oversight

Public Accounting Firms: Mandated Study on Consolidation and Competition

Published by the Government Accountability Office on 2003-07-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States General Accounting Office

GAO          Report to the Senate Committee on
             Banking, Housing, and Urban Affairs and
             the House Committee on Financial
             Services

July 2003
             PUBLIC
             ACCOUNTING FIRMS
             Mandated Study on
             Consolidation and
             Competition




GAO-03-864
             a
                                                July 2003


                                                PUBLIC ACCOUNTING FIRMS

                                                Mandated Study on Consolidation and
Highlights of GAO-03-864, a report to the       Competition
Senate Committee on Banking, Housing,
and Urban Affairs and the House
Committee on Financial Services




The audit market for large public               Domestically and globally, there are only a few large firms capable of auditing
companies is an oligopoly, with the             large public companies, which raises potential choice, price, quality, and
largest firms auditing the vast                 concentration risk concerns. A common concentration measure used in
majority of public companies and                antitrust analysis, the Hirschman-Herfindahl Index (HHI) indicates that the
smaller firms facing significant
                                                largest firms have the potential for significant market power following mergers
barriers to entry into the market.
Mergers among the largest firms in              among the largest firms and the dissolution of Arthur Andersen (see fig. below).
the 1980s and 1990s and the                     Although GAO found no evidence of impaired competition to date, the
dissolution of Arthur Andersen in               significant changes that have occurred in the profession may have implications
2002 significantly increased                    for competition and public company choice, especially in certain industries, in
concentration among the largest                 the future.
firms, known as the “Big 4.” These
four firms currently audit over 78              Existing research on audit fees did not conclusively identify a direct correlation
percent of all U.S. public                      with consolidation. GAO found that fees have started to increase, and most
companies and 99 percent of all                 experts expect the trend to continue as the audit environment responds to
public company sales. This                      recent and ongoing changes in the audit market. Research on quality and
consolidation and the resulting
                                                independence did not link audit quality and auditor independence to
concentration have raised a
number of concerns. To address                  consolidation and generally was inconclusive. Likewise, GAO was unable to
them, the Sarbanes-Oxley Act of                 draw clear linkages between consolidation and capital formation but did observe
2002 mandated that GAO study                    potential impacts for some smaller companies seeking to raise capital.
                                                However, given the unprecedented changes occurring in the audit market, GAO
•    the factors contributing to the            observes that past behavior may not be indicative of future behavior, and these
     mergers;                                   potential implications may warrant additional study in the future, including
•    the implications of                        preventing further consolidation and maintaining competition.
     consolidation on competition
     and client choice, audit fees,             Finally, GAO found that smaller accounting firms faced significant barriers to
     audit quality, and auditor                 entry—including lack of staff, industry and technical expertise, capital
     independence;
                                                formation, global reach, and reputation—into the large public company audit
•    the impact of consolidation on
     capital formation and                      market. As a result, market forces are not likely to result in the expansion of the
     securities markets; and                    current Big 4. Furthermore, certain factors and conditions could cause a further
•    barriers to entry faced by                 reduction in the number of major accounting firms.
     smaller accounting firms in
     competing with the largest                 Hirschman-Herfindahl Indexes, 1988-2002
     firms for large public company
     audits.




www.gao.gov/cgi-bin/getrpt?GAO-03-864.

To view the full product, including the scope
and methodology, click on the link above.
For more information, contact Davi M.
D'Agostino (202) 512-8678 or
d'agostinod@gao.gov.
Contents



Letter                                                                                                  1
                             Results in Brief                                                           4
                             Background                                                                 7
                             Several Key Factors Spurred Consolidation in the 1980s and
                               1990s                                                                   12
                             Audit Market Has Become More Highly Concentrated, Leaving Large
                               Public Companies with Few Choices                                       15
                             Linking Consolidation to Audit Price, Quality, and Auditor
                               Independence Is Difficult                                               31
                             Consolidation Appears to Have Had Little Effect on Capital
                               Formation or Securities Markets to Date, and Future
                               Implications Are Unclear                                                42
                             Smaller Accounting Firms Face Numerous Barriers to Entry into the
                               Top Tier                                                                45
                             Observations                                                              52
                             Agency Comments and Our Evaluation                                        53


Appendixes
              Appendix I:    Scope and Methodology                                                     
                             Identifying the Factors for Consolidation                                 55
                             Impact of Consolidation on Competition, Auditor Choices, Audit
                               Fees, and Audit Quality and Auditor Independence                        56
                             Data Analysis Used a Variety of Sources                                   56
                             We Used the Doogar and Easley (1998) Model of Audit Market
                               Structure to Assess Concentration in a Purely Price Competitive
                               Framework                                                               58
                             Impact of Consolidation on Capital Formation and Securities
                               Market                                                                  65
                             Identifying Barriers to Entry                                             65
             Appendix II:    GAO Surveys of Public Accounting Firms and Fortune 1000
                             Public Companies                                                          67
             Appendix III:   Arthur Andersen Case Study                                               101
                             Background                                                               101
                             Most Andersen Clients Switched to a Big 4 Firm                           101
                             Largest Clients Switched to Big 4 Firms                                  103
                             Thirteen Percent of Former Andersen Clients Switched to Non-Big 4
                               Firms                                                                  106
                             Former Andersen Clients by Industry Sectors                              107
             Appendix IV:    Analysis of Big 4 Firms’ Specialization by Industry Sector               110



                             Page i                                     GAO-03-864 Public Accounting Firms
                         Contents




                         Limitations of SIC Analysis                                                110
                         Industry Specialization Can Limit Public Company Choice                    115
           Appendix V:   GAO Contacts and Staff Acknowledgments                                     134
                         GAO Contacts                                                               134
                         Acknowledgments                                                            134


Glossary                                                                                            135


Tables                   Table 1: Twenty-five Largest Accounting Firms by Total Revenue,
                                   Partners, and Staff Resources (U.S. Operations), 2002             17
                         Table 2: List of Selected Tight Oligopolies, as of 1996                     24
                         Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms
                                   (U.S. Operations), 1988 and 2002                                  47
                         Table 4: Largest U.S. Accounting Firms (Global Operations),
                                   2002                                                              48
                         Table 5: Simulation One—Market Shares, Actual and Simulated
                                   with Various Switching Costs, 2002                                61
                         Table 6: Simulation Two—Market Shares, Actual and Simulated by
                                   Client Assets, 2002                                               62
                         Table 7: Simulation Three—Market Shares, Merger Analysis with
                                   Various Efficiency Assumptions, 2002                              63
                         Table 8: Former Andersen Public Company Clients (Actual and
                                   Percentage) Categorized by Assets, Big 4, and Other Firms,
                                   as of December 2002                                              105
                         Table 9: Former Andersen Public Company Clients (Number and
                                   Percentage) Categorized by Assets and Big 4 Firm, as of
                                   December 31, 2002                                                106
                         Table 10: Former Andersen Clients Hired by Other Firms, as of
                                   December 31, 2002                                                107
                         Table 11: New Firms for Former Andersen Clients by SIC Code, as of
                                   December 31, 2002                                                108
                         Table 12: Description of Selected SIC Groups                               112
                         Table 13: Industries in Which the Big 4 Have a Significant Presence
                                   (10 percent or More)                                             130
                         Table 14: Industries in Which the Big 4 Have a Significant Presence
                                   (25 percent or more)                                             132


Figures                  Figure 1: Accounting Firm Services as a Percentage of Revenue,
                                   1975, 1987-2002                                                    9
                         Figure 2: Significant Mergers of the 1980s and 1990s                        11



                         Page ii                                      GAO-03-864 Public Accounting Firms
Contents




Figure 3: Hirschman-Herfindahl Indexes, 1988-2002                          19
Figure 4: Hirschman-Herfindahl Indexes (Based on Number of
           Clients), 2002                                                  20
Figure 5: Percentage of Public Company Audit Market (by Total
           Sales Audited), 1988, 1997, and 2002                            21
Figure 6: Percentage of Public Company Audit Market (by Number
           of Clients), 1988, 1997, and 2002                               23
Figure 7: Percentage of Assets Audited in Selected Industries, 1997
           and 2002                                                        28
Figure 8: Changes in Audit Fees (Actual), 1984-2000                        33
Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of
           Total Sales Audited, 1988-2001                                  34
Figure 10: Where Andersen’s Public Company Clients Went,
           2001-2002                                                      102
Figure 11: New Firms for Former Andersen Public Company Clients,
           2001- 2002                                                     103
Figure 12: Average Assets of Former Andersen Pubic Company
           Clients by New Firm, 2001-2002                                 104
Figure 13: Percentages of Assets Audited by the Big 4 in Selected
           Industries, 1997 and 2002                                      116
Figure 14: Percentages of Assets Audited in Industries Potentially
           Impacted by the PriceWaterhouseCoopers Merger and
           Dissolution of Andersen, 1997 and 2002                         125




Page iii                                    GAO-03-864 Public Accounting Firms
Contents




Abbreviations

AA          Arthur Andersen LLP
AICPA       American Institute of Certified Public Accountants
Amex        American Stock Exchange
AY          Arthur Young LLP
CEO         chief executive officer
CL          Coopers & Lybrand LLP
DHS         Deloitte Haskins & Sells LLP
DOJ         Department of Justice
DT          Deloitte & Touche LLP
EW          Ernst & Whinney LLP
EY          Ernst & Young LLP
FTC         Federal Trade Commission
GAAP        generally accepted accounting principles
GAAS        generally accepted auditing standards
HHI         Hirschman-Herfindahl Index
KPMG        KPMG (or KPMG Peat Marwick prior to February 1995)
NYSE        New York Stock Exchange
PAR         Public Accounting Report
PCAOB       Public Company Accounting Oversight Board
PW          Price Waterhouse LLP
PWC         PricewaterhouseCoopers LLP
SEC         Securities and Exchange Commission
SECPS       SEC Practice Section of AICPA
SIC         Standard Industry Classification
TR          Touche Ross LLP
UAA         Uniform Accountancy Act



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Page iv                                               GAO-03-864 Public Accounting Firms
A
United States General Accounting Office
Washington, D.C. 20548



                                    July 30, 2003                                                                                     Leter




                                    The Honorable Richard C. Shelby
                                    Chairman
                                    The Honorable Paul S. Sarbanes
                                    Ranking Minority Member
                                    Committee on Banking, Housing, and Urban Affairs
                                    United States Senate

                                    The Honorable Michael G. Oxley
                                    Chairman
                                    The Honorable Barney Frank
                                    Ranking Minority Member
                                    Committee on Financial Services
                                    House of Representatives

                                    There are hundreds of public accounting firms that audit public companies
                                    in the United States. However, a small number of very large firms have
                                    traditionally provided audit and attest services for the majority of public
                                    companies, particularly large national and multinational companies.1 The
                                    number of firms widely considered capable of providing audit services to
                                    large national and multinational companies decreased from eight (“the Big
                                    8”) in the 1980s to four (“the Big 4”) today.2 The reduction was the result of
                                    mergers involving six of the top eight firms since the late 1980s and the
                                    abrupt dissolution of Arthur Andersen LLP (Andersen) in 2002. The Big 4
                                    firms are substantially larger than the other U.S. or international
                                    accounting firms, each with thousands of partners, tens of thousands of
                                    employees, offices located around the world, and annual revenues in the
                                    billions of dollars. These four firms currently audit over 78 percent of all

                                    1
                                     For the purpose of this report, public companies are defined as those that are listed on the
                                    American Stock Exchange (Amex), NASDAQ, or the New York Stock Exchange (NYSE), or
                                    with stock traded on other over-the-counter markets such as Pink Sheets. Large public
                                    companies generally include those with over $1 billion in annual revenue unless otherwise
                                    noted.
                                    2
                                     For the purpose of this report, we refer to the Big 8 and Big 4 firms as the “top tier,” based
                                    on total revenue and staff size. The Big 8 were Arthur Andersen LLP, Arthur Young LLP,
                                    Coopers & Lybrand LLP, Deloitte Haskins & Sells LLP, Ernst & Whinney LLP, Peat Marwick
                                    Mitchell LLP, Price Waterhouse LLP, and Touche Ross LLP. The Big 4 are Deloitte & Touche
                                    LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers LLP. Any reference to
                                    “smaller firms” includes any of the other more than 700 firms that audit public companies.
                                    When we present firm rankings, we do so based on annual total revenues in the United
                                    States unless otherwise noted.




                                    Page 1                                                   GAO-03-864 Public Accounting Firms
U.S. public companies and 99 percent of public company annual sales.
Internationally, the Big 4 dominate the market for audit services.

Big 8 mergers and Andersen’s sudden dissolution have prompted
heightened concerns about concentration among the largest accounting
firms and the potential effect on competition and various other factors. As
a result, Congress mandated in the Sarbanes-Oxley Act of 2002 that we
study these issues.3 Specifically, we were asked to study (1) the factors
leading to the mergers among the largest public accounting firms in the
1980s and 1990s; (2) the impact of consolidation on competition, including
the availability of auditor choices for large national and multinational
public companies; (3) the impact of consolidation on the cost, quality, and
independence of audit services; (4) the impact of consolidation on capital
formation and securities markets; and (5) the barriers to entry faced by
smaller firms in competing with the largest firms for large national and
multinational public company clients.

To evaluate the factors contributing to consolidation among the largest
firms, we interviewed current and former partners of large public
accounting firms involved in past mergers and Department of Justice (DOJ)
and Federal Trade Commission (FTC) officials. However, we did not review
any antitrust analyses conducted by DOJ specific to the proposed mergers
of the 1980s and 1990s. According to DOJ officials, most of the firm
documents had been returned to the relevant parties, and other documents
were viewed as “predecisional” by DOJ. While GAO’s statute provides us
with access to predecisional information absent a certification by the
President or the Director of the Office of Management and Budget, we were
more interested in the reasons for the mergers than DOJ’s analysis in
approving the mergers. Therefore, we used other sources to obtain the
necessary information for this report. We also collected information from
and coordinated with the Securities and Exchange Commission (SEC) and
its counterparts from the other six members (Canada, France, Germany,
Italy, Japan, and the United Kingdom) of the Group of Seven nations as
required in the mandate. To evaluate the impact of consolidation on
competition and auditor choice, audit fees, and audit quality and auditor
independence, we consulted with academics, researchers, U.S. and foreign


3
 Pub. L. No. 107-204 § 701 (2002), the Sarbanes-Oxley Act significantly overhauled the
oversight and regulation of the accounting profession. Its purpose was to strengthen
corporate governance requirements and improve transparency and accountability, among
other things.




Page 2                                               GAO-03-864 Public Accounting Firms
regulators, and trade associations and collected data and descriptive
statistics for analysis. We also employed a simple model of pure price
competition, in which clients choose auditors based on price, ignoring
factors such as quality or reputation, to assess whether the current high
degree of concentration in the market for audit services is necessarily
inconsistent with a purely price competitive setting. Additionally, as of July
11, 2003, we had received 47 responses to a survey of the 97 largest
accounting firms—those with at least 10 corporate clients registered with
SEC—on their views of accounting firm consolidation and its potential
implications. This report also includes responses from 148 of 250 randomly
sampled, Fortune 1000 public companies on their experiences with their
auditor of record and their views on the potential implications of
consolidation. We plan to issue a subsequent report in September 2003 on
client responses received through July 30, 2003. Lastly, we interviewed a
judgmental sample of 20 chairs of audit committees for Fortune 1000
companies to obtain their views on consolidation and competition. To
address the issue of the impact of consolidation and concentration on
capital formation and securities markets, we interviewed representatives
from institutional investors, investment banks, self-regulatory
organizations, and credit rating agencies, among others, and we consulted
with academics and reviewed relevant literature. To identify any barriers to
competition faced by accounting firms, we reviewed existing state and
federal requirements and interviewed knowledgeable officials. We also
employed the previously cited economic model by simulating mergers
among smaller firms in order to assess whether, in a purely price
competitive environment, such mergers could lead to viable competitors to
the Big 4 for large national and multinational clients. We also obtained
information from the American Institute of Certified Public Accountants
(AICPA).4 Appendix I contains a full description of our scope and
methodology.

We conducted our work in Chicago, Illinois, New York, New York, and
Washington, D.C., between October 2002 and July 2003.



4
 Historically, the accounting profession maintained a voluntary, self-regulatory system
through AICPA that included setting professional standards, monitoring compliance with
professional standards, disciplining members for improper acts and substandard
performance, and conducting oversight of the industry. The Sarbanes-Oxley Act established
the Public Company Accounting Oversight Board to oversee the audit of public companies,
including registering public accounting firms; establishing audit standards; and conducting
compliance inspections, investigations, and disciplinary proceedings.




Page 3                                                 GAO-03-864 Public Accounting Firms
Results in Brief   According to officials involved in mergers among Big 8 firms, consolidation
                   of the largest public accounting firms was driven by many factors but
                   primarily by the need and desire to (1) keep pace with the growing size and
                   global reach of the public companies the firms served, (2) achieve greater
                   economies of scale as they modernized operations and other technological
                   capabilities, and (3) expand industry-specific and technical expertise.
                   Mergers with compatible firms—usually other Big 8 firms—were the
                   quickest way to fill gaps in geographic coverage, expand global reach, and
                   build industry-specific expertise. Moreover, mergers provided firms an
                   opportunity to rapidly increase their capital bases to spread risk and create
                   greater economies of scale as they modernized operations, particularly
                   information technology and training systems. Lastly, some firms merged to
                   maintain their size relative to larger competitors and to maintain their
                   position among the top tier.

                   While the market for audit services to public companies has become
                   increasingly concentrated—with significant barriers to entry into the
                   market for audit services for large public companies in particular—and the
                   largest accounting firms (domestically and globally) have increasingly had
                   the potential to exercise significant market power, we found no empirical
                   evidence that competition in the audit services market has been impaired
                   to date. However, given the dissolution of Andersen and other significant
                   changes in accounting firm operations, it is unclear whether the Big 4 will
                   exercise any increased market power. To assess whether the current high
                   degree of concentration in the market for audit services is necessarily
                   inconsistent with a price-competitive setting, we employed a simple model
                   of pure price competition in which clients choose auditors based on price.5
                   The model’s simulation results were very similar to the prevailing actual
                   market shares, a result suggesting that the observed high degree of
                   concentration to date is not necessarily inconsistent with a price-
                   competitive environment. The most observable impact of consolidation
                   appears to be on the limited number of auditor alternatives for large
                   national and multinational companies that require firms with extensive

                   5
                    R. Doogar and R. Easley, “Concentration without Differentiation: A New Look at the
                   Determinants of Audit Market Concentration,” Journal of Accounting and Economics, vol.
                   25 (1998): 235-253. The Doogar and Easley model is premised on the assumption of pure
                   price competition, in which clients choose auditors solely based on price, ignoring factors
                   such as quality or reputation. In this framework, audit clients will gravitate to larger and
                   more efficient audit firms, where efficiency is defined by the partner-to-staff, or leverage,
                   ratio. Companies with lower leverage ratios are more efficient and can therefore bid lower
                   prices for audit engagements.




                   Page 4                                                  GAO-03-864 Public Accounting Firms
staff resources, industry-specific and technical expertise, geographic
coverage, and international reputation. In many cases, the auditor
alternatives are further limited due to potential conflicts of interest,
Sarbanes-Oxley requirements, including independence rules, or the need
for industry-specific expertise—all of which may serve to effectively
reduce the number of eligible alternatives to three or in many cases fewer.6
Given the unprecedented changes occurring in the audit market and
potential competitive implications, these issues raise concerns about
further consolidation and lack of viable alternatives in certain industries.

Isolating the impact of consolidation on audit fees, audit quality, and
auditor independence is difficult, given the significant changes that have
occurred and are occurring in the accounting profession. Researchers
using small samples of aggregate billings of companies and other proxies
for audit fees (such as average audit revenues) found consolidation did not
appear to affect audit fees, which generally remained flat or decreased
slightly between 1989 and the mid-1990s (inflation adjusted). However,
since the late 1990s, audit fees appear to have increased, in part due to the
changing audit environment and increased client expectations. Concerning
the impact of consolidation on audit quality or auditor independence, we
found no research linking changes to consolidation; instead, the research
attempted to measure changes in audit quality and auditor independence in
general. The existing research and accounting experts we consulted had
mixed views on both audit quality and auditor independence. Given the
numerous ongoing changes in the market, past behavior may not be
indicative of the future and, therefore, we observe that these and other
factors may warrant attention given the potential price, quality, and
concentration risk implications.

We found no evidence to suggest that consolidation among the firms had
directly impacted capital formation or the securities markets, nor did we
find research that directly addressed how consolidation might affect
capital formation or the securities markets. Given the important assurance
role the auditor plays in the capital markets by attesting to the fairness of
the financial information presented by company management, market
participants often expect public companies to use one of the Big 4. While
this expectation or preference is less likely to impact large national and
multinational public companies, consolidation may have consequences for


6
 Sarbanes-Oxley requires that SEC enact independence rules, which address areas such as
prohibited nonaudit services, audit partner rotation, and conflicts of interest.




Page 5                                               GAO-03-864 Public Accounting Firms
smaller, less established companies. For example, to the extent that the Big
4 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 4 auditor.

Finally, we found that smaller accounting firms faced significant barriers to
entry into the audit market for large national and multinational public
companies. First, smaller firms generally lack the staff, technical expertise,
and global reach to audit large and complex national and multinational
public companies. In this regard, the large public companies that
responded to our survey to date indicated that smaller firms lacked the
requisite capacity to audit their operations. For example, based on the
average number of partners and nonpartner professional staff
internationally, the Big 4 had almost three times as many partners and over
five times as many nonpartner professional staff as the average for the next
three largest firms. We also employed the previously cited economic model
by simulating mergers among smaller firms in order to assess whether, in a
purely price-competitive environment, such mergers could lead to viable
competitors to the Big 4 for large national and multinational clients. We
found that, in general, any new firm resulting from such mergers would still
lack the resources necessary to compete, to any significant degree, with the
Big 4 for larger clients. Second, capital market participants are familiar
with the Big 4 and are hesitant to recommend that companies use firms
with whom they are not familiar. Third, many of the eight largest firms
below the Big 4 with whom we spoke said that litigation risks and
insurance costs associated with auditing a large public company made
growth into the large public company market less attractive than other
growth opportunities. Fourth, raising the amount of capital to build the
infrastructure necessary to audit large multinational companies is difficult,
in part because the partnership structure of accounting firms limits these
firms’ ability to raise outside capital. Finally, certain state laws make it
difficult for firms to expand nationally. For example, firms face the burden
and additional expense of obtaining state licenses for staff across the
country. As a result of these barriers, we observe that market forces are not
likely to result in the expansion of the current Big 4. However, it is unclear
what, if anything, can be done to address these issues.

This report makes no recommendations. We provided copies of a draft of
this report to SEC, DOJ, the Public Company Accounting Oversight Board
(PCAOB), and AICPA. DOJ provided additional information on the extent



Page 6                                         GAO-03-864 Public Accounting Firms
                               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 the final report. SEC, DOJ,
                               and AICPA provided technical comments, which have been incorporated
                               where appropriate. PCAOB had no comments.



Background                     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.



Full Disclosure Critical for   The Securities Act of 1933 and the Securities Exchange Act of 1934
Market Confidence              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



                               Page 7                                         GAO-03-864 Public Accounting Firms
                               markets for public companies’ securities, can only exist if reasonable
                               investors perceive auditors as independent and expert professionals who
                               will conduct thorough audits.



Repeal of Ban on               For many decades, public accountants, like members of other professions,
Advertising and Solicitation   could not advertise, solicit clients, or participate in a competitive bidding
                               process for clients. These restrictions were set by AICPA, which directed
Created More Competitive
                               the professional code of conduct for its members, and the state
Environment                    accountancy boards for the 50 states, District of Columbia, Guam, Puerto
                               Rico, and U.S. Virgin Islands.7 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.



Expansion and Contraction      Historically, accounting firms offered a broad range of services to their
of Management Consulting       clients. In addition to traditional services such as audit and attest services
                               and tax services, firms also offered consulting services in areas such as
Services Raised Concerns
                               information technology. As figure 1 illustrates, over the past several
about Auditor                  decades, the provision of management consulting services increased
Independence                   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.8 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.

                               7
                                State boards of accountancy, operating under the authority of individual state laws, adopt
                               rules that govern licensing for practice in their jurisdiction, including educational and
                               experience qualifications, continuing professional education requirements, and the manner
                               and use of the title “certified public accountant.”
                               8
                                The Big 5 were Andersen, Deloitte & Touche, Ernst & Young, KPMG, and
                               PricewaterhouseCoopers.




                               Page 8                                                 GAO-03-864 Public Accounting Firms
Figure 1: Accounting Firm Services as a Percentage of Revenue, 1975, 1987-2002
Percent

70


60


50


40


30


20


10


 0
     1975    1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

               Audit and attest services

               Management consulting services

               Tax services
Sources: Senate Subcommittee on Reports, Accounting and Management, Committee on Government Operations,
The Accounting Establishment, 95th Congress, 1st Session, March 31, 1977; Public Accounting Report, 1987-2002.

Note: The information included in the subcommittee report was based on 1975 data.


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.




Page 9                                                                      GAO-03-864 Public Accounting Firms
                             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.9 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
                             2003.10 The new rules placed additional limitations on management
                             consulting and other nonaudit services that firms could provide to their
                             audit clients.



Big 8 Mergers and Andersen   Although U.S. accounting firms have used mergers and acquisitions to help
Dissolution Brought about    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
the Big 4                    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.11 Because of the extensive


                             9
                              Senate Subcommittee on Reports, Accounting and Management, Committee on
                             Government Operations, The Accounting Establishment, 95th Congr.,1st Sess., March 31,
                             1977. This study is commonly known as the Metcalf Report.
                             10
                              Pub. L. 107-204, Title II § 201- §206 and 17 CFR Parts 210 and 240, Final Rule: Revision of
                             the Commission’s Auditor Independence Requirements.
                             11
                                  KPMG Peat Marwick is now known as KPMG.




                             Page 10                                                GAO-03-864 Public Accounting Firms
                                                                     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.



Figure 2: Significant Mergers of the 1980s and 1990s


                                1987      1988      1989     1990         1991     1992   1993     1994   1995   1996   1997     1998     1999     2000      2001     2002




             1986
           The Big 8
                                                                                                                                                 dissolved
         Arthur Andersen               Arthur Andersen                           Arthur Andersen                         Arthur Andersen


           Peat Marwick                      KPMG                                                                        Pricewaterhouse-                           Deloitte
                                                                                  Ernst & Young
             Mitchell                     Peat Marwick                                                                       Coopers                                & Touche

              Coopers                       Coopers                                 Deloitte
                                                                                                                          Ernst & Young                        Ernst & Young
             & Lybrand                     & Lybrand                                & Touche

                                                                                     KPMG                                      Deloitte                      Pricewaterhouse-
         Ernst & Whinney               Ernst & Whinney
                                                                                  Peat Marwick                                 & Touche                          Coopers

                                                                                    Coopers
         Price Waterhouse              Price Waterhouse                                                                         KPMG                                 KPMG
                                                                                   & Lybrand


           Arthur Young                   Arthur Young                       Price Waterhouse


             Deloitte                      Deloitte
          Haskins & Sells               Haskins & Sells


           Touche Ross                    Touche Ross




                                KMG


Sources: Interviews with Big 4 and Public Accounting Report, 1986-2002.




                                                                     Page 11                                                               GAO-03-864 Public Accounting Firms
                         Note: Firms are ranked by total U.S. revenue.


                         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.



Several Key Factors      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
Spurred Consolidation    the immense growth of U.S. businesses internationally, desire for greater
in the 1980s and 1990s   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




                         Page 12                                         GAO-03-864 Public Accounting Firms
                             firms merged to increase or maintain their market share and maintain their
                             market position among the top tier.



Globalization of Clients     According to representatives of the Big 4 firms, globalization was a driving
Prompted Need for Greater    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
Global Reach                 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.



Growing Complexity of        In addition to responding to globalization, representatives of the firms told
Client Operations Prompted   us that some of the mergers served to increase their industry-specific and
                             technical expertise and expand and build management-consulting
Need for Greater Industry-
                             operations to better serve the complex needs of their rapidly evolving
Specific and Technical       clients. Each of the Big 8 firms had different strengths and industry
Expertise                    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


                             Page 13                                        GAO-03-864 Public Accounting 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.12 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.



Mergers Enabled Firms to    Like public companies, the accounting firms were undergoing dramatic
Achieve Greater Economies   technological change and innovation in the 1980s and 1990s. According to
                            firm officials, firms were beginning to transition to computer-based
of Scale                    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

                            12
                             The term, “economies of scope,” refers to the notion that a producer’s average total cost of
                            production decreases as a result of increasing the number of different goods it produces.




                            Page 14                                                 GAO-03-864 Public Accounting Firms
                            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.



Mergers Helped Firms        Many accounting firms also merged to maintain or increase their market
Increase Market Share and   share in order to hold their market position among top-tier firms.
                            Furthermore, some firms believed that some of their foreign affiliates
Maintain Market Position
                            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.



Audit Market Has            Since 1988, the audit market has become increasingly concentrated,
                            especially in the market for large national and multinational company
Become More Highly          audits, leaving these companies with fewer choices. The 1989 and 1998
Concentrated, Leaving       mergers led to significant increases in certain key concentration measures
                            typically used by DOJ and FTC to evaluate potential mergers for antitrust
Large Public                concerns. These measures indicate highly concentrated markets in which
Companies with Few          the Big 4 have the potential to exercise significant market power. In
Choices                     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



                            Page 15                                        GAO-03-864 Public Accounting Firms
                          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.



Large Public Company      By any measure, the large public company audit market is a tight oligopoly,
Audit Market is a Tight   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
Oligopoly
                          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.




                          Page 16                                      GAO-03-864 Public Accounting Firms
Table 1: Twenty-five Largest Accounting Firms by Total Revenue, Partners, and Staff Resources (U.S. Operations), 2002

                                                          Audit and
                                                 Total        attest            Tax            MCS
                                             revenue       revenue        revenue         revenue
                                           (dollars in   (dollars in    (dollars in     (dollars in      Professional
Firm                                         millions)     millions)      millions)       millions)             Staff          Partners      Total staff      Offices
Deloitte & Touche                               $5,900      $2,124           $1,239          $2,006              19,835            2,618          22,453            81
Ernst & Young                                    4,515        2,664           1,716                 0            15,078            2,118          17,196            86
PricewaterhouseCoopers                           4,256        2,596             979                 0            16,774            2,027          18,801           113
KPMG                                             3,200        2,016           1,184                 0            10,967            1,535          12,502           122
Grant Thornton                                    400           200             136               64               2,068             312           2,380            51
BDO Seidman                                       353           145             145               64               1,229             281           1,510            37
BKD                                               211            93               65              53                 972             193           1,165            26
Crowe, Chizek and Co.                             205            45               37              88                 936             101           1,037            12
McGladrey & Pullen                                203           187               16                0              1,894             475           2,369            86
Moss Adams                                        163            64               62              37                 758             179              937           25
Plante & Moran                                    161            79               45              37                 714             161              875           15
Clifton Gunderson                                 137            55               36              48                 850             140              990           39
Virchow, Krause & Co.                              96            35               32              21                 536               60             596           11
Larson Allen                                       79            27               21              23                 401               73             474             8
Richard A. Eisner & Co.                            69            30               20              18                 280               70             350             3
Eide Bailly                                        62            25               11              13                 464               59             523           13
J.H. Cohn                                          60            30               16                4                193               58             251             8
Reznick Fedder &
Silverman                                          58            33               18                8                350               32             382             4
Cherry, Bekaert & Holland                          54            26               19                6                363               45             408           23
Berdon                                             54            20               19              14                 289               38             327             2
Wipfli Ullrich Bertelson                           52            27               16                8                335               62             397           16
M.R.Weiser & Co.                                   51            29               18                4                248               32             280             3
Rothstein, Kass & Co.                              50            39               11                1                303               16             319             4
Goodman & Co.                                      49            26               22                1                450               69             519             9
Schenck Business
Solutions                                          48            16               16                7                267               41             308           12
Sources: Public Accounting Report, 2002-2003.

                                                           Notes: Revenues from audit and attest, tax, and management consulting services (MCS) may not
                                                           equal total revenues due to rounding or exclusion of certain nontraditional services offered by firm.
                                                           Companies are ranked in Public Accounting Report by revenues. Figures are self-reported by the audit
                                                           firms. Note that Deloitte & Touche’s relative ranking reflects the fact that it is the only one of the Big 4
                                                           with revenues from MSC.




                                                           Page 17                                                          GAO-03-864 Public Accounting Firms
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.

Moreover, concentration measures, such as the Hirschman-Herfindahl
Index (HHI), which are used by DOJ and FTC to aid in the interpretation of
market concentration data, raise potential concerns about the level of
competition among accounting firms when calculated using recent data.13
As figure 3 illustrates, following the merger of Price Waterhouse and
Coopers & Lybrand and the dissolution of Andersen, the market consisted
of firms with the potential for significant market power. As a general rule,
an HHI below 1,000 indicates a market predisposed to perform
competitively and one that is unlikely to have adverse competitive effects.
Conversely, an HHI above 1,800 indicates a highly concentrated market in
which firms have the potential for significant market power—the ability to
profitably maintain prices above competitive levels for a significant period
of time. Sellers with market power may also lessen competition on
dimensions other than price such as product quality, service, or innovation.
In addition to using concentration measures, DOJ considers barriers to
entry and other competitive factors such as coordinated interaction among
firms, conditions conducive to establishing coordination among firms, firm-
specific price increases, alternative and differentiated products, changing
market conditions, and the ability of rival sellers to replace lost
competition. As figure 3 also shows, the criminal indictment of Andersen


13
  The HHI is calculated by summing the squared individual market shares of all accounting
firms (public company clients). For example, a market consisting of four firms with market
shares of 35 percent, 30 percent, 20 percent, and 10 percent has an HHI of 2,625 (352 + 302 +
202 + 102). The HHI reflects both the distribution of the market shares among top firms and
the composition of the market outside of the top firms. We have computed concentration
ratios and the HHI based on summary tables included in Who Audits America for the
relevant years.




Page 18                                                 GAO-03-864 Public Accounting Firms
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.



Figure 3: Hirschman-Herfindahl Indexes, 1988-2002
3,000                      Post merger                                                Post merger
                           (Ernst & Young;                                            (PricewaterhouseCoopers)
                           Deloitte & Touche)
2,500



2,000


                                                                                      Post Arthur
1,500                                                                                 Andersen dissolution



1,000



  500



    0
        1988           1990     1991     1992   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002

                  HHI (Sales)

                  Potential for significant market power
Source: Who Audits America, 1988-2002.



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.




Page 19                                                                GAO-03-864 Public Accounting Firms
Figure 4: Hirschman-Herfindahl Indexes (Based on Number of Clients), 2002
HHI

3,000



2,500



2,000
                                                                                                     Potential for
                                                                                                     significant
                                                                                                     market power
1,500



1,000



     500



       0
                25




                          0



                                    00




                                               0



                                                         0



                                                                       00



                                                                                       0
                          $5




                                              25



                                                        50




                                                                                                00
                                                                                  ,00
            -$




                                    $1




                                                                  1,0
                                              -$



                                                        -$




                                                                                            5,0
                     5-




                                                                                  $5
                               0-
           $1




                                                                  -$




                                                                                           >$
                     $2




                                         00



                                                   50




                                                                                 0-
                               $5



                                         $1



                                                   $2



                                                             00



                                                                            ,00
                                                             $5



                                                                            $1

           Markets defined by sales of companies (in millions)
Source: Who Audits America, 2002.



Analysis of the four-firm concentration ratio also indicates that
concentration among the top four accounting firms has increased
significantly since 1988.14 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


14
  For this measure, the top four firms are determined by the percentage of total sales
audited. The four-firm concentration ratio is the aggregate sales audited by the top four
firms as a percentage of total sales audited. We have computed concentration ratios based
on summary tables included in Who Audits America for the relevant years. These summary
tables omit certain small auditors that audit small public companies not listed on Amex,
NASDAQ, or NYSE.




Page 20                                                                     GAO-03-864 Public Accounting Firms
                                                                top four firms audited 99 percent of public company total sales with no
                                                                significant competitors (see fig. 5).



Figure 5: Percentage of Public Company Audit Market (by Total Sales Audited), 1988, 1997, and 2002
                  1988                                                                1997


                                                           2% Others                                                                                 1% Others
                                                           Arthur Young
                                  7%                                                                                          13%                    KPMG
                    21%                 8%                 Touche Ross                                            19%

                                                9%         Deloitte Haskins & Sells                                                   15%            Coopers & Lybrand
               14%                                                                                          18%
                                          11%              Ernst & Whinney
                                                                                                                                  16%                Arthur Andersen
                    14%          14%                                                                                18%
                                                           KPMG


                                                           Arthur Andersen                                                                           Deloitte & Touche
                                                           Coopers & Lybrand                                                                         Price Waterhouse
                                                           Price Waterhouse                                                                          Ernst & Young
                                                 Four-firm concentration ratio = 63 percent                                          Four-firm concentration ratio = 71 percent


                                                                                     2002


                                                                                                              1% Others


                                                                                              18%             KPMG

                                                                            34%

                                                                                               23%            Ernst & Young

                                                                                   24%
                                                                           Source: GAO.



                                                                                                              Deloitte & Touche
                                                                                                              PricewaterhouseCoopers
                                                                                                     Four-firm concentration ratio = 99 percent
Source: Who Audits America, 1988, 1997, 2002.




                                                                Page 21                                                          GAO-03-864 Public Accounting Firms
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).15 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.




15
 Market shares are generally calculated using the dollar value of sales as we have done in
the text above and as shown in figure 5. FTC and DOJ note that measures such as sales,
shipments, or production are the best indicators of future competitive significance.
Nevertheless, we have also computed concentration ratios based on the number of clients
for descriptive purposes.




Page 22                                                GAO-03-864 Public Accounting Firms
Figure 6: Percentage of Public Company Audit Market (by Number of Clients), 1988, 1997, and 2002
                            1988                                                                                         1997

                                                           Arthur Young                                                                               Price Waterhouse
                                7%                                                                                            9%
                                        8%                 Touche Ross                                           18%
                    18%                                                                                                             11%               Coopers & Lybrand
                                                8%         Deloitte Haskins & Sells

               16%                              8%         Price Waterhouse                                17%                         13%            Deloitte & Touche


                   14%                 10%                 Coopers & Lybrand
                                                                                                                                15%                   Others
                                                                                                                   17%
                               11%
                                                           Ernst & Whinney

                                                           Arthur Andersen                                                                            Arthur Andersen
                                                           KPMG                                                                                       KPMG
                                                           Others                                                                                     Ernst & Young
                                                 Four-firm concentration ratio = 51 percent                                           Four-firm concentration ratio = 65 percent

                                                                                     2002



                                                                                              16%              Deloitte & Touche
                                                                             22%

                                                                                                19%            KPMG

                                                                           22%
                                                                                         21%
                                                                                                               PricewaterhouseCoopers


                                                                                                               Ernst & Young
                                                                                                               Others
                                                                                                      Four-firm concentration ratio = 78 percent
Source: Who Audits America, 1988, 1997, 2002.




                                                                 Page 23                                                             GAO-03-864 Public Accounting Firms
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.16 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.



Table 2: List of Selected Tight Oligopolies, as of 1996

Market                                         Leading companies
Cereals                                        Kellogg, General Mills, General Foods
Beer                                           Anheuser-Busch, Miller, Coors
Airlines                                       American, United, Northwest, Delta, USAir
Garbage disposal                               Waste-Management, Browning-Ferris
Automobiles                                    General Motors, Ford, Chrysler, Toyota
Locomotives                                    General Electric, General Motors
Carbonated drinks                              Coca-Cola, PepsiCo
Recordings                                     Warner, Sony, BMG, Polygram, EMI, MCA
Express delivery                               Federal Express, UPS, Airborne Freight
Soaps and detergents                           Procter & Gamble, Colgate, Lever
Meat packing                                   Iowa Beef Packers, Cargill, ConAgra
Automobile rentals                             Hertz (Ford), Avis, Budget (Ford), Alamo, National (GM)
Athletic shoes                                 Nike, Reebok, Adidas
Toys                                           Mattel, Hasbro
Source: W. Shepherd, The Economics of Industrial Organization, 4th ed. (London: Prentice-Hall, 1997).

Notes: This list includes a variety of tight oligopolies, and it does not attempt to compare or infer
similarities aside from market concentration. It includes leading companies from the U.S. market
perspective. The companies in certain markets may have also changed since 1996.




16
 Collusion refers to a usually secret agreement among competing firms (mostly
oligopolistic firms) in an industry to control the market, raise the market price, and
otherwise act like a monopoly. While overt collusion involves an explicit formal agreement
among the firms, under tacit collusion each firm seems to be acting independently with no
explicit agreement, perhaps each responding to the same market conditions, but ultimately
the result is the same as it is under an explicit agreement.




Page 24                                                                         GAO-03-864 Public Accounting Firms
Consolidation Does Not      Despite the high degree of concentration among accounting firms, with
Appear to Have Impaired     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
Price Competition to Date   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.17 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


                            17
                             The simulation is based on 5,448 industrial companies and their auditors. According to
                            data obtained from Who Audits America, the Big 4 audited 62.2 percent of these companies.
                            In this 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.
                            In an alternative simulation, we initiated the process without assigning clients to a
                            particular firm and allowed accounting firms to compete for each client. The results were
                            consistent with the above analysis; in fact, the Big 4 were predicted to audit 1-2 percent
                            more of the 5,448 industrial clients than the actual percentage audited, depending on the
                            cost of switching auditors (see app. I for complete results).




                            Page 25                                                GAO-03-864 Public Accounting Firms
                          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.



Large Public Companies    The most observable impact of consolidation among accounting firms
Have Limited Number of    appeared to be the limited number of auditor choices for most large
                          national and multinational public companies if they voluntarily switched
Accounting Firm Choices   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.




                          Page 26                                        GAO-03-864 Public Accounting Firms
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.18 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.19 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.



18
  Historically, firm consolidation in particular industries was often driven by the fact that a
few largre companies dominated certain industries. Accounting firm “industry
specialization” can be captured by a firm’s relatively high market share, in terms of client
assets or cllient sales, in a given industry. The observation that a few accounting firms audit
the vast majority of company assets in a given industry does not necessarily indicate that
they audit many companies in that industry—in fact, these few “specialists” may audit only a
few very large companies. While firms that are not considered to be specialists in a given
indusry may audit a large number of smaller companies, they may not have the requisite
excess staff capacity or technical expertise necessary to handle the larger clients in that
industry, which is implied by the term specialization. Industries conducive to specialization
would tend to preclude other firms from easily entering the market and challenging
specialist firms’ market share.
19
 Industry specialization or expertise ranked third in importance behind quality of services
offered (99 percent) and reputation or name recognition (82 percent).




Page 27                                                  GAO-03-864 Public Accounting Firms
Figure 7: Percentage of Assets Audited in Selected Industries, 1997 and 2002

  General building contractors (1997)                                        General building contractors (2002)

                                                 0.6% Other                                                        1.6% Other
                                                 0.6% Price Waterhouse                                             3.3% KPMG
                                                 3.3% KPMG
                                                 Deloitte & Touche
                                                                                                                   PricewaterhouseCoopers
                                    13.3%
                                                                                                   15.0%

         32.9%
                                         17.7%
                                                 Coopers & Lybrand                                  19.4%
                                                                                  60.7%
                                                                                                                   Deloitte & Touche

                    31.6%
                                                                                                                                       80.1%

                                                 Arthur Andersen
                                                 Ernst & Young       64.5%                                         Ernst & Young


  Petroleum and coal products (1997)                                         Petroleum and coal products (2002)

                                                 0.1% Other                                                        0.0% Other
                                                 1.0% Deloitte & Touche                                            2.2% KPMG
                                                 4.3% KPMG                                                         3.1% Deloitte & Touche
                                                 Coopers & Lybrand

                                    11.1%                                                                          Ernst & Young

                                                                                                   18.2%
         33.2%

                                         21.9%    Ernst & Young
                                                                                                                                       94.6%
                                                                                     76.4%
                    28.5%

                                                                                                                   Pricewaterhouse-
                                                 Price Waterhouse                                                  Coopers
                                                 Arthur Andersen     61.7%
Source: Who Audits America, 1997 and 2002.




                                                   Page 28                                               GAO-03-864 Public Accounting Firms
  Transportation by air (1997)                                                   Transportation by air (2002)

                                                    0.0% Coopers & Lybrand
                                                    0.1% Other                                                                   0.1% Other
                                                    0.3% Price Waterhouse                                                        0.4% Pricewaterhouse-
                                                                                                                                         Coopers
                                                    1.4% Deloitte & Touche                                                       KPMG
                                                    KPMG
                                                                                                          13.4%
                                   20.8%

        39.9%
                                                                                       48.7%

                                                                                                             37.4%
                                                                                                                                 Deloitte & Touche
                              37.5%

                                                                                                                                                     86.1%
                                                    Ernst & Young
                                                                         77.4%
                                                    Arthur Andersen                                                              Ernst & Young

  Nondepository institutions (1997)                                              Nondepository institutions (2002)

                                                     0.9% Coopers & Lybrand
                                                     2.8% Price Waterhouse                                                       2.9% Other
                                                     2.8% Other                                                                  3.8% Ernst & Young
                                                     3.6% Ernst & Young                                                          3.8% Pricewaterhouse-
                                                                                                                                         Coopers
                                                     Deloitte & Touche
                                       8.3%

                                             8.9%   Arthur Andersen
                                                                                                                28.4%
                                                                                        59.5%                                    Deloitte & Touche
            72.8%
                                                                         81.7%
                                                                                                                                                     87.9%


                                                    KPMG                                                                         KPMG

Source: Who Audits America, 1997 and 2002.

                                                       Note: Selected industries presented for illustrative purposes, and additional examples are included in
                                                       appendix IV.




                                                       Page 29                                                       GAO-03-864 Public Accounting Firms
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.




Page 30                                        GAO-03-864 Public Accounting Firms
Linking Consolidation          We found little empirical evidence to link past consolidation to changes in
                               audit fees, quality, and auditor independence. Given the significant changes
to Audit Price, Quality,       that have occurred in the accounting profession since the mid-1980s, we
and Auditor                    were also unable to isolate the impact of consolidation from other factors.
                               However, researchers (relying on analyses based on aggregate billings of
Independence Is                small samples of companies or proxies for audit fees, such as average audit
Difficult                      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.



Research on Changes in         Existing research indicated that audit fees (measured in different ways)
Audit Fees Used a Variety of   generally remained flat or decreased slightly from the late 1980s through
                               the mid-1990s but have been increasing since the late 1990s (inflation
Measures but Did Not           adjusted). However, we were unable to isolate the effects of consolidation
Conclusively Determine         and competition from the numerous other changes that have affected
Effects from Consolidation     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




                               Page 31                                       GAO-03-864 Public Accounting Firms
fees charged to a small sample of companies (Menon and Williams).20 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 1996.21 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 1995.22 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.


20
 S. Invancevich and A. Zardkoohi, “An Exploratory Analysis of the 1989 Accounting Firm
Megamergers,” Accounting Horizons, vol. 14, no. 4 (2000): 155-136. K. Menon and D.
Williams, “Long-Term Trends in Audit Fes,” Auditing: A Journal of Practice and Theory,
vol. 20, no. 1 (2001): 115-136. The samples included cllients of Big 6 audit firms that
voluntarily disclosed audit fee data in SEC filings (between 68 and 90 companies for each
year). The fee data have been adjusted for inflation.
21
 In 1997, the Big 6 were Arthur Andersen, Coopers & Lybrand, Deloitte & Touche, Ernst &
Young, KPMG, and Price Waterhouse. For Ernst & Young and Deloitte & Touche, the
researchers found the average audit price fell from $503.6 to $441.84 per million dollars of
assets audited. The “fees” for the remaining Big 6 fell from $441.28 to $378.4 per million
dollars of assets audited in 1989-1996.
22
   Manufacturers Alliance/MAPI, Survey on Outside Audit Fees, 2000. Manufacturers
Alliance provides executive education and business research services.




Page 32                                                 GAO-03-864 Public Accounting Firms
Figure 8: Changes in Audit Fees (Actual), 1984-2000
Fees per $100

0.08


0.07


0.06


0.05


0.04


0.03


0.02


0.01


0.00
       1985                       1989             1993             1996             1999       2002
        Year

                   U.S. fees

                   Foreign fees
Source: Manufacturers Alliance.


Note: This graph depicts the average fees for audit services paid by companies as a percentage of the
average total revenue of the companies. Given that this fee analysis is based on a small sample of
public companies and the results incorporate changing revenue classifications and refinements in the
underlying survey questions, the results should be viewed in the context of those companies surveyed
and not the market overall.




Page 33                                                      GAO-03-864 Public Accounting Firms
Figure 9: Net Average Audit Revenues for Big 4, as a Percentage of Total Sales
Audited, 1988-2001
Fees per $10 of sales audited

0.0147


0.0126


0.0105


0.0084


0.0063


0.0042


0.0021


0.0000
         1988     1989     1990     1991     1992     1993    1994     1995     1996   1997   1998   1999   2000   2001
Sources: Public Accounting Report, various editions; Who Audits America, 1988-2001.

Note: This graph depicts average audit revenue for the top-tier accounting firms as a percentage of the
average total sales audited by the accounting firms. This estimate is used for trend analysis and should
be viewed as only a rough proxy for the audit fee in part because the firms’ revenues include clients
other than public companies. See appendix I for details.


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.23 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.24 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

23
 According to an SEC report, in 2000 audit fees for the Fortune 1000 public companies
were.03 percent of company revenue on average. Securities and Exchange Commission,
Office of the Chief Accountant, “Independence Rule Proxy Disclosures: Independent
Accountants Fees,” (2001).
24
  The term loss leader implies that the firms bid unrealistically low fees (“low-balling”) to
obtain a new client. Once the new client is secured, the low audit fee, which alone may not
be adequate to cover the cost of an audit and provide the firm with a reasonable margin, is
offset by additional fees generated from other services, such as management consulting and
tax.




Page 34                                                                       GAO-03-864 Public Accounting Firms
                            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.25
                            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.



Linking Consolidation to    Although we identified no research directly studying the impact of
Audit Quality and Auditor   consolidation among the accounting firms on audit quality or auditor
                            independence, we did find limited research that attempted to measure
Independence Is Difficult
                            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.

                            25
                             L. Kimmel and S. Vazquez, “The Increased Financial and Non-Financial Cost of Staying
                            Public,” Foley & Lardner, Attorneys at Law (2003).




                            Page 35                                              GAO-03-864 Public Accounting Firms
Research Offers Competing         Audit quality and auditor independence are, in general, difficult to observe
Theories on Factors Influencing   or measure. Theory suggests that auditor independence and audit quality
Audit Quality and Auditor         are inextricably linked, with auditor independence being an integral
Independence                      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.26

                                  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.27 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


                                  26
                                    These definitions are commonly used in the academic literature, reflecting the assessment
                                  of capital market participants, and are consistent with those used in the professional
                                  literature that describe audit quality in terms of audit risk. This definition of auditor
                                  independence is provided in L. DeAngelo, “Auditor Independence, ‘Low Balling,’ and
                                  Disclosure Regulation,” Journal of Accounting and Economics, vol. 3 (1981): 113-127. This
                                  definition of audit quality is provided in L. DeAngelo, “Auditor Size and Audit Quality,”
                                  Journal of Accounting and Economics, vol. 3 (1981): 183-199.
                                  27
                                    Concern over auditor independence has typically centered on the provision of nonaudit
                                  services to a company by its incumbent auditor, a concern based on the assumption that an
                                  auditor is willing to sacrifice its independence in exchange for retaining a client that may
                                  pay large fees for nonaudit services. Historically, some have argued that the provision of
                                  nonaudit services to an audit client can impair auditor independence by creating an
                                  economic bond between an auditor and its client. Other researchers note that an economic
                                  bond could result from large audit fees, too, and, especially, that auditors also have market-
                                  based institutional incentives to act independently and remain independent of their public
                                  company clients. Numerous academic studies suggest that auditors face an expected cost
                                  for compromising their independence, namely loss of reputation and litigation costs, which
                                  is corroborated by historical evidence.




                                  Page 36                                                 GAO-03-864 Public Accounting Firms
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. 28 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.




28
  For example, the notion of differential audit quality is dismissed in American Institute of
Certified Public Accountants, The Commission on Auditors’ Responsibilities: Report,
Conclusions, and Recommendations, New York: AICPA (1978): 111. However, Weiss
Ratings Inc., “The Worsening Crisis of Confidence on Wall Street: The Role of Auditing
Firms,” 2002, reported that smaller accounting firms issued a higher percentage of going-
concern warnings on their clients that subsequently went bankrupt than did four of the five
largest firms, from January 2001 through June 2002.




Page 37                                                 GAO-03-864 Public Accounting Firms
Studies Often Use Restatements,   Audit quality is not generally measurable and tends only to be made public
Going-Concern Opinions, and       when a company experiences financial difficulties and its investors have a
Earnings Management to            reason to question it.29 Studies addressing audit quality and auditor
Measure Audit Quality and         independence have typically focused on financial statement restatements,
Auditor Independence              going-concern opinions, and earnings management or manipulation.30

                                  Financial statement restatements due to accounting improprieties have
                                  been used by some as a measure of audit quality.31 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.32 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.


                                  29
                                     In such a framework, capturing differential audit quality is particularly elusive: If no
                                  problem were found in a given company’s financial reports, it is not necessarily the case that
                                  the corresponding audit was of high quality.
                                  30
                                   These studies generally approached the issues from the perspective of capital market
                                  participants. Another avenue through which researchers have attempted to assess audit
                                  quality was the analysis of data on litigation involving auditors. However, auditor litigation
                                  data suffer from more serious measurement issues. For example, see Z. Palmrose, “An
                                  Analysis of Auditor Litigation and Audit Service Quality,” The Accounting Review, vol. 63,
                                  no. 1 (1988): 55-73.
                                  31
                                   Financial statement restatements can be triggered for a variety of reasons, including
                                  evolving interpretations of existing accounting standards, and are not necessarily the result
                                  of audit failures.
                                  32
                                    For example, see Huron Consulting Group, “An Analysis of Restatement Matters: Rules,
                                  Errors, Ethics,” Internet-Based Report, 2003; U.S. General Accounting Office, Financial
                                  Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining
                                  Challenges, GAO-03-138 (Washington, D.C.: October 2002); and M. Wu, “Earnings
                                  Restatements: A Capital Market Perspective,” Working Paper, New York University, 2002.
                                  These studies reported restatements based on when they were announced or reported
                                  rather than the periods affected by the restatements. Some restatements announced in the
                                  late 1990s could be the result of heightened SEC activity designed to curb earnings
                                  manipulation, and the marked decline in the stock market beginning in 2000 may have also
                                  contributed to the discovery of many reporting improprieties that had previously gone
                                  undiscovered during the stock market expansion.




                                  Page 38                                                  GAO-03-864 Public Accounting Firms
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.33 One study found that
during the 1990s accounting firms issued fewer going-concern audit
opinions to financially stressed companies prior to bankruptcy.34 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.35 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.36
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-


33
  A going-concern opinion indicates substantial doubt in the audited report regarding the
ability of a company to continue as a “going concern.” Academic research has noted that
there are two types of misclassification in the context of going-concern opinions: (1) a
company receives a going-concern opinion but subsequently remains viable or (2) a
company enters bankruptcy but did not receive a prior going-concern opinion. The latter is
the focus of the studies to which we refer. It is important to note that, technically, neither
type of misclassification is a reporting error from the perspective of professional auditing
standards, but capital market participants do not necessarily share this view, as they can be
impacted by both.
34
 M. Geiger and K. Raghunandan, “Going-Concern Opinions in the ‘New’ Legal
Environment,” Accounting Horizons, vol. 16, no. 1 (2002): 17-26. The authors define a
company as “financially stressed” if it exhibits at least one of the following features: (1)
negative working capital, (2) negative retained earnings, or (3) a bottom-line loss. (See
Glossary for definitions.)
35
  Weiss Ratings (2002) also found that accounting firms almost universally failed to warn the
public of accounting irregularities over this period. Of the 33 instances of accounting
irregularities investigated, in only two cases did an accounting firm issue warnings about
the companies involved. Because it examined a relatively brief period, this study does not
weigh in on whether the propensity to warn investors has increased or decreased over time,
however.
36
   Additional references are provided in K. Raghunandan and K. Rama, “Audit Reports for
Companies in Financial Distress: Before and After SAS No. 59,” Auditing: A Journal of
Practice and Theory, vol. 14, no. 1 (1995): 50-63.




Page 39                                                   GAO-03-864 Public Accounting Firms
                               concern opinions.37 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.38 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). 39

Despite Contrasting Views on   Existing research on audit quality and auditor independence presents
Audit Quality, Experts and     inconclusive results, suffers from problematic measurement issues, and
Professionals Did Not View     generally does not consider or compare these factors over extended time
Consolidation as Cause         periods. Many academics and other accounting experts we contacted


                               37
                                M. DeFond, K. Raghunandan, and R. Subramanyam, “Do Non-Audit Service Fees Impair
                               Auditor Independence? Evidence from Going Concern Audit Opinions,” Journal of
                               Accounting Research, vol. 40, no. 4 (2002): 1247-1274.
                               38
                                It is also possible that auditors providing nonaudit services to their audit clients are more
                               tolerant of earnings management but draw the line at compromising the integrity of the
                               audit opinion.
                               39
                                R. Frankel, M. Johnson, and K. Nelson, “The Relation between Auditors’ Fees for Nonaudit
                               Services and Earnings Management,” The Accounting Review, vol. 77 (2002): 71-105; W.
                               Kinney, Jr., and R. Libby, “Discussion of ‘The Relation between Auditors’ Fees for Nonaudit
                               Services and Earnings Management,’” The Accounting Review, vol. 77 (2002): 107-114; and J.
                               Reynolds and J. Francis, “’Does Size Matter? The Influence of Large Clients on Office-Level
                               Auditor Reporting Decisions,” Journal of Accounting and Economics, vol. 30 (2001): 375-
                               400.




                               Page 40                                                  GAO-03-864 Public Accounting Firms
                              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.

Academics and Other Experts   In general, many of the people with whom we spoke—representing
Said Other Factors Affected   academia, the profession, regulators, and large public companies—
Audit Quality and Auditor     believed that other factors could potentially have had a greater effect on
Independence                  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.




                              Page 41                                       GAO-03-864 Public Accounting Firms
                        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.40 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.41



Consolidation Appears   Although accounting firms play an important role in capital formation and
                        the efficient functioning of securities markets, we found no evidence to
to Have Had Little      suggest that consolidation among accounting firms has had an impact on
Effect on Capital       either of these to date. Moreover, we were unable to find research directly
                        addressing how consolidation among accounting firms might affect capital
Formation or            formation or the securities markets in the future.
Securities Markets to
Date, and Future        Capital formation and the securities markets are driven by a number of
                        interacting factors, including interest rates, risk, and supply and demand.
Implications Are        Isolating any impact of consolidation among accounting firms on capital
Unclear                 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


                        40
                         For example, in 1994 the U.S. Supreme Court held that the federal securities laws do not
                        provide a private cause of action for aiding and abetting securities fraud. Central Bank of
                        Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994). The Private Securities
                        Litigation Reform Act made it more difficult for a plaintiff suing a company and its auditor to
                        collect damages from the accounting firm. In 1998 Congress passed the Securities Litigation
                        Uniform Standards Act of 1998, Pub. L. No. 105-353, which restricted class actions and
                        certain consolidated actions that make specific allegations involving the purchase or sale of
                        a security.
                        41
                             Geiger and Raghunandan (2002).




                        Page 42                                                  GAO-03-864 Public Accounting Firms
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.42
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.43 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.




42
  A recent study of some of Andersen’s public company clients reported that their stock
prices were adversely impacted by Andersen’s admission to shredding documents,
providing some empirical evidence of the capital market impact resulting from an auditor’s
loss of reputation and the subsequent concerns about the quality of its audits in general. See
P. Chaney and K. Philipich, “Shredded Reputation: The Cost of Audit Failure,” Journal of
Accounting Research, vol. 40, no. 4 (2002): 1221-1245.
43
 For example, see R. Dye, “Auditing Standards, Legal Liability, and Auditor Wealth,”
Journal of Political Economy, vol. 101, no. 5 (1993): 887-914.




Page 43                                                 GAO-03-864 Public Accounting 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.44 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.45 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


44
  Some capital market participants suggested that the litigation risk faced by underwriters
was a primary reason why underwriters generally prefer that their public company clients
engage Big 4 accounting firms for audit services in their securities offering processes. The
Securities Act of 1933 assigned certain responsibilities to the auditor and underwriter in
connection with their participation in a securities offering, and both may be held liable in
the event of a material misstatement or omission in the offering documents. To discharge its
“due diligence” responsibilities (the process of investigation into the details of a potential
investment, such as an examination of operations and management and the verification of
material facts), an underwriter must demonstrate that it has reviewed an issuer’s financial
information. In performing its due diligence, the underwriter relies on the expertise of
professional auditors to review certain financial information and to provide “comfort
letters” (an independent auditor’s letter, required in securities underwriting agreements, to
assure that information in the registration statement and prospectus is correctly prepared
and that no material changes have occurred since their preparation) evidencing any
reviews. Given its liability risk, an underwriter may prefer that a client in the securities
offering process engage a Big 4 accounting firm, which has a larger capital base than any
non-Big 4 firm, to more effectively redistribute this risk. Underwriters also prefer the Big 4
because they may have more experience with the capital formation process, more capacity
to meet deadlines, and can provide more assistance throughout the process.
45
   Initial public offering underpricing generally refers to the difference between the offering
price and the market clearing price at issuance of a company’s security, which can be
translated directly into the initial market-adjusted return earned by a market participant
who buys the security at its offering price and sells it at its first-day closing price. For
example, see M. Willenborg, “Empirical Analysis of the Economic Demand for Auditing in
the Initial Public Offerings Market,” Journal of Accounting Research, vol. 37, no. 1 (1999):
225-238, and R. Beatty, “Auditor Reputation and the Pricing of Initial Public Offerings,” The
Accounting Review, vol. 64, no. 4 (1989): 693-709.




Page 44                                                  GAO-03-864 Public Accounting Firms
                         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.



Smaller Accounting       Unlike the Big 4, which have established global operations and
                         infrastructure, smaller accounting firms face considerable barriers to entry,
Firms Face Numerous      such as the lack of capacity and capital limitations, when competing for the
Barriers to Entry into   audits of large national and multinational public companies. First, smaller
                         firms generally lack the staff resources, technical expertise, and global
the Top Tier             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.




                         Page 45                                       GAO-03-864 Public Accounting Firms
Smaller Firms Generally       Perhaps the most difficult challenge facing smaller firms is the lack of staff
Lack Staff Resources,         resources, technical expertise, and global reach necessary to audit most
                              large national and multinational companies and their often complex
Technical Expertise, and      operations. Moreover, 91 percent (117 of 129) of public companies
Global Reach to Audit Large   responding to our survey who would not consider using a non-Big 4 firm as
Public Companies              their auditor said that the capacity of the firm was of great or very great
                              importance in their unwillingness to do so.46 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.47




                              46
                               Two of the three most frequently cited reasons given for not considering a non-Big 4 firm
                              were capacity of the firm (117 of 129 respondents) and technical skills/knowledge (117 of
                              129 respondents).
                              47
                               This discussion of markets is limited to the public company audit market and associated
                              competition. Public accounting firms actually compete in a variety of niche markets, such as
                              the audit market for small public companies, nonprofit companies, private companies, and
                              governmental agencies.




                              Page 46                                                GAO-03-864 Public Accounting Firms
Table 3: Big 8 and Big 4 versus Next Largest Tier Accounting Firms (U.S.
Operations), 1988 and 2002

                                                               Average
                                                             number of                 Average
                           Average real    Average         professional      Average number of
Accounting              revenue (dollars number of                 staff   number of       SEC
firms                        in millions) partners         (nonpartner)       offices   clients
1988
Big 8                                 $1,566       1,126         10,991             105          1,359
Next tier                                  288      364           2,118              57            234
Gap                                     1,278       762           8,874              48          1,125
2002
Big 4                                   4,468      2,029         15,664             101          2,046
Next tier                                  290      292           1,532              47            245
Gap                                     4,178      1,736         14,132              54          1,801
Source: Public Accounting Report, 1989 and 2003.

Notes: The next tier includes Laventhol & Horwath, Grant Thornton, BDO Seidman, and McGladrey &
Pullen in 1988 (based on the next four largest ranked firms by total public company sales audited); for
2002, Laventhol & Horwath is replaced by Crowe, Chizek and Company. Average real revenue figures
have been adjusted for inflation. Gap figures may not sum due to rounding.


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



Page 47                                                        GAO-03-864 Public Accounting Firms
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.



Table 4: Largest U.S. Accounting Firms (Global Operations), 2002

                                                     Revenue                          Professional
                                                   (dollars in                                staff
Accounting firms                                  thousands)         Partners         (nonpartner)
Big 4
   PricewaterhouseCoopers                              $13,782           7,020               97,109
   Deloitte & Touche                                    12,500           6,714               73,810
   KPMG                                                 10,720           6,600               69,100
   Ernst & Young                                        10,124           6,131               60,713
Next tier
   BDO Seidman                                           2,395           2,182               16,078
   Grant Thornton                                        1,840           2,256               14,019
   McGladrey & Pullen                                    1,829           2,245               12,775
Source: Public Accounting Report, 2003.

Notes: This table is limited to U.S.-based firms with global operations. Some foreign firms may have
operations comparable to smaller U.S. firms.


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.




Page 48                                                     GAO-03-864 Public Accounting Firms
Smaller Firms Lack Global     Smaller firms face a challenge to establish recognition and credibility
Reputation                    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     Increased litigation risk presents another barrier for smaller firms seeking
and Insurance Costs Make      to audit larger public companies as they face difficulties managing this risk
                              and obtaining affordable insurance. Like many of the challenges faced by
Large Company Audit
                              smaller firms, this is a challenge for all firms. However, assuming that
Market Less Attractive Than   smaller firms were able to purchase additional insurance to cover the new
Other Options                 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.48 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


                              48
                                The other two most-cited factors having an upward influence on costs were changing
                              accounting principles and standards/complexity of audits (47 of 47) and price of talent or
                              training (43 of 47).




                              Page 49                                                GAO-03-864 Public Accounting Firms
                             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.



Raising Capital for Growth   Access to capital is another critical element to an accounting firm’s ability
Is Difficult                 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



                             Page 50                                        GAO-03-864 Public Accounting Firms
                              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.



State Requirements Pose       While all accounting firms must comply with state requirements such as
Obstacles for Smaller Firms   licensing, smaller firms that lack an existing infrastructure of national
                              offices face increased costs and burden to establish geographic coverage
in Particular
                              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



                              Page 51                                       GAO-03-864 Public Accounting Firms
               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.49 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.



Observations   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


               49
                The AICPA’s SEC Practice Section (SECPS) was a part of the former self-regulatory
               system. SECPS was overseen by the Public Oversight Board (POB), which represented the
               public interest on all matters affecting public confidence in the integrity of the audit
               process. SECPS required AICPA member accounting firms to subject their professional
               practices to peer review and oversight by POB and SEC.




               Page 52                                              GAO-03-864 Public Accounting Firms
                      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.



Agency Comments and   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
Our Evaluation        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




                      Page 53                                        GAO-03-864 Public Accounting Firms
staff have any questions concerning this work. Key contributors are
acknowledged in appendix V.




Davi M. D’Agostino
Director, Financial Markets and
 Community Investment




Page 54                                     GAO-03-864 Public Accounting Firms
Appendix I

Scope and Methodology                                                                                   AA
                                                                                                         ppp
                                                                                                           ep
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                          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.



Identifying the Factors   To identify the factors contributing to consolidation among accounting
                          firms, we interviewed past and current partners of public accounting firms
for Consolidation         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



                          Page 55                                      GAO-03-864 Public Accounting Firms
                        Appendix I
                        Scope and Methodology




                        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.



Impact of               To evaluate the impact of consolidation on competition, auditor choices,
                        audit fees, and audit quality and auditor independence, we consulted with
Consolidation on        academics and other researchers, U.S. and foreign regulators, and trade
Competition, Auditor    associations, and we reviewed relevant academic literature. Most of the
                        research studies cited in this report have been published in highly
Choices, Audit Fees,    regarded, refereed academic journals. These studies were also reviewed by
and Audit Quality and   GAO’s economists, who determined that they did not raise serious
Auditor Independence    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.



Data Analysis Used a    To address the structure of the audit market we computed concentration
                        ratios and Hirschman-Herfindahl indexes for 1988 to 2002 using the Who
Variety of Sources      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



                        Page 56                                      GAO-03-864 Public Accounting Firms
Appendix I
Scope and Methodology




analyses, including the analyses of the top and lower tiers of accounting
firms, contained in the report.1 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.




1
 Top-tier firms would include the Big 8 in 1988 and the Big 4 in 2002. Likewise, the next-tier
firms would include Grant Thornton, BDO Seidman, BKD, Crowe, Chizek and Co.,
McGladrey & Pullen, Moss Adams, Plante & Moran and Clifton Gunderson in 2002.




Page 57                                                  GAO-03-864 Public Accounting Firms
                        Appendix I
                        Scope and Methodology




We Used the Doogar      We also employed a simple model of pure price competition, in which
                        clients choose auditors based on price, ignoring factors such as quality or
and Easley (1998)       reputation, to assess whether the current high degree of concentration in
Model of Audit Market   the market for audit services is necessarily inconsistent with a price-
                        competitive setting.2 We worked with Professor Rajib Doogar, University of
Structure to Assess     Illinois at Urbana-Champaign, and Professor Robert Easley, University of
Concentration in a      Notre Dame, to expand and update their 1998 model using 2002 data. Our
Purely Price            sample consisted of 5,448 companies listed on the American Stock
                        Exchange, NASDAQ, and New York Stock Exchange, and other companies
Competitive             with stock traded on other over-the-counter markets identified from Who
Framework               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.



Model Assumptions       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.3 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

                        2
                         R. Doogar and R. Easley, “Concentration without Differentiation: A New Look at the
                        Determinants of Audit Market Concentration,” Journal of Accounting and Economics, vol.
                        25 (1998): 235-253.
                        3
                        This assumption implies that the model’s results are not driven by economies of scale.




                        Page 58                                               GAO-03-864 Public Accounting Firms
                 Appendix I
                 Scope and Methodology




                 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.



Simulation One   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).4 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




                 4
                  In the “short run,” each accounting firm’s size, as captured by the number of partners, is
                 fixed. The algorithm allows companies to switch auditors whenever they can find a lower
                 price, and clients who gain the most from a change are allowed to switch first. As long as
                 there is a dissatisfied client, the model resigns the client, recalculates costs for all clients,
                 and looks to identify any newly dissatisfied clients. This process is repeated until
                 equilibrium is reached.




                 Page 59                                                    GAO-03-864 Public Accounting Firms
Appendix I
Scope and Methodology




in 2002, and the model of price competition consistently predicted that this
tier of firms would audit 68 percent or more of the total.5 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.




5
 While the Big 4 audited over 95 percent of the total assets of these industrial companies,
they audited 68 percent of the log of total assets.




Page 60                                                 GAO-03-864 Public Accounting Firms
                                                                    Appendix I
                                                                    Scope and Methodology




Table 5: Simulation One—Market Shares, Actual and Simulated with Various Switching Costs, 2002

                                                                                                                           Switching cost (percent)
                                                            Actual market
                                                                    share
Accounting firms                                                (percent)                            25                  20                 15          10            5           0
Deloitte & Touche                                                         14.94                  14.94              14.94              15.58         17.24        19.09       22.00
Ernst & Young                                                             19.73                  19.73              19.73              19.73         19.73        18.78       14.90
PricewaterhouseCoopers                                                    18.98                  18.98              18.98              18.98         18.98        19.15       22.37
KPMG                                                                      14.38                  14.38              14.38              14.38         14.38        13.76       10.91
McGladrey & Pullen                                                          0.82                   0.82               0.82               0.84          0.88        0.93        1.01
Grant Thornton                                                              4.21                   4.21               4.21               3.93          2.95        2.25        1.81
BDO Seidman                                                                 3.13                   1.72               1.42               1.14          0.96        0.79        0.69
BKD                                                                         0.10                   0.40               0.46               0.48          0.52        0.55        0.61
Moss Adams                                                                  0.30                   0.30               0.33               0.35          0.36        0.38        0.42
Plante & Moran                                                              0.14                   0.28               0.31               0.32          0.35        0.38        0.40
Clifton Gunderson                                                           0.01                   0.41               0.46               0.49          0.54        0.59        0.66
Crowe, Chizek and Co.                                                       0.15                   0.78               0.95               1.08          1.23        1.37        1.64
Richard A. Eisner & Co.                                                     0.37                   0.35               0.28               0.23          0.20        0.17        0.15
Goodman & Co                                                                0.04                   0.23               0.26               0.28          0.31        0.34        0.38
Wipfli Ullrich Bertelson                                                    0.02                   0.14               0.16               0.18          0.19        0.21        0.23
Virchow, Krause & Co.                                                       0.13                   0.42               0.49               0.58          0.64        0.72        0.85
Eide Bailly                                                                 0.02                   0.29               0.34               0.38          0.43        0.47        0.56
J.H. Cohn                                                                   0.24                   0.19               0.17               0.14          0.12        0.11        0.09
Parente Randolph                                                            0.03                   0.10               0.11               0.12          0.12        0.12        0.14
Source: Doogar and Easley (1998). The simulations were conducted by R. Doogar, University of Illinois, and R. Easley, University of Notre Dame.

                                                                    Notes: Market share is based on the log of total company assets. Partner-to-staff (leverage) ratios for
                                                                    two outliers (small regional firms) were replaced with the market average. The simulated market
                                                                    shares vary depending on the assumed switching costs, which range from no costs associated with
                                                                    switching to a 25 percent increase in costs associated with switching.




Simulation Two                                                      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




                                                                    Page 61                                                                       GAO-03-864 Public Accounting Firms
                                                                     Appendix I
                                                                     Scope and Methodology




                                                                     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.



Table 6: Simulation Two—Market Shares, Actual and Simulated by Client Assets, 2002

                                                                                          Client asset class (millions)
                                              Over $1,000-                     $500-           $250-           $100-                         $25- Less than     Total              Total
Accounting firms                             $5,000  5,000                     1,000             500             250       $50-100             50       $25 (number)           (percent)
Panel A:
Actual number of clients
(2002)
Big 4                                             271           489               353             394             493            353          336            697       3,386      62.2%
Middle 15                                            1              8                 8             15              50             51             86         343         562        10.3
Fringe 754                                           0              4                 2               8             28             42             91        1,325      1,500        27.5
Total                                             272           501               363             417             571            446          513           2,365      5,448       100.0
Panel B:
Simulated number of
clients (2002)
Big 4                                               265           482             353             395             515            376          368            731       3,485      64.0%
Middle 15                                                6          12                7             12              34             30             65         386         552        10.1
Fringe 754                                               1              7             3             10              22             40             80        1,248      1,411        25.9
Total                                               272           501             363             417             571            446          513           2,365      5,448       100.0
Source: Doogar and Easley (1998). The simulations were conducted by R. Doogar, University of Illinois, and R. Easley, University of Notre Dame.

                                                                     Notes: For Simulation Two, companies were placed in one of eight asset classes, depending on size:
                                                                     (1) assets greater than $5 billion, (2) assets between $1 and $5 billion, (3) assets between $500 million
                                                                     and $1 billion, (4) assets between $250 million and $500 million, (5) assets between $100 million and
                                                                     $250 million, (6) assets between $50 million and $100 million, (7) assets between $25 million and $50
                                                                     million, and (8) assets less than $25 million. Market share is based on total number of clients. Partner-
                                                                     to-staff (leverage) ratios for two outliers (small regional firms) were replaced with the market average.




Simulation Three                                                     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




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              Scope and Methodology




              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.



              Table 7: Simulation Three—Market Shares, Merger Analysis with Various Efficiency
              Assumptions, 2002


                                                                Simulated market shares
                                                                        Remaining
                                                                                10
                                                                           middle            Big 4
              Efficiency                                  Merged             firms           firms      Other firms
              assumption                          firms (percent)        (percent)       (percent)        (percent)
              No merger
              Simulated 2002                                   4.5%            5.1%          70.1%            20.2%
              Merger
              No efficiency gains                                4.2              5.2          70.4              20.2
              Some efficiency gains                              6.4              5.0          68.9              19.7
              Strong efficiency gains                          11.2               4.8          65.4              18.7
              Source: Doogar and Easley (1998). The simulations were conducted by R. Doogar, University of
              Illinois, and R. Easley, University of Notre Dame.
              Notes: Market share is based on the log of total company assets. Partner-to-staff (leverage) ratios for
              two outliers (small regional firms) were replaced with the market average.




Survey Data   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




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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,



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                          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.



Impact of                 To address the issue of the impact of consolidation and concentration
                          among large accounting firms on capital formation and securities markets,
Consolidation on          we interviewed representatives from accounting firms, investment banks,
Capital Formation and     institutional investors, SEC, self-regulatory organizations, credit agencies,
                          and retail investors, among others. We also consulted with numerous
Securities Markets        academics and reviewed relevant economic literature.



Identifying Barriers to   To identify the barriers to entry that accounting firms face in the public
                          company audit market, we discussed competition and competitive barriers
Entry                     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



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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.




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Fortune 1000 Public Companies                                                                                                     Appendx
                                                                                                                                        Ii




              Survey of U.S. Public Accounting Firms1
              U.S. General Accounting Office
              Introduction
              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.


              Definitions
              · "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.




              1
                 This questionnaire is a reproduction of the actual web-based survey instrument. Instructions, help screens and
              menus are not displayed. Response numbers, percentages or other statistics for each numeric question have been
              superimposed on the questionnaire, but percentages may not sum to 100% due to rounding. The appearance of * in
              place of a statistic indicates that there were 3 or fewer responses to that question.



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Public Accounting Firm Background
Please provide the following information so that we can contact you if we have any questions:

       Name of Primary Contact: ______________________
       Title: ______________________
       Firm Name: ______________________
       Telephone: ______________________
       E-mail Address: ______________________

1. Is your public accounting firm currently a member of the AICPA's SEC Practice Section?
   N=47
       1.     Yes              100%
       2.     No                 0%
       3.     No Answer

2. At this time, does your public accounting firm plan to register with the PCAOB?
   N=47
       1.     Yes               96%
       2.     No                 0%
       3.     Uncertain          4%
       4.     No Answer

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.

    Total Audit Clients
    Total number of public companies for which firm
       served as auditor of record last fiscal year :             N=45 Mean=116 Median=18 Range=2 - 2,528

    Multinational or Foreign Public Company Audit Clients
    Revenue of $5 billion or more:                                                                     N=*
    Revenue of more than $1 billion but less than $5 billion:                                          N=*
    Revenue of more than $100 million but less than $1 billion:                                        N=*
    Revenue of less than $100 million:                                 N=12 Mean=3 Median=2 Range=1 - 15

    Domestic Public Company Audit Clients
    Revenue of $5 billion or more:                                                                     N=*
    Revenue of more than $1 billion but less than $5 billion:                                          N=*
    Revenue of more than $100 million but less than $1 billion:        N=13 Mean=6 Median=2 Range=1 - 50
    Revenue of less than $100 million:                              N=44 Mean=32 Median=17 Range=2 - 232




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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?
   N=47
        1.      Yes (click to go to Question 5.) 6%
        2.      No (click to go to Question 6.) 94%
        3.      No Answer

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
   to public companies whose primary business activity was in a specific industry. (Note: the
   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. F Accommodations and Food Services N=2
    2. F Administrative and Support Services and Waste Management and Remediation Services N=2
    3. F Agricultural, Forestry, Fishing, and Hunting N=0
    4. F Ambulatory Health Care Services N=1
    5. F Arts, Entertainment, and Recreation N=5
    6. F Construction N=2
    7. F Educational Services N=0
    8. F Finance and Insurance N=19
    9. F Information Services N=13
    10. F Management of Companies and Enterprises N=0
    11. F Manufacturing--Chemical N=2
    12. F Manufacturing-Computer and Electronic Products N=9
    13. F Manufacturing-Food N=1
    14. F Manufacturing-Paper N=0
    15. F Manufacturing-Primary Metal N=1
    16. F Manufacturing-Transportation Equipment N=2
    17. F Manufacturing-Other N=14
    18. F Mining N=5


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     19. F   Professional, Scientific, and Technical Services   N=10
     20. F   Public Administration N=0
     21. F   Real Estate and Rental and Leasing N=6
     22. F   Trade--Retail N=4
     23. F   Trade--Wholesale N=4
     24. F   Transportation and Warehousing N=2
     25. F   Utilities N=2
     26. F   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%.

         Audit, review, and attest                                         N=45 Mean=53 Median=49 Range=25 - 100
         Tax                                                                   N=43 Mean=30 Median=30 Range=10 - 55
         Management Consulting                                                  N=25 Mean=14 Median=10 Range=2 - 40
         Other services                                                         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%.

Large (revenue of $5 billion or more) domestic and multinational
or foreign public company audit, review, and attest clients                                                      N=*

Mid-sized and small (revenue less than $5 billion) domestic or multinational
or foreign public company audit, review, and attest clients                    N=43 Mean=36 Median=25 Range=1 – 100

All private company audit, review, and attest clients                          N=42 Mean=52 Median=55 Range=8 – 98

All government audit, review, and attest clients                               N=23 Mean=14 Median=10 Range=1 – 60

Other audit, review, and attest clients                                         N=18 Mean=16 Median=12 Range=1 - 90




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9. Does your firm plan to offer audit, review, and attestation services to large public companies
   during the next 5 years?
   N=47
       1.    Yes (Click to go to Question 10.) 19%
       2.    No                                  79%
       3.    Uncertain                            2%
       4.    No Answer

       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.
    N=47
    1.     Completed This Part of Survey 100%
    2.     Not completed                   0%


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




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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.
    N=47
       1.    Yes                                 64%
       2.    No (Click to go to Question 16.)    36%
       3.    No Answer


15. IF YES: What size firm(s) did your firm merge with or acquire? Please check all that apply.
    N=30
       1.   Firm(s) with larger net revenue       N=3
       2.   Firm(s) with similar net revenue      N=7
       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.
    N=45
        1.     Yes                60%
        2.     No                 40%
        3.     No Answer

       Please explain:




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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.
    N=46
        1.     Yes - we joined an affiliation since 1987                                      50%
        2.     No - but we joined an affiliation before 1987                                  17%
        3.     No - we once were a member of an affiliation but are no longer                   4%
        4.     No - never                                                                     28%
        5.     No Answer

       Please explain:




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




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18. How important was each of the following reasons in your firm's decisions to consolidate?
    Click one button in each row.

                                           Very Great     Great       Moderate       Some     Little or No    No
                                           Importance   Importance   Importance    Importance Importance     Answer
To increase market share/to increase
                                             20%          33%          30%            0%          17%
revenue N=30
To establish presence in new geographic
                                             17%          33%          13%           10%          27%
areas N=30
To decrease costs/achieve economies of
                                             13%          23%          27%           13%          23%
scale N=30
To gain talented staff N=30
                                             20%          27%          33%           10%          10%
To expand audit, review, and attest
                                              7%          40%          30%           10%          13%
services N=30
To enhance audit, review, and attest
                                              3%          40%          30%           10%          17%
services N=30
To expand management consulting
                                              7%          13%          27%           13%          40%
services N=30
To enhance management consulting
                                              7%          17%          30%            7%          40%
services N=30
To gain certain clients N=30
                                              0%          10%          13%           20%          57%
To establish presence in new client
                                              3%          23%          23%           33%          17%
industries N=30
To gain prestige N=30
                                              3%          20%          33%           17%          27%
To gain access to capital N=30
                                              7%           3%           7%           13%          70%
To compete more successfully against
                                             17%          43%           3%           23%          13%
rivals N=30
For succession planning/ retirement
                                              7%           7%          17%           17%          53%
options for partners N=30
To improve the quality of the audit N=30
                                              0%          23%          23%           13%          40%
Other reason - describe in the box below
                                              N=1          N=1          N=0           N=0         N=2
N=4

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?
    N=30
        1.     Yes, previously unable to provide, but are now able                 0%
        2.     Yes, previously able to provide and increased our ability          27%
        3.     No, our ability remained unchanged                                 73%
        4.     No Answer


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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.

   Click here

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.


                                              Very Great   Great    Moderate     Some     Little or No    No
                                               Extent      Extent    Extent      Extent      Extent      Answer
Not a good financial arrangement N=27           37%         44%       11%         0%           7%
Timing was not right N=27                       19%         15%       15%         26%         26%
Potential firm(s) available to consolidate
with did not have the right mix of              15%        30%       19%          4%         33%
services N=27
Risk profile of potential firm(s) available
                                                12%        20%       20%          20%        28%
to consolidate N=25
Wanted to maintain existing clientele
                                                12%        23%       19%          4%         42%
N=26
Wanted to stay specialized in existing
                                                19%         8%        8%          12%        54%
niche market N=26
Wanted to maintain autonomy N=29                52%        21%       10%          7%         10%
Wanted to maintain identity N=30                43%        20%       20%          7%         10%
Not enough market-based pressure to
                                                11%        21%       32%          11%        25%
make consolidation necessary N=28
Not enough competitive pressures to
                                                14%        21%       21%          18%        25%
make consolidation necessary N=28
Pension issues N=25                             12%         4%        4%          8%         72%
Not interested N=22
                                                23%         9%       36%          5%         27%
Other reason - describe in the box below
                                                N=1        N=2        N=0         N=0        N=0
N=3

If "Other reason" -- Please describe:




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.



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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.)
    N=47
       1.     Greatly increased                 51%
       2.     Moderately increased              47%
       3.     Remained the same                  2%
       4.     Moderately decreased               0%
       5.     Greatly decreased                  0%
       6.     No Answer

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.
                                            Great     Moderate                 Moderate      Great
                                           Upward      Upward     Little or No Downward    Downward     No
                                          Influence   Influence    Influence   Influence   Influence   Answer
    Changing accounting principles
    and auditing standards/complexity
                                            49%         51%          0%          0%          0%
    of audits and accounting standards
    N=47
    Litigation/insurance N=46               39%         43%         17%          0%          0%
    Price of talent/training N=47           40%         51%         9%            %          %
     Marketing N=47                         4%          28%         66%          2%          0%
    Technology N=46                         17%         37%         15%          28%         2%
    The consolidation activity that has
    occurred starting in 1987 among         0%          23%         74%          2%          0%
    the largest accounting firms N=43
    The consolidation activity that has
    occurred within your firm (leave
                                            0%          17%         69%          10%         3%
    "No Answer" checked if your firm
    has not consolidated) N=29
    Other factor - describe in the box
                                            N=1         N=1          N=1         N=0         N=0
    below N=3
       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.)
    N=47
        1.     Greatly increased                  26%
        2.     Moderately increased               70%
        3.     Remained the same                   4%
        4.     Moderately decreased                0%
        5.     Greatly decreased                   0%
        6.     No Answer



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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.)

                                             Great     Moderate                 Moderate      Great
                                            Upward      Upward     Little or No Downward    Downward     No
                                           Influence   Influence    Influence   Influence   Influence   Answer
Changing accounting principles and
auditing standards/complexity of audits      28%         64%          9%          0%          0%
and accounting standards N=47
Litigation/insurance N=47                    21%         57%         21%          0%          0%
Price of talent/training N=47                34%         60%         6%           0%          0%
Marketing N=47                               2%          21%         74%          2%          0%
Technology N=47                              11%         38%         19%          30%         2%
The consolidation activity that has
occurred starting in 1987 among the          0%          26%         70%          5%          0%
largest accounting firms N=43
The consolidation activity that has
occurred within your firm (leave "No
                                             0%          7%          90%          3%          0%
Answer" checked if your firm has not
consolidated) N=29
Other factor - describe in the box below
                                             N=1         N=0          N=0         N=0         N=0
N=1

If "Other factor" -- Please describe:




25. Has it become harder or easier for your firm to maintain audit quality in the past decade?
    N=47
       1.      Much Harder                        11%
       2.      Somewhat Harder                    68%
       3.      Little or No Change                17%
       4.      Somewhat Easier                     2%
       5.      Much Easier                         2%
       6.      No Answer




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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?

                                           Made       Made     Little or      Made     Made
                                           Much     Somewhat     No         Somewhat   Much       No
                                           Harder    Harder     Effect        Easier   Easier    Answer
Ability to recruit and retain qualified
                                            0%        63%       20%           2%        2%
staff N=46
Skills of staff members N=46                9%        50%       35%           4%        2%
Technology N=46                             0%        17%       24%           59%       0%
 Changing accounting principles and
auditing standards/complexity of audits    37%        57%        7%           0%        0%
and accounting standards N=46
 Risk factors N=46                         26%        59%       15%           0%        0%
The consolidation activity that has
occurred starting in 1987 among the         0%        2%        95%           2%        0%
largest accounting firms N=43
The consolidation activity that has
occurred within your firm (leave "No
                                            3%        10%       80%           3%        3%
Answer" checked if your firm has not
consolidated) N=30
Other factor - describe in the box below
                                            N=0       N=1        N=0          N=0      N=0
N=1

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?
    N=47
        1.      Much Harder                        4%
        2.      Somewhat Harder                   26%
        3.      Little or No Change               66%
        4.      Somewhat Easier                    4%
        5.      Much Easier                        0%
        6.      No Answer

        Please explain:




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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?

                                           Made       Made     Little or      Made     Made
                                           Much     Somewhat     No         Somewhat   Much       No
                                           Harder    Harder     Effect        Easier   Easier    Answer
Profitability of non-audit services N=43    0%        12%       88%            0%       0%
Tenure of relationship with client N=43     0%        9%        86%            5%       0%
Increased regulations N=43                  12%       40%       44%            5%       0%
The consolidation activity that has
occurred starting in 1987 among the         0%        7%        90%           2%        0%
largest accounting firms N=42
The consolidation activity that has
occurred within your firm (leave "No
                                            7%        11%       79%           4%        0%
Answer" checked if your firm has not
consolidated) N=28
Other factor - describe in the box below
                                            N=0       N=2        N=2          N=0      N=0
N=4

If "Other factor" -- Please describe:




29. Has it become harder or easier to maintain personal independence as an auditor in the past
    decade?
    N=47
       1.      Much Harder                        2%
       2.      Somewhat Harder                   17%
       3.      Little or No Change               77%
       4.      Somewhat Easier                    4%
       5.      Much Easier                        0%
       6.      No Answer

        Please explain:




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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?
    N=23
       1.      Much Harder                        26%
       2.      Somewhat Harder                    17%
       3.      Little or No Change                48%
       4.      Somewhat Easier                     9%
       5.      Much Easier                         0%
       6.      No Answer

        Please explain:




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?
                                           Made       Made     Little or      Made     Made
                                           Much     Somewhat     No         Somewhat   Much      No
                                           Harder    Harder     Effect        Easier   Easier   Answer
Insurance costs N=21                        19%       14%       67%            0%       0%
Quality/skill of staff N=21                 5%        19%       67%           10%       0%
Advertising/Name recognition N=21           38%       0%        48%           14%       0%
Threat of litigation to your firm N=21      19%       14%       67%            0%       0%
Threat of litigation to clients N=20        15%       5%        75%            5%       0%
 Offering non-audit services N=21           10%       5%        76%           10%       0%
 Tenure of relationship with client N=21    10%       14%       57%           19%       0%
Changing independence standards N=21        0%        14%       81%            5%       0%
The consolidation activity that has
occurred starting in 1987 among the         0%        24%       62%           14%       0%
largest accounting firms N=21
The consolidation activity that has
occurred within your firm (leave "No
                                            7%        0%        67%           20%       7%
Answer" checked if your firm has not
consolidated) N=15
Other factor - describe in the box below
                                            N=0       N=1        N=3          N=1      N=0
N=5

If "Other factor" -- Please describe:




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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.

                                         Great       Some      Little or No     Some       Great       Not
                                        Increase    Increase     Change        Decrease   Decrease   Applicable
Large public companies N=38               0%          11%          21%           0%         0%         68%
Mid-sized public companies N=39           0%          21%          26%           0%         3%         51%
Small public companies N=47               38%         49%           4%           2%         6%          0%
Other/private companies N=45              22%         60%          16%           0%         2%         0%


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?
    N=47
        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.    No 36%
        4.    No Answer

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?
    N=47
        1.     Yes - Please enter approximate number in the box below 72%
        2.     No 28%
        3.     No Answer

       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?

                                      Very Great    Great      Moderate     Some      Little or No     Don’t
                                      Competition Competition Competition Competition Competition      Know
Large public companies N=37             19%         16%          5%         11%           11%          38%
Mid-sized public companies N=39         18%         26%         15%         10%            3%          28%
Small public companies N=47              9%         49%         40%          2%            0%           0%
Other/private companies N=46            33%         48%         17%          0%            0%           2%




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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?

                                             Great      Some                     Some        Great
                                          Increase in Increase in Little or No Decrease in Decrease in    Don’t
                                          Competition Competition   Change     Competition Competition    Know
Large public companies N=38                   8%         18%          11%        16%          5%          42%
Mid-sized public companies N=40              10%         20%          20%        15%          3%          33%
Small public companies N=47                   4%         26%          43%        23%          2%           2%
Other/private companies N=47                  9%         21%          51%        11%          2%           6%



37. How, if at all, has the consolidation activity of the largest accounting firms affected each of
    the following areas?
                                                                    Little or
                                            Greatly    Somewhat       No         Somewhat     Greatly     Don’t
                                           Increased   Increased     Effect      Decreased   Decreased    Know
Opportunity for your firm to provide
                                             3%          11%         54%           8%          5%         19%
service to large public companies N=37
Opportunity for your firm to provide
service to small and mid-sized public        15%         53%         30%           2%          0%         0%
companies N=47
Opportunity for your firm to provide
                                             17%         43%         34%           0%          2%         4%
service to private companies N=47
 Other area - describe in the box below
                                             N=0         N=0          N=1          N=0         N=0        N=0
N=1

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?
    N=46
       1.     Greatly increased competition                      2%
       2.     Moderately increased competition                  39%
       3.     Little or no effect                               28%
       4.     Moderately decreased competition                  22%
       5.     Greatly decreased competition                      7%
       6.     Don't know                                         2%
       7.     No Answer




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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?

                                           Very Great   Great      Moderate     Some     Little or No    Don’t
                                            Extent      Extent      Extent      Extent      Extent       Know
Start-up costs N=42                          21%         29%         31%         7%           7%          5%
Globalization of markets N=41                27%         27%         27%         7%           5%          7%
Not being a "Big 4" firm N=42                74%         21%         2%          0%           0%          2%
Potential liability costs/risk
                                             43%         33%        12%          5%          5%          2%
exposure/Insurance N=42
 Credibility with financial markets and
                                             64%         26%         7%          0%          0%          2%
investment bankers N=42
 Cost of obtaining/maintaining
                                             19%         33%        29%          14%         2%          2%
appropriate personnel N=42
 Technology N=42                             7%          21%        33%          29%         7%          2%
 Complexity N=42                             19%         40%        19%          12%         7%          2%
Other impediment - describe in the box
                                              N=5        N=1         N=0         N=1        N=0          N=1
below N=8


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?
    N=43
        1.     Yes                   70%
        2.     No                    30%
        3.     No Answer

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.

                                            Very Great  Great     Moderate    Some     Little or No      Don’t
                                           Impediment Impediment Impediment Impediment Impediment        Know
The Sarbanes-Oxley Act of 2002 N=46           24%        26%        28%        9%           9%            4%
State licensing requirements N=45              2%        4%         31%        20%         38%            4%
Other regulation - describe in the FIRST
                                              0%         7%         21%          7%         21%          43%
box below N=14
 Other regulation - describe in the
                                              N=0        N=0         N=1         N=0        N=1          N=7
SECOND box below N=9




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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?

                                                                    Neither
                                           Strongly   Moderately   Favor nor    Moderately   Strongly    Don’t
                                            Favor      Favor        Oppose       Oppose      Oppose      Know
Government action to break up the Big 4
                                             4%         13%          16%          20%         47%        0%
N=45
Government action to assist the non-Big
                                            13%         11%          18%          20%         38%        0%
4 firms N=45
Let market forces operate without
                                            53%         16%          22%           7%          2%        0%
intervention N=45
Other action - describe in the FIRST box
                                            N=2          N=2         N=0           N=0        N=0        N=3
below N=7
 Other action - describe in the SECOND
                                            N=1          N=1         N=0           N=0        N=0        N=3
box below N=5

If "Other action" -- Please describe FIRST additional action:




If second "Other action" -- Please describe SECOND additional action:




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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.
    N=47
    1.    Completed This Part of Survey 100%
    2.    Not completed                     0%


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.

       Click here




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                                    United States General Accounting Office


                                    Survey of Public Companies

Introduction                                       Instructions

The Sarbanes-Oxley Act of 2002 mandated that       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.
Congress, study the impact of the recent
consolidation of firms in the accounting           This questionnaire should be completed by the
profession.                                        Chief Financial Officer (CFO) or other
                                                   executive of this organization who can provide
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.
                                                   Please return the completed questionnaire in the
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    address is:
ensure the validity of our research.
                                                          U. S. General Accounting Office
The results of the survey will be compiled and            Attn: Cecile Trop
presented in summary form only as part of our             200 W. Adams Street, #700
report, and GAO will not release individually             Chicago, IL 60606
identifiable data from this survey, unless
compelled by law or required to do so by the       If you have any questions or concerns about this
Congress.                                          survey, please contact:

                                                          Michelle Pannor
                                                          Telephone: (202) 512-3608
                                                          Email: pannorm@gao.gov

                                                   Thank you for participating in this survey.




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Background


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
                                           N=148 Mean=82.3 Median=95 Range=12-100

 _____% of our revenues are derived from operations outside of the United States
                                           N=106 Mean=24.7 Median=20 Range=0-88

  100 % Total revenues


2. If your company was founded in the past decade, in what year was it founded?
   Please enter 4-digit year.

   _______________ Year founded


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.

    ______________________________ Name of auditor

   _______________________________ 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                                           N=8
   2.     Tax-related services (e.g., tax preparation)                             N=123
   3.     Assistance with company debt and equity offerings (e.g. comfort letters) N=98
   4.     Other services - please describe: _____________________________________________

          _______________________________________________________________________




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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.
   N=146

    $_________________ Annual fees                                 Mean=$3,343,726
                                                                   Median=$1,500,000
                                                                   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.
   N=147

   1.     Yes - how many: ________                                 37%
   2.     No         SKIP TO NEXT PAGE                             63%



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.

    ________________________ Name of auditor           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                             N=0
   2.     Expansion of our company required an auditor of record that could meet new demands
                                                                                  N=6
   3.     New regulations forbidding use of auditor for management consulting and other services
                                                                                  N=2
   4.     Fees for audit and attest services                                      N=7
   5.     Concern about reputation of our auditor of record                       N=9
   6.     Our auditor of record was going out of business                         N=29
   7.     Our auditor of record resigned                                          N= 0
   8.     Relationship with our auditor of record was no longer working           N=4
   9.     Other – please describe: ______________________________________________

          __________________________________________________________________


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 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.
    N=50

     1.     Not applicable – did not employ Arthur Andersen               32%
     2.     Yes, switched to partner’s new firm                           34%
     3.     No, switched to other firm –                                  34%
     please explain: _______________________________________________________________

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.
     N=147

     1.     Greatly increased                                                           33%
     2.     Somewhat increased                                                          60%
     3.     Little or no change                                                         2%
     4.     Somewhat decreased                                                          4%
     5.     Greatly decreased                                                           1%




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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.
    N=145

   1.      Not applicable – have not changed auditors                                    72%
   -----------------------------------------------------------
   2.      Greatly increased                                                             5%
   3.      Somewhat increased                                                            14%
   4.      Little or no change                                                           6%
   5.      Somewhat decreased                                                            2%
   6.      Greatly decreased                                                             0%

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?
    N=147

   1.     Great upward influence                                                         7%
   2.     Moderate upward influence                                                      41%
   3.     Little or no influence                                                         46%
   4.     Moderate downward influence                                                    1%
   5.     Great downward influence                                                       0%
   ----------------------------------------------------------
   6.     Don’t know                                                                     5%

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.
   N=147

   1.     Much better                                                                    10%
   2.     Somewhat better                                                                33%
   3.     Little or no change                                                            37%
   4.     Somewhat worse                                                                 16%
   5.     Much worse                                                                     3%
   ----------------------------------------------------------
   6.     Don’t know                                                                     1%




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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.
    N=143

   1.      Not applicable – have not changed auditors                                73%
   ----------------------------------------------------------
   2.      Much better                                                               4%
   3.      Somewhat better                                                           10%
   4.      Little or no change                                                       8%
   5.      Somewhat worse                                                            4%
   6.      Much worse                                                                1%
   -----------------------------------------------------------
   7.      Don’t know                                                                0%


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?
    N=147

   1.     Very positive influence                                                    2%
   2.     Somewhat positive influence                                                14%
   3.     Little or no influence                                                     64%
   4.     Somewhat negative influence                                                16%
   5.     Very negative influence                                                    0%
   ----------------------------------------------------------
   6.     Don’t know                                                                 4%

16. If you have experienced a change in audit quality, please explain:
    If you have not experienced a change, please enter “none.”

   _________________________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________




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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.
  N=147

   1.      Much more independent                                                      12%
   2.      Somewhat more independent                                                  48%
   3.      Little or no change                                                        38%
   4.      Somewhat less independent                                                  1%
   5.      Much less independent                                                      1%
   ----------------------------------------------------------
   6.      Don’t know                                                                 1%


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.
    N=144

   1.      Not applicable – have not changed auditors                                 73%
   ----------------------------------------------------------
   2.      Much more independent                                                      5%
   3.      Somewhat more independent                                                  11%
   4.      Little or no change                                                        11%
   5.      Somewhat less independent                                                  0%
   6.      Much less independent                                                      0%
   ----------------------------------------------------------
   7.      Don’t know                                                                 0%




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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.
    N=147

   1.     Very positive influence                                                      3%
   2.     Somewhat positive influence                                                  5%
   3.     Little or no influence                                                       72%
   4.     Somewhat negative influence                                                  15%
   5.     Very negative influence                                                      1%
   ----------------------------------------------------------
   6.     Don’t know                                                                   4%



20. How satisfied are you with your current auditor of record?
    Please check one box
    N=147

   1.     Very satisfied                                                               44%
   2.     Somewhat satisfied                                                           36%
   3.     Neither satisfied nor dissatisfied                                           8%
   4.     Somewhat dissatisfied                                                        11%
   5.     Very dissatisfied                                                            1%
   ----------------------------------------------------------
   6.     Don’t know                                                                   0%




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Competition in the Public Accounting Profession

     21. Would you consider using a non-Big 4 firm for audit and attest services?
         Please check one box
         N=147

         1.      Not applicable – already use a non-Big 4 firm               SKIP TO QUESTION 23
                                                                                      3%
         2.      Yes              SKIP TO QUESTION 23                                 8%
         3.      No                                                                   88%


     22. IF NO: How important are the following reasons in explaining why you would not consider
         using a non-Big 4 firm? Please check one box in each row.

                                      Very Great     Great       Moderate       Some       Little or No    Don’t
                                      Importance   Importance   Importance    Importance   Importance      Know
                                         (1)          (2)          (3)           (4)           (5)          (6)
Geographic presence that our
company requires of an auditor          38%          27%          17%            9%            9%           0%
N=128
Technical skill/knowledge of
industry                                63%          28%           6%            3%            0%           0%
N=129

Capacity of audit firm                  50%          41%           8%            1%            1%           0%
N=129

Reputation of audit firm                58%          33%           9%            0%            0%           0%
N=129
Contractual obligation to use a
Big 4 firm (e.g., with banks,            7%          13%          15%           10%           48%           7%
lenders, or landlords)
N=128
Inferred obligation to use a Big 4
firm (e.g., with banks, lenders, or     19%          25%          18%           12%           21%           5%
landlords)
N=127
Our Board of Directors would
not allow it                            25%          34%          15%            4%            4%          18%
N=125
Other - please describe:
                                         N=9          N=3          N=0           N=0          N=0          N=7
N=19




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     23. If you had to switch your auditor of record, how easy or difficult would each of the following
         stages be? Please check one box in each row.
                                   Very       Somewhat     Neither Easy    Somewhat    Very         Don’t
                                  Difficult    Difficult   nor Difficult     Easy      Easy         Know
                                     (1)         (2)            (3)          (4)        (5)           (6)
Identifying eligible candidates
                                    1%          12%            7%            14%       67%           0%
N=147
Reviewing proposals and
selecting the new auditor           3%          38%            29%           21%       10%           0%
N=146
Transitioning to the new
auditor (e.g., training)           38%          54%            5%            1%        1%            1%
N=147
Other - please describe:
N=19                               N=11         N=2            N=0           N=0       N=0           N=6


     24. Aside from your current auditor of record, how many firms do you think your company would
         have as options if you needed to change auditors?
         Please enter the number of firms to which your company could switch.
         N=145
         __________________ firm(s)

     Range of responses=0–3                    N=137          94%
     Range of responses=4–8                    N=8            6%

         Please explain: ___________________________________________________________

         _________________________________________________________________________



     25. Do you think the number of firms your company has as options for auditing and attest services
         is enough? Please check one box.
         N=147

         1.     Yes                                                                           58%
         2.     No                                                                            42%

         Please explain: ___________________________________________________________

         _________________________________________________________________________

         _________________________________________________________________________



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     26. Would your company choose as your auditor of record an accounting firm that currently audits
         one of your competitors? Please check one box.
         N=146

         1.     Yes                                                                       91%
         2.     No                                                                        9%

         Please explain: ___________________________________________________________

         _________________________________________________________________________

         _________________________________________________________________________


     27. If you had to choose a new auditor of record, how important would each of the following factors
         be to your decision? Please check one box in each row.

                                    Very Great     Great       Moderate    Some     Little or No     Don’t
                                    Importance   Importance   Importance Importance Importance       Know
                                       (1)          (2)          (3)         (4)         (5)          (6)
Price
                                      15%          39%          36%          8%          2%           0%
N=146

Number of services offered
                                       5%          33%          32%         20%         10%           1%
N=147

Quality of services offered
                                      76%          23%           1%          0%          0%           0%
N=148
Industry specialization or
Expertise                             51%          29%          16%          4%          0%           0%
N=148
Reputation or name recognition
of the auditor                        43%          39%          12%          5%          1%           0%
N=148
Auditor’s proximity to your
company’s headquarters                 7%          27%          40%          9%         16%           0%
N=148
Ability of auditor to handle your
company’s international               33%          18%           7%          8%         34%           1%
operations
N=144
Chemistry/perceived ability to
effectively work with engagement      32%          43%          18%          5%          2%           0%
team
N=148
Other - please describe:               N=5          N=2          N=0        N=0         N=0           N=5
N=12


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     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.
         N=148

         1.      Much harder                                                                         5%
         2.      Somewhat harder                                                                     18%
         3.      Little or no effect                                                                 69%
         4.      Somewhat easier                                                                     3%
         5.      Much easier                                                                         0%
         ----------------------------------------------------------
         6.      Don’t know                                                                          5%

     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.
         N=148

         1.      Greatly increased competition                                                       1%
         2.      Somewhat increased competition                                                      9%
         3.      Little or no effect               SKIP TO QUESTION 31                               50%
         4.      Somewhat decreased competition                                                      24%
         5.      Greatly decreased competition                                                       11%
     ----------------------------------------------------------
         6.      Don’t know                                                                          4%

     30. How, if at all, has this change in competition affected each of the following areas?
                                   Greatly       Somewhat        Little or No   Somewhat     Greatly         Don’t
                                  Increased      Increased          Effect      Decreased   Decreased        Know
                                     (1)              (2)             (3)          (4)         (5)            (6)
Costs
                                    13%              61%              14%         6%          0%              7%
N=71

Quality of service
                                     1%              15%              42%         34%         0%              7%
N=71
Auditor independence at the
overall firm level                   1%              11%              66%         15%         0%              6%
N=71
Auditor independence at the
individual partner level             4%              10%              69%         8%          0%              8%
N=71
Other - please describe:            N=2              N=1              N=1         N=0         N=0            N=1
N=5



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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.

   ______________ number of firms

   N=126

   Range of responses=0–3              N=29                   23%
   Range of responses=4–5              N=71                   56%
   Range of responses=6–8              N=26                   21%

   Please explain: ___________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________



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.

   ______________ number of firms

   N=112

   Range of responses=0–2                             N=5            5%
   Range of responses=3–4                             N=13           12.5%
   Range of responses=5–8                             N=81           72%
   Range of responses=10+                             N=13           12.5%

   Please explain: ___________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________




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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.
    N=148

   1.     Yes                                                                 22%
   2.     No                                                                  62%
   3.     Don’t know                                                          16%

   Please explain: ___________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________

   _________________________________________________________________________


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.

                             Strongly   Somewhat Neither Favor    Somewhat      Strongly        Don’t
                              Favor       Favor   nor Oppose       Oppose       Oppose          Know
                               (1)         (2)          (3)           (4)          (5)           (6)
Government action to
break up the Big 4             3%         8%           13%           21%          54%            0%
N=72
Government action to
assist the non-Big 4 firms     3%         21%          11%           15%          50%            0%
N=72
Let market forces operate
without intervention          48%         28%          14%           4%           3%             3%
N=71
Other - please describe:
N=8
                              N=7         N=1          N=0           N=0          N=0           N=0

Other - please describe:
N=2
                              N=1         N=0          N=0           N=0          N=1           N=0

Other - please describe:
N=0
                              N=0         N=0          N=0           N=0          N=0           N=0




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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.




                                                                                      Page 15 of 15




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Appendix III

Arthur Andersen Case Study                                                                                          Appendx
                                                                                                                          iI




Background              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, 2002.1 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.2



Most Andersen Clients   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
Switched to a Big 4     the 1,085 companies reviewed, 938 switched to one of the Big 4 (87
Firm                    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).




                        1
                         The data we analyzed are from Who Audits America, 2001- 2002. We tracked the companies
                        that left Andersen, beginning with the last quarter of 2001 because some companies began
                        leaving Andersen once the firm came under suspicion.
                        2
                         We also administered a survey to a random sample of 250 Fortune 1000 public companies,
                        of which 148 companies responded, and 34 of the 148 respondents were former Andersen
                        clients. We found that half of the 34 former Andersen clients switched to the new firm of the
                        former Andersen partner who was in charge of their audit.




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Figure 10: Where Andersen’s Public Company Clients Went, 2001-2002


                                              All other accounting firms
                              13%




                   87%                        Big 4 accounting firms




Source: Who Audits America, 2001-2002.

Note: Numbers are rounded and adjusted to equal 100.




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Figure 11: New Firms for Former Andersen Public Company Clients, 2001- 2002


       Percentage of total clients

       30



       25

                                                                                                                                   BDO Seidman (23)
       20                                                                                                          16%

       15
                                                                                                       53%
                                                                                                                        31%        Grant Thornton (45)

       10



         5
                                                                                                                                   Other (79)

         0
               EY        KPMG             DT     PwC     All other
              (286)      (272)           (221)   (159)     (147)
             Firms (actual number of clients)


Source: Who Audits America, 2001-2002.

                                                             Note: Percentages are rounded and adjusted to equal 100.




Largest Clients                                              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 Big 4                                            switched to Grant Thornton. We found that the Big 4 audited approximately
Firms                                                        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).




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Figure 12: Average Assets of Former Andersen Pubic Company Clients by New
Firm, 2001-2002
Average assets (dollars in millions)

4,000


3,500


3,000


2,500


2,000


1,500


1,000


  500


    0
           EY       KPMG          DT     PwC   All other
        Firms
Source: Who Audits America, 2001-2002.



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.




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Table 8: Former Andersen Public Company Clients (Actual and Percentage) Categorized by Assets, Big 4, and Other Firms, as of
December 2002


                                                                            Asset ranges (millions)
                                          Greater than
Accounting firm                                $5,000     $5,000-1,000       $1,000-500       $500-100       Less than $100              Total
Actual public company
clients
Big 4                                              85               180               111             291               271               938
Other                                               1                 5                 5              26               110               147
Total                                              86               185               116             317               381             1,085
Percentage of public
company clients
Big 4                                            99%                97%               96%         92%                   71%              87%
Other                                               1                 3                 4               8                 29               13
Total                                             100               100               100             100               100               100
Source: Who Audits America, 2001– 2002.


                                                         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.




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Table 9: Former Andersen Public Company Clients (Number and Percentage) Categorized by Assets and Big 4 Firm, as of
December 31, 2002

                                                                               Asset ranges (millions)
                                          Greater than          Between          $1,000-500            $500-100 Less than $100
Accounting firm                                $5,000       $5,000-1,000             million             million        million                  Total
Number of company
clients
DT                                                 21                  54                 28                  70                 48                   221
EY                                                 19                  61                 32                  96                 78                   286
KPMG                                               25                  43                 31                  75                 98                   272
PwC                                                20                  22                 20                  50                 47                   159
Total                                              85                 180                111                 291               271                    938
Percentage of public
company clients
DT                                               25%                 30%                25%                 24%                18%                24%
EY                                                 22                  34                 29                  33                 29                    30
KPMG                                               29                  24                 28                  26                 36                    29
PwC                                                24                  12                 18                  17                 17                    17
Total                                             100                 100                100                 100               100                    100
Source: Who Audits America, 2001- 2002.

                                                         Notes: Deloitte & Touche (DT), Ernst & Young (EY), KPMG, and PricewaterhouseCoopers (PwC).
                                                         Percentages may not sum to 100 due to rounding.




Thirteen Percent of                                      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
Former Andersen                                          percent switched to BDO Seidman (fig. 11). The average asset size of a
Clients Switched to                                      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
Non-Big 4 Firms                                          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.




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                      Table 10: Former Andersen Clients Hired by Other Firms, as of December 31, 2002

                                                               Number of former     Percentage of     Average assets
                      Accounting firm                           Andersen clients      total clients        (millions)
                      Big 4                                                 938               87%             $2,508
                      Grant Thornton                                         45                  4               644
                      BDO Seidman                                            23                  2                54
                      Other                                                  79                  7               193
                      Total                                               1,085                100             2,210
                      Source: Who Audits America, 2001–2002.




Former Andersen       Of the 1,085 former Andersen clients, we were able to classify 926
                      companies into 56 different industry sectors.3 We observed that former
Clients by Industry   Andersen clients in 22 industry sectors stayed with a Big 4 firm, while
Sectors               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.




                      3
                       One hundred fifty-nine companies that did not have SIC codes reported in Who Audits
                      America were excluded from this analysis.




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                                                 Arthur Andersen Case Study




Table 11: New Firms for Former Andersen Clients by SIC Code, as of December 31, 2002


                                                                              New accounting firm
SIC code   Economic group                                              DT      EY       KPMG            PwC           Other
10         Primary metals                                                       1            1
13         Oil and gas extraction                                        2      1            5             1              3
15         General building contractors                                  2      3            1                            2
17         Special trade contractors                                     1      3                          1
20         Food and kindred products                                     2      1            5             1              3
22         Textile mill products                                         1                                 4              2
23         Apparel and other textile products                            3      1            1             1              1
24         Lumber and wood products                                      1      3            2                            1
25         Furniture and fixtures                                        1      3                          2
26         Paper and allied products                                     3                   1
27         Printing and publishing                                       2      4            3                            2
28         Chemicals and allied products                                 7     13          16             11              4
29         Petroleum and coal products                                          2                          1
30         Rubber and miscellaneous plastics                             1      4            3             2              1
31         Leather and leather products                                  2
32         Stone, clay and glass products                                1      3            1             2
33         Primary metal industries                                      7      3            1                            2
34         Fabricated metal products                                     3      3            2             1
35         Industrial machinery and equipment                            8     16          13             11              9
36         Electronic and other electric equipment                       9     13          16              9             10
37         Transportation equipment                                      4      7            4             1              3
38         Instruments and related products                             10     12          19              6              8
39         Miscellaneous manufacturing industries                        1      3            2                            1
41         Local and interurban passenger transit                                                          1
42         Trucking and warehousing                                      4      1            6
45         Transportation by air                                         4      2            1
48         Communications                                                8     12          14             11              5
49         Electric, gas and sanitary services                          22      5            3             9              2
50         Wholesale trade – durable goods                               2      4            5             2              3
51         Wholesale trade – nondurable goods                            4      4            5             1              2
53         General merchandise stores                                    3                   1             2
54         Food stores                                                                       2             1              1
55         Automotive dealers and service stations                       1      1                                         2
56         Apparel and accessory stores                                  1      2            4




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                                                     Appendix III
                                                     Arthur Andersen Case Study




(Continued From Previous Page)
                                                                                              New Accounting Firm
SIC code        Economic Group                                                DT               EY           KPMG               PwC             Other
57              Furniture and home furnishings stores                           1
58              Eating and drinking places                                      1                3                4                2                3
59              Miscellaneous retail                                            8                2                7                1                3
60              Depository institutions                                         8                9               18              10                 7
61              Nondepository institutions                                      1                1                5                2                2
62              Security and commodity brokers                                                   1                3                1
63              Insurance carriers                                              1                3                                 1                2
64              Insurance agents, brokers and service                           1                3                                 2
65              Real estate                                                     2                3                3                1                1
67              Holding and other investment services                           4               20               13                1                7
70              Hotels and other lodging places                                 5                5                1                1
72              Personal services                                               1                3                                                  2
73              Business services                                              24               34               35              14               28
75              Auto repair, services, and parking                                               2                2
76              Miscellaneous repair services                                                                     1                                 1
78              Motion pictures                                                                  2
79              Amusement and recreation services                               7                1                                 1                3
80              Health services                                                 2                7                2                1                3
82              Educational services                                                             2                                 1
83              Social services                                                                  1                                 1
86              Membership organizations                                                         1
87              Engineering and management services                             2                8                3                6                7
Source: Who Audits America, 2002.

                                                     Note: The Big 4 are Deloitte & Touche (DT); Ernst & Young (EY); KPMG; and PricewaterhouseCoopers
                                                     (PwC).




                                                     Page 109                                                 GAO-03-864 Public Accounting Firms
Appendix IV

Analysis of Big 4 Firms’ Specialization by
Industry Sector                                                                                                   Appendx
                                                                                                                        iIV




                     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.1



Limitations of SIC   The purpose of this analysis is to illustrate that certain firms dominate
                     particular industries or groups, and companies may consider only these
Analysis             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.



                     1
                      SIC codes are arranged in a very structured, hierarchical manner; and for the purposes of
                     this report, we have focused on the 2-digit SIC code; the first digit designates a major
                     Economic Division, such as agriculture or manufacturing; the second digit designates an
                     Economic Major Group, such as crop production.




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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.2 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).




2
 To test the reliability of this database, we preformed various checks on random samples of
the data, compared results we obtained using the data to published work in the area and
relied on previous academic research, which verified the completeness and accuracy of the
data. For example R. Doogar and R. Easley, “Concentration without Differentiation: A New
Look at the Determinants of Audit Market Concentration,” Journal of Accounting and
Economics, vol. 25 (1998): 235-253, compared auditor information contained in the
Compustat, Dow-Jones Disclosure and Who Audits America and found no discrepancies.
The data issues are also discussed in appendix I.




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Table 12: Description of Selected SIC Groups

Major group (SIC code)   Description
10                       Metal mining
                         This major group includes establishments primarily engaged in mining, developing mines, or exploring for
                         metallic minerals (ores). This major group also includes all ore dressing and beneficiating operations,
                         whether performed at mills operated in conjunction with the mines served or at mills, such as custom mills,
                         operated separately.
13                       Oil and gas extraction
                         This major group includes establishments primarily engaged in (1) producing crude petroleum and natural
                         gas, (2) extracting oil from oil sands and oil shale, (3) producing natural gasoline and cycle condensate, and
                         (4) producing gas and hydrocarbon liquids from coal at the mine site.
15                       General building contractors
                         This major group includes general contractors and operative builders primarily engaged in the construction of
                         residential, farm, industrial, commercial, or other buildings. General building contractors who combine a
                         special trade with the contracting are included in this major group.
24                       Lumber and wood products
                         This major group includes establishments engaged in cutting timber and pulpwood; merchant sawmills, lath
                         mills, shingle mills, cooperage stock mills, planting mills, and plywood mills and veneer mills engaged in
                         producing lumber and wood basic materials; and establishments engaged in manufacturing finished articles
                         made entirely or mainly of wood or related materials.
25                       Furniture and fixtures
                         This major group includes establishments engaged in manufacturing household, office, public building, and
                         restaurant furniture; and office and store fixtures.
26                       Paper and allied products
                         This major group includes establishments primarily engaged in the manufacture of pulps from wood and
                         other cellulose fibers, and from rags; the manufacture of paper and paperboard; and the manufacture of
                         paper and paperboard into converted products, such as paper coated off the paper machine, paper bags,
                         paper boxes, and envelopes.
27                       Printing and publishing
                         This major group includes establishments engaged in printing by one or more common processes, such as
                         letterpress; lithography (including offset), gravure, or screen; and those establishments that perform services
                         for the printing trade, such as bookbinding and platemaking. This major group also includes establishments
                         engaged in publishing newspapers, books, and periodicals, regardless of whether they do their own printing.
28                       Chemicals and allied products
                         This major group includes establishments producing basic chemicals, and establishments manufacturing
                         products by predominantly chemical processes. Establishments classified in this major group manufacture
                         three general classes of products: (1) basic chemicals, such as acids, salts, and organic chemicals; (2)
                         chemical products to be used in further manufacture, such as synthetic fibers, plastics materials, dry colors,
                         and pigments; and (3) finished chemical products to be used for ultimate consumption, such as drugs,
                         cosmetics, and soaps; or to be used as materials or supplies in other industries, such as paints, fertilizers,
                         and explosives.
29                       Petroleum and coal products
                         This major group includes establishments primarily engaged in petroleum refining, manufacturing paving and
                         roofing materials, and compounding lubricating oils and greases from purchased materials.




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(Continued From Previous Page)
Major group (SIC code)   Description
33                       Primary metal industries
                         This major group includes establishments engaged in smelting and refining ferrous and nonferrous metals
                         from ore, pig, or scrap; in rolling, drawing, and alloying metals; in manufacturing castings and other basic
                         metal products; and in manufacturing nails, spikes, and insulated wire and cable.
34                       Fabricated metal products
                         This major group includes establishments engaged in fabricating ferrous and nonferrous metal products,
                         such as metal cans, tinware, handtools, cutlery, general hardware, nonelectric heating apparatus, fabricated
                         structural metal products, metal forgings, metal stampings, ordnance (except vehicles and guided missiles),
                         and a variety of metal and wire products, not elsewhere classified.
35                       Industrial and commercial machinery and computer equipment (Industry machinery and equipment)
                         This major group includes establishments engaged in manufacturing industrial and commercial machinery
                         and equipment and computers. Included are the manufacture of engines and turbines; farm and garden
                         machinery; construction, mining, and oil field machinery; elevators and conveying equipment; hoists, cranes,
                         monorails, and industrial trucks and tractors; metalworking machinery; special industry machinery; general
                         industrial machinery; computer and peripheral equipment and office machinery; and refrigeration and
                         service industry machinery. Machines powered by built-in or detachable motors ordinarily are included in this
                         major group, with the exception of electrical household appliances. Power-driven handtools are included in
                         this major group, whether electric or otherwise driven.
37                       Transportation equipment
                         This major group includes establishments engaged in manufacturing equipment for transportation of
                         passengers and cargo by land, air, and water. Important products produced by establishments classified in
                         this major group include motor vehicles, aircraft, guided missiles and space vehicles, ships, boats, railroad
                         equipment, and miscellaneous transportation equipment, such as motorcycles, bicycles, and snowmobiles.
                         Establishments primarily engaged in manufacturing equipment used for moving materials on farms; in mines
                         and on construction sites; in individual plants; in airports; or on other locations off the highway are classified
                         in Major Group 35.
42                       Trucking and warehouse
                         This major group includes establishments furnishing local or long-distance trucking or transfer services, or
                         those engaged in the storage of farm products, furniture and other household goods, or commercial goods of
                         any nature.
44                       Water transportation
                         This major group includes establishments engaged in freight and passenger transportation on the open seas
                         or inland waters, and establishments furnishing such incidental services as towing, and canal operation. This
                         major group also includes excursion boats, sight-seeing boats, and water taxis.
45                       Transportation by air
                         This major group includes establishments engaged in furnishing domestic and foreign transportation by air
                         and also those operating airports and flying fields and furnishing terminal services including air courier
                         services and air passenger carriers.
48                       Communications
                         This major group includes establishments furnishing point-to-point communications services, whether
                         intended to be received aurally or visually; and radio and television broadcasting. This major group also
                         includes establishments primarily engaged in providing paging and beeper services and those engaged in
                         leasing telephone lines or other methods of telephone transmission, such as optical fiber lines and
                         microwave or satellite facilities, and reselling the use of such methods to others.




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(Continued From Previous Page)
Major group (SIC code)                 Description
49                                     Electric, gas, and sanitary services
                                       This major group includes establishments engaged in the generation, transmission, and/or distribution of
                                       electricity or gas or steam. Such establishments may be combinations of any of the above three services and
                                       also include other types of services, such as transportation, communications, and refrigeration. Water and
                                       irrigation systems, and sanitary systems engaged in the collection and disposal of garbage, sewage, and
                                       other wastes by means of destroying or processing materials, are also included.
60                                     Depository institutions
                                       This major group includes institutions that are engaged in deposit banking or closely related functions,
                                       including fiduciary activities.
61                                     Nondepository institutions
                                       This major group includes establishments engaged in extending credit in the form of loans, but not engaged
                                       in deposit banking.
62                                     Security and commodity brokers
                                       This major group includes establishments engaged in the underwriting, purchase, sale, or brokerage of
                                       securities and other financial contracts on their own account or for the account of others; and exchanges,
                                       exchange clearinghouses, and other services allied with the exchange of securities and commodities.
67                                     Holding and other investment offices (holding and other investment companies)
                                       This major group includes investment trusts, investment companies, holding companies, and miscellaneous
                                       investment offices.
70                                     Hotels and other lodging places
                                       This major group includes commercial and noncommercial establishments engaged in furnishing lodging, or
                                       lodging and meals, and camping space and camping facilities.
73                                     Business services
                                       This major group includes establishments primarily engaged in rendering services, not elsewhere classified,
                                       to business establishments on a contract or fee basis, such as advertising, credit reporting, collection of
                                       claims, mailing, reproduction, stenographic, news syndicates, computer programming, photocopying,
                                       duplicating, data processing, services to buildings, and help supply services.

80                                     Health services
                                       This major group includes establishments primarily engaged in furnishing medical, surgical, and other health
                                       services to persons. Establishments of associations or groups, such as Health Maintenance Organizations,
                                       primarily engaged in providing medical or other health services to members are included; but those, which
                                       limit their services to the provision of insurance against hospitalization or medical costs, are classified in
                                       Insurance, Major Group 63.
Source: U.S. Bureau of Census, http://www.census.gov/epcd/www/naicstab.htm (7/20/2003) and U.S. Department of Labor, http://www.osha.gov/oshstants/oshstats.(7/20/2003)




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Industry Specialization   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
Can Limit Public          over 70 percent of the total assets audited in 2002. As a result, it might be
Company Choice            difficult for a large company to find an auditor with the requisite industry
                          expertise and staff capacity.3 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.




                          3
                           This assumes that a firm does not have sufficient expertise and staff resources if it audits
                          only a small share of industry assets (defined here by major economic group).




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Figure 13: Percentages of Assets Audited by the Big 4 in Selected Industries, 1997 and 2002

  Metal mining (1997)                                                         Metal mining (2002)

                                                 0.4% Deloitte & Touche
                                                                                                                     0.6% Deloitte & Touche
                                                 1.2% Other
                                                                                                                     2.4% Other
                                                 3.9% KPMG
                                                                                                                     KPMG
                                                 Ernst & Young
                                                                                                    6.4%
                                    9.1%


         37.6%
                                         16.8%   Coopers & Lybrand
                                                                                   50.1%
                                                                                                      40.6%
                                                                                                                     Ernst & Young
                          31.0%
                                                                                                                                        90.7%
                                                 Arthur Andersen
                                                                      68.6%                                          Pricewaterhouse-
                                                 Price Waterhouse                                                    Coopers

  General building contractors (1997)                                         General building contractors (2002)

                                                  0.6% Other                                                         1.6% Other
                                                  0.6% Price Waterhouse                                              3.3% KPMG
                                                  3.3% KPMG
                                                  Deloitte & Touche
                                                                                                                     PricewaterhouseCoopers
                                    13.3%
                                                                                                      15.0%

         32.9%
                                         17.7%
                                                  Coopers & Lybrand                                   19.4%
                                                                                   60.7%
                                                                                                                    Deloitte & Touche

                    31.6%
                                                                                                                                        80.1%

                                                 Arthur Andersen
                                                 Ernst & Young        64.5%                                         Ernst & Young
Source: Who Audits America, 1997 and 2002.




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  Chemical and allied products (1997)                                           Chemical and allied products (2002)


                                                     1.1% Other                                                       1.5% Other
                                                     KPMG                                                             KPMG


                                 11.7%                                                             10.6%
            21.0%
                                                                                                                      Ernst & Young
                                                     Ernst & Young                                        14.1%
                                         14.6%
                                                                                    48.7%
        20.6%
                                       15.0%                                                       25.1%
                        16.0%                        Price Waterhouse
                                                                                                                      Deloitte & Touche

                                                     Coopers & Lybrand                                                                    73.8%
                                                                                                                      Pricewaterhouse-
                                                    Arthur Andersen
                                                                        41.6%                                         Coopers
                                                    Deloitte & Touche


  Industry machinery and equipment (1997)                                       Industry machinery and equipment (2002)


                                                    0.4% Other                                                        1.0% Other
                                                    4.6% Coopers & Lybrand                                            Deloitte & Touche
                                                    5.4% Deloitte & Touche
                                                                                                   6.3%
                                                    Arthur Andersen                                                   Ernst & Young
                                         5.7%                                                         11.4%
                                                    Ernst & Young
                                             5.7%
        45.5%
                                                                                    51.9%
                                                                                                      29.5%
                                 32.6%
                                                                                                                      Pricewaterhouse-
                                                                                                                      Coopers
                                                    Price Waterhouse
                                                                                                                                          81.4%
                                                                        78.1%
                                                    KPMG                                                              KPMG
Source: Who Audits America, 1997 and 2002.




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  Transportation by air (1997)                                                   Transportation by air (2002)

                                                    0.0% Coopers & Lybrand
                                                    0.1% Other                                                            0.1% Other
                                                    0.3% Price Waterhouse                                                 0.4% Pricewaterhouse-
                                                                                                                                 Coopers
                                                    1.4% Deloitte & Touche                                                KPMG
                                                    KPMG
                                                                                                     13.4%
                                   20.8%

        39.9%
                                                                                     48.7%

                                                                                                        37.4%
                                                                                                                          Deloitte & Touche
                              37.5%

                                                                                                                                              86.1%
                                                    Ernst & Young
                                                                         77.4%
                                                    Arthur Andersen                                                       Ernst & Young

  Nondepository institutions (1997)                                              Nondepository institutions (2002)

                                                     0.9% Coopers & Lybrand
                                                     2.8% Price Waterhouse                                                2.9% Other
                                                     2.8% Other                                                           3.8% Ernst & Young
                                                     3.6% Ernst & Young                                                   3.8% Pricewaterhouse-
                                                                                                                                 Coopers
                                                     Deloitte & Touche
                                       8.3%

                                             8.9%   Arthur Andersen
                                                                                                          28.4%
                                                                                      59.5%                               Deloitte & Touche
            72.8%
                                                                         81.7%
                                                                                                                                              87.9%

                                                    KPMG
                                                                                                                          KPMG
Source: Who Audits America, 1997 and 2002.




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  Business services (1997)                                                   Business Services (2002)


                                                 0.8% Other
                                                 4.3% Price Waterhouse                                                 Ernst & Young
                                                 KPMG                                           6.3%                   KPMG
                                   6.3%
                                                 Arthur Andersen                                       8.7%
                                        8.8%
                                                                                                                       Deloitte & Touche
                                                                                                        11.2%
        51.6%                            12.8%   Deloitte & Touche
                                                                                   60.8%
                                                                                                       12.9%
                                15.4%                                                                                  Other


                                                 Ernst & Young
                                                                                                                                           73.7%

                                                 Coopers         67.0%                                                 Pricewaterhouse-
                                                 & Lybrand                                                             Coopers


  Oil and gas extraction (1997)                                              Oil and gas extraction (2002)

                                                 0.3% Other
                                                 2.6% KPMG                                                             0.9% Other
                                                 5.1% Deloitte & Touche                                                5.3% Deloitte & Touche
                                                                                                                       Ernst & Young
                                                 Coopers & Lybrand
                                                                                                    12.1%
                                      13.8%

         45.1%
                                        15.9%                                                          18.3%
                                                                                   63.4%                               KPMG
                                                 Arthur Andersen


                          17.2%                                                                                                            81.7%

                                                 Ernst & Young
                                                                     62.3%                                             Pricewaterhouse-
                                                 Price Waterhouse                                                      Coopers
Source: Who Audits America, 1997 and 2002.




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  Furniture and fixtures (1997)                                                  Furniture and fixtures (2002)


                                                     1.5% Coopers & Lybrand
                                                                                                                           1.2% Other
                                                     3.3% Other
                                                     KPMG                                                                  KPMG
                                                                                                    6.1%
                                   7.0%                                                                                    Deloitte & Touche
                                                     Ernst & Young
                                                                                                         11.1%
                                         7.5%

                                             9.4%    Deloitte & Touche
         49.1%                                                                                             13.2%          Ernst & Young

                                                                                       68.4%
                                22.2%
                                                                                                                                               81.6%
                                                    Price Waterhouse
                                                                         71.3%                                            Pricewaterhouse-
                                                    Arthur Andersen                                                       Coopers


  Petroleum and coal products (1997)                                             Petroleum and coal products (2002)

                                                     0.1% Other                                                           0.0% Other
                                                     1.0% Deloitte & Touche                                               2.2% KPMG
                                                     4.3% KPMG                                                            3.1% Deloitte & Touche
                                                     Coopers & Lybrand

                                    11.1%                                                                                 Ernst & Young

                                                                                                        18.2%
         33.2%

                                         21.9%       Ernst & Young
                                                                                                                                               94.6%
                                                                                          76.4%
                    28.5%


                                                    Price Waterhouse                                                      Pricewaterhouse-
                                                    Arthur Andersen
                                                                         61.7%
                                                                                                                          Coopers
Source: Who Audits America, 1997 and 2002.




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  Transportation equipment (1997)                                            Transportation equipment (2002)
                                                 0.1% Other
                                                 1.1% KPMG                                                           0.2% Other
                                                 1.4% Arthur Andersen                                                1.6% KPMG
                                                 Price Waterhouse                                                    Ernst & Young
                                5.9%             Ernst & Young                                   8.8%
                                       6.9%



         46.3%                                                                   45.4%
                                                                                                    44.0%
                                 38.4%                                                                               Deloitte & Touche

                                                 Coopers
                                                 & Lybrand                                                                               89.4%
                                                                     84.7%
                                                                                                                     Pricewaterhouse-
                                                 Deloitte & Touche                                                   Coopers


  Electric, gas, and sanitary services (1997)                                Electric, gas, and sanitary services (2002)

                                                 0.4% Other
                                                 2.9% Ernst & Young                                                  0.5% Other
                                                 3.3% KPMG                                                           5.8% Ernst & Young
                                                                                                                     KPMG
                                                 Price Waterhouse
                                                                                                     7.3%
                                    11.9%
          35.8%

                                         17.7%   Coopers & Lybrand
                                                                                                      24.2%          Pricewaterhouse-
                                                                                   62.2%                             Coopers


                     28.0%                                                                                                               86.4%


                                                 Deloitte & Touche
                                                 Arthur Andersen     63.8%                                           Deloitte & Touche
Source: Who Audits America, 1997 and 2002.




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  Security and commodity brokers (1997)                                    Security and commodity brokers (2002)
                                                0.0% Other                                                        0.1% Other
                                                0.0% Arthur Andersen                                              2.7% Pricewaterhouse-
                                                0.6% Price Waterhouse                                                    Coopers
                                                1.3% KPMG                                                         3.0% KPMG
                                                Coopers & Lybrand


                                   20.9%

                                                                                                                 Ernst & Young
        46.8%                                                                                       37.3%
                                                                                56.8%

                                30.3%
                                                                                                                                     94.1%
                                                Deloitte
                                                & Touche
                                                           77.1%
                                                Ernst                                                            Deloitte & Touche
                                                & Young


  Health services (1997)                                                   Health services (2002)


                                                1.6% Other                                                        2.6% Other
                                                4.4% Price Waterhouse
                                                                                                                  5.0% Deloitte & Touche
                                                5.3% Deloitte & Touche

                                                Coopers & Lybrand                                                PricewaterhouseCoopers
                                        9.2%
                                                                                                    18.5%

         45.0%                          10.2%   Arthur Andersen
                                                                               44.1%



                           24.2%                                                               29.8%

                                                                                                                 KPMG
                                                KPMG                                                                             73.9%
                                                Ernst & Young      69.2%                                         Ernst & Young
Source: Who Audits America, 1997 and 2002.




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  Depository institutions (1997)                                              Depository institutions (2002)


                                                    1.2% Other                                                          2.2% Other
                                                    Coopers & Lybrand
                                                                                                                        Deloitte & Touche
                              6.5%                  Arthur Andersen
                                  6.6%                                                                11.2%
                                                    Deloitte & Touche
         31.6%                               8.3%                                                                       Ernst & Young
                                                                                   35.6%                   15.8%


                                       19.7%
                                                    Price Waterhouse
                 26.1%                                                                             35.2%

                                                                                                                       Pricewaterhouse-
                                                    Ernst & Young                                                      Coopers              70.8%
                                                                    57.7%                                              KPMG
                                                    KPMG
Source: Who Audits America, 1997 and 2002.




                                                      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



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Industry Sector




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.




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Figure 14: Percentages of Assets Audited in Industries Potentially Impacted by the PriceWaterhouseCoopers Merger and
Dissolution of Andersen, 1997 and 2002

  Lumber and wood products (1997)                                            Lumber and wood products (2002)
                                                 0.5% Ernst & Young
                                                 0.7% KPMG
                                                 0.8% Other
                                                 2.7% Coopers & Lybrand                                             1.0% Other
                                                 3.8% Price Waterhouse                                              Deloitte & Touche

                                                                                                 8.7%
                                                 Deloitte
                                                 & Touche
                                      9.0%
                                                                                                                    PricewaterhouseCoopers
                                                                                                     18.4%
                                                                                42.8%

                                                                     91.5%
                   82.5%
                                                                                                29.1%

                                                                                                                   KPMG            71.9%
                                                 Arthur Andersen                                                   Ernst & Young



  Printing and publishing (1997)                                             Printing and publishing (2002)

                                                 1.7% Other
                                                 KPMG                                                               2.0% Other
                                                                                                                    KPMG
                               7.5%              Coopers & Lybrand
                                                                                                  13.9%
                                       9.0%
         32.5%
                                                                                 37.5%
                                         13.5%   Deloitte & Touche
                                                                                                      21.5%         Deloitte & Touche


                                  14.0%
               21.7%                                                                      25.1%
                                                 Price Waterhouse
                                                                                                                   Ernst & Young
                                                 Ernst & Young                                                                          62.6%
                                                                     54.2%                                         Pricewaterhouse-
                                                 Arthur Andersen
                                                                                                                   Coopers
Source: Who Audits America, 1997 and 2002.




                                                   Page 125                                              GAO-03-864 Public Accounting Firms
                                                      Appendix IV
                                                      Analysis of Big 4 Firms’ Specialization by
                                                      Industry Sector




  Water transportation (1997)                                                   Water transportation (2002)


                                                    0.1% Other                                                          0.0% Other
                                                    1.9% Coopers & Lybrand
                                                                                                                        Deloitte & Touche
                                                    Deloitte & Touche

                                10.6%                                                              9.8%
                                                                                                                        KPMG

                                                    KPMG                                                  9.9%
         34.7%                          11.6%


                                                                                     60.1%                20.1%
                                       16.7%                                                                           Ernst & Young
                                                    Ernst & Young
                   24.4%
                                                                                                                                            80.2%

                                                    Arthur Andersen
                                                                        59.1%                                          Pricewaterhouse-
                                                    Price Waterhouse                                                   Coopers


  Holding and other investment companies (1997)                                 Holding and other investment companies (2002)


                                                    3.7% Coopers & Lybrand
                                                    3.8% Price Waterhouse                                               4.7% Other
                                                    4.5% Deloitte & Touche
                                                                                                                        PricewaterhouseCoopers
                                                    Other
                                             7.0%                                                      15.4%

         35.4%                                                                      33.8%
                                         14.6%
                                                    Ernst & Young                                       19.4%
                                                                                                                        KPMG


                       31.0%                                                               26.8%


                                                    KPMG                                                               Deloitte & Touche
                                                                        66.4%                                                               60.6%
                                                    Arthur Andersen                                                    Ernst & Young
Source: Who Audits America, 1997 and 2002.




                                                      Page 126                                                GAO-03-864 Public Accounting Firms
                                                   Appendix IV
                                                   Analysis of Big 4 Firms’ Specialization by
                                                   Industry Sector




  Primary metals (1997)                                                      Primary metals (2002)

                                                 0.2% Other                                                         1.0% Other
                                                 0.3% KPMG                                                          1.2% KPMG
                                                 5.4% Deloitte & Touche
                                                                                                                    Deloitte & Touche
                                                 Arthur Andersen

                                     9.2%                                                        11.7%

         30.8%

                                        25.7%                                                        26.8%
                                                 Ernst & Young                    59.3%
                                                                                                                   Ernst & Young

                  28.2%
                                                                                                                                        86.1%

                                                 Coopers & Lybrand
                                                                      59.0%                                        Pricewaterhouse-
                                                 Price Waterhouse                                                  Coopers


  Paper and allied products (1997)                                           Paper and allied products (2002)


                                                 0.8% Other                                                         0.1% Other
                                                 KPMG                                                               KPMG

                               9.0%                                                              12.8%
                                                 Coopers & Lybrand

                                       11.8%
         35.5%                                                                                                      PricewaterhouseCoopers
                                                                                                        18.6%
                                                                                44.2%
                                         13.4%
                                                 Ernst & Young


              15.0%            14.5%                                                            24.3%

                                                 Price Waterhouse
                                                                                                                   Ernst & Young
                                                 Deloitte & Touche                                                                      68.5%
                                                 Arthur Andersen
                                                                     50.5%                                         Deloitte & Touche
Source: Who Audits America, 1997 and 2002.




                                                   Page 127                                               GAO-03-864 Public Accounting Firms
                                                  Appendix IV
                                                  Analysis of Big 4 Firms’ Specialization by
                                                  Industry Sector




  Trucking and warehousing (1997)                                           Trucking and warehousing (2002)
                                                0.6% Other                                                      1.9% Pricewaterhouse-
                                                1.5% Price Waterhouse                                                   Coopers
                                                4.3% Coopers & Lybrand                                          2.7% Other
                                                4.5% Deloitte & Touche
                                                                                                                Ernst & Young


                                                KPMG
                                                                                                 16.2%
                                        15.3%
        46.7%                                                                   49.6%

                                                                                                29.5%
                               27.1%
                                                                                                                Deloitte & Touche
                                                Ernst & Young
                                                                    73.8%                                                           79.1%

                                                Arthur Andersen                                                 KPMG


  Communications (1997)                                                     Communications (2002)


                                                0.2% Other                                                      2.3% Other
                                                5.9% KPMG                                                       5.7% Ernst & Young
                                                Deloitte & Touche
                                     6.1%                                                                       KPMG
                                                                                                    7.2%
                                                Price Waterhouse
          30.8%                         13.5%

                                                                                                    23.8%       Pricewaterhouse-
                                                                                 61.0%                          Coopers
                                     18.8%
               24.6%                            Ernst & Young
                                                                                                                                    84.8%


                                                Arthur Andersen
                                                                     55.4%                                      Deloitte & Touche
                                                Coopers & Lybrand
Source: Who Audits America, 1997 and 2002.




                                                  Page 128                                            GAO-03-864 Public Accounting Firms
                                                       Appendix IV
                                                       Analysis of Big 4 Firms’ Specialization by
                                                       Industry Sector




  Hotels and other lodging (1997)                                               Hotels and other lodging (2002)

                                                     0.0% Price Waterhouse
                                                     0.3% Coopers & Lybrand
                                                     1.1% Other
                                                     1.7% Deloitte & Touche                                             1.4% Other
                                                     2.4% Ernst & Young                                                 KPMG
                                                     KPMG
                                   6.0%                                                               12.8%

                                                                                                                        PricewaterhouseCoopers
                                                                                                            14.4%
                                                                                    41.7%
                                                                94.6%
                     88.6%
                                                                                                    29.7%

                                                                                                                       Deloitte & Touche
                                                     Arthur                                                                                 71.4%
                                                                                                                       Ernst & Young
                                                     Andersen


  Fabricated metal products (1997)                                              Fabricated metal products (2002)

                                                      1.8% Other
                                                      4.3% Deloitte & Touche                                            1.5% Other
                                                                                                                        Deloitte & Touche
                                                      Ernst & Young
                                                                                                      12.9%
                                       12.4%
            27.1%
                                                                                    36.0%
                                             14.6%    Coopers & Lybrand                                     24.5%
                                                                                                                        KPMG


              23.4%                16.4%
                                                                                              25.2%
                                                      Arthur Andersen
                                                                                                                       Ernst & Young
                                                     KPMG
                                                                        50.5%                                          Pricewaterhouse-     61.2%
                                                     Price Waterhouse                                                  Coopers
Source: Who Audits America, 1997 and 2002.




                                                       Page 129                                               GAO-03-864 Public Accounting Firms
                                              Appendix IV
                                              Analysis of Big 4 Firms’ Specialization by
                                              Industry Sector




                                              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.



Table 13: Industries in Which the Big 4 Have a Significant Presence (10 percent or More)

                                                                               Firms with 10 percent of more of the industry
SIC          Economic group                                          DT                EY             KPMG            PwC
10           Primary metals                                                            ✔                              ✔
13           Oil and gas extraction                                                    ✔              ✔               ✔
15           General building contractors                            ✔                 ✔                              ✔
17           Special trade contractors                               ✔                 ✔                              ✔
20           Food and kindred products                               ✔                 ✔              ✔               ✔
22           Textile mill products                                                     ✔                              ✔
23           Apparel and other textile products                      ✔                                                ✔
24           Lumber and wood products                                                  ✔              ✔               ✔
25           Furniture and fixtures                                  ✔                 ✔                              ✔
26           Paper and allied products                               ✔                 ✔              ✔               ✔
27           Printing and publishing                                 ✔                 ✔              ✔               ✔
28           Chemicals and allied products                           ✔                 ✔              ✔               ✔
29           Petroleum and coal products                                               ✔                              ✔
30           Rubber and miscellaneous plastics                                         ✔              ✔               ✔
31           Leather and leather products                            ✔                 ✔                              ✔
32           Stone, clay and glass products                          ✔                 ✔                              ✔
33           Primary metal industries                                ✔                 ✔                              ✔
34           Fabricated metal products                               ✔                 ✔              ✔               ✔
35           Industrial machinery and equipment                                        ✔              ✔               ✔
36           Electronic and other electric equipment                                   ✔              ✔               ✔
37           Transportation equipment                                ✔                                                ✔
38           Instruments and related products                        ✔                 ✔                              ✔



                                              Page 130                                              GAO-03-864 Public Accounting Firms
                                                      Appendix IV
                                                      Analysis of Big 4 Firms’ Specialization by
                                                      Industry Sector




(Continued From Previous Page)
                                                                                          Firms with 10 percent of more of the industry
SIC                 Economic group                                              DT                 EY                  KPMG               PWC
39                  Miscellaneous manufacturing industries                                         ✔                   ✔                  ✔
42                  Trucking and warehousing                                    ✔                  ✔                   ✔
45                  Transportation by air                                       ✔                  ✔                   ✔
48                  Communications                                                                 ✔                   ✔                  ✔
49                  Electric, gas and sanitary services                         ✔                                                         ✔
50                  Wholesale trade – durable goods                                                ✔                   ✔                  ✔
51                  Wholesale trade – nondurable goods                          ✔                  ✔                   ✔                  ✔
53                  General merchandise stores                                  ✔                  ✔                   ✔                  ✔
54                  Food stores                                                 ✔                                      ✔                  ✔
56                  Apparel and accessory stores                                ✔                  ✔                   ✔                  ✔
57                  Furniture and homefurnishing stores                                            ✔                   ✔
58                  Eating and drinking places                                  ✔                  ✔                   ✔                  ✔
59                  Miscellaneous retail                                        ✔                  ✔                   ✔
60                  Depository institutions                                     ✔                  ✔                   ✔                  ✔
61                  Nondepository institutions                                  ✔                                      ✔
62                  Security and commodity brokers                              ✔                  ✔
63                  Insurance carriers                                          ✔                  ✔                   ✔                  ✔
64                  Insurance agents, brokers and service                                                              ✔                  ✔
65                  Real estate                                                 ✔                  ✔                   ✔                  ✔
67                  Holding and other investment offices                        ✔                  ✔                   ✔                  ✔
70                  Hotels and other lodging places                             ✔                  ✔                   ✔                  ✔
72                  Personal services                                           ✔                                                         ✔
73                  Business services                                           ✔                                                         ✔
78                  Motion pictures                                                                ✔                                      ✔
79                  Amusement and recreation services                           ✔                  ✔                   ✔                  ✔
80                  Health services                                                                ✔                   ✔                  ✔
87                  Engineering and management services                         ✔                  ✔                   ✔                  ✔
Source: Who Audits America, 2002.

                                                      Note: We have arbitrarily defined significant presence as auditing 10 percent or more of the total
                                                      assets within an industry.




                                                      Page 131                                                      GAO-03-864 Public Accounting Firms
                                               Appendix IV
                                               Analysis of Big 4 Firms’ Specialization by
                                               Industry Sector




Table 14: Industries in Which the Big 4 Have a Significant Presence (25 percent or more)

                                                                                Firms with 25 percent of more of the industry
SIC code     Economic group                                           DT                EY             KPMG            PwC
10           Primary metals                                                             ✔                              ✔
13           Oil and gas extraction                                                                                    ✔
15           General building contractors                                               ✔
17           Special trade contractors                                ✔                 ✔
20           Food and kindred products                                                  ✔                              ✔
22           Textile mill products                                                      ✔                              ✔
23           Apparel and other textile products                       ✔                                                ✔
24           Lumber and wood products                                                   ✔              ✔
25           Furniture and fixtures                                                                                    ✔
26           Paper and allied products                                ✔
27           Printing and publishing                                                    ✔                              ✔
28           Chemicals and allied products                            ✔                                                ✔
29           Petroleum and coal products                                                                               ✔
30           Rubber and miscellaneous plastics                                          ✔                              ✔
31           Leather and leather products                                                                              ✔
32           Stone, clay, and glass products                                            ✔
33           Primary metal industries                                                   ✔                              ✔
34           Fabricated metal products                                                  ✔                              ✔
35           Industrial machinery and equipment                                                        ✔               ✔
36           Electronic and other electric equipment                                    ✔                              ✔
37           Transportation equipment                                                   ✔                              ✔
38           Instruments and related products                                                                          ✔
39           Miscellaneous manufacturing industries                                     ✔
42           Trucking and warehousing                                 ✔                                ✔
45           Transportation by air                                    ✔                 ✔              ✔
48           Communications                                                             ✔                              ✔
49           Electric, gas, and sanitary services                     ✔
50           Wholesale trade – durable goods                                            ✔                              ✔
51           Wholesale trade – nondurable goods                                         ✔
53           General merchandise stores                               ✔                 ✔
54           Food stores                                              ✔                                                ✔
56           Apparel and accessory stores                             ✔




                                               Page 132                                              GAO-03-864 Public Accounting Firms
                                                      Appendix IV
                                                      Analysis of Big 4 Firms’ Specialization by
                                                      Industry Sector




(Continued From Previous Page)
                                                                                          Firms with 25 percent of more of the industry
SIC code            Economic group                                              DT                 EY                  KPMG               PwC
57                  Furniture and homefurnishing stores                                            ✔                   ✔
58                  Eating and drinking places                                                     ✔                   ✔
59                  Miscellaneous retail                                        ✔                  ✔
60                  Depository institutions                                                                            ✔                  ✔
61                  Nondepository institutions                                  ✔                                      ✔
62                  Security and commodity brokers                              ✔                  ✔
63                  Insurance carriers                                          ✔                  ✔
64                  Insurance agents, brokers, and service                                                                                ✔
65                  Real estate                                                 ✔                                      ✔                  ✔
67                  Holding and other investment offices                        ✔                  ✔
70                  Hotels and other lodging places                             ✔                  ✔
72                  Personal services                                           ✔                                                         ✔
73                  Business services                                                                                                     ✔
78                  Motion pictures                                                                ✔                                      ✔
79                  Amusement and recreation services                           ✔
80                  Health services                                                                ✔                   ✔
87                  Engineering and management services                                            ✔
Source: Who Audits America.

                                                      Note: We have arbitrarily defined significant presence as auditing 25 percent or more of the total
                                                      assets within an industry.




                                                      Page 133                                                      GAO-03-864 Public Accounting Firms
Appendix V

GAO Contacts and Staff Acknowledgments                                                       Append
                                                                                                  x
                                                                                                  i
                                                                                                  V




GAO Contacts      Davi M. D’Agostino, (202) 512-8678
                  Orice M. Williams, (202) 512-8678



Acknowledgments   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.




                  Page 134                                  GAO-03-864 Public Accounting Firms
Glossary



Antitrust                     The general process of preventing monopoly practices or breaking up
                              monopolies that restrict competition. The term antitrust derives from the
                              common use of the trust organizational structure in the late 1800s and early
                              1900s to monopolize markets.



Federal antitrust laws        A series of federal laws intended to maintain competition and prevent
                              businesses from getting a monopoly or unfairly obtaining or exerting
                              market power. The first of these, the Sherman Antitrust Act, was passed in
                              1890. Two others, the Clayton Act and the Federal Trade Commission Act,
                              were enacted in 1914. These laws impose restrictions on business
                              ownership, control, mergers, pricing, and how businesses go about
                              competing (or cooperating) with each other.



Audit and attest services     Services provided for professional examination and verification of a
                              company’s accounting documents and supporting data for the purpose of
                              rendering an opinion on the fairness with which they present, in all
                              material respects, the financial position, results of operations, and its cash
                              flows, and conformity with generally accepted accounting principles.



Audit fee                     Fee paid by a company to an audit accounting firm for the professional
                              examination and verification of its accounting documents and supporting
                              data.



Auditor, auditor of record,   Generally refers to an independent public accounting firm registered with
and public accounting firm    SEC that performs audits and reviews of public company financial
                              statements and prepares attestation reports filed with SEC. In the future,
                              these public accounting firms must be registered with Public Company
                              Accounting Oversight Board (PCAOB) as required by the Sarbanes-Oxley
                              Act of 2002.



Auditor independence          The idea that the auditor of record is exclusively concerned with
                              examination and verification of a company’s accounting documents and
                              supporting data without bias or conflicts of interest. Professional auditing
                              standards require an auditor to be independent and avoid situations that
                              may lead others to doubt its independence, referred to as being



                              Page 135                                       GAO-03-864 Public Accounting Firms
                      Glossary




                      independent in fact as well as in appearance. Auditor independence is an
                      important factor in establishing the credibility of the audit opinion.



Audit market          The organized exchange of audit and attest services between buyers and
                      sellers within a specific geographic area and during a given period of time.



Barriers to entry     Institutional, governmental, technological, or economic factors that limit
                      the flow of new entrants into profitable markets. Possible barriers to entry
                      may include resources, patents and copyrights or technical expertise,
                      reputation, litigation and insurance risks, and start-up costs. Barriers to
                      entry are a key reason for market power. In particular, monopoly and
                      oligopoly often owe their market power to assorted barriers to entry.



Bottom line loss      Occurs when gross sales minus taxes, interest, depreciation, and other
                      expenses are negative. Also called negative net earnings, income, or profit.



Capital formation     The transfer of savings from households and governments to the business
                      sector, resulting in increased output and economic expansion. The transfer
                      of funds to businesses for investment can occur through financial
                      intermediaries such as banks or through financial markets such as the
                      stock market. (For the purpose of this report, we focus on public capital
                      markets.)



Competition           In general, the actions of two or more rivals in pursuit of the same
                      objective. In the context of markets, the specific objective is selling or
                      buying goods. Competition tends to come in two varieties -- competition
                      among the few, which is a market with a small number of sellers (or
                      buyers), such that each seller (or buyer) has some degree of market
                      control, and competition among the many, which is a market with so many
                      buyers and sellers that none is able to influence the market price or
                      quantity exchanged.



Concentration ratio   The proportion of total output in an industry that is produced by a given
                      number of the largest firms in the industry. The two most common



                      Page 136                                      GAO-03-864 Public Accounting Firms
                        Glossary




                        concentration ratios are for the four largest firms and the eight largest
                        firms. The four-firm concentration ratio is the proportion of total output
                        produced by the four largest firms in the industry and the eight-firm
                        concentration ratio is the proportion of total output produced by the eight
                        largest firms in the industry



Due diligence           The process of investigation performed by investors, accountants and
                        other market participants into the details of a potential investment, such as
                        an examination of operations and management and the verification of
                        material facts. Obtaining a comment letter written by independent
                        accountants to an underwriter is part of that underwriter's due diligence.



Economies of scale      Declining long-run average costs that occur as a firm increases all inputs
                        and expands its scale of production, realized through operational
                        efficiencies. Economies of scale can be accomplished because as
                        production increases, the cost of producing each additional unit falls.



Economies of scope      Declining long-run average costs that occur due to changes in the mix of
                        output between two or more products. This refers to the potential cost
                        savings from joint production – even if the products are not directly related
                        to each other. Economies of scope are also said to exist if it is less costly
                        for one firm to produce two separate products than for two specialized
                        firms to produce them separately.



Hirschman-Herfindahl    A measure of concentration of the production in an industry that is
Index (HHI)             calculated as the sum of the squares of market shares for each firm. This is
                        an alternative method of summarizing the degree to which an industry is
                        oligopolistic and the relative concentration of market power held by the
                        largest firms in the industry. The HHI gives a better indication of the
                        relative market power of the largest firms than can be found with the four-
                        firm and eight-firm concentration ratios.



Going-concern opinion   Opinion that expresses substantial doubt about whether or not a company
                        will continue to operate for 1 year beyond the financial statement date or
                        go out of business and liquidate its assets. Indicated when there are




                        Page 137                                      GAO-03-864 Public Accounting Firms
                   Glossary




                   substantial doubts about whether the company will be able to generate
                   and/or raise enough resources to stay operational.



Industry           A collection of firms that produce similar products sold in the same
                   market. The concept of industry is most often used synonymously with
                   market in most microeconomic analysis.



Loss Leader        The term loss leader implies that the firms bid unrealistically low fees
                   (“low-balling”) to obtain a new client. Once the new client is secured, the
                   low audit fee, which alone may not be adequate to cover the cost of an
                   audit and provide the firm with a reasonable margin, is offset by additional
                   fees generated from other services, such as management consulting and
                   tax.



Market             The organized exchange of commodities (goods, services, or resources)
                   between buyers and sellers within a specific geographic area and during a
                   given period of time.



Market power       The power to profitably maintain prices above competitive levels for a
                   significant amount of time. More generally, if it is the ability of sellers to
                   exert influence over the price or quantity of a good, service, or commodity
                   exchanged in a market. Market power depends on the number of
                   competitors.



Market structure   The manner in which a market is organized, based largely on the number of
                   firms in the industry. The four basic market structure models are perfect
                   competition, monopoly, monopolistic competition, and oligopoly. The
                   primary difference between each is the number of firms on the supply side
                   of a market. Both perfect competition and monopolistic competition have a
                   large number of relatively small firms selling output. Oligopoly has a small
                   number of relatively large firms. Monopoly has a single firm.



Peer review        A part of the accounting profession’s former self-regulatory system
                   whereby accounting firms reviewed other firm’s quality control systems for



                   Page 138                                       GAO-03-864 Public Accounting Firms
                            Glossary




                            compliance with standards and membership requirements. The Sarbanes-
                            Oxley Act of 2002 significantly overhauled the oversight and regulation of
                            the accounting profession. Among other things, it established the Public
                            Company Accounting Oversight Board to oversee the audit of public
                            companies, including registering public accounting firms, establishing
                            standards, and conducting compliance inspections, investigations, and
                            disciplinary proceedings.



Predatory pricing           The process in which a firm with market power reduces prices below
                            average total cost with the goal of forcing competitors into bankruptcy.
                            This practice is most commonly undertaken by oligopolistic firms seeking
                            to expand their market shares and gain greater market control. Antitrust
                            laws have outlawed predatory pricing, but this practice can be difficult to
                            prove.



Publicly listed companies   A company which has issued securities (through an offering) that are
(public companies)          traded on the open market. Used synonymously with public company. For
                            the purposes of this report public companies include companies listed on
                            the New York Stock Exchange, American Stock Exchange, NASDAQ or
                            traded on other over-the-counter markets such as Pink Sheets.



Retained earnings           Earnings not paid out as dividends but instead reinvested in the core
                            business or used to pay off debt. Also called earned surplus, accumulated
                            earnings, or unappropriated profit.



Tight oligopoly             An oligopolistic market structure where the four firms hold over 60 percent
                            of the market. A loose oligopoly is a market structure with 8-15 firms and a
                            four-firm concentration ratio below 40 percent.



Working capital             Current assets minus current liabilities. Working capital measures how
                            much in liquid assets a company has available to build its business. The
                            number can be positive or negative, depending on how much debt the
                            company is carrying. In general, companies that have a lot of working
                            capital will be more successful since they can expand and improve their
                            operations.




(250104)                    Page 139                                     GAO-03-864 Public Accounting Firms
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