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