Consolidation and Competition in Public Accounting
An Analysis of the GAO Report

By Robert Bloom and David C. Schirm

In conducting this study, the GAO took the following steps:

• 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.

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