Following the 1929 stock market crash, legislation was passed that required companies seeking to raise funds from the public to provide audited financial statements to their investors. The Securities Act of 1933 and the Securities Exchange Act of 1934 established the principle of full disclosure, which requires that public companies provide full and accurate information to the investing public. Under these federal securities laws, public companies are responsible for the preparation and content of financial statements that are complete and accurate and are presented in conformity with U.S. generally accepted accounting principles (GAAP). Financial statements, which disclose a company’s financial position (balance sheet), stockholders’ equity, results of operations (income statement), and cash flows, are an essential component of the disclosure system on which the U.S. capital and credit markets are based. Federal securities laws also require that public companies have the financial statements they prepare audited by an independent public accountant. The independent public accountant’s audit is critical to the financial reporting process because the audit subjects companies’ financial statements to scrutiny on behalf of shareholders and creditors to whom company management is accountable. The auditor is the independent link between management and those who rely on the financial statements. The statutory independent audit requirement, in effect, grants a franchise to the nation’s public accountants, as an audit opinion on a public company’s financial statements must be secured before an issuer of securities can go to market, have the securities listed on the nation’s stock exchanges, or comply with the reporting requirements of the securities laws. Having auditors attest to the reliability of financial statements of public companies is intended to increase public and investor confidence in the fairness of the financial information. Moreover, investors and other users of financial statements expect auditors to bring integrity, independence, objectivity, and professional competence to the financial reporting process and to prevent the issuance of misleading financial statements. The resulting sense of confidence in companies’ audited financial statements, which is key to the efficient functioning of the markets for public companies’ securities, can exist only if reasonable investors perceive auditors as independent and expert professionals who will conduct thorough audits. In the event that companies are alleged to have misled the public or presented falsified financial information, the accounting firms that performed those audits are also sometimes included in suits brought by investors or actions pursued by regulators. Accounting Firm Structure Most accounting firms that audit public companies in the United States are organized as partnerships. Unlike corporations, which generally issue stock to their shareholders in exchange for capital to conduct their operations, accounting firms structured as partnerships obtain capital from their partners. To conduct an audit of a public company, an accounting firm establishes an engagement team that is typically headed by a lead audit partner and includes a concurring audit partner, audit staff and managers, and, as needed, technical specialists. The lead audit partner has responsibility for decision making on significant auditing, accounting, and reporting matters that affect the financial statements; reviewing the audit work; and maintaining regular contact with management and the audit committee. The concurring audit partner is responsible for reviewing the audit. To provide technical assistance to engagement teams, the larger accounting firms have national offices staffed with experts in auditing and accounting standards. These national offices are made up of accounting and auditing technical specialists who assist engagement teams by responding to complex questions, researching answers, and providing guidance to individual audit teams. These specialists also provide guidance to the entire firm on handling issues that arise during the course of audits, including evaluating the fair presentation of the financial statements. Although the largest U.S. accounting firms have used mergers and acquisitions to help build their businesses and expand nationally and internationally since the early part of the twentieth century, in the late 1980s the eight largest firms—known as the Big 8—began merging with each other. As shown in figure 1, by 2000 various mergers among the largest accounting firms had left five large firms that accounted for the majority of audit revenues among firms auditing public companies. In 2002, the market consolidated further to 4 large firms after the Department of Justice criminally indicted Arthur Andersen on obstruction of justice charges stemming from the firm’s role as auditor of Enron Corporation. The indictment and subsequent conviction of Arthur Andersen led to a mass exodus of its partners and staff, as well as clients. As a result, the firm was dissolved in 2002. Public companies and the accounting profession have experienced many reporting and auditing changes in recent years. In the aftermath of various financial scandals at large public companies such as Enron and WorldCom in the early 2000s, new legislation was passed to help restore investor confidence in the nation’s capital markets. The Sarbanes-Oxley Act of 2002 (the Act) introduced major reforms to public company financial reporting and auditing that were intended to improve the accuracy and reliability of financial reporting and enhance auditors’ independence and audit quality. The reforms include the following: Section 404(a) of the Act requires that in each annual financial report filed with SEC the management of public companies must (1) state its responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and (2) assess the effectiveness of its internal control structure and procedures for financial reporting. Section 404(b) requires that each public company’s accounting firm must attest to and report on management’s assessment of the effectiveness of internal control over financial reporting. A separate provision prohibits the company’s auditor from providing certain nonaudit services, including bookkeeping, appraisal services, actuarial services, and internal audit outsourcing services. Another provision requires the mandatory rotation of lead and reviewing audit partners after they have provided audit services to a particular public company for 5 consecutive years. The Act also established the PCAOB as a private-sector nonprofit organization subject to SEC oversight. PCAOB’s mission is to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports. Table 1 shows other provisions affecting the corporate governance, auditing, and financial reporting of public companies. The PCAOB has several responsibilities, including registering public accounting firms that prepare audit reports for public companies; establishing auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for public companies; conducting inspections of registered public accounting firms; and conducting investigations and disciplinary proceedings of registered public accounting firms and those associated with such firms. Under the Act, SEC was granted oversight and enforcement authority over PCAOB and must approve rules proposed by PCAOB for them to become effective. PCAOB is required to annually inspect registered accounting firms that provide audit reports for more than 100 issuers and at least triennially inspect firms with fewer issuers. It conducted its first accounting firm inspections during 2003, but these inspections were limited in scope and were performed only on the largest firms. Since 2004, PCAOB has conducted full scope inspections of accounting firms of all sizes. As required in the Sarbanes-Oxley Act, PCAOB has issued individual reports to the accounting firms explaining issues identified in the inspections and has also issued reports covering common observations from their inspection process. The Sarbanes-Oxley Act also mandated that we study (1) the factors contributing to the mergers among the largest accounting firms in the 1980s and 1990s; (2) the implications of consolidation on competition and client choice, audit fees, audit quality, and auditor independence; (3) the effect of consolidation on capital formation and securities markets; and (4) barriers to entry faced by smaller accounting firms in competing with the largest firms for large public company audits. In 2003, we issued our report Public Accounting Firms: Mandated Study on Consolidation and Competition (GAO-03-864). We concluded in 2003 that the audit market was in the midst of unprecedented change. The market had become more highly concentrated, and the largest firms, as well as other accounting firms, faced tremendous challenges as they adapted to new risks and responsibilities, new independence standards, a new business model, and a new oversight structure, among other things. In many cases it was unclear what the ultimate outcome of the changes would be, and we noted that past findings might not reflect the future situation. We also identified several important issues that we believed warranted additional attention and study by the appropriate regulatory or enforcement agencies, such as the effect of the existing level of concentration on audit price and quality. Since 2003, significant activity related to management reporting and auditing standards has continued to occur. In 2002, 2003, and 2004, SEC issued rules and guidance on implementing some of the Sarbanes-Oxley Act’s provisions. Among these was the requirement that a public company’s chief executive officer and chief financial officer certify in quarterly and annual reports issued after August 29, 2002, that their company’s financial statements fairly present in material respects the company’s financial condition (Section 302). In June 2003, SEC issued final rules to implement Section 404 of the Sarbanes-Oxley Act. Section 404(a) requires company management, in each annual report filed with SEC, to state their responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting and to assess the effectiveness of its internal control structure and procedures for financial reporting. Section 404(b), which requires the registered accounting firm to attest to and report on management’s assessment of the effectiveness of its internal control over financial reporting was implemented later. Public companies whose outstanding stock held by the public was valued at $75 million or more—known as accelerated filers—were first required to comply with Section 404(a) and (b) for fiscal years ending on or after November 15, 2004.