Consolidation
and Competition in Public Accounting
An Analysis of the GAO Report
By
Robert Bloom and David C. Schirm
JUNE 2005
- The Sarbanes-Oxley Act of 2002 (SOA) charged the General
Accounting Office (GAO, which changed its name to the Government
Accountability Office in 2004) with examining the factors
underlying audit mergers in the 1980s and 1990s, and the effects
of such consolidation on competition, cost, quality, and independence
in auditing, as well as on capital formation and the obstacles
facing smaller audit firms in attempting to compete with the
Big Four (Ernst & Young, Deloitte & Touche, KPMG,
and PricewaterhouseCoopers). The GAO released its report,
“Public Accounting Firms: Mandated Study on Consolidation
and Competition,”July 2003, on the first anniversary
of the SOA. In
conducting this study, the GAO took the following steps:
n Interviewed partners in the major accounting firms involved
in mergers;
-
Collected information from the SEC and international counterparts;
-
Consulted with researchers on audit completion, quality,
and fees;
-
Surveyed many accounting firms about consolidation;
-
Interviewed 20 audit committee chairs from Fortune 500
companies;
-
Interviewed institutional investors and investment banks;
and
-
Used a simple model of pure price competition in a simulation
of smaller firm mergers to assess the impact of consolidation.
Today’s
Auditing Environment
The
GAO did not perceive a problem with today’s marketplace,
where only four major accounting firms remain worldwide.
These firms dominate the market for auditing services: the
Big Four audit more than 78% of all U.S. public companies,
representing 99% of public company sales. Because each of
the Big Four is dominant in particular fields of specialization,
many companies have, for practical purposes, only one or
two firms from which to select. For example, Pricewater-
houseCoopers dominates the petroleum and coal industry,
while KPMG covers financial institutions.
Concern
about competition in the audit industry became especially
acute after Arthur Andersen’s demise in 2002, although
this is not referred to in the GAO report. In addition,
a recent court action by the SEC forbade Ernst & Young
from accepting new public-company audits for six months,
due to Ernst & Young’s violations of audit independence
rules (SEC Initial Decision Release 249, April 16, 2004).
The
fact that this suspension period was only six months may
stem from consideration of the limited competition currently
existing in the audit industry. The terms of this action
also required Ernst & Young to appoint a special consultant
to review the firm’s independence policies and procedures.
Additionally, the firm had to pay $1.7 million, plus interest,
and had to cease and desist from nonindependent engagements
with audit clients. Ernst & Young decided not to appeal.
The
Auditing Oligopoly
The
report points out that the market for audit services to
large public companies has become a “tight oligopoly,”
defined as a market structure in which the top four providers
control at least 60% of the market and other entities face
significant barriers to entry into the market.
In
1997 and 2002, the four-firm concentration ratios measured
by the number of clients for the public company audit market
were 65% and 78%, respectively. Measured by total sales
of audited public companies, the four-firm concentration
ratios for those years were even higher: 71% and 99%. Measures
of concentration such as the Big Four concentration ratio—the
percentage of market share accounted for by the four largest
firms in the industry—and the Hirschman-Herfindahl
Index—calculated as the sum of the squares of market
shares for each firm—reflect a tight oligopoly over
the market for public-company auditing.
While
the GAO found that audit fees have been increasing recently,
existing research did not provide a basis for attributing
the increase to the consolidation of audit firms. Fee increases
are attributable at least in part to the changing audit
environment and the anticipation of increasing scrutiny
of publicly disclosed financial information. In the 1980s
and 1990s, as the report asserts, some experts contended
that audit fees may have been kept low because audit services
served as “loss leaders” for the major firms
to secure more lucrative consulting services from their
clients. The GAO itself uncovered no research evidence connecting
audit quality and independence, both of which are difficult
to measure, to consolidation. Moreover, it found no clear
linkage between consolidation and capital formation. Nevertheless,
the GAO observed the following:
[T]o
the extent that the Big Four evaluate the profitability
and risk of auditing companies, they might become more
selective about retaining their smaller, potentially less
profitable or higher risk audit clients. In turn, these
smaller companies might face increasing costs of capital
if investors were to react adversely to their not using
a Big Four auditor.
The
GAO report develops hypothetical scenarios dealing with
audit firms’ market power. For example, to the extent
that one firm dominates a specific industry, its interpretations
of particular accounting standards could become existing
practice. If the SEC struck down those interpretations,
this firm and its clients could be exposed to significant
liabilities and affect an entire industry. The authors,
however, consider this scenario far-fetched. A company can
pursue its preferred accounting approach without consulting
its auditor in advance, and can subsequently see if the
auditor agrees. In addition, specialization by an audit
firm in a particular area, because it entails greater knowledge
and expertise, can benefit its clients.
Analyzing
Market Concentration
Based
on GAO survey data from accounting firms and their clients
and from existing empirical research, the GAO found no evidence
of an impaired market for audit services, despite the observed
concentration of market share by the Big Four. To address
whether the observed concentration in the market for audit
services could arise in a purely competitive price market,
the authors used a pure-competition model of the audit market
structure developed in 1998 by Rajib Doogar and Robert F.
Easley, and performed simulations applying 2002 data for
audit firms of each of 5,448 U.S. publicly traded industrial
companies. Contrary to earlier studies of U.S. audit firm
concentration, which relied on assumptions of audit service
differences or scale economies in audit costs to explain
the observed market concentration, the Doogar-Easley model
assumes an environment of undifferentiated audit services,
where suppliers price at marginal cost in order to maximize
their profits and buyers choose their audit firm based only
on its price. The sets of audit firms and clients, client
size and audit firm size, and partner/staff ratios are assumed
as constant in the short run. While the model assumes that
the scale of each audit firm’s operations is fixed,
the ratio of partners to staff determines the firm’s
cost of production, which is jointly determined along with
the pricing of audit services in this price-competitive,
profit-maximizing environment.
In
their 1998 study of U.S. audit-firm concentration, Doogar
and Easley found that simulations using their model closely
predicted observed market concentration. Simulations also
generated Big Four market shares very close to observed
levels in 2002. Moreover, simulation results indicated that
a merger of the five largest audit firms below the Big Four
would take away only a limited market share from the Big
Four, even assuming that the newly merged firm attained
the same degree of efficiency as the Big Four. According
to the GAO report, the “observed high degree of concentration
to date is not necessarily inconsistent with a price competitive
environment.”
Limitations
of the Doogar-Easley model include the assumptions of audit
services undifferentiated by quality, reputation, or area
of expertise. Additionally, the model assumes that an audit
firm has no ability to lower the average cost of its services
as the scale of its operations increases. While the results
of simulations suggest that observed market concentration
is not inconsistent with a competitive price environment,
Doogar and Easley stress that their model is short-run oriented,
and thus cannot explain changes in audit-firm concentration
over the long run [“Concentration without Differentiation:
A New Look at the Determination of Audit Market Concentration,”
Journal of Accounting and Economics, 25 (1998)].
In
contrast to the previously identified limitations of the
Doogar-Easley model, GAO interviews of past and present
partners of accounting firms, officials from the U.S. Department
of Justice, the Federal Trade Commission, the SEC, and regulators
in Europe and Japan suggest that mergers of large accounting
firms have occurred in order to keep up with the growing
size of public companies audited worldwide, to attain economies
of scale in technology, and to enhance industry expertise.
These mergers have aided audit firms in increasing their
market share and in maintaining their market position in
particular industries.
Nevertheless,
the GAO does not expect smaller audit firms to fill the
vacuum left by the mergers of the former Big Eight firms
and the dissolution of Arthur Andersen, because the smaller
firms lack the requisite manpower, expertise, and funding.
The report asserts that even if several smaller firms were
to merge, they would still be unable to compete with the
Big Four because of a lack of resources. Additionally, the
Big Four have established reputations; smaller firms are
not as well known. Litigation and insurance costs associated
with auditing large public companies make growth in this
market less attractive than other opportunities. Furthermore,
attempting to raise the capital needed to audit large public
companies is a major obstacle, because audit partnerships
limit the ability to secure external funds. Finally, differing
licensure requirements for staff by different states discourage
audit firms from national growth.
The
GAO report also examines recent historical developments
in the major accounting firms. One in particular is the
expansion and recent contractions of management consulting
services because of auditor independence issues. According
to the report, “By 1998, revenues from management
consulting services increased to an average of 45 percent
of the [then] Big 5’s, including Andersen’s
revenues for that year. However, by 2000, firms had begun
to sell or divest portions of their consulting … and
average revenue … decreased to 30 percent.”
Recently, three of the Big Four (the exception being Deloitte
& Touche) have sold or divested parts, but not necessarily
all, of their consulting practices.
Implications
of SOA
SOA
could reduce the number of audit choices that a large public
company would have in the future, assuming the company employs
a Big Four auditor and contracts with another Big Four firm
for nonaudit services. The GAO report offers just such an
example, involving a multinational petroleum company currently
using a Big Four firm for auditing and another for outsourcing
its internal audit function. When this company seeks to
change its auditor to comply with an auditor-rotation policy
established by its board of directors, the company would
have only two audit firms from which to select.
The
report also observes that audit quality and independence
are difficult to measure. In particular, research provides
competing hypotheses on the effects of audit competition,
audit tenure, and audit firm size on audit quality and independence.
Greater competition could adversely affect quality and independence,
because companies could find various reasons to replace
their auditor, such as a firm’s greater willingness
to accept management’s accounting policies. Greater
competition could also mean less influence by each audit
firm on accounting policy. In addition, larger audit firms
are less dependent on any one client, thus enhancing their
independence.
While
the report lacks specific recommendations, it contains particular
findings, the most notable being that the environment for
audit services is functioning well and price competition
has not been impaired. Nevertheless, the report emphasizes
the possibility of future trouble. The report contends that
the Big Four will encounter significant challenges in the
future, including adapting to new risks, new standards,
and new oversight. The report notes that agencies could
monitor the level of concentration on price and quality.
Certain steps could be taken to prevent further concentration,
including possible government intervention to foster competition.
Concentration in particular industries may call for additional
analysis and attention. The report maintains that addressing
barriers to entry into the large public company audit market
may be useful as well.
Too
Few to Fail?
In
what may seem like a reaction to the demise of Arthur Andersen,
the report recommends the following:
[I]t
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. …
[W]hen
appropriate, hold partners and employees rather than the
entire firm accountable … However, it is equally
important that concerns about the firms’ viability
be balanced against the firms’ believing they are
“too few to fail.”
While
the GAO report makes no statement on the subject, in 2002
some observers preferred that the Justice Department should
have allowed Andersen to remain in business, thereby fostering
competition in auditing, and instead pursued only the partners
and other employees involved in the Enron scandal. Should
a regulator be faced with a similar situation in the future,
no one can tell what implications their decision will have
on the public-company audit marketplace.
Robert
Bloom, PhD, is a professor of accountancy, and David
C. Schirm, PhD, is chair of the department of economics
and finance, both at the Boler School of Business, John Carroll
University, University Heights, Ohio. |