(nonpartner): Big 4: 97,109.

Accounting firms: Big 4: Deloitte & Touche; Revenue: (dollars in 
thousands): Big 4: 12,500; Partners: Big 4: 6,714; Professional staff 
(nonpartner): Big 4: 73,810.

Accounting firms: Big 4: KPMG; Revenue: (dollars in thousands): Big 4: 
10,720; Partners: Big 4: 6,600; Professional staff (nonpartner): Big 4: 
69,100.

Accounting firms: Big 4: Ernst & Young; Revenue: (dollars in 
thousands): Big 4: 10,124; Partners: Big 4: 6,131; Professional staff 
(nonpartner): Big 4: 60,713.

Accounting firms: Next tier.

Accounting firms: BDO Seidman; Revenue: (dollars in thousands): 
2,395; Partners: 2,182; Professional staff (nonpartner): 
16,078.

Accounting firms: Grant Thornton; Revenue: (dollars in 
thousands): 1,840; Partners: 2,256; Professional staff 
(nonpartner): 14,019.

Accounting firms: McGladrey & Pullen; Revenue: (dollars in 
thousands): 1,829; Partners: 2,245; Professional staff 
(nonpartner): 12,775.

Source: Public Accounting Report, 2003.

Notes: This table is limited to U.S.-based firms with global 
operations. Some foreign firms may have operations comparable to 
smaller U.S. firms.

[End of table]

While some of the smaller firms have international operations, we found 
that some public companies and others were either unaware that they had 
such operations or were uncertain of the degree of cohesive service 
that these smaller firms could provide through their global 
affiliations. The various national practices of any given Big 4 firm 
are separate and independent legal entities, but they often share 
common resources, support systems, audit procedures, and quality and 
internal control structures. Market participants said that the 
affiliates of smaller firms, in contrast, tended to have lower degrees 
of commonality. Rather than a tight network, they described smaller 
firms' international affiliations as associations or cooperatives in 
which there was less sharing of resources and internal control systems. 
In addition, they said that quality standards, practices and procedures 
might be less uniform between smaller firm affiliates, which raised 
concerns for multinational public companies.

Smaller Firms Lack Global Reputation:

Smaller firms face a challenge to establish recognition and credibility 
among large national and multinational public companies and, as 
discussed previously, capital market participants. One reason capital 
market participants often prefer a Big 4 auditor is because of their 
higher level of familiarity with the Big 4. For example, some large 
public companies said that some of the smaller accounting firms could 
provide audit services to certain large national public companies, 
depending on the complexity of the companies' operations. These 
individuals added, however, that boards of directors of these companies 
might not consider this option. Others said that despite recent 
accounting scandals involving the Big 4, many capital market 
participants continued to expect the use of the Big 4 for audit 
services. Thus, companies seeking to establish themselves as worthy 
investments may continue to engage one of the Big 4 to increase their 
credibility to investors. Eighty-two percent (121 of 148) of the public 
companies that responded to our survey indicated that reputation or 
name recognition was of great or very great importance to them in 
choosing an auditor. This was the second-most-cited factor, exceeded 
only by quality.

Increased Litigation Risk and Insurance Costs Make Large Company Audit 
Market Less Attractive Than Other Options:

Increased litigation risk presents another barrier for smaller firms 
seeking to audit larger public companies as they face difficulties 
managing this risk and obtaining affordable insurance. Like many of the 
challenges faced by smaller firms, this is a challenge for all firms. 
However, assuming that smaller firms were able to purchase additional 
insurance to cover the new risk exposure, most smaller firms lacked the 
size needed to achieve economies of scale to spread their litigation 
risk and insurance costs across a larger capital base. According to 83 
percent of firms (38 of the 46) that responded to our survey, 
litigation and insurance factors have had a great or moderate upward 
influence on their costs, which they indicated have increased 
significantly.[Footnote 48] Specifically, some of the firms with whom 
we spoke said that their deductibles and premiums have increased 
substantially and coverage had become more limited. Given the recent 
high-profile accounting scandals and escalating litigation involving 
accounting firms, some firms said that insurance companies saw 
increased risk and uncertainty from insuring firms that audited public 
companies. As a result, some of the smaller firms with whom we spoke 
said they had or were considering limiting their practices to nonpublic 
clients. Others said that the greater risk associated with auditing 
large public companies was a key factor in their decisions not to 
attempt to expand their existing operations in the public company audit 
market.

Finally, many of the largest non-Big 4 firms said that they had ample 
opportunities for growth in the mid-sized public company segment of the 
public company audit market and in the private company audit market. In 
addition, smaller firms said that they could attract large companies as 
clients for other audit-related and nonaudit services such as forensic 
audits, management consulting services, and internal audits. In their 
efforts to maximize profits, these smaller firms said they were 
targeting market segments in which they were best positioned to 
compete, which generally did not include the large public company audit 
market.

Raising Capital for Growth Is Difficult:

Access to capital is another critical element to an accounting firm's 
ability to generate the capacity needed to establish the network and 
infrastructure to audit large multinational companies. Several firms 
cited the lack of capital as one of the greatest barriers to growth and 
the ability to serve larger clients. They said that the partnership 
structure of most public accounting firms was one factor that limited 
the ability of all firms to raise capital but posed a particular 
challenge for smaller firms. Under a partnership structure, accounting 
firms are unable to raise capital through the public markets. To expand 
their operations, accounting firms must look to other options, such as 
borrowing from financial institutions, merging with other accounting 
firms, growing the business without merging, or tapping the personal 
resources of their partners and employees. Raising capital through 
borrowing may be difficult because accounting firms as professional 
service organizations may lack the collateral needed to secure loans.

While mergers provide a way for firms to grow and expand their capital 
base, the smaller firms with whom we spoke indicated that they were not 
interested in merging with other similarly sized firms. Some firms said 
that they did not see the economic benefits or business advantages of 
doing so while others said that they wanted to maintain their unique 
identity.

We also employed the Doogar and Easley (1998) model by simulating 
mergers among smaller firms in order to assess whether, in a purely 
price competitive environment, such mergers could lead to viable 
competitors to the Big 4 for large national and multinational clients. 
In particular, we merged the five largest firms below the Big 4 in 
terms of the number of partners (Grant Thornton, BDO Seidman, Baid 
Kurtz & Dobson, McGladrey & Pullen, and Moss Adams) and simulated the 
market to see if the newly merged firm could attract public companies 
(of any size) away from the Big 4. We first assumed that the newly 
merged firm would become as efficient as the Big 4, as measured by the 
staff-to-partner ratio. Under this best-case scenario, we projected 
this firm's market share would be 11.2 percent, compared with the five 
firms' actual collective 2002 market share of 8.6 percent, indicating a 
2.6 percentage-point gain in market share. However, when we assumed 
lesser efficiency gains, the merged firm's projected market share 
ranged from 4.5 percent (no efficiency gains) to 6.4 percent (some 
efficiency gains), indicating that the merged firm's market share would 
be lower than their collective market share (see app. II). Even 
ignoring many real world considerations, such as reputation and global 
reach, these results illustrated the difficulty faced to date by any 
potential competitor to the Big 4 firms in the market for large public 
company audits.

State Requirements Pose Obstacles for Smaller Firms in Particular:

While all accounting firms must comply with state requirements such as 
licensing, smaller firms that lack an existing infrastructure of 
national offices face increased costs and burden to establish 
geographic coverage needed for auditing most large public companies. 
All 50 states, the District of Columbia, Guam, Puerto Rico, and the 
U.S. Virgin Islands have laws governing the licensing of certified 
public accountants, including requirements for education, examination, 
and experience.

While each jurisdiction restricts the use of the title "certified 
public accountant" to individuals who are registered as such with the 
state regulatory authority, the other licensure requirements are not 
uniform. State boards have been working toward a more uniform system 
based on the Uniform Accountancy Act (UAA), which is a model licensing 
law for state regulation within the accounting profession. The UAA 
seeks adoption of the idea of "substantial equivalency" with regard to 
education, examinations, and experience, so that states recognize each 
other's certification as "substantially equivalent" to their own. 
According to National Association of State Boards of Accountancy and 
AICPA officials, fewer than half (23) of the jurisdictions had agreed 
to the equivalency practice as of July 1, 2003.

Some firms expressed concerns that potential state and federal 
duplication of oversight could pose more of a burden for smaller firms 
than the Big 4 and might induce some smaller firms to stop auditing 
public companies altogether. Specifically, to mirror the federal 
oversight structure, most states (37) implemented statutorily required 
peer reviews for firms registered in the state. Until 2002, these 
requirements were generally consistent with the peer review process 
conducted by AICPA's SEC Practice Section.[Footnote 49] However, 
Sarbanes-Oxley created PCAOB to establish auditing standards and 
oversee firms' compliance with those standards. Unlike the old peer 
review that focused on a firm's overall operations, PCAOB plans to 
conduct inspections of a firm's public company practice. Whether this 
inspection will be sufficient to satisfy the peer review requirements 
under state law or whether firms with private clients would have to be 
subject to both state-and federal-level reviews is unclear at this 
time.

Observations:

The audit market is in the midst of unprecedented change and evolution. 
It has become more highly concentrated, and the Big 4, as well as all 
accounting firms, face tremendous challenges as they adapt to new risks 
and responsibilities, new independence standards, a new business model, 
and a new oversight structure, among other things. In many cases it is 
unclear what the ultimate outcome will be and our findings about past 
behavior may not reflect what the situation will be in the future. 
Therefore, we have identified several important issues that we believe 
warrant additional attention and study by the appropriate regulatory or 
enforcement agencies at some point. First, agencies could evaluate and 
monitor the effect of the existing level of concentration on price and 
quality to see if there are any changes in the firms' ability to 
exercise market power. This is especially important as the firms move 
to a new business model with management consulting becoming a less 
significant source of revenue. Second, the issue of what, if anything, 
can or should be done to prevent further consolidation of the Big 4 
warrants consideration. Such an analysis could determine the possible 
impact of increased concentration through the voluntary or involuntary 
exit of one of the current Big 4 firms. If the effects were seen as 
detrimental, regulatory and enforcement agencies could evaluate the 
types of actions that could be taken to mitigate the impact or develop 
contingency plans to deal with the impact of further consolidation. 
Part of this analysis would be to evaluate the pros and cons of various 
forms of government intervention to maintain competition or mitigate 
the effects of market power. Third, it is important that regulators and 
enforcement agencies continue to balance the firms' and the 
individuals' responsibilities when problems are uncovered and to target 
sanctions accordingly. For example, when appropriate, hold partners and 
employees rather than the entire firm accountable and consider the 
implications of possible sanctions on the audit market. However, it is 
equally important that concerns about the firms' viability be balanced 
against the firms' believing they are "too few to fail" and the ensuing 
moral hazard such a belief creates. Fourth, Big 4 market share 
concentration, particularly in key industries, may warrant ongoing and 
additional analysis, including evaluating ways to increase accounting 
firm competition in certain industries by limiting market shares. 
Finally, it is unclear what can be done to address existing barriers to 
entry into the large public company market. However, it may be useful 
to evaluate whether addressing these barriers could prevent further 
concentration in the top tier. Part of this evaluation could include 
determining whether there are acceptable ways to hold partners 
personally liable while reasonably limiting the firms' exposure, but at 
the same time increasing the firms' ability to raise capital.

Agency Comments and Our Evaluation:

We provided copies of a draft of this report to SEC, DOJ, PCAOB, and 
AICPA for their comment. We obtained oral comments from DOJ officials 
from the Antitrust and Criminal Divisions, who provided additional 
information on the extent to which coordination with antitrust 
officials and consideration of the competitive implications of the 
Andersen criminal indictment occurred. As a result, we clarified the 
language provided in this report. SEC, DOJ, and AICPA provided 
technical comments, which have been incorporated into this report where 
appropriate. PCAOB had no comments.

We are sending copies of this report to the Chairman and Ranking 
Minority Member of the House Committee on Energy and Commerce. We are 
also sending copies of this report to the Chairman of SEC, the Attorney 
General, the Chairman of PCAOB, and other interested parties. This 
report will also be available at no cost on GAO's Internet homepage at 
http//www.gao.gov.

This report was prepared under the direction of Orice M. Williams, 
Assistant Director. Please contact her or me at (202) 512-8678 if you 
or your staff have any questions concerning this work. Key contributors 
are acknowledged in appendix V.

Davi M. D'Agostino 
Director, Financial Markets and Community Investment:

Signed by Davi M. D'Agostino: 

[End of section]

Appendixes:

Appendix I: Scope and Methodology:

As mandated by Section 701 of the Sarbanes-Oxley Act of 2002 (P.L. 107-
204) and as agreed with your staff, our objectives were to study (1) 
the factors leading to the mergers among the largest public accounting 
firms in the 1980s and 1990s; (2) the impact of consolidation on 
competition, including the availability of auditor choices for large 
national and multinational public companies; (3) the impact of 
consolidation on the cost, quality, and independence of audit services; 
(4) the impact of consolidation on capital formation and securities 
markets; and (5) the barriers to entry faced by smaller firms in 
competing with the largest firms for large national and multinational 
public company clients.

We conducted our work in Chicago, Illinois, New York, New York, and 
Washington, D.C., from October 2002 through July 2003.

Identifying the Factors for Consolidation:

To identify the factors contributing to consolidation among accounting 
firms, we interviewed past and current partners of public accounting 
firms involved in Big 8 mergers, and officials from the Department of 
Justice (DOJ) and Federal Trade Commission (FTC). Specifically, we 
conducted in-depth interviews with senior partners of the Big 4 firms 
and, to the extent possible, the former partners, chairmen, and chief 
executive officers (CEO) of the Big 8 who were instrumental in their 
firms' decisions to consolidate. We asked these officials to recount in 
detail their firms' histories of consolidation and their views on the 
impetus for merging. We also conducted interviews with senior DOJ 
officials about the studies and investigations they had undertaken to 
determine whether the mergers would raise antitrust issues. We did not, 
however, review any of the antitrust analyses conducted by DOJ specific 
to any of the proposed mergers during the 1980s and 1990s. We requested 
DOJ's antitrust analysis and related documentation from the mergers 
among the largest firms in 1987 and 1997. According to DOJ officials, 
most of the firm documents had been returned to the relevant parties, 
and other documents were viewed as "predecisional" by DOJ. While GAO's 
statute provides us with access to predecisional information absent a 
certification by the President or the Director of the Office of 
Management and Budget, we were more interested in the reasons for the 
mergers than DOJ's analysis in approving the mergers. Therefore, we 
used other sources to obtain the necessary information for this report. 
To the extent possible, we obtained copies of public decisions made by 
FTC in the 1970s and 1980s concerning the ability to advertise by 
professional service firms, including the accounting firms. As directed 
by the mandate, we coordinated with the Securities and Exchange 
Commission (SEC) and SEC's counterparts from the Group of Seven nations 
(Canada, France, Germany, Italy, Japan, United Kingdom, and United 
States). To do this, we met with the representatives of the appropriate 
regulatory agencies under the auspices of the International 
Organization of Securities Commissions and obtained additional 
information relevant to their countries. We also conducted a literature 
review of existing studies on the history of the accounting profession 
and consolidation.

Impact of Consolidation on Competition, Auditor Choices, Audit Fees, 
and Audit Quality and Auditor Independence:

To evaluate the impact of consolidation on competition, auditor 
choices, audit fees, and audit quality and auditor independence, we 
consulted with academics and other researchers, U.S. and foreign 
regulators, and trade associations, and we reviewed relevant academic 
literature. Most of the research studies cited in this report have been 
published in highly regarded, refereed academic journals. These studies 
were also reviewed by GAO's economists, who determined that they did 
not raise serious methodological concerns. However, the inclusion of 
these studies is purely for research purposes and does not imply that 
we deem them definitive. We sent out 26 structured questionnaires 
regarding the impact of consolidation on choice, price, and quality to 
a cross section of academics and other experts (with backgrounds in 
accounting, securities, and industrial organization) and received 14 
responses. We also collected data and calculated our own descriptive 
statistics for analysis. Using audit market data from various sources, 
we computed concentration ratios and Hirschman-Herfindahl indexes and 
conducted trend analyses and tests of statistical independence. We also 
employed a simple model of pure price competition, in which clients 
choose auditors based on price, ignoring factors such as quality or 
reputation, to assess whether the current high degree of concentration 
in the market for audit services is necessarily inconsistent with a 
purely price competitive setting. To augment our empirical findings, we 
conducted two surveys. Finally, we interviewed a judgmental sample of 
20 chairpersons of audit committees of Fortune 1000 companies to obtain 
their views on consolidation and competition.

Data Analysis Used a Variety of Sources:

To address the structure of the audit market we computed concentration 
ratios and Hirschman-Herfindahl indexes for 1988 to 2002 using the Who 
Audits America database, a directory of public companies with detailed 
information for each company, including the auditor of record, 
maintained by Spencer Phelps of Data Financial Press. We used Public 
Accounting Report (PAR) and other sources for the remaining trend and 
descriptive analyses, including the analyses of the top and lower tiers 
of accounting firms, contained in the report.[Footnote 50] Data on 
audit fees were obtained from a variety of academic and other sources, 
including Manufacturers Alliance. The proxy for audit fees that we 
constructed was based on numerous issues of PAR and Who Audits America. 
Given the data used and the manner in which our proxy was constructed, 
this should be considered to be a rough proxy and is used for 
illustrative trend analysis in this report. To verify the reliability 
of these data sources, we performed several checks to test the 
completeness and accuracy of the data. Random samples of the Who Audits 
America database were crosschecked with SEC proxy filings and other 
publicly available information. Descriptive statistics calculated 
using the database were also compared with similar statistics from 
published research. Moreover, Professors Doogar and Easley (see next 
section for fuller discussion), who worked with us on the modeling 
component of the study, compared random samples from Compustat, Dow-
Jones Disclosure, and Who Audits America and found no discrepancies. 
Because of the lag in updating some of the financial information, the 
results should be viewed as estimates useful for describing market 
concentration. We performed similar, albeit more limited, tests on PAR 
data. However, these data are self-reported by the accounting firms and 
it should be noted that the firms are not subject to the same reporting 
and financial disclosure requirements as SEC registrants.

We Used the Doogar and Easley (1998) Model of Audit Market Structure to 
Assess Concentration in a Purely Price Competitive Framework:

We also employed a simple model of pure price competition, in which 
clients choose auditors based on price, ignoring factors such as 
quality or reputation, to assess whether the current high degree of 
concentration in the market for audit services is necessarily 
inconsistent with a price-competitive setting.[Footnote 51] We worked 
with Professor Rajib Doogar, University of Illinois at Urbana-
Champaign, and Professor Robert Easley, University of Notre Dame, to 
expand and update their 1998 model using 2002 data. Our sample 
consisted of 5,448 companies listed on the American Stock Exchange, 
NASDAQ, and New York Stock Exchange, and other companies with stock 
traded on other over-the-counter markets identified from Who Audits 
America. To ensure consistency with Doogar and Easley (1998), we 
limited the market studied to only industrial companies. The 
information on accounting firms, such as number of partners and staff, 
was obtained from PAR. Professors Doogar and Easley performed the 
simulations.

To determine whether the tight oligopoly in the audit market in 2002 
could be explained with a model of pure price competition, we ran three 
market simulations. In the first simulation, we allowed the firms to 
compete for clients to determine market share in a simulated price-
competitive market. For the second simulation, we assigned companies to 
their current auditor and simulated the market to see if the accounting 
firms could defend their market share in a purely price-competitive 
market. Finally, we combined several smaller firms to see if they could 
successfully compete with the Big 4 for larger clients. In each 
simulation, the computer-generated market mimicked a process of pure 
price competition in which firms bid for each client, based on the 
short-term cost of performing the audit.

Model Assumptions:

The model makes several principal assumptions. First, the model assumes 
that firms produce audits with a constant returns-to-scale technology 
using a fixed number of partners and a variable number of 
staff.[Footnote 52] Second, it assumes that firms seek to minimize cost 
(maximize profits), which determines each firm's optimal staff-to-
partner, or leverage, ratio. Third, the model assumes that firms 
compete in a market characterized by perfect price competition--firms 
bid their incremental costs for audits and clients choose auditors 
solely on price so that firm expertise, quality, and reputation, among 
other things, are not considered. In the model, firms with lower 
leverage ratios are more efficient and can therefore bid lower prices 
for audit engagements than less efficient firms, and thus clients will 
gravitate to more efficient accounting firms. Because data on partners 
and staff published by PAR are reported at the consolidated level for 
the entire accounting firm, not just the audit division, some error may 
be introduced into the measure of leverage. In this model and 
simulation framework, a client's size is captured by the natural 
logarithm (log) of its total assets, which has been shown to be a good 
predictor of audit hours and thus audit effort. The model ignores all 
client characteristics that may influence audit fees but not "out-of-
pocket" costs of audit production. Liability and litigation costs are 
assumed to be zero.

Although our survey responses revealed that other factors such as 
expertise, global reach, and reputation play an important role in 
selecting an accounting firm, it is notable that a simple model, which 
does not take these factors into consideration, is able to simulate 
actual market shares that currently exist. Our work shows how publicly 
available data and the Doogar and Easley (1998) model can be combined 
to address important audit market concentration issues that are not 
easily addressed, especially given limited data on audit fees.

Simulation One:

A short-run equilibrium is obtained when accounting firms compete on 
price until every client seeking an auditor is satisfied (that is, it 
has received the lowest price possible).[Footnote 53] After all clients 
have been assigned to an auditor, the incumbent firm charges its client 
a fee equal to the second-lowest bid. The results are then generated 
based on various assumed levels of switching costs (the cost of 
changing auditors). As table 5 illustrates, the model of price 
competition was able to closely predict the actual 2002 market shares, 
regardless of the level of switching cost assumed. Of the 5,448 
industrial companies, the Big 4 audited 68 percent of the log of 
assets:

in 2002, and the model of price competition consistently predicted that 
this tier of firms would audit 68 percent or more of the 
total.[Footnote 54] In fact, collectively the Big 4 firms are predicted 
to audit 1-2 percent more than the actual percentage audited, depending 
on the cost of switching auditors. As table 5 also illustrates, we 
found that if switching costs are prohibitively expensive (20 percent 
or above) companies will not switch auditors and price competition will 
have no impact on the Big 4's market share.

Table 5: Simulation One--Market Shares, Actual and Simulated with 
Various Switching Costs, 2002:

Accounting firms: Deloitte & Touche; Actual market: share: (percent): 
14.94; Switching cost (percent): 25: 14.94; Switching cost 
(percent): 20: 14.94; Switching cost (percent): 15: 15.58; Switching 
cost (percent): 10: 17.24; Switching cost (percent): 5: 19.09; 
Switching cost (percent): 0: 22.00.

Accounting firms: Ernst & Young; Actual market: share: (percent): 
19.73; Switching cost (percent): 25: 19.73; Switching cost 
(percent): 20: 19.73; Switching cost (percent): 15: 19.73; Switching 
cost (percent): 10: 19.73; Switching cost (percent): 5: 18.78; 
Switching cost (percent): 0: 14.90.

Accounting firms: PricewaterhouseCoopers; Actual market: share: 
(percent): 18.98; Switching cost (percent): 25: 18.98; 
Switching cost (percent): 20: 18.98; Switching cost (percent): 15: 
18.98; Switching cost (percent): 10: 18.98; Switching cost (percent): 
5: 19.15; Switching cost (percent): 0: 22.37.

Accounting firms: KPMG; Actual market: share: (percent): 14.38; 
Switching cost (percent): 25: 14.38; Switching cost (percent): 
20: 14.38; Switching cost (percent): 15: 14.38; Switching cost 
(percent): 10: 14.38; Switching cost (percent): 5: 13.76; Switching 
cost (percent): 0: 10.91.

Accounting firms: McGladrey & Pullen; Actual market: share: (percent): 
0.82; Switching cost (percent): 25: 0.82; Switching cost 
(percent): 20: 0.82; Switching cost (percent): 15: 0.84; Switching cost 
(percent): 10: 0.88; Switching cost (percent): 5: 0.93; Switching cost 
(percent): 0: 1.01.

Accounting firms: Grant Thornton; Actual market: share: (percent): 
4.21; Switching cost (percent): 25: 4.21; Switching cost 
(percent): 20: 4.21; Switching cost (percent): 15: 3.93; Switching cost 
(percent): 10: 2.95; Switching cost (percent): 5: 2.25; Switching cost 
(percent): 0: 1.81.

Accounting firms: BDO Seidman; Actual market: share: (percent): 3.13; 
Switching cost (percent): 25: 1.72; Switching cost (percent): 
20: 1.42; Switching cost (percent): 15: 1.14; Switching cost (percent): 
10: 0.96; Switching cost (percent): 5: 0.79; Switching cost (percent): 
0: 0.69.

Accounting firms: BKD; Actual market: share: (percent): 0.10; 
Switching cost (percent): 25: 0.40; Switching cost (percent): 20: 0.46; 
Switching cost (percent): 15: 0.48; Switching cost (percent): 10: 0.52; 
Switching cost (percent): 5: 0.55; Switching cost (percent): 0: 0.61.

Accounting firms: Moss Adams; Actual market: share: (percent): 0.30; 
Switching cost (percent): 25: 0.30; Switching cost (percent): 
20: 0.33; Switching cost (percent): 15: 0.35; Switching cost (percent): 
10: 0.36; Switching cost (percent): 5: 0.38; Switching cost (percent): 
0: 0.42.

Accounting firms: Plante & Moran; Actual market: share: (percent): 
0.14; Switching cost (percent): 25: 0.28; Switching cost 
(percent): 20: 0.31; Switching cost (percent): 15: 0.32; Switching cost 
(percent): 10: 0.35; Switching cost (percent): 5: 0.38; Switching cost 
(percent): 0: 0.40.

Accounting firms: Clifton Gunderson; Actual market: share: (percent): 
0.01; Switching cost (percent): 25: 0.41; Switching cost 
(percent): 20: 0.46; Switching cost (percent): 15: 0.49; Switching cost 
(percent): 10: 0.54; Switching cost (percent): 5: 0.59; Switching cost 
(percent): 0: 0.66.

Accounting firms: Crowe, Chizek and Co; Actual market: share: 
(percent): 0.15; Switching cost (percent): 25: 0.78; Switching 
cost (percent): 20: 0.95; Switching cost (percent): 15: 1.08; Switching 
cost (percent): 10: 1.23; Switching cost (percent): 5: 1.37; Switching 
cost (percent): 0: 1.64.

Accounting firms: Richard A. Eisner & Co; Actual market: share: 
(percent): 0.37; Switching cost (percent): 25: 0.35; Switching 
cost (percent): 20: 0.28; Switching cost (percent): 15: 0.23; Switching 
cost (percent): 10: 0.20; Switching cost (percent): 5: 0.17; Switching 
cost (percent): 0: 0.15.

Accounting firms: Goodman & Co; Actual market: share: (percent): 0.04; 
Switching cost (percent): 25: 0.23; Switching cost (percent): 
20: 0.26; Switching cost (percent): 15: 0.28; Switching cost (percent): 
10: 0.31; Switching cost (percent): 5: 0.34; Switching cost (percent): 
0: 0.38.

Accounting firms: Wipfli Ullrich Bertelson; Actual market: share: 
(percent): 0.02; Switching cost (percent): 25: 0.14; Switching 
cost (percent): 20: 0.16; Switching cost (percent): 15: 0.18; Switching 
cost (percent): 10: 0.19; Switching cost (percent): 5: 0.21; Switching 
cost (percent): 0: 0.23.

Accounting firms: Virchow, Krause & Co; Actual market: share: 
(percent): 0.13; Switching cost (percent): 25: 0.42; Switching 
cost (percent): 20: 0.49; Switching cost (percent): 15: 0.58; Switching 
cost (percent): 10: 0.64; Switching cost (percent): 5: 0.72; Switching 
cost (percent): 0: 0.85.

Accounting firms: Eide Bailly; Actual market: share: (percent): 0.02; 
Switching cost (percent): 25: 0.29; Switching cost (percent): 
20: 0.34; Switching cost (percent): 15: 0.38; Switching cost (percent): 
10: 0.43; Switching cost (percent): 5: 0.47; Switching cost (percent): 
0: 0.56.

Accounting firms: J.H. Cohn; Actual market: share: (percent): 0.24; 
Switching cost (percent): 25: 0.19; Switching cost (percent): 
20: 0.17; Switching cost (percent): 15: 0.14; Switching cost (percent): 
10: 0.12; Switching cost (percent): 5: 0.11; Switching cost (percent): 
0: 0.09.

Accounting firms: Parente Randolph; Actual market: share: (percent): 
0.03; Switching cost (percent): 25: 0.10; Switching cost 
(percent): 20: 0.11; Switching cost (percent): 15: 0.12; Switching cost 
(percent): 10: 0.12; Switching cost (percent): 5: 0.12; Switching cost 
(percent): 0: 0.14.

Source: Doogar and Easley (1998). The simulations were conducted by R. 
Doogar, University of Illinois, and R. Easley, University of Notre 
Dame.

Notes: Market share is based on the log of total company assets. 
Partner-to-staff (leverage) ratios for two outliers (small regional 
firms) were replaced with the market average. The simulated market 
shares vary depending on the assumed switching costs, which range from 
no costs associated with switching to a 25 percent increase in costs 
associated with switching.

[End of table]

Simulation Two:

In the second market simulation, we assigned clients to their current 
auditor and simulated the market to see if the accounting firms could 
defend their market share in a purely competitive market. As table 6 
shows, the model predicted that the Big 4 would audit 64.0 percent of 
the total market, compared with the Big 4 actual market share of 62.2 
in 2002. Moreover, the model predicted that the Big 4 would audit 96.3 
percent of companies in the sample with assets greater than $250 
million compared 
with the 97.0 percent actually audited by the Big 4 in 2002. 
Additionally, Doogar and Easley (1998) found that the model of pure 
price competition could explain the pattern of market shares in 1995.

Table 6: Simulation Two--Market Shares, Actual and Simulated by Client 
Assets, 2002:

Accounting firms: Panel A: Actual number of clients (2002):

Accounting firms: Big 4; Accounting firms: Panel A: Actual number of 
clients (2002): 271; Client asset class (millions): $1,000-5,000: Panel 
A: Actual number of clients (2002): 489; Client asset class (millions): 
$500-1,000: Panel A: Actual number of clients (2002): 353; Client asset 
class (millions): $250-500: Panel A: Actual number of clients (2002): 
394; Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 493; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 353; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 336; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 697; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 3,386; Total (percent): Panel A: 
Actual number of clients (2002): 62.2%.

Accounting firms: Middle 15; Accounting firms: Panel A: Actual number 
of clients (2002): 1; Client asset class (millions): $1,000-5,000: 
Panel A: Actual number of clients (2002): 8; Client asset class 
(millions): $500-1,000: Panel A: Actual number of clients (2002): 8; 
Client asset class (millions): $250-500: Panel A: Actual number of 
clients (2002): 15; Client asset class (millions): $100-250: Panel A: 
Actual number of clients (2002): 50; Client asset class (millions): 
$50-100: Panel A: Actual number of clients (2002): 51; Client asset 
class (millions): $25-50: Panel A: Actual number of clients (2002): 86; 
Client asset class (millions): Less than $25: Panel A: Actual number of 
clients (2002): 343; Client asset class (millions): Total (number): 
Panel A: Actual number of clients (2002): 562; Total (percent): Panel 
A: Actual number of clients (2002): 10.3.

Accounting firms: Fringe 754; Accounting firms: Panel A: Actual number 
of clients (2002): 0; Client asset class (millions): $1,000-5,000: 
Panel A: Actual number of clients (2002): 4; Client asset class 
(millions): $500-1,000: Panel A: Actual number of clients (2002): 2; 
Client asset class (millions): $250-500: Panel A: Actual number of 
clients (2002): 8; Client asset class (millions): $100-250: Panel A: 
Actual number of clients (2002): 28; Client asset class (millions): 
$50-100: Panel A: Actual number of clients (2002): 42; Client asset 
class (millions): $25-50: Panel A: Actual number of clients (2002): 91; 
Client asset class (millions): Less than $25: Panel A: Actual number of 
clients (2002): 1,325; Client asset class (millions): Total (number): 
Panel A: Actual number of clients (2002): 1,500; Total (percent): Panel 
A: Actual number of clients (2002): 27.5.

Accounting firms: Total; Accounting firms: Panel A: Actual number of 
clients (2002): 272; Client asset class (millions): $1,000-5,000: Panel 
A: Actual number of clients (2002): 501; Client asset class (millions): 
$500-1,000: Panel A: Actual number of clients (2002): 363; Client asset 
class (millions): $250-500: Panel A: Actual number of clients (2002): 
417; Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 571; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 446; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 513; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 2,365; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 5,448; Total (percent): Panel A: 
Actual number of clients (2002): 100.0.

Accounting firms: Panel B: Simulated number of clients (2002):

Accounting firms: Big 4; Accounting firms: Panel A: Actual number of 
clients (2002): 265; Client asset class (millions): $1,000-5,000: Panel 
A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: Simulated 
number of clients (2002): 482; Client asset class (millions): $500-
1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: Panel 
B: Simulated number of clients (2002): 353; Client asset class 
(millions): $250-500: Panel A: Actual number of clients (2002): 395; 
Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 515; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 376; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 368; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 731; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 3,485; Total (percent): Panel A: 
Actual number of clients (2002): 64.0%.

Accounting firms: Middle 15; Accounting firms: Panel A: Actual number 
of clients (2002): 6; Client asset class (millions): $1,000-5,000: 
Panel A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: 
Simulated number of clients (2002): 12; Client asset class (millions): 
$500-1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: 
Panel B: Simulated number of clients (2002): 7; Client asset class 
(millions): $250-500: Panel A: Actual number of clients (2002): 12; 
Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 34; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 30; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 65; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 386; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 552; Total (percent): Panel A: Actual 
number of clients (2002): 10.1.

Accounting firms: Fringe 754; Accounting firms: Panel A: Actual number 
of clients (2002): 1; Client asset class (millions): $1,000-5,000: 
Panel A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: 
Simulated number of clients (2002): 7; Client asset class (millions): 
$500-1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: 
Panel B: Simulated number of clients (2002): 3; Client asset class 
(millions): $250-500: Panel A: Actual number of clients (2002): 10; 
Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 22; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 40; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 80; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 1,248; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 1,411; Total (percent): Panel A: 
Actual number of clients (2002): 25.9.

Accounting firms: Total; Accounting firms: Panel A: Actual number of 
clients (2002): 272; Client asset class (millions): $1,000-5,000: Panel 
A: Actual number of clients (2002): 489: 8: 4: 501: Panel B: Simulated 
number of clients (2002): 501; Client asset class (millions): $500-
1,000: Panel A: Actual number of clients (2002): 353: 8: 2: 363: Panel 
B: Simulated number of clients (2002): 363; Client asset class 
(millions): $250-500: Panel A: Actual number of clients (2002): 417; 
Client asset class (millions): $100-250: Panel A: Actual number of 
clients (2002): 571; Client asset class (millions): $50-100: Panel A: 
Actual number of clients (2002): 446; Client asset class (millions): 
$25-50: Panel A: Actual number of clients (2002): 513; Client asset 
class (millions): Less than $25: Panel A: Actual number of clients 
(2002): 2,365; Client asset class (millions): Total (number): Panel A: 
Actual number of clients (2002): 5,448; Total (percent): Panel A: 
Actual number of clients (2002): 100.0.

Source: Doogar and Easley (1998). The simulations were conducted by R. 
Doogar, University of Illinois, and R. Easley, University of Notre 
Dame.

Notes: For Simulation Two, companies were placed in one of eight asset 
classes, depending on size: (1) assets greater than $5 billion, (2) 
assets between $1 and $5 billion, (3) assets between $500 million and 
$1 billion, (4) assets between $250 million and $500 million, (5) 
assets between $100 million and $250 million, (6) assets between $50 
million and $100 million, (7) assets between $25 million and $50 
million, and (8) assets less than $25 million. Market share is based on 
total number of clients. Partner-to-staff (leverage) ratios for two 
outliers (small regional firms) were replaced with the market average.

[End of table]

Simulation Three:

Finally, we merged the five largest firms below the Big 4 in terms of 
the number of partners (capacity)--Grant Thornton, BDO Seidman, Baid 
Kurtz & Dobson, McGladrey & Pullen, and Moss Adams--and simulated the 
market to see if the newly merged firm could successfully win clients 
from the Big 4 (see table 7). Measured by the log of assets, these 
firms collectively audited 8.6 percent of the actual market in 2002. 
However, when we simulated the market to begin the process, the model 
predicted these firms would collectively audit only 4.5 percent of the 
market, while the Big 4 would audit 70.1 percent. When we simulated the 
merger of the:

five firms and assumed no efficiency gains would result, the merged 
firm's market share declined slightly. When modest efficiency gains 
were permitted, the merged firm gained market share, to 6.4 percent, 
and was able to attract a few of the Big 4's larger clients. Finally, 
in the best-case scenario in which we allowed the newly merged firm to 
become as efficient as the Big 4 (strong efficiency gains), the market 
share increased to 11.2 percent, and both the Big 4 and remaining 
accounting firms lost market share to the merged firm. However, since 
the five firms actually audited 8.6 percent of the market in 2002 
collectively, the simulated mergers only resulted in a market share 
increase of 2.6 percentage points in the best-case scenario.

Table 7: Simulation Three--Market Shares, Merger Analysis with Various 
Efficiency Assumptions, 2002:

Efficiency assumption: No merger:

Efficiency assumption: Simulated 2002; Simulated market shares: Merged: 
firms (percent): No merger: 4.5%; Simulated market shares: Remaining 
10: No merger: 5.1%; Simulated market shares: No merger: 70.1%; 
Simulated market shares: Other firms (percent): No merger: 20.2%.

Efficiency assumption: Merger:

Efficiency assumption: No efficiency gains; Simulated market shares: 
Merged: firms (percent): No merger: 4.2; Simulated market shares: 
Remaining 10: No merger: 5.2; Simulated market shares: No merger: 70.4; 
Simulated market shares: Other firms (percent): No merger: 20.2.

Efficiency assumption: Some efficiency gains; Simulated market shares: 
Merged: firms (percent): No merger: 6.4; Simulated market shares: 
Remaining 10: No merger: 5.0; Simulated market shares: No merger: 68.9; 
Simulated market shares: Other firms (percent): No merger: 19.7.

Efficiency assumption: Strong efficiency gains; Simulated market 
shares: Merged: firms (percent): No merger: 11.2; Simulated market 
shares: Remaining 10: No merger: 4.8; Simulated market shares: No 
merger: 65.4; Simulated market shares: Other firms (percent): No 
merger: 18.7.

Source: Doogar and Easley (1998). The simulations were conducted by R. 
Doogar, University of Illinois, and R. Easley, University of Notre 
Dame.

Notes: Market share is based on the log of total company assets. 
Partner-to-staff (leverage) ratios for two outliers (small regional 
firms) were replaced with the market average.

[End of table]

Survey Data:

To augment our empirical analysis, we conducted two sample surveys to 
get information from the largest accounting firms and their clients. 
First, we surveyed representatives of each of the 97 largest accounting 
firms--those with 10 or more corporate clients that are registered with 
SEC--about their experience consolidating with other firms, their views 
on consolidation's effects on competition, and what they thought were 
the potential implications of consolidation for auditor choice, audit 
fees, audit quality, and auditor independence within their industry. We 
identified the 97 firms and obtained name and address information for 
the executive to be contacted primarily from the membership list of the 
American Institute of Certified Public Accountants' (AICPA) SEC 
Practice Section. To develop our questionnaire, we consulted a number 
of experts at SEC, AICPA, and others knowledgeable about the accounting 
profession. We also pretested our questionnaire with two of the Big 4 
firms, four other firms among the largest 97, and two small firms. We 
began our Web-based survey on May 23, 2003, and included all usable 
responses as of July 11, 2003, to produce this report. One of the 97 
firms was found to be ineligible for the survey because the answers of 
another responding firm comprised the activity of the former, so the 
final population surveyed was 96 firms. We received 47 usable responses 
from these 96 firms, for an overall response rate of 49 percent. 
However, the number of responses to individual questions may be fewer 
than 47, depending on how many responding firms were eligible to or 
chose to answer a particular question.

Second, we surveyed a random sample of 250 of the 960 largest publicly 
held companies. We created this population from the 2003 list of the 
Fortune 1000 companies produced by Fortune, a division of Time, Inc., 
after removing 40 private firms from this list. We mailed a paper 
questionnaire to the chief financial officers, or other executives 
performing that role, requesting their views on the services they 
received from their auditor of record, the effects of consolidation on 
competition among accounting firms, and its potential implications. To 
develop this questionnaire, we consulted with AICPA and SEC and 
pretested with six large public companies from a variety of industries. 
The survey began on May 6, 2003. We removed one company that had gone 
out of business, and received 148 usable responses as of July 11, 2003, 
from the final sample of 249 companies, for an overall response rate of 
59 percent. Again, the number of responses to individual questions may 
fluctuate, depending on how many respondents answered each question. We 
plan to issue a subsequent report in September 2003 on client responses 
received through July 30, 2003.

While the public company survey results came from a random sample drawn 
from the population of Fortune 1000 companies and thus could be 
weighted to statistically represent that larger group, we are reporting 
totals and percentages only for those companies (and accounting firms) 
actually returning questionnaires. Since the small number of 
respondents to both surveys at the time of publication could 
significantly differ in their answers from the answers nonrespondents 
might have given had they participated, it is particularly risky to 
project the results of our survey to not only the nonrespondents, but 
also to the part of the public company population we did not sample. 
There are other practical difficulties in conducting any survey that 
may also contribute to errors in survey results. For example, 
differences in how a question is interpreted or the sources of 
information available to respondents can introduce unwanted variability 
into the survey results. We included steps in both the data collection 
and data analysis stages to minimize such errors. In addition to the 
questionnaire testing and development measures mentioned above, we 
followed up with the sample firms and clients with e-mails and 
telephone calls to encourage them to respond and offer assistance. We 
also checked and edited the survey data and programs used to produce 
our survey results.

Finally, we conducted structured interviews with a judgmental sample of 
20 chairs of audit committees for Fortune 1000 companies to obtain 
their views on audit services, consolidation, and competition within 
the audit market. Our selection criteria included geographic location, 
the company's industry, and the chairperson's availability. The audit 
chairpersons whom we interviewed all had a background in business and 
most had been or were currently serving as CEOs of a Fortune 1000 
company. On average, the chairpersons we interviewed served on over two 
boards in addition to the board on which they sat for purposes of the 
interview. On average, they served as chairpersons of the audit 
committee for just over 2 years, served as a member on the audit 
committee for over 5 years, and served on that Fortune 1000 company's 
board of directors for over 7 years.

Impact of Consolidation on Capital Formation and Securities Markets:

To address the issue of the impact of consolidation and concentration 
among large accounting firms on capital formation and securities 
markets, we interviewed representatives from accounting firms, 
investment banks, institutional investors, SEC, self-regulatory 
organizations, credit agencies, and retail investors, among others. We 
also consulted with numerous academics and reviewed relevant economic 
literature.

Identifying Barriers to Entry:

To identify the barriers to entry that accounting firms face in the 
public company audit market, we discussed competition and competitive 
barriers with representatives of a cross section of public accounting 
firms, large public companies, various government agencies, the 
accounting profession and trade associations, institutional investors, 
securities underwriters, self-regulatory organizations, credit rating 
agencies, and other knowledgeable officials. We obtained information 
from the National Association of State Boards of Accountancy and AICPA. 
We also reviewed existing state and federal requirements. Finally, we 
used the Doogar and Easley (1998) model to roughly assess whether 
mergers between non-Big 4 firms could potentially increase the number 
of accounting firms capable of auditing large national and 
multinational companies.

[End of section]

Appendix II: GAO Surveys of Public Accounting Firms and Fortune 1000 
Public Companies:

[See PDF for image]

[End of figure]

Appendix III: Arthur Andersen Case Study:

Background:

In 2001, Arthur Andersen LLP (Andersen) was the fourth-largest public 
accounting firm in the United States, with global net revenues of over 
$9 billion. On March 7, 2002, Andersen was indicted by a federal grand 
jury and charged with obstructing justice for destroying evidence 
relevant to investigations into the 2001 financial collapse of Enron. 
At the time of its indictment, Andersen performed audit and attest 
services for about 2,400 public companies in the United States, 
including many of the largest public companies in the world. In 
addition, Andersen served private companies and provided additional 
professional services such as tax and consulting services.

This appendix is an analysis of 1,085 former Andersen public company 
clients that switched to a new public accounting firm between October 
1, 2001, and December 31, 2002.[Footnote 55]In addition to identifying 
the new public accounting firms of the former Andersen clients, we 
determined which firms attracted the largest clients and how many 
Andersen clients switched to non-Big 4 firms.[Footnote 56]

Most Andersen Clients Switched to a Big 4 Firm:

Between October 2001 and December 2002, 1,085 public companies audited 
by Andersen switched to a new auditor of record. As figure 10 
illustrates, of the 1,085 companies reviewed, 938 switched to one of 
the Big 4 (87 percent), and 147 switched to a non-Big 4 firm (13 
percent). Among the Big 4, Ernst & Young attracted the largest number 
of former Andersen clients, followed by KPMG, Deloitte & Touche, and 
PricewaterhouseCoopers (see fig. 11). Of the former Andersen clients 
who switched to a non-Big 4 firm, 45 switched to Grant Thornton (4 
percent) and 23 switched to BDO Seidman (2 percent).

Figure 10: Where Andersen's Public Company Clients Went, 2001-2002:

[See PDF for image]

Note: Numbers are rounded and adjusted to equal 100.

[End of figure]

Figure 11: New Firms for Former Andersen Public Company Clients, 2001-
2002:

[See PDF for image]

Note: Percentages are rounded and adjusted to equal 100.

[End of figure]

Largest Clients Switched to Big 4 Firms:

We found that almost all former Andersen clients with total assets 
above $5 billion switched to a Big 4 firm. The one exception, Global 
Crossing, switched to Grant Thornton. We found that the Big 4 audited 
approximately 98 percent of the total assets of the 1,085 former 
Andersen clients that switched auditors between October 1, 2001, and 
December 31, 2002. As illustrated in figure 12, PricewaterhouseCoopers, 
although attracting the smallest number of Andersen clients (159), 
tended to attract the largest clients based on average total company 
asset size ($3.9 billion). Comparatively, former Andersen clients that 
switched to Deloitte & Touche and KPMG averaged total assets of $3.0 
billion and $2.4 billion, respectively. In addition, Ernst & Young, 
although attracting the largest number of Andersen clients, tended to 
attract smaller clients based on average total company asset size ($1.5 
billion).

Figure 12: Average Assets of Former Andersen Pubic Company Clients by 
New Firm, 2001-2002:

[See PDF for image]

[End of figure]

We also analyzed former Andersen clients by asset size and determined 
how many of its clients switched to Big 4 versus other firms. As table 
8 illustrates, the vast majority of the largest former Andersen clients 
switched to one of the Big 4 firms. With the exception of the smallest 
asset class, 90 percent or more of the former Andersen clients switched 
to one of the Big 4 firms.

Table 8: Former Andersen Public Company Clients (Actual and Percentage) 
Categorized by Assets, Big 4, and Other Firms, as of December 2002:

Accounting firm: Actual public company clients:

Accounting firm: Big 4; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 85; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 180; Asset ranges (millions): 
$1,000-500: Actual public company clients: 111; Asset ranges 
(millions): $500-100: Actual public company clients: 291; Asset ranges 
(millions): Less than $100: Actual public company clients: 271; Asset 
ranges (millions): Total: Actual public company clients: 938.

Accounting firm: Other; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 1; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 5; Asset ranges (millions): 
$1,000-500: Actual public company clients: 5; Asset ranges (millions): 
$500-100: Actual public company clients: 26; Asset ranges (millions): 
Less than $100: Actual public company clients: 110; Asset ranges 
(millions): Total: Actual public company clients: 147.

Accounting firm: Total; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 86; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 185; Asset ranges (millions): 
$1,000-500: Actual public company clients: 116; Asset ranges 
(millions): $500-100: Actual public company clients: 317; Asset ranges 
(millions): Less than $100: Actual public company clients: 381; Asset 
ranges (millions): Total: Actual public company clients: 1,085.

Accounting firm: Percentage of public company clients:

Accounting firm: Big 4; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 99%; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 97%; Asset ranges (millions): 
$1,000-500: Actual public company clients: 96%; Asset ranges 
(millions): $500-100: Actual public company clients: 92%; Asset ranges 
(millions): Less than $100: Actual public company clients: 71%; Asset 
ranges (millions): Total: Actual public company clients: 87%.

Accounting firm: Other; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 1; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 3; Asset ranges (millions): 
$1,000-500: Actual public company clients: 4; Asset ranges (millions): 
$500-100: Actual public company clients: 8; Asset ranges (millions): 
Less than $100: Actual public company clients: 29; Asset ranges 
(millions): Total: Actual public company clients: 13.

Accounting firm: Total; Asset ranges (millions): Greater than $5,000: 
Actual public company clients: 100; Asset ranges (millions): $5,000-
1,000: Actual public company clients: 100; Asset ranges (millions): 
$1,000-500: Actual public company clients: 100; Asset ranges 
(millions): $500-100: Actual public company clients: 100; Asset ranges 
(millions): Less than $100: Actual public company clients: 100; Asset 
ranges (millions): Total: Actual public company clients: 100.

Source: Who Audits America, 2001-2002.

[End of table]

We also looked at the movement of former Andersen clients to the Big 4 
firms within the asset range groups. As table 9 shows, KPMG was hired 
by the highest percentage of former Andersen clients in both the 
largest and smallest asset groups, while Ernst & Young was hired by the 
highest percentage of former Andersen clients with assets between $100 
million and $5 billion.

Table 9: Former Andersen Public Company Clients (Number and Percentage) 
Categorized by Assets and Big 4 Firm, as of December 31, 2002:

[See PDF for image]

Source: Who Audits America, 2001-2002.

Notes: Deloitte & Touche (DT), Ernst & Young (EY), KPMG, and 
PricewaterhouseCoopers (PwC). Percentages may not sum to 100 due to 
rounding.

[End of table]

Thirteen Percent of Former Andersen Clients Switched to Non-Big 4 
Firms:

Of the former Andersen clients, 147 (13 percent) switched to a non-Big 
4 firm. Of the 147 firms, 31 percent switched to Grant Thornton and 16 
percent switched to BDO Seidman (fig. 11). The average asset size of a 
company that switched to a non-Big 4 firm was $309 million, which is 
approximately $2.2 billion less than the average asset size of a 
company that switched to a Big 4 firm. As table 10 illustrates, the 
average asset size of a company that switched to Grant Thornton was 
$644 million, and the average asset size of a company that switched to 
BDO Seidman was $54 million. The 147 public company clients that did 
not engage a Big 4 firm switched to one of 52 non-Big 4 firms.

Table 10: Former Andersen Clients Hired by Other Firms, as of December 
31, 2002:

Accounting firm: Big 4; Number of former Andersen clients: 938; 
Percentage of total clients: 87%; Average assets (millions): $2,508.

Accounting firm: Grant Thornton; Number of former Andersen clients: 45; 
Percentage of total clients: 4; Average assets (millions): 644.

Accounting firm: BDO Seidman; Number of former Andersen clients: 23; 
Percentage of total clients: 2; Average assets (millions): 54.

Accounting firm: Other; Number of former Andersen clients: 79; 
Percentage of total clients: 7; Average assets (millions): 193.

Accounting firm: Total; Number of former Andersen clients: 1,085; 
Percentage of total clients: 100; Average assets (millions): 2,210.

Source: Who Audits America, 2001-2002.

[End of table]

Former Andersen Clients by Industry Sectors:

Of the 1,085 former Andersen clients, we were able to classify 926 
companies into 56 different industry sectors.[Footnote 57] We observed 
that former Andersen clients in 22 industry sectors stayed with a Big 4 
firm, while former Andersen clients in 34 industry sectors switched to 
a non-Big 4 firm. Within some industries certain accounting firms were 
hired more often than others. For example, Ernst & Young attracted 
former Andersen clients in more industry sectors overall than any other 
firm (49 of the 56 industry sectors). We also observed that within 16 
industries KPMG attracted more former Andersen clients than other firms 
(see table 11).

It is important to review this analysis in the context of its 
limitations. Specifically, defining markets by SIC codes can exaggerate 
the level of concentration because, like the audit market, a few large 
companies dominate many industry sectors (see table 2). To mitigate the 
potential for bias, we limited our analysis to the 2-digit SIC codes 
rather than the 4-digit codes. There are additional methodological 
issues with defining markets by SIC codes. First, the audited 
companies' lines of business, not the business of the accounting firms, 
defines the markets. Second, some companies that could be included in a 
particular industry are not included because no SIC code identifier was 
provided in the database that we used. Moreover, assignment of a 
company to a particular SIC code sometimes involves judgment, which may 
create bias.

Table 11: New Firms for Former Andersen Clients by SIC Code, as of 
December 31, 2002:

[See PDF for image]

Source: Who Audits America, 2002.

Note: The Big 4 are Deloitte & Touche (DT); Ernst & Young (EY); KPMG; 
and PricewaterhouseCoopers (PwC).

[End of table]

[End of section]

Appendix IV: Analysis of Big 4 Firms' Specialization by Industry 
Sector:

The concentration that exists across accounting firms that audit public 
companies is even more pronounced in certain industry sectors. For 
example, in certain industry sectors, two firms audit over 70 percent 
of the assets. Because public companies generally prefer auditors with 
established records of industry expertise and requisite capacity, their 
viable choices are even more limited than the Big 4. This appendix 
provides additional descriptive statistics on selected industries in 
the U.S. economy using U.S. Standard Industry Classification (SIC) 
codes--numerical codes designed by the federal government to create 
uniform descriptions of business establishments.[Footnote 58]

Limitations of SIC Analysis:

The purpose of this analysis is to illustrate that certain firms 
dominate particular industries or groups, and companies may consider 
only these firms as having the requisite expertise to provide audit and 
attest services for their operations. However, it is important to 
review this analysis in the context of its limitations. Specifically, 
defining markets by SIC codes can exaggerate the level of concentration 
because, like the audit market, a few large companies dominate many 
industry sectors (see table 2). For example, in the petroleum industry, 
we were able to identify only 25 publicly listed companies in 2002, 20 
of which were audited by the Big 4. Because PricewaterhouseCoopers and 
Ernst & Young audit the six largest companies, they audit 95 percent of 
the assets in this industry. To mitigate the potential for bias, we 
limited our analysis to the 2-digit SIC codes rather than the more 
specific 4-digit codes.

There are additional methodological issues with defining markets by SIC 
codes. First, the audited companies' lines of business, not the 
business of the accounting firms, defines the markets. Second, some 
companies that could be included in a particular industry are not 
included because no SIC code identifier was provided in the database 
that we used. Moreover, assignment of a company to a particular SIC 
code sometimes involves judgment, which may create bias. Finally, the 
methodology assumes different accounting firms are in separate markets 
and cannot easily move from auditing one type of industry to another.

The total assets data come from the 1997 and 2002 editions of Who 
Audits America, which has detailed information on public companies, 
including current and former auditor and SIC code.[Footnote 59] Because 
some companies are not classifiable establishments, others do not list 
SIC codes because they operate in many lines of business, or the 
necessary information might have been missing in some cases, the data 
only include companies that had a 4-digit, 3-digit or 2-digit SIC code 
in the 1997 and 2002 versions of the database (8,724 companies in 1997 
and 9,569 companies in 2002). All SIC codes were converted to 2-digit 
codes (major group) for analysis. Table 12 lists and defines each SIC 
major economic group analyzed here and in the body of the report. In 
computing concentration ratios for each accoounting firm in the various 
industry groups, we used total assets audited. However, the results 
generally are not sensitive to the use of a different measure (such as 
total sales).

Table 12: Description of Selected SIC Groups:

Major group (SIC code): 10; Description: Metal mining; This major group 
includes establishments primarily engaged in mining, developing mines, 
or exploring for metallic minerals (ores). This major group also 
includes all ore dressing and beneficiating operations, whether 
performed at mills operated in conjunction with the mines served or at 
mills, such as custom mills, operated separately.

Major group (SIC code): 13; Description: Oil and gas extraction; This 
major group includes establishments primarily engaged in (1) producing 
crude petroleum and natural gas, (2) extracting oil from oil sands and 
oil shale, (3) producing natural gasoline and cycle condensate, and (4) 
producing gas and hydrocarbon liquids from coal at the mine site.

Major group (SIC code): 15; Description: General building contractors; 
This major group includes general contractors and operative builders 
primarily engaged in the construction of residential, farm, industrial, 
commercial, or other buildings. General building contractors who 
combine a special trade with the contracting are included in this major 
group.

Major group (SIC code): 24; Description: Lumber and wood products; This 
major group includes establishments engaged in cutting timber and 
pulpwood; merchant sawmills, lath mills, shingle mills, cooperage stock 
mills, planting mills, and plywood mills and veneer mills engaged in 
producing lumber and wood basic materials; and establishments engaged 
in manufacturing finished articles made entirely or mainly of wood or 
related materials.

Major group (SIC code): 25; Description: Furniture and fixtures; This 
major group includes establishments engaged in manufacturing household, 
office, public building, and restaurant furniture; and office and store 
fixtures.

Major group (SIC code): 26; Description: Paper and allied products; 
This major group includes establishments primarily engaged in the 
manufacture of pulps from wood and other cellulose fibers, and from 
rags; the manufacture of paper and paperboard; and the manufacture of 
paper and paperboard into converted products, such as paper coated off 
the paper machine, paper bags, paper boxes, and envelopes.

Major group (SIC code): 27; Description: Printing and publishing; This 
major group includes establishments engaged in printing by one or more 
common processes, such as letterpress; lithography (including offset), 
gravure, or screen; and those establishments that perform services for 
the printing trade, such as bookbinding and platemaking. This major 
group also includes establishments engaged in publishing newspapers, 
books, and periodicals, regardless of whether they do their own 
printing.

Major group (SIC code): 28; Description: Chemicals and allied products; 
This major group includes establishments producing basic chemicals, and 
establishments manufacturing products by predominantly chemical 
processes. Establishments classified in this major group manufacture 
three general classes of products: (1) basic chemicals, such as acids, 
salts, and organic chemicals; (2) chemical products to be used in 
further manufacture, such as synthetic fibers, plastics materials, dry 
colors, and pigments; and (3) finished chemical products to be used for 
ultimate consumption, such as drugs, cosmetics, and soaps; or to be 
used as materials or supplies in other industries, such as paints, 
fertilizers, and explosives.

Major group (SIC code): 29; Description: Petroleum and coal products; 
This major group includes establishments primarily engaged in petroleum 
refining, manufacturing paving and roofing materials, and compounding 
lubricating oils and greases from purchased materials.

Major group (SIC code): 33; Description: Primary metal industries; This 
major group includes establishments engaged in smelting and refining 
ferrous and nonferrous metals from ore, pig, or scrap; in rolling, 
drawing, and alloying metals; in manufacturing castings and other basic 
metal products; and in manufacturing nails, spikes, and insulated wire 
and cable.

Major group (SIC code): 34; Description: Fabricated metal products; 
This major group includes establishments engaged in fabricating ferrous 
and nonferrous metal products, such as metal cans, tinware, handtools, 
cutlery, general hardware, nonelectric heating apparatus, fabricated 
structural metal products, metal forgings, metal stampings, ordnance 
(except vehicles and guided missiles), and a variety of metal and wire 
products, not elsewhere classified.

Major group (SIC code): 35; Description: Industrial and commercial 
machinery and computer equipment (Industry machinery and equipment); 
This major group includes establishments engaged in manufacturing 
industrial and commercial machinery and equipment and computers. 
Included are the manufacture of engines and turbines; farm and garden 
machinery; construction, mining, and oil field machinery; elevators and 
conveying equipment; hoists, cranes, monorails, and industrial trucks 
and tractors; metalworking machinery; special industry machinery; 
general industrial machinery; computer and peripheral equipment and 
office machinery; and refrigeration and service industry machinery. 
Machines powered by built-in or detachable motors ordinarily are 
included in this major group, with the exception of electrical 
household appliances. Power-driven handtools are included in this major 
group, whether electric or otherwise driven.

Major group (SIC code): 37; Description: Transportation equipment; This 
major group includes establishments engaged in manufacturing equipment 
for transportation of passengers and cargo by land, air, and water. 
Important products produced by establishments classified in this major 
group include motor vehicles, aircraft, guided missiles and space 
vehicles, ships, boats, railroad equipment, and miscellaneous 
transportation equipment, such as motorcycles, bicycles, and 
snowmobiles. Establishments primarily engaged in manufacturing 
equipment used for moving materials on farms; in mines and on 
construction sites; in individual plants; in airports; or on other 
locations off the highway are classified in Major Group 35.

Major group (SIC code): 42; Description: Trucking and warehouse; This 
major group includes establishments furnishing local or long-distance 
trucking or transfer services, or those engaged in the storage of farm 
products, furniture and other household goods, or commercial goods of 
any nature.

Major group (SIC code): 44; Description: Water transportation; This 
major group includes establishments engaged in freight and passenger 
transportation on the open seas or inland waters, and establishments 
furnishing such incidental services as towing, and canal operation. 
This major group also includes excursion boats, sight-seeing boats, and 
water taxis.

Major group (SIC code): 45; Description: Transportation by air; This 
major group includes establishments engaged in furnishing domestic and 
foreign transportation by air and also those operating airports and 
flying fields and furnishing terminal services including air courier 
services and air passenger carriers.

Major group (SIC code): 48; Description: Communications; This major 
group includes establishments furnishing point-to-point communications 
services, whether intended to be received aurally or visually; and 
radio and television broadcasting. This major group also includes 
establishments primarily engaged in providing paging and beeper 
services and those engaged in leasing telephone lines or other methods 
of telephone transmission, such as optical fiber lines and microwave or 
satellite facilities, and reselling the use of such methods to others.

Major group (SIC code): 49; Description: Electric, gas, and sanitary 
services This major group includes establishments engaged in the 
generation, transmission, and/or distribution of electricity or gas or 
steam. Such establishments may be combinations of any of the above 
three services and also include other types of services, such as 
transportation, communications, and refrigeration. Water and 
irrigation systems, and sanitary systems engaged in the collection and 
disposal of garbage, sewage, and other wastes by means of destroying or 
processing materials, are also included.

Major group (SIC code): 60; Description: Depository institutions; This 
major group includes institutions that are engaged in deposit banking 
or closely related functions, including fiduciary activities.

Major group (SIC code): 61; Description: Nondepository institutions; 
This major group includes establishments engaged in extending credit in 
the form of loans, but not engaged in deposit banking.

Major group (SIC code): 62; Description: Security and commodity 
brokers; This major group includes establishments engaged in the 
underwriting, purchase, sale, or brokerage of securities and other 
financial contracts on their own account or for the account of others; 
and exchanges, exchange clearinghouses, and other services allied with 
the exchange of securities and commodities.

Major group (SIC code): 67; Description: Holding and other investment 
offices (holding and other investment companies); This major group 
includes investment trusts, investment companies, holding companies, 
and miscellaneous investment offices.

Major group (SIC code): 70; Description: Hotels and other lodging 
places; This major group includes commercial and noncommercial 
establishments engaged in furnishing lodging, or lodging and meals, and 
camping space and camping facilities.

Major group (SIC code): 73; Description: Business services; This major 
group includes establishments primarily engaged in rendering services, 
not elsewhere classified, to business establishments on a contract or 
fee basis, such as advertising, credit reporting, collection of claims, 
mailing, reproduction, stenographic, news syndicates, computer 
programming, photocopying, duplicating, data processing, services to 
buildings, and help supply services.

Major group (SIC code): 80; Description: Health services; This major 
group includes establishments primarily engaged in furnishing medical, 
surgical, and other health services to persons. Establishments of 
associations or groups, such as Health Maintenance Organizations, 
primarily engaged in providing medical or other health services to 
members are included; but those, which limit their services to the 
provision of insurance against hospitalization or medical costs, are 
classified in Insurance, Major Group 63.

Source: U.S. Bureau of Census, http://www.census.gov/epcd/www/
naicstab.htm (7/20/2003) and U.S. Department of Labor, http://
www.osha.gov/oshstants/oshstats.(7/20/2003):

[End of table]

Industry Specialization Can Limit Public Company Choice:

As figure 13 shows, in selected industries specialization can often 
limit the number of auditor choices to two--in each case, two auditors 
account for over 70 percent of the total assets audited in 2002.As a 
result, it might be difficult for a large company to find an auditor 
with the requisite industry expertise and staff capacity.[Footnote 60] 
Figure 13 also shows that while a few firms dominated certain 
industries in 1997 before the merger of Price Waterhouse and Coopers & 
Lybrand and dissolution of Arthur Andersen, there were fewer industries 
where two firms accounted for more than 70 percent of the total sales 
audited; and in most cases, at least one of the remaining Big 6 firms 
audited a significant share (greater than 10 percent) of the industry.

Figure 13: Percentages of Assets Audited by the Big 4 in Selected 
Industries, 1997 and 2002:

[See PDF for image]

[End of figure]

The dissolution of Andersen in 2002 and the merger of Price Waterhouse 
and Coopers & Lybrand in 1998 appear to have impacted many industries, 
including those in the primary metals, general building contractors, 
furniture and fixtures, petroleum and coal products, transportation by 
air, and electric, gas, and sanitary services groups included in figure 
13. Moreover, figure 14 shows the remaining major economic groups with 
20 or more companies for which Andersen audited roughly 25 percent or 
more of the total assets in the industry or Price Waterhouse and 
Coopers & Lybrand both had significant presence in 1997. As the figure 
indicates, in many of these sectors Ernst & Young and Deloitte & Touche 
acquired significant market share by 2002. Because the Big 4 firms have 
increased their presence in these industries formerly dominated by 
Andersen or Price Waterhouse and Coopers & Lybrand, the number of firms 
with industry expertise appears to have remained unchanged in most 
cases. The mergers between Price Waterhouse and Coopers & Lybrand did 
not impact choice in most industries because the firms generally 
dominated different industries as figure 13 and figure 14 show. This 
highlights that one of the factors contributing to the mergers was the 
desire to increase industry expertise. However, there are some 
industries (petroleum and coal products, communications, primary 
metals, and fabricated metals among others) that may have experienced a 
reduction in the number of viable alternatives for companies that 
consider industry expertise important when choosing an auditor.

Figure 14: Percentages of Assets Audited in Industries Potentially 
Impacted by the PriceWaterhouseCoopers Merger and Dissolution of 
Andersen, 1997 and 2002:

[See PDF for image]

[End of figure]

Table 13 provides a list of industries defined by 2-digit SIC codes 
with 25 or more companies and also indicates where each of the Big 4 
firms audit at least 10 percent of the total industry assets. As the 
table illustrates, there are very few industries where all four of the 
top-tier firms have a major presence. In many industries, only two or 
three of the Big 4 firms audit 10 percent or more of the total assets 
in an industry. Of the 49 industries represented, less than one-third 
(16) have a significant presence (10 percent or more) of all four 
firms. Moreover, as table 14 illustrates, if the threshold is increased 
to 25 percent or more of total assets audited, then almost all (48 of 
49) of the industries have a significant presence of only one or two 
firms.

Table 13: Industries in Which the Big 4 Have a Significant Presence (10 
percent or More):

[See PDF for image]

Source: Who Audits America, 2002.

Note: We have arbitrarily defined significant presence as auditing 10 
percent or more of the total assets within an industry.

[End of table]

Table 14: Industries in Which the Big 4 Have a Significant Presence (25 
percent or more):

SIC code: 10; Economic group: Primary metals; Firms with 25 percent of 
more of the industry: DT: No; Firms with 25 percent of more of the 
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG: 
No; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 13; Economic group: Oil and gas extraction; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 15; Economic group: General building contractors; Firms with 
25 percent of more of the industry: DT: No; Firms with 25 percent 
of more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: No.

SIC code: 17; Economic group: Special trade contractors; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: Yes; Firms with 25 percent of more of the industry: 
KPMG: No; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 20; Economic group: Food and kindred products; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 22; Economic group: Textile mill products; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 23; Economic group: Apparel and other textile products; Firms 
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent 
of more of the industry: EY: No; Firms with 25 percent of more of 
the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 24; Economic group: Lumber and wood products; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: 4; Firms with 25 percent of more of the 
industry: KPMG: 4; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 25; Economic group: Furniture and fixtures; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: 4.

SIC code: 26; Economic group: Paper and allied products; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: No.

SIC code: 27; Economic group: Printing and publishing; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 28; Economic group: Chemicals and allied products; Firms with 
25 percent of more of the industry: DT: Yes; Firms with 25 percent of 
more of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 29; Economic group: Petroleum and coal products; Firms with 
25 percent of more of the industry: DT: No; Firms with 25 percent 
of more of the industry: EY: No; Firms with 25 percent of more of 
the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 30; Economic group: Rubber and miscellaneous plastics; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: Yes; Firms with 25 percent of more 
of the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 31; Economic group: Leather and leather products; Firms with 
25 percent of more of the industry: DT: No; Firms with 25 percent 
of more of the industry: EY: No; Firms with 25 percent of more of 
the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 32; Economic group: Stone, clay, and glass products; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: Yes; Firms with 25 percent of more 
of the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: No.

SIC code: 33; Economic group: Primary metal industries; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 34; Economic group: Fabricated metal products; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 35; Economic group: Industrial machinery and equipment; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: No; Firms with 25 percent of 
more of the industry: KPMG: Yes; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 36; Economic group: Electronic and other electric equipment; 
Firms with 25 percent of more of the industry: DT: No; Firms with 
25 percent of more of the industry: EY: Yes; Firms with 25 percent of 
more of the industry: KPMG: No; Firms with 25 percent of more of 
the industry: PwC: Yes.

SIC code: 37; Economic group: Transportation equipment; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 38; Economic group: Instruments and related products; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: No; Firms with 25 percent of 
more of the industry: KPMG: No; Firms with 25 percent of more of 
the industry: PwC: Yes.

SIC code: 39; Economic group: Miscellaneous manufacturing industries; 
Firms with 25 percent of more of the industry: DT: No; Firms with 
25 percent of more of the industry: EY: Yes; Firms with 25 percent of 
more of the industry: KPMG: No; Firms with 25 percent of more of 
the industry: PwC: No.

SIC code: 42; Economic group: Trucking and warehousing; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 45; Economic group: Transportation by air; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: Yes; Firms with 25 percent of more of the industry: 
KPMG: Yes; Firms with 25 percent of more of the industry: PwC: No.

SIC code: 48; Economic group: Communications; Firms with 25 percent of 
more of the industry: DT: No; Firms with 25 percent of more of the 
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG: 
[Empty]; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 49; Economic group: Electric, gas, and sanitary services; 
Firms with 25 percent of more of the industry: DT: Yes; Firms with 25 
percent of more of the industry: EY: No; Firms with 25 percent of 
more of the industry: KPMG: No; Firms with 25 percent of more of 
the industry: PwC: No.

SIC code: 50; Economic group: Wholesale trade - durable goods; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: Yes; Firms with 25 percent of more 
of the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: Yes.

SIC code: 51; Economic group: Wholesale trade - nondurable goods; Firms 
with 25 percent of more of the industry: DT: No; Firms with 25 
percent of more of the industry: EY: Yes; Firms with 25 percent of more 
of the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: No.

SIC code: 53; Economic group: General merchandise stores; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: Yes; Firms with 25 percent of more of the industry: 
KPMG: No; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 54; Economic group: Food stores; Firms with 25 percent of 
more of the industry: DT: Yes; Firms with 25 percent of more of the 
industry: EY: No; Firms with 25 percent of more of the industry: 
KPMG: No; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 56; Economic group: Apparel and accessory stores; Firms with 
25 percent of more of the industry: DT: Yes; Firms with 25 percent of 
more of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: No.

SIC code: 57; Economic group: Furniture and homefurnishing stores; 
Firms with 25 percent of more of the industry: DT: No; Firms with 
25 percent of more of the industry: EY: Yes; Firms with 25 percent of 
more of the industry: KPMG: Yes; Firms with 25 percent of more of the 
industry: PwC: No.

SIC code: 58; Economic group: Eating and drinking places; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 59; Economic group: Miscellaneous retail; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: Yes; Firms with 25 percent of more of the industry: 
KPMG: No; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 60; Economic group: Depository institutions; Firms with 25 
percent of more of the industry: DT: No; Firms with 25 percent of 
more of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC: 
4.

SIC code: 61; Economic group: Nondepository institutions; Firms with 25 
percent of more of the industry: DT: Yes; Firms with 25 percent of more 
of the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: Yes; Firms with 25 percent of more of the industry: PwC: 
No.

SIC code: 62; Economic group: Security and commodity brokers; Firms 
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent 
of more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: No.

SIC code: 63; Economic group: Insurance carriers; Firms with 25 percent 
of more of the industry: DT: Yes; Firms with 25 percent of more of the 
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG: 
[Empty]; Firms with 25 percent of more of the industry: PwC: No.

SIC code: 64; Economic group: Insurance agents, brokers, and service; 
Firms with 25 percent of more of the industry: DT: No; Firms with 
25 percent of more of the industry: EY: No; Firms with 25 percent 
of more of the industry: KPMG: No; Firms with 25 percent of more 
of the industry: PwC: Yes.

SIC code: 65; Economic group: Real estate; Firms with 25 percent of 
more of the industry: DT: Yes; Firms with 25 percent of more of the 
industry: EY: No; Firms with 25 percent of more of the industry: 
KPMG: Yes; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 67; Economic group: Holding and other investment offices; 
Firms with 25 percent of more of the industry: DT: Yes; Firms with 25 
percent of more of the industry: EY: Yes; Firms with 25 percent of more 
of the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: No.

SIC code: 70; Economic group: Hotels and other lodging places; Firms 
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent 
of more of the industry: EY: Yes; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: No.

SIC code: 72; Economic group: Personal services; Firms with 25 percent 
of more of the industry: DT: Yes; Firms with 25 percent of more of the 
industry: EY: No; Firms with 25 percent of more of the industry: 
KPMG: No; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 73; Economic group: Business services; Firms with 25 percent 
of more of the industry: DT: No; Firms with 25 percent of more of 
the industry: EY: No; Firms with 25 percent of more of the 
industry: KPMG: No; Firms with 25 percent of more of the industry: 
PwC: Yes.

SIC code: 78; Economic group: Motion pictures; Firms with 25 percent of 
more of the industry: DT: No; Firms with 25 percent of more of the 
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG: 
[Empty]; Firms with 25 percent of more of the industry: PwC: Yes.

SIC code: 79; Economic group: Amusement and recreation services; Firms 
with 25 percent of more of the industry: DT: Yes; Firms with 25 percent 
of more of the industry: EY: No; Firms with 25 percent of more of 
the industry: KPMG: No; Firms with 25 percent of more of the 
industry: PwC: No.

SIC code: 80; Economic group: Health services; Firms with 25 percent of 
more of the industry: DT: No; Firms with 25 percent of more of the 
industry: EY: Yes; Firms with 25 percent of more of the industry: KPMG: 
4; Firms with 25 percent of more of the industry: PwC: No.

SIC code: 87; Economic group: Engineering and management services; 
Firms with 25 percent of more of the industry: DT: No; Firms with 
25 percent of more of the industry: EY: Yes; Firms with 25 percent of 
more of the industry: KPMG: No; Firms with 25 percent of more of 
the industry: PwC: No.

Source: Who Audits America.

Note: We have arbitrarily defined significant presence as auditing 25 
percent or more of the total assets within an industry.

[End of table]

[End of section]

Appendix V: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Davi M. D'Agostino, (202) 512-8678     
Orice M. Williams, (202) 512-8678:

Acknowledgments:

In addition to those individuals named above, Martha Chow, Edda 
Emmanuelli-Perez, Lawrance Evans, Jr., Marc Molino, Michelle Pannor, 
Carl Ramirez, Barbara Roesmann, Derald Seid, Jared Stankosky, Paul 
Thompson, Richard Vagnoni, and Walter Vance made key contributions to 
this report.

[End of section]

Glossary:

Antitrust:

The general process of preventing monopoly practices or breaking up 
monopolies that restrict competition. The term antitrust derives from 
the common use of the trust organizational structure in the late 1800s 
and early 1900s to monopolize markets.

Federal antitrust laws:

A series of federal laws intended to maintain competition and prevent 
businesses from getting a monopoly or unfairly obtaining or exerting 
market power. The first of these, the Sherman Antitrust Act, was passed 
in 1890. Two others, the Clayton Act and the Federal Trade Commission 
Act, were enacted in 1914. These laws impose restrictions on business 
ownership, control, mergers, pricing, and how businesses go about 
competing (or cooperating) with each other.

Audit and attest services:

Services provided for professional examination and verification of a 
company's accounting documents and supporting data for the purpose of 
rendering an opinion on the fairness with which they present, in all 
material respects, the financial position, results of operations, and 
its cash flows, and conformity with generally accepted accounting 
principles.

Audit fee:

Fee paid by a company to an audit accounting firm for the professional 
examination and verification of its accounting documents and supporting 
data.

Auditor, auditor of record, and public accounting firm:

Generally refers to an independent public accounting firm registered 
with SEC that performs audits and reviews of public company financial 
statements and prepares attestation reports filed with SEC. In the 
future, these public accounting firms must be registered with Public 
Company Accounting Oversight Board (PCAOB) as required by the Sarbanes-
Oxley Act of 2002.

Auditor independence:

The idea that the auditor of record is exclusively concerned with 
examination and verification of a company's accounting documents and 
supporting data without bias or conflicts of interest. Professional 
auditing standards require an auditor to be independent and avoid 
situations that may lead others to doubt its independence, referred to 
as being independent in fact as well as in appearance. Auditor 
independence is an important factor in establishing the credibility of 
the audit opinion.

Audit market:

The organized exchange of audit and attest services between buyers and 
sellers within a specific geographic area and during a given period of 
time.

Barriers to entry:

Institutional, governmental, technological, or economic factors that 
limit the flow of new entrants into profitable markets. Possible 
barriers to entry may include resources, patents and copyrights or 
technical expertise, reputation, litigation and insurance risks, and 
start-up costs. Barriers to entry are a key reason for market power. In 
particular, monopoly and oligopoly often owe their market power to 
assorted barriers to entry.

Bottom line loss:

Occurs when gross sales minus taxes, interest, depreciation, and other 
expenses are negative. Also called negative net earnings, income, or 
profit.

Capital formation:

The transfer of savings from households and governments to the business 
sector, resulting in increased output and economic expansion. The 
transfer of funds to businesses for investment can occur through 
financial intermediaries such as banks or through financial markets 
such as the stock market. (For the purpose of this report, we focus on 
public capital markets.):

Competition:

In general, the actions of two or more rivals in pursuit of the same 
objective. In the context of markets, the specific objective is selling 
or buying goods. Competition tends to come in two varieties --
competition among the few, which is a market with a small number of 
sellers (or buyers), such that each seller (or buyer) has some degree 
of market control, and competition among the many, which is a market 
with so many buyers and sellers that none is able to influence the 
market price or quantity exchanged.

Concentration ratio:

The proportion of total output in an industry that is produced by a 
given number of the largest firms in the industry. The two most common 
concentration ratios are for the four largest firms and the eight 
largest firms. The four-firm concentration ratio is the proportion of 
total output produced by the four largest firms in the industry and the 
eight-firm concentration ratio is the proportion of total output 
produced by the eight largest firms in the industry:

Due diligence:

The process of investigation performed by investors, accountants and 
other market participants into the details of a potential investment, 
such as an examination of operations and management and the 
verification of material facts. Obtaining a comment letter written by 
independent accountants to an underwriter is part of that underwriter's 
due diligence.

Economies of scale:

Declining long-run average costs that occur as a firm increases all 
inputs and expands its scale of production, realized through 
operational efficiencies. Economies of scale can be accomplished 
because as production increases, the cost of producing each additional 
unit falls.

Economies of scope:

Declining long-run average costs that occur due to changes in the mix 
of output between two or more products. This refers to the potential 
cost savings from joint production - even if the products are not 
directly related to each other. Economies of scope are also said to 
exist if it is less costly for one firm to produce two separate 
products than for two specialized firms to produce them separately.

Hirschman-Herfindahl Index (HHI):

A measure of concentration of the production in an industry that is 
calculated as the sum of the squares of market shares for each firm. 
This is an alternative method of summarizing the degree to which an 
industry is oligopolistic and the relative concentration of market 
power held by the largest firms in the industry. The HHI gives a better 
indication of the relative market power of the largest firms than can 
be found with the four-firm and eight-firm concentration ratios.

Going-concern opinion:

Opinion that expresses substantial doubt about whether or not a company 
will continue to operate for 1 year beyond the financial statement date 
or go out of business and liquidate its assets. Indicated when there 
are substantial doubts about whether the company will be able to 
generate and/or raise enough resources to stay operational.

Industry:

A collection of firms that produce similar products sold in the same 
market. The concept of industry is most often used synonymously with 
market in most microeconomic analysis.

Loss Leader:

The term loss leader implies that the firms bid unrealistically low 
fees ("low-balling") to obtain a new client. Once the new client is 
secured, the low audit fee, which alone may not be adequate to cover 
the cost of an audit and provide the firm with a reasonable margin, is 
offset by additional fees generated from other services, such as 
management consulting and tax.

Market:

The organized exchange of commodities (goods, services, or resources) 
between buyers and sellers within a specific geographic area and during 
a given period of time.

Market power:

The power to profitably maintain prices above competitive levels for a 
significant amount of time. More generally, if it is the ability of 
sellers to exert influence over the price or quantity of a good, 
service, or commodity exchanged in a market. Market power depends on 
the number of competitors.

Market structure:

The manner in which a market is organized, based largely on the number 
of firms in the industry. The four basic market structure models are 
perfect competition, monopoly, monopolistic competition, and 
oligopoly. The primary difference between each is the number of firms 
on the supply side of a market. Both perfect competition and 
monopolistic competition have a large number of relatively small firms 
selling output. Oligopoly has a small number of relatively large firms. 
Monopoly has a single firm.

Peer review:

A part of the accounting profession's former self-regulatory system 
whereby accounting firms reviewed other firm's quality control systems 
for
compliance with standards and membership requirements. The Sarbanes-
Oxley Act of 2002 significantly overhauled the oversight and regulation 
of the accounting profession. Among other things, it established the 
Public Company Accounting Oversight Board to oversee the audit of 
public companies, including registering public accounting firms, 
establishing standards, and conducting compliance inspections, 
investigations, and disciplinary proceedings.

Predatory pricing:

The process in which a firm with market power reduces prices below 
average total cost with the goal of forcing competitors into 
bankruptcy. This practice is most commonly undertaken by oligopolistic 
firms seeking to expand their market shares and gain greater market 
control. Antitrust laws have outlawed predatory pricing, but this 
practice can be difficult to prove.

Publicly listed companies (public companies):

A company which has issued securities (through an offering) that are 
traded on the open market. Used synonymously with public company. For 
the purposes of this report public companies include companies listed 
on the New York Stock Exchange, American Stock Exchange, NASDAQ or 
traded on other over-the-counter markets such as Pink Sheets.

Retained earnings:

Earnings not paid out as dividends but instead reinvested in the core 
business or used to pay off debt. Also called earned surplus, 
accumulated earnings, or unappropriated profit.

Tight oligopoly:

An oligopolistic market structure where the four firms hold over 60 
percent of the market. A loose oligopoly is a market structure with 8-
15 firms and a four-firm concentration ratio below 40 percent.

Working capital:

Current assets minus current liabilities. Working capital measures how 
much in liquid assets a company has available to build its business. 
The number can be positive or negative, depending on how much debt the 
company is carrying. In general, companies that have a lot of working 
capital will be more successful since they can expand and improve their 
operations.

(250104):

FOOTNOTES

[1] For the purpose of this report, public companies are defined as 
those that are listed on the American Stock Exchange (Amex), NASDAQ, or 
the New York Stock Exchange (NYSE), or with stock traded on other over-
the-counter markets such as Pink Sheets. Large public companies 
generally include those with over $1 billion in annual revenue unless 
otherwise noted.

[2] For the purpose of this report, we refer to the Big 8 and Big 4 
firms as the "top tier," based on total revenue and staff size. The Big 
8 were Arthur Andersen LLP, Arthur Young LLP, Coopers & Lybrand LLP, 
Deloitte Haskins & Sells LLP, Ernst & Whinney LLP, Peat Marwick 
Mitchell LLP, Price Waterhouse LLP, and Touche Ross LLP. The Big 4 are 
Deloitte & Touche LLP, Ernst & Young LLP, KPMG LLP, and 
PricewaterhouseCoopers LLP. Any reference to "smaller firms" includes 
any of the other more than 700 firms that audit public companies. When 
we present firm rankings, we do so based on annual total revenues in 
the United States unless otherwise noted.

[3] Pub. L. No. 107-204  701 (2002), the Sarbanes-Oxley Act 
significantly overhauled the oversight and regulation of the accounting 
profession. Its purpose was to strengthen corporate governance 
requirements and improve transparency and accountability, among other 
things. 

[4] Historically, the accounting profession maintained a voluntary, 
self-regulatory system through AICPA that included setting professional 
standards, monitoring compliance with professional standards, 
disciplining members for improper acts and substandard performance, and 
conducting oversight of the industry. The Sarbanes-Oxley Act 
established the Public Company Accounting Oversight Board to oversee 
the audit of public companies, including registering public accounting 
firms; establishing audit standards; and conducting compliance 
inspections, investigations, and disciplinary proceedings.

[5] R. Doogar and R. Easley, "Concentration without Differentiation: A 
New Look at the Determinants of Audit Market Concentration," Journal of 
Accounting and Economics, vol. 25 (1998): 235-253. The Doogar and 
Easley model is premised on the assumption of pure price competition, 
in which clients choose auditors solely based on price, ignoring 
factors such as quality or reputation. In this framework, audit clients 
will gravitate to larger and more efficient audit firms, where 
efficiency is defined by the partner-to-staff, or leverage, ratio. 
Companies with lower leverage ratios are more efficient and can 
therefore bid lower prices for audit engagements.

[6] Sarbanes-Oxley requires that SEC enact independence rules, which 
address areas such as prohibited nonaudit services, audit partner 
rotation, and conflicts of interest. 

[7] State boards of accountancy, operating under the authority of 
individual state laws, adopt rules that govern licensing for practice 
in their jurisdiction, including educational and experience 
qualifications, continuing professional education requirements, and 
the manner and use of the title "certified public accountant."

[8] The Big 5 were Andersen, Deloitte & Touche, Ernst & Young, KPMG, 
and PricewaterhouseCoopers.

[9] Senate Subcommittee on Reports, Accounting and Management, 
Committee on Government Operations, The Accounting Establishment, 95TH 
Congr.,1ST Sess., March 31, 1977. This study is commonly known as the 
Metcalf Report.

[10] Pub. L. 107-204, Title II  201-206 and 17 CFR Parts 210 and 240, 
Final Rule: Revision of the Commission's Auditor Independence 
Requirements.

[11] KPMG Peat Marwick is now known as KPMG.

[12] The term, "economies of scope," refers to the notion that a 
producer's average total cost of production decreases as a result of 
increasing the number of different goods it produces.

[13] The HHI is calculated by summing the squared individual market 
shares of all accounting firms (public company clients). For example, a 
market consisting of four firms with market shares of 35 percent, 30 
percent, 20 percent, and 10 percent has an HHI of 2,625 (352+ 3022 
2020+ 102). The HHI reflects both the distribution of the market shares 
among top firms and the composition of the market outside of the top 
firms. We have computed concentration ratios and the HHI based on 
summary tables included in Who Audits America for the relevant years. 

[14] For this measure, the top four firms are determined by the 
percentage of total sales audited. The four-firm concentration ratio is 
the aggregate sales audited by the top four firms as a percentage of 
total sales audited. We have computed concentration ratios based on 
summary tables included in Who Audits America for the relevant years. 
These summary tables omit certain small auditors that audit small 
public companies not listed on Amex, NASDAQ, or NYSE.

[15] Market shares are generally calculated using the dollar value of 
sales as we have done in the text above and as shown in figure 5. FTC 
and DOJ note that measures such as sales, shipments, or production are 
the best indicators of future competitive significance. Nevertheless, 
we have also computed concentration ratios based on the number of 
clients for descriptive purposes. 

[16] Collusion refers to a usually secret agreement among competing 
firms (mostly oligopolistic firms) in an industry to control the 
market, raise the market price, and otherwise act like a monopoly. 
While overt collusion involves an explicit formal agreement among the 
firms, under tacit collusion each firm seems to be acting independently 
with no explicit agreement, perhaps each responding to the same market 
conditions, but ultimately the result is the same as it is under an 
explicit agreement.

[17] The simulation is based on 5,448 industrial companies and their 
auditors. According to data obtained from Who Audits America, the Big 4 
audited 62.2 percent of these companies. In this simulation, we 
assigned clients to their current auditor and simulated the market to 
see if the accounting firms could defend their market share in a purely 
competitive market. In an alternative simulation, we initiated the 
process without assigning clients to a particular firm and allowed 
accounting firms to compete for each client. The results were 
consistent with the above analysis; in fact, the Big 4 were predicted 
to audit 1-2 percent more of the 5,448 industrial clients than the 
actual percentage audited, depending on the cost of switching auditors 
(see app. I for complete results).

[18] Historically, firm consolidation in particular industries was 
often driven by the fact that a few largre companies dominated certain 
industries. Accounting firm "industry specialization" can be captured 
by a firm's relatively high market share, in terms of client assets or 
cllient sales, in a given industry. The observation that a few 
accounting firms audit the vast majority of company assets in a given 
industry does not necessarily indicate that they audit many companies 
in that industry--in fact, these few "specialists" may audit only a few 
very large companies. While firms that are not considered to be 
specialists in a given indusry may audit a large number of smaller 
companies, they may not have the requisite excess staff capacity or 
technical expertise necessary to handle the larger clients in that 
industry, which is implied by the term specialization. Industries 
conducive to specialization would tend to preclude other firms from 
easily entering the market and challenging specialist firms' market 
share.

[19] Industry specialization or expertise ranked third in importance 
behind quality of services offered (99 percent) and reputation or name 
recognition (82 percent).

[20] S. Invancevich and A. Zardkoohi, "An Exploratory Analysis of the 
1989 Accounting Firm Megamergers," Accounting Horizons, vol. 14, no. 4 
(2000): 155-136. K. Menon and D. Williams, "Long-Term Trends in Audit 
Fes," Auditing: A Journal of Practice and Theory, vol. 20, no. 1 
(2001): 115-136. The samples included cllients of Big 6 audit firms 
that voluntarily disclosed audit fee data in SEC filings (between 68 
and 90 companies for each year). The fee data have been adjusted for 
inflation.

[21] In 1997, the Big 6 were Arthur Andersen, Coopers & Lybrand, 
Deloitte & Touche, Ernst & Young, KPMG, and Price Waterhouse. For Ernst 
& Young and Deloitte & Touche, the researchers found the average audit 
price fell from $503.6 to $441.84 per million dollars of assets 
audited. The "fees" for the remaining Big 6 fell from $441.28 to $378.4 
per million dollars of assets audited in 1989-1996.

[22] Manufacturers Alliance/MAPI, Survey on Outside Audit Fees, 2000. 
Manufacturers Alliance provides executive education and business 
research services.

[23] According to an SEC report, in 2000 audit fees for the Fortune 
1000 public companies were.03 percent of company revenue on average. 
Securities and Exchange Commission, Office of the Chief Accountant, 
"Independence Rule Proxy Disclosures: Independent Accountants Fees," 
(2001).

[24] The term loss leader implies that the firms bid unrealistically 
low fees ("low-balling") to obtain a new client. Once the new client is 
secured, the low audit fee, which alone may not be adequate to cover 
the cost of an audit and provide the firm with a reasonable margin, is 
offset by additional fees generated from other services, such as 
management consulting and tax.

[25] L. Kimmel and S. Vazquez, "The Increased Financial and Non-
Financial Cost of Staying Public," Foley & Lardner, Attorneys at Law 
(2003).

[26] These definitions are commonly used in the academic literature, 
reflecting the assessment of capital market participants, and are 
consistent with those used in the professional literature that describe 
audit quality in terms of audit risk. This definition of auditor 
independence is provided in L. DeAngelo, "Auditor Independence, 'Low 
Balling,' and Disclosure Regulation," Journal of Accounting and 
Economics, vol. 3 (1981): 113-127. This definition of audit quality is 
provided in L. DeAngelo, "Auditor Size and Audit Quality," Journal of 
Accounting and Economics, vol. 3 (1981): 183-199.

[27] Concern over auditor independence has typically centered on the 
provision of nonaudit services to a company by its incumbent auditor, a 
concern based on the assumption that an auditor is willing to sacrifice 
its independence in exchange for retaining a client that may pay large 
fees for nonaudit services. Historically, some have argued that the 
provision of nonaudit services to an audit client can impair auditor 
independence by creating an economic bond between an auditor and its 
client. Other researchers note that an economic bond could result from 
large audit fees, too, and, especially, that auditors also have market-
based institutional incentives to act independently and remain 
independent of their public company clients. Numerous academic studies 
suggest that auditors face an expected cost for compromising their 
independence, namely loss of reputation and litigation costs, which is 
corroborated by historical evidence.

[28] For example, the notion of differential audit quality is dismissed 
in American Institute of Certified Public Accountants, The Commission 
on Auditors' Responsibilities: Report, Conclusions, and 
Recommendations, New York: AICPA (1978): 111. However, Weiss Ratings 
Inc., "The Worsening Crisis of Confidence on Wall Street: The Role of 
Auditing Firms," 2002, reported that smaller accounting firms issued a 
higher percentage of going-concern warnings on their clients that 
subsequently went bankrupt than did four of the five largest firms, 
from January 2001 through June 2002.

[29] In such a framework, capturing differential audit quality is 
particularly elusive: If no problem were found in a given company's 
financial reports, it is not necessarily the case that the 
corresponding audit was of high quality.

[30] These studies generally approached the issues from the perspective 
of capital market participants. Another avenue through which 
researchers have attempted to assess audit quality was the analysis of 
data on litigation involving auditors. However, auditor litigation data 
suffer from more serious measurement issues. For example, see Z. 
Palmrose, "An Analysis of Auditor Litigation and Audit Service 
Quality," The Accounting Review, vol. 63, no. 1 (1988): 55-73.

[31] Financial statement restatements can be triggered for a variety of 
reasons, including evolving interpretations of existing accounting 
standards, and are not necessarily the result of audit failures.

[32] For example, see Huron Consulting Group, "An Analysis of 
Restatement Matters: Rules, Errors, Ethics," Internet-Based Report, 
2003; U.S. General Accounting Office, Financial Statement Restatements: 
Trends, Market Impacts, Regulatory Responses, and Remaining Challenges, 
GAO-03-138 (Washington, D.C.: October 2002); and M. Wu, "Earnings 
Restatements: A Capital Market Perspective," Working Paper, New York 
University, 2002. These studies reported restatements based on when 
they were announced or reported rather than the periods affected by the 
restatements. Some restatements announced in the late 1990s could be 
the result of heightened SEC activity designed to curb earnings 
manipulation, and the marked decline in the stock market beginning in 
2000 may have also contributed to the discovery of many reporting 
improprieties that had previously gone undiscovered during the stock 
market expansion.

[33] A going-concern opinion indicates substantial doubt in the audited 
report regarding the ability of a company to continue as a "going 
concern." Academic research has noted that there are two types of 
misclassification in the context of going-concern opinions: (1) a 
company receives a going-concern opinion but subsequently remains 
viable or (2) a company enters bankruptcy but did not receive a prior 
going-concern opinion. The latter is the focus of the studies to which 
we refer. It is important to note that, technically, neither type of 
misclassification is a reporting error from the perspective of 
professional auditing standards, but capital market participants do not 
necessarily share this view, as they can be impacted by both.

[34] M. Geiger and K. Raghunandan, "Going-Concern Opinions in the 'New' 
Legal Environment," Accounting Horizons, vol. 16, no. 1 (2002): 17-26. 
The authors define a company as "financially stressed" if it exhibits 
at least one of the following features: (1) negative working capital, 
(2) negative retained earnings, or (3) a bottom-line loss. (See 
Glossary for definitions.)

[35] Weiss Ratings (2002) also found that accounting firms almost 
universally failed to warn the public of accounting irregularities over 
this period. Of the 33 instances of accounting irregularities 
investigated, in only two cases did an accounting firm issue warnings 
about the companies involved. Because it examined a relatively brief 
period, this study does not weigh in on whether the propensity to warn 
investors has increased or decreased over time, however.

[36] Additional references are provided in K. Raghunandan and K. Rama, 
"Audit Reports for Companies in Financial Distress: Before and After 
SAS No. 59," Auditing: A Journal of Practice and Theory, vol. 14, no. 1 
(1995): 50-63.

[37] M. DeFond, K. Raghunandan, and R. Subramanyam, "Do Non-Audit 
Service Fees Impair Auditor Independence? Evidence from Going Concern 
Audit Opinions," Journal of Accounting Research, vol. 40, no. 4 (2002): 
1247-1274.

[38] It is also possible that auditors providing nonaudit services to 
their audit clients are more tolerant of earnings management but draw 
the line at compromising the integrity of the audit opinion.

[39] R. Frankel, M. Johnson, and K. Nelson, "The Relation between 
Auditors' Fees for Nonaudit Services and Earnings Management," The 
Accounting Review, vol. 77 (2002): 71-105; W. Kinney, Jr., and R. 
Libby, "Discussion of 'The Relation between Auditors' Fees for Nonaudit 
Services and Earnings Management,'" The Accounting Review, vol. 77 
(2002): 107-114; and J. Reynolds and J. Francis, "'Does Size Matter? 
The Influence of Large Clients on Office-Level Auditor Reporting 
Decisions," Journal of Accounting and Economics, vol. 30 (2001): 375-
400.

[40] For example, in 1994 the U.S. Supreme Court held that the federal 
securities laws do not provide a private cause of action for aiding and 
abetting securities fraud. Central Bank of Denver v. First Interstate 
Bank of Denver, 511 U.S. 164 (1994). The Private Securities Litigation 
Reform Act made it more difficult for a plaintiff suing a company and 
its auditor to collect damages from the accounting firm. In 1998 
Congress passed the Securities Litigation Uniform Standards Act of 
1998, Pub. L. No. 105-353, which restricted class actions and certain 
consolidated actions that make specific allegations involving the 
purchase or sale of a security.

[41] Geiger and Raghunandan (2002).

[42] A recent study of some of Andersen's public company clients 
reported that their stock prices were adversely impacted by Andersen's 
admission to shredding documents, providing some empirical evidence of 
the capital market impact resulting from an auditor's loss of 
reputation and the subsequent concerns about the quality of its audits 
in general. See P. Chaney and K. Philipich, "Shredded Reputation: The 
Cost of Audit Failure," Journal of Accounting Research, vol. 40, no. 4 
(2002): 1221-1245.

[43] For example, see R. Dye, "Auditing Standards, Legal Liability, and 
Auditor Wealth," Journal of Political Economy, vol. 101, no. 5 (1993): 
887-914.

[44] Some capital market participants suggested that the litigation 
risk faced by underwriters was a primary reason why underwriters 
generally prefer that their public company clients engage Big 4 
accounting firms for audit services in their securities offering 
processes. The Securities Act of 1933 assigned certain responsibilities 
to the auditor and underwriter in connection with their participation 
in a securities offering, and both may be held liable in the event of a 
material misstatement or omission in the offering documents. To 
discharge its "due diligence" responsibilities (the process of 
investigation into the details of a potential investment, such as an 
examination of operations and management and the verification of 
material facts), an underwriter must demonstrate that it has reviewed 
an issuer's financial information. In performing its due diligence, the 
underwriter relies on the expertise of professional auditors to review 
certain financial information and to provide "comfort letters" (an 
independent auditor's letter, required in securities underwriting 
agreements, to assure that information in the registration statement 
and prospectus is correctly prepared and that no material changes have 
occurred since their preparation) evidencing any reviews. Given its 
liability risk, an underwriter may prefer that a client in the 
securities offering process engage a Big 4 accounting firm, which has a 
larger capital base than any non-Big 4 firm, to more effectively 
redistribute this risk. Underwriters also prefer the Big 4 because they 
may have more experience with the capital formation process, more 
capacity to meet deadlines, and can provide more assistance throughout 
the process.

[45] Initial public offering underpricing generally refers to the 
difference between the offering price and the market clearing price at 
issuance of a company's security, which can be translated directly into 
the initial market-adjusted return earned by a market participant who 
buys the security at its offering price and sells it at its first-day 
closing price. For example, see M. Willenborg, "Empirical Analysis of 
the Economic Demand for Auditing in the Initial Public Offerings 
Market," Journal of Accounting Research, vol. 37, no. 1 (1999): 225-
238, and R. Beatty, "Auditor Reputation and the Pricing of Initial 
Public Offerings," The Accounting Review, vol. 64, no. 4 (1989): 693-
709.

[46] Two of the three most frequently cited reasons given for not 
considering a non-Big 4 firm were capacity of the firm (117 of 129 
respondents) and technical skills/knowledge (117 of 129 respondents).

[47] This discussion of markets is limited to the public company audit 
market and associated competition. Public accounting firms actually 
compete in a variety of niche markets, such as the audit market for 
small public companies, nonprofit companies, private companies, and 
governmental agencies. 

[48] The other two most-cited factors having an upward influence on 
costs were changing accounting principles and standards/complexity of 
audits (47 of 47) and price of talent or training (43 of 47).

[49] The AICPA's SEC Practice Section (SECPS) was a part of the former 
self-regulatory system. SECPS was overseen by the Public Oversight 
Board (POB), which represented the public interest on all matters 
affecting public confidence in the integrity of the audit process. 
SECPS required AICPA member accounting firms to subject their 
professional practices to peer review and oversight by POB and SEC.

[50] Top-tier firms would include the Big 8 in 1988 and the Big 4 in 
2002. Likewise, the next-tier firms would include Grant Thornton, BDO 
Seidman, BKD, Crowe, Chizek and Co., McGladrey & Pullen, Moss Adams, 
Plante & Moran and Clifton Gunderson in 2002.

[51] R. Doogar and R. Easley, "Concentration without Differentiation: A 
New Look at the Determinants of Audit Market Concentration," Journal of 
Accounting and Economics, vol. 25 (1998): 235-253.

[52] This assumption implies that the model's results are not driven by 
economies of scale.

[53] In the "short run," each accounting firm's size, as captured by 
the number of partners, is fixed. The algorithm allows companies to 
switch auditors whenever they can find a lower price, and clients who 
gain the most from a change are allowed to switch first. As long as 
there is a dissatisfied client, the model resigns the client, 
recalculates costs for all clients, and looks to identify any newly 
dissatisfied clients. This process is repeated until equilibrium is 
reached.

[54] While the Big 4 audited over 95 percent of the total assets of 
these industrial companies, they audited 68 percent of the log of total 
assets.

[55] The data we analyzed are from Who Audits America, 2001-2002. We 
tracked the companies that left Andersen, beginning with the last 
quarter of 2001 because some companies began leaving Andersen once the 
firm came under suspicion.

[56] We also administered a survey to a random sample of 250 Fortune 
1000 public companies, of which 148 companies responded, and 34 of the 
148 respondents were former Andersen clients. We found that half of the 
34 former Andersen clients switched to the new firm of the former 
Andersen partner who was in charge of their audit.

[57] One hundred fifty-nine companies that did not have SIC codes 
reported in Who Audits America were excluded from this analysis.

[58] SIC codes are arranged in a very structured, hierarchical manner; 
and for the purposes of this report, we have focused on the 2-digit SIC 
code; the first digit designates a major Economic Division, such as 
agriculture or manufacturing; the second digit designates an Economic 
Major Group, such as crop production.

[59] To test the reliability of this database, we preformed various 
checks on random samples of the data, compared results we obtained 
using the data to published work in the area and relied on previous 
academic research, which verified the completeness and accuracy of the 
data. For example R. Doogar and R. Easley, "Concentration without 
Differentiation: A New Look at the Determinants of Audit Market 
Concentration," Journal of Accounting and Economics, vol. 25 (1998): 
235-253, compared auditor information contained in the Compustat, Dow-
Jones Disclosure and Who Audits America and found no discrepancies. The 
data issues are also discussed in appendix I.

[60] This assumes that a firm does not have sufficient expertise and 
staff resources if it audits only a small share of industry assets 
(defined here by major economic group).

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