Public Accounting Firms: Mandated Study on Consolidation and Competition
Published: 2003-07-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The audit market for large public companies is an oligopoly, with the largest firms auditing the vast majority of public companies and smaller firms facing significant barriers to entry into the market. Mergers among the largest firms in the 1980s and 1990s and the dissolution of Arthur Andersen in 2002 significantly increased concentration among the largest firms, known as the "Big 4." These four firms currently audit over 78 percent of all U.S. public companies and 99 percent of all public company sales. This consolidation and the resulting concentration have raised a number of concerns. To address them, the Sarbanes-Oxley Act of 2002 mandated that GAO study (1) the factors contributing to the mergers; (2) the implications of consolidation on competition and client choice, audit fees, audit quality, and auditor independence; (3) the impact 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.
section_title: What GAO Found
paragraphs: Domestically and globally, there are only a few large firms capable of auditing large public companies, which raises potential choice, price, quality, and concentration risk concerns. A common concentration measure used in antitrust analysis, the Hirschman-Herfindahl Index (HHI) indicates that the largest firms have the potential for significant market power following mergers among the largest firms and the dissolution of Arthur Andersen. Although GAO found no evidence of impaired competition to date, the significant changes that have occurred in the profession may have implications for competition and public company choice, especially in certain industries, in the future. Existing research on audit fees did not conclusively identify a direct correlation with consolidation. GAO found that fees have started to increase, and most experts expect the trend to continue as the audit environment responds to recent and ongoing changes in the audit market. Research on quality and independence did not link audit quality and auditor independence to consolidation and generally was inconclusive. Likewise, GAO was unable to draw clear linkages between consolidation and capital formation but did observe potential impacts for some smaller companies seeking to raise capital. However, given the unprecedented changes occurring in the audit market, GAO observes that past behavior may not be indicative of future behavior, and these potential implications may warrant additional study in the future, including preventing further consolidation and maintaining competition. Finally, GAO found that smaller accounting firms faced significant barriers to entry--including lack of staff, industry and technical expertise, capital formation, global reach, and reputation--into the large public company audit market. As a result, market forces are not likely to result in the expansion of the current Big 4. Furthermore, certain factors and conditions could cause a further reduction in the number of major accounting firms.

section_title: Letter
paragraphs: There are hundreds of public accounting firms that audit public companies  in the United States. However, a small number of very large firms have  traditionally provided audit and attest services for the majority of public  companies, particularly large national and multinational companies. The  number of firms widely considered capable of providing audit services to  large national and multinational companies decreased from eight (“the Big  8”) in the 1980s to four (“the Big 4”) today. The reduction was the result of  mergers involving six of the top eight firms since the late 1980s and the  abrupt dissolution of Arthur Andersen LLP (Andersen) in 2002. The Big 4  firms are substantially larger than the other U.S. or international  accounting firms, each with thousands of partners, tens of thousands of  employees, offices located around the world, and annual revenues in the  billions of dollars. These four firms currently audit over 78 percent of all  U.S. public companies and 99 percent of public company annual sales.  Internationally, the Big 4 dominate the market for audit services.
Big 8 mergers and Andersen’s sudden dissolution have prompted  heightened concerns about concentration among the largest accounting  firms and the potential effect on competition and various other factors. As  a result, Congress mandated in the Sarbanes-Oxley Act of 2002 that we  study these issues. Specifically, we were asked to study (1) the factors  leading to the mergers among the largest public accounting firms in the  1980s and 1990s; (2) the impact of consolidation on competition, including  the availability of auditor choices for large national and multinational  public companies; (3) the impact of consolidation on the cost, quality, and  independence of audit services; (4) the impact of consolidation on capital  formation and securities markets; and (5) the barriers to entry faced by  smaller firms in competing with the largest firms for large national and  multinational public company clients.
To evaluate the factors contributing to consolidation among the largest  firms, we interviewed current and former partners of large public  accounting firms involved in past mergers and Department of Justice (DOJ)  and Federal Trade Commission (FTC) officials. However, we did not review  any antitrust analyses conducted by DOJ specific to the proposed mergers  of the 1980s and 1990s. According to DOJ officials, most of the firm  documents had been returned to the relevant parties, and other documents  were viewed as “predecisional” by DOJ. While GAO’s statute provides us  with access to predecisional information absent a certification by the  President or the Director of the Office of Management and Budget, we were  more interested in the reasons for the mergers than DOJ’s analysis in  approving the mergers. Therefore, we used other sources to obtain the  necessary information for this report. We also collected information from  and coordinated with the Securities and Exchange Commission (SEC) and  its counterparts from the other six members (Canada, France, Germany,  Italy, Japan, and the United Kingdom) of the Group of Seven nations as  required in the mandate. To evaluate the impact of consolidation on  competition and auditor choice, audit fees, and audit quality and auditor  independence, we consulted with academics, researchers, U.S. and foreign  regulators, and trade associations and collected data and descriptive  statistics for analysis. We also employed a simple model of pure price  competition, in which clients choose auditors based on price, ignoring  factors such as quality or reputation, to assess whether the current high  degree of concentration in the market for audit services is necessarily  inconsistent with a purely price competitive setting. Additionally, as of July  11, 2003, we had received 47 responses to a survey of the 97 largest  accounting firms—those with at least 10 corporate clients registered with  SEC—on their views of accounting firm consolidation and its potential  implications. This report also includes responses from 148 of 250 randomly  sampled, Fortune 1000 public companies on their experiences with their  auditor of record and their views on the potential implications of  consolidation. We plan to issue a subsequent report in September 2003 on  client responses received through July 30, 2003. Lastly, we interviewed a  judgmental sample of 20 chairs of audit committees for Fortune 1000  companies to obtain their views on consolidation and competition. To  address the issue of the impact of consolidation and concentration on  capital formation and securities markets, we interviewed representatives  from institutional investors, investment banks, self-regulatory  organizations, and credit rating agencies, among others, and we consulted  with academics and reviewed relevant literature. To identify any barriers to  competition faced by accounting firms, we reviewed existing state and  federal requirements and interviewed knowledgeable officials. We also  employed the previously cited economic model by simulating mergers  among smaller firms in order to assess whether, in a purely price  competitive environment, such mergers could lead to viable competitors to  the Big 4 for large national and multinational clients. We also obtained  information from the American Institute of Certified Public Accountants  (AICPA). Appendix I contains a full description of our scope and  methodology.
We conducted our work in Chicago, Illinois, New York, New York, and  Washington, D.C., between October 2002 and July 2003.
subsections: section_title: Background
paragraphs: For over 70 years, the public accounting profession, through its  independent audit function, has played a critical role in financial reporting  and disclosure, which supports the effective functioning of U.S. capital  markets. Over this period, the accounting profession and the accounting  firms have undergone significant changes, including changes in the scope  of services provided in response to the changing needs of their clients.  Following significant mergers among the Big 8 in the 1980s and 1990s and  the dissolution of Arthur Andersen in 2002, market share among the  accounting firms became more concentrated and dominated by the Big 4.
subsections: section_title: Full Disclosure Critical for Market Confidence
paragraphs: The Securities Act of 1933 and the Securities Exchange Act of 1934  established the principle of full disclosure, which requires that public  companies provide full and accurate information to the investing public.  Moreover, these federal securities laws require that public companies have  their financial statements audited by an independent public accountant.  While officers and directors of a public company are responsible for the  preparation and content of financial statements that fully and accurately  reflect the company’s financial condition and the results of its operations,  public accounting firms, which function as independent external auditors,  provide an additional safeguard. The external auditor is responsible for  auditing the financial statements in accordance with generally accepted  auditing standards to provide reasonable assurance that a company’s  financial statements are fairly presented in all material respects in  accordance with generally accepted accounting principles.
Public and investor confidence in the fairness of financial reporting is  critical to the effective functioning of U.S. capital markets. Auditors attest  to the reliability of financial statements of public companies. Moreover,  investors and other users of financial statements expect auditors to bring  integrity, independence, objectivity, and professional competence to the  financial reporting process and to prevent the issuance of misleading  financial statements. The resulting sense of confidence in companies’  financial statements, which is key to the efficient functioning of the  markets for public companies’ securities, can only exist if reasonable  investors perceive auditors as independent and expert professionals who  will conduct thorough audits.
section_title: Repeal of Ban on Advertising and Solicitation Created More Competitive Environment
paragraphs: For many decades, public accountants, like members of other professions,  could not advertise, solicit clients, or participate in a competitive bidding  process for clients. These restrictions were set by AICPA, which directed  the professional code of conduct for its members, and the state  accountancy boards for the 50 states, District of Columbia, Guam, Puerto  Rico, and U.S. Virgin Islands. Beginning in the 1970s, FTC, DOJ, and  individual professionals began to challenge the legality of these restrictions  through various court actions. As a result of these challenges, AICPA and  state boards adopted new rules that targeted only false, misleading, or  deceptive advertising; liberalized restrictions on solicitation; and changed  bans on competitive bidding. While large public companies generally did  not switch auditors based on price competition, increased competition and  solicitations served as incentives for incumbent firms to continually offer  competitive fees to retain their clients.
section_title: Expansion and Contraction of Management Consulting Services Raised Concerns about Auditor Independence
paragraphs: Historically, accounting firms offered a broad range of services to their  clients. In addition to traditional services such as audit and attest services  and tax services, firms also offered consulting services in areas such as  information technology. As figure 1 illustrates, over the past several  decades, the provision of management consulting services increased  substantially. For example, in 1975, on average, management consulting  services comprised 11 percent of the Big 8’s total revenues, ranging from 5  percent to 16 percent by firm. By 1998, revenues from management  consulting services increased to an average of 45 percent, ranging from 34  to 70 percent of the Big 5’s revenues for that year. However, by 2000, firms  had begun to sell or divest portions of their consulting business and  average revenue from management consulting services had decreased to  about 30 percent of the Big 5’s total revenues.
Although all of the Big 4 firms continue to offer certain consulting services,  three of the Big 4 have sold or divested portions of their consulting  businesses. PricewaterhouseCoopers’ consulting practice was sold to  International Business Machines Corp.; KPMG’s consulting practice  became BearingPoint; and Ernst & Young sold its practice to Cap Gemini  Group S.A. While it has contemplated doing so, Deloitte & Touche has not  divested its management consulting practice.
The increase in the provision of management consulting and other  nonaudit services contributed to growing regulatory and public concern  about auditor independence. Although auditor independence standards  have always required that the accounting firm be independent both in fact  and in appearance, concern over auditor independence is a long-standing  and continuing issue for accounting firms. During the late 1970s, when  consulting services represented only a small portion of the Big 8’s revenue,  a congressional study noted that an auditor’s ability to remain independent  was diminished when the firm provided both consulting and audit services  to the same client. A number of subsequent studies resulted in various  actions taken by both the accounting firms and SEC to enhance the real  and perceived independence of auditors. By 2000, SEC proposed to amend  its rules on auditor independence because of the growing concern that the  increase in nonaudit services had impaired auditor independence. The  rules that were promulgated in 2001 amended SEC’s existing rules  regarding auditor independence and identified certain nonaudit services  that in some instances may impair the auditor’s independence, among other  things. The amendments also required most public companies to disclose  in their annual financial statements certain information about nonaudit  services provided by their auditor. Following the implementation of the  Sarbanes-Oxley Act in 2002, SEC issued new independence rules in March    2003. The new rules placed additional limitations on management  consulting and other nonaudit services that firms could provide to their  audit clients.
section_title: Big 8 Mergers and Andersen Dissolution Brought about the Big 4
paragraphs: Although U.S. accounting firms have used mergers and acquisitions to help  build their businesses and expand nationally and internationally since the  early part of the twentieth century, in the late 1980s Big 8 firms began to  merge with one another. As shown in figure 2, the first such merger in 1987  between Peat Marwick Mitchell, one of the Big 8, and KMG Main Hurdman,  a non-Big 8 U.S. affiliate of the European firm, Klynveld Main Goerdeler,  resulted in the creation of KPMG Peat Marwick. Because of the extensive  network Klynveld Main Goerdeler had in Europe, which none of the other  Big 8 had, the merged firm became the largest accounting firm worldwide  and the second largest U.S. firm until 1989. In 1989, six of the Big 8 firms  explored merging. In June 1989, the first merger among the Big 8 involved  fourth-ranked Ernst & Whinney and sixth-ranked Arthur Young to form  Ernst & Young. The resulting firm became the largest firm nationally (and  internationally). In August 1989, seventh-ranked Deloitte Haskins & Sells  and eighth-ranked Touche Ross merged to form Deloitte & Touche. The  resulting firm became the third largest firm nationally (and internationally).  A proposed merger between Andersen and Price Waterhouse was called off  in September 1989.
In 1997, four firms proposed additional mergers. The first two were Price  Waterhouse and Coopers & Lybrand. Soon thereafter, the leaders of Ernst  & Young and KPMG Peat Marwick announced a proposal to merge their  two firms. DOJ and the European Commission of the European Union  initiated studies of both merger requests. However, Ernst & Young and  KPMG Peat Marwick subsequently withdrew their proposal. In 1998, sixth- ranked Price Waterhouse merged with fifth-ranked Coopers & Lybrand to  become the second-ranked firm, PricewaterhouseCoopers.
To evaluate these mergers, DOJ, as indicated in its Merger Guidelines, used  various measures to determine whether the mergers were likely to create  or enhance market power and should, therefore, be challenged. DOJ  assessed whether the merger would result in a concentrated market,  increase the likelihood of adverse competitive effects, and whether entry of  other competitors into the market would be timely, likely, and sufficient   “to deter or counteract the competitive effects of concern.” DOJ then  evaluated whether the mergers would result in efficiency gains that could  not be achieved by other means and whether one of the parties to the  merger would be likely to fail and exit the market if the transaction was not  approved.
Finally, the market consolidated to the Big 4 in 2002. The criminal  indictment of fourth-ranked Andersen for obstruction of justice stemming  from its role as auditor of Enron Corporation led to a mass exodus of  Andersen partners and staff as well as clients. Andersen was dissolved in  2002.
section_title: Several Key Factors Spurred Consolidation in the 1980s and 1990s
paragraphs: Any one or a combination of several key factors were cited by the Big 4 and  others as spurring the mergers of the Big 8 in the 1980s and 1990s—notably  the immense growth of U.S. businesses internationally, desire for greater  economies of scale, and need and desire to build or expand industry- specific and technical expertise, among others. First, the trend toward  corporate globalization led to an increased demand for accounting firms  with greater global reach. Second, some firms wanted to achieve greater  economies of scale as they modernized their operations and built staff  capacity and to spread risk over a broader capital base. Third, some firms  wanted to build industry-specific or technical expertise as the operations of  their clients became increasingly complex and diversified. Finally, some  firms merged to increase or maintain their market share and maintain their  market position among the top tier.
subsections: section_title: Globalization of Clients Prompted Need for Greater Global Reach
paragraphs: According to representatives of the Big 4 firms, globalization was a driving  force behind the mergers of the 1980s and 1990s. As their clients expanded  their operations around the world, the top-tier firms felt pressure to expand  as well as to provide service to their clients. The trend toward corporate  globalization, which continues today, was spurred in part by the lowering  of trade barriers. Moreover, by the mid-1990s, the overall economic  environment was changing dramatically as technological and  telecommunications advances changed the way businesses operated. As a  result, large U.S. companies operated worldwide and more foreign-based  companies entered U.S. markets. Although all of the Big 8 had offices in  certain countries, they did not have extensive networks that enabled them  to provide comprehensive services to large multinational clients. Some of  the smaller Big 8 firms had difficulty attracting and retaining strong foreign  affiliates. Mergers with compatible firms were the quickest way to fill gaps  in geographic coverage. For instance, in the 1980s, Ernst & Whinney had an  established network in the Pacific Rim countries while Arthur Young did  not. Likewise, Price Waterhouse had a network in South America while  Coopers & Lybrand’s network was in Europe.
In addition to expanding their reach and staff capacity, firms believed that  they needed to establish global networks to stay abreast of country-specific  generally accepted accounting principles and regulations. Globalization  also had raised a number of tax issues that required firms to have networks  able to accommodate clients with operations in a growing number of  countries. To have successful global networks, the Big 8 needed affiliations  with prominent foreign firms.
section_title: Growing Complexity of Client Operations Prompted Need for Greater Industry- Specific and Technical Expertise
paragraphs: In addition to responding to globalization, representatives of the firms told  us that some of the mergers served to increase their industry-specific and  technical expertise and expand and build management-consulting  operations to better serve the complex needs of their rapidly evolving  clients. Each of the Big 8 firms had different strengths and industry  specializations. Through mergers, firms were able to build expertise across  more industries and diversify their operations. For example, the Ernst &  Whinney and Arthur Young merger brought together two firms that  specialized in healthcare and technology, respectively. Similarly, the Price  Waterhouse and Coopers & Lybrand merger brought together two firms  that dominated the market for audit services in the energy and gas and  telecommunications industries, respectively.
In addition, firm officials said that some of the mergers of the 1980s and  1990s were spurred by the need and desire to build or expand management  consulting services, which, as discussed previously, were becoming a larger  percentage of revenue. Officials also said that the mergers allowed them to  achieve economies of scope by offering a broader range of services to  clients. As firms merged, they were able to create synergies and offer their  clients extensive services beyond traditional audit and attest services such  as tax consulting, internal audit, and information systems support. In order  to remain competitive, some firms merged to build upon different  operating strengths such as consulting services versus auditing. For  example, the Deloitte Haskins & Sells and Touche Ross merger brought  together a firm with substantial audit and tax consulting operations and a  firm with a strong management consulting business.
In the same era, some firm officials said that they had to build their  technical expertise in areas such as derivatives and other complex financial  arrangements used by their clients. Firms also needed to build their  expertise to address a series of changes to the U.S. tax code and the  regulatory requirements faced by their clients in other countries.  Strengthening a firm’s technical expertise was critical, because some firms  believed that clients were increasingly selecting their auditors based on  specialized expertise and geographic coverage. Firms began to provide  technological support and services to clients that were modernizing their  operations.
section_title: Mergers Enabled Firms to Achieve Greater Economies of Scale
paragraphs: Like public companies, the accounting firms were undergoing dramatic  technological change and innovation in the 1980s and 1990s. According to  firm officials, firms were beginning to transition to computer-based  accounting systems and develop new auditing approaches that required a  considerable capital commitment. By expanding their capital base through  mergers, firms planned to create economies of scale by spreading  infrastructure costs from modernizing across a broader capital base. Some  firm officials said that mergers were critical to the firms’ modernization  because, unlike their clients, accounting firms could not raise new capital  by issuing securities. Because of their prevailing partnership structures, the  firms’ capital bases were largely dependent upon partner-generated capital.
In addition to economies of scale, firm officials said that they also expected  that mergers would increase overall staff capacity and result in more  efficient delivery of services and more effective allocation of resources in  order to better respond to market demands. The broader capital bases also  allowed firms to invest substantial resources in staff training and  development. Big 4 representatives said that staff training and development  were critical in attracting and retaining quality staff necessary to offer  services demanded by clients. Firm officials said that they also expected  that economies of scale would improve operational efficiencies and offset  declining profit margins as competition increased.
section_title: Mergers Helped Firms Increase Market Share and Maintain Market Position
paragraphs: Many accounting firms also merged to maintain or increase their market  share in order to hold their market position among top-tier firms.  Furthermore, some firms believed that some of their foreign affiliates  would change affiliations if they perceived that greater advantages in  seeking and retaining client business could be obtained through affiliation  with a larger firm. The mergers of the 1980s resulted in a growing disparity  in size between the largest and smallest of the Big 8. Big 4 representatives  told us that merging was a practical alternative to trying to build the  business through internal growth. For example, when seventh-ranked  Deloitte Haskins & Sells and eighth-ranked Touche Ross merged, they  became the third-ranked firm. The creation of Deloitte & Touche resulted in  Coopers & Lybrand being the second smallest of the top tier until it merged  with the smallest top-tier firm, Price Waterhouse, in 1998 to become  PricewaterhouseCoopers, the second-largest firm.
section_title: Audit Market Has Become More Highly Concentrated, Leaving Large Public Companies with Few Choices
paragraphs: Since 1988, the audit market has become increasingly concentrated,  especially in the market for large national and multinational company  audits, leaving these companies with fewer choices. The 1989 and 1998  mergers led to significant increases in certain key concentration measures  typically used by DOJ and FTC to evaluate potential mergers for antitrust  concerns. These measures indicate highly concentrated markets in which  the Big 4 have the potential to exercise significant market power. In  addition to using concentration measures, we employed a simple model of  pure price competition to assess whether the current high degree of  concentration in the market for audit services was necessarily inconsistent  with a purely price-competitive setting. Regardless of the ability of the  firms to exercise market power or not, consolidation has limited the  number of choices of accounting firms for large national and multinational  companies that require firms with requisite staff resources, industry- specific and technical expertise, extensive geographic coverage, and  international reputation. In some cases, the choices would be further  limited due to conflicts of interest, independence rules, and industry  specialization.
subsections: section_title: Large Public Company Audit Market is a Tight Oligopoly
paragraphs: By any measure, the large public company audit market is a tight oligopoly,  which is defined as the top four firms accounting for more than 60 percent  of the market and other firms facing significant barriers to entry into the  market. In the large public company audit market, the Big 4 now audit over  97 percent of all public companies with sales over $250 million, and other  firms face significant barriers to entry into the market. As table 1  illustrates, when comparing the top 25 firms on the basis of total revenues,  partners, and staff resources, the Big 4 do not have any smaller-firm  competitors, a situation that has given rise to renewed concerns about a  possible lack of effective competition in the market for large company  audit services.
The Big 4 accounting firms dominate internationally as well, with over $47  billion in total global net revenues for 2002, according to a February 2003  edition of Public Accounting Report. Moreover, information provided by  officials from foreign regulators suggests that the national markets for  audit services to large public companies in the other countries tend to be as  highly concentrated as they are in the United States, with the Big 4  accounting firms auditing a vast majority of these large public company  clients. For example, according to regulatory officials the Big 4 audited  over 80 percent of all public companies in Japan and at least 90 percent of  all listed companies in the Netherlands in 2002, while the Big 4 firms were  the auditors for virtually all major listed companies in the United Kingdom.  According to Italian regulators, in 2001 the Big 5 audited over 80 percent of  listed companies in Italy. and subsequent dissolution resulted in the HHI increasing to 2,566, well  above the threshold for significant market power. It is unclear whether and  to what extent the Antitrust Division was consulted and to what extent  DOJ’s Antitrust Division had input into the decision to criminally indict  Andersen.
In 2002, we found that the most significant concentration among  accounting firms was in the large public company market segment. As  figure 4 shows, although consistently above 1,000, HHIs (based on number  of clients) for firms auditing public companies with total sales between $1  million and $100 million are all below the 1,800 threshold. However, HHIs  for companies with sales over $100 million are consistently above the 1,800  threshold, indicating the potential for significant market power in the  market for larger company audits.
Analysis of the four-firm concentration ratio also indicates that  concentration among the top four accounting firms has increased  significantly since 1988. As shown in figure 5, in 1988 the top four firms  (Price Waterhouse, Andersen, Coopers & Lybrand, and KPMG) audited 63  percent of total public company sales. The next four firms (Ernst &  Whinney, Arthur Young, Deloitte Haskins & Sells, and Touche Ross) were  significant competitors, auditing 35 percent of total public company sales.  Also shown in figure 5, by 1997 the top four firms audited 71 percent of  public company total sales, with two major competitors (Coopers &  Lybrand and KPMG) auditing an additional 28 percent. Finally, by 2002, the  top four firms audited 99 percent of public company total sales with no  significant competitors (see fig. 5).
Likewise, the four-firm concentration ratio based on the total number of  public company clients increased from 51 percent in 1988 to 65 percent in  1997 and to 78 percent in 2002 (see fig. 6). Not surprisingly, the larger  public company segment of the market is even more concentrated than the  overall market. For example, the Big 4 audit roughly 97 percent of all public  companies with sales between $250 million and $5 billion and almost all  public companies with sales greater than $5 billion.
Effective competition does not require pure competitive conditions;  however, a tight oligopoly raises concerns because the firms may exercise  market power, and the concentrated structure of the market makes  successful collusion, overt or tacit, easier. In terms of market  concentration, the audit market does not differ from numerous other  markets in the United States that are also characterized by high degrees of  concentration (see table 2). Although the resulting structures are similar,  the factors contributing to the market structures and the competitive  environments may be fundamentally different.
section_title: Consolidation Does Not Appear to Have Impaired Price Competition to Date
paragraphs: Despite the high degree of concentration among accounting firms, with  four firms auditing more than 78 percent of all public companies and 99  percent of all public company sales, we found no evidence that price  competition to date has been impaired. As indicated in table 2, much of the  economy is concentrated, but U.S. markets are generally considered quite  competitive. Thus, market concentration data can overstate the  significance of a tight oligopoly on competition. While concentration ratios  and HHI are good indicators of market structure, these measures only  indicate the potential for oligopolistic collusion or the exercise of market  power. As market structure has historically been thought to influence  market conduct and economic performance, there is concern that a tight  oligopoly in the audit market might have resulted in detrimental effects on  both purchasers of audit services and users of audited financial statements.
We employed a simple model of pure price competition to assess whether  the high degree of concentration in the market for audit services was  necessarily inconsistent with a price-competitive setting. The model is  designed to simulate a market driven by pure price competition, in which  clients choose auditors on price—neither quality nor reputation, for  example, is a factor. The model’s simulation results suggest that a market  driven solely by price competition could also result in a high degree of  market concentration. We found that the model simulated market shares  that were close to the actual market shares of the Big 4, which are thought  to be driven by a number of other factors including quality, reputation, and  global reach. (See app. I for a detailed discussion of the model, results, and  limitations.) Specifically, the model predicted that the Big 4 would audit 64  percent of companies in the sampled market, compared with the Big 4  actual market share of 62.2 percent in 2002 for the companies included in  the simulation. Moreover, the model predicted that the Big 4 would audit  96.3 percent of companies in the sample with assets greater than $250  million, compared with the 97 percent of these companies actually audited  by the Big 4 in 2002. While evidence to date does not appear to indicate that  competition in the market for audit services has been impaired, the  increased degree of concentration coupled with the recently imposed  restrictions on the provision of nonaudit services by incumbent auditors to  their audit clients could increase the potential for collusive behavior or the  exercise of market power.
section_title: Large Public Companies Have Limited Number of Accounting Firm Choices
paragraphs: The most observable impact of consolidation among accounting firms  appeared to be the limited number of auditor choices for most large  national and multinational public companies if they voluntarily switched  auditors or were required to do so, such as through mandatory firm  rotation. Of the public companies responding to our survey to date, 88  percent (130 of 147) said that they would not consider using a smaller (non- Big 4) firm for audit and attest services. See appendix II for survey  questionnaires and responses. In addition, our analysis of 1,085 former  Andersen clients that changed auditors between October 2001 and  December 2002 suggested that public companies (especially large  companies) overwhelmingly preferred the Big 4. Only one large public  company with assets over $5 billion that was audited by Andersen switched  to a smaller firm. See appendix III for a detailed analysis.
For most large public companies, the maximum number of choices has  gone from eight in 1988 to four in 2003. According to our preliminary  survey results, a large majority (94 percent or 137 of 145) of public  companies that responded to our survey to date said that they had three or  fewer alternatives were they to switch accounting firms. All 20 of the audit  chairpersons with whom we spoke believed that they had three or fewer  alternatives. Of the companies responding to our survey, 42 percent (61 of  147) said that they did not have enough options for audit and attest  services. However, when asked whether steps should be taken to increase  the number of available choices, results revealed that 76 percent (54 of 71)  of public companies responding to our survey to date said they would  strongly favor or somewhat favor letting market forces operate without  government intervention.
We also found that client choices could be even further limited due to  potential conflicts of interest, the new independence rules, and industry  specialization by the firms—all of which may further reduce the number of  available alternatives to fewer than three. First, the Big 4 tend to specialize  in particular industries and, as our preliminary survey results indicated,  public companies that responded often preferred firms with established  records of industry-specific expertise, which could further reduce a  company’s number of viable choices. For example, 80 percent (118 of 148)  of the public companies responding to our survey to date said industry  specialization or expertise would be of great or very great importance to  them if they had to choose a new auditor. When asked why they would not  consider an alternative to the Big 4, 91 percent (117 of 129) of public  companies responding to date cited technical skills or knowledge of their  industry as a reason of great or very great importance.
As figure 7 shows, in selected industries, specialization can often limit the  number of firm choices to two—in each case, two firms accounted for well  over 70 percent of the total assets audited in each industry in 2002. As a  result, it might be difficult for a large company to find a firm with the  requisite industry-specific expertise and staff capacity. Figure 7 also shows  the impact of the Price Waterhouse and Coopers & Lybrand merger and  dissolution of Andersen on industry specialization and associated client  choice. While two firms also dominated the four selected industries in 1997,  this concentration became much more pronounced by 2002, as illustrated  in figure 7. See appendix IV for a detailed discussion of industry  specialization and further industry-specific examples and limitations of this  type of analysis.
Industry specialization, as captured by a relatively high market share of  client assets or client sales in a given industry, may also be indicative of a  firm’s dominance in that industry on a different level. As a hypothetical  example, consider a highly concentrated industry, with several very large  companies and numerous smaller companies, in which a single accounting  firm audits a significant portion of the industry assets. This firm’s  interpretation of accounting standards specific to the industry could  become the prevailing standard practice in that industry due to the firm’s  dominant role. If, subsequently, these interpretations were found to be  inappropriate (by some influential external third party, for example), the  firm as well as the companies audited by that firm could be exposed to  heightened liability risk, which could potentially have a severe negative  impact on that industry as a whole as well as the firm.
Finally, the new independence rules established under the Sarbanes-Oxley  Act of 2002, which limit the nonaudit services firms can provide to their  audit clients, may also serve to reduce the number of auditor choices for  some large public companies. As a hypothetical example, suppose that a  large multinational petroleum company that used one Big 4 firm for its  audit and attest services and another Big 4 firm for its outsourced internal  audit function wanted to hire a new accounting firm because its board of  directors decided that the company should change auditors every 7 years.  In this case, this company would appear to have two remaining alternatives  if it believed that only the Big 4 had the global reach and staff resources  necessary to audit its operations. However, one of the remaining two Big 4  firms did not enter a bid because its market niche in this industry was small  companies. Consequently, this company would be left with one realistic  alternative. Although hypothetical, this scenario spotlights another concern  that focuses on the potential exercise of market power, as it is highly  probable the remaining firm would be aware of its competitive position.  Conceivably, there are other scenarios and circumstances in which such a  company would have no viable alternatives for its global audit and attest  needs.
section_title: Linking Consolidation to Audit Price, Quality, and Auditor Independence Is Difficult
paragraphs: We found little empirical evidence to link past consolidation to changes in  audit fees, quality, and auditor independence. Given the significant changes  that have occurred in the accounting profession since the mid-1980s, we  were also unable to isolate the impact of consolidation from other factors.  However, researchers (relying on analyses based on aggregate billings of  small samples of companies or proxies for audit fees, such as average audit  revenues) generally found that audit fees remained flat or increased slightly  since 1989. Additionally, although not focused on consolidation, a variety of  studies have attempted to measure overall changes in audit quality and  auditor independence. The results varied, and we spoke with numerous  accounting experts who offered varying views about changes in quality and  independence. Like audit fees, a variety of factors, such as the increasing  importance of management consulting services provided to clients, make  attributing any changes, real or perceived, to any one of the factors  difficult.
subsections: section_title: Research on Changes in Audit Fees Used a Variety of Measures but Did Not Conclusively Determine Effects from Consolidation
paragraphs: Existing research indicated that audit fees (measured in different ways)  generally remained flat or decreased slightly from the late 1980s through  the mid-1990s but have been increasing since the late 1990s (inflation  adjusted). However, we were unable to isolate the effects of consolidation  and competition from the numerous other changes that have affected  accounting firms and how they conduct business. These changes included  evolving audit scope, the growth of management consulting services,  technological developments, and evolving audit standards and legal  reforms that altered audit firms’ litigation exposure. Given potential  changes in the scope of the audit, only the public accounting firms  themselves can accurately determine whether hourly audit fees have  increased or decreased since 1989. In general, the scope of an audit is a  function of client complexity and risk.
Although there are very little data on changes in audit fees over time and  existing studies used a variety of approaches to measure audit fees, two  recent academic studies are widely cited. One used a proxy measure for the  audit fee (Ivancevich and Zardkoohi) and the other was based on actual fees charged to a small sample of companies (Menon and Williams). For  the period following the mergers of the late 1980s, both studies found that  audit fees declined through the mid 1990s. Using audit revenues per  accounting firm divided by the dollar value of assets audited as a proxy for  the audit fee, Ivancevich and Zardkoohi found that “fees” fell for both the  merged firms (Ernst & Young and Deloitte & Touche) and the remaining Big  6 accounting firms from 1989 through 1996. Similarly, Menon and Williams  found that the average real audit fee per client declined from $3.4 million in  1989 to $2.8 million in 1997, the year Price Waterhouse and Coopers &  Lybrand announced their proposed merger. Moreover, although the results  were limited due to the small sample size used in the regression analysis,  the study did not find any evidence that the Big 6 mergers resulted in a  permanent increase in fees.
In addition, as figure 8 illustrates, the periodic survey of actual audit fees of  about 130 companies conducted by Manufacturers Alliance also found a  similar downward trend in audit fees per $100 of public company revenues  in 1989 (and earlier) through 1995. In 1995, the Private Securities  Litigation Reform Act was enacted, which limited the liability exposure of  accounting firms, among others. However, the survey revealed a slight  increase from 1995 through 1999 for U.S. and foreign companies. Figure 8  shows that U.S. companies also paid lower fees than their foreign  counterparts over the survey period. Separately, using net average audit  revenues for the top tier as a percentage of total sales audited as a proxy  for audit fees, we found that audit fees declined slightly from 1989 through  1995 and increased from 1995 through 2001 (see fig. 9). However, no  determination can be made as to whether consolidation negatively or  positively impacted audit fees in either case.
Although audit fees are generally a relatively small percentage of a public  company’s revenue, recent evidence suggests audit fees have increased  significantly since 2000 and there are indications they may increase further  in the future. Some experts believe that during the 1980s and 1990s audit  services became “loss leaders” in order for accounting firms to gain entry  into other more lucrative professional service markets, primarily  management consulting services.  Therefore, evidence of flat audit fees  since 1989 and the relatively small percentage of company revenue in 2000  may reveal little about the possible market power produced by having  fewer firms. Likewise, historical fees (especially certain proxy measures of  audit fees) reveal little about the potential for noncompetitive pricing in the  future given the new independence rules and evolving business model.
According to one source, average audit fees for Standard & Poor’s 500  companies increased 27 percent in 2002 due primarily to new requirements  and changing audit practices in the wake of recent accounting scandals.  Moreover, many market participants, experts, and academics with whom  we consulted believe prices will increase further due to the implementation  of the Sarbanes-Oxley requirements and related changes in the scope of  certain audit services and possible changes in auditing standards. Because  of these important changes and the potential for market power, it would be  difficult to isolate the portion of any price increase resulting from  noncompetitive behavior.
Likewise, nearly all accounting firms that responded to our survey said that  both costs and fees have increased over the past decade, but that costs  have increased more: 24 firms (51 percent) said their costs have “greatly”  increased, and another 22 firms (47 percent) said that costs have  “moderately” increased. However, when asked about the fees they charge,  only 12 of the 47 firms (26 percent) responded that the fees they charge  have greatly increased while another 33 firms (70 percent) said that their  fees had moderately increased. When public companies were asked about  fees, 93 percent (137 of 147) of the public companies that responded to our  survey to date said that audit fees had somewhat or greatly increased over  the past decade and 48 percent (70 of 147) said that consolidation had a  great or moderate upward influence on those fees. Some companies  indicated that most of this increase has occurred in the last few years.
section_title: Linking Consolidation to Audit Quality and Auditor Independence Is Difficult
paragraphs: Although we identified no research directly studying the impact of  consolidation among the accounting firms on audit quality or auditor  independence, we did find limited research that attempted to measure  general changes in audit quality and auditor independence, and we  explored these issues with market participants and researchers. We found  that theoretical and empirical research on both issues to date present  mixed and inconclusive results as, in general, measurement issues made it  difficult to assess changes in audit quality or auditor independence.
subsections: section_title: Research Offers Competing Theories on Factors Influencing Audit Quality and Auditor Independence
paragraphs: Audit quality and auditor independence are, in general, difficult to observe  or measure. Theory suggests that auditor independence and audit quality  are inextricably linked, with auditor independence being an integral  component of audit quality. One widely cited academic study defined  auditor independence as the probability that an auditor would report a  discovered problem in a company’s financial reports while another widely  cited academic study defined audit quality as the joint probability that an  auditor would discover a problem in a company’s financial reports and,  further, that the auditor would report the problem.
Research offers competing theories that address how competition among  firms, auditor tenure, and accounting firm size—all factors that could be  influenced directly by consolidation—might impact auditor independence  and, thus, audit quality. For example, some research hypothesized that  increased competition could have a negative effect, as a client’s  opportunities and incentives to replace an incumbent auditor might  increase for reasons ranging from minimizing audit fees to a desire for a  more compliant auditor. However, other research hypothesized that  increased competition could reduce the probability that some accounting  firms could exercise disproportionate influence over the establishment of  accounting principles and policies. Likewise, auditor tenure might also  have a positive or negative impact. Some research hypothesized that an  auditor that served a given client for a longer period of time may be more  valuable to that client due to its deeper familiarity with and deeper insight  into the client’s operations, which would allow the auditor to become less  dependent on the client for information about the client’s operations.  However, other research hypothesized that increased tenure could result in  complacency, lack of innovation, less rigorous audit procedures, and a  reflexive confidence in the client. Some research hypothesized that an  accounting firm’s size might also have an impact, as a larger firm might  become less dependent on a given client than a smaller firm.
Academic research suggests that larger auditors will perform higher quality  audits and there are many studies employing proxies for audit quality that  frequently report results consistent with such a notion. However, given its  unobservable nature, there does not appear to be definitive evidence  confirming the existence of differential audit quality between the Big 4  accounting firms and other auditors. Some researchers have dismissed the  notion of differential audit quality, while others have questioned the  assumption that the larger firms provide higher quality audits. Some  experts with whom we consulted asserted that there was a quality  differential, while others were not convinced of this. One academic told us  that the question of differential audit quality was difficult to answer, since  large accounting firms generally handle most large company audits. This  individual also suggested that smaller accounting firms could provide the  same audit quality as larger accounting firms, provided that these smaller  firms only accepted clients within their expertise and service potential.
section_title: Studies Often Use Restatements, Going-Concern Opinions, and Earnings Management to Measure Audit Quality and Auditor Independence
paragraphs: Audit quality is not generally measurable and tends only to be made public  when a company experiences financial difficulties and its investors have a  reason to question it. Studies addressing audit quality and auditor  independence have typically focused on financial statement restatements,  going-concern opinions, and earnings management or manipulation.
Financial statement restatements due to accounting improprieties have  been used by some as a measure of audit quality. By this measure, there is  some evidence suggesting that audit quality may have declined over the  1990s, as several recent studies have found that financial statement  restatements due to accounting irregularities have been increasing, and  those by larger companies have been increasing as well. As larger  companies typically employ larger accounting firms, which have been  perceived historically by some as providing higher quality audits, this trend  toward larger company financial statement restatements may heighten  concerns about potentially pervasive declining audit quality. In addition, in  some recent high-profile restatement cases it appeared that the auditors  identified problems but failed to ensure that management appropriately  addressed their concerns, raising questions about auditor independence.
Another measure that has been employed by researchers to gauge audit  quality is whether an auditor issues a going-concern opinion warning  investors prior to a company’s bankruptcy filing. One study found that  during the 1990s accounting firms issued fewer going-concern audit  opinions to financially stressed companies prior to bankruptcy. This study  found that auditors were less likely to issue going-concern opinions in  1996-1997 than in 1992-1993, and again less likely to issue such opinions in  1999-2000 than in 1996-1997. Moreover, another study that analyzed going-  concern opinions found that accounting firms failed to warn of nearly half  of the 228 bankruptcies identified from January 2001 through June 2002,  despite the fact that nearly 9 out of 10 of these companies displayed at least  two indicators of financial stress. However, numerous prior studies also  found that approximately half of all companies filing for bankruptcy in  selected periods prior to the 1990s did not have prior going-concern  opinions in their immediately preceding financial statements either.  Another study focusing on going-concern opinions over a relatively short,  recent time period examined whether there was an association between  nonaudit fees and auditor independence, but it found no significant  association between the two using auditors’ propensity to issue going- concern opinions. This study’s findings were consistent with market- based institutional incentives dominating expected benefits from auditors  compromising their independence.
Corporate earnings reported in companies’ annual filings (to which  auditors attest fairness) can be an important factor in investors’ investment  decisions, and can be used by corporate boards and institutional investors  in assessing company performance and management quality, and in  structuring loans and other contractual arrangements. As such, they can  have an impact on securities prices and managers’ compensation, among  other things. Earnings management or manipulation (captured by, for  example, managers’ propensity to meet earnings targets) is another  measure that has been used by researchers to capture audit quality,  although in this case an auditor’s influence on its clients’ earnings  characteristics is likely to be less direct and there can be more significant  measurement problems. While there has been growing anecdotal and  empirical evidence of earnings management, research using this measure  to determine whether audit quality or auditor independence was impaired  yielded mixed results. For example, while one recent study suggested that  nonaudit fees impair the credibility of financial reports, another cast doubt  on its results, and another found evidence consistent with auditors  increasing their independence in response to greater financial dependence  (that is, for larger clients).
section_title: Despite Contrasting Views on Audit Quality, Experts and Professionals Did Not View Consolidation as Cause
paragraphs: Existing research on audit quality and auditor independence presents  inconclusive results, suffers from problematic measurement issues, and  generally does not consider or compare these factors over extended time  periods. Many academics and other accounting experts we contacted  indicated that they believed audit quality had declined since 1989. However,  others, including small accounting firms and large company clients that  responded to our survey to date, believed that audit quality had not  decreased. For example, 43 percent (63 of 147) of public companies that  responded believed the overall quality had gotten much or somewhat better  over the past decade, while 18 percent (27 of 147) felt it had gotten much or  somewhat worse. Of the public companies that responded to our survey to  date, 60 percent (88 of 147) indicated that their auditor had become much  more or somewhat more independent over the last decade. However, some  accounting firms acknowledged that achieving auditor independence was  difficult: 10 percent (14 of the 147) accounting firms that responded to our  survey said that it had become much or somewhat harder to maintain  independence at the firm level in the past decade and 19 percent (9 of the  47) indicated that it had become much more difficult or somewhat harder  to maintain independence at the individual partner level over the past  decade.
Even if audit quality or auditor independence has been affected, it would be  difficult to determine any direct link to consolidation among accounting  firms because of numerous other structural changes that occurred both  within and outside of the audit market. When we asked our survey  respondents how consolidation influenced the quality of audit services they  received, 64 percent (94 of 147) of the public companies responding to date  and 95 percent (41 of 43) of accounting firms said that consolidation had  little or no effect. However, some academics we contacted believed that  consolidation might have indirectly influenced audit quality during the  1990s, with some suggesting, for example, that concentration among a few  firms enabled the largest accounting firms to exercise greater influence  over the audit standard setting process and regulatory requirements.
section_title: Academics and Other Experts Said Other Factors Affected Audit Quality and Auditor Independence
paragraphs: In general, many of the people with whom we spoke—representing  academia, the profession, regulators, and large public companies— believed that other factors could potentially have had a greater effect on  audit quality than consolidation. According to knowledgeable individuals  with whom we spoke, a variety of factors may have had a more direct  impact on audit quality and auditor independence than consolidation. For  example, they cited the removal of restrictions against advertising and  direct solicitation of clients, the increased relative importance of  management consulting services to accounting firms, legal reforms,  changing auditing standards, and a lack of emphasis on the quality of the  audit by clients and some capital market participants.
Several individuals who were knowledgeable about accounting firm history  suggested that when advertising and direct solicitation of other firms’  clients began to be permitted in the 1970s, the resulting competitive  pressure on audit prices led accounting firms to look for ways to reduce the  scope of the audit, resulting in a decline in audit quality. Many of the  experts with whom we consulted also suggested that the entry of  accounting firms into more lucrative management consulting services led  to conflict-of-interest issues that compromised the integrity and quality of  the audit service.
Other sources noted that, as a result of several legal reforms during the  1990s, it became more difficult and less worthwhile for private plaintiffs to  assert civil claims against auditors and audit quality may also have  suffered. This view was supported by a study that concluded that  accounting firms were less likely to warn investors about financially  troubled companies following the litigation reforms of the 1990s.
section_title: Consolidation Appears to Have Had Little Effect on Capital Formation or Securities Markets to Date, and Future Implications Are Unclear
paragraphs: Although accounting firms play an important role in capital formation and  the efficient functioning of securities markets, we found no evidence to  suggest that consolidation among accounting firms has had an impact on  either of these to date. Moreover, we were unable to find research directly  addressing how consolidation among accounting firms might affect capital  formation or the securities markets in the future.
Capital formation and the securities markets are driven by a number of  interacting factors, including interest rates, risk, and supply and demand.  Isolating any impact of consolidation among accounting firms on capital  formation or the securities markets is difficult because of the complex  interaction among factors that may influence the capital formation process,  and we were unable to do so. Moreover, most capital market participants  and other experts with whom we spoke were either unsure or did not  believe that consolidation had any directly discernible impact on capital  formation or the securities markets. Some said that the broader issues  facing accounting firms, such as the recent accounting-related scandals  involving Enron and WorldCom, might have affected the capital markets by  reducing investor confidence, but that these were not necessarily linked to  consolidation.
The informational role played by accounting firms is key to reducing the  disparity in information between a company’s management and capital  market participants regarding the company’s financial condition, thus  enhancing resource allocation. Consequently, to the extent that  consolidation might affect audit quality, especially the perception of audit  quality, the cost and allocation of capital could be affected. For example, a  perceived decline in audit quality for a given company might lead the  capital markets to view that company’s financial statements with increased  skepticism, potentially increasing the company’s cost of capital as well as  altering the capital allocation decisions of capital market participants.  The liability to which accounting firms are subject also creates a form of  “insurance” to investors through an auditor’s assurance role, which  provides investors with a claim on an accounting firm in the event of an  audit failure. To the extent that consolidation increased the capital bases  of some accounting firms, investors might view this as potentially  increasing loss recovery in the event of an audit failure involving those  firms. However, it is unclear whether there has been or would be any  impact on investor behavior, either positive or negative, due to the  increased capital base of some firms.
Although there appears to be no direct effect from consolidation of the Big  8 on the capital markets to date, some capital market participants and  anecdotal evidence suggested that investment bankers and institutional  investors, both of whom are integral to the capital formation process, often  prefer that public companies use the Big 4 to audit their financial  statements. Although such a preference does not appear to represent  much of a constraint to large national and multinational companies, it  could have an impact on other, smaller companies accessing the capital  markets, as a company’s use of a less well-known accounting firm might  create added uncertainty on the part of investors and could possibly lead to  delays in accessing new capital. For example, some research indicated that  there was less initial public offering underpricing for companies that used  Big 8 or larger accounting firms, as opposed to those that engaged smaller  accounting firms. According to firm officials, as larger accounting firms  reevaluate their portfolio of clients, some smaller public companies may no  longer be able to engage the Big 4 or other large accounting firms with  whom capital market participants are more familiar. Thus, partially as a  result of a market with fewer accounting firms able or willing to provide  audit services to larger public companies, some smaller companies could  be hindered in their ability to raise capital.
Because the audit market has become more concentrated, the Big 4 have  been increasing their focus on gaining the audit contracts of larger public  companies. In the process, the Big 4 shed some of their clients, particularly  smaller ones, which they viewed as not profitable or as posing  unacceptable risks to their firms. Likewise, smaller firms said that they  have undergone similar risk assessment and client retention processes, and  they have also shed some clients that no longer satisfied their client  criteria. Moreover, the possible reduction in the number of accounting  firms willing to audit public companies in the wake of the passage of  Sarbanes-Oxley could further impact the availability and cost of capital for  some smaller companies, particularly companies for whom the accounting  firms may doubt the profitability of the audit engagements. As noted  earlier, familiarity with an accounting firm on the part of capital market  participants could lead to easier, less expensive access to the capital  markets.
section_title: Smaller Accounting Firms Face Numerous Barriers to Entry into the Top Tier
paragraphs: Unlike the Big 4, which have established global operations and  infrastructure, smaller accounting firms face considerable barriers to entry,  such as the lack of capacity and capital limitations, when competing for the  audits of large national and multinational public companies. First, smaller  firms generally lack the staff resources, technical expertise, and global  reach to audit large multinational companies. Second, public companies  and markets appear to prefer the Big 4 because of their established  reputation. Third, the increased litigation risk and insurance costs  associated with auditing public companies generally create disincentives  for smaller firms to actively compete for large public company clients.  Fourth, raising the capital to expand their existing infrastructure to  compete with the Big 4, which already have such operations in place, is  also a challenge, in part because of the partnership structure of accounting  firms. Finally, certain state laws, such as state licensing requirements,  make it harder for smaller firms that lack a national presence to compete.  The firms with whom we spoke, including the Big 4, all told us that they did  not foresee any of the other accounting firms being able to grow to  compete with the Big 4 for large national and multinational public company  clients in the near future.
subsections: section_title: Smaller Firms Generally Lack Staff Resources, Technical Expertise, and Global Reach to Audit Large Public Companies
paragraphs: Perhaps the most difficult challenge facing smaller firms is the lack of staff  resources, technical expertise, and global reach necessary to audit most  large national and multinational companies and their often complex  operations. Moreover, 91 percent (117 of 129) of public companies  responding to our survey who would not consider using a non-Big 4 firm as  their auditor said that the capacity of the firm was of great or very great  importance in their unwillingness to do so. Large multinational  companies are generally more complex to audit and require more auditors  with greater experience and training. The complexity of a public company  audit depends on many factors, such as the number of markets in which the  company competes, the size of the company, the nature of the company’s  business, the variety of revenue streams it has, and organizational changes.  It is not uncommon for an audit of a large national or multinational public  company to require hundreds of staff.
Most smaller firms lack the staff resources necessary to commit hundreds  of employees to a single client, which limits smaller firms’ ability to  compete with the Big 4 for large audit clients. Yet, without having large  clients, it is difficult to build the capacity needed to attract large clients.  Even with global networks and affiliations, the capacity gap between the  fourth- and fifth-ranked firms is significant. For example, the smallest Big 4  firm in terms of 2002 partners and nonpartner professional staff from U.S.  operations, KPMG, is over five times the size of the fifth-largest firm, Grant  Thornton. As table 3 illustrates, the gap between the top tier and the next  tier has grown significantly since 1988. This gap spans revenue, number of  partners, professional staff size, offices, and number of SEC clients. The  result is a dual market structure—one market where the Big 4 compete  with several smaller accounting firms for medium and small public  companies and another market where essentially only the Big 4 compete  for the largest public company clients.
Although firms of all sizes expressed some difficulty attracting staff with  specialized audit or industry-specific expertise, smaller firms said that this  was particularly difficult. Further, some smaller firms told us that they had  difficulty keeping talented employees, especially those with sought-after  expertise, from leaving for jobs with the Big 4. The Big 4 can afford to more  highly compensate employees and also offer a wider range of opportunities  than smaller firms. Moreover, the public companies that responded to our  survey to date ranked industry specialization or expertise as the third most  important consideration in selecting an auditor. Some company officials  also said that they preferred a firm to have a “critical mass” or depth of staff  with the requisite expertise and knowledge, which generally required a firm  of a certain size.
In addition to smaller firms having staff resource and technical expertise  constraints, some public companies said that their auditor had to have  sufficient global reach to audit their international operations. Without  extensive global networks, most smaller firms face significant challenges in  competing for large multinational clients. As table 4 illustrates, the  disparity in capacity between the Big 4 and the next three largest firms’  global operations was even more dramatic than the comparison between  their U.S. operations. For example, on average, the Big 4 had over 75,000  nonpartner professional staff and over 6,600 partners compared to the next  three largest firms with over 14,000 nonpartner professional staff and  around 2,200 partners.
While some of the smaller firms have international operations, we found  that some public companies and others were either unaware that they had  such operations or were uncertain of the degree of cohesive service that  these smaller firms could provide through their global affiliations. The  various national practices of any given Big 4 firm are separate and  independent legal entities, but they often share common resources, support  systems, audit procedures, and quality and internal control structures.  Market participants said that the affiliates of smaller firms, in contrast,  tended to have lower degrees of commonality. Rather than a tight network,  they described smaller firms’ international affiliations as associations or  cooperatives in which there was less sharing of resources and internal  control systems. In addition, they said that quality standards, practices and  procedures might be less uniform between smaller firm affiliates, which  raised concerns for multinational public companies.
section_title: Smaller Firms Lack Global Reputation
paragraphs: Smaller firms face a challenge to establish recognition and credibility  among large national and multinational public companies and, as discussed  previously, capital market participants. One reason capital market  participants often prefer a Big 4 auditor is because of their higher level of  familiarity with the Big 4. For example, some large public companies said  that some of the smaller accounting firms could provide audit services to  certain large national public companies, depending on the complexity of  the companies’ operations. These individuals added, however, that boards  of directors of these companies might not consider this option. Others said  that despite recent accounting scandals involving the Big 4, many capital  market participants continued to expect the use of the Big 4 for audit  services. Thus, companies seeking to establish themselves as worthy  investments may continue to engage one of the Big 4 to increase their  credibility to investors. Eighty-two percent (121 of 148) of the public  companies that responded to our survey indicated that reputation or name  recognition was of great or very great importance to them in choosing an  auditor. This was the second-most-cited factor, exceeded only by quality.
section_title: Increased Litigation Risk and Insurance Costs Make Large Company Audit Market Less Attractive Than Other Options
paragraphs: Increased litigation risk presents another barrier for smaller firms seeking  to audit larger public companies as they face difficulties managing this risk  and obtaining affordable insurance. Like many of the challenges faced by  smaller firms, this is a challenge for all firms. However, assuming that  smaller firms were able to purchase additional insurance to cover the new  risk exposure, most smaller firms lacked the size needed to achieve  economies of scale to spread their litigation risk and insurance costs across  a larger capital base. According to 83 percent of firms (38 of the 46) that  responded to our survey, litigation and insurance factors have had a great  or moderate upward influence on their costs, which they indicated have  increased significantly. Specifically, some of the firms with whom we  spoke said that their deductibles and premiums have increased  substantially and coverage had become more limited. Given the recent  high-profile accounting scandals and escalating litigation involving  accounting firms, some firms said that insurance companies saw increased  risk and uncertainty from insuring firms that audited public companies. As  a result, some of the smaller firms with whom we spoke said they had or  were considering limiting their practices to nonpublic clients. Others said  that the greater risk associated with auditing large public companies was a  key factor in their decisions not to attempt to expand their existing  operations in the public company audit market.
Finally, many of the largest non-Big 4 firms said that they had ample  opportunities for growth in the mid-sized public company segment of the  public company audit market and in the private company audit market. In  addition, smaller firms said that they could attract large companies as  clients for other audit-related and nonaudit services such as forensic  audits, management consulting services, and internal audits. In their efforts  to maximize profits, these smaller firms said they were targeting market  segments in which they were best positioned to compete, which generally  did not include the large public company audit market.
section_title: Raising Capital for Growth Is Difficult
paragraphs: Access to capital is another critical element to an accounting firm’s ability  to generate the capacity needed to establish the network and infrastructure  to audit large multinational companies. Several firms cited the lack of  capital as one of the greatest barriers to growth and the ability to serve  larger clients. They said that the partnership structure of most public  accounting firms was one factor that limited the ability of all firms to raise  capital but posed a particular challenge for smaller firms. Under a  partnership structure, accounting firms are unable to raise capital through  the public markets. To expand their operations, accounting firms must look  to other options, such as borrowing from financial institutions, merging  with other accounting firms, growing the business without merging, or  tapping the personal resources of their partners and employees. Raising  capital through borrowing may be difficult because accounting firms as  professional service organizations may lack the collateral needed to secure  loans.
While mergers provide a way for firms to grow and expand their capital  base, the smaller firms with whom we spoke indicated that they were not  interested in merging with other similarly sized firms. Some firms said that  they did not see the economic benefits or business advantages of doing so  while others said that they wanted to maintain their unique identity.
We also employed the Doogar and Easley (1998) model by simulating  mergers among smaller firms in order to assess whether, in a purely price  competitive environment, such mergers could lead to viable competitors to  the Big 4 for large national and multinational clients. In particular, we  merged the five largest firms below the Big 4 in terms of the number of  partners (Grant Thornton, BDO Seidman, Baid Kurtz & Dobson, McGladrey  & Pullen, and Moss Adams) and simulated the market to see if the newly  merged firm could attract public companies (of any size) away from the Big  4. We first assumed that the newly merged firm would become as efficient  as the Big 4, as measured by the staff-to-partner ratio. Under this best-case  scenario, we projected this firm’s market share would be 11.2 percent,  compared with the five firms’ actual collective 2002 market share of 8.6  percent, indicating a 2.6 percentage-point gain in market share. However,  when we assumed lesser efficiency gains, the merged firm’s projected  market share ranged from 4.5 percent (no efficiency gains) to 6.4 percent  (some efficiency gains), indicating that the merged firm’s market share  would be lower than their collective market share (see app. II). Even  ignoring many real world considerations, such as reputation and global  reach, these results illustrated the difficulty faced to date by any potential  competitor to the Big 4 firms in the market for large public company audits.
section_title: State Requirements Pose Obstacles for Smaller Firms in Particular
paragraphs: While all accounting firms must comply with state requirements such as  licensing, smaller firms that lack an existing infrastructure of national  offices face increased costs and burden to establish geographic coverage  needed for auditing most large public companies. All 50 states, the District  of Columbia, Guam, Puerto Rico, and the U.S. Virgin Islands have laws  governing the licensing of certified public accountants, including  requirements for education, examination, and experience.
While each jurisdiction restricts the use of the title “certified public  accountant” to individuals who are registered as such with the state  regulatory authority, the other licensure requirements are not uniform.  State boards have been working toward a more uniform system based on  the Uniform Accountancy Act (UAA), which is a model licensing law for  state regulation within the accounting profession. The UAA seeks adoption  of the idea of “substantial equivalency” with regard to education,  examinations, and experience, so that states recognize each other’s  certification as “substantially equivalent” to their own. According to  National Association of State Boards of Accountancy and AICPA officials,  fewer than half (23) of the jurisdictions had agreed to the equivalency  practice as of July 1, 2003.
Some firms expressed concerns that potential state and federal duplication  of oversight could pose more of a burden for smaller firms than the Big 4  and might induce some smaller firms to stop auditing public companies  altogether. Specifically, to mirror the federal oversight structure, most  states (37) implemented statutorily required peer reviews for firms  registered in the state. Until 2002, these requirements were generally  consistent with the peer review process conducted by AICPA’s SEC  Practice Section. However, Sarbanes-Oxley created PCAOB to establish  auditing standards and oversee firms’ compliance with those standards.  Unlike the old peer review that focused on a firm’s overall operations,   PCAOB plans to conduct inspections of a firm’s public company practice.  Whether this inspection will be sufficient to satisfy the peer review  requirements under state law or whether firms with private clients would  have to be subject to both state- and federal-level reviews is unclear at this  time.
section_title: Observations
paragraphs: The audit market is in the midst of unprecedented change and evolution. It  has become more highly concentrated, and the Big 4, as well as all  accounting firms, face tremendous challenges as they adapt to new risks  and responsibilities, new independence standards, a new business model,  and a new oversight structure, among other things. In many cases it is  unclear what the ultimate outcome will be and our findings about past  behavior may not reflect what the situation will be in the future. Therefore,  we have identified several important issues that we believe warrant  additional attention and study by the appropriate regulatory or  enforcement agencies at some point. First, agencies could evaluate and  monitor the effect of the existing level of concentration on price and quality  to see if there are any changes in the firms’ ability to exercise market  power. This is especially important as the firms move to a new business  model with management consulting becoming a less significant source of  revenue. Second, the issue of what, if anything, can or should be done to  prevent further consolidation of the Big 4 warrants consideration. Such an  analysis could determine the possible impact of increased concentration  through the voluntary or involuntary exit of one of the current Big 4 firms.  If the effects were seen as detrimental, regulatory and enforcement  agencies could evaluate the types of actions that could be taken to mitigate  the impact or develop contingency plans to deal with the impact of further  consolidation. Part of this analysis would be to evaluate the pros and cons  of various forms of government intervention to maintain competition or  mitigate the effects of market power. Third, it is important that regulators  and enforcement agencies continue to balance the firms’ and the  individuals’ responsibilities when problems are uncovered and to target  sanctions accordingly. For example, when appropriate, hold partners and  employees rather than the entire firm accountable and consider the  implications of possible sanctions on the audit market. However, it is  equally important that concerns about the firms’ viability be balanced  against the firms’ believing they are “too few to fail” and the ensuing moral  hazard such a belief creates. Fourth, Big 4 market share concentration,  particularly in key industries, may warrant ongoing and additional analysis,  including evaluating ways to increase accounting firm competition in  certain industries by limiting market shares. Finally, it is unclear what can  be done to address existing barriers to entry into the large public company  market. However, it may be useful to evaluate whether addressing these  barriers could prevent further concentration in the top tier. Part of this  evaluation could include determining whether there are acceptable ways to  hold partners personally liable while reasonably limiting the firms’  exposure, but at the same time increasing the firms’ ability to raise capital.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided copies of a draft of this report to SEC, DOJ, PCAOB, and  AICPA for their comment. We obtained oral comments from DOJ officials  from the Antitrust and Criminal Divisions, who provided additional  information on the extent to which coordination with antitrust officials and  consideration of the competitive implications of the Andersen criminal  indictment occurred. As a result, we clarified the language provided in this  report.   SEC, DOJ, and AICPA provided technical comments, which have  been incorporated into this report where appropriate. PCAOB had no  comments.
We are sending copies of this report to the Chairman and Ranking Minority  Member of the House Committee on Energy and Commerce. We are also  sending copies of this report to the Chairman of SEC, the Attorney General,  the Chairman of PCAOB, and other interested parties. This report will also  be available at no cost on GAO’s Internet homepage at http//www.gao.gov.
This report was prepared under the direction of Orice M. Williams,  Assistant Director. Please contact her or me at (202) 512-8678 if you or your  staff have any questions concerning this work. Key contributors are  acknowledged in appendix V.
section_title: Scope and Methodology
paragraphs: As mandated by Section 701 of the Sarbanes-Oxley Act of 2002 (P.L. 107- 204) and as agreed with your staff, our objectives were to study (1) the  factors leading to the mergers among the largest public accounting firms in  the 1980s and 1990s; (2) the impact of consolidation on competition,  including the availability of auditor choices for large national and  multinational public companies; (3) the impact of consolidation on the  cost, quality, and independence of audit services; (4) the impact of  consolidation on capital formation and securities markets; and (5) the  barriers to entry faced by smaller firms in competing with the largest firms  for large national and multinational public company clients.
We conducted our work in Chicago, Illinois, New York, New York, and  Washington, D.C., from October 2002 through July 2003.
subsections: section_title: Identifying the Factors for Consolidation
paragraphs: To identify the factors contributing to consolidation among accounting  firms, we interviewed past and current partners of public accounting firms  involved in Big 8 mergers, and officials from the Department of Justice  (DOJ) and Federal Trade Commission (FTC). Specifically, we conducted in- depth interviews with senior partners of the Big 4 firms and, to the extent  possible, the former partners, chairmen, and chief executive officers (CEO)  of the Big 8 who were instrumental in their firms’ decisions to consolidate.  We asked these officials to recount in detail their firms’ histories of  consolidation and their views on the impetus for merging. We also  conducted interviews with senior DOJ officials about the studies and  investigations they had undertaken to determine whether the mergers  would raise antitrust issues. We did not, however, review any of the  antitrust analyses conducted by DOJ specific to any of the proposed  mergers during the 1980s and 1990s. We requested DOJ’s antitrust analysis  and related documentation from the mergers among the largest firms in  1987 and 1997. According to DOJ officials, most of the firm documents had  been returned to the relevant parties, and other documents were viewed as  “predecisional” by DOJ. While GAO’s statute provides us with access to  predecisional information absent a certification by the President or the  Director of the Office of Management and Budget, we were more interested  in the reasons for the mergers than DOJ’s analysis in approving the  mergers. Therefore, we used other sources to obtain the necessary  information for this report. To the extent possible, we obtained copies of  public decisions made by FTC in the 1970s and 1980s concerning the ability  to advertise by professional service firms, including the accounting firms.  As directed by the mandate, we coordinated with the Securities and  Exchange Commission (SEC) and SEC’s counterparts from the Group of  Seven nations (Canada, France, Germany, Italy, Japan, United Kingdom,  and United States). To do this, we met with the representatives of the  appropriate regulatory agencies under the auspices of the International  Organization of Securities Commissions and obtained additional  information relevant to their countries. We also conducted a literature  review of existing studies on the history of the accounting profession and  consolidation.
section_title: Impact of Consolidation on Competition, Auditor Choices, Audit Fees, and Audit Quality and Auditor Independence
paragraphs: To evaluate the impact of consolidation on competition, auditor choices,  audit fees, and audit quality and auditor independence, we consulted with  academics and other researchers, U.S. and foreign regulators, and trade  associations, and we reviewed relevant academic literature. Most of the  research studies cited in this report have been published in highly  regarded, refereed academic journals. These studies were also reviewed by  GAO’s economists, who determined that they did not raise serious  methodological concerns. However, the inclusion of these studies is purely  for research purposes and does not imply that we deem them definitive. We  sent out 26 structured questionnaires regarding the impact of consolidation  on choice, price, and quality to a cross section of academics and other  experts (with backgrounds in accounting, securities, and industrial  organization) and received 14 responses. We also collected data and  calculated our own descriptive statistics for analysis. Using audit market  data from various sources, we computed concentration ratios and  Hirschman-Herfindahl indexes and conducted trend analyses and tests of  statistical independence. We also employed a simple model of pure price  competition, in which clients choose auditors based on price, ignoring  factors such as quality or reputation, to assess whether the current high  degree of concentration in the market for audit services is necessarily  inconsistent with a purely price competitive setting. To augment our  empirical findings, we conducted two surveys. Finally, we interviewed a  judgmental sample of 20 chairpersons of audit committees of Fortune 1000  companies to obtain their views on consolidation and competition.
section_title: Data Analysis Used a Variety of Sources
paragraphs: To address the structure of the audit market we computed concentration  ratios and Hirschman-Herfindahl indexes for 1988 to 2002 using the Who  Audits America database, a directory of public companies with detailed  information for each company, including the auditor of record, maintained  by Spencer Phelps of Data Financial Press. We used Public Accounting  Report (PAR) and other sources for the remaining trend and descriptive  analyses, including the analyses of the top and lower tiers of accounting  firms, contained in the report. Data on audit fees were obtained from a  variety of academic and other sources, including Manufacturers Alliance.  The proxy for audit fees that we constructed was based on numerous  issues of PAR and Who Audits America. Given the data used and the  manner in which our proxy was constructed, this should be considered to  be a rough proxy and is used for illustrative trend analysis in this report. To  verify the reliability of these data sources, we performed several checks to  test the completeness and accuracy of the data. Random samples of the  Who Audits America database were crosschecked with SEC proxy filings  and other publicly available information. Descriptive statistics calculated  using the database were also compared with similar statistics from  published research. Moreover, Professors Doogar and Easley (see next  section for fuller discussion), who worked with us on the modeling  component of the study, compared random samples from Compustat, Dow- Jones Disclosure, and Who Audits America and found no discrepancies.  Because of the lag in updating some of the financial information, the results  should be viewed as estimates useful for describing market concentration.  We performed similar, albeit more limited, tests on PAR data. However,  these data are self-reported by the accounting firms and it should be noted  that the firms are not subject to the same reporting and financial disclosure  requirements as SEC registrants.
section_title: We Used the Doogar and Easley (1998) Model of Audit Market Structure to Assess Concentration in a Purely Price Competitive Framework
paragraphs: We also employed a simple model of pure price competition, in which  clients choose auditors based on price, ignoring factors such as quality or  reputation, to assess whether the current high degree of concentration in  the market for audit services is necessarily inconsistent with a price- competitive setting. We worked with Professor Rajib Doogar, University of  Illinois at Urbana-Champaign, and Professor Robert Easley, University of  Notre Dame, to expand and update their 1998 model using 2002 data. Our  sample consisted of 5,448 companies listed on the American Stock  Exchange, NASDAQ, and New York Stock Exchange, and other companies  with stock traded on other over-the-counter markets identified from Who  Audits America. To ensure consistency with Doogar and Easley (1998), we  limited the market studied to only industrial companies. The information  on accounting firms, such as number of partners and staff, was obtained  from PAR. Professors Doogar and Easley performed the simulations.
To determine whether the tight oligopoly in the audit market in 2002 could  be explained with a model of pure price competition, we ran three market  simulations. In the first simulation, we allowed the firms to compete for  clients to determine market share in a simulated price-competitive market.  For the second simulation, we assigned companies to their current auditor  and simulated the market to see if the accounting firms could defend their  market share in a purely price-competitive market. Finally, we combined  several smaller firms to see if they could successfully compete with the Big  4 for larger clients. In each simulation, the computer-generated market  mimicked a process of pure price competition in which firms bid for each  client, based on the short-term cost of performing the audit.
subsections: section_title: Model Assumptions
paragraphs: The model makes several principal assumptions. First, the model assumes  that firms produce audits with a constant returns-to-scale technology using  a fixed number of partners and a variable number of staff. Second, it  assumes that firms seek to minimize cost (maximize profits), which  determines each firm’s optimal staff-to-partner, or leverage, ratio. Third, the  model assumes that firms compete in a market characterized by perfect  price competition—firms bid their incremental costs for audits and clients  choose auditors solely on price so that firm expertise, quality, and  reputation, among other things, are not considered. In the model, firms  with lower leverage ratios are more efficient and can therefore bid lower  prices for audit engagements than less efficient firms, and thus clients will  gravitate to more efficient accounting firms. Because data on partners and  staff published by PAR are reported at the consolidated level for the entire  accounting firm, not just the audit division, some error may be introduced  into the measure of leverage. In this model and simulation framework, a  client’s size is captured by the natural logarithm (log) of its total assets,  which has been shown to be a good predictor of audit hours and thus audit  effort. The model ignores all client characteristics that may influence audit  fees but not “out-of-pocket” costs of audit production. Liability and  litigation costs are assumed to be zero.
Although our survey responses revealed that other factors such as  expertise, global reach, and reputation play an important role in selecting  an accounting firm, it is notable that a simple model, which does not take  these factors into consideration, is able to simulate actual market shares  that currently exist. Our work shows how publicly available data and the  Doogar and Easley (1998) model can be combined to address important  audit market concentration issues that are not easily addressed, especially  given limited data on audit fees.
section_title: Simulation One
paragraphs: A short-run equilibrium is obtained when accounting firms compete on  price until every client seeking an auditor is satisfied (that is, it has  received the lowest price possible). After all clients have been assigned to  an auditor, the incumbent firm charges its client a fee equal to the second- lowest bid. The results are then generated based on various assumed levels  of switching costs (the cost of changing auditors). As table 5 illustrates, the  model of price competition was able to closely predict the actual 2002  market shares, regardless of the level of switching cost assumed. Of the  5,448 industrial companies, the Big 4 audited 68 percent of the log of assets in 2002, and the model of price competition consistently predicted that this  tier of firms would audit 68 percent or more of the total. In fact,  collectively the Big 4 firms are predicted to audit 1-2 percent more than the  actual percentage audited, depending on the cost of switching auditors. As  table 5 also illustrates, we found that if switching costs are prohibitively  expensive (20 percent or above) companies will not switch auditors and  price competition will have no impact on the Big 4’s market share.
section_title: Simulation Two
paragraphs: In the second market simulation, we assigned clients to their current  auditor and simulated the market to see if the accounting firms could  defend their market share in a purely competitive market. As table 6 shows,  the model predicted that the Big 4 would audit 64.0 percent of the total  market, compared with the Big 4 actual market share of 62.2 in 2002.  Moreover, the model predicted that the Big 4 would audit 96.3 percent of  companies in the sample with assets greater than $250 million compared with the 97.0 percent actually audited by the Big 4 in 2002. Additionally,  Doogar and Easley (1998) found that the model of pure price competition  could explain the pattern of market shares in 1995.
section_title: Simulation Three
paragraphs: Finally, we merged the five largest firms below the Big 4 in terms of the  number of partners (capacity)—Grant Thornton, BDO Seidman, Baid Kurtz  & Dobson, McGladrey & Pullen, and Moss Adams—and simulated the  market to see if the newly merged firm could successfully win clients from  the Big 4 (see table 7). Measured by the log of assets, these firms  collectively audited 8.6 percent of the actual market in 2002. However,  when we simulated the market to begin the process, the model predicted  these firms would collectively audit only 4.5 percent of the market, while  the Big 4 would audit 70.1 percent. When we simulated the merger of the five firms and assumed no efficiency gains would result, the merged firm’s  market share declined slightly. When modest efficiency gains were  permitted, the merged firm gained market share, to 6.4 percent, and was  able to attract a few of the Big 4’s larger clients. Finally, in the best-case  scenario in which we allowed the newly merged firm to become as efficient  as the Big 4 (strong efficiency gains), the market share increased to 11.2  percent, and both the Big 4 and remaining accounting firms lost market  share to the merged firm. However, since the five firms actually audited 8.6  percent of the market in 2002 collectively, the simulated mergers only  resulted in a market share increase of 2.6 percentage points in the best-case  scenario.
section_title: Survey Data
paragraphs: To augment our empirical analysis, we conducted two sample surveys to  get information from the largest accounting firms and their clients. First,  we surveyed representatives of each of the 97 largest accounting firms— those with 10 or more corporate clients that are registered with SEC— about their experience consolidating with other firms, their views on  consolidation’s effects on competition, and what they thought were the  potential implications of consolidation for auditor choice, audit fees, audit  quality, and auditor independence within their industry. We identified the  97 firms and obtained name and address information for the executive to  be contacted primarily from the membership list of the American Institute  of Certified Public Accountants’ (AICPA) SEC Practice Section. To develop  our questionnaire, we consulted a number of experts at SEC, AICPA, and  others knowledgeable about the accounting profession. We also pretested  our questionnaire with two of the Big 4 firms, four other firms among the  largest 97, and two small firms. We began our Web-based survey on May 23,  2003, and included all usable responses as of July 11, 2003, to produce this  report. One of the 97 firms was found to be ineligible for the survey  because the answers of another responding firm comprised the activity of  the former, so the final population surveyed was 96 firms. We received 47  usable responses from these 96 firms, for an overall response rate of 49  percent. However, the number of responses to individual questions may be  fewer than 47, depending on how many responding firms were eligible to or  chose to answer a particular question.
Second, we surveyed a random sample of 250 of the 960 largest publicly  held companies. We created this population from the 2003 list of the  Fortune 1000 companies produced by Fortune, a division of Time, Inc.,  after removing 40 private firms from this list. We mailed a paper  questionnaire to the chief financial officers, or other executives performing  that role, requesting their views on the services they received from their  auditor of record, the effects of consolidation on competition among  accounting firms, and its potential implications. To develop this  questionnaire, we consulted with AICPA and SEC and pretested with six  large public companies from a variety of industries. The survey began on  May 6, 2003. We removed one company that had gone out of business, and  received 148 usable responses as of July 11, 2003, from the final sample of  249 companies, for an overall response rate of 59 percent. Again, the  number of responses to individual questions may fluctuate, depending on  how many respondents answered each question. We plan to issue a  subsequent report in September 2003 on client responses received through  July 30, 2003.
While the public company survey results came from a random sample  drawn from the population of Fortune 1000 companies and thus could be  weighted to statistically represent that larger group, we are reporting totals  and percentages only for those companies (and accounting firms) actually  returning questionnaires. Since the small number of respondents to both  surveys at the time of publication could significantly differ in their answers  from the answers nonrespondents might have given had they participated,  it is particularly risky to project the results of our survey to not only the  nonrespondents, but also to the part of the public company population we  did not sample. There are other practical difficulties in conducting any  survey that may also contribute to errors in survey results. For example,  differences in how a question is interpreted or the sources of information  available to respondents can introduce unwanted variability into the survey  results. We included steps in both the data collection and data analysis  stages to minimize such errors. In addition to the questionnaire testing and  development measures mentioned above, we followed up with the sample  firms and clients with e-mails and telephone calls to encourage them to  respond and offer assistance. We also checked and edited the survey data  and programs used to produce our survey results.
Finally, we conducted structured interviews with a judgmental sample of 20  chairs of audit committees for Fortune 1000 companies to obtain their  views on audit services, consolidation, and competition within the audit  market. Our selection criteria included geographic location, the company’s  industry, and the chairperson’s availability. The audit chairpersons whom  we interviewed all had a background in business and most had been or  were currently serving as CEOs of a Fortune 1000 company. On average,  the chairpersons we interviewed served on over two boards in addition to  the board on which they sat for purposes of the interview. On average, they  served as chairpersons of the audit committee for just over 2 years, served  as a member on the audit committee for over 5 years, and served on that  Fortune 1000 company’s board of directors for over 7 years.
section_title: Impact of Consolidation on Capital Formation and Securities Markets
paragraphs: To address the issue of the impact of consolidation and concentration  among large accounting firms on capital formation and securities markets,  we interviewed representatives from accounting firms, investment banks,  institutional investors, SEC, self-regulatory organizations, credit agencies,  and retail investors, among others. We also consulted with numerous  academics and reviewed relevant economic literature.
section_title: Identifying Barriers to Entry
paragraphs: To identify the barriers to entry that accounting firms face in the public  company audit market, we discussed competition and competitive barriers  with representatives of a cross section of public accounting firms, large  public companies, various government agencies, the accounting profession  and trade associations, institutional investors, securities underwriters, self- regulatory organizations, credit rating agencies, and other knowledgeable  officials. We obtained information from the National Association of State  Boards of Accountancy and AICPA. We also reviewed existing state and  federal requirements. Finally, we used the Doogar and Easley (1998) model  to roughly assess whether mergers between non-Big 4 firms could  potentially increase the number of accounting firms capable of auditing  large national and multinational companies.
section_title: GAO Surveys of Public Accounting Firms and Fortune 1000 Public Companies
paragraphs: To provide a thorough, fair and balanced report to Congress on these issues, it is essential that  we obtain the experiences and viewpoints of a representative sample of public accounting firms.
Your firm has been selected from a group of public accounting firms comprising the  American Institute of Certified Public Accountants' (AICPA) SEC Practice Section member  firms and other public accounting firms that performed audits of public companies registered  with the SEC, which are not members of the AICPA's SEC Practice Section. In conducting these  studies, the GAO is asking for your cooperation and assistance by providing the views of your  public accounting firm on industry consolidation and the potential effects of mandatory audit  firm rotation. This survey should be completed by the senior executive of your firm (e.g. the  Chief Executive Officer/Managing Partner) or their designated representative(s) who can  respond for the firm on matters of industry consolidation and mandatory firm rotation. · "Public company" refers to issuers of securities subject to the financial reporting requirements  of the Securities Exchange Act of 1934, the Investment Company Act of 1940, and registered  with the Securities and Exchange Commission (SEC). For purposes of this survey, mutual funds  and investment trusts that meet the statutory definition of issuer of securities are considered  public companies.   · "Multinational or foreign public company" is a public company with significant operations  (10 percent or more of total revenue) in one or more countries outside the United States.  · "Domestic public company" is a public company with no significant operations (10 percent or  more of total revenue) outside the United States.  · "auditor," "auditor of record" and "public accounting firm" refer to an independent public  accounting firm registered with the SEC that performs audits and reviews of public company  financial statements and prepares attestation reports filed with the SEC. In the future, these  public accounting firms must be registered with the Public Company Accounting Oversight  Board (PCAOB) as required by the Sarbanes-Oxley Act.
Please provide the following information so that we can contact you if we have any questions:  Name of Primary Contact:  ______________________  1.  Is your public accounting firm currently a member of the AICPA's SEC Practice Section?  1. 2. 3. 2.  At this time, does your public accounting firm plan to register with the PCAOB?  1. 2. 3. 4. 3.  In total and for each of the following categories, approximately how many public companies  did your public accounting firm serve as auditor of record during your firm's last fiscal  year? Enter numeric digit in each box.
N=44 Mean=32 Median=17 Range=2 - 232 4. With respect to your public company audit, review, and attest clients during your firm's last  fiscal year, did you serve as auditor of record for a public company or number of public  companies that together represent over 25% of the market share of a specific industry?  1.
Yes (click to go to Question 5.)
2.
No (click to go to Question 6.) 94%  3. 5. Please identify each industry for which your public company audit, review, and attest clients  during your firms last fiscal year represented, in the aggregate, at least 25% of the public  company market share in the industry. In addition for each industry identified please also  provide your firm's estimate of the aggregate market share your public company clients  represent and the basis your firm used for estimating market share (for example, share of  number of public companies in an industry, share of industry revenue, share of industry  market capitalization, etc.)  6. With respect to your firm's public company audit, review, and attest clients during your firm's  last fiscal year, please indicate those industries for which 5 percent or more of your public  company audit, review, and attest practice resources (based on hours, staff, etc.) were devoted  following industry classification is based on the North American Industry Classification  System (NAICS). Generally, we have included classifications covering each NAICS industry  sector and, with respect to the Manufacturing sector, selected sub-sectors.)  1.    Accommodations and Food Services   N=2 2.    Administrative and Support Services and Waste Management and Remediation Services   N=2 3.    Agricultural, Forestry, Fishing, and Hunting      N=0 4.    Ambulatory Health Care Services      N=1 5.    Arts, Entertainment, and Recreation      N=5 6.    Construction      N=2 7.    Educational Services      N=0 8.    Finance and Insurance      N=19 9.    Information Services      N=13 10.  Management of Companies and Enterprises      N=0 11.   Manufacturing--Chemical      N=2 12.   Manufacturing-Computer and Electronic Products      N=9 13.   Manufacturing-Food      N=1 14.   Manufacturing-Paper      N=0 15.   Manufacturing-Primary Metal      N=1 16.   Manufacturing-Transportation Equipment      N=2 17.   Manufacturing-Other      N=14 18.   Mining      N=5 19.   Professional, Scientific, and Technical Services      N=10 20.   Public Administration      N=0 21.   Real Estate and Rental and Leasing      N=6 22.   Trade--Retail      N=4 23.   Trade--Wholesale      N=4 24.   Transportation and Warehousing      N=2 25.  Utilities      N=2 26.  Other - please specify in box below      N=21  If you checked "Other" industries - specify below:  7. Approximately what percentage of your firm's total revenue (from U.S. operations) came from  each of the following types of services during your firm's last fiscal year? Please fill in the  percentages so that they add up to 100%.
N=45 Mean=53 Median=49 Range=25 - 100 N=43 Mean=30 Median=30 Range=10 - 55 N=25 Mean=14 Median=10 Range=2 - 40 N=37 Mean=14 Median=10 Range=1 - 40 8. Approximately what percentage of your firm's audit, review, and attest revenue from U.S.  operations came from each of the following categories of clients during your firm's last fiscal  year? Please fill in the percentages so that they add up to 100%.
N=18 Mean=16 Median=12 Range=1 - 90 9. Does your firm plan to offer audit, review, and attestation services to large public companies  during the next 5 years?  1.
Yes (Click to go to Question 10.) 19% 2. 3. 4.
Please explain why your firm currently does not plan to offer audit, review, and attest  services to large (revenues of $5 billion or more) public companies during the next 5  years?  10. Approximately how many times did your firm succeed another public accounting firm as  auditor of record for a public company client during your firm's last three fiscal years?
N=45 Mean=39 Median=10 Range=1 - 414 11. Since December 31, 2001 approximately how many times did your firm succeed Arthur  Andersen as auditor of record for a public company client?
N=17 Mean=49 Median=2 Range=1 - 308 12. When your answers to the "Public Accounting Firm Background" part of this survey  are final and ready to be used by GAO, please click the "Completed This Part of  Survey" button below. 1.
Completed This Part of Survey   100%  2. 13. Please click the "Next Section" button at the bottom of the page to continue with the  questionnaire, or click the link below to return to the main menu.
Click here CONSOLIDATION IN THE PUBLIC ACCOUNTING PROFESSION  We are focusing on the trend towards consolidation in the public accounting profession starting  in 1987, when consolidation activity among the largest accounting firms began.
Your Firm's Consolidation History  Please consider whether your firm has combined with another to form a new entity or has  restructured in any way that involved the assumption of new assets and services. Please include  any mergers or acquisitions as consolidation events.  14. Has your firm been involved in one or more consolidations since 1987?
Please check one box.  1. 2.
No (Click to go to Question 16.)
3. 15. IF YES: What size firm(s) did your firm merge with or acquire? Please check all that apply. 1.
Firm(s) with larger net revenue  2.
Firm(s) with similar net revenue   3.
Firm(s) with smaller net revenue   N=25 4.
Other - please describe in box below N=2 If you checked "Other" - please describe below:  16. Starting in 1987, has your firm declined any opportunities to participate in consolidation activity that would have significantly increased its market share? Please click one button. 1. 2. 3.
Please explain:  17. Apart from consolidations, has your firm entered into any affiliations - such as networks,  alliances, global organizations, or other arrangements - with other accounting firms in the  U.S. or internationally to provide audit, review, and attest services since 1987?  Please click  one button. 1.
Yes - we joined an affiliation since 1987  2.
No - but we joined an affiliation before 1987  3.
No - we once were a member of an affiliation but are no longer  4. 5.
If your firm HAS been involved in any form of consolidation activity, please answer the  following questions; otherwise click below to skip to the next applicable question.
Click here 18. How important was each of the following reasons in your firm's decisions to consolidate?
Click one button in each row.
To increase market share/to increase  To establish presence in new geographic  To decrease costs/achieve economies of  To gain talented staff  N=30 To expand audit, review, and attest  To enhance audit, review, and attest  To gain certain clients  N=30 To establish presence in new client  To gain access to capital  N=30 To compete more successfully against  To improve the quality of the audit N=30 Other reason - describe in the box below  If "Other reason" -- Please describe:  19. Has your consolidation activity enabled your firm to provide or increase audit, review, and  attest services to large domestic or multinational clients? 1.
Yes, previously unable to provide, but are now able  2.
Yes, previously able to provide and increased our ability  3.
No, our ability remained unchanged  4.
No Answer  Please continue with the next question if your firm has ever DECLINED AN OPPORTUNITY to  participate in a consolidation activity that would have significantly increased its market share  OR if has NOT been involved in a consolidation since 1987; otherwise click on the link below to  skip to the next applicable question.  20. To what extent does each of the following reasons explain why your firm did NOT  participate in a consolidation activity? Click one button in each row.
Consolidation in the Accounting Profession  ALL FIRMS: This next section asks you to consider the relative role that the consolidation  activity of the largest accounting firms, among other things, has played in influencing certain  aspects of the accounting profession in the past decade. Please base your response on your  experience in the past decade, or if this is not possible, on the time frame that reflects your  experience.  21. How have your costs for performing audit, review, and attest services changed in the past  decade? (Please adjust for inflation and volume of business.)  1. 2. 3. 4. 5. 6. 22. Many factors impact costs in different ways. In which way have each of the following  influenced your audit, review, and attest operating costs, if at all, over the past decade?  (Please adjust for inflation and volume of business where appropriate.) Click one button in  each row.  of audits and accounting standards  The consolidation activity that has  occurred starting in 1987 among  the largest accounting firms   N=43 The consolidation activity that has  occurred within your firm  (leave  "No Answer" checked if your firm  has not consolidated) N=29 Other factor - describe in the box  If “other factor” – please describe: 23. How have your audit, review, and attest fees (for example, net rate per billable hour) changed  in the past decade? (Please adjust for inflation and volume of business.)        1.  2. 3. 4. 5. 6.
No Answer  24. In which way has each of the following influenced your audit, review, and attest fees, if at  all, in the past decade? (Please adjust for inflation and volume of business where  appropriate.)
The consolidation activity that has  occurred starting in 1987 among the  The consolidation activity that has  occurred within your firm (leave "No  Answer" checked if your firm has not  Other factor  - describe in the box below If "Other factor" -- Please describe:  25. Has it become harder or easier for your firm to maintain audit quality in the past decade?  1. 2. 3. 4. 5. 6.
No Answer  26. In which way has each of the following contributed to making it harder or easier for your  firm to maintain audit quality in the past decade?
Ability to recruit and retain qualified  Skills of staff members  N=46  The consolidation activity that has  occurred starting in 1987 among the  The consolidation activity that has  occurred within your firm (leave "No  Answer" checked if your firm has not  Other factor - describe in the box below  If "Other factor" -- Please describe:  27. Has it become harder or easier for your firm to maintain independence as an auditor at the  firm level in the past decade?  1. 2. 3. 4. 5. 6.
Please explain:  28. In which way has each of the following contributed to making it harder or easier to maintain  independence as an auditor at the firm level in the past decade?
Profitability of non-audit services  N=43  Tenure of relationship with client  N=43  The consolidation activity that has  occurred starting in 1987 among the  The consolidation activity that has  occurred within your firm (leave "No  Answer" checked if your firm has not  Other factor - describe in the box below  If "Other factor" -- Please describe:  29. Has it become harder or easier to maintain personal independence as an auditor in the past  decade? 1. 2. 3. 4. 5. 6.
Please explain:  30. Has it become harder or easier for your firm to successfully compete to be the auditor of  record for large domestic or multinational public clients in the past decade?   1. 2. 3. 4. 5. 6. 31. In which way has each of the following contributed to making it harder or easier for your  firm to successfully compete to be the auditor of record for large domestic or multinational  public clients in the past decade?
Threat of litigation to your firm  N=21 Threat of litigation to clients  N=20   Tenure of relationship with client  N=21  The consolidation activity that has  occurred starting in 1987 among the  The consolidation activity that has  occurred within your firm (leave "No  Answer" checked if your firm has not  Other factor - describe in the box below  If "Other factor" -- Please describe:  32. Please indicate whether you have experienced a net increase or decrease over the past decade  in the following types of clients for whom your firm performs audit, review, and attest  services. 33. Has your firm lost any audit, review, and attest clients to other accounting firms specifically  because the client(s) wanted another firm to help them prepare for an initial public offering  or subsequent issuance of securities?  1.
Yes - client went to a Big 4 firm for IPO or other securities issuance 47%  2.
Yes - client went to a NON-Big 4 firm for IPO or other securities issuance  17% 3. 4. 34. In the past five years, has your firm accepted any new clients specifically to assist their initial  public offerings or subsequent issuance of securities?  1.
Yes - Please enter approximate number in the box below 72%  2. 3.
If "Yes" -- enter an approximate number of clients, using numeric digits:  Competition in the Accounting Profession  35. Based on your experience, how would you describe the current level of competition among  public accounting firms as a whole in providing audit, review, and attest services to the  following types of companies?
2%  36. Based on your experience, how has the overall level of competition to provide audit, review,  and attest services to each of the following types of companies changed in the past decade as a result of the consolidation activity that has occurred in the accounting profession?  37. How, if at all, has the consolidation activity of the largest accounting firms affected each of  the following areas?
Opportunity for your firm to provide  service to large public companies  N=37  Opportunity for your firm to provide  service to small and mid-sized public  Opportunity for your firm to provide  service to private companies  N=47   Other area - describe in the box below If "Other area" -- Please describe:  38. Overall, how do you think that the consolidation activity that has occurred in the accounting  profession in the past decade has affected competition?  1. 2. 3. 4. 5. 6. 7.
No Answer  Impediments to Competition (Barriers to Entry)  39. To what extent do you think that each of the following is an impediment for accounting firms  wishing to provide audit, review, and attest service to large domestic or multinational public companies that are subject to the securities laws?
Not being a "Big 4" firm  N=42   Credibility with financial markets and  Other impediment - describe in the box  IF "OTHER IMPEDIMENT" -- Please describe:  40. Are there any federal or state regulations that impede competition among public accounting  firms to provide audit, review, and attest services to public companies?  1. 2. 3. 41. For each of the following federal or state regulatory requirements, please indicate how much  of an impediment, if any, that requirement is to competition among public accounting firms  in the United States. Please also list any additional federal and/or state regulations that  impede competition.
The Sarbanes-Oxley Act of 2002  N=46  Other regulation - describe in the FIRST   Other regulation - describe in the  SECOND box below  N=9 If "Other regulation" -- Please describe FIRST additional regulation:  If second "Other regulation" -- Please describe SECOND additional regulation:  42. Would you favor or oppose the following actions to increase competition to provide audit,  review, and attest services for large domestic or multinational public clients?
Government action to break up the Big 4   Government action to assist the non-Big  Let market forces operate without  Other action - describe in the FIRST box   Other action - describe in the SECOND  If "Other action" -- Please describe FIRST additional action:  If second "Other action" -- Please describe SECOND additional action:  43. Do you have any additional comments on any of the issues covered by this survey? Please  use the space below to make additional comments or clarifications of any answers you gave  in this survey.  44. When your answers to the “Consolidation in the Public Accounting Profession” part of  the survey are final and ready to be used by GAO, please click the “Completed This  Part of Survey” button below. 1.
Completed This Part of Survey   100%  2. 45. Please click the "Next Section" button at the bottom of the page to continue with the  questionnaire, or click the link below to return to the main menu.
Please complete this questionnaire specifically  the U.S. General Accounting Office (GAO), the  for the company named in the cover letter, and  independent research and investigative arm of  not for any subsidiaries or related companies.
This questionnaire should be completed by the  profession.
To provide a thorough, fair, and balanced report  historical information on mergers, operations  to Congress, it is essential that we obtain the  and finance, as well as report the corporate  experiences and viewpoints of a representative  policy of this firm. sample of public companies.
Your company was selected randomly from the  enclosed envelope within 10 business days of  2002 list of Fortune 1000 companies. It is  receipt.  If the envelope is misplaced, our  important for every selected firm to respond to  ensure the validity of our research.
Congress.
Telephone:  (202) 512-3608 Email:  pannorm@gao.gov   Thank you for participating in this survey.
Page 1 of 15  1.  Approximately what percentage of your company’s total revenues are derived from operations  within and outside of the United States?
Please enter percentages totaling 100%.      _____%   of our revenues are derived from operations within the United States       _____%   of our revenues are derived from operations outside of the United States    2.  If your company was founded in the past decade, in what year was it founded?
Please enter 4-digit year. 3.  What is the name of your company’s current auditor of record and when did this firm become  your auditor of record?   Please enter name of auditor and 4-digit year hired.        _______________________________  First year employed as auditor  4.  What type of services does your auditor of record currently provide to your company? Please check all that apply.
1.
Only audit and attest services    2.
Tax-related services (e.g., tax preparation)
3.
Assistance with company debt and equity offerings (e.g. comfort letters)  N=98   4.
Other services - please describe: _____________________________________________  Page 2 of 15  5.  Approximately how much were the total annual fees that your company paid to your auditor of  record for audit and attest services during your last fiscal year?
Please enter approximate dollar figure.
Range=$13,807-$62,000,000  6.  Starting in 1987, when consolidation of the largest accounting firms began, or since your  company was founded (if that occurred after 1987), has your company employed more than one  auditor of record? Please check one box.
1.
Yes - how many: ________            2.
No              SKIP TO NEXT PAGE    7.  What were the names and tenures of the most recent previous auditor(s) of record your company  has employed since 1987?  Please name up to two of the most recent previous auditors and  years employed. from (year)_____ to (year)_______   ________________________ Name of auditor          from (year)_____ to (year)_______  8.  Which of the following reasons explain why your company changed auditor of record one or  more times since 1987? Please check all that apply.
1.
Our company had a mandatory rotation policy       2.
Expansion of our company required an auditor of record that could meet new demands         3.
New regulations forbidding use of auditor for management consulting and other services        4.
Fees for audit and attest services         5.
Concern about reputation of our auditor of record           6.
Our auditor of record was going out of business             7.
Our auditor of record resigned          8.
Relationship with our auditor of record was no longer working          9.
Page 3 of 15  9.  If your company previously employed Arthur Andersen as your auditor of record and switched  to another firm in the past two years, did you switch to the firm to which your previous Arthur  Andersen partner moved? Please check one box. 1.
Not applicable – did not employ Arthur Andersen  2.
Yes, switched to partner’s new firm    3.
No, switched to other firm –     Consolidation in the Accounting Profession  We are focusing on the trend toward consolidation that has occurred in the public accounting  profession starting in 1987, when consolidation activity among the largest firms began, primarily the  consolidation of the “Big 8” into the “Big 4.”  This section asks you to consider how your company’s  relationship with its auditor of record, and the audit services it provides, has changed over this time  frame.  Although a number of factors may have influenced these changes, we would like you to  assess the influence of consolidation in the accounting profession in particular.  Please base your  answers on your experience in the past decade or, if this is not possible, on the time frame that  reflects your experience.  10. How have the fees that your company pays for audit and attest services changed over the past  decade? If it is not possible for you to answer for the past decade, please base your answer on  the time frame that best reflects your experiences. Please check one box. 1.  2.  3.  4.  5.
Page 4 of 15  11. If your company changed auditors within the last two years, how have the fees your company  pays your current auditor of record changed compared to the fees paid to your previous auditor?
Please check one box. 1.
Not applicable – have not changed auditors    ----------------------------------------------------------- 2.  3.  4.  5.  6.  12. In your opinion, how has the consolidation of the largest accounting firms over the past decade  influenced the fees that your company pays for auditing and attest services?
1.    2.    3.    4.  5. ----------------------------------------------------------   6.  13. Audit quality is often thought to include the knowledge and experience of audit 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.
Do you believe that the overall quality of audit services your company receives has gotten better  or worse over the past decade? Please check one box.
1.    2.    3.  4. 5. ---------------------------------------------------------- 6.
Page 5 of 15  14. If your company changed auditors within the last two years, do you believe that the overall  quality of audit services your company receives from your current auditor is better or worse  than the overall quality of audit services your company received from its previous auditor?
Please check one box. 1.
Not applicable – have not changed auditors    ----------------------------------------------------------   2.    3.    4.    5.  6. ----------------------------------------------------------- 7.  15. In your opinion, how has the consolidation of the largest accounting firms over the past decade  influenced the quality of audit and attest services that your company receives?  1.  2.  3.  4.  5. ----------------------------------------------------------   6.  16. If you have experienced a change in audit quality, please explain: If you have not experienced a change, please enter “none.”
Page 6 of 15  17. Auditor independence is often thought to relate to the accounting firm’s ability and willingness  to appropriately deal with (a) financial reporting issues that may indicate materially misstated  financial statements; (b) the appearance of independence in terms of the other services a firm is  allowed to and chooses to provide to their clients; and (c) how much influence clients appear to  have in the audit decisions.
Do you believe that your company’s auditor(s) has become more or less independent over the  past decade? Please check one box.  1.  2.  3.  4.  5. ---------------------------------------------------------- 6. 18. If your company changed auditors within the last two years, do you believe that your current  auditor is more or less independent than your previous auditor?
Please check one box. 1.
Not applicable – have not changed auditors    ---------------------------------------------------------- 2. 3.  4.  5.  6. ---------------------------------------------------------- 7.
Page 7 of 15  19. In your opinion, how has the consolidation of the largest accounting firms over the past decade  influenced the ability of your auditor of record to maintain independence in the audit and attest  services it provides to your company?  Please check one box. 1.  2.  3.  4.  5. ---------------------------------------------------------- 6. 20. How satisfied are you with your current auditor of record?  1.  2.  3.  4.  5. ---------------------------------------------------------- 6.
subsections: section_title: N=146
subsections: section_title: Other - please describe:
paragraphs: Page 11 of 15  28. Has the consolidation of the largest accounting firms over the past decade made it harder or  easier for your company to satisfactorily select an auditor and maintain a relationship with that  auditor? Please check one box. 1.  2.  3.  4.  5. ---------------------------------------------------------- 6. 29. How, if at all, has the consolidation of the largest accounting firms over the past decade affected  competition in the provision of audit and attest services? If it is not possible for you to answer  for the past decade, please base your answer on the time frame that best reflects your  experiences. Please check one box.  1.  2.  3.
Little or no effect                 SKIP TO QUESTION 31  4.  5.  ----------------------------------------------------------    6.  30. How, if at all, has this change in competition affected each of the following areas?  (1) (2) (3) (4) (5) (6)
section_title: N=71
subsections: section_title: Other - please describe:
paragraphs: Page 12 of 15  31. What do you believe is the minimum number of accounting firms necessary to provide audit  and attest services to large national and multinational public companies? Please enter a  number. 32. What do you believe is the optimal number of accounting firms for providing audit and attest  services to large national and multinational public companies?  Please enter a number.
Page 13 of 15  33. Do you suggest that any actions be taken to increase competition in the provision of audit and  attest services for large national and multinational public companies?  Please check one box. 1.  2.  3.  34. Would you favor or oppose the following actions to increase competition to provide audit and  attest services for large national and multinational clients? Please check one box in each row. (1) (2) (3) (4) (5) (6)
Page 14 of 15  35. Do you have any additional comments on any of the issues covered by this survey?
Please use the space below to make additional comments or clarifications of any answers you  gave in this survey.
Thank you for your assistance with this survey!
Please return it in the envelope provided.
section_title: Arthur Andersen Case Study
subsections: section_title: Background
paragraphs: In 2001, Arthur Andersen LLP (Andersen) was the fourth-largest public  accounting firm in the United States, with global net revenues of over $9  billion. On March 7, 2002, Andersen was indicted by a federal grand jury  and charged with obstructing justice for destroying evidence relevant to  investigations into the 2001 financial collapse of Enron. At the time of its  indictment, Andersen performed audit and attest services for about 2,400  public companies in the United States, including many of the largest public  companies in the world. In addition, Andersen served private companies  and provided additional professional services such as tax and consulting  services.
This appendix is an analysis of 1,085 former Andersen public company  clients that switched to a new public accounting firm between October 1,  2001, and December 31, 2002.In addition to identifying the new public  accounting firms of the former Andersen clients, we determined which  firms attracted the largest clients and how many Andersen clients switched  to non-Big 4 firms.
section_title: Most Andersen Clients Switched to a Big 4 Firm
paragraphs: Between October 2001 and December 2002, 1,085 public companies audited  by Andersen switched to a new auditor of record. As figure 10 illustrates, of  the 1,085 companies reviewed, 938 switched to one of the Big 4 (87  percent), and 147 switched to a non-Big 4 firm (13 percent). Among the Big  4, Ernst & Young attracted the largest number of former Andersen clients,  followed by KPMG, Deloitte & Touche, and PricewaterhouseCoopers (see  fig. 11). Of the former Andersen clients who switched to a non-Big 4 firm,  45 switched to Grant Thornton (4 percent) and 23 switched to BDO  Seidman (2 percent).
section_title: Largest Clients Switched to Big 4 Firms
paragraphs: We found that almost all former Andersen clients with total assets above $5  billion switched to a Big 4 firm. The one exception, Global Crossing,  switched to Grant Thornton. We found that the Big 4 audited approximately  98 percent of the total assets of the 1,085 former Andersen clients that  switched auditors between October 1, 2001, and December 31, 2002. As  illustrated in figure 12, PricewaterhouseCoopers, although attracting the  smallest number of Andersen clients (159), tended to attract the largest  clients based on average total company asset size ($3.9 billion).  Comparatively, former Andersen clients that switched to Deloitte & Touche  and KPMG averaged total assets of $3.0 billion and $2.4 billion,  respectively. In addition, Ernst & Young, although attracting the largest  number of Andersen clients, tended to attract smaller clients based on  average total company asset size ($1.5 billion).
We also analyzed former Andersen clients by asset size and determined  how many of its clients switched to Big 4 versus other firms. As table 8  illustrates, the vast majority of the largest former Andersen clients  switched to one of the Big 4 firms. With the exception of the smallest asset  class, 90 percent or more of the former Andersen clients switched to one of  the Big 4 firms.
We also looked at the movement of former Andersen clients to the Big 4  firms within the asset range groups. As table 9 shows, KPMG was hired by  the highest percentage of former Andersen clients in both the largest and  smallest asset groups, while Ernst & Young was hired by the highest  percentage of former Andersen clients with assets between $100 million  and $5 billion.
section_title: Thirteen Percent of Former Andersen Clients Switched to Non-Big 4 Firms
paragraphs: Of the former Andersen clients, 147 (13 percent) switched to a non-Big 4  firm. Of the 147 firms, 31 percent switched to Grant Thornton and 16  percent switched to BDO Seidman (fig. 11). The average asset size of a  company that switched to a non-Big 4 firm was $309 million, which is  approximately $2.2 billion less than the average asset size of a company  that switched to a Big 4 firm. As table 10 illustrates, the average asset size  of a company that switched to Grant Thornton was $644 million, and the  average asset size of a company that switched to BDO Seidman was $54  million. The 147 public company clients that did not engage a Big 4 firm  switched to one of 52 non-Big 4 firms.
section_title: Former Andersen Clients by Industry Sectors
paragraphs: Of the 1,085 former Andersen clients, we were able to classify 926  companies into 56 different industry sectors. We observed that former  Andersen clients in 22 industry sectors stayed with a Big 4 firm, while  former Andersen clients in 34 industry sectors switched to a non-Big 4 firm.  Within some industries certain accounting firms were hired more often  than others. For example, Ernst & Young attracted former Andersen clients  in more industry sectors overall than any other firm (49 of the 56 industry  sectors). We also observed that within 16 industries KPMG attracted more  former Andersen clients than other firms (see table 11).
It is important to review this analysis in the context of its limitations.  Specifically, defining markets by SIC codes can exaggerate the level of  concentration because, like the audit market, a few large companies  dominate many industry sectors (see table 2). To mitigate the potential for  bias, we limited our analysis to the 2-digit SIC codes rather than the 4-digit  codes. There are additional methodological issues with defining markets by  SIC codes. First, the audited companies’ lines of business, not the business  of the accounting firms, defines the markets. Second, some companies that  could be included in a particular industry are not included because no SIC  code identifier was provided in the database that we used. Moreover,  assignment of a company to a particular SIC code sometimes involves  judgment, which may create bias.
section_title: Analysis of Big 4 Firms’ Specialization by Industry Sector
paragraphs: The concentration that exists across accounting firms that audit public  companies is even more pronounced in certain industry sectors. For  example, in certain industry sectors, two firms audit over 70 percent of the  assets. Because public companies generally prefer auditors with  established records of industry expertise and requisite capacity, their viable  choices are even more limited than the Big 4. This appendix provides  additional descriptive statistics on selected industries in the U.S. economy  using U.S. Standard Industry Classification (SIC) codes—numerical codes  designed by the federal government to create uniform descriptions of  business establishments.
subsections: section_title: Limitations of SIC Analysis
paragraphs: The purpose of this analysis is to illustrate that certain firms dominate  particular industries or groups, and companies may consider only these  firms as having the requisite expertise to provide audit and attest services  for their operations. However, it is important to review this analysis in the  context of its limitations. Specifically, defining markets by SIC codes can  exaggerate the level of concentration because, like the audit market, a few  large companies dominate many industry sectors (see table 2). For  example, in the petroleum industry, we were able to identify only 25  publicly listed companies in 2002, 20 of which were audited by the Big 4.  Because PricewaterhouseCoopers and Ernst & Young audit the six largest  companies, they audit 95 percent of the assets in this industry. To mitigate  the potential for bias, we limited our analysis to the 2-digit SIC codes rather  than the more specific 4-digit codes.
There are additional methodological issues with defining markets by SIC  codes. First, the audited companies’ lines of business, not the business of  the accounting firms, defines the markets. Second, some companies that  could be included in a particular industry are not included because no SIC  code identifier was provided in the database that we used. Moreover,  assignment of a company to a particular SIC code sometimes involves  judgment, which may create bias. Finally, the methodology assumes  different accounting firms are in separate markets and cannot easily move  from auditing one type of industry to another.
The total assets data come from the 1997 and 2002 editions of Who Audits  America, which has detailed information on public companies, including  current and former auditor and SIC code. Because some companies are  not classifiable establishments, others do not list SIC codes because they  operate in many lines of business, or the necessary information might have  been missing in some cases, the data only include companies that had a 4- digit, 3-digit or 2-digit SIC code in the 1997 and 2002 versions of the  database (8,724 companies in 1997 and 9,569 companies in 2002). All SIC  codes were converted to 2-digit codes (major group) for analysis. Table 12  lists and defines each SIC major economic group analyzed here and in the  body of the report. In computing concentration ratios for each accoounting  firm in the various industry groups, we used total assets audited. However,  the results generally are not sensitive to the use of a different measure  (such as total sales).
section_title: Industry Specialization Can Limit Public Company Choice
paragraphs: As figure 13 shows, in selected industries specialization can often limit the  number of auditor choices to two—in each case, two auditors account for  over 70 percent of the total assets audited in 2002. As a result, it might be  difficult for a large company to find an auditor with the requisite industry  expertise and staff capacity. Figure 13 also shows that while a few firms  dominated certain industries in 1997 before the merger of Price  Waterhouse and Coopers & Lybrand and dissolution of Arthur Andersen,  there were fewer industries where two firms accounted for more than 70  percent of the total sales audited; and in most cases, at least one of the  remaining Big 6 firms audited a significant share (greater than 10 percent)  of the industry.
The dissolution of Andersen in 2002 and the merger of Price Waterhouse  and Coopers & Lybrand in 1998 appear to have impacted many industries,  including those in the primary metals, general building contractors,  furniture and fixtures, petroleum and coal products, transportation by air,  and electric, gas, and sanitary services groups included in figure 13.  Moreover, figure 14 shows the remaining major economic groups with 20 or  more companies for which Andersen audited roughly 25 percent or more of  the total assets in the industry or Price Waterhouse and Coopers & Lybrand  both had significant presence in 1997. As the figure indicates, in many of  these sectors Ernst & Young and Deloitte & Touche acquired significant  market share by 2002. Because the Big 4 firms have increased their  presence in these industries formerly dominated by Andersen or Price  Waterhouse and Coopers & Lybrand, the number of firms with industry  expertise appears to have remained unchanged in most cases. The mergers  between Price Waterhouse and Coopers & Lybrand did not impact choice  in most industries because the firms generally dominated different  industries as figure 13 and figure 14 show. This highlights that one of the  factors contributing to the mergers was the desire to increase industry  expertise. However, there are some industries (petroleum and coal  products, communications, primary metals, and fabricated metals among  others) that may have experienced a reduction in the number of viable  alternatives for companies that consider industry expertise important  when choosing an auditor.
Table 13 provides a list of industries defined by 2-digit SIC codes with 25 or  more companies and also indicates where each of the Big 4 firms audit at  least 10 percent of the total industry assets. As the table illustrates, there  are very few industries where all four of the top-tier firms have a major  presence. In many industries, only two or three of the Big 4 firms audit 10  percent or more of the total assets in an industry. Of the 49 industries  represented, less than one-third (16) have a significant presence (10  percent or more) of all four firms. Moreover, as table 14 illustrates, if the  threshold is increased to 25 percent or more of total assets audited, then  almost all (48 of 49) of the industries have a significant presence of only  one or two firms.
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to those individuals named above, Martha Chow, Edda  Emmanuelli-Perez, Lawrance Evans, Jr., Marc Molino, Michelle Pannor,  Carl Ramirez, Barbara Roesmann, Derald Seid, Jared Stankosky, Paul  Thompson, Richard Vagnoni, and Walter Vance made key contributions to  this report.
section_title: Glossary
subsections: section_title: GAO’s Mission
paragraphs: The General Accounting Office, the audit, evaluation and investigative arm of  Congress, exists to support Congress in meeting its constitutional responsibilities  and to help improve the performance and accountability of the federal government  for the American people. GAO examines the use of public funds; evaluates federal  programs and policies; and provides analyses, recommendations, and other  assistance to help Congress make informed oversight, policy, and funding  decisions. GAO’s commitment to good government is reflected in its core values of  accountability, integrity, and reliability.
section_title: Obtaining Copies of GAO Reports and Testimony
paragraphs: The fastest and easiest way to obtain copies of GAO documents at no cost is  through the Internet. GAO’s Web site (www.gao.gov) contains abstracts and full- text files of current reports and testimony and an expanding archive of older  products. The Web site features a search engine to help you locate documents  using key words and phrases. You can print these documents in their entirety,  including charts and other graphics.
Each day, GAO issues a list of newly released reports, testimony, and  correspondence. GAO posts this list, known as “Today’s Reports,” on its Web site  daily. The list contains links to the full-text document files. To have GAO e-mail this  list to you every afternoon, go to www.gao.gov and select “Subscribe to   e-mail alerts” under the “Order GAO Products” heading.
subsections: section_title: Order by Mail or Phone
section_title: To Report Fraud, Waste, and Abuse in Federal Programs
section_title: Public Affairs