Public Accounting Firms: Mandated Study on Consolidation and	 
Competition (30-JUL-03, GAO-03-864).				 
                                                                 
The audit market for large public companies is an oligopoly, with
the largest firms auditing the vast majority of public companies 
and smaller firms facing significant barriers to entry into the  
market. Mergers among the largest firms in the 1980s and 1990s	 
and the dissolution of Arthur Andersen in 2002 significantly	 
increased concentration among the largest firms, known as the	 
"Big 4." These four firms currently audit over 78 percent of all 
U.S. public companies and 99 percent of all public company sales.
This consolidation and the resulting concentration have raised a 
number of concerns. To address them, the Sarbanes-Oxley Act of	 
2002 mandated that GAO study (1) the factors contributing to the 
mergers; (2) the implications of consolidation on competition and
client choice, audit fees, audit quality, and auditor		 
independence; (3) the impact of consolidation on capital	 
formation and securities markets; and (4) barriers to entry faced
by smaller accounting firms in competing with the largest firms  
for large public company audits.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-864 					        
    ACCNO:   A07817						        
  TITLE:     Public Accounting Firms: Mandated Study on Consolidation 
and Competition 						 
     DATE:   07/30/2003 
  SUBJECT:   Accounting standards				 
	     Corporate audits					 
	     Corporate mergers					 
	     Auditing standards 				 
	     Competition					 

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GAO-03-864

                                       A

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

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

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

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

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

This is a work of the U. S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
separately.

Letter

July 30, 2003 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.

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 S: 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.

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.

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
pricecompetitive 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.

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.

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
lessprofitable 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

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

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

Created More Competitive process for clients. These restrictions were set
by AICPA, which directed

Environment the professional code of conduct for its members, and the
state

accountancy boards for the 50 states, District of Columbia, Guam, Puerto
Rico, and U. S. Virgin Islands. 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

Services Raised Concerns and tax services, firms also offered consulting
services in areas such as about Auditor

information technology. As figure 1 illustrates, over the past several
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.

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.

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

the Big 4 early part of the twentieth century, in the late 1980s Big 8
firms began to

merge with one another. As shown in figure 2, the first such merger in
1987 between Peat Marwick Mitchell, one of the Big 8, and KMG Main
Hurdman, a non- Big 8 U. S. affiliate of the European firm, Klynveld Main
Goerdeler, resulted in the creation of KPMG Peat Marwick. 11 Because of
the extensive 9 Senate Subcommittee on Reports, Accounting and Management,
Committee on

Government Operations, The Accounting Establishment, 95 th Congr., 1 st
Sess., March 31, 1977. This study is commonly known as the Metcalf Report.

10 Pub. L. 107- 204, Title II S: 201- S: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.

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 Ernst & Young

PricewaterhouseCoopers Deloitte

Mitchell Peat Marwick

& Touche Coopers

Coopers Deloitte

Ernst & Young Ernst & Young

& Lybrand & Lybrand

& Touche Ernst & Whinney

Ernst & Whinney KPMG

Deloitte PricewaterhouseCoopers

Peat Marwick & Touche Price Waterhouse

Price Waterhouse Coopers

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.

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, sixthranked 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

Spurred Consolidation others as spurring the mergers of the Big 8 in the
1980s and 1990s* notably the immense growth of U. S. businesses
internationally, desire for greater

in the 1980s and 1990s economies of scale, and need and desire to build or
expand industryspecific

and technical expertise, among others. First, the trend toward corporate
globalization led to an increased demand for accounting firms with greater
global reach. Second, some firms wanted to achieve greater economies of
scale as they modernized their operations and built staff capacity and to
spread risk over a broader capital base. Third, some firms wanted to build
industry- specific or technical expertise as the operations of their
clients became increasingly complex and diversified. Finally, some

firms merged to increase or maintain their market share and maintain their
market position among the top tier. 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
Global Reach their operations around the world, the top- tier firms felt
pressure to expand as well as to provide service to their clients. The
trend toward corporate globalization, which continues today, was spurred
in part by the lowering of trade barriers. Moreover, by the mid- 1990s,
the overall economic environment was changing dramatically as
technological and

telecommunications advances changed the way businesses operated. As a
result, large U. S. companies operated worldwide and more foreign- based
companies entered U. S. markets. Although all of the Big 8 had offices in
certain countries, they did not have extensive networks that enabled them

to provide comprehensive services to large multinational clients. Some of
the smaller Big 8 firms had difficulty attracting and retaining strong
foreign affiliates. Mergers with compatible firms were the quickest way to
fill gaps in geographic coverage. For instance, in the 1980s, Ernst &
Whinney had an established network in the Pacific Rim countries while
Arthur Young did not. Likewise, Price Waterhouse had a network in South
America while

Coopers & Lybrand*s network was in Europe. In addition to expanding their
reach and staff capacity, firms believed that they needed to establish
global networks to stay abreast of country- specific generally accepted
accounting principles and regulations. Globalization also had raised a
number of tax issues that required firms to have networks able to
accommodate clients with operations in a growing number of countries. To
have successful global networks, the Big 8 needed affiliations with
prominent foreign firms.

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

Need for Greater IndustrySpecific technical expertise and expand and build
management- consulting

and Technical operations to better serve the complex needs of their
rapidly evolving Expertise

clients. Each of the Big 8 firms had different strengths and industry
specializations. Through mergers, firms were able to build expertise
across more industries and diversify their operations. For example, the
Ernst &

Whinney and Arthur Young merger brought together two firms that
specialized in healthcare and technology, respectively. Similarly, the
Price Waterhouse and Coopers & Lybrand merger brought together two firms

that dominated the market for audit services in the energy and gas and
telecommunications industries, respectively. In addition, firm officials
said that some of the mergers of the 1980s and 1990s were spurred by the
need and desire to build or expand management consulting services, which,
as discussed previously, were becoming a larger

percentage of revenue. Officials also said that the mergers allowed them
to achieve economies of scope by offering a broader range of services to
clients. 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
of Scale

firm officials, firms were beginning to transition to computer- based
accounting systems and develop new auditing approaches that required a
considerable capital commitment. By expanding their capital base through
mergers, firms planned to create economies of scale by spreading
infrastructure costs from modernizing across a broader capital base. Some
firm officials said that mergers were critical to the firms* modernization
because, unlike their clients, accounting firms could not raise new
capital

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.

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.

Maintain Market Position Furthermore, some firms believed that some of
their foreign affiliates

would change affiliations if they perceived that greater advantages in
seeking and retaining client business could be obtained through
affiliation with a larger firm. The mergers of the 1980s resulted in a
growing disparity in size between the largest and smallest of the Big 8.
Big 4 representatives told us that merging was a practical alternative to
trying to build the business through internal growth. For example, when
seventh- ranked Deloitte Haskins & Sells and eighth- ranked Touche Ross
merged, they became the third- ranked firm. The creation of Deloitte &
Touche resulted in Coopers & Lybrand being the second smallest of the top
tier until it merged with the smallest top- tier firm, Price Waterhouse,
in 1998 to become PricewaterhouseCoopers, the second- largest firm.

Audit Market Has Since 1988, the audit market has become increasingly
concentrated,

Become More Highly especially in the market for large national and
multinational company

audits, leaving these companies with fewer choices. The 1989 and 1998
Concentrated, Leaving mergers led to significant increases in certain key
concentration measures Large Public typically used by DOJ and FTC to
evaluate potential mergers for antitrust

Companies with Few concerns. These measures indicate highly concentrated
markets in which

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

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,
industryspecific 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
Oligopoly

of the market and other firms facing significant barriers to entry into
the market. In the large public company audit market, the Big 4 now audit
over 97 percent of all public companies with sales over $250 million, and
other

firms face significant barriers to entry into the market. As table 1
illustrates, when comparing the top 25 firms on the basis of total
revenues, partners, and staff resources, the Big 4 do not have any
smaller- firm competitors, a situation that has given rise to renewed
concerns about a possible lack of effective competition in the market for
large company audit services.

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.

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, firmspecific 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 (35 2 + 30 2 + 20 2 + 10 2 ).
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.

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.

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

- $50 $100

$250 $500

$1 - - - $1,000 $5,000

$5,000 $25 $50 $100 $250 - - > $500 $1,000 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.

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.

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.

Figure 6: Percentage of Public Company Audit Market (by Number of
Clients), 1988, 1997, and 2002 1988 1997

Arthur Young Price Waterhouse

7% 9%

18% 8%

Touche Ross

18% 11%

Coopers & Lybrand

8%

Deloitte Haskins & Sells

16% 8%

Price Waterhouse

17% 13%

Deloitte & Touche

14% 10% Coopers & Lybrand

17% 15% Others

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.

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.

Tabl e 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
Toy s Mattel, Hasbro Source: W. Shepherd, The Economics of Industrial
Organization, 4 th 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.

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 Price Competition to Date

percent of all public company sales, we found no evidence that price
competition to date has been impaired. As indicated in table 2, much of
the economy is concentrated, but U. S. markets are generally considered
quite competitive. Thus, market concentration data can overstate the
significance of a tight oligopoly on competition. While concentration
ratios and HHI are good indicators of market structure, these measures
only indicate the potential for oligopolistic collusion or the exercise of
market power. As market structure has historically been thought to
influence market conduct and economic performance, there is concern that a
tight oligopoly in the audit market might have resulted in detrimental
effects on both purchasers of audit services and users of audited
financial statements.

We employed a simple model of pure price competition to assess whether the
high degree of concentration in the market for audit services was
necessarily inconsistent with a price- competitive setting. The model is
designed to simulate a market driven by pure price competition, in which
clients choose auditors on price* neither quality nor reputation, for
example, is a factor. The model*s simulation results suggest that a market
driven solely by price competition could also result in a high degree of

market concentration. We found that the model simulated market shares that
were close to the actual market shares of the Big 4, which are thought to
be driven by a number of other factors including quality, reputation, and
global reach. (See app. I for a detailed discussion of the model, results,
and limitations.) Specifically, the model predicted that the Big 4 would
audit 64

percent of companies in the sampled market, compared with the Big 4 actual
market share of 62. 2 percent in 2002 for the companies included in the
simulation. 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).

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

Accounting Firm Choices national and multinational public companies if
they voluntarily switched

auditors or were required to do so, such as through mandatory firm
rotation. Of the public companies responding to our survey to date, 88
percent (130 of 147) said that they would not consider using a smaller
(nonBig 4) firm for audit and attest services. See appendix II for survey
questionnaires and responses. In addition, our analysis of 1,085 former
Andersen clients that changed auditors between October 2001 and December
2002 suggested that public companies (especially large companies)
overwhelmingly preferred the Big 4. Only one large public

company with assets over $5 billion that was audited by Andersen switched
to a smaller firm. See appendix III for a detailed analysis. For most
large public companies, the maximum number of choices has gone from eight
in 1988 to four in 2003. According to our preliminary survey results, a
large majority (94 percent or 137 of 145) of public companies that
responded to our survey to date said that they had three or fewer
alternatives were they to switch accounting firms. All 20 of the audit

chairpersons with whom we spoke believed that they had three or fewer
alternatives. Of the companies responding to our survey, 42 percent (61 of
147) said that they did not have enough options for audit and attest
services. However, when asked whether steps should be taken to increase
the number of available choices, results revealed that 76 percent (54 of
71) of public companies responding to our survey to date said they would
strongly favor or somewhat favor letting market forces operate without
government intervention.

We also found that client choices could be even further limited due to
potential conflicts of interest, the new independence rules, and industry
specialization by the firms* all of which may further reduce the number of
available alternatives to fewer than three. First, the Big 4 tend to
specialize in particular industries and, as our preliminary survey results
indicated,

public companies that responded often preferred firms with established
records of industry- specific expertise, which could further reduce a
company*s number of viable choices. 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).

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

60.7% 19.4% 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

33.2% 18.2% 21.9%

Ernst & Young

94.6% 76.4% 28.5%

PricewaterhouseCoopers Price Waterhouse Arthur Andersen

61.7%

Source: Who Audits America, 1997 and 2002.

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.

Linking Consolidation We found little empirical evidence to link past
consolidation to changes in

to Audit Price, Quality, audit fees, quality, and auditor independence.
Given the significant changes 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.

Independence Is However, researchers (relying on analyses based on
aggregate billings of

Difficult small samples of companies or proxies for audit fees, such as
average audit

revenues) generally found that audit fees remained flat or increased
slightly since 1989. Additionally, although not focused on consolidation,
a variety of studies have attempted to measure overall changes in audit
quality and auditor independence. The results varied, and we spoke with
numerous accounting experts who offered varying views about changes in
quality and independence. Like audit fees, a variety of factors, such as
the increasing importance of management consulting services provided to
clients, make attributing any changes, real or perceived, to any one of
the factors

difficult. 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
Measures but Did Not

the mid- 1990s but have been increasing since the late 1990s (inflation
Conclusively Determine

adjusted). However, we were unable to isolate the effects of consolidation
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

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.

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.

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.

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 Is Difficult independence, we did find limited research that
attempted to measure

general changes in audit quality and auditor independence, and we explored
these issues with market participants and researchers. We found that
theoretical and empirical research on both issues to date present mixed
and inconclusive results as, in general, measurement issues made it
difficult to assess changes in audit quality or auditor independence.

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

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 marketbased 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.

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 goingconcern warnings on their clients that
subsequently went bankrupt than did four of the five largest firms, from
January 2001 through June 2002.

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.

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 going33

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.

concern opinions. 37 This study*s findings were consistent with
marketbased 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.

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.

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

to Have Had Little the efficient functioning of securities markets, we
found no evidence to

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 Formation or

addressing how consolidation among accounting firms might affect capital
Securities Markets to

formation or the securities markets in the future. Date, and Future

Capital formation and the securities markets are driven by a number of
Implications Are

interacting factors, including interest rates, risk, and supply and
demand. 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).

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.

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.

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 Firms Face Numerous

infrastructure, smaller accounting firms face considerable barriers to
entry, 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 the Top Tier

firms generally lack the staff resources, technical expertise, and global
reach to audit large multinational companies. Second, public companies and
markets appear to prefer the Big 4 because of their established
reputation. Third, the increased litigation risk and insurance costs
associated with auditing public companies generally create disincentives
for smaller firms to actively compete for large public company clients.
Fourth, raising the capital to expand their existing infrastructure to
compete with the Big 4, which already have such operations in place, is
also a challenge, in part because of the partnership structure of
accounting firms. Finally, certain state laws, such as state licensing
requirements, make it harder for smaller firms that lack a national
presence to compete. The firms with whom we spoke, including the Big 4,
all told us that they did not foresee any of the other accounting firms
being able to grow to compete with the Big 4 for large national and
multinational public company clients in the near future.

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 Technical Expertise, and

large national and multinational companies and their often complex Global
Reach to Audit Large

operations. Moreover, 91 percent (117 of 129) of public companies
responding to our survey who would not consider using a non- Big 4 firm as
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.

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

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.

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

Large Company Audit and obtaining affordable insurance. Like many of the
challenges faced by

Market Less Attractive Than smaller firms, this is a challenge for all
firms. However, assuming that

Other Options smaller firms were able to purchase additional insurance to
cover the new

risk exposure, most smaller firms lacked the size needed to achieve
economies of scale to spread their litigation risk and insurance costs
across a larger capital base. According to 83 percent of firms (38 of the
46) that responded to our survey, litigation and insurance factors have
had a great or moderate upward influence on their costs, which they
indicated have increased significantly. 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).

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

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

in Particular offices face increased costs and burden to establish
geographic coverage

needed for auditing most large public companies. All 50 states, the
District of Columbia, Guam, Puerto Rico, and the U. S. Virgin Islands have
laws governing the licensing of certified public accountants, including
requirements for education, examination, and experience.

While each jurisdiction restricts the use of the title *certified public
accountant* to individuals who are registered as such with the state
regulatory authority, the other licensure requirements are not uniform.
State boards have been working toward a more uniform system based on the
Uniform Accountancy Act (UAA), which is a model licensing law for

state regulation within the accounting profession. The UAA seeks adoption
of the idea of *substantial equivalency* with regard to education,
examinations, and experience, so that states recognize each other*s
certification as *substantially equivalent* to their own. According to
National Association of State Boards of Accountancy and AICPA officials,
fewer than half (23) of the jurisdictions had agreed to the equivalency
practice as of July 1, 2003. Some firms expressed concerns that potential
state and federal duplication

of oversight could pose more of a burden for smaller firms than the Big 4
and might induce some smaller firms to stop auditing public companies

altogether. Specifically, to mirror the federal oversight structure, most
states (37) implemented statutorily required peer reviews for firms
registered in the state. Until 2002, these requirements were generally
consistent with the peer review process conducted by AICPA*s SEC

Practice Section. 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.

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

Our Evaluation AICPA for their comment. We obtained oral comments from DOJ
officials

from the Antitrust and Criminal Divisions, who provided additional
information on the extent to which coordination with antitrust officials
and consideration of the competitive implications of the Andersen criminal
indictment occurred. As a result, we clarified the language provided in
this report. SEC, DOJ, and AICPA provided technical comments, which have
been incorporated into this report where appropriate. PCAOB had no
comments.

We are sending copies of this report to the Chairman and Ranking Minority
Member of the House Committee on Energy and Commerce. We are also sending
copies of this report to the Chairman of SEC, the Attorney General, the
Chairman of PCAOB, and other interested parties. This report will also

be available at no cost on GAO*s Internet homepage at http// www. gao.
gov. This report was prepared under the direction of Orice M. Williams,
Assistant Director. Please contact her or me at (202) 512- 8678 if you or
your

staff have any questions concerning this work. Key contributors are
acknowledged in appendix V.

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

Appendi Appendi xes x I

Scope and Methodology 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

for Consolidation firms, we interviewed past and current partners of
public accounting firms

involved in Big 8 mergers, and officials from the Department of Justice
(DOJ) and Federal Trade Commission (FTC). Specifically, we conducted
indepth interviews with senior partners of the Big 4 firms and, to the
extent possible, the former partners, chairmen, and chief executive
officers (CEO)

of the Big 8 who were instrumental in their firms* decisions to
consolidate. We asked these officials to recount in detail their firms*
histories of consolidation and their views on the impetus for merging. We
also conducted interviews with senior DOJ officials about the studies and
investigations they had undertaken to determine whether the mergers

would raise antitrust issues. We did not, however, review any of the
antitrust analyses conducted by DOJ specific to any of the proposed
mergers during the 1980s and 1990s. We requested DOJ*s antitrust analysis
and related documentation from the mergers among the largest firms in

1987 and 1997. According to DOJ officials, most of the firm documents had
been returned to the relevant parties, and other documents were viewed as
*predecisional* by DOJ. While GAO*s statute provides us with access to
predecisional information absent a certification by the President or the
Director of the Office of Management and Budget, we were more interested
in the reasons for the mergers than DOJ*s analysis in approving the
mergers. Therefore, we used other sources to obtain the necessary

information for this report. To the extent possible, we obtained copies of
public decisions made by FTC in the 1970s and 1980s concerning the ability
to advertise by professional service firms, including the accounting
firms. As directed by the mandate, we coordinated with the Securities and

Exchange Commission (SEC) and SEC*s counterparts from the Group of

Seven nations (Canada, France, Germany, Italy, Japan, United Kingdom, and
United States). To do this, we met with the representatives of the
appropriate regulatory agencies under the auspices of the International
Organization of Securities Commissions and obtained additional information
relevant to their countries. We also conducted a literature

review of existing studies on the history of the accounting profession and
consolidation.

Impact of To evaluate the impact of consolidation on competition, auditor
choices, Consolidation on

audit fees, and audit quality and auditor independence, we consulted with
academics and other researchers, U. S. and foreign regulators, and trade
Competition, Auditor

associations, and we reviewed relevant academic literature. Most of the
Choices, Audit Fees,

research studies cited in this report have been published in highly and
Audit Quality and

regarded, refereed academic journals. These studies were also reviewed by
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
Variety of Sources

ratios and Hirschman- Herfindahl indexes for 1988 to 2002 using the Who
Audits America database, a directory of public companies with detailed
information for each company, including the auditor of record, maintained
by Spencer Phelps of Data Financial Press. We used Public Accounting
Report (PAR) and other sources for the remaining trend and descriptive

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

We Used the Doogar We also employed a simple model of pure price
competition, in which

and Easley (1998) clients choose auditors based on price, ignoring factors
such as quality or

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
pricecompetitive Structure to Assess

setting. 2 We worked with Professor Rajib Doogar, University of
Concentration in a

Illinois at Urbana- Champaign, and Professor Robert Easley, University of
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

Competitive Exchange, NASDAQ, and New York Stock Exchange, and other
companies

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.

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 secondlowest

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.

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.

Tabl e 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

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.

Tabl e 6: Simulation Two* Market Shares, Actual and Simulated by Client
Assets, 2002 Client asset class (millions) Over $1, 000-

$500- $250500 $100-

$25- Less than Tot al Tot al Accounting firms $5,000 5,000 1,000 250 $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

Tot al 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

Tot al 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. Partnerto-
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

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.

Tabl e 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

quality, and auditor independence within their industry. We identified the
97 firms and obtained name and address information for the executive to be
contacted primarily from the membership list of the American Institute of
Certified Public Accountants* (AICPA) SEC Practice Section. To develop our
questionnaire, we consulted a number of experts at SEC, AICPA, and others
knowledgeable about the accounting profession. We also pretested

our questionnaire with two of the Big 4 firms, four other firms among the
largest 97, and two small firms. We began our Web- based survey on May 23,
2003, and included all usable responses as of July 11, 2003, to produce
this report. One of the 97 firms was found to be ineligible for the survey
because the answers of another responding firm comprised the activity of
the former, so the final population surveyed was 96 firms. We received 47
usable responses from these 96 firms, for an overall response rate of 49

percent. However, the number of responses to individual questions may be
fewer than 47, depending on how many responding firms were eligible to or
chose to answer a particular question.

Second, we surveyed a random sample of 250 of the 960 largest publicly
held companies. We created this population from the 2003 list of the
Fortune 1000 companies produced by Fortune, a division of Time, Inc.,
after removing 40 private firms from this list. We mailed a paper
questionnaire to the chief financial officers, or other executives
performing that role, requesting their views on the services they received
from their auditor of record, the effects of consolidation on competition
among accounting firms, and its potential implications. To develop this
questionnaire, we consulted with AICPA and SEC and pretested with six

large public companies from a variety of industries. The survey began on
May 6, 2003. We removed one company that had gone out of business, and
received 148 usable responses as of July 11, 2003, from the final sample
of 249 companies, for an overall response rate of 59 percent. Again, the
number of responses to individual questions may fluctuate, depending on
how many respondents answered each question. We plan to issue a subsequent
report in September 2003 on client responses received through July 30,
2003.

While the public company survey results came from a random sample drawn
from the population of Fortune 1000 companies and thus could be weighted
to statistically represent that larger group, we are reporting totals and
percentages only for those companies (and accounting firms) actually
returning questionnaires. Since the small number of respondents to both
surveys at the time of publication could significantly differ in their
answers from the answers nonrespondents might have given had they
participated,

it is particularly risky to project the results of our survey to not only
the nonrespondents, but also to the part of the public company population
we did not sample. There are other practical difficulties in conducting
any survey that may also contribute to errors in survey results. For
example, differences in how a question is interpreted or the sources of
information available to respondents can introduce unwanted variability
into the survey

results. We included steps in both the data collection and data analysis
stages to minimize such errors. In addition to the questionnaire testing
and development measures mentioned above, we followed up with the sample
firms and clients with e- mails and telephone calls to encourage them to
respond and offer assistance. We also checked and edited the survey data
and programs used to produce our survey results.

Finally, we conducted structured interviews with a judgmental sample of 20
chairs of audit committees for Fortune 1000 companies to obtain their
views on audit services, consolidation, and competition within the audit
market. Our selection criteria included geographic location, the company*s
industry, and the chairperson*s availability. The audit chairpersons whom
we interviewed all had a background in business and most had been or were
currently serving as CEOs of a Fortune 1000 company. On average, the
chairpersons we interviewed served on over two boards in addition to

the board on which they sat for purposes of the interview. On average,
they served as chairpersons of the audit committee for just over 2 years,
served as a member on the audit committee for over 5 years, and served on
that Fortune 1000 company*s board of directors for over 7 years.

Impact of To address the issue of the impact of consolidation and
concentration Consolidation on

among large accounting firms on capital formation and securities markets,
we interviewed representatives from accounting firms, investment banks,
Capital Formation and

institutional investors, SEC, self- regulatory organizations, credit
agencies, Securities Markets

and retail investors, among others. We also consulted with numerous
academics and reviewed relevant economic literature.

Identifying Barriers to To identify the barriers to entry that accounting
firms face in the public

Entry company audit market, we discussed competition and competitive
barriers

with representatives of a cross section of public accounting firms, large
public companies, various government agencies, the accounting profession
and trade associations, institutional investors, securities underwriters,
selfregulatory organizations, credit rating agencies, and other
knowledgeable

officials. We obtained information from the National Association of State
Boards of Accountancy and AICPA. We also reviewed existing state and
federal requirements. Finally, we used the Doogar and Easley (1998) model

to roughly assess whether mergers between non- Big 4 firms could
potentially increase the number of accounting firms capable of auditing
large national and multinational companies.

GAO Surveys of Public Accounting Firms and

Appendi x II

Fortune 1000 Public Companies Survey of U. S. Public Accounting Firms 1 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.

1

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

2

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. 2. 3. 4. 5. 6. 7. 8. 9. 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. )

19.

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

5

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:

6

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

7

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

8

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. 9

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

10

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

11

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:

12

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:

13

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:

14

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% 15

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

16

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 17

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:

18

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

19

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. Page 1 of 15

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: _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Page 2 of 15

5. Approximately how much were the total annual fees that your company
paid to your auditor of record for audit and attest services during your
last fiscal year? Please enter approximate dollar figure.

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: : _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Page 3 of 15

9. If your company previously employed Arthur Andersen as your auditor of
record and switched to another firm in the past two years, did you switch
to the firm to which your previous Arthur Andersen partner moved? Please
check one box.

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% Page 4 of 15

11. If your company changed auditors within the last two years, how have
the fees your company pays your current auditor of record changed compared
to the fees paid to your previous auditor? Please check one box.

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%

Page 5 of 15

14. If your company changed auditors within the last two years, do you
believe that the overall quality of audit services your company receives
from your current auditor is better or worse than the overall quality of
audit services your company received from its previous auditor?

Please check one box.

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.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Page 6 of 15

17. Auditor independence is often thought to relate to the accounting firm
s ability and willingness to appropriately deal with ( a) financial
reporting issues that may indicate materially misstated financial
statements; ( b) the appearance of independence in terms of the other
services a firm is allowed to and chooses to provide to their clients; and
( c) how much influence clients appear to have in the audit decisions.

Do you believe that your company s auditor( s) has become more or less
independent over the past decade? Please check one box.

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%

Page 7 of 15

19. In your opinion, how has the consolidation of the largest accounting
firms over the past decade influenced the ability of your auditor of
record to maintain independence in the audit and attest services it
provides to your company? Please check one box.

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%

Page 8 of 15

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 Page 9 of 15

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

N= 147 1% 12% 7% 14% 67% 0%

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: _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Page 10 of 15

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

N= 146 15% 39% 36% 8% 2% 0%

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

Quality of services offered N= 148 76% 23% 1% 0% 0% 0%

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

Page 11 of 15

28. Has the consolidation of the largest accounting firms over the past
decade made it harder or easier for your company to satisfactorily select
an auditor and maintain a relationship with that auditor? Please check one
box.

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

N= 71 13% 61% 14% 6% 0% 7%

Quality of service

N= 71 1% 15% 42% 34% 0% 7%

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

Page 12 of 15

31. What do you believe is the minimum number of accounting firms
necessary to provide audit and attest services to large national and
multinational public companies? Please enter a number.

_ _ _ _ _ _ _ _ _ _ _ _ _ _ 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: _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

Page 13 of 15

33. Do you suggest that any actions be taken to increase competition in
the provision of audit and attest services for large national and
multinational public companies? Please check one box.

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

Page 14 of 15

35. Do you have any additional comments on any of the issues covered by
this survey? Please use the space below to make additional comments or
clarifications of any answers you gave in this survey.

Thank you for your assistance with this survey! Please return it in the
envelope provided.

Page 15 of 15

Appendi x III

Arthur Andersen Case Study 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

Switched to a Big 4 by Andersen switched to a new auditor of record. As
figure 10 illustrates, of

the 1, 085 companies reviewed, 938 switched to one of the Big 4 (87 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.

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.

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

Switched to Big 4 billion switched to a Big 4 firm. The one exception,
Global Crossing,

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).

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.

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.

Tabl e 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 Tot al 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 Tot al 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 Tot al 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

Former Andersen firm. Of the 147 firms, 31 percent switched to Grant
Thornton and 16

percent switched to BDO Seidman (fig. 11). The average asset size of a
Clients Switched to

company that switched to a non- Big 4 firm was $309 million, which is Non-
Big 4 Firms

approximately $2.2 billion less than the average asset size of a company
that switched to a Big 4 firm. As table 10 illustrates, the average asset
size of a company that switched to Grant Thornton was $644 million, and
the average asset size of a company that switched to BDO Seidman was $54
million. The 147 public company clients that did not engage a Big 4 firm
switched to one of 52 non- Big 4 firms.

Tabl e 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

Tot al 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.

Tabl e 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

(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).

Analysis of Big 4 Firms* Specialization by

Appendi x IV

Industry Sector 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
Analysis

particular industries or groups, and companies may consider only these
firms as having the requisite expertise to provide audit and attest
services for their operations. However, it is important to review this
analysis in the context of its limitations. Specifically, defining markets
by SIC codes can exaggerate the level of concentration because, like the
audit market, a few large companies dominate many industry sectors (see
table 2). For example, in the petroleum industry, we were able to identify
only 25 publicly listed companies in 2002, 20 of which were audited by the
Big 4. Because PricewaterhouseCoopers and Ernst & Young audit the six
largest companies, they audit 95 percent of the assets in this industry.
To mitigate the potential for bias, we limited our analysis to the 2-
digit SIC codes rather than the more specific 4- digit codes. There are
additional methodological issues with defining markets by SIC

codes. First, the audited companies* lines of business, not the business
of the accounting firms, defines the markets. Second, some companies that
could be included in a particular industry are not included because no SIC
code identifier was provided in the database that we used. Moreover,
assignment of a company to a particular SIC code sometimes involves
judgment, which may create bias. Finally, the methodology assumes
different accounting firms are in separate markets and cannot easily move
from auditing one type of industry to another. 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.

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.

Tabl e 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.

(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.

(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)

Industry Specialization As figure 13 shows, in selected industries
specialization can often limit the

Can Limit Public number of auditor choices to two* in each case, two
auditors account for

over 70 percent of the total assets audited in 2002. As a result, it might
be 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).

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 Ernst & Young

KPMG

9.1% 6.4%

37.6% 16.8%

Coopers & Lybrand

50.1% 40.6% Ernst & Young

31.0% 90.7%

Arthur Andersen

68.6%

PricewaterhouseCoopers Price Waterhouse

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

60.7% 19.4% Deloitte & Touche

31.6% 80.1%

Arthur Andersen Ernst & Young

64.5%

Ernst & Young Source: Who Audits America, 1997 and 2002.

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

14.6% 14.1%

48.7% 20.6% 15.0%

25.1% 16.0%

Price Waterhouse Deloitte & Touche

Coopers & Lybrand

73.8%

Arthur Andersen PricewaterhouseCoopers

Deloitte & Touche

41.6% 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%

PricewaterhouseCoopers Price Waterhouse

81.4% 78.1% KPMG

KPMG Source: Who Audits America, 1997 and 2002.

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

1.4% Deloitte & Touche Coopers

KPMG KPMG

13.4% 20.8%

39.9% 48.7%

37.4% 37.5%

Deloitte & Touche

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 Deloitte & Touche

Coopers

8.3% 8.9%

Arthur Andersen

59.5% 28.4% Deloitte & Touche

72.8% 81.7%

87.9%

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

Business services (1997) Business Services (2002) 0.8% Other

4.3% Price Waterhouse Ernst & Young

KPMG

6.3%

KPMG

6.3% 8.7%

Arthur Andersen

8.8% 11.2%

Deloitte & Touche

51.6% 12.8% Deloitte & Touche

60.8% 12.9%

15.4%

Other Ernst & Young

73.7%

Coopers

67.0%

PricewaterhouseCoopers & Lybrand

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

13.8% 12.1%

45.1% 15.9%

18.3% 63.4%

KPMG Arthur Andersen

17.2% 81.7%

Ernst & Young

62.3%

PricewaterhouseCoopers Price Waterhouse Source: Who Audits America, 1997
and 2002.

Furniture and fixtures (1997) Furniture and fixtures (2002) 1.5% Coopers &
Lybrand

3.3% Other

1.2% Other KPMG

KPMG

6.1% 7.0%

Deloitte & Touche Ernst & Young

11.1% 7.5%

49.1% 9.4%

Deloitte & Touche

13.2%

Ernst & Young

68.4% 22.2%

81.6%

Price Waterhouse

71.3%

PricewaterhouseCoopers Arthur Andersen

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

33.2% 18.2% 21.9%

Ernst & Young

76.4% 94.6%

28.5%

Price Waterhouse

61.7%

PricewaterhouseCoopers Arthur Andersen Source: Who Audits America, 1997
and 2002.

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%

38.4% 44.0%

Deloitte & Touche Coopers & Lybrand

89.4% 84.7%

PricewaterhouseCoopers Deloitte & Touche

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%

PricewaterhouseCoopers

62.2% 28.0%

86.4%

Deloitte & Touche

63.8%

Arthur Andersen Deloitte & Touche

Source: Who Audits America, 1997 and 2002.

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% 46.8% 37.3% Ernst & Young

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.

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%

35.6% Ernst & Young

15.8% 19.7%

Price Waterhouse

26.1% 35.2%

PricewaterhouseCoopers Ernst & Young

70.8%

KPMG

57.7% 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

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.

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

7.5%

KPMG Coopers & Lybrand

13.9% 9.0%

32.5% 37.5% 13.5%

Deloitte & Touche

21.5%

Deloitte & Touche

21.7% 14.0% 25.1%

Price Waterhouse Ernst & Young Ernst & Young

54.2% PricewaterhouseCoopers

62.6%

Arthur Andersen Source: Who Audits America, 1997 and 2002.

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%

PricewaterhouseCoopers Price Waterhouse

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

15.4% 7.0%

35.4% 33.8%

14.6%

Ernst & Young

19.4%

KPMG

31.0% 26.8%

KPMG

66.4%

Deloitte & Touche Arthur Andersen

Ernst & Young

60.6%

Source: Who Audits America, 1997 and 2002.

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%

PricewaterhouseCoopers Price Waterhouse

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% 18.6%

PricewaterhouseCoopers

44.2% 13.4%

Ernst & Young

15.0% 14.5%

24.3%

Price Waterhouse Ernst & Young Deloitte & Touche

50.5% 68.5%

Arthur Andersen Deloitte & Touche

Source: Who Audits America, 1997 and 2002.

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% 27.1%

29.5%

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%

61.0% 23.8% PricewaterhouseCoopers

18.8% 24.6%

Ernst & Young

84.8%

Arthur Andersen

55.4%

Coopers & Lybrand Deloitte & Touche

Source: Who Audits America, 1997 and 2002.

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%

14.4%

PricewaterhouseCoopers

41.7% 94.6% 88.6%

29.7%

Deloitte & Touche

71.4%

Arthur 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

12.4% 12.9%

27.1% 36.0%

14.6%

Coopers & Lybrand

24.5%

KPMG

23.4% 16.4%

25.2%

Arthur Andersen Ernst & Young

KPMG

50.5% PricewaterhouseCoopers

61.2%

Price Waterhouse Source: Who Audits America, 1997 and 2002.

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.

Tabl e 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

(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.

Tabl e 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

(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.

Appendi x V

GAO Contacts and Staff Acknowledgments 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.

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

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

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
fourfirm 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

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

Glossary

compliance with standards and membership requirements. The SarbanesOxley
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)

a

GAO United States General Accounting Office

Domestically and globally, there are only a few large firms capable of
auditing large public companies, which raises potential choice, price,
quality, and concentration risk concerns. A common concentration measure
used in antitrust analysis, the Hirschman- Herfindahl Index (HHI)
indicates that the largest firms have the potential for significant market
power following mergers among the largest firms and the dissolution of
Arthur Andersen (see fig. below). Although GAO found no evidence of
impaired competition to date, the

significant changes that have occurred in the profession may have
implications for competition and public company choice, especially in
certain industries, in the future. Existing research on audit fees did not
conclusively identify a direct correlation with consolidation. GAO found
that fees have started to increase, and most experts expect the trend to
continue as the audit environment responds to

recent and ongoing changes in the audit market. Research on quality and
independence did not link audit quality and auditor independence to
consolidation and generally was inconclusive. Likewise, GAO was unable to
draw clear linkages between consolidation and capital formation but did
observe potential impacts for some smaller companies seeking to raise
capital. However, given the unprecedented changes occurring in the audit
market, GAO observes that past behavior may not be indicative of future
behavior, and these potential implications may warrant additional study in
the future, including preventing further consolidation and maintaining
competition.

Finally, GAO found that smaller accounting firms faced significant
barriers to entry* including lack of staff, industry and technical
expertise, capital formation, global reach, and reputation* into the large
public company audit market. As a result, market forces are not likely to
result in the expansion of the current Big 4. Furthermore, certain factors
and conditions could cause a further reduction in the number of major
accounting firms.

Hirschman- Herfindahl Indexes, 1988- 2002 The audit market for large
public companies is an oligopoly, with the largest firms auditing the vast
majority of public companies and

smaller firms facing significant barriers to entry into the market.
Mergers among the largest firms in the 1980s and 1990s and the

dissolution of Arthur Andersen in 2002 significantly increased
concentration among the largest firms, known as the *Big 4.* These four
firms currently audit over 78 percent of all U. S. public companies and 99
percent of all public company sales. This consolidation and the resulting

concentration have raised a number of concerns. To address them, the
Sarbanes- Oxley Act of 2002 mandated that GAO study

the factors contributing to the mergers;

the implications of consolidation on competition and client choice, audit
fees, audit quality, and auditor independence;

the impact of consolidation on capital formation and securities markets;
and

barriers to entry faced by smaller accounting firms in competing with the
largest 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. Highlights of GAO- 03- 864, a 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

Page i GAO- 03- 864 Public Accounting Firms

Contents

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Contents

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Contents

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Page 1 GAO- 03- 864 Public Accounting Firms United States General
Accounting Office Washington, D. C. 20548

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Page 29 GAO- 03- 864 Public Accounting Firms Note: Selected industries
presented for illustrative purposes, and additional examples are included
in appendix IV.

Transportation by air (1997) Transportation by air (2002) Nondepository
institutions (1997) Nondepository institutions (2002)

0.0% Coopers & Lybrand

0.1% Other

0.3% Price Waterhouse Ernst & Young

1.4% Deloitte & Touche Arthur Andersen KPMG

0.4% Pricewaterhouse Coopers

0.1% Other KPMG

Deloitte & Touche Ernst & Young

20.8% 37.5% 39.9%

13.4% 37.4% 48.7%

2.8% Other

2.8% Price Waterhouse KPMG

Deloitte & Touche

0.9% Coopers & Lybrand Arthur Andersen

3.6% Ernst & Young

2.9% Other

3.8% Pricewaterhouse Coopers

Deloitte & Touche KPMG

3.8% Ernst & Young

8.9% 8.3%

72.8% 28.4% 59.5% 77.4%

86.1% 81.7%

87.9%

Source: Who Audits America, 1997 and 2002.

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Appendix I

Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix I Scope and Methodology

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Appendix II

Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix II GAO Surveys of Public Accounting Firms and Fortune 1000 Public
Companies

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Appendix III

Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix III Arthur Andersen Case Study

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Appendix IV

Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix IV Analysis of Big 4 Firms* Specialization by Industry Sector

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Appendix V

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Glossary Page 136 GAO- 03- 864 Public Accounting Firms

Glossary Page 137 GAO- 03- 864 Public Accounting Firms

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