Audits of Public Companies: Continued Concentration in Audit Market for Large Public Companies Does Not Call for Immediate Action
Published: 2008-01-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO has prepared this report under the Comptroller General's authority as part of a continued effort to assist Congress in reviewing concentration in the market for public company audits. The small number of large international accounting firms performing audits of almost all large public companies raises interest in potential effects on competition and the choices available to large companies needing an auditor. This report examines (1) concentration in the market for public company audits, (2) the potential for smaller accounting firms' growth to ease market concentration, and (3) proposals that have been offered by others for easing concentration and the barriers facing smaller firms in expanding their market shares. GAO surveyed a random sample of almost 600 large, medium, and small public companies on their experiences with their auditors. GAO also interviewed the four largest accounting firms and surveyed all other U.S. accounting firms that audit at least one public company. GAO also developed an econometric model that analyzed the extent to which various factors, including concentration and new auditing requirements, affected fee levels. To supplement this work, GAO interviewed market participants, including public companies, investors, accounting firms, academics, and regulators. This report makes no recommendations.
section_title: What GAO Found
paragraphs: While the small public company audit market is much less concentrated, the four largest accounting firms continue to audit almost all large public companies. According to GAO's survey, 82 percent of large public companies--the Fortune 1000--saw their choice of auditor as limited to three or fewer firms, and about 60 percent viewed competition in their audit market as insufficient. Most small public companies reported being satisfied with the auditor choices available to them. Although audit fees rose significantly in recent years, market participants attributed these increases to expanding accounting and auditing requirements and higher costs for accounting firm personnel. GAO's model also found that factors other than concentration appeared to explain audit fee levels. Public company officials generally acknowledged that audit quality had increased. Although current concentration does not appear to be having a significant adverse effect, the loss of another large firm would further reduce large companies' auditor choice and could affect audit fee competitiveness. Smaller accounting firms face various challenges in expanding to audit more public companies, although most are not interested in these clients. As a result, concentration in the audit market for large public companies is likely to continue. Large public companies that GAO surveyed said that smaller firms lacked the capacity and technical expertise they wanted in an auditor. Audit firms that GAO surveyed said that adding qualified staff and increasing their name recognition were the most significant challenges they faced in expanding their public company audit practices. Some have taken steps to increase their capacity by joining networks with other firms. Academics and business groups have put forth proposals to reduce audit market concentration and address challenges facing smaller accounting firms, including capping auditors' liability and creating an office to share technical expertise. Market participants raised questions about the overall effectiveness, feasibility, and benefit of these proposals, and none were widely supported. Given the lack of significant adverse effect of concentration in the current environment and that no clear consensus exists on how to reduce concentration, no compelling need for immediate action appears to exist.

section_title: Letter
paragraphs: Public and investor confidence in the reliability of financial reporting is  critical to the effective functioning of the U.S. capital markets. Federal  securities laws require that a company raising capital by issuing securities  to the public have an independent public accountant perform an audit of  the company’s financial statements to provide reasonable assurance about  whether the financial statements are fairly presented. Since the 1980s, a  small number of large U.S. accounting firms have traditionally performed  audits for the vast majority of the public company market (when measured  by the share of total audit fees collected). Among the clients of these large  firms are almost all of the largest U.S. companies. The small number of  large accounting firms performing such audits has decreased as a result of  mergers and the dissolution of one firm, falling from eight in the 1980s to  four today. These four firms—referred to here as the largest firms—have  thousands of partners, tens of thousands of employees, offices located  around the world, and each had more than one thousand public company  audit clients for 2006. The next four largest accounting firms—referred to  here as midsize firms—operate nationally, and to some extent,  internationally but have substantially fewer employees and partners, and  each had less than 500 public company audit clients for 2006. All other  accounting firms—referred to here as smaller firms—audit regional and  local public companies and have fewer than 100 public company clients.
With the audit market concentrated among the four largest firms, concerns  have been raised about the number of choices that companies have when  selecting an auditor and the extent of competition in the market. In 2003,  we conducted a study (mandated by the Sarbanes-Oxley Act) on  consolidation that had occurred in the accounting profession. Our study  followed the dissolution of one of the then-five largest accounting firms,  Arthur Andersen. At that time, we found that although audits for large  public companies were highly concentrated among the largest accounting  firms, the market for audit services appeared competitive according to  various indicators. Given that several years have passed since the  dissolution of Arthur Andersen and the passage of the Sarbanes-Oxley Act,  which introduced reforms to public reporting and auditing, this report  provides an update on the trends in the market for public company audits  that we identified in 2003 in the market for public company audits. Among  the changes affecting the audit market that have occurred since our last  report are additional requirements for public companies and auditors to  assess, report on and attest to companies’ internal control practices,  restrictions intended to ensure the accounting firm’s independence that  limit public companies’ ability to use their auditors for certain other  services, and the creation of a new oversight body for accounting firms.
We prepared this report under the Comptroller General’s authority to  conduct evaluations on his own initiative as part of a continued effort to  assist Congress in reviewing concentration in the market for public  company audits. Specifically, this report examines (1) the level of  concentration in the market for public company audits and the impact of  this concentration, (2) the potential for increased capacity among midsize  and smaller accounting firms to ease market concentration, and (3)  proposals that have been offered by others for easing concentration in the  market for public company audits and the barriers facing midsize and  smaller firms in expanding their market share for public company audits.
To address these objectives, we collected data and analyzed changes in  companies’ choice of auditors and in audit fees, computed concentration  ratios and other measures of concentration. We developed an econometric  model to evaluate how various factors, including the level of market  concentration, could explain fees that public companies paid to their  auditors. To obtain the views of public companies and accounting firms on  audit competition and challenges, we conducted two surveys. First, we  surveyed a random sample of 595 of more than 6,000 publicly held  companies, some of which had recently changed auditors. Our sample  included large public companies (those in the Fortune 1000); midsize  public companies (those outside the Fortune 1000 with market  capitalizations—the value of the total outstanding shares of stock—above  $75 million); and small companies with less than $75 million in market  capitalization. Our response rate for this survey was 73 percent. Because  our survey was based on a random sample of the population, it is subject  to sampling errors. The likely range of these errors for any survey  statistics is no greater than plus or minus 12 percentage points, unless  otherwise noted. In addition, we surveyed representatives of all 434 U.S.  accounting firms that audited at least 1 public company in 2006 and were  registered with the Public Company Accounting Oversight Board  (PCAOB). Our response rate was 58 percent.Results from our survey of  accounting firms are limited to those midsize and smaller firms with five  or more public company clients. Instead of surveying the four largest  firms, we conducted separate structured interviews with representatives  from each firm to obtain their views on the issues covered in the survey.
This report does not contain all the results from the surveys, but the  surveys themselves and a more complete tabulation of the results can be  viewed at http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP. We also  interviewed staff from the Securities and Exchange Commission (SEC),  PCAOB, Department of Justice (DOJ); academics; private consultants;  trade associations; accounting firms; public companies; and insurance  companies. To obtain information about the strengths and weaknesses of  various proposals that have been offered to address concentration and the  challenges that midsize and smaller firms face, we also held a roundtable  discussion on July 10, 2007, involving 18 market participants, including  representatives of accounting firms, public companies, investors,  academics, and insurers. For more information on our scope and  methodology, see appendix I.
We conducted this performance audit in New York City and Washington,  D.C., from October 2006 to January 2008 in accordance with generally  accepted government auditing standards. Those standards require that we  plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
subsections: section_title: Background
paragraphs: Following the 1929 stock market crash, legislation was passed that  required companies seeking to raise funds from the public to provide  audited financial statements to their investors. The Securities Act of 1933  and the Securities Exchange Act of 1934 established the principle of full  disclosure, which requires that public companies provide full and accurate  information to the investing public. Under these federal securities laws,  public companies are responsible for the preparation and content of  financial statements that are complete and accurate and are presented in  conformity with U.S. generally accepted accounting principles (GAAP).  Financial statements, which disclose a company’s financial position  (balance sheet), stockholders’ equity, results of operations (income  statement), and cash flows, are an essential component of the disclosure  system on which the U.S. capital and credit markets are based.
Federal securities laws also require that public companies have the  financial statements they prepare audited by an independent public  accountant. The independent public accountant’s audit is critical to the  financial reporting process because the audit subjects companies’  financial statements to scrutiny on behalf of shareholders and creditors to  whom company management is accountable. The auditor is the  independent link between management and those who rely on the  financial statements. The statutory independent audit requirement, in  effect, grants a franchise to the nation’s public accountants, as an audit  opinion on a public company’s financial statements must be secured  before an issuer of securities can go to market, have the securities listed  on the nation’s stock exchanges, or comply with the reporting  requirements of the securities laws.
Having auditors attest to the reliability of financial statements of public  companies is intended to increase public and investor confidence in the  fairness of the financial information. Moreover, investors and other users  of financial statements expect auditors to bring integrity, independence,  objectivity, and professional competence to the financial reporting process  and to prevent the issuance of misleading financial statements. The  resulting sense of confidence in companies’ audited financial statements,  which is key to the efficient functioning of the markets for public  companies’ securities, can exist only if reasonable investors perceive  auditors as independent and expert professionals who will conduct  thorough audits. In the event that companies are alleged to have misled  the public or presented falsified financial information, the accounting  firms that performed those audits are also sometimes included in suits  brought by investors or actions pursued by regulators.
Accounting Firm Structure  Most accounting firms that audit public companies in the United States are  organized as partnerships. Unlike corporations, which generally issue  stock to their shareholders in exchange for capital to conduct their  operations, accounting firms structured as partnerships obtain capital  from their partners. To conduct an audit of a public company, an  accounting firm establishes an engagement team that is typically headed  by a lead audit partner and includes a concurring audit partner, audit staff  and managers, and, as needed, technical specialists. The lead audit partner  has responsibility for decision making on significant auditing, accounting,  and reporting matters that affect the financial statements; reviewing the  audit work; and maintaining regular contact with management and the  audit committee. The concurring audit partner is responsible for reviewing  the audit.
To provide technical assistance to engagement teams, the larger  accounting firms have national offices staffed with experts in auditing and  accounting standards. These national offices are made up of accounting  and auditing technical specialists who assist engagement teams by  responding to complex questions, researching answers, and providing  guidance to individual audit teams. These specialists also provide  guidance to the entire firm on handling issues that arise during the course  of audits, including evaluating the fair presentation of the financial  statements.
subsections: section_title: Mergers and the Loss of a Major Firm Have Resulted in a National and International Market Dominated by Four Large Firms
paragraphs: Although the largest U.S. accounting firms have used mergers and  acquisitions to help build their businesses and expand nationally and  internationally since the early part of the twentieth century, in the late  1980s the eight largest firms—known as the Big 8—began merging with  each other. As shown in figure 1, by 2000 various mergers among the  largest accounting firms had left five large firms that accounted for the  majority of audit revenues among firms auditing public companies.
In 2002, the market consolidated further to 4 large firms after the  Department of Justice criminally indicted Arthur Andersen on obstruction  of justice charges stemming from the firm’s role as auditor of Enron  Corporation. The indictment and subsequent conviction of Arthur  Andersen led to a mass exodus of its partners and staff, as well as clients.  As a result, the firm was dissolved in 2002.
section_title: Statutory Changes Affecting Requirements for Public Companies and Their Auditors
paragraphs: Public companies and the accounting profession have experienced many  reporting and auditing changes in recent years. In the aftermath of various  financial scandals at large public companies such as Enron and WorldCom  in the early 2000s, new legislation was passed to help restore investor  confidence in the nation’s capital markets. The Sarbanes-Oxley Act of  2002 (the Act) introduced major reforms to public company financial  reporting and auditing that were intended to improve the accuracy and  reliability of financial reporting and enhance auditors’ independence and  audit quality. The reforms include the following:    Section 404(a) of the Act requires that in each annual financial report filed  with SEC the management of public companies must (1) state its  responsibility for establishing and maintaining an adequate internal  control structure and procedures for financial reporting and (2) assess the  effectiveness of its internal control structure and procedures for financial  reporting.
Section 404(b) requires that each public company’s accounting firm must  attest to and report on management’s assessment of the effectiveness of  internal control over financial reporting.
A separate provision prohibits the company’s auditor from providing  certain nonaudit services, including bookkeeping, appraisal services,  actuarial services, and internal audit outsourcing services.
Another provision requires the mandatory rotation of lead and reviewing  audit partners after they have provided audit services to a particular public  company for 5 consecutive years.
The Act also established the PCAOB as a private-sector nonprofit  organization subject to SEC oversight. PCAOB’s mission is to oversee the  audits of public companies in order to protect the interests of investors  and further the public interest in the preparation of informative, fair, and  independent audit reports. Table 1 shows other provisions affecting the  corporate governance, auditing, and financial reporting of public  companies.
The PCAOB has several responsibilities, including  registering public accounting firms that prepare audit reports for public  companies;    establishing auditing, quality control, ethics, independence, and other  standards relating to the preparation of audit reports for public  companies;   conducting inspections of registered public accounting firms; and    conducting investigations and disciplinary proceedings of registered  public accounting firms and those associated with such firms.
Under the Act, SEC was granted oversight and enforcement authority over  PCAOB and must approve rules proposed by PCAOB for them to become  effective.
PCAOB is required to annually inspect registered accounting firms that  provide audit reports for more than 100 issuers and at least triennially  inspect firms with fewer issuers. It conducted its first accounting firm  inspections during 2003, but these inspections were limited in scope and  were performed only on the largest firms. Since 2004, PCAOB has  conducted full scope inspections of accounting firms of all sizes. As  required in the Sarbanes-Oxley Act, PCAOB has issued individual reports  to the accounting firms explaining issues identified in the inspections and  has also issued reports covering common observations from their  inspection process.
The Sarbanes-Oxley Act also mandated that we study (1) the factors  contributing to the mergers among the largest accounting firms in the  1980s and 1990s; (2) the implications of consolidation on competition and  client choice, audit fees, audit quality, and auditor independence; (3) the  effect of consolidation on capital formation and securities markets; and  (4) barriers to entry faced by smaller accounting firms in competing with  the largest firms for large public company audits. In 2003, we issued our  report Public Accounting Firms: Mandated Study on Consolidation and  Competition (GAO-03-864). We concluded in 2003 that the audit market  was in the midst of unprecedented change. The market had become more  highly concentrated, and the largest firms, as well as other accounting  firms, faced tremendous challenges as they adapted to new risks and  responsibilities, new independence standards, a new business model, and  a new oversight structure, among other things. In many cases it was  unclear what the ultimate outcome of the changes would be, and we noted  that past findings might not reflect the future situation. We also identified  several important issues that we believed warranted additional attention  and study by the appropriate regulatory or enforcement agencies, such as  the effect of the existing level of concentration on audit price and quality.
section_title: Significant Audit and Accounting Standards and Rules Changes Since 2003
paragraphs: Since 2003, significant activity related to management reporting and  auditing standards has continued to occur. In 2002, 2003, and 2004, SEC  issued rules and guidance on implementing some of the Sarbanes-Oxley  Act’s provisions. Among these was the requirement that a public  company’s chief executive officer and chief financial officer certify in  quarterly and annual reports issued after August 29, 2002, that their  company’s financial statements fairly present in material respects the  company’s financial condition (Section 302). In June 2003, SEC issued  final rules to implement Section 404 of the Sarbanes-Oxley Act. Section  404(a) requires company management, in each annual report filed with  SEC, to state their responsibility for establishing and maintaining an  adequate internal control structure and procedures for financial reporting  and to assess the effectiveness of its internal control structure and  procedures for financial reporting. Section 404(b), which requires the  registered accounting firm to attest to and report on management’s  assessment of the effectiveness of its internal control over financial  reporting was implemented later. Public companies whose outstanding  stock held by the public was valued at $75 million or more—known as  accelerated filers—were first required to comply with Section 404(a) and  (b) for fiscal years ending on or after November 15, 2004. Public  companies with stock in public hands valued at less than $75 million— called nonaccelerated filers—were granted several extensions but are now  expected to comply with these Section 404 requirements over the next 2  years—for Section 404(a) in fiscal years ending after December 15, 2007,  and for Section 404(b) in the first annual filing after December 15, 2008.
PCAOB issued its first audit standard on December 17, 2003, which the  SEC approved on May 14, 2004, and, as of August 2007, has issued a total  of five audit standards. On July 25, 2007, SEC approved Auditing Standard  No. 5, An Audit of Internal Control Over Financial Reporting That is  Integrated with an Audit of Financial Statements, to replace Auditing  Standard No. 2, An Audit of Internal Control Over Financial Reporting  Performed in Conjunction with an Audit of Financial Statements.  According to PCAOB, Auditing Standard No. 2 was more costly than  expected, and the related effort involved in complying with it appeared to  be more than was necessary to conduct an effective audit of internal  controls over financial reporting. Specifically, PCAOB noted that auditors  were focusing on minutiae that were unlikely to affect the financial  statements and that audit programs were not tailored to small companies.  Auditing Standard No. 5, which is expected to address some of the cost  issues, became effective for audits in fiscal years ending on or after  November 15, 2007.
Other accounting and financial reporting standards and requirements have  been implemented in recent years. Between January 2003 and August 2007,  the Financial Accounting Standards Board (FASB), which issues the  accounting standards that SEC recognizes as GAAP for public companies,  issued 11 statements (Nos. 149 through 159) and revised statement  number 123. These statements cover a range of topics including financial  instruments, fair value, and pensions. In addition, other guidance has been  issued by the FASB emerging issues task force (EITF), SEC, and other  groups. For instance, FASB issued EITF Issue No. 06-6, “Debtor’s  Accounting for a Modification (or Exchange) of Convertible Debt  Instruments” in November 2006. SEC issued Staff Accounting Bulletin  Number 108 on September 13, 2006, summarizing the views of the staff  regarding the process of quantifying financial statement misstatements.
These recent changes to accounting and financial reporting standards and  guidance add to an already highly complex set of standards and rules for  public company financial reporting. Currently GAAP consists of more than  2,000 separate pronouncements issued in various forms by numerous  bodies including SEC, FASB, American Institute of Certified Public  Accountants (AICPA), and others. SEC Chairman Cox has stated that “our  current system of financial reporting has become unnecessarily complex  for investors, companies, and the markets generally.” In June 2007, SEC  established the SEC Advisory Committee on Improvements to Financial  Reporting to study the causes of complexity and recommend ways to  make financial reports clearer and more beneficial to investors, reduce  costs and unnecessary burdens for preparers, and better use advances in  technology to enhance all aspects of financial reporting.
section_title: With Continued Audit Market Concentration, Large Public Companies See Limited Choices, but No Apparent Significant Effect on Fees
paragraphs: Despite some reduction since 2002, the overall public company audit  market has remained highly concentrated. For large public companies, the  market remains highly concentrated, with the four largest accounting  firms auditing the financial statements of almost all large public  companies. However, the audit market for smaller public companies has  become much less concentrated since 2002. Larger public companies  indicated that the industry expertise and technical capability that they  sought in an auditor generally meant that their choices were limited to the  largest accounting firms in this highly concentrated market. Those we  spoke to and surveyed had mixed views on the extent to which the current  level of concentration adversely affected choice, audit prices, and audit  quality, but most participants did not see the current level of  concentration as significantly affecting these aspects of competition.  Although audit fees have increased and public companies’ opinions of the  adequacy of competition in the audit market varied, other factors appear  to explain the recent fee increases. While the current level of  concentration does not appear to be having significant adverse effect, the  loss of another of the larger firms would further increase concentration  and limit company choices and may affect price competition. Regulators  overseeing the functioning of the audit market could take several actions  in response to another large audit firm’s leaving the market.
subsections: section_title: Overall Market for Public Company Audits Remains Highly Concentrated
paragraphs: To assess the degree of concentration in a market, we used the preferred  practice of examining the proportion of each competing seller’s—in this  case accounting firms—share of the overall revenue collected. In the case  of accounting firms, the revenue measured is the total amount of fees  these firms collected. Using data from Audit Analytics, which collects  audit fee information from the filings public companies submit to SEC, we  found that the largest firms collected 94 percent of all audit fees paid by  public companies in 2006, slightly less than the 96 percent they collected  in 2002. As a result, the overall market continues to represent a tight  oligopoly, which is a concentrated market in which a small number of  firms have large enough market share to potentially use their market  power, either unilaterally or through collusion, to greatly influence price  and other business practices to their advantage.
A key statistical measure used to assess market concentration and the  potential for firms to exercise market power is the Hirschman-Herfindahl  Index (HHI). The HHI for a market is calculated using the various market  shares (in the case of the audit market, measured by total audit fees  collected) of all the firms competing to offer services within that market.  In 2006, the HHI for the overall market for public company audits was  2,300. According to guidelines issued jointly by the Department of Justice  (DOJ) and the Federal Trade Commission (FTC), an HHI above 1,800  indicates a highly concentrated market. Analyzing the audit market by  industry and region reveals that many industries have similarly highly  concentrated audit markets. For example, in 2006 the HHI of the audit  market in the utilities sector was over 3,500. The audit market was also  similarly concentrated for companies across six major geographic regions  of the country. (App. II contains further discussion of overall market  concentration.)
In addition to the potential for dominant competitors to use their market  power to charge uncompetitive prices, highly concentrated markets also  raise other competitive concerns. For example, firms with significant  market power have the potential to reduce the quality of their products or  to cut back on the services they provide because the lack of competitive  alternatives would limit customers’ ability to obtain services elsewhere.  Similarly, firms that dominate a given market may feel less pressure to  introduce innovative products and services. Finally, a highly concentrated  market increases the potential for the dominant firms to engage in  coordinated actions that can harm clients, such as coordinating actions to  influence the development of standards that raise costs for their  customers. However, the presence of high market shares does not  necessarily mean that anticompetitive behavior is occurring. Competition  in an oligopoly can also be intense and result in a market with competitive  prices, innovation, and high-quality products.
Markets with a few large dominant firms can form for natural reasons and  can also be beneficial. As we reported in 2003, several key factors spurred  the increased consolidation in the market that resulted from the mergers  of the eight largest accounting firms in the 1980s and 1990s. For example,  as U.S. corporations have increasingly expanded into global markets, their  need for accounting firms with greater global reach also increased. Many  public companies have developed more complex operations and financial  transactions, such as the increasing use of derivatives and other financial  arrangements, and these changes increased the need for auditors with  specialized industry-specific or technical expertise.
Further, some accounting firms wanted to modernize their operations,  build their staff capacity, and spread their risk over a broader capital base,  and large firms can achieve greater economies of scale by spreading  certain fixed costs, such as staff training, over an expanded client base.  Therefore, the size of the largest firms may enable them to develop  sufficient technical expertise and the ability to conduct work globally to  meet the needs of complex multinational audit clients and to do so at a  lower cost than could be provided by smaller audit firms. Some academic  sources have also suggested that the size of the largest firms may give  them the ability to resist potential pressure from large public company  clients to reduce or compromise audit quality.
section_title: Although Smaller Public Company Market Has Become Less Concentrated, Concentration in the Market for Large Companies Persists
paragraphs: Although the market is concentrated overall, the degree of market  concentration, and, thus, the extent to which the largest firms dominate,  declines with the size of public companies. As shown in figure 2, the  proportion of large public companies audited by one of the largest  accounting firms has not changed since 2002. However, the proportion of  the smallest public companies that used the largest auditors fell by half  from 2002 to 2006. Specifically, the share of public companies with less  than $100 million in revenue audited by the largest firms decreased from  44 percent to 22 percent over this period. As figure 2 shows, smaller  accounting firms now serve as auditors for many of the companies that  had previously used the largest firms. The share of companies with  revenues between $100 and $500 million that the largest firms audited also  declined during this period from 90 to 71 percent. Officials from the largest  accounting firms and other market participants told us resource  constraints in the aftermath of the Arthur Andersen collapse and the  Sarbanes-Oxley Act led the largest firms to resign from auditing some  smaller companies or raised their audit fees higher than some smaller  companies were willing to pay.
As the share of smaller companies audited by the largest firms has  declined, concentration in the audit market for these companies has eased  significantly. By grouping public companies by their revenues and  calculating HHIs for these groupings, we found that while the audit market  for larger public companies with revenues greater than $500 million  remained highly concentrated, the market for smaller public companies  with 500 million in revenue or less had become much less concentrated.  As figure 3 shows, between 2002 and 2006 the HHI for the audit market for  the smallest public companies—those with annual revenues of less than  $100 million—declined from a level of 1,400 to about 800. According to  DOJ and FTC guidelines, a market with an HHI of less than 1000 is  considered to be unconcentrated, and no competitor would likely have the  ability to exert market power. The audit market for public companies with  revenues between $100 million and $500 million also became less  concentrated. The HHI for this market fell from a 2002 level indicating  high concentration to a 2006 level indicating only moderate concentration.
section_title: In Concentrated Market, Some Companies Perceive Limited Auditor Choice
paragraphs: Many of the largest public companies—those in the Fortune 1000—told us  that they generally found the audit firm attributes they sought only in the  largest accounting firms, and as a result, many of these companies saw  their number of auditor choices as insufficient. Midsize and small  companies were generally more likely than large companies to report that  they had more than three choices.
subsections: section_title: Large Public Companies and Auditor Choices
paragraphs: In the current concentrated market, large companies perceived their  choices as limited, in part because these companies generally said, if they  had to choose a new auditor, they were not likely to use accounting firms  smaller than the largest firms. Our survey of the audit committee chairs  of almost 600 public companies based in the United States showed that 86  percent of large public companies in the Fortune 1000 were not likely to  use a midsize accounting firm and that none were likely to use a smaller  accounting firm as a new auditor of record. In explaining their position,  these companies most frequently cited the auditor’s ability to handle the  size and complexity of their company’s operations as being of great or very  great importance (92 percent). In addition, 80 percent cited the auditor’s  technical capability with accounting principles and auditing standards and  67 percent cited the need for industry specialization or expertise as of  great or very great importance as reasons why they would not consider a  midsize or smaller auditor. Similarly, in interviews and comments on our  survey, some company officials noted that they chose the largest firms  because they believed that these firms had the attributes the company  needed, while midsize and smaller firms did not. For example, the audit  committee chair of one large company commented that the company  would not choose a midsize or smaller auditor because the company’s  industry was very complex, and, therefore, the company needed an auditor  with specific industry experience. The chief financial officer (CFO) of  another large public company noted that because of the company’s size  and international operations, the largest firms were the only viable  options.
The need to comply with independence standards and other factors can  further limit the number of choices available to large public companies for  their auditor of record. As required under the Sarbanes-Oxley Act, SEC  rules, and auditing standards, a company’s auditor must be independent.  Public companies are prohibited from obtaining audits from firms that  also provide the company with certain nonaudit services, including  bookkeeping, design and implementation of financial information systems,  valuation services, and internal audit outsourcing services. Ninety-six  percent of large companies reported that they used one of the largest firms  for some nonaudit services, potentially further reducing the number of  choices for their auditor of record if they are precluded from using those  firms due to independence rules. According to our survey data, 27 percent  of large public companies that had not switched auditors since 2003  reported that the independence restrictions on using certain firms were of  at least some importance in deciding to retain their current auditor,  although only 9 percent listed these restrictions as of great or very great  importance.
In interviews, officials from a few large public companies indicated that  they maintained options while remaining in compliance with  independence requirements by not using at least one of the largest firms  for prohibited nonaudit services, in some cases by using smaller firms for  these services. In this way, they hoped to ensure that they would have at  least one independent firm to choose if they had to change auditors. Some  interviewees we spoke with suggested that companies using only the  largest firms for both audit and nonaudit services could be unnecessarily  limiting their choices because many midsize and smaller firms were  capable of handling certain nonaudit services.
A few companies may feel constrained in their choice of auditors for other  reasons. For example, some companies’ desire to avoid using a  competitor’s auditor can reduce the number of choices they have,  according to several industry participants. However, over 90 percent of the  large companies that responded to our 2003 survey were willing to choose  a firm as their auditor regardless of whether that firm also audited a  competitor. Further, some market participants and regulators noted that  in certain industries, large public companies may have more limited  choices because one or more of the largest firms was not very active in  those industries. For example, in 2006 one of the largest firms held 77  percent of the market for public company audits in the agriculture,  forestry, fishing, and hunting industry, while another of the largest firms  had only a 1 percent market share.
Consistent with reporting that they were not likely to use midsize and  smaller audit firms, large companies also indicated that they had a limited  number of firms to choose from, and many believed that this number was  generally insufficient. According to our survey, about 80 percent of large  public companies said that they would have three or fewer accounting  firms (other than their current auditor of record) to choose from if they  needed to change primary auditors. The proportion of large companies  that reported having three or fewer choices was about the same for both  domestic and multinational companies. Furthermore, over half (57  percent) of large public companies stated that the number of accounting  firms that they could choose among was not adequate. Forty-three  percent of large public companies that responded to the survey we  conducted for our 2003 report indicated that they had insufficient choices  for an auditor of record.
Large public companies’ preference for the largest audit firms was  illustrated by the firms these companies choose when they changed  auditors. Although some public companies maintain their relationships  with the same audit firm for many years, there were almost 6,000 changes  in auditors between 2003 and 2007. We analyzed data from Audit Analytics  and found that 102 large companies had changed auditors between  January 1, 2003, and June 30, 2007. Of the 95 large companies that were  previously audited by one of the largest firms, 88 (93 percent) of these  companies changed from one of the largest auditors to another of the  largest auditors. Only seven switched to a midsize auditor. The remaining  seven large companies that changed auditors during this period had been  previously audited by a midsize or smaller auditor, but switched to one of  the largest firms. (App. III shows more analysis of the data on auditor  changes and the reasons these companies reported for changing auditors.)
section_title: Midsize and Small Public Companies and Auditor Choices
paragraphs: Although many midsize public companies reported that their choice of  auditors was limited, smaller companies generally reported having more  choices than larger companies, if they had to change auditors. For  example, among midsize companies, 59 percent of multinational and 52  percent of domestic companies reported that their choices were limited to  three or fewer firms (fig. 4). In contrast, only about one-third (34 percent)  of small companies indicated that they were restricted to three or fewer  accounting firms and over 40 percent said that they had six or more  choices.
Based on our survey, midsize and small public companies were more  likely than large companies to consider using midsize or smaller  accounting firms if they had to choose a new auditor. About half (51  percent) of midsize companies would consider using midsize firms and 16  percent would consider using smaller firms. Further, 74 percent of small  public companies would consider using smaller firms.
In addition, compared with large companies, more midsize and small  companies were satisfied with the number of choices they had for possible  auditors. As shown in figure 5, about half of midsize and less than a fifth of  small companies reported that the number of choices they had was not  enough.
However, about 60 percent of midsize multinational companies reported  that they would have three or fewer choices if they had to change auditors  and about half said the number of choices was not enough.
Our analysis also showed that many midsize and small public companies  have moved to midsize or smaller auditors. Since 2003, over 1,400 midsize  and small companies that had been audited by one of the largest firms  have changed auditors. Of these, almost 1,100 (about 74 percent) engaged  midsize or smaller firms as their new auditors and about 360 (about 25  percent) chose another one of the largest auditors (fig. 6). In contrast, only  13 percent of midsize and small companies that left midsize auditors and 3  percent of midsize and small companies that left smaller auditors  subsequently engaged one of the largest firms.
section_title: Although Opinions on the Impact of Concentration in the Large Public Company Market Varied, Other Factors Appeared to Account for Recent Fee Increases
paragraphs: Opinions varied on the effect of concentration on competition and on the  sufficiency of competition in the market for public company audits. Many  of the market participants we interviewed felt that competition was quite  strong and not significantly affected by concentration. For example,  representatives of the largest firms told us that they competed intensely  with each other. Some of the public company officials we spoke with also  saw the audit market as competitive. For example, the audit committee  chair of one large public company said that although a major competitor  was lost when Arthur Andersen dissolved, the market had adjusted and  was still competitive. However, several companies we surveyed  commented that, with few firms to choose from, the market did not have  enough competition. For example, the CFO of a midsize company said that  consolidation in the market had led to a decline of value-added services by  auditors and an escalation of audit pricing. Another company official that  responded to our survey stated that the audit market was an oligopoly  with little price competition and too little concern for service. The CFO for  another company commented on our survey that something needed to be  done to force more competition, while a different CFO commented that  although more competition was desirable, action to break up the largest  firms was not warranted.
Based on the results of our survey, 57 percent of public companies thought  that the level of competition for audit services for their company was  sufficient. However, while about 70 percent of small companies saw the  level of competition as adequate, only about 40 percent of large Fortune  1000 companies shared this view (fig. 7). About half of midsize companies  saw the level of competition as adequate.
Although highly concentrated markets typically raise concerns about price  competition, our analysis indicated that other factors appeared to explain  the increases in audit fees in recent years. Data on audit fees paid by  public companies show that these fees have increased substantially since  2000, a period that included the dissolution of Arthur Andersen and the  passage of the Sarbanes-Oxley Act. Audit fees have risen for companies of  all sizes and across industries and regions. However, the fee increases, as  a percentage of client company assets, were most dramatic for smaller  companies. Between 2000 and 2006, median fees as a percent of assets  more than quadrupled (a 334 percent increase) for companies with less  than $100 million in revenue, more than tripled (a 239 percent increase)  for companies with revenue between $100 million and $1 billion, and  almost tripled (a 190 percent increase) for companies with revenue over  $1 billion. After these increases, median fees were about $111,000 for  companies with less than $100 million in revenue, $900,000 for companies  with revenue between $100 million and $1 billion, and $3,156,000 for  companies with revenue greater than $1 billion. Although audit fees  increased significantly on average for all sizes of firms, the amount that  companies spend on audit fees generally remains a small portion of their  overall revenues.
Market participants and others cited various factors that had contributed  to recent fee increases. The most significant factors that staff from the  largest firms cited in interviews were the increasing complexity of  accounting and financial reporting standards and the additional  requirements of new auditing standards that had increased the amount of  work involved in audits and the need for technical expertise. For example,  one of the largest firms noted that the number of experts on staff at the  firm more than doubled between 2003 and 2007. Many market participants  noted similar factors as impacting fees. The largest firms also cited the  increased costs of attracting and retaining talented staff and specialists.  Similarly, midsize and smaller firms reported on our survey that the top  four factors increasing their costs since 2003 were complexity of  accounting principles and auditing standards, additional requirements of  new standards, the time and effort necessary to prepare for PCAOB  inspections, and the costs incurred to hire and train staff.
In particular, the Sarbanes-Oxley Act, which increased the amount of audit  work performed at public companies, was frequently cited as one of the  major factors in the recent fee increases. This legislation introduced a  number of new requirements for audits of public companies, and many  market participants told us that the new requirements accounted for much  of the fee increases since 2002. Representatives from some audit firms we  spoke to said that section 404 of the act had, where implemented,  substantially increased their workload and costs for implementing new  methodologies and staff training. (Section 404 requires the accounting firm  to attest to, and report on, management’s assessment of the effectiveness  of its internal control over financial reporting.) In addition, 84 percent of  companies reporting that their audit fees had increased since 2003  indicated on our survey that the audit of internal control over financial  reporting was one of the reasons for the increase. To date, only larger  public companies—which SEC calls accelerated filers—have had to  comply with the new requirements for assessing these internal controls.  Smaller public companies—those considered nonaccelerated filers—are  scheduled to fully comply with the new audit requirements in annual  filings after December 15, 2008, potentially resulting in further increases in  these companies’ audit fees.
Independence requirements may also have changed the way some firms  price audits, resulting in rising fees. DOJ officials and others stated that  audit firms were now less likely to price audits as a loss leader in order to  sell nonaudit services because of these requirements in the Sarbanes- Oxley Act.
subsections: section_title: Effects of Concentration on Fee Increases
paragraphs: The results of an econometric model we developed to assess the extent to  which various factors could be influencing audit fees in recent years also  indicated that factors other than concentration appear to explain audit  fees. Our model analyzes the extent to which audit fees paid by public  companies appear to be explained by a variety of factors that could affect  those fees. For example, our model included such variables as the  concentration within the audit market for a particular industry (as  measured by HHI), the size of the company, whether the company’s fiscal  year ends during a busy period, whether the company completed a  Sarbanes-Oxley Section 404 internal control audit, the number of times the  company changed auditors, and other factors that could affect the  company’s audit fees. Appendix V explains our model in detail.
The results of our model suggested that higher audit market concentration  across individual industries was not associated with higher audit fees.  Specifically, our model found that, in general, public companies operating  in industrial sectors with more concentrated audit markets were not  paying higher audit fees than companies in sectors with less concentrated  audit markets. However, for the largest companies we found some  evidence that audit market concentration within an industry did have a  very small effect on fees. More precisely, after isolating the effect of other  factors, our model results indicated that large companies in industries  with audit markets that were 10 percent more concentrated than the  average industry sector (as measured by HHI) paid on average about half a  percent more in audit fees than other large companies. By comparison, the  model results also indicated, after controlling for other factors, that  companies that completed the Sarbanes-Oxley section 404 internal control  audit, which increased the amount of work done by auditors, paid roughly  45 percent more in audit fees than companies that did not complete the  internal control audit. This finding was consistent with estimates from  other studies that examined the effect of the implementation of this  requirement. Although factors other than concentration appeared to  explain audit fee levels, the available data did not allow us to conclude  that audit fees were competitive overall or to determine whether  individual companies were charged competitive fees.
In addition, the analysis we conducted with our model indicated that  individual accounting firms appeared to charge higher fees when they  controlled a large portion of the audit market within a particular industry,  but this finding did not appear to be the result of anticompetitive pricing.  Rather, it appeared that these firms may have been charging a premium for  their industry expertise. We found that the price premiums received by  accounting firms that collected a large share of the revenues from audits  conducted within an industry sector were similar across all sizes of  companies, including those small companies that typically have many  accounting firms to choose from. This suggests that higher fees are more  likely the result of these firms being able to charge premiums as the result  of their industry expertise rather than of anticompetitive pricing. For  example, a firm with industry expertise may develop and market audit  services that are specific to clients in the industry and that provide a level  of service exceeding that provided by other firms in the same industry. If  this is the case, the higher fees these firms may charge could reflect the  specialized service they offer rather than anticompetitive pricing.
section_title: Other Potential Effects of Concentration
paragraphs: While some market participants expressed concern that concentration in  the audit market could negatively affect audit quality, others said that the  quality of audits had improved in recent years. According to DOJ and FTC  guidance on analyzing market competitiveness, sellers with market power  may lessen competition on dimensions other than price, such as product  quality, service, or innovation. However, even in highly concentrated  markets, including oligopolies, competition among sellers may lead to  innovation and high-quality products. The effect of concentration on audit  quality is difficult to measure empirically. However, we asked market  participants about their views on several aspects of audit quality, including  the experience and technical capability of their accounting firm’s partners  and staff, the firm’s ability to efficiently respond to client needs, and its  ability and willingness to appropriately identify and surface material  reporting issues in financial reports. Most market participants who  commented on audit quality in our interviews and many on our survey said  that audit quality had improved, which some attributed to the Sarbanes- Oxley Act. However, four others, including some academics, a former  regulatory official, and an industry consultant with whom we spoke,  expressed concerns that concentration was affecting the quality of audits.  For example, one said that that having only four firms in the market  resulted in low-quality audits that harmed investors. Appendix IV provides  more information on trends in audit costs and quality.
High concentration may also diminish competition because dominant  sellers, in this case accounting firms, may be more likely or more able to  engage in coordinated interaction in ways that can affect auditing  practices or prices. Some market participants we interviewed expressed  concern that the prevalence of the largest firms on advisory panels or  standard-setting bodies enabled them to coordinate actions to influence  the development of new standards in a way that hampered competition or  otherwise disadvantaged public company audit clients. However, most  market participants we spoke to did not express such concerns.
section_title: Further Concentration Could Adversely Affect Audit Fees and Limit Choices
paragraphs: Although the current level of concentration does not appear to be having  significant adverse effect, the potential for further concentration in the  audit market did raise concerns. Further concentration could arise as a  result of several events. For example, audit firms face the risk that civil  litigation could result in their insolvency or inability to continue  operations. Since 1998, audit firms may have paid at least ten settlements  or awards of $100 million or more that have resulted from private  litigation. In addition, a jury recently found BDO Seidman, the sixth- largest accounting firm, liable for $521.7 million in damages, although BDO  Seidman plans to appeal the verdict. Several officials we spoke with  commented that litigation increases during periods of high market  volatility. As a result, litigation-related costs to auditors could increase in  the case of an economic downturn. Officials from the largest firms told us  that litigation costs have significantly increased since 2003. Some officials  we interviewed from the largest firms and the insurance industry told us  that the largest firms do not have insurance coverage to protect against the  largest claims, both because insurance at that level is not available and  because of fear that having more insurance could induce plaintiffs to seek  higher awards. However, full information on litigation risk and costs and  accounting firms’ insurance coverage is not publicly available, so we could  not identify the magnitude of the risk that litigation poses to these firms.  Some officials we spoke with also suggested that litigation could damage a  firm’s reputation, causing the firm to fail if its clients began seeking other  firms for their audits. For example, according to some academics,  Laventhol & Horwath, the seventh-largest accounting firm in 1990,  declared bankruptcy that year in part due to a series of class action  lawsuits that resulted in a loss of reputation and the firm’s inability to  attract new work.
Firms also face the risk of failure from federal or state regulatory action  and criminal prosecution, among other reasons. State Boards of  Accountancy can revoke accounting firms’ licenses to practice in their  state for violating board rules or for other reasons. Under SEC rules,  convicted felons shall be suspended from practicing before the SEC, so an  accounting firm convicted of a felony could not continue to audit its SEC- registered clients and would likely fail. Further, an indictment for a felony  could contribute to a firm’s failure if clients began leaving in anticipation  of a potential conviction. For example, many of Arthur Andersen’s clients  had changed to a different auditor even before Arthur Andersen was  convicted of obstruction of justice for destroying Enron-related  documents in 2002. The market for public company audits could also  become significantly more concentrated if any of the existing largest or  midsize firms chose to discontinue operations for other reasons.  Mismanagement of a firm’s financial obligations could also lead to its  bankruptcy.
As has happened in the past, a merger could also lead to further  concentration in the market. DOJ and the Federal Trade Commission  published Horizontal Merger Guidelines for use in determining whether a  merger is likely substantially to lessen competition. The guidelines include  steps for assessing whether the merger would significantly increase  concentration, the potential for any of the firms to exercise market power  after the merger, and the difficulty of entry into the market for new firms.  Concerns that DOJ raised about a proposed merger of accounting firms in  the late 1990s suggest that the agency would be less likely to approve any  future mergers among the largest accounting firms. In 1997, shortly after  two of the six largest firms at the time, PriceWaterhouse and Coopers &  Lybrand, announced their intention to merge, two of the other six largest  firms, KPMG Peat Marwick and Ernst & Young, also announced plans to  combine their operations. According to the DOJ Antitrust Division’s 1999  Annual Report, these two firms abandoned their plans to merge after DOJ  raised concerns that this merger would have “adversely affected  competition by reducing the already limited number of firms providing  auditing services to Fortune 1000 companies.”
The loss of another large accounting firm from the audit market could  significantly increase the level of concentration. If one of the largest firms  failed or left the market, concentration would increase if many of this  firm’s public company clients engaged one of the remaining three largest  audit firms. To illustrate the effect of such an event, we simulated the  effect of the failure or exit of the smallest of the largest firms. To  redistribute the clients of this firm, we assigned them to other firms in the  same proportion as the clients of Arthur Andersen were distributed after  that firm dissolved. Under this scenario, the resulting HHI of the overall  audit market would rise from 2,300 to roughly 3,000, substantially above  what DOJ considers to be a highly concentrated market. The increase in  HHI would likely be even greater in the large public company market.  Higher concentration could increase the risk that the remaining large  accounting firms would exercise market power to raise prices and  coordinate their actions among themselves to the detriment of their  clients. Appendix II contains more information on our simulations of the  result of the loss of one of the largest firms through a failure or a merger.
Further concentration could have various other negative effects on public  companies and their investors. While many public companies and other  market participants indicated that there were enough auditors to choose  from, further concentration would leave large companies with potentially  only one or two choices for a new auditor, as our survey indicated that 86  percent of large companies would likely only use one of the largest  auditors if they had to switch auditors. Many interviewees said that this  would not be enough choices. As in the current market, independence  rules that prevent companies from using as their auditor firms that provide  them with certain nonaudit services could further limit these choices.  Also, companies in specialized industries could have fewer choices if some  accounting firms do not operate in those industries. Many we interviewed  also suggested that further concentration would reduce competition and  potentially increase the cost of an audit.
Further, public company officials stated that changing auditors could be  costly for the companies involved. According to our survey results, 44  percent of large companies that had not recently changed auditors  reported that the burdens of time, effort, and cost were of great or very  great importance in their decision not to change auditors. In addition, only  102 large (Fortune 1000) public company auditor changes occurred  between January 2003 and June 2007, suggesting that large companies  preferred to use the same auditor from year to year. If the market were  further concentrated among three large firms, the affected companies  would need to change auditors and incur the associated costs. Similarly, to  the extent the remaining largest firms resigned as auditors for smaller  clients as they absorbed the failed firm’s larger clients, these small  companies would incur the costs of finding a new auditor. Finally, the  market disruption caused by a firm failure or exit from the market could  affect companies’ abilities to obtain timely audits of their financial  statements, reducing the audited financial information available to  investors.
section_title: Regulators Could Act to Mitigate the Effects of Further Concentration
paragraphs: If the number of large accounting firms were to decrease, the  organizations with oversight responsibility for the public company audit  market could act to mitigate the effects on the market. The organizations  that have a role in overseeing aspects of the public company audit market  include SEC, PCAOB, and DOJ. SEC is responsible for protecting  investors, maintaining efficient markets, and facilitating capital formation  and also oversees PCAOB. Similarly, PCAOB is responsible for overseeing  the auditors of public companies in order to protect the interests of  investors and further the public interest in the preparation of informative,  fair, and independent audit reports. In the event of the loss of one of the  largest firms, the agencies’ actions could vary according to the facts and  circumstances of the situation, such as the size of the affected firm, the  reason the firm left the market, or the degree to which an orderly  transition of audit services was available. For example, in order to support  its mission and address temporary market disruptions and difficulties  companies had in meeting financial reporting deadlines when Arthur  Andersen was indicted in 2002, SEC issued a number of measures  providing guidance and regulatory relief to Arthur Andersen’s clients. This  rulemaking provided Arthur Andersen clients with extended deadlines to  submit audited financial statements and hotline numbers for companies  and investors to call with questions. Through the International  Organization of Securities Commissions (IOSCO), SEC is also working  with other securities regulators around the world to identify possible  actions regulators could consider in responding to events affecting the  availability of audit services and to develop information for regulators to  consider in contingency planning and crisis management.
Although it does not have a direct role in addressing the loss of a large  accounting firm from the market, DOJ would have a role in reviewing  proposed mergers involving accounting firms. As part of ensuring  competition in the U.S. economy, the Antitrust Division of DOJ is  responsible for enforcing antitrust laws. Under DOJ merger guidelines, the  division would challenge any merger likely to substantially lessen  competition. DOJ officials explained that action on their part would only  occur if a merger among current competitors was proposed or if an  antitrust or criminal case was brought against one of the firms. As a result,  the division has not been formally reviewing trends in the market. When  asked whether the Antitrust Division might review the competitiveness of  the market if one of the largest firms exited the market for reasons other  than a merger, an official stated that the division might analyze the market  using publicly available information and offer its expertise and advice to  other regulators. However, the division does not have the authority to  formally investigate the market or request proprietary information from  firms or companies in such a situation.
section_title: Midsize and Smaller Firms Face Challenges Auditing Public Companies, and Growth in These Firms Is Unlikely to Ease Concentration in the Large Public Company Audit Market
paragraphs: Growth in the capacity of midsize and smaller audit firms is unlikely to  reduce concentration in the large company audit market, at least in the  near term, for two reasons. First, our survey and interviews with  representatives of these firms suggest that over 70 percent of midsize and  smaller firms are not interested in expanding their market share by adding  additional large public company audit clients because they would face  additional risks and give up existing profitable activities to do so. Second,  firms that do want to audit large public companies continue to face  challenges to expanding their public company practices. Chief among  these challenges are having adequate capacity (e.g., staff and geographic  coverage) to audit large public companies, acquiring the needed technical  capability and industry specialization, and developing name recognition  and a reputation for this kind of work. Similar challenges also affect  midsize and smaller firms that audit small and midsize public companies.  Some firms are taking actions to reduce certain challenges, such as  increasing their geographic reach by joining networks and affiliations. But  many firms and market participants we interviewed also said that the  growth of smaller firms was unlikely to ease concentration in the market  for auditors of large public companies.
subsections: section_title: Midsize and Smaller Firms Face Several Disincentives and Challenges to Entering the Large Public Company Audit Market
paragraphs: While most midsize and smaller audit firms expect to grow in the next five  years, only a small number want to enter or expand their share of the large  company audit market, in part because they would face additional risks  and forego currently profitable nonaudit activities to do so. According to  our survey of the 118 accounting firms with at least 5 public company  clients, the 4 midsize firms and 79 percent of the smaller firms that  responded expected to increase the number of public companies they  audited in the next 5 years. However, when asked if they would consider  expanding their market share if they had the opportunity to add  acceptable clients, 74 percent of both midsize and smaller firms said that  they were not interested in serving as auditor for additional large public  companies. Some firms and market participants told us that the  possibility of being sued created a disincentive against entering or  expanding in the audit market for large companies because the failure of  one large client could jeopardize the audit firm. Large companies can pose  a greater financial risk to their auditors than smaller clients. The amount  shareholders recovered in settlements of class action lawsuits against  public companies and their auditors tends to increase in proportion to the  company’s market capitalization. Midsize and smaller firms also may not  be seeking to perform audits of large public companies, because they have  had new opportunities to provide companies of all sizes with nonaudit  services, such as consulting, since 2003. The Sarbanes-Oxley Act’s  independence standards prohibit firms from providing clients whose  financial statements they audit with some of the nonaudit services that  they were accustomed to providing. As a result, many smaller firms have  moved into this area. However, 21 percent of midsize and smaller firms  said that they would be willing to enter or expand their share of market for  auditing large companies, given the opportunity and acceptable potential  clients, but emphasized the challenges they faced in doing so.
subsections: section_title: Firm Capacity to Audit Larger Companies
paragraphs: According to midsize and smaller firms responding to our survey, their  capacity to audit large public companies poses the greatest challenge to  them entering this market and reducing its concentration. According to  our survey, the firms’ capacity is the top reason that large public  companies give to explain why they would not consider using a midsize or  smaller firm. Specifically, 92 percent of those companies said that the  inability of midsize and smaller firms to handle their company’s size and  complexity was of great or very great importance in their unwillingness to  consider them (fig. 8). For example, the audit committee chairman of a  large technology manufacturing company we interviewed said that an  auditor smaller than the company’s current large firm could not audit a  business of his company’s size. Similarly, the audit committee chair for a  large automobile manufacturer told us that large companies did not  consider using midsize firms because those firms did not have the number  of experienced staff that the firms had.
To meaningfully reduce concentration in the large public company market,  then, midsize and smaller firms would need to staff audit teams that were  large enough to serve multiple large public companies. However, these  firms face challenges recruiting and retaining staff. As we reported in 2003,  it is not uncommon for an audit of a large national or multinational public  company to require hundreds of staff, and most midsize and smaller firms  do not have the staff resources necessary to commit hundreds of  employees to a single client. As table 2 illustrates, the largest firms have  significantly more capacity, in terms of staff and partners than midsize and  smaller firms.
To approach the capacity of the largest firms, midsize and smaller firms  would have to grow substantially. The gap between the largest and midsize  firms is significant, however. Combined, the four midsize firms still have  over 2,600 fewer professional staff than the smallest of the largest firms,  KPMG. The midsize firms also have significantly fewer public company  clients. But midsize and smaller firms told us that obtaining additional  staff to expand their audit practices was difficult. Specifically, 58 percent  of midsize and smaller firms responding to our survey that want to audit  large public companies said that the ability to recruit and retain qualified  staff was a great or very great impediment to expansion. While the  representatives from the largest firms told us that they also faced this  challenge, one smaller firm representative said obtaining sufficient  numbers of staff was particularly difficult for smaller firms, which have  fewer resources (salaries and benefits) to use in competing for talent with  the largest firms, the public companies themselves, and others needing  public accountants. According to many market participants we  interviewed, the demand for qualified accountants has increased  significantly in recent years because accounting firms, including the  largest firms, need additional staff to conduct the audits of internal  controls required in section 404 of the Sarbanes-Oxley Act. Firms are not  only competing with each other for staff, but also with public companies  that need additional accounting staff to comply with certain requirements  of Sarbanes-Oxley. In addition, firms are competing with regulators who  need more staff to oversee the accounting profession. In the face of this  increased demand, hiring such staff has become more expensive.
Constraints on midsize and smaller firms’ geographic reach also reduced  the likelihood that the growth of these firms will reduce concentration in  the large company market. As table 2 shows, midsize and smaller firms  generally have fewer offices than the largest firms. Accounting firm  representatives also told us that these firms have a smaller presence in  foreign countries than the largest firms. According to our survey, 66  percent of large companies that would not consider using a midsize or  smaller firm said that these firms’ geographic presence was of great or  very great importance in explaining their unwillingness to do so. Large  multinational companies in particular need auditors that have a presence  in all of the countries in which they operate. While many midsize and  smaller firms partner with other independent firms to expand their  geographic reach, a few company officials we interviewed said that most  of the international networks these firms belong to are not extensive  enough to meet their companies’ needs. In addition, many market  participants we interviewed were concerned that the quality standards,  practices, and internal controls of these networks and affiliations might be  less uniform than those prevailing in the international networks of the  largest firms.
Accounting firm representatives we interviewed had mixed views on the  global capabilities of midsize and smaller firms. In spite of companies’  views on the importance of firms’ abilities to provide global services, only  one-third of midsize and smaller firms responding to our survey that want  to audit large public companies said that their firms’ international reach  was a great or very great impediment to expansion. For example, one  accounting firm official told us that midsize firms and affiliations had good  global capabilities and global operations. However, another accounting  firm official told us that the global networks used by midsize and smaller  firms needed to add standardized quality controls in order to improve.
section_title: Technical Capability and Industry Specialization
paragraphs: The technical capabilities and specialized industry knowledge of midsize  and smaller firms that want to enter the large public company market can  also limit these firms’ ability to enter this market and reduce its  concentration. According to our survey, 80 percent of large public  companies that would not consider using a midsize or smaller firm said  that such firms’ technical capabilities with accounting principles and  auditing standards was a great or very great reason why they would not do  so. One official from a large public company whom we interviewed said  that accounting firms’ technical capabilities differentiate the largest and  smaller firms and that smaller firms did not have the resources to keep up  with changing auditing standards and increasingly complex accounting  rules around the world. Other company officials we interviewed also said  that technical capabilities were an important reason why large and  complex companies do not use midsize and smaller firms.
Several representatives of smaller accounting firms also told us that their  firms had difficulty maintaining their technical capabilities. For example,  one representative of a smaller firm noted that his firm had less depth in  terms of technical expertise than larger firms especially when it came to  complex transactions. Other firms said that maintaining technical  expertise was time-consuming and costly. Two representatives of smaller  firms noted that keeping up with new standards and guidance from  multiple sources was also difficult, requiring the firms to revise guidance  for their staff as new standards were implemented or to purchase costly  prepared guidance materials from external sources. However, firms see  this as less of an issue than do their clients. Only 21 percent of accounting  firms responding to our survey that want to audit large companies said  that the complexity of accounting principles and auditing standards were a  great or very great impediment to expansion, compared to 80 percent of  clients.
In addition, having sufficient industry expertise can be challenging for  firms that want to audit large public companies. According to our survey,  67 percent of large public companies that would not consider using  midsize and smaller firms said that such firms’ industry specialization or  expertise was of great or very great importance in their unwillingness to  do so. Some large public companies told us that they needed this kind of  industry expertise in their auditor. For example, the audit committee  chairman for a large insurance company told us that when he chooses an  audit firm, industry expertise was the most important factor he  considered. He said that his company’s audit firm must have experience  with other companies in the insurance industry and doubted that midsize  or smaller firms could meet these requirements.
Several representatives of smaller accounting firms whom we interviewed  said that industry expertise was a significant barrier to auditing large  public companies. For instance, a representative of one smaller  accounting firm noted that before accepting a new client, her firm was  very careful to ensure that it has the right expertise to do the audit. She  said that since the firm’s expertise was in distribution and manufacturing,  the firm would not accept a financial institution client. An official from  another midsize firm told us that industry specialization was important  because audits were not commodities. Instead, these accounting firms  specialized in certain industries and had particular areas of expertise. This  emphasis on industry expertise can limit midsize and smaller firms’ ability  to expand their businesses to serve companies that operate in industries  outside of their specialty. However, only 17 percent of accounting firms  responding to our survey that want to audit large companies said that  specialized technical or industry expertise was a great or very great  impediment to expansion.
section_title: Accounting Firm Reputation
paragraphs: Another major barrier to midsize and smaller firms’ ability to obtain large  company clients is that these auditors do not have the reputations the  largest firms enjoy. According to our survey, 65 percent of large  companies that would not consider using a midsize or smaller firm said  that reputation or name recognition were great or very great reasons that  they were unwilling to do so. In addition, company officials told us that  they were confident that the largest firms could meet their companies’  audit needs because these auditors had well-established reputations for  quality. These officials were less familiar with the smaller firms’ work and  thus were uncertain about the ability of such a firm to adequately serve  their companies. Market participants told us that conducting due diligence  on unfamiliar firms was time-consuming, in part because information was  not readily available. Furthermore, although PCAOB has begun inspecting  accounting firms’ audit work, many market participants we interviewed  said that the information currently available from the PCAOB inspection  reports was not sufficient to judge a firm’s audit capabilities. For example,  some noted that part of the inspection results were not published,  inspection reports were not always timely, and PCAOB did not make an  overall judgment on a firm’s quality.
Companies are also responding to their perceptions of investors’  preferences when they choose one of the largest auditors. According to  our survey, 54 percent of large companies that would not consider using a  midsize or smaller firm said that the expectations or requirements of  shareholders, banks, lenders, or the underwriters that help the company  raise capital were of great or very great importance in their unwillingness  to do so. Institutional investors and investment banks often use a  company’s financial statements and audits as the starting point in an  investment decision and want to have confidence in the auditor that  reviewed the financial statements. Similarly, representatives from an  investment bank and an institutional investor told us that they preferred  auditors with established reputations because of a lack of familiarity with  capabilities of most midsize and smaller firms. One company official we  interviewed said that she did not know why a larger company would not  want to use one of the largest firms, given that these firms’ name  recognition provided underwriters with a certain comfort level. In  addition, investment bank representatives told us that they want  companies to use auditors with sufficient financial resources to withstand  a liability judgment against them. For example, if an investment deal  falters, the investment bank or underwriter may have to assume more of  the settlement costs if the audit firm cannot bear its share. Furthermore,  one investor told us that the largest firms’ greater financial resources  made them better able to survive a large client’s failure.
Midsize and smaller firms agree that name recognition and reputation pose  a challenge to entering the audit market for large companies. Fifty percent  of accounting firms responding to our survey that want to audit large  companies said that name recognition or reputation with potential clients  was a great or very great impediment to expansion. Similarly, 54 percent of  these firms cited name recognition or credibility with financial markets  and investment bankers as a great or very great impediment to expansion.  In addition, some accounting firm representatives we interviewed said that  midsize and smaller firms have had fewer opportunities to compete with  the largest firms for large companies’ business and do not have well- established reputations. However, one midsize firm representative noted  that reputation should become less of an impediment as more companies  moved from the largest firms to smaller firms and these firms’ work  became better known.
An analysis of data on firms that audit initial public offerings (IPOs)  illustrates investors’ preferences for the largest firms in certain situations.  While midsize and smaller firms’ combined share of the IPO market has  grown progressively, rising from 18 percent to 40 percent since 2003, the  largest firms have consistently audited the majority of IPOs (fig. 9). Staff  from some investment firms that underwrite stock issuances for public  companies told us that in the past they generally had expected the  companies for which they raised capital to use one of the largest firms for  IPOs but that now these organizations were more willing to accept smaller  audit firms. For example, an official from one investment firm told us that  the firm now generally accepted two of the midsize audit firms for IPOs or  securities issuances. However, as figure 9 shows, most of the companies  that went public with a midsize or smaller auditor were smaller. In  addition, these firms’ share of IPOs of larger companies (those with  revenues greater than $150 million) rose from none in 2003 to about 13  percent in 2007.
Midsize and smaller firms responding to our survey indicated that they had  had mixed experiences assisting clients with IPOs. All of the midsize firms  and 82 percent of smaller firms responding to our survey had assisted new  and existing clients with an IPO or subsequent securities issuance.  However, two of the four midsize firms, as well as 36 percent of the  smaller firms, reported losing clients that wanted another firm, often one  of the largest firms, to help them prepare for an IPO or subsequent  securities issuance.
section_title: Similar Challenges Affect Midsize and Smaller Accounting Firms in the Market for Small and Midsize Companies
paragraphs: Midsize and smaller accounting firms responding to our survey said that  they faced challenges even in competing in the market for smaller public  company audits. Our survey respondents in this market generally reported  that the challenges they faced were significant impediments to increasing  the number of public companies they served. As shown in figure 10, these  challenges, such as firms’ capacity, global reach, and technical capability  or expertise, are similar to those facing midsize and smaller firms that  want to audit large companies.
To increase their capacity and geographic reach, accounting firms need  the financial capital to hire new staff or acquire other audit firms, but  capital constraints and expansion costs pose an impediment to growth for  some midsize and smaller firms. While this constraint could affect firms of  all sizes, midsize and smaller firms have fewer partners from whom they  can obtain capital. Of the midsize and smaller firms responding to our  survey that focus on smaller companies, 65 percent said that the costs of  hiring and training additional staff were a great or very great impediment  to expansion. According to an accounting firm representative we  interviewed, some smaller firms can be constrained from raising capital to  expand their businesses because of the partnership structure, which  requires individual partners to pool their own assets or assume debt for  acquisitions and other growth activities, such as hiring new staff.  However, one midsize firm representative said that raising capital for  expansion was not an impediment for his firm.
Smaller firms responding to our survey also told us that complying with  the many different requirements individual states impose could hinder  their efforts to audit clients with operations in multiple states. Each of the  50 states and 5 U.S. territories have state boards of accountancy that have  sole authority for establishing licensing requirements for certified public  accountants in their jurisdictions. If a company’s business operations  extend across state lines, auditors may need to get temporary  certifications in each of the states where they will conduct audit work.  These requirements can range in complexity and cost among the several  states. Some firms we interviewed said that complying with multiple state  licensing requirements was difficult and often expensive. However, only 27  percent of midsize and smaller firms responding to our survey that focus  on smaller companies said that varied state licensing requirements were  great or very great impediments to expansion. Furthermore, some  representatives of accounting firms whom we interviewed said that  multiple state requirements did not stop them from competing for new  clients.
section_title: Smaller Audit Firms Are Taking Actions to Expand Their Market Share, but Challenges Remain
paragraphs: Many midsize and smaller firms have taken steps to reduce the challenges  that they face and have successfully expanded their share of the audit  market for small and midsize companies somewhat in recent years. In  some cases, these firms have expanded their audit practices in niches that  allow them to use their expertise, rather than attempting to serve clients in  new industries. Some midsize and smaller firms told us that, while having  staff with a certain type of expertise could be a barrier in trying to serve all  types of companies, it did not hinder them if they focused on a more select  set of industries. They said that this approach had allowed them to build  their reputations in specialty areas, which may enable them to acquire  progressively larger clients, and grow incrementally. Other firms told us  that they had expanded their practices through mergers and acquisitions,  adding new industry expertise, increasing their capacity, and extending  their geographic reach. Smaller firms that responded to our survey  generally viewed this approach as effective for increasing the number of  companies they audited, with 73 percent saying that it was at least  somewhat effective. Some representatives of midsize firms whom we  interviewed also said that acquisitions were an effective way to expand  into regions where they did not already have an office.
While funding for expanding midsize and smaller accounting firms  typically came from loans from financial institutions, merging with other  accounting firms, or the personal resources of the firm’s partners, a small  number of firms are using a different method of increasing their access to  capital. These firms have established alternative practice structures, in  which the firm engaged in attest services is closely aligned with another  organization that performs other nonaudit services. One example is where  owners of the accounting firm sell the nonaudit portion of their practice to  a new entity, which may be publicly or privately owned. The work the firm  previously conducted is then essentially divided into two separately  controlled entities, one of which conducts most of the firm’s nonaudit and  attest work, while the other conducts audits. Owners of the audit firm are  also employees of the nonaudit entity, and the audit firm generally leases  employees, office space, equipment, administrative support, and other  services from this entity. Audit firms gain additional access to capital from  the initial sale of the nonaudit entity or loans from the new entity that they  can use for acquisitions and other growth activities. However, some firms  with alternative practice structures told us that getting approval for their  organizations from some states was challenging and that they were subject  to additional scrutiny because their uncommon structure raised concerns  about independence. In addition, 63 percent of midsize and smaller firms  responding to our survey said that alternative practice structures would  only be slightly or not at all effective in helping them increase their market  share.
Finally, according to representatives of two accounting firm networks and  affiliations of independent firms, these organizations help midsize and  smaller firms deal with some of the challenges they face. As we have seen,  some midsize and smaller firms join these networks in order to extend  their geographic reach. In two cases that we reviewed, we found that the  structure of these organizations varies widely. One organization was  described as having a focused mission and high standards that member  firms must continuously meet, while a representative from another said  that the organization functioned primarily as a vehicle to share best  practices and refer business to other member firms. All midsize firms and  over 60 percent of smaller firms responding to our survey belonged to a  network or affiliation, generally to increase competitiveness with larger  firms and extend their national and international reach. One network  representative we spoke to told us that the network’s main benefit was its  ability to serve clients that were expanding, especially internationally, by  partnering with other firms in the network. In interviews, officials from  two smaller firms also told us that networks and affiliations provided  opportunities to serve new clients either by partnering with other firms or  through referral services.
Midsize and smaller firms that responded to our survey had mixed views  about the ability of these networks and affiliations to help increase their  market share. Some market participants thought that networks’ value  could be limited because, unlike the global networks of the largest firms,  the member firms of these networks and affiliations did not share a  common set of methodologies or internal controls. In general, the firms in  networks wanted to maintain their individuality in order to avoid being  held liable for another firm’s audit work. In addition, officials from two  smaller firms that are members of a network expressed concern that the  proposed independence standards of the International Federation of  Accountants—the global organization for the accounting profession that  develops international standards on ethics, auditing and assurance,  education, and public sector accounting standards—could present  additional challenges for networks because of the broad way that the  standards define networks. Officials with the International Federation of  Accountants told us that the standards were still under consideration and  that comments and concerns from accounting firms on this issue were still  under review.
While the practices discussed above have helped smaller accounting firms  to reduce some of the challenges they face, certain barriers are likely to  persist, particularly in the market for large company audits. While focusing  on niche markets can deepen a firm’s expertise, just as mergers,  acquisitions, and networks can increase firms’ capacity and geographic  reach, midsize and smaller firms are still much smaller than their large  firm competitors and have much less experience in the large company  audit market. Some market participants think that building up smaller  firms’ capacity, experience, and reputation to serve large companies is  likely to be a long-term process, thus their growth is unlikely to ease  concentration.
section_title: Proposals for Addressing Concentration and Increasing Market Share for Smaller Auditors Have Significant Disadvantages
paragraphs: Over the years, academics, industry groups, and other market participants  have offered a range of proposals that are intended to reduce the risks of  current and further concentration, or address the expansion challenges  facing midsize and smaller audit firms. We considered a number of these  proposals and found that, while each could offer certain benefits, each  proposal also presents at least some significant disadvantages, and market  participants generally saw these proposals as having limited effectiveness,  feasibility, and benefit. Since the current level of concentration does not  appear to be having significant adverse effect, and the proposals we  reviewed were generally not seen as effective in addressing the risks of  concentration or challenges facing smaller firms without serious  drawbacks, we found no compelling need to take action.
subsections: section_title: Proposals Others Have Made for Reducing the Risks of the Current Level of Concentration Involve Trade-offs
paragraphs: Several proposals have been offered to reduce the risks of the current  level of concentration, including mandatory audit firm rotation, audit firm  financial statement disclosure, and breaking up the largest firms into more  firms.
subsections: section_title: Mandatory Audit Firm Rotation
paragraphs: Some academic and industry sources have suggested that requiring public  companies to periodically change auditors could reduce the current level  of concentration. Such mandatory audit firm rotation would limit the  period of years that an accounting firm could serve as the auditor for a  particular public company. Our survey results show that companies often  retain their auditors for long periods of time. For example, according to  our survey results, approximately 40 percent of public companies had  used their current auditor for at least 5 years, and almost a quarter had  used their current auditor for at least 10 years. While generally proposed  as a means of enhancing auditor independence by periodically bringing in  a new auditor for a “fresh look” at a company’s financial statements,  mandatory rotation could potentially reduce concentration to the extent  that it provided more opportunities for midsize and smaller firms to  compete to provide audit services to public companies.
Although mandatory auditor rotation would increase opportunities to  compete, it would not increase the number of viable competitors, and  views on its effectiveness as a means of reducing concentration were  mixed. For example, 44 percent of midsize and smaller firms responding to  our survey stated that mandatory rotation would be at least a somewhat  effective way for their firms to gain more public company clients, and 52  percent of respondents thought that it would be only slightly or not at all  effective. One person we interviewed noted that mandatory rotation  might not be feasible, since some companies had very limited choices due  in part to the restrictions of independence requirements. Another market  participant noted that mandatory rotation would not necessarily reduce  concentration because large public companies would likely just rotate to  another one of the largest firms. In a 2003 report on the potential effects of  mandatory audit firm rotation, we found similar results. Based on surveys  we conducted for that report, 83 percent of accounting firms that audit 10  or more companies and 66 percent of Fortune 1000 public companies  stated that under mandatory auditor rotation, the market for public  company audits would either become more concentrated or remain about  the same. Further, more than half of accounting firms that audit 10 or  more companies felt that mandatory audit firm rotation would reduce the  number of firms willing and able to compete for public company audits.
In addition, market participants we spoke with raised other concerns  about mandatory audit firm rotation. Some said that mandatory rotation  would increase both audit firms’ and public companies’ costs. In our 2003  report, we found that many audit firms and large companies surveyed  believed that mandatory rotation would increase initial year audit-related  costs by more than 30 percent. For example, we reported that audit firms  could incur higher marketing costs as they increased efforts to acquire or  retain clients. With new auditors every few years, public companies also  would incur higher support costs for assisting the new audit firm in  understanding the companies’ operations, systems, and financial reporting  practices. Others expressed concern that new audit firms would need a  period of time to become fully familiar with a client’s operations. Lacking  knowledge, and the time that would be required to acquire it, could  increase the risk of an auditor not detecting financial reporting issues that  could materially affect the company’s financial statements.
Other recently implemented regulatory changes may have already  provided at least one of the benefits this proposal is designed to provide.  The Sarbanes-Oxley Act requires mandatory rotation of lead and reviewing  audit partners after they have provided audit services to a particular public  company for five consecutive years. Many market participants we  interviewed for our 2003 report suggested that this requirement, when  fully implemented, could achieve some of the independence benefits  related to a new auditor’s having a fresh look at a company’s financial  statements.
section_title: Audit Firm Financial Statement Disclosure
paragraphs: Another proposal that has been offered would require public company  auditors to provide financial information that could also be used to assess  the competitiveness of audit fee levels. Some market participants and  others advocate requiring accounting firms that audit public companies to  disclose detailed financial information, such as their own revenues and  profits. They have noted that providing this information could increase the  transparency of the market and help participants evaluate its profitability,  and the information could also help market regulators and others evaluate  whether firms were charging prices above competitive levels.
Jurisdictions outside the United States have begun requiring audit firms to  disclose some financial information, but the results have been unclear. In  the United Kingdom, audit firms are required to file financial information.  However, because U.K. accounting firms provide many services, some find  the consolidated financial statement to be of limited usefulness in  assessing the economics of the firms’ audit services. As a result, based on  the advice of a group of market participants, the U.K. Financial Reporting  Council recommended that audit firms disclose the financial results of  their work on statutory audits and directly related services, so that  “clearer and more comparable information on the profitability of audit  work” would be available. In addition, beginning in 2008, audit firms that  carry out statutory audits in the European Union are required to file  information on fees charged for audits and other services, as well as data  on the basis for partners’ compensation.
Most market participants we interviewed on this proposal did not believe  that requiring audit firms to publicly disclose their financial results would  be very effective in reducing the risk of anticompetitive pricing among the  largest accounting firms. Some market participants we spoke with  indicated that such financial statements would not provide useful  information for evaluating whether firms were charging fees above  competitive levels. Others familiar with the accounting profession have  commented that regulators already had the authority to request certain  financial information from firms if needed. Therefore, this proposal might  not have any direct effect on market competition.
section_title: Breaking Up the Largest Firms into More Firms
paragraphs: Some academics and former regulators have suggested that requiring one  or more of the largest firms to spin off a large portion of their operations  to create more than four firms with the capacity to audit large public  companies could ease current concentration. Breaking up the largest firms  would at least temporarily decrease concentration and mitigate the  adverse effect of one of the firms exiting the market or failing. Firms in  other markets have been split up in the past—for example, Standard Oil  and the American Tobacco Company in 1911; meatpacking firms in 1920;  and AT&T, which owned all regional operating telephone companies, in  1984. In some of these cases, some of the resulting companies merged in  later years after market or technological changes.
Market participants we spoke with expressed concerns about the potential  adverse effects of forcing the largest firms to divest themselves of some of  their operations. For example, several indicated that splitting the firms  could entail significant costs and diminish the economies of scale and  depth of expertise that currently allow the largest firms to audit large  public companies with complex technical needs and worldwide  operations. The result could be increased audit costs and decreased  quality of audits performed. In the public company survey we conducted  for our 2003 report on accounting firm consolidation we found that 79  percent of survey respondents opposed breaking up the largest firms.
Though a few we interviewed thought that this proposal would be  effective in reducing concentration, those we interviewed on this topic  generally agreed that it was not very feasible and that it could be  complicated, difficult, and costly. These adverse results seem especially  disruptive in the absence of compelling evidence that current levels of  concentration were causing harm.
section_title: Reducing the Impact or Risk of Litigation Could Prevent Further Concentration, but Proposals to Achieve This Goal Have Been Questioned
paragraphs: The risk of being sued appears to reduce some audit firms’ willingness to  seek out additional public company clients. We reported in 2003 that  litigation risk was a barrier for smaller firms seeking to audit larger public  companies because of the difficulty of managing this risk and of obtaining  affordable liability insurance. In the survey we conducted for this report,  over half (61 percent) of midsize and smaller audit firms reported that  liability/tort reform would be at least somewhat effective in helping them  increase their market share. Further, litigation could result in even more  market concentration if firms that were sued ultimately went out of  business. Several proposals have been made to reduce the potential for  litigation to cause further concentration in the market for audit services,  including placing caps on auditors’ liability and targeting enforcement  against responsible individuals, among others.
subsections: section_title: Liability Caps
paragraphs: A number of market participants and academics, and a recent report  commissioned by Senator Charles Schumer and New York City Mayor  Michael Bloomberg have recently advocated placing caps on auditors’  potential liability as a means of reducing the risk of litigation that could  lead to the loss of another large audit firm. Liability caps would limit the  overall amount that an audit firm would have to pay in connection with a  lawsuit involving the work it performed for one of its public company  clients. Some of the proposals have suggested caps that are fixed across  the entire market, while others would base caps on the fees the auditor  received or the client’s market capitalization. Some have argued that caps  would not only decrease litigation risk but would also increase the  availability of insurance. Both of these developments could reduce the risk  of a firm failing because of litigation. In addition, some believe liability  caps could also lead to increased efficiencies if audit firms could reduce  the amount of time they spent protecting themselves against lawsuits.
While some market participants thought that capping auditors’ liability  would be beneficial, others pointed out that such caps could have negative  effects and would not protect firms against all risks that could lead to  failure. Some of the former regulators and a representative of investors we  spoke with were concerned that having less potential liability would limit  the extent to which audit firms were held responsible for their work and  could lead to lower audit quality. Others were concerned that caps would  limit investors’ ability to recoup losses they incurred if an auditor was  found to have committed fraud. In addition, caps would not reduce the  risk that firms face from enforcement actions, which could also lead to  failure. Finally, a few questioned the fairness of capping liability for  auditors but not for others who faced similar risk, such as public  companies and investment banks.
section_title: Targeting Enforcement Actions against Responsible Individuals
paragraphs: As we have noted, audit firms could also fail as a result of a regulatory  enforcement action, increasing market concentration. Some market  participants have suggested that having regulatory or enforcement  agencies target their efforts against responsible partners rather than entire  organizations would reduce the risk that an audit firm might fail for this  reason. DOJ has the authority to take criminal enforcement action against  individuals, corporations, or partnership entities. For example, DOJ  indicted Arthur Andersen as a firm for obstruction of justice in 2002, but  also indicted four current or former Ernst & Young partners in 2007 for  alleged tax fraud conspiracy and other charges related to marketing tax  shelters. In 2005, DOJ indicted 19 individuals, including 16 former KPMG  partners, on charges related to marketing fraudulent tax shelters but  recently entered into a deferred prosecution agreement with the firm  itself. As part of the agreement, charges would not be brought against  KPMG as long as the firm followed the terms and conditions of the  agreement, which included agreeing to pay $456 million in fines,  restitution, and penalties. Advocates of targeting the responsible  individuals rather than the firm argue that DOJ should consider the  negative consequences for public companies of further consolidation  against the benefits of criminal indictment against a firm. DOJ guidance  states that prosecutors must consider, among other factors, whether an  indictment would cause “disproportionate harm” to employees who have  not been proven personally culpable and the effect of prosecution on the  public in determining whether to charge a firm. DOJ officials declined to  comment on whether they took the potential negative consequences of  firm failure into consideration when making decisions in the Ernst &  Young and KPMG cases or whether they would do so in similar cases in  the future.
section_title: Other Proposals to Reduce Auditors’ Liability for Alleged Wrongdoing
paragraphs: One proposal would seek to reduce the potential for further concentration  due to the loss of an audit firm by changing how auditors attest to the  fairness of financial statements. Officials from the six largest accounting  firms and proponents of this proposal stated in a paper on serving global  markets that what auditors could reasonably uncover in an audit was  limited. However, the attestation that auditors currently make states, “In  our opinion, the financial statements present fairly, in all material  respects, the financial position of the company … and the results of its  cash flows” which one commenter said fails to convey the uncertainty  associated with financial statements and audits. The accounting firm paper  on serving global markets states that, in the current environment,  company managers, investors, and others may have expectations for  audits that are too high—for example, that an auditor has detected all  possible fraud in a company’s financial statements. Thus, some propose  changing the format and wording of the auditor’s attestation to reflect the  varying certainty that an auditor can give to different parts of financial  statements. Some market participants we interviewed believed that  including more descriptive information in the attestation would be helpful,  while several others thought such a change would not make a difference in  firms’ liability risk and could make the attestation complex and confusing.
Another proposal, this one involving financial statement insurance, has  also been suggested as a means of reducing auditors’ litigation risk.  Instead of having companies appoint and pay for their own external  auditors, this proposal advocates creating financial statement insurance  that would be provided by insurance companies. This insurance would  provide coverage for investors in the public company against losses  suffered as a result of problems with the company’s published financial  statements. Insurance companies, to lower their risk of such losses, would  then appoint and pay audit firms to attest to the accuracy of the financial  statements. The auditors’ opinions would assist the insurance companies  in setting future premiums and coverage levels.
Such financial statement insurance may be a way of lowering the risk of  the loss of another large audit firm because auditors would be agents of  the insurance companies. Depending on how relevant laws regulating  financial statement insurance were structured, proponents note that  liability would generally be shifted to insurers and away from auditors.  Further, because each policy would be tailored to a particular audit  engagement, one proponent has argued that more insurance than is  currently available would be available under this proposal, although some  risky companies may not be able to obtain it. However, most of the market  participants we discussed this proposal with did not favor it, citing the  significant changes it would make to the current audit function and federal  securities laws and the fact that insurance companies themselves might  not be interested in insuring financial statements in this way or qualified to  do so.
section_title: Proposed Actions to Help Reduce the Challenges Facing Smaller Firms Would Offer Limited Benefits
paragraphs: Various entities have made proposals intended to help smaller firms  expand their share of the audit market for public companies. These  include allowing outside ownership, creating a shared experts office,  standardizing licensing and registration standards, and establishing an  accounting firm accreditation program.
subsections: section_title: Outside Ownership of Accounting Firms
paragraphs: Some market participants have suggested that allowing parties other than  the firm’s partners to own or invest in audit firms could increase these  firms’ financial resources and allow them to hire the additional staff  needed to serve larger companies. According to AICPA, under all states’  laws, certified public accountants (CPAs) must make up the majority  ownership of all accounting firms, and other owners must be active  participants in the firms. These requirements were intended to preserve  audit quality by ensuring auditor independence according to one market  participant and an industry report.
Market participants pointed out the potential negative effects of allowing  outside ownership of accounting firms, and most of the accounting firms  responding to our survey agreed that being able to raise capital from such  sources would have little if any effect on their ability to expand their  market share. Opponents of extending outside ownership argue that,  without CPAs as majority owners, external shareholders might make  business decisions in a firm’s economic interests that compromise its  independence for purposes of performing audits. One report  recommending consideration of changing outside ownership rules  indicated that appropriate safeguards would be needed to ensure  independence and audit quality. Several of the midsize and smaller firms  we interviewed said that access to capital did not pose a significant  impediment to expansion, because firms currently raised sufficient capital  through traditional channels such as loans backed by the partnership and,  in some cases, alternative practice structures. In fact, 61 percent of  midsize and smaller firm survey respondents said that increasing their  access to capital would be only slightly effective or not at all effective in  helping them increase the number of audit clients they served. Firms told  us that the shortage of qualified accountants in the labor market rather  than limited access to capital was their primary impediment to growth.
section_title: Shared Experts Office
paragraphs: Creating a shared entity staffed with accounting experts with specialized  technical and industry expertise to supplement smaller firms’ technical  capabilities for performing public company audits could provide midsize  and smaller firms with advice on accounting standards and audit  procedures. A shared experts office could be similar in concept to the  “national offices” maintained by larger firms to provide advice to their  staff auditors on complex and emerging issues. According to some market  participants, smaller audit firms can currently obtain assistance through  various technical support services offered by FASB, AICPA, SEC, and  networks or affiliations they may be a member of. But some market  participants told us that services such as those the SEC provides were not  heavily used, either because auditors and companies feared reprisals if  they alerted regulators to potential problems they might be facing or  because they did not expect a timely response.
Market participants we interviewed noted that creating a shared experts  office that many firms could use would have various advantages and  disadvantages. Several market participants said a shared experts office  that provided comprehensive support and guidance on complex  accounting and auditing issues could be effective, especially if it were  established within an appropriate organization. However, most did not  think that establishing such an office would be feasible. Some market  participants that we interviewed said that a shared office’s effectiveness  would be limited. For instance, one participant noted that a shared experts  office would lack the “tone at the top” that a firm’s national office  provides. Others noted that staff at an external office could find it difficult  to obtain all the needed facts from firms in order to make an accurate  determination. Also, market participants said that the shortage of  individuals with the required expertise could make establishing an  external office challenging. Finally, some market participants said that  such an office would face challenges because it could face legal liability if  its staff gave out erroneous guidance that resulted in criminal or civil  litigation. Furthermore, other organizations such as AICPA have  considered establishing similar offices in the past but did not because they  could not identify ways to overcome these challenges.
Finally, midsize and smaller firms responding to our survey had mixed  views on the effectiveness of this proposal as a means of expanding the  number of public companies they could audit. Only 8 percent of midsize  and smaller firms said that having access to specialized technical and  industry expertise would be very effective in helping them expand their  public company client base, and 55 percent said that it would be  somewhat or moderately effective.
section_title: Uniform Licensing and Registration Standards
paragraphs: Easing restrictions that hindered their ability to operate in multiple states  could potentially increase the ability of smaller accounting firms to serve  more public company clients. Many accounting firm officials and industry  groups have said that differences in auditor licensing and registration  standards across states are costly and make operating in multiple  jurisdictions burdensome. AICPA and the National Association of State  Boards of Accountancy (NASBA) have developed the Uniform  Accountancy Act, a suggested model for state legislation that was recently  amended to provide a comprehensive system under which CPAs would  have mobility to practice in more than one state with minimal barriers.  However, each state will have to implement these changes identically to  create the uniform system, and some market participants we interviewed  said that states are unlikely to do so. The AICPA is working with NASBA  and the state boards of accountancy to develop uniform legislation and  accountancy rules in each state to eliminate some of the barriers that exist  for CPAs who perform work across state lines. If the current initiative is  successful, the regulatory burdens associated with licensing will be  significantly improved. However, such a system is not likely to help reduce  concentration because some firms we interviewed said that although  complying with varying state standards was challenging, it did not prevent  them from competing for new clients or entering new markets.
section_title: Accounting Firm Accreditation
paragraphs: Finally, providing more information about the capabilities of midsize and  smaller firms could make public companies more aware of lesser-known  firms and potentially increase these companies’ willingness to consider  additional firms as their auditor. Some market participants have suggested  that establishing an accounting firm accreditation program would help  establish midsize and smaller firms’ reputations by providing companies  and investors with additional information about their audit capabilities. An  accreditation program could be similar to the programs used for colleges  and universities, which use nationally recognized accrediting agencies to  determine whether institutions meet established standards and thus  acceptable levels of quality. Accounting firm accreditation, whether  carried out by a government agency or approved private organization,  could use a similar approach to certify firms as being able to audit certain  types of companies.
Company officials and other market participants told us that having  additional information about unfamiliar firms could be beneficial. For  example, investors told us they tended to prefer firms with well- established reputations and that conducting due diligence on the unknown  firms’ qualifications required extra work. Several other market  participants thought that providing additional information about firms  through an accreditation program could be at least a moderately effective  and feasible way to establish firms’ reputations. One accounting firm  official thought that having a credible organization endorsing firms as  qualified to conduct audits for companies of certain sizes would help  companies make informed decisions and increase their choices of  auditors.
However, other market participants raised concerns about the costs and  burden that accreditation would impose on firms. For example, according  to Department of Education guidelines universities have to complete an in- depth self-evaluation that measures their performance against the  established standards and undergo on-site evaluations in order to earn  accreditation. Following accreditation, the accrediting body monitors and  periodically reevaluates the universities’ accreditation status. Some  participants thought that the burden of this process could outweigh any  benefits.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Chairman of the SEC, the  Chairman of the PCAOB, DOJ, and the Department of the Treasury for  their review and comment. We received technical comments from SEC,  PCAOB, and DOJ that were incorporated where appropriate. Treasury had  no comments.
We are sending copies of this report to interested congressional  committees and subcommittees; the Chairman, SEC; the Chairman,  PCAOB; DOJ; and Treasury. We will also make copies available to others  on request. In addition, the report will be available at no charge on the  GAO Web site at http://www.gao.gov.
If you have any questions concerning this report, please contact Orice M.  Williams at (202) 512-8678 or williamso@gao.gov, Jeanette M. Franzel at  (202) 512-9471 or franzelj@gao.gov, or Thomas J. McCool at (202) 512-2642  or mccoolt@gao.gov. Contact points for our Offices of Congressional  Relations and Public Affairs may be found on the last page of this report.  See appendix VI for a list of other staff who contributed to the report.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This work was conducted under the Comptroller General’s authority. Our  objectives were to study (1) the level of concentration among the market  for public company audits and the impact of this concentration, (2) the  potential for increased capacity among midsize and smaller accounting  firms to ease market concentration, and (3) proposals that have been  offered by others for easing concentration in the market for public  company audits and the barriers facing midsize and smaller firms in  expanding their market share for public company audits.
We conducted this performance audit in New York City and Washington,  D.C., from October 2006 to January 2008 in accordance with generally  accepted government auditing standards. Those standards require that we  plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives.
To determine the level of concentration among the market for public  company audits and its effect we collected data and calculated our own  descriptive statistics for analysis. Using audit market data from various  sources, we analyzed auditor changes and changes in audit fees, computed  concentration ratios and Hirschman-Herfindahl indexes, and conducted  trend analyses. We also developed and employed an econometric model to  analyze the relationship between concentration and fees. Appendix V  contains more details about this model. To augment these data, we  interviewed academics, private consultants, trade associations, accounting  firms, public companies, and Securities and Exchange Commission (SEC)  and Public Company Accounting Oversight Board (PCAOB) officials. We  also reviewed relevant academic literature. Most of the research studies  citied in this report have been published in academic journals. These  studies were also reviewed by our economists, who determined that they  did not raise serious methodological concerns and were reliable for our  limited purpose. However, the inclusion of these studies is purely for  research purposes and does not imply that we deem them definitive.  Finally, we surveyed public companies and accounting firms about their  views on these topics. Our work did not include evaluating the quality or  viability of the accounting firms that perform public company audits.
To determine the potential for the growth of midsize and smaller firms to  affect concentration in the market for public company audits we reviewed  relevant literature and included questions on this topic in our survey of  public companies and accounting firms. In addition, we obtained data on  the auditors chosen by initial public offerings (IPO) from SEC filings and  analyzed this data. We also analyzed data related to the size of the largest,  midsize, and smaller firms. We assessed the reliability of this data and  found that it was reasonably sufficient for our purposes. We also  interviewed representatives of accounting firms, public companies,  investment banks, institutional investors, venture capital firms, and trade  associations.
To determine what proposals have been offered to address further  concentration and the challenges midsize and smaller firms face we  reviewed academic literature, as well as government and industry papers,  and interviewed representatives of accounting firms, public companies,  and other industry participants. We obtained information about the  effectiveness, feasibility, and overall benefit of these proposals through  our survey results and individual and group interviews with  representatives from accounting firms, public companies, investment  banks, institutional investors, academics, insurance companies, and  former SEC officials. We also met with officials from SEC, PCAOB, and  the Department of Justice (DOJ) to obtain their views on the advantages  and disadvantages of these proposals. We obtained much of this  information at a roundtable discussion we held on July 10, 2007, that  involved 18 market participants from across all the sectors mentioned  above. The overall objectives of the roundtable were to provide an  opportunity for the participants from different sectors and viewpoints to  engage in an in depth discussion of the significance of concentration in the  market, challenges facing midsize and smaller firms, and the strengths and  weaknesses of proposals previously identified, as well as to identify  additional proposals. To encourage open and candid input from the  various parties, we agreed not to attribute any input from either our  general data collection effort or the roundtable to specific organizations or  individuals.
subsections: section_title: Data Analysis
paragraphs: To address the structure of the audit market we computed concentration  ratios and Hirschman-Herfindahl indexes (HHI) for 2000 to 2006 using  Audit Analytics, an online market intelligence service maintained by Ives  Group, Incorporated. Audit Analytics provides, among other things, a  database of audit fees by company since 2000, along with demographic  and financial information. We also used the Audit Analytics database to  analyze changes in the audit fees companies have paid by various size  categories. Audit Analytics also provides a comprehensive listing of all  reported auditor changes that includes data on the date of change,  departing auditor, engaged auditor, nature of the change (dismissal or  resignation), any going concern flags or other accounting issues, and any  fee disputes or fee reductions. Using this database, we identified 5,867  auditor changes from January 2003 through June 30, 2007. For our  econometric model we also used data on audit opinions (going concern  opinions), restatements, 404 compliance (internal control), and late filers  that were also maintained by Ives Group in the Audit Analytics database.  We used Public Accounting Report (PAR) and other sources for the  remaining trend and descriptive analyses, including the analyses of the top  and lower sizes of accounting firms, contained in the report.
In addition to reviewing the data collection methods and management  controls over these databases that we conducted for a previous report, we  assessed the reliability of the current data in other ways. We performed  several checks to verify the reliability of the Audit Analytics databases. For  example, we crosschecked random samples from each of the Audit  Analytics databases with SEC proxy and annual filings and other publicly  available information. Additionally, we compared our HHI calculations  based on Audit Analytics data to HHI calculations based on the Who  Audits America database, a directory of public companies with detailed  information for each company, including the auditor of record, maintained  by Spencer Phelps of Data Financial Press. We also spoke with other users  of the Audit Analytics data. While we determined that these data were  sufficiently reliable for the purpose of presenting trends in audit fees and  auditor changes, as we have previously reported, the descriptive statistics  on audit fees contained in the report should be viewed in light of a number  of data challenges. First, the Audit Analytics audit fee database does not  include fees for companies that did not disclose audit fees paid to their  independent auditor in an SEC filing. Second, some companies included  in the database—especially small companies—did not report complete  financial data. We handled missing data by dropping companies with  incomplete financial data from any analysis involving the use of such data.  As a result, we are not dealing with the entire population included in the  Audit Analytics database but rather with a large subset. Because of these  issues, the results should be viewed as estimates of audit fees and market  concentration based on a large sample rather than precise estimates based  on the entire population. Moreover, the sample we used to produce the  estimates throughout the report does not include funds, trusts,  nonoperating companies, or subsidiaries of another public company.
For a previous report we performed similar, albeit more limited, tests on  PAR data, and concluded that they were appropriate for its use in this  report. However, these data are self-reported by the accounting firms,  which are not subject to the same reporting and financial disclosure  requirements as SEC registrants. Moreover, while the data are suitable for  comparing the largest firms to midsize and smaller firms, caution should  be used in comparing midsize and smaller firms to each other.
To assess the market for new publicly traded companies we obtained data  using SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR)  system, a database that includes information on registered companies’  initial public offering (IPO) in the United States. SEC’s EDGAR database is  the primary source for information on IPOs since all companies issuing  securities that list on the major exchanges, OTC Bulletin Board (OTCBB),  as well as those that meet certain criteria for listing on the Pink Sheets,  must register securities with the SEC. In a previous report, we  crosschecked these data with NASDAQ data on NASDAQ IPOs for  consistency. For our analysis of size of the companies going public and  their auditor of record, we dropped companies from our analysis that were  missing the requisite revenue data in the database. We looked at a sample  of these companies and concluded that companies dropped from our  sample are largely companies that used either pro forma or partial year  revenues in their preliminary filings, or were funds, trusts or banks. While  funds and trust have been eliminated in our empirical work in this report,  some publicly traded banks have also been excluded in our analysis of  IPOs by size. As dropping these companies still left a large sample from  which we computed the descriptive statistics contained in our report, this  data limitation is minor in the context of this report.
section_title: Survey Data
paragraphs: To augment our empirical analysis, we conducted two confidential surveys  to obtain information from accounting firms and their public company  clients. First, we surveyed a random sample of 595 publicly held  companies. We created this population from the Audit Analytics database.  Our initial population included over 6,900 U.S.-based public companies  that traded on major exchanges (NYSE, NASDAQ, AMEX, OTCBB),  excluding foreign filers, funds and trusts, and benefit plans. Our sample  was allocated across six strata: (1) large companies (Fortune 1000) that  had changed auditors since 2003, (2) medium-size companies (greater than  $75 million in market capitalization, but not Fortune 1000) that had  changed auditors since 2003, (3) small companies (less than $75 million in  market capitalization) that had changed auditors since 2003, (4) large  companies that had not changed auditors since 2003, (5) medium-size  companies that had not changed auditors since 2003, and (6) small  companies that had not changed auditors since 2003. The survey included  questions related to companies’ audit services and the selection and  engagement of the company’s auditor. To develop the questionnaire, we  consulted with individuals knowledgeable about the accounting  profession, including representatives of Financial Executives International  and public companies. We also pretested our questionnaire with three  public companies of different sizes and industries. We directed our survey  to the audit committee chair—or other member of the audit committee— where available. We obtained names and addresses for audit committee  members from Audit Analytics. If no audit committee information was  available, we conducted additional research and identified a member of  the company’s management, typically the chief financial officer, as the  recipient of the questionnaire.
We mailed paper questionnaires on May 22, 2007. Those companies not  completing the questionnaire were sent a replacement questionnaire and  another reminder letter in June and July. On June 12 and 13, we also made  phone calls to the corporate headquarters of 210 companies whose audit  committee chair or other selected informant had not responded in an  attempt to reach that person to encourage response. After excluding 29  sampled companies that we found to be ineligible for the population, we  received 406 usable responses as of August 15, 2007 from the final sample  of 566 companies, for an overall response rate of 73 percent (table 3).  Again, the number of responses to individual questions may fluctuate,  depending on how many respondents answered each question.
The public company survey results came from a random sample drawn  from our population of U.S. publicly traded companies and, thus, could be  weighted to statistically represent that larger group. We weighted our  sample to adjust for nonresponse by company size. In our analysis, we did  detect a small amount of nonresponse bias among small public companies  traded over the counter. We analyzed the result of this nonresponse on  selected estimates. We concluded that the nonresponse did not affect our  findings or conclusions. Unless otherwise noted, the margin of error for  public company survey results used in the report was less than 12  percentage points.
Second, we surveyed representatives of a take-all sample of the entire  population—437 midsize and smaller U.S. accounting firms that audited at  least one public company in 2006 (as identified by information in the Audit  Analytics database) and were also registered with PCAOB. Each of the  midsize firms operates nationally and to some extent internationally,  audits more than 100 public companies, and has around $1 billion in  revenue or less. The smaller firms audit regional and local public  companies and have fewer than 100 public company clients. We used the  survey to obtain firms’ views on their plans regarding engagements with  public companies, participation in associations, competition, audit costs  and quality, and related issues. We obtained name and address information  for the executives to be contacted from registration applications filed with  PCAOB. To develop our questionnaire, we consulted a number of experts  knowledgeable about the accounting profession, including representatives  of PCAOB. We also pretested our questionnaire with one of the four  largest firms, a midsize firm, and two smaller firms.
We began our Web-based survey on May 16, 2007, and included all usable  responses as of August 15, 2007 to produce this report. After we removed  three firms found to be ineligible for the survey (merged out of existence,  or without at least one publicly held U.S. client), the final eligible  population we surveyed was 434 firms. See table 4 for the final disposition  of our sample, including the subset of firms with five or more publicly held  clients that we chose to report statistics for in this product.
Those firms not completing the questionnaire were sent up to four emails  starting on June 1, 2007, and a sample of firms not responding were called  to attempt to gain their participation on June 13 and 14. A paper version of  the questionnaire was provided upon request, and firms could respond  using this questionnaire by fax or mail.
We received 251 usable responses from these 434 firms, for an overall  response rate of 58 percent. However, the number of responses to  individual questions may be fewer than 251, depending on how many  responding firms were eligible or chose to answer a particular question. In  addition, we determined during our pretests that many of the survey  questions were irrelevant for the largest firms, so we administered  selected survey questions orally to representatives of each of the largest  firms and conducted indepth individual interviews with representatives of  each of these firms. That information is reported separately from the firm  survey results.
While the accounting firm survey results came from a census of the  population, we limited our analysis in this report to the 118 responding  firms with 5 or more publicly held clients because the response rate of  firms with only 1-4 clients was significantly lower (53 percent) than for the  larger firms (65 percent). Our analysis suggested that those small firms  responding were different from those that did not, in terms of geography  and number of clients. We were concerned that some small firms did not  respond because the prospect of more auditing work for publicly held  clients did not appeal to them and, thus, they found the survey request  irrelevant. The small firms that responded could have answered the survey  questions differently than the nonresponding small firms would have. As a  result, reporting percentages based on responding small firms with one to  four clients could introduce bias into results if those results were  generalized to all accounting firms that audited at least one publicly traded  company.
In addition to potential nonresponse bias, there are other practical  difficulties in conducting any survey that may contribute to errors in  survey results. For example, differences in how a question is interpreted  or the sources of information available to respondents can introduce  unwanted variability into the survey results. We included steps in both the  data collection and data analysis stages to minimize such errors. In  addition to the questionnaire testing and development measures  mentioned above, we followed up with the firms and clients with letters, e- mails, and telephone calls to encourage them to respond and offer  assistance. Before the surveys began, we mailed notification letters to both  survey samples, encouraging them to respond and asking them to correct  improper contact information. We also checked and edited the survey data  and programs used to produce our survey results. In addition to the survey  statistics cited in this report, all survey questions and the frequencies of  responses to each question are presented in a supplemental product that  can be found on our Web site at http://www.gao.gov/cgi-bin/getrpt?GAO- 08-164SP.
section_title: Appendix II: Other Issues Related to Concentration in the Audit Market
paragraphs: Although having eased slightly recently, the overall market for public  company audits continues to be highly concentrated among the largest  accounting firms. In assessing the degree of concentration in a market, the  standard practice uses the proportion of each competing firm’s share of  the overall revenue collected. By analyzing data from Audit Analytics,  which collects audit information from the filings public companies submit  to the Securities and Exchange Commission (SEC), we found that the  overall extent to which the largest firms dominate the amount of total  audit fees collected continues to be very high. As shown in table 5, 94  percent of the total amount of audit fees paid by public companies went to  the largest firms in 2006. This is slightly lower than the 96 percent of audit  fees the largest firms earned in 2002. As a result, the general market can  still be characterized as a tight oligopoly, which is a market dominated by  a small number of sellers with the risk that these firms could greatly  influence price and other market factors.
The largest firms are significantly larger than their nearest competitors.  According to data from the Public Accounting Report, which collects self- reported financial information from accounting firms, the combined audit  revenue of the four midsize firms is slightly less than one-half the audit  revenue of the smallest of the largest firms. Similarly, as shown in figure  11, the market share as measured by audit fees of each of the largest firms  individually is much larger than the market share of the other groups  combined.
subsections: section_title: Overall Audit Market and Many Specific Industries Are Highly Concentrated
paragraphs: Another key statistical measure that is used to assess the degree to which  a market is dominated by relatively few firms also shows that the public  company audit market is highly concentrated. The Hirschman-Herfindahl  Index (HHI) is one of the concentration measures used by government  agencies, such as DOJ and the Federal Trade Commission, to aid in the  assessment of market structure and potential market power. An HHI for a  market is calculated using the various market shares of the firms  competing to offer goods or services within it. According to merger  guidelines issued by DOJ, an HHI below 1,000 indicates a market that is  predisposed to perform competitively and one that is unlikely to have  adverse competitive effects. An HHI between 1,000 and 1,800 indicates a  moderately concentrated market, while an HHI above 1,800 indicates a  highly concentrated market.
As shown in figure 12, the HHI in 2006 for the overall market for public  company audits—as determined based on the audit fees collected by  accounting firms auditing public companies—was 2,300, a level  considered to be significantly concentrated. This represents a slight  decline since 2002, when the audit market’s HHI was around 2,390 after it  peaked following the dissolution of Arthur Andersen.
We also found that analyzing the audit market by region and industry  reveals that many industries were similarly highly concentrated and that  concentration also exists across six major geographic regions of the  country. We segmented the market into distinct economic sector  (industry) audits and distinct regional audits. As figure 13 illustrates, all  industries are above the threshold for significant market power and have  generally shown some improvement since 2002, but some sectors are  significantly more concentrated than others. A number of these industry- specific markets would not only be considered tight oligopolies but would  also be considered dominant firm markets (one firm holding over 60  percent of the market with no significant competitors). For example, Ernst  & Young accounts for 77 percent of all audit fees collected in the  agricultural sector while, the second largest firm only holds 12 percent of  the market.
Similarly, we found regional markets in the United States such the Mid- Atlantic and the Midwest to be somewhat more concentrated than the  Western regions, although all were highly concentrated.
section_title: Loss of One of the Largest Firms Would Result in Even Higher Concentration
paragraphs: In the event of further mergers, acquisitions, or closures of large firms, the  market would become even more concentrated. To determine the effect of  further concentration, we simulated the effect of the failure or exit of one  of the largest firms and the effect of a merger between two of the largest  firms. When simulating the effect of the failure or exit of the smallest of  the largest firms, we distributed the clients of the failed firm among the  remaining firms in the same proportion as the clients of Arthur Andersen  were distributed after that firm dissolved. Under this scenario, the  resulting HHI of the overall audit market would rise from 2,300 to roughly  3,000 which is considerably further above what DOJ considers to be a  concentrated market (fig. 14). Further, figure 14 shows that if we segment  the audit market by size, that the increase in HHI would be greatest among  large companies. Higher concentration could increase the risk that the  remaining large accounting firms could exercise market power to raise  prices and coordinate their actions among themselves to the detriment of  their clients.
The figure also shows that a merger between two of the largest firms could  significantly increase concentration for the overall audit market. To  identify the result of such a merger, we simulated the effect of a merger  between the two smallest of the largest firms and found that HHI for the  market as a whole would increase from 2,300 to 3,124, which is again well  above DOJ’s threshold for a concentrated market and higher than in the  case of a firm failure. As with the case of a firm failure, segmenting the  audit market by size illustrates the biggest increase in HHI would occur in  the market for large public company audits, which according to our  simulation would rise from 2,558 to 3,476 (fig. 14).
section_title: Appendix III: Analysis of Auditor Changes
paragraphs: In the last few years, companies that changed their auditor switched to a  midsize or smaller accounting firm more frequently than to one of the  largest firms. We analyzed data from the Audit Analytics database of over  8,000 auditor changes among companies registered with the Securities and  Exchange Commission (SEC) and listed on major exchanges (NYSE,  NASDAQ and AMEX), as well as those traded through other exchanges  such as OTCBB. Through this analysis, we identified 5,867 total changes in  auditors between January 2003 and June 2007. As shown in table 6, the  largest firms lost a net total of 1,149 clients, while the midsize and smaller  firms picked up a net total of 282 and 867 clients, respectively.
Table 6 also shows that while midsize and smaller firms gained a larger  number of clients, the largest firms still retained the clients that, on  average, have higher revenues and pay larger audit fees than the  companies that switched to a midsize or smaller firm. Therefore, despite  the largest firms experiencing a net loss of over one thousand clients, most  of these were smaller companies with lower revenues and audit fees.  Companies that changed from one of the largest firms to another had  average revenues of over $1 billion, while companies that changed from  one of the largest firms to a smaller firm had average revenues of just over  $60 million.
Within these changes, we also found that midsize firms gained clients in  particular regions and industries. Overall, as shown in table 7, the largest  firms lost clients in every region of the United States (Mid-Atlantic, New  England, Southeast, Midwest, Southwest, and West). In contrast, the  midsize firms experienced net gains in clients in all of these regions,  especially in the Midwest where they acquired 27 percent of the  companies that changed auditors. Smaller firms also added clients in all  regions, most notably in the West, where 329 additional companies  selected them to serve as the auditor of record. This represents 82 percent  of the changes made in that region. Incidentally, the Western region is also  the area in which the largest firms suffered their worst losses and the  midsize firms generally experienced their weakest gains.
Our analysis of companies that ultimately selected one of the largest firms  or a midsize firm shows that midsize firms have made inroads into certain  industry sectors. In sectors in which there were at least 30 changes, Grant  Thornton captured more than 20 percent of the companies that switched  in mining; certain manufacturing; wholesale trade; information;  professional, scientific, and technical services; and accommodation and  food services. BDO Seidman also secured over 20 percent of the changes  in six sectors with at least 30 changes: certain manufacturing; wholesale  trade; information; professional, scientific, and technical services;  management of companies and enterprises; and administrative, support,  and waste management and remediation services. Finally, Crowe Chizek  was the only firm in the top eight to engage more than 20 percent of the  finance and insurance companies that switched to one of the largest firms  or a midsize firm.
Companies reported a number of different reasons for changing auditors.  According to our survey results, large companies that recently changed  auditors frequently reported that they did so to obtain better customer  service (69 percent). Many large companies also reported changing  auditors to obtain a better working relationship with their auditor (67  percent). Others said they changed auditors to obtain lower fees (26  percent).
In interviews, representatives of public companies, accounting firms, and  other market participants attributed many of the midsize and small  company auditor changes to the aftermath of the Sarbanes-Oxley Act,  which, among other things, enhanced auditor independence and required  increased reviews of public companies’ internal controls (which initially  affected larger public companies) and prompted the largest firms to focus  on providing those services to their large clients. This increased workload  increased the largest firms’ costs and fees and necessitated that some  smaller public companies expand their options and look to midsize or  smaller firms. Officials from two of the largest firms told us that they did  make changes to their client portfolios in the period after Sarbanes-Oxley  was passed, including resigning as auditor of record from some clients for  risk or capacity constraint reasons. On our survey of the over 400 U.S.  accounting firms that audit public companies, midsize and smaller  accounting firms responding also reported resigning as auditor of record  for risk mitigation reasons, specific issues with the client, or fees being  insufficient to cover audit costs. Midsize and small companies that  recently changed auditors indicated on our survey that they did so to  obtain better customer service, a better working relationship with their  auditor, lower fees or because their auditor resigned. In addition, some  companies commented that they changed because their auditor was too  busy and expensive for them or because their auditor wanted to focus on  larger clients. A few reported, however, that they changed auditors  because the auditor went out of business or merged with another firm.
section_title: Appendix IV: Trends in Audit Costs and Quality
paragraphs: Various factors likely affected changes in audit fees and audit quality since  the demise of Enron and Arthur Andersen. According to our data analysis,  survey, and interviews, audit costs and quality seem to have increased in  recent years. Additional work associated with new and increasingly  complex accounting and auditing standards, cost increases associated  with auditor changes and with acquiring and retaining audit staff, new  costs associated with regulatory oversight of public company audits and  other requirements of the Sarbanes-Oxley Act (the Act), and some firms’  recovering more of their costs have likely contributed to increases in audit  fees. Similarly, while many of these factors have been cited as reasons for  why it has been increasingly hard for accounting firms to maintain audit  quality, market participants generally agreed that these changes have  contributed to improved audit quality.
subsections: section_title: Factors Influencing Audit Costs
paragraphs: To varying degrees, different factors likely contributed to increased audit  fees since 2001 including firms’ performing additional audit work, higher  costs commonly associated with auditor changes and with acquiring and  retaining audit staff, increases associated with the new public company  audit oversight structure and auditors expanded interaction with audit  committees, and firms’ recovering more of their costs through audit fees.  Many market participants have noted that the number and complexity of  requirements associated with accounting and auditing standards have  contributed to firms performing new and additional procedures to help  comply with the new requirements and reduce audit and litigation risk.  Since 2000, public companies and their auditor have, where applicable,  had to deal with new and expanded accounting standards dealing with  hedge activities, derivatives, other financial instruments, impaired assets,  and intangible assets including goodwill. In addition, firms have had to  deal with new and expanded audit standards related to fraud, audit  documentation, and fair value measurements and disclosures.
In response to the demise of Arthur Andersen in 2002, more than 1,000 of  its public company audit clients had to find new audit firms. In addition, as  firms and public companies adjust to market-related changes following the  2002 Sarbanes-Oxley Act, auditor change has continued. Our analysis of  auditor changes found that between 2003 and 2007 almost 6,000 auditor  changes occurred. Echoing our 2003 study of audit firm rotation, some  market participants we spoke to said that changing auditors would  increase public company audit-related costs. As part of our 2003 study of  audit firm rotation, we surveyed large (Fortune 1000) public companies  and firms that audited more than 10 public companies and more than 67  percent of companies and firms responded that a change in auditor would  likely increase firms’ initial year audit costs and public company audit  support costs—taken together—by more than 30 percent. In addition,  accounting firms we have spoken to and surveyed cited increased costs of  attracting and retaining talented audit staff and specialists. Many of those  commenting on this factor linked the higher costs of attracting and  retaining talented staff to the increased capacity-related demands facing  the firms associated with implementing the Act.
Also, the Act established a new major audit requirement that has  significantly expanded the scope of financial audits for public companies  by requiring, among other things, that their auditor assess and report on  the effectiveness of their internal control over financial reporting (Section  404b). Representatives from all sizes of accounting firms we spoke to said  that the new audit requirement related to internal controls, which  generally became effective for the 2004 audits of the largest public  companies, has resulted in a substantial increase in their workload and  related costs associated with additional audit staff and expertise, and audit  methodologies. Until 2008, auditors for only the largest public companies,  those considered to be accelerated filers, have had to comply with the new  internal control audit-related requirements. Firms that audit smaller public  companies, those considered nonaccelerated filers, are scheduled to  comply with the new audit requirement with annual filings after December  15, 2008. When effective for smaller public companies, the requirement is  expected to further increase their audit fees.
The accounting firms that we have spoken to noted that, in addition to  requiring new internal control work; other requirements of the Act have  contributed to increased audit costs and the fees charged to public  companies. The Act established a new regulatory oversight structure for  firms that audit public companies with the creation of the Public Company  Accounting Oversight Board (PCAOB). To date, PCAOB has established  firm registration and inspection programs and has adopted auditing  standards that Securities and Exchange Commission (SEC) has approved  that registered firms must follow. Several firms we have spoken to since  the PCAOB was established noted that they have incurred additional costs  to support PCAOB-related activities, as well as respond to the audit  documentation standard and a shorter audit partner rotation period  mandated by the Act. In addition, since a key provision of the Act made  public company audit committees responsible for hiring the firm and  overseeing the audit, some firms we spoke to said they have seen a  substantial increase in their staffs’ interaction with the audit committees  members, which has added to audit costs.
A number of firms we spoke to also noted that the Act’s stricter  independence requirements may have contributed to higher audit fees by  causing some firms to change the way they price their audit service. The  stricter independence requirements were intended to significantly limit the  types of nonaudit services firms can sell to their audit clients without  impairing the firm’s independence. Department of Justice (DOJ) officials  and others we spoke to stated that the significant limits on firms’  opportunities to sell audit clients nonaudit services make them less likely  to under price audits as a loss leader. To the extent that firms in the past  have underpriced their audits expecting to sell nonaudit services which  are now prohibited, it is reasonable to believe that these firms have  increased their audit fees to cover their audit cost.
The results of our survey of midsize and smaller firms and our discussions  with the largest firms generally confirmed the factors that have increased  the audit cost fees. All four of the largest firms reported in interviews that  the increasing complexity of accounting and auditing standards and the  additional requirements of new standards were factors having a significant  effect on the cost of audits. The largest firms and the other firms differed  only slightly on other factors that have significantly affected audit cost.  The largest firms noted costs to attract and retain talented staff and costs  related to litigation as the two other top factors contributing to increased  audit costs. In addition to the requirements of new standards and the price  of talent, the other firms cited the time and effort to prepare for the  PCAOB inspection and the complexity of accounting principles and  auditing standards as their top factors.
The results of our survey of the audit committee chairs of over 500 public  companies also show that increases in audit hours and rates charged by  firms and other factors have led to increased audit fees. Public companies  that reported increasing audit fees reported that changes in the number of  hours by the audit engagement team (85 percent) and senior partners (73  percent), as well as changes in hourly rates of the audit team and senior  partners (76 percent), led to increased audit fees. In addition, of those  public companies reporting that their audit costs had increased since 2003,  84 percent reported that the additional requirement for an audit of internal  control over financial reporting was a factor in the increase of their audit.
section_title: Factors Influencing Audit Quality
paragraphs: While management has the primary responsibility for the quality and  reliability of a public company’s financial statements, the auditor is  responsible for providing reasonable assurance, through an independent  audit, about the reliability of the company’s financial statements. Investors  need to know that the financial statements on which they make  investment decisions are reliable and the independent audit plays a vital  role in assuring their reliability. In a prior report, we defined a quality audit  as one conducted, in accordance with applicable auditing standards to  provide reasonable assurance about whether the audited financial  statements are presented in accordance with applicable accounting  principles and are free of material misstatements. Audit quality is often  thought to include the experience and technical capability of the auditing  firm partners and staff, the capability to efficiently respond to a client’s  needs, and the ability and willingness to appropriately identify and surface  material reporting issues in financial reports. When high quality public  company audits are performed, management and investors are more likely  to rely on the financial statements and the financial information they  contain.
subsections: section_title: Audit Oversight
paragraphs: For decades, the public accounting profession was, in practice, self- regulated, taking responsibility for establishing auditing standards and  administering a program designed to oversee the activities of independent  public accounting firms that audit companies whose securities are  registered with the SEC. While given statutory authority for establishing  rules governing financial reports for publicly traded companies in the  1930s, SEC permitted the accounting profession (American Institute of  Certified Public Accountants (AICPA)) to set auditing standards, subject  to SEC’s oversight of the standard-setting process. Concerns raised with  the audits of public companies in the 1970s focused attention on the need  to improve the quality control mechanisms used by firms to ensure that  professional standards were being met. In response, AICPA revised its  approach to setting audit standards in 1979 by establishing the Auditing  Standards Board, which was designed to have a more efficient standard- setting process through a body composed of representatives from firms of  all sizes and nonpublic accounting organizations. In 1977, AICPA instituted  two voluntary peer review programs—one for firms performing audits of  public companies and one for those performing audits of private  companies—designed to review the systems of audit quality controls for  participating firms’ audits of companies. Also, in 1977, AICPA created the  Public Oversight Board to represent the public interest by overseeing the  audit standards-setting process and the voluntary peer review program.
The purpose of the peer review program AICPA established was to provide  the public with assurance that a firm performing auditing services for  companies registered with SEC had an effective quality control system  that provided reasonable assurance that its audits were in compliance  with generally accepted auditing standards. According to the AICPA, a  number of large accounting firms had been using peer reviews to enhance  audit quality as far back as the early 1960s. In 1988, AICPA made peer  review mandatory for all member firms performing auditing and  accounting services.
To enhance auditor independence, improve audit quality, and restore  investor confidence in response to the major accountability breakdowns at  Enron and WorldCom, the Congress, through the enactment of the  Sarbanes-Oxley Act, replaced the profession’s longstanding self-regulatory  structure for public company audits with an independent regulatory  structure administered by PCAOB. Among its other responsibilities, the  Act made PCAOB responsible for establishing auditing and other  professional standards applicable to the audits of public companies by  registered firms and inspecting those firms which perform public company  audits. Since its establishment in 2002, PCAOB has designated certain  existing auditing and quality control standards issued by the Auditing  Standards Board through April 2003 as its interim standards, while  focusing its attention on issuing new and modifying certain interim  auditing standards. As of September 2007, PCAOB has not issued either  new or modified quality control standards.
In addition to its work on standards, PCAOB is responsible, through its  inspection program, for evaluating the auditor’s application of existing  audit and related requirements standards to promote high quality audits.  The PCAOB inspection program replaced the AICPA’s peer review  program that evaluated firms’ public company auditing practices.
section_title: Views on Audit Quality
paragraphs: Many factors can affect audit quality including auditing, accounting, and  quality control standards; accounting firm inspections; and audit staff  quality; and the availability of qualified audit staff. In asking accounting  firms about audit quality, we considered audit quality to include the  experience and technical capability of the audit firm partners and staff as  well as the capability to efficiently respond to a client’s needs and identify  and communicate material reporting issues in financial reports. All of the  largest firms and over 80 percent of the midsize and 3 accounting firms  responding to our survey said that, since 2003, it has been harder to  maintain audit quality. This widely held view likely reflects the significant  changes in the auditing environment since 2003 and the capacity demands  facing the profession as audits have become more complex, requirements  have expanded, and the PCAOB’s inspection program has been  implemented. Together these changes have increased emphasis on audit  quality. Midsize and smaller accounting firms participating in our survey  indicated that several factors have made it harder to maintain audit  quality, with the most significant being the complexity of the accounting  principles and auditing standards (92 percent), staff experience and  technical capability with complex accounting principles and auditing  standards (90 percent), and availability of qualified staff (84 percent). The  largest firms’ views on audit quality were also in line with those of the  survey respondents. Representatives of all of the largest firms indicated  that the complexity of the accounting principles and auditing standards  and staff experience and technical capability with complex accounting  principles and auditing standards have made maintaining audit quality  harder. In addition, three of the four firms indicated the availability of  qualified staff has made maintaining audit quality harder. During  interviews, some representatives of the largest firms noted that they have  significantly increased the number of staff in their national offices who  provide technical consultations to the audit teams due to the complexity  of the accounting principles and auditing standards. Also, during  interviews, representatives of accounting firms mentioned that they have  faced stiffer competition in hiring due to companies expanding their  accounting and internal audit departments, SEC and PCAOB increasing  their staff, and consulting firms wanting experienced accountants to help  their clients implement section 404.
During our interviews, all of the largest firms and in replying to the survey,  all of the midsize firms who responded, indicated that the increased role of  the audit committee made maintaining audit quality easier. Only 23  percent of the smaller survey respondents shared this view. Also, half of  the largest and midsize firms responded that complying with PCAOB  inspections made maintaining audit quality easier as compared with only 8  percent of the smaller firm survey respondents.
Despite the fact that accounting firms reported it was harder to maintain  audit quality, market participants we spoke to who commented on audit  quality generally noted that they thought audit quality had improved.  Similarly, public companies think several aspects of audit quality have  increased in recent years. In our survey to public companies, we asked  about specific aspects of audit quality and how those aspects have  changed since 2003. While companies reported that several aspects of  quality have remained the same, the aspects the public company survey  respondents indicated increased most significantly were the amount of  time spent by audit engagement team (77 percent), the addition of audit of  internal control over financial reporting as required in the Sarbanes-Oxley  Act (73 percent), and amount of time spent by senior partners and experts  (72 percent). Company officials and others we interviewed also generally  said that overall audit quality had increased in recent years. One controller  we interviewed said that overall audit quality had become lax before the  Sarbanes-Oxley Act was passed. However, he thinks that quality has  changed significantly in recent years and auditors are much more rigorous.  While public companies we surveyed were generally satisfied with their  auditor of record considering the scope of the audit, the fees paid for audit  services and the quality they received, several respondents commented  that the requirements in Sarbanes-Oxley have led to significant increases  in audit work and fees. Some survey respondents also questioned whether  these higher costs exceeded the benefits of the additional requirements.
section_title: Appendix V: Econometric Analysis of the Effect of Industry Concentration on Audit Fees
paragraphs: The current structure of the market for audit services has raised concerns  about the potential for anticompetitive pricing, especially for the largest  public company clients. While the classic oligopoly theory suggests that  prices of goods and services are positively associated with market  concentration, the modern theory of industrial organization makes no  clear statement regarding the impact of concentration on competition.  Therefore, to investigate the relationship between concentration and audit  fees, we compiled a panel data set using Audit Analytics data. The data  initially contained observations on over 12,000 companies over a seven- year period from 2000 to 2006 excluding funds, trusts, and nonoperating  entities. To analyze the relationship as validly as the data constraints  allowed, we employed various panel data modeling techniques. While the  results suggest that the increase in audit fees appears largely unrelated to  supplier concentration, in part because of all the contemporaneous  changes occurring in the market and other modeling and data limitations,  these findings should not necessarily be viewed as definitive or as proof  that that market for audit services is competitive. This appendix provides  additional information on the construction of our database, econometric  model, additional descriptive statistics and the limitations of the analysis.
subsections: section_title: The Panel Data Sample Was Created by Compiling Several Audit Analytics Databases
paragraphs: To construct the database used to estimate the econometric model we  compiled audit fee and financial data and additional information on the  thousands of public companies audited by the largest, midsize, and other  public accounting firms. Audit Analytics, an online intelligence service  maintained by Ives Group, Incorporated provides, among other things, a  database of fees paid by public companies to their auditors back to 2000  with demographic and financial information. In addition, we added  information on these companies using the Late Filer, Internal Control,  Restatement, Auditor Change and Audit Opinion databases also  maintained by Audit Analytics. In this manner, we were able to include  information on the risk and auditing characteristics of the companies as  additional control variables in the resultant econometric model. Moreover,  a panel data set, that is data pooled across all companies over the 2000 to  2006 period, allowed us to account for variances in audit fees across  companies and over time as well as use techniques that enhance the  validity of the parameter estimates. We deleted from our sample various  entities including funds, plans and trusts, subsidiaries with parent data  already included in the database, blank check and nonoperating entities  and duplicate entries. Table 8 reports the descriptive statistics on the  resultant panel data set. Because some companies either did not exist until  the later years, merged with other companies, went private, entered into  bankruptcy, or otherwise failed to report at some point over the period,  not all the companies have the requisite data for each year. Moreover,  companies were not required to report audit fees until 2001. As a result,  the panel is unbalanced. The public companies clients remaining in our  sample were used initially to investigate two related questions:    When other important factors influencing audit fees are accounted for, do  companies operating in more concentrated sectors of the economy pay  higher fees?
When other important factors influencing audit fees are accounted for, do  companies audited by accounting firms with higher market shares in a  certain sector pay higher fees?
Our panel data approach investigates industry (economic sector)  concentration (HHI) from 2000 to 2006 since there is variation in the  degree of concentration across industries and within industries over time.  We also investigate variation in audit firm market share of a particular  industry, and therefore, potential market power, over the 2000-2006 period  as well. Our econometric model is estimated to gauge whether or not audit  fees can be explained by changes in these concentration variables.  Sullivan (2007) takes a different approach in addressing anticompetitive  pricing, using auditor change (switching) data from 1988 to 2005 and  similarly attributes audit fee increases to the new regulatory environment  and increased effort on the part of auditors rather than anticompetitive  behavior. Asthana, et al. (2004) examines audit fess from 2000 to 2002 and  concludes that the increase in the fee premium charged by the largest  firms was the result of decreased competition in the audit market for  multinational companies due to the exit of Arthur Andersen. However, as  Sullivan (2007) points out, the authors cannot control for trends in audits  fees that predate the Arthur Andersen dismantlement.
section_title: Econometric Modeling Procedures for Handling Panel Data
paragraphs: Panel data provides potential advantages over pure cross sectional and  pure time series designs and allows us to factor out the time- and space- invariant components of the data. As a result, panel data are able to  identify and measure effects that are not detectable in other designs. There  are two commonly accepted approaches to estimating panel data—the  random-effects model and the fixed-effects model. In the fixed effects  model individual effects are estimated, in this case, for each company to  reflect the assumption that special features specific to each company— such as audit risk, management style, skill of internal auditors or audit  committee, or internal control processes—can be captured best with a  different, time-invariant intercept for each company. In a random effects  model, in this context, these individual effects are captured through  treating the intercept as a random variable with a unique error term for  each company. While each model has its advantages and disadvantages,  the random effects model is appropriate when we can plausibly assume  that the individual effects (which are unobserved and unmeasured in the  model) are uncorrelated with the explanatory variables that are measured  and included in the model. Otherwise the fixed effects model is preferred,  especially as a control for omitted variables bias, as it is in this context  (see discussion below).
Using panel data—data across companies and over time—the basic model  takes the form:  (1) yit = θ + Xitβ + Zδ + εit where y = the dependent variable (audit fees paid by the company to its  auditor).
X = a matrix of explanatory variables that varies across time and  individual companies. These are variables that help capture the  characteristics of the public company client, the characteristics of  the auditing industry, the characteristics of the auditor, and the  characteristics of the audit engagement as well as variables that for  control the effect of Sarbanes-Oxley.
Z = a matrix of variables that vary across companies but for each  individual company are constant across the six years. The variables  are essentially the variables that indicate the number of auditor  changes over the period, indicate whether or not a company was a  client of Arthur Andersen in 2002 as well as regional and industry  dummy variables.  θ = constant term.  i = 1, 2, . . ., 12,749 and represents the individual companies in the  initial panel.  t = 1, 2, . . ., 6 and represents the number of years (2000-2006).
As is the typical case with panel data, we have a large number of cross- sections (public companies) and a relatively small number of time periods.  Therefore we specify the composite error structure for the disturbance  term as follows:  (2) εit = α + ηit where α = company-specific error component which captures the  unobserved heterogeneity across companies (either as a fixed- or random- effect).
E(Xitηit) = 0 (there is no correlation between ηit and Xit).
The α is the individual effect which can be treated as either fixed or  random. The fixed- and random-effect models which take account of the  repetition inherent in the data and allow us to use the individual  differences effectively. Correspondingly, if we treat the individual effect as  zero we can estimate the model using the simple ordinary least squares  (OLS) procedure. This is a pooled OLS regression model where we assume  the intercept and slope coefficients are constant across time and space  and the normal error term (ηit) captures differences over time and  individual companies. However, when the true model is random-effects  model, pooling the observations in this manner using OLS produces biased  estimates that are also not efficient when compared to the more complex  generalized least squares (GLS) procedure (outlined below). Moreover, the  pooled OLS model is also susceptible to omitted variables bias. Likelihood  ratio tests strongly rejected the pooled OLS model in favor of the fixed- effects and therefore OLS would be inappropriate in this regard as well.
The random effects model can be thought of as a regression with a random constant term.  In other words, it is assumed that the intercept is a random outcome variable that is a  function of a mean value plus a random error. the new disturbance term which incorporates the individual random effect  of each company, the appropriate method for producing estimates is GLS.  Feasible GLS derives an estimate of the covariance matrix of the error  term and uses the information (heteroscedasticity from repeated  observations of the same crosssection unit) to estimate the coefficients in  the model.
The drawback to this approach is that it forces one to make the strong  assumption that the unobserved random-effects are uncorrelated with the  explanatory variables in the model E(Xitα) = 0 in addition to the standard  assumption E(Xitηit) = 0). As a result, the random effect treatment of the  panel data may also produce estimates that suffer from the inconsistency  due to omitted variables. Therefore, the validity of the results would  depend more heavily on the control variables included in the model to  capture differences across companies, unless the omitted variables  (unobserved heterogeneity across company) are uncorrelated with the  concentration variables. If this is the case, the random-effect model may  produce more appropriate estimates than the fixed-effects model. In our  case, the Hausman test, which formally tests whether the omitted  variables are correlated with the other regressors in the model, clearly  rejected the random-effect model in favor of the fixed-effects model.  Therefore, the results section of this appendix focuses primarily the fixed  effects models (see below). serially correlated across time, invalidating OLS estimates. fees. Moreover, in many cases the fixed effects estimates will still produce  consistent estimates even when the random effects model is valid.
section_title: Variables Included in the Model
paragraphs: SEC disclosure requirements now require companies to disclose audit fees  paid to the external auditor and that these fees paid be broken down into  the following categories: (1) audit fees, (2) audit-related fees, (3) tax fees,  and (4) all other fees. Audit-related fees can include fees paid to the  external auditor for due diligence services, internal control reviews or  other work that is traditionally performed by the independent accountant.  The dependent variable in our econometric models is total audit fees,  which is composed of audit fees and audit-related fees. While the results  we report below use this measure of fees, we also used audit fees (without  audit-related fees) for each company in some models as a sensitivity test.  More importantly, because SEC disclosure requirements were not in effect  during 2000 and for a portion of 2001, some observations are based on  firm-specific practices for categorizing fees rather than the more uniform  categorization initiated by SEC regulations. We deal with this  econometrically by dropping 2000 and 2001 in some specifications for  sensitivity analysis, and, when these years are included, time fixed-effects  are used to control for potential difference in the recording of audit fees.
The primary variables of interest are the industry concentration variables  defined by two-digit North American Industry Classification System  (NAICS) codes: (1) the share of the market held by a company’s auditor of  record in a given year in a given industry sector (Sharef) and (2) the  Hirschman-Herfindahl Index (HHI1) for the industry sector in which the  company operates in a given year. Both concentration variables are based  on the total audit fees collected. The HHI is calculated by summing the  squared market shares of all the firms auditing public company clients in a  given industry. As table 9 illustrates, the HHI’s computed for the various  sectors of the economy vary across sectors over time. We also interacted  the HHI variable with measures of company size, to allow for distinct  effects for large and small companies. We did not include companies  operating in the public administration sector in our econometric analysis  as there were an insufficient number of companies to reliably determine  concentration. Similarly, in some econometric specifications we dropped  Agricultural and Warehousing companies as the numbers fell below 30 and  15 companies respectively in most years.
While the HHI variable captures the impact of overall concentration on  audit fees, the market share variable can capture two distinct types of  effects. One the one hand, market share can be an indicator of a firm’s  degree of monopoly power and large shares can give substantial market  power to the firm if there are no significant competitors. On the other  hand, high market share could result in economies of scale and lower  costs which are then passed on to clients in the form of lower audit fees.  In the case of the market for audit services the market share variable  could also proxy for industry expertise (quality-differentiated services),  which would justify higher fees. Therefore, a positive relationship between  market share and audit fees would be consistent with both market power  and an expertise or quality premium. We further explore this with a  number of models to determine whether individual market power  (monopolistic pricing) or industry expertise most likely explains the  positive relationship we find between market share and audit fees (see  results section).
Although, the fixed effect model guards against time invariant omitted  variables bias, it is always advisable to explore possible causes of  heterogeneity. We included a number of control variables in an attempt to  capture the variation in audit fees across companies related to audit effort  (size), risk factors and complexity. Table 10 includes a listing of the  various variables included in the econometric models, ranging from  company size (assets) to indicators of a restatement, a going concern  opinion, negative earnings, late filings and controls for Sarbanes-Oxley  (SOX). Sarbanes-Oxley added new costs to the standard audit, especially  the Section 404 Report on internal controls in 2004. Over the sample there  are some companies that complete the yearly internal control review  beginning in 2004 and other that do not. We controlled for this explicitly  with a dummy variable, as well as an additional dummy if the company  was found to have inadequate controls. As some of these variables may  also be related to the concentration variables, controlling for them also  enhances the internal validity of the parameter estimates.
Since accounting firms are now prohibited from providing services such as  financial information system implementation and design, internal auditing,  and a number of other services, any cross subsidization (or low-balling) of  the audit that potentially existed in the early years (2000 and 2001) is less  likely in the later years in our sample. Moreover, as indicated above, the  sample consists of fees reported under the old SEC rules for 2000 and  2001, and fees reported under the new rule for 2002 through 2006. As a  result, we also included time period fixed effects to control for regulatory  changes, changes in the scope and complexity of audit engagements,  changes in the manner in which, the audit was priced or audit fees were  categorized and recorded, and other forces that can be captured by a  company-invariant (consistent across companies) fixed effect. Collectively  the variables and techniques help capture the characteristics, of the public  company client (effect of the amount of effort required by the auditor), of  the auditing industry (e.g., pricing differences across accounting firms), of  the auditor (e.g., knowledge advantages due to specialization) and of the  engagement (e.g., busy season) and help explain the variation in audit fees  across companies. All appropriate variables were adjusted for inflation.
As table 11 shows there is a low degree of correlation between most of the  explanatory variables in the panel. However, there is a high degree of  correlation between the market share variable, the dummy indicating  whether a firm is an industry expert and the dummy variable which  indicates whether a company is audited by one of the largest accounting  firms (Big 4/5 dummy variable). In fact, principal components analysis  suggests the Big 4/5 dummy variable adds very little to a model once the  market share variable is included. As a result the Big 4/5 is not included in  a given model if the market share variable is also being estimated. We also  drop the expert variable in some specifications for sensitivity analysis in  lieu of the somewhat high correlation with the market share and the  interaction variables. It should be noted however, the correlation between  HHI and market share is relatively low.
section_title: Results
paragraphs: We ran roughly 100 different models, including several pooled OLS,  random-effects and fixed-effects models with varied specifications as  sensitivity tests. Given the number of issues that plague the simple OLS  model and that formal tests strongly rejected the pooled OLS model in  favor of fixed-effects, we do not report the pooled OLS results in this  appendix. Moreover, since the Hausman test overwhelming rejected the  random-effects in favor of the fixed-effect model, we present the results  for the random-effects models for comparison only. Note, also, that the  time invariant variables (Z), such as number of auditor changes over the  period, and industry and region indicators appear in the random-effects  model but not in the fixed-effects models as these variables are collinear  with the unique fixed-effect estimated for each company. The random and  fixed-effects models run on 2002 through 2006 data suggest that, in  general, companies operating in more concentrated industries do not pay  higher fees when other important drivers of audit fees are included (table  12). Moreover, focusing on the fixed-effect results, we found this result to  hold even when we included 2000 and 2001 in the analysis or if we include  only the post Sarbanes-Oxley years (2003-2006). In all cases, the HHI is  positive but statistically insignificant.
To explore the differences between different size companies, we also  interacted the HHI variable with a dummy variable that indicates whether  a company exceeds $250 million in assets. This variable is both positive  and significant, indicating that larger firms operating in more concentrated  industries may pay higher fees, but we note that this effect is very small.  Because this was an arbitrary definition which would include a number of  companies considered small by other sources, we varied our definition of  large using various cut-off values. When we defined large as $1 billion or  $3.5 billion in assets the results remain the same. Consistently the  estimates suggest that a 10 percent increase in the HHI for large  companies results in an increase in audit fees around 0.5 percent. Since  the dissolution of Andersen initiated an increase in the HHI by about 18  percent, the model suggests that the result on audit fees for the largest  public companies would have been less than 1 percent. By comparison  the estimated effect of the 404 internal control requirements resulted in  roughly a 45 percent increase in audit fees, while issuing a financial  restatement is associated roughly with an 11 percent increase in fees.  However, when we ran the models only on companies with assets greater  than $250 million in assets (or any other sub-samples of large companies  defined by assets) we found no relationship between industry  concentration and audit fees for these companies. When we defined large  by some measures we found a negative but statistically insignificant  relationship between HHI and audit fees. Further, when we ran the model  only on clients of the largest firms the coefficients on the interaction term  were either much smaller (substantively insignificant) or statistically  insignificant. As a result, this finding regarding the price impact for larger  companies may not be robust and should be interpreted with caution.
The models also consistently show that accounting firms holding a larger  market share of the industry in which the public company operates are  found to charge higher fees (Sharef is statistically significant and positive  in each instance) but this leaves open the question as to whether the  empirical evidence is supportive of expertise-quality-differentiated  services or anticompetitive pricing. Unfortunately, these are extremely  difficult issues to address in a rigorous and comprehensive manner.  Similar to other studies, we investigated the audit fee-market share  relationship in various large and small client segments of the market. We  found that market share-related price premium also exists in the small  client segment of the market and these premiums were not statistically  different from those that existed in the large company segment of the  market (table 13). Even when we ran the model on companies with assets  below 100 million, we still found a statistically significant and positive  relationship between the auditor’s share of the market (Sharef) and audit  fees. It should be noted that the HHI for this sector was well below the  critical value of 1,000 in 2006. Therefore, the persistence of this positive  relationship between market share and audit fees in all segments of the  market—even those predisposed to perform competitively—suggest it is  more likely due to industry or technical expertise (quality-differentiated  service) and in the case of the larger firms, brand-name reputation. A firm  with industry expertise may exploit its specialization by developing and  marketing audit-related services which are specific to clients in the  industry and provide a higher level of assurance. If this is the case, such  firms could earn a return on this investment by charging higher audit fees  than other firms and remain competitive for the most relevant  opportunities, even at a premium price. It should be noted that Oxera  (2006), using similar modeling techniques, interpreted this association as  an indicator of market power in U.K. audit markets but did not  acknowledge the presence of quality differentiated services and industry  expertise nor report any further investigation to unpack the relationship.
We conducted a number of sensitivity test to examine the robustness of  our findings. For example, we used the log of audit fees—net of audit- related fees—as the dependent variable and obtained similar results. To  investigate whether multicollinearity was an issue, we ran a number of  models excluding the potentially collinear variables and obtained similar  results. We also altered the functional form, using market share instead of  logged market share, and obtained results which more strongly supported  our initial results. Because estimated coefficients of the fee determinants  could differ significantly for the largest and other auditors, we also ran the  model separately for these two classes of firms. To address potential  problems of endogeneity we estimated the relationships using two-stage  least squares. Finally, to investigate whether the results were sensitive to  unbalanced nature of the data—the number of companies in the sample  for each industry differs across the years—we estimated the model using  sample probability weights, where the weights are based on the number of  companies in a given industry (or alternatively total revenues, fees paid or  assets). In our case, this amounted to de-meaning the data to obtain the  fixed effects estimates and then running weighted least squares.  Consistently, we found no evidence of a positive and significant  relationship between industry concentration and audit fees.
While our analysis suggests the increase in audit fees appears largely  unrelated to supplier concentration, it is difficult to determine the extent  to which audit pricing is consistent with competitive behavior with the  available data because of all the contemporaneous changes occurring in  the market. As a result these results should be interpreted with a  consideration of a number of limitations. First, this is an aggregate  analysis and, therefore, does not demonstrate that all companies receive a  competitive price (local markets may be important). Moreover, the  absence of evidence of uncompetitive pricing does not necessarily imply  that we can conclude that the market is competitive from a pricing  perspective. Second, our results are based on one battery of tests focused  on industry (economic sector) concentration and this does not imply that  it is the definitive way to examine the effect of concentration on prices.  While evidence suggests that some sectors have particularly complex  audits and sector-specific expertise is an important determinant of auditor  choice many companies are involved in activities that cut across multiple  industries raising some questions about characterizing industry-specific  markets as unique audit markets, especially for large firms. Our  investigation was undertaken because it appeared to be a useful way to  consider the effect of concentration given the available data. Additional  data may allow for analysis that may address the issue more completely or  more validly. Third, although the fixed effect estimator is robust to the  omission of any relevant time-invariant variables and we have explained  over 90 percent of the variation in fees, if there are time-varying  differences that have been omitted, the results could be biased. As  complexity and inherent risk of the individual client audits could vary over  time there is some concern that financial variables traditionally included  in the literature could not be included here (e.g. number of subsidiaries,  inventory and receivables). However, this threat should be balanced  against the power of the fixed-effects estimator which may capture some  of this effect.
Fourth, our conclusion that quality-differentiation and industry expertise  most likely better explains market dynamics than monopolistic pricing,  while standard in the academic literature, critically hinges on the smaller  company segment actually performing competitively. We, like others, have  made this assumption based on the low HHI statistics computed for that  segment of the market and other market indicators that suggest  competitive pricing for smaller companies. Users of this report should  note that our tests of individual market power were limited and the results  should be interpreted in light of this limitation. Fifth, potential  measurement error in the audit fee variable, assuming it is random, would  make it more likely that we would conclude that a relationship does not  exist when indeed it does. Given the large amount of the variation in fees  we have explained and the techniques we have used, this (statistical  validity) would not appear to be an issue.
section_title: Appendix VI: GAO Contacts and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Cody Goebel and John J. Reilly  Jr., Assistant Directors; William Bates; Tania Calhoun; Emily Chalmers;  William R. Chatlos; Bob Dacey; Francis Dymond; Lawrance Evans Jr.;  Kristen Kociolek; Annamarie Lopata; Kimberly McGatlin; Marc Molino; Jill  M. Naamane; Karen O’Conor; Carl Ramirez; Nicole Riggs; John Saylor;  Jeremy Schwartz; Estelle Tsay; Richard Vagnoni; Ethan Wozniak; and Tory  Wudtke also made key contributions to this report.