Audits of Public Companies: Continued Concentration in Audit	 
Market for Large Public Companies Does Not Call for Immediate	 
Action (09-JAN-08, GAO-08-163). 				 
                                                                 
GAO has prepared this report under the Comptroller General's	 
authority as part of a continued effort to assist Congress in	 
reviewing concentration in the market for public company audits. 
The small number of large international accounting firms	 
performing audits of almost all large public companies raises	 
interest in potential effects on competition and the choices	 
available to large companies needing an auditor. This report	 
examines (1) concentration in the market for public company	 
audits, (2) the potential for smaller accounting firms' growth to
ease market concentration, and (3) proposals that have been	 
offered by others for easing concentration and the barriers	 
facing smaller firms in expanding their market shares. GAO	 
surveyed a random sample of almost 600 large, medium, and small  
public companies on their experiences with their auditors. GAO	 
also interviewed the four largest accounting firms and surveyed  
all other U.S. accounting firms that audit at least one public	 
company. GAO also developed an econometric model that analyzed	 
the extent to which various factors, including concentration and 
new auditing requirements, affected fee levels. To supplement	 
this work, GAO interviewed market participants, including public 
companies, investors, accounting firms, academics, and		 
regulators. This report makes no recommendations.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-08-163 					        
    ACCNO:   A79510						        
  TITLE:     Audits of Public Companies: Continued Concentration in   
Audit Market for Large Public Companies Does Not Call for	 
Immediate Action						 
     DATE:   01/09/2008 
  SUBJECT:   Accountants					 
	     Auditing procedures				 
	     Auditing standards 				 
	     Auditors						 
	     Audits						 
	     Competition					 
	     Corporate audits					 
	     Fees						 
	     Program evaluation 				 
	     Reporting requirements				 
	     Accounting procedures				 
	     Cost accounting					 
	     Accounting standards				 

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GAO-08-163

   

     * [1]Results in Brief
     * [2]Background

          * [3]Accounting Firm Structure
          * [4]Mergers and the Loss of a Major Firm Have Resulted in a Nati
          * [5]Statutory Changes Affecting Requirements for Public Companie
          * [6]Significant Audit and Accounting Standards and Rules Changes

     * [7]With Continued Audit Market Concentration, Large Public Comp

          * [8]Overall Market for Public Company Audits Remains Highly Conc
          * [9]Although Smaller Public Company Market Has Become Less Conce
          * [10]In Concentrated Market, Some Companies Perceive Limited Audi

               * [11]Large Public Companies and Auditor Choices
               * [12]Midsize and Small Public Companies and Auditor Choices

          * [13]Although Opinions on the Impact of Concentration in the Larg

               * [14]Factors Increasing Audit Fees
               * [15]Effects of Concentration on Fee Increases
               * [16]Other Potential Effects of Concentration

          * [17]Further Concentration Could Adversely Affect Audit Fees and
          * [18]Regulators Could Act to Mitigate the Effects of Further Conc

     * [19]Midsize and Smaller Firms Face Challenges Auditing Public Co

          * [20]Midsize and Smaller Firms Face Several Disincentives and Cha

               * [21]Firm Capacity to Audit Larger Companies
               * [22]Technical Capability and Industry Specialization
               * [23]Accounting Firm Reputation

          * [24]Similar Challenges Affect Midsize and Smaller Accounting Fir
          * [25]Smaller Audit Firms Are Taking Actions to Expand Their Marke

     * [26]Proposals for Addressing Concentration and Increasing Market

          * [27]Proposals Others Have Made for Reducing the Risks of the Cur

               * [28]Mandatory Audit Firm Rotation
               * [29]Audit Firm Financial Statement Disclosure
               * [30]Breaking Up the Largest Firms into More Firms

          * [31]Reducing the Impact or Risk of Litigation Could Prevent Furt

               * [32]Liability Caps
               * [33]Targeting Enforcement Actions against Responsible
                 Individual
               * [34]Other Proposals to Reduce Auditors' Liability for
                 Alleged Wr

          * [35]Proposed Actions to Help Reduce the Challenges Facing Smalle

               * [36]Outside Ownership of Accounting Firms
               * [37]Shared Experts Office
               * [38]Uniform Licensing and Registration Standards
               * [39]Accounting Firm Accreditation

     * [40]Agency Comments and Our Evaluation

          * [41]Data Analysis
          * [42]Survey Data
          * [43]Overall Audit Market and Many Specific Industries Are Highly
          * [44]Loss of One of the Largest Firms Would Result in Even Higher
          * [45]Factors Influencing Audit Costs
          * [46]Factors Influencing Audit Quality

               * [47]Audit Oversight
               * [48]Views on Audit Quality

          * [49]The Panel Data Sample Was Created by Compiling Several Audit
          * [50]Econometric Modeling Procedures for Handling Panel Data
          * [51]Variables Included in the Model
          * [52]Results

     * [53]GAO Contacts
     * [54]Staff Acknowledgments
     * [55]GAO's Mission
     * [56]Obtaining Copies of GAO Reports and Testimony

          * [57]Order by Mail or Phone

     * [58]To Report Fraud, Waste, and Abuse in Federal Programs
     * [59]Congressional Relations
     * [60]Public Affairs

Report to Congressional Addressees

United States Government Accountability Office

GAO

January 2008

AUDITS OF PUBLIC COMPANIES

Continued Concentration in Audit Market for Large Public Companies Does
Not Call for Immediate Action

GAO-08-163

Contents

Letter 1

Results in Brief 4
Background 6
With Continued Audit Market Concentration, Large Public Companies See
Limited Choices, but No Apparent Significant Effect on Fees 15
Midsize and Smaller Firms Face Challenges Auditing Public Companies, and
Growth in These Firms Is Unlikely to Ease Concentration in the Large
Public Company Audit Market 37
Proposals for Addressing Concentration and Increasing Market Share for
Smaller Auditors Have Significant Disadvantages 51
Agency Comments and Our Evaluation 63
Appendix I Objectives, Scope, and Methodology 66
Appendix II Other Issues Related to Concentration in the Audit Market 75
Appendix III Analysis of Auditor Changes 82
Appendix IV Trends in Audit Costs and Quality 86
Appendix V Econometric Analysis of the Effect of Industry Concentration on
Audit Fees 94
Appendix VI GAO Contacts and Staff Acknowledgments 114

Tables

Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting
Public Companies and Accounting Firms 11
Table 2: Largest, Midsize, and Smaller Accounting Firm Capacity, 2006 40
Table 3: Disposition of Public Company Sample 71
Table 4: Disposition of Accounting Firms Selected for Survey 72
Table 5: Market Shares of Audit Fees by Accounting Firm Size 75
Table 6: Public Companies Changing Accounting Firms, January 2003 to June
2007 82
Table 7: Percentage and Number of Changes Public Companies Made in
Auditors, by Region 84
Table 8: Descriptive Statistics of the Panel Data Set, 2000-2006 95
Table 9: Hirchman-Herfindahl Indexes by Sector, 2000-2006 101
Table 10: Primary Variables in the Econometric Analysis 103
Table 11: Correlation Matrix, GAO Panel Data Set, Select Variables 105
Table 12: Random-Effects and Fixed-Effects Models Explaining Log of Fees
106
Table 13: Fixed Models Explaining Log of Fees, by Market Segments,
2001-2006 109

Figures

Figure 1: Significant Mergers of the 1980s and 1990s 9
Figure 2: Public Companies and Their Auditors, 2002 and 2006 19
Figure 3: Hirschman-Herfindahl Indexes for Public Company Market Segments
Grouped by Company Revenues 20
Figure 4: Percentage of Midsize and Small Companies That Reported Having
Three or Fewer Choices for Auditor 25
Figure 5: Percentage of Small and Midsize Companies Reporting They Did Not
Have Enough Choices for Auditor 26
Figure 6: Changes in Auditors among Small and Midsize Public Companies 27
Figure 7: Percentage of Public Companies Indicating That the Level of
Audit Market Competition Was Sufficient 28
Figure 8: Firms' Challenges in Auditing Large Public Companies 39
Figure 9: IPOs, 2003-2007 46
Figure 10: Midsize and Smaller Firms' Challenges in Auditing Small and
Midsize Companies 47
Figure 11: 2006 Market Shares of Each of the Largest Firms Compared to
Other Firms, as Measured by Audit Fees 76
Figure 12: Hirschman-Herfindahl Indexes, 2000-2006 78
Figure 13: Hirschman-Herfindahl Indexes, Markets Segmented by Industry 79
Figure 14: HHI with Simulated Firm Failure or Merger 81

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Abbreviations

AICPA American Institute of Certified Public Accountants
AMEX American Stock Exchange
CAQ Center for Audit Quality
CEO chief executive officer
CFO chief financial officer
CPA certified public accountant
DOJ Department of Justice
EDGAR Electronic Data Gathering, Analysis, and Retrieval system
EITF Emerging Issues Task Force
FASB Financial Accounting Standards Board
FTC Federal Trade Commission
GAAP generally accepted accounting principles
GAAS generally accepted auditing standards
GLS generalized least squares
HHI Hirschman-Herfindahl Index
IOSCO International Organization of Securities Commissions
IPO initial public offering
NAICS North American Industry Classification System
NASBA National Association of State Boards of Accountancy
NYSE New York Stock Exchange
OLS ordinary least squares
OTCBB Over the Counter Bulletin Board
PAR Public Accounting Report
PCAOB Public Company Accounting Oversight Board
SEC Securities and Exchange Commission

United States Government Accountability Office
Washington, DC 20548

January 9, 2008

Congressional Addressees

Public and investor confidence in the reliability of financial reporting
is critical to the effective functioning of the U.S. capital markets.
Federal securities laws require that a company raising capital by issuing
securities to the public have an independent public accountant perform an
audit of the company's financial statements to provide reasonable
assurance about whether the financial statements are fairly presented.
Since the 1980s, a small number of large U.S. accounting firms have
traditionally performed audits for the vast majority of the public company
market (when measured by the share of total audit fees collected). Among
the clients of these large firms are almost all of the largest U.S.
companies.^1 The small number of large accounting firms performing such
audits has decreased as a result of mergers and the dissolution of one
firm, falling from eight in the 1980s to four today.^2 These four
firms--referred to here as the largest firms--have thousands of partners,
tens of thousands of employees, offices located around the world, and each
had more than one thousand public company audit clients for 2006.^3 The
next four largest accounting firms--referred to here as midsize
firms--operate nationally, and to some extent, internationally but have
substantially fewer employees and partners, and each had less than 500
public company audit clients for 2006.^4 All other accounting
firms--referred to here as smaller firms--audit regional and local public
companies and have fewer than 100 public company clients.^5

^1For 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 whose stock is traded off these
exchanges--for example, through OTC Bulletin Board (OTCBB), excluding
funds, trusts, nonoperating companies, or subsidiaries of another public
company. Large public companies generally include those on the Fortune
1000 list, unless otherwise noted.

^2The 8 largest firms in the 1980s 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.
For the purposes of this report, the largest firms include Deloitte &
Touche LLP, Ernst & Young LLP, KPMG LLP, and PricewaterhouseCoopers LLP.
In our 2003 report on consolidation and competition, we referred to this
group as the "top tier" based on revenue and staff size. See GAO, Public
Accounting Firms: Mandated Study on Consolidation and Competition,
[61]GAO-03-864 (Washington, D.C.: July 30, 2003). In our mandated study on
audit firm rotation, we defined Tier 1 as firms with 10 or more public
company clients. See GAO, Public Accounting Firms: Required Study on the
Potential Effects of Mandatory Audit Firm Rotation, [62]GAO-04-216
(Washington, D.C.: Nov. 21, 2003).

^3The largest firms each audited more than 1,200 public companies for 2006
according to Public Accounting Report. These firms are commonly referred
to as the "Big 4" firms.

With the audit market concentrated among the four largest firms, concerns
have been raised about the number of choices that companies have when
selecting an auditor and the extent of competition in the market. In 2003,
we conducted a study (mandated by the Sarbanes-Oxley Act) on consolidation
that had occurred in the accounting profession. Our study followed the
dissolution of one of the then-five largest accounting firms, Arthur
Andersen. At that time, we found that although audits for large public
companies were highly concentrated among the largest accounting firms, the
market for audit services appeared competitive according to various
indicators.^6 Given that several years have passed since the dissolution
of Arthur Andersen and the passage of the Sarbanes-Oxley Act, which
introduced reforms to public reporting and auditing, this report provides
an update on the trends in the market for public company audits that we
identified in 2003 in the market for public company audits.^7 Among the
changes affecting the audit market that have occurred since our last
report are additional requirements for public companies and auditors to
assess, report on and attest to companies' internal control practices,
restrictions intended to ensure the accounting firm's independence that
limit public companies' ability to use their auditors for certain other
services, and the creation of a new oversight body for accounting firms.

We prepared this report under the Comptroller General's authority to
conduct evaluations on his own initiative as part of a continued effort to
assist Congress in reviewing concentration in the market for public
company audits. Specifically, this report examines (1) the level of
concentration in the market for public company audits and the impact of
this concentration, (2) the potential for increased capacity among midsize
and smaller accounting firms to ease market concentration, and (3)
proposals that have been offered by others for easing concentration in the
market for public company audits and the barriers facing midsize and
smaller firms in expanding their market share for public company audits.

^4The midsize firms--BDO Seidman LLP, Crowe Chizek & Company LLC, Grant
Thornton LLP, and McGladrey and Pullen LLP--each audited more than 100 but
fewer than 425 public companies for 2006 and had around $1 billion in
revenue or less according to Public Accounting Report.

^5In addition, a large number of accounting firms have no public company
clients.

^6GAO, Public Accounting Firms: Mandated Study on Consolidation and
Competition, [63]GAO-03-864 (Washington, D.C.: July 30, 2003).

^7Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (July 30,
2002).

To address these objectives, we collected data and analyzed changes in
companies' choice of auditors and in audit fees, computed concentration
ratios and other measures of concentration. We developed an econometric
model to evaluate how various factors, including the level of market
concentration, could explain fees that public companies paid to their
auditors. To obtain the views of public companies and accounting firms on
audit competition and challenges, we conducted two surveys. First, we
surveyed a random sample of 595 of more than 6,000 publicly held
companies, some of which had recently changed auditors.^8 Our sample
included large public companies (those in the Fortune 1000); midsize
public companies (those outside the Fortune 1000 with market
capitalizations--the value of the total outstanding shares of stock--above
$75 million); and small companies with less than $75 million in market
capitalization.^9 Our response rate for this survey was 73 percent.^10
Because our survey was based on a random sample of the population, it is
subject to sampling errors. The likely range of these errors for any
survey statistics is no greater than plus or minus 12 percentage points,
unless otherwise noted. In addition, we surveyed representatives of all
434 U.S. accounting firms that audited at least 1 public company in 2006
and were registered with the Public Company Accounting Oversight Board
(PCAOB). Our response rate was 58 percent.^11 Results from our survey of
accounting firms are limited to those midsize and smaller firms with five
or more public company clients. Instead of surveying the four largest
firms, we conducted separate structured interviews with representatives
from each firm to obtain their views on the issues covered in the survey.
This report does not contain all the results from the surveys, but the
surveys themselves and a more complete tabulation of the results can be
viewed at [64]http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP . We also
interviewed staff from the Securities and Exchange Commission (SEC),
PCAOB, Department of Justice (DOJ); academics; private consultants; trade
associations; accounting firms; public companies; and insurance companies.
To obtain information about the strengths and weaknesses of various
proposals that have been offered to address concentration and the
challenges that midsize and smaller firms face, we also held a roundtable
discussion on July 10, 2007, involving 18 market participants, including
representatives of accounting firms, public companies, investors,
academics, and insurers. For more information on our scope and
methodology, see appendix I.

^8Our initial population included over 6,900 U.S.-based public companies
that traded on major exchanges (NYSE, NASDAQ, AMEX, OTCBB). Company
estimates throughout the report do not include funds, trusts, nonoperating
companies, or subsidiaries of another public company.

^9According to these criteria, approximately 872 companies are large,
3,212 companies are midsize, and 2,822 companies are small.

^10Unless otherwise noted, results from our public company survey are
representative of and generalized to the larger public company population
our sample was drawn from.

^11Unless otherwise noted, accounting firm survey results do not include
the responses of the largest firms or firms with four or fewer audit
clients. Also, data for smaller firms refer to survey respondents only and
cannot be generalized to all smaller firms because of lower response rates
for this group.

We conducted this performance audit in New York City and Washington, D.C.,
from October 2006 to January 2008 in accordance with generally accepted
government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide a
reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.

Results in Brief

Although the market for small public company audits has become much less
concentrated since 2002, the continuing concentration in the market for
larger public companies limits these companies' auditor choices but does
not appear to have significantly affected audit fees. According to our
analysis, the largest accounting firms audit 98 percent of the more than
1,500 largest public companies--those with annual revenues of more than $1
billion. In contrast, midsize and smaller firms audit almost 80 percent of
the more than 3,600 smallest companies--those with annual revenues of less
than $100 million. Larger public companies we surveyed indicated that the
industry expertise and technical capability that they sought in an auditor
generally meant that their choices were limited to the largest accounting
firms. According to our survey of a random sample drawn from a population
of more than 6,000 public companies, almost 60 percent of large companies
indicated that the number of accounting firms from which they could choose
was not adequate, although some company officials described taking steps
to ensure that they would have at least one alternative firm they could
use under the more restrictive auditor independence rules. In contrast,
about 75 percent of the smallest public companies saw their number of
auditor choices as sufficient. While audit fees have increased
significantly in recent years, many market participants that we
interviewed attributed fee increases to additional audit work and expanded
accounting and audit requirements and higher costs to hire, train, and
retain qualified staff. In addition, the econometric model we developed to
evaluate the relationship between market concentration and audit fees
indicated that factors other than concentration appeared to explain the
recent fee increases. The level of market concentration also does not
appear to be affecting audit quality as many of our survey respondents and
those we interviewed said that audit quality had improved, which some
attributed to the Sarbanes-Oxley Act. Although the current level of
concentration does not appear to be having significant adverse effect,
public company officials and others we interviewed indicated that a merger
or the failure of one of the largest firms would further reduce companies'
auditor choices and could potentially result in higher audit fees and
fewer choices. The various federal organizations that have a role in
overseeing activities in the audit market, including SEC, PCAOB, and DOJ,
are prepared to take various actions to help minimize the disruption to
the market if further concentration occurred.

The concentration in the large public company audit market is also
unlikely to be reduced in the near term by midsize and smaller accounting
firms because a significant majority is not interested in auditing large
public companies and those that are interested face various challenges in
expanding their capability to do so. Over 70 percent of midsize and
smaller accounting firms indicated that they were not attempting to obtain
large public company clients. Approximately 90 percent of large public
companies we surveyed cited lack of capacity as a reason why they would
not consider using midsize or smaller firms as their auditor. As a result,
many of these firms would have to greatly expand their staffing and
geographic capabilities to serve such companies. However, the most
frequent impediment to expansion cited by accounting firms responding to
our survey was difficulty finding staff. Smaller firms also saw their lack
of name recognition and reputation as preventing them from obtaining more
large public company clients. Other difficulties that some accounting
firms cited in obtaining more public company clients included limited
access to capital and difficulty complying with multiple state licensing
requirements. Some firms have taken steps to address such challenges, such
as mergers or joining networks.

Various proposals by academics and business groups have been put forth to
reduce the risks of current and further audit market concentration and the
challenges facing midsize and smaller accounting firms, but each proposal
also has disadvantages. For example, some have suggested that requiring
one or more of the largest firms to spin off a portion of their operations
to create more than four firms with the capacity to audit large public
companies could ease current concentration. However, market participants
we spoke with raised concerns that splitting up these firms could reduce
their economies of scale and the depth of expertise that currently allow
the largest firms to effectively and efficiently audit large companies.
Some have also put forth proposals to reduce the risk of further
concentration that could arise if one of the largest firms leaves the
market as the result of a large litigation judgment or a regulatory
action. Proposals to reduce this risk include placing caps on auditors'
liability and having regulators or others take enforcement actions only
against responsible partners or employees rather than the firm as whole.
However, some of the academics and others we spoke with saw such liability
caps and enforcement limitations as potentially reducing the incentives
for auditors to conduct quality work. Other proposals have been offered to
help midsize and smaller firms expand their market share, thus potentially
easing concentration. These proposals include allowing outside ownership
of these firms in order to provide capital to expand their operations,
creating a group of accounting and auditing experts to provide needed
expertise to smaller auditing firms, and establishing a professionwide
accreditation program to help these firms overcome some of the name
recognition and reputation challenges they face. However, while each
action could offer benefits, market participants generally saw these
proposals as having limited effectiveness, feasibility, and benefit.

In light of limited evidence that the currently concentrated market for
large public company audits has created significant adverse impact and the
general lack of any proposals that were clearly seen as effective in
addressing the risks of concentration or challenges facing smaller firms
without serious drawbacks, we found no compelling need to take action. As
a result, this report does not include any recommendations. We provided
copies of a draft of this report to SEC, DOJ, PCAOB, and the Department of
the Treasury. SEC, PCAOB, and DOJ provided technical comments, which have
been incorporated where appropriate. Treasury had no comments.

Background

Following the 1929 stock market crash, legislation was passed that
required companies seeking to raise funds from the public to provide
audited financial statements to their investors. The Securities Act of
1933 and the Securities Exchange Act of 1934 established the principle of
full disclosure, which requires that public companies provide full and
accurate information to the investing public. Under these federal
securities laws, public companies are responsible for the preparation and
content of financial statements that are complete and accurate and are
presented in conformity with U.S. generally accepted accounting principles
(GAAP). Financial statements, which disclose a company's financial
position (balance sheet), stockholders' equity, results of operations
(income statement), and cash flows, are an essential component of the
disclosure system on which the U.S. capital and credit markets are based.

Federal securities laws also require that public companies have the
financial statements they prepare audited by an independent public
accountant. The independent public accountant's audit is critical to the
financial reporting process because the audit subjects companies'
financial statements to scrutiny on behalf of shareholders and creditors
to whom company management is accountable. The auditor is the independent
link between management and those who rely on the financial statements.
The statutory independent audit requirement, in effect, grants a franchise
to the nation's public accountants, as an audit opinion on a public
company's financial statements must be secured before an issuer of
securities can go to market, have the securities listed on the nation's
stock exchanges, or comply with the reporting requirements of the
securities laws.

Having auditors attest to the reliability of financial statements of
public companies is intended to increase public and investor confidence in
the fairness of the financial information. Moreover, investors and other
users of financial statements expect auditors to bring integrity,
independence, objectivity, and professional competence to the financial
reporting process and to prevent the issuance of misleading financial
statements. The resulting sense of confidence in companies' audited
financial statements, which is key to the efficient functioning of the
markets for public companies' securities, can exist only if reasonable
investors perceive auditors as independent and expert professionals who
will conduct thorough audits. In the event that companies are alleged to
have misled the public or presented falsified financial information, the
accounting firms that performed those audits are also sometimes included
in suits brought by investors or actions pursued by regulators.

Accounting Firm Structure

Most accounting firms that audit public companies in the United States are
organized as partnerships. Unlike corporations, which generally issue
stock to their shareholders in exchange for capital to conduct their
operations, accounting firms structured as partnerships obtain capital
from their partners. To conduct an audit of a public company, an
accounting firm establishes an engagement team that is typically headed by
a lead audit partner and includes a concurring audit partner, audit staff
and managers, and, as needed, technical specialists. The lead audit
partner has responsibility for decision making on significant auditing,
accounting, and reporting matters that affect the financial statements;
reviewing the audit work; and maintaining regular contact with management
and the audit committee. The concurring audit partner is responsible for
reviewing the audit.^12

To provide technical assistance to engagement teams, the larger accounting
firms have national offices staffed with experts in auditing and
accounting standards. These national offices are made up of accounting and
auditing technical specialists who assist engagement teams by responding
to complex questions, researching answers, and providing guidance to
individual audit teams. These specialists also provide guidance to the
entire firm on handling issues that arise during the course of audits,
including evaluating the fair presentation of the financial statements.

Mergers and the Loss of a Major Firm Have Resulted in a National and
International Market Dominated by Four Large Firms

Although the largest U.S. accounting firms have used mergers and
acquisitions to help build their businesses and expand nationally and
internationally since the early part of the twentieth century, in the late
1980s the eight largest firms--known as the Big 8--began merging with each
other. As shown in figure 1, by 2000 various mergers among the largest
accounting firms had left five large firms that accounted for the majority
of audit revenues among firms auditing public companies.

^12SEC Release No. 33-8183, Strengthening the Commission's Requirements
Regarding Auditor Independence, 68 Fed. Reg. 6006 (Feb. 5, 2003).

Figure 1: Significant Mergers of the 1980s and 1990s

In 2002, the market consolidated further to 4 large firms after the
Department of Justice criminally indicted Arthur Andersen on obstruction
of justice charges stemming from the firm's role as auditor of Enron
Corporation. The indictment and subsequent conviction of Arthur Andersen
led to a mass exodus of its partners and staff, as well as clients. As a
result, the firm was dissolved in 2002.^13

^13In May 2005, the Supreme Court reversed the criminal conviction of
Arthur Andersen. Arthur Andersen LLP v. United States, 544 U.S. 696
(2005).

Statutory Changes Affecting Requirements for Public Companies and Their Auditors

Public companies and the accounting profession have experienced many
reporting and auditing changes in recent years. In the aftermath of
various financial scandals at large public companies such as Enron and
WorldCom in the early 2000s, new legislation was passed to help restore
investor confidence in the nation's capital markets.^14 The Sarbanes-Oxley
Act of 2002 (the Act) introduced major reforms to public company financial
reporting and auditing that were intended to improve the accuracy and
reliability of financial reporting and enhance auditors' independence and
audit quality. The reforms include the following:

           o Section 404(a) of the Act requires that in each annual financial
           report filed with SEC the management of public companies must (1)
           state its responsibility for establishing and maintaining an
           adequate internal control structure and procedures for financial
           reporting and (2) assess the effectiveness of its internal control
           structure and procedures for financial reporting.

           o Section 404(b) requires that each public company's accounting
           firm must attest to and report on management's assessment of the
           effectiveness of internal control over financial reporting.

           o A separate provision prohibits the company's auditor from
           providing certain nonaudit services, including bookkeeping,
           appraisal services, actuarial services, and internal audit
           outsourcing services.

           o Another provision requires the mandatory rotation of lead and
           reviewing audit partners after they have provided audit services
           to a particular public company for 5 consecutive years.

           The Act also established the PCAOB as a private-sector nonprofit
           organization subject to SEC oversight. PCAOB's mission is to
           oversee the audits of public companies in order to protect the
           interests of investors and further the public interest in the
           preparation of informative, fair, and independent audit reports.
           Table 1 shows other provisions affecting the corporate governance,
           auditing, and financial reporting of public companies.

^14Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (July
30, 2002).

Table 1: Summary of Selected Sarbanes-Oxley Act Provisions Affecting
Public Companies and Accounting Firms

Provision                   Main requirements                              
Section 101: Public Company Establishes the PCAOB to oversee the audit of  
Accounting Oversight Board  public companies that are subject to the       
                               securities laws.                               
Section 201: Services       Registered accounting firms cannot provide     
Outside the Scope of        certain nonaudit services to a public company  
Practice of Auditors        if the firm also serves as the auditor of the  
                               financial statements for the public company.   
                               Examples of prohibited nonaudit services       
                               include bookkeeping, appraisal or valuation    
                               services, internal audit outsourcing services, 
                               and management functions.                      
Section 301: Public Company Listed company audit committees are            
Audit Committees            responsible for the appointment, compensation, 
                               and oversight of the registered accounting     
                               firm, including the resolution of              
                               disagreements between the registered           
                               accounting firm and company management         
                               regarding financial reporting. Audit committee 
                               members must be independent.                   
Section 302: Corporate      For each annual and quarterly report filed     
Responsibility for          with SEC, the chief executive officer (CEO)    
Financial Reports           and chief financial officer (CFO) must certify 
                               that they have reviewed the report and, based  
                               on their knowledge, the report does not        
                               contain untrue statements or omissions of a    
                               material fact resulting in a misleading report 
                               and that, based on their knowledge, the        
                               financial information in the report is         
                               presented fairly.                              
Section 404: Management     This section consists of two parts (a and b).  
Assessment of Internal      First, in each annual report filed with SEC,   
Controls                    company management must state its              
                               responsibility for establishing and            
                               maintaining an adequate internal control       
                               structure and procedures for financial         
                               reporting, and assess the effectiveness of its 
                               internal control structure and procedures for  
                               financial reporting. Second, the registered    
                               accounting firm must attest to, and report on, 
                               management's assessment of the effectiveness   
                               of its internal control over financial         
                               reporting.                                     
Section 407: Disclosure of  Public companies must disclose in periodic     
Audit Committee Financial   reports to SEC whether the audit committee     
Expert                      includes at least one member who is a          
                               financial expert and, if not, the reasons why. 

Source: GAO.

The PCAOB has several responsibilities, including

           o registering public accounting firms that prepare audit reports
           for public companies;

           o establishing auditing, quality control, ethics, independence,
           and other standards relating to the preparation of audit reports
           for public companies;

           o conducting inspections of registered public accounting firms;
           and

           o conducting investigations and disciplinary proceedings of
           registered public accounting firms and those associated with such
           firms.

           Under the Act, SEC was granted oversight and enforcement authority
           over PCAOB and must approve rules proposed by PCAOB for them to
           become effective.^15

           PCAOB is required to annually inspect registered accounting firms
           that provide audit reports for more than 100 issuers and at least
           triennially inspect firms with fewer issuers.^16 It conducted its
           first accounting firm inspections during 2003, but these
           inspections were limited in scope and were performed only on the
           largest firms. Since 2004, PCAOB has conducted full scope
           inspections of accounting firms of all sizes. As required in the
           Sarbanes-Oxley Act, PCAOB has issued individual reports to the
           accounting firms explaining issues identified in the inspections
           and has also issued reports covering common observations from
           their inspection process.^17

           The Sarbanes-Oxley Act also mandated that we study (1) the factors
           contributing to the mergers among the largest accounting firms in
           the 1980s and 1990s; (2) the implications of consolidation on
           competition and client choice, audit fees, audit quality, and
           auditor independence; (3) the effect of consolidation on capital
           formation and securities markets; and (4) barriers to entry faced
           by smaller accounting firms in competing with the largest firms
           for large public company audits. In 2003, we issued our report
           Public Accounting Firms: Mandated Study on Consolidation and
           Competition ( [65]GAO-03-864 ). We concluded in 2003 that the
           audit market was in the midst of unprecedented change. The market
           had become more highly concentrated, and the largest firms, as
           well as other accounting firms, faced tremendous challenges as
           they adapted to new risks and responsibilities, new independence
           standards, a new business model, and a new oversight structure,
           among other things. In many cases it was unclear what the ultimate
           outcome of the changes would be, and we noted that past findings
           might not reflect the future situation. We also identified several
           important issues that we believed warranted additional attention
           and study by the appropriate regulatory or enforcement agencies,
           such as the effect of the existing level of concentration on audit
           price and quality.
			  
^15Pub. L. No. 107-204, S 107, 116 Stat. 745, 765.

^16An issuer is a company that issues or proposes to issue securities that
are registered under section 12 of the Securities Exchange Act of 1934 (15
U.S.C. S 78l) or that is required to file reports under section 15(d) (15
U.S.C. S 78o(d)), or that files or has filed a registration statement that
has not yet become effective under the Securities Act of 1933 (15 U.S.C. S
77a et seq.) and that it has not withdrawn.

^17See PCAOB Release No. 2005-023, Report on the Initial Implementation of
Auditing Standard No. 2, An Audit of Internal Control Over Financial
Reporting Performed in Conjunction with an Audit of Financial Statements
(Nov. 30, 2005); PCAOB Release No. 2007-001, Observations on Auditors'
Implementation of PCAOB Standards Relating to Auditors' Responsibilities
with Respect to Fraud (Jan. 22, 2007); PCAOB Release No. 2007-004, Report
on the Second-Year Implementation of Auditing Standard No. 2, An Audit of
Internal Control over Financial Reporting Performed in Conjunction with an
Audit of Financial Statements (Apr. 18, 2007); and PCAOB Release No.
2007-010, Report on the PCAOB's 2004, 2005, and 2006 Inspections of
Domestic Triennially Inspected Firms (Oct. 22, 2007).
			  
			  Significant Audit and Accounting Standards and Rules Changes Since 2003

           Since 2003, significant activity related to management reporting
           and auditing standards has continued to occur. In 2002, 2003, and
           2004, SEC issued rules and guidance on implementing some of the
           Sarbanes-Oxley Act's provisions. Among these was the requirement
           that a public company's chief executive officer and chief
           financial officer certify in quarterly and annual reports issued
           after August 29, 2002, that their company's financial statements
           fairly present in material respects the company's financial
           condition (Section 302).^18 In June 2003, SEC issued final rules
           to implement Section 404 of the Sarbanes-Oxley Act.^19 Section
           404(a) requires company management, in each annual report filed
           with SEC, to state their responsibility for establishing and
           maintaining an adequate internal control structure and procedures
           for financial reporting and to assess the effectiveness of its
           internal control structure and procedures for financial reporting.
           Section 404(b), which requires the registered accounting firm to
           attest to and report on management's assessment of the
           effectiveness of its internal control over financial reporting was
           implemented later. Public companies whose outstanding stock held
           by the public was valued at $75 million or more--known as
           accelerated filers--were first required to comply with Section
           404(a) and (b) for fiscal years ending on or after November 15,
           2004.^20 Public companies with stock in public hands valued at
           less than $75 million--called nonaccelerated filers--were granted
           several extensions but are now expected to comply with these
           Section 404 requirements over the next 2 years--for Section 404(a)
           in fiscal years ending after December 15, 2007, and for Section
           404(b) in the first annual filing after December 15, 2008.
			  
^18Section 302 specifically requires an officer to certify that he or she
has reviewed the report and that, based on his or her knowledge, the
report does not contain any untrue statement; the certifying officers are
responsible for internal controls; they have made certain disclosures to
the audit committee; and, they have indicated any significant changes to
internal controls subsequent to the date of their evaluation. SEC Release
No. 33-8124, Certification of Disclosure in Companies' Quarterly and
Annual Reports, 67 Fed. Reg. 57276 (Sept. 9, 2002).

^19SEC Release No. 33-8238, Management's Report on Internal Control Over
Financial Reporting and Certification of Disclosure in Exchange Act
Periodic Reports, 68 Fed. Reg. 36636 (June 18, 2003).			
  
           PCAOB issued its first audit standard on December 17, 2003, which
           the SEC approved on May 14, 2004, and, as of August 2007, has
           issued a total of five audit standards. On July 25, 2007, SEC
           approved Auditing Standard No. 5, An Audit of Internal Control
           Over Financial Reporting That is Integrated with an Audit of
           Financial Statements, to replace Auditing Standard No. 2, An Audit
           of Internal Control Over Financial Reporting Performed in
           Conjunction with an Audit of Financial Statements. According to
           PCAOB, Auditing Standard No. 2 was more costly than expected, and
           the related effort involved in complying with it appeared to be
           more than was necessary to conduct an effective audit of internal
           controls over financial reporting. Specifically, PCAOB noted that
           auditors were focusing on minutiae that were unlikely to affect
           the financial statements and that audit programs were not tailored
           to small companies. Auditing Standard No. 5, which is expected to
           address some of the cost issues, became effective for audits in
           fiscal years ending on or after November 15, 2007.

           Other accounting and financial reporting standards and
           requirements have been implemented in recent years. Between
           January 2003 and August 2007, the Financial Accounting Standards
           Board (FASB), which issues the accounting standards that SEC
           recognizes as GAAP for public companies, issued 11 statements
           (Nos. 149 through 159) and revised statement number 123. These
           statements cover a range of topics including financial
           instruments, fair value, and pensions. In addition, other guidance
           has been issued by the FASB emerging issues task force (EITF),
           SEC, and other groups. For instance, FASB issued EITF Issue No.
           06-6, "Debtor's Accounting for a Modification (or Exchange) of
           Convertible Debt Instruments" in November 2006. SEC issued Staff
           Accounting Bulletin Number 108 on September 13, 2006, summarizing
           the views of the staff regarding the process of quantifying
           financial statement misstatements.
			  
^20SEC defines a public company as an accelerated filer if it meets two
conditions. First, it must have a public float of $75 million or more as
of the last business day of its most recently completed second fiscal
quarter. Second, it must have filed at least one annual report with the
SEC. Initially accelerated filers were required to file for years ending
after June 15, 2004, but SEC granted an extension to November 15, 2004.
See SEC Release No. 33-8392, Management's Report on Internal Control over
Financial Reporting and Certification of Disclosure in Exchange Act
Periodic Reports, 69 Fed. Reg. 9722 (Mar. 1, 2004).			  

           These recent changes to accounting and financial reporting
           standards and guidance add to an already highly complex set of
           standards and rules for public company financial reporting.
           Currently GAAP consists of more than 2,000 separate pronouncements
           issued in various forms by numerous bodies including SEC, FASB,
           American Institute of Certified Public Accountants (AICPA), and
           others. SEC Chairman Cox has stated that "our current system of
           financial reporting has become unnecessarily complex for
           investors, companies, and the markets generally."^21 In June 2007,
           SEC established the SEC Advisory Committee on Improvements to
           Financial Reporting to study the causes of complexity and
           recommend ways to make financial reports clearer and more
           beneficial to investors, reduce costs and unnecessary burdens for
           preparers, and better use advances in technology to enhance all
           aspects of financial reporting.
			  
			  With Continued Audit Market Concentration, Large Public Companies
			  See Limited Choices, but No Apparent Significant Effect on Fees

           Despite some reduction since 2002, the overall public company
           audit market has remained highly concentrated. For large public
           companies, the market remains highly concentrated, with the four
           largest accounting firms auditing the financial statements of
           almost all large public companies. However, the audit market for
           smaller public companies has become much less concentrated since
           2002. Larger public companies indicated that the industry
           expertise and technical capability that they sought in an auditor
           generally meant that their choices were limited to the largest
           accounting firms in this highly concentrated market. Those we
           spoke to and surveyed had mixed views on the extent to which the
           current level of concentration adversely affected choice, audit
           prices, and audit quality, but most participants did not see the
           current level of concentration as significantly affecting these
           aspects of competition. Although audit fees have increased and
           public companies' opinions of the adequacy of competition in the
           audit market varied, other factors appear to explain the recent
           fee increases. While the current level of concentration does not
           appear to be having significant adverse effect, the loss of
           another of the larger firms would further increase concentration
           and limit company choices and may affect price competition.
           Regulators overseeing the functioning of the audit market could
           take several actions in response to another large audit firm's
           leaving the market.
			  
^21SEC Press Release No. 2007-123.

           Overall Market for Public Company Audits Remains Highly Concentrated

           To assess the degree of concentration in a market, we used the
           preferred practice of examining the proportion of each competing
           seller's--in this case accounting firms--share of the overall
           revenue collected. In the case of accounting firms, the revenue
           measured is the total amount of fees these firms collected. Using
           data from Audit Analytics, which collects audit fee information
           from the filings public companies submit to SEC, we found that the
           largest firms collected 94 percent of all audit fees paid by
           public companies in 2006, slightly less than the 96 percent they
           collected in 2002. As a result, the overall market continues to
           represent a tight oligopoly, which is a concentrated market in
           which a small number of firms have large enough market share to
           potentially use their market power, either unilaterally or through
           collusion, to greatly influence price and other business practices
           to their advantage.^22

           A key statistical measure used to assess market concentration and
           the potential for firms to exercise market power is the
           Hirschman-Herfindahl Index (HHI).^23 The HHI for a market is
           calculated using the various market shares (in the case of the
           audit market, measured by total audit fees collected) of all the
           firms competing to offer services within that market. In 2006, the
           HHI for the overall market for public company audits was 2,300.
           According to guidelines issued jointly by the Department of
           Justice (DOJ) and the Federal Trade Commission (FTC), an HHI above
           1,800 indicates a highly concentrated market. Analyzing the audit
           market by industry and region reveals that many industries have
           similarly highly concentrated audit markets. For example, in 2006
           the HHI of the audit market in the utilities sector was over
           3,500. The audit market was also similarly concentrated for
           companies across six major geographic regions of the country.^24
           (App. II contains further discussion of overall market
           concentration.)
			  
^22A tight oligopoly is generally defined as a market in which four
providers hold over 60 percent of the market and other firms face
significant barriers to entry into the market.

^23The Hirschman-Herfindahl Index is one of the concentration measures
that government agencies, including the Department of Justice (DOJ) and
the Federal Trade Commission, use when assessing concentration to enforce
U.S. antitrust laws.
			  
           In addition to the potential for dominant competitors to use their
           market power to charge uncompetitive prices, highly concentrated
           markets also raise other competitive concerns. For example, firms
           with significant market power have the potential to reduce the
           quality of their products or to cut back on the services they
           provide because the lack of competitive alternatives would limit
           customers' ability to obtain services elsewhere. Similarly, firms
           that dominate a given market may feel less pressure to introduce
           innovative products and services. Finally, a highly concentrated
           market increases the potential for the dominant firms to engage in
           coordinated actions that can harm clients, such as coordinating
           actions to influence the development of standards that raise costs
           for their customers. However, the presence of high market shares
           does not necessarily mean that anticompetitive behavior is
           occurring. Competition in an oligopoly can also be intense and
           result in a market with competitive prices, innovation, and
           high-quality products.

           Markets with a few large dominant firms can form for natural
           reasons and can also be beneficial. As we reported in 2003,
           several key factors spurred the increased consolidation in the
           market that resulted from the mergers of the eight largest
           accounting firms in the 1980s and 1990s.^25 For example, as U.S.
           corporations have increasingly expanded into global markets, their
           need for accounting firms with greater global reach also
           increased. Many public companies have developed more complex
           operations and financial transactions, such as the increasing use
           of derivatives and other financial arrangements, and these changes
           increased the need for auditors with specialized industry-specific
           or technical expertise.

           Further, some accounting firms wanted to modernize their
           operations, build their staff capacity, and spread their risk over
           a broader capital base, and large firms can achieve greater
           economies of scale by spreading certain fixed costs, such as staff
           training, over an expanded client base. Therefore, the size of the
           largest firms may enable them to develop sufficient technical
           expertise and the ability to conduct work globally to meet the
           needs of complex multinational audit clients and to do so at a
           lower cost than could be provided by smaller audit firms. Some
           academic sources have also suggested that the size of the largest
           firms may give them the ability to resist potential pressure from
           large public company clients to reduce or compromise audit
           quality.
			  
^24We found that the Mid-Atlantic and Midwest regional audit markets were
somewhat more concentrated than the western regions, although all regional
audit markets were highly concentrated.

^25 [66]GAO-03-864 , 12-15.

           Although Smaller Public Company Market Has Become Less Concentrated,
			  Concentration in the Market for Large Companies Persists

           Although the market is concentrated overall, the degree of market
           concentration, and, thus, the extent to which the largest firms
           dominate, declines with the size of public companies. As shown in
           figure 2, the proportion of large public companies audited by one
           of the largest accounting firms has not changed since 2002.
           However, the proportion of the smallest public companies that used
           the largest auditors fell by half from 2002 to 2006. Specifically,
           the share of public companies with less than $100 million in
           revenue audited by the largest firms decreased from 44 percent to
           22 percent over this period. As figure 2 shows, smaller accounting
           firms now serve as auditors for many of the companies that had
           previously used the largest firms. The share of companies with
           revenues between $100 and $500 million that the largest firms
           audited also declined during this period from 90 to 71 percent.
           Officials from the largest accounting firms and other market
           participants told us resource constraints in the aftermath of the
           Arthur Andersen collapse and the Sarbanes-Oxley Act led the
           largest firms to resign from auditing some smaller companies or
           raised their audit fees higher than some smaller companies were
           willing to pay.

           Figure 2: Public Companies and Their Auditors, 2002 and 2006

           Note: Totals do not always add to 100 percent due to rounding.

           As the share of smaller companies audited by the largest firms has
           declined, concentration in the audit market for these companies
           has eased significantly. By grouping public companies by their
           revenues and calculating HHIs for these groupings, we found that
           while the audit market for larger public companies with revenues
           greater than $500 million remained highly concentrated, the market
           for smaller public companies with 500 million in revenue or less
           had become much less concentrated.^26 As figure 3 shows, between
           2002 and 2006 the HHI for the audit market for the smallest public
           companies--those with annual revenues of less than $100
           million--declined from a level of 1,400 to about 800. According to
           DOJ and FTC guidelines, a market with an HHI of less than 1000 is
           considered to be unconcentrated, and no competitor would likely
           have the ability to exert market power. The audit market for
           public companies with revenues between $100 million and $500
           million also became less concentrated. The HHI for this market
           fell from a 2002 level indicating high concentration to a 2006
           level indicating only moderate concentration.
			  
^26Figures do not include a number of companies with missing financial
data. The category of companies with greater than $1 billion in revenue
roughly corresponds to the Fortune 1000 list. In 2006, the smallest
company on the Fortune 1000 list had revenues just over $1.4 billion. As a
result, the $1 billion and over segment shown in the figure includes the
Fortune 1000, as well as other large companies.

           Figure 3: Hirschman-Herfindahl Indexes for Public Company Market
           Segments Grouped by Company Revenues
			  
			  In Concentrated Market, Some Companies Perceive Limited Auditor Choice

           Many of the largest public companies--those in the Fortune
           1000--told us that they generally found the audit firm attributes
           they sought only in the largest accounting firms, and as a result,
           many of these companies saw their number of auditor choices as
           insufficient. Midsize and small companies were generally more
           likely than large companies to report that they had more than
           three choices.
			  
			    Large Public Companies and Auditor Choices

           In the current concentrated market, large companies perceived
           their choices as limited, in part because these companies
           generally said, if they had to choose a new auditor, they were not
           likely to use accounting firms smaller than the largest firms.^27
           Our survey of the audit committee chairs of almost 600 public
           companies based in the United States showed that 86 percent of
           large public companies in the Fortune 1000 were not likely to use
           a midsize accounting firm and that none were likely to use a
           smaller accounting firm as a new auditor of record.^28 In
           explaining their position, these companies most frequently cited
           the auditor's ability to handle the size and complexity of their
           company's operations as being of great or very great importance
           (92 percent). In addition, 80 percent cited the auditor's
           technical capability with accounting principles and auditing
           standards and 67 percent cited the need for industry
           specialization or expertise as of great or very great importance
           as reasons why they would not consider a midsize or smaller
           auditor. Similarly, in interviews and comments on our survey, some
           company officials noted that they chose the largest firms because
           they believed that these firms had the attributes the company
           needed, while midsize and smaller firms did not. For example, the
           audit committee chair of one large company commented that the
           company would not choose a midsize or smaller auditor because the
           company's industry was very complex, and, therefore, the company
           needed an auditor with specific industry experience. The chief
           financial officer (CFO) of another large public company noted that
           because of the company's size and international operations, the
           largest firms were the only viable options.

           The need to comply with independence standards and other factors
           can further limit the number of choices available to large public
           companies for their auditor of record. As required under the
           Sarbanes-Oxley Act, SEC rules, and auditing standards, a company's
           auditor must be independent. Public companies are prohibited from
           obtaining audits from firms that also provide the company with
           certain nonaudit services, including bookkeeping, design and
           implementation of financial information systems, valuation
           services, and internal audit outsourcing services.^29 Ninety-six
           percent of large companies reported that they used one of the
           largest firms for some nonaudit services, potentially further
           reducing the number of choices for their auditor of record if they
           are precluded from using those firms due to independence rules.
           According to our survey data, 27 percent of large public companies
           that had not switched auditors since 2003 reported that the
           independence restrictions on using certain firms were of at least
           some importance in deciding to retain their current auditor,
           although only 9 percent listed these restrictions as of great or
           very great importance.^30
			  
^27For the remainder of this report, we define large companies as those
that are members of the Fortune 1000, midsize companies as those that have
market capitalization of $75 million or greater but are not in the Fortune
1000, and small companies as those with market capitalization of less than
$75 million. Using this definition, 12.6 percent of the 6,906 companies in
our survey population are large, 46.5 percent are midsize, and 40.9
percent are small.

^28Unless otherwise noted, the margin of error for public company survey
results was less than 12 percentage points.

           In interviews, officials from a few large public companies
           indicated that they maintained options while remaining in
           compliance with independence requirements by not using at least
           one of the largest firms for prohibited nonaudit services, in some
           cases by using smaller firms for these services. In this way, they
           hoped to ensure that they would have at least one independent firm
           to choose if they had to change auditors. Some interviewees we
           spoke with suggested that companies using only the largest firms
           for both audit and nonaudit services could be unnecessarily
           limiting their choices because many midsize and smaller firms were
           capable of handling certain nonaudit services.

           A few companies may feel constrained in their choice of auditors
           for other reasons. For example, some companies' desire to avoid
           using a competitor's auditor can reduce the number of choices they
           have, according to several industry participants. However, over 90
           percent of the large companies that responded to our 2003 survey
           were willing to choose a firm as their auditor regardless of
           whether that firm also audited a competitor.^31 Further, some
           market participants and regulators noted that in certain
           industries, large public companies may have more limited choices
           because one or more of the largest firms was not very active in
           those industries. For example, in 2006 one of the largest firms
           held 77 percent of the market for public company audits in the
           agriculture, forestry, fishing, and hunting industry, while
           another of the largest firms had only a 1 percent market share.^32
			  
^29Sections 201 and 2(a)(8) of the Sarbanes-Oxley Act. Nonaudit services
are any professional services provided to a company by a registered public
accounting firm, other than those provided to a company in connection with
an audit or a review of the company's financial statements.

^30The most common reasons large companies reported for retaining their
current auditor included satisfaction with their current auditor, that
auditor's technical expertise compared with other firms, and the burden of
changing auditors. See [67]http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP
for more detailed survey results.			  

           Consistent with reporting that they were not likely to use midsize
           and smaller audit firms, large companies also indicated that they
           had a limited number of firms to choose from, and many believed
           that this number was generally insufficient. According to our
           survey, about 80 percent of large public companies said that they
           would have three or fewer accounting firms (other than their
           current auditor of record) to choose from if they needed to change
           primary auditors. The proportion of large companies that reported
           having three or fewer choices was about the same for both domestic
           and multinational companies. Furthermore, over half (57 percent)
           of large public companies stated that the number of accounting
           firms that they could choose among was not adequate.^33
           Forty-three percent of large public companies that responded to
           the survey we conducted for our 2003 report indicated that they
           had insufficient choices for an auditor of record.

           Large public companies' preference for the largest audit firms was
           illustrated by the firms these companies choose when they changed
           auditors. Although some public companies maintain their
           relationships with the same audit firm for many years, there were
           almost 6,000 changes in auditors between 2003 and 2007. We
           analyzed data from Audit Analytics and found that 102 large
           companies had changed auditors between January 1, 2003, and June
           30, 2007.^34 Of the 95 large companies that were previously
           audited by one of the largest firms, 88 (93 percent) of these
           companies changed from one of the largest auditors to another of
           the largest auditors. Only seven switched to a midsize auditor.
           The remaining seven large companies that changed auditors during
           this period had been previously audited by a midsize or smaller
           auditor, but switched to one of the largest firms. (App. III shows
           more analysis of the data on auditor changes and the reasons these
           companies reported for changing auditors.)
			  
^31The survey for our 2003 report was sent to a random sample of Fortune
1000 companies to collect information on their experiences with their
auditors of record. The response rate for this survey was 64 percent, but
the results were not generalizable to the population of large public
companies. See GAO, Accounting Firm Consolidation: Selected Large Public
Company Views on Audit Fees, Quality, Independence, and Choice,
[68]GAO-03-1158 (Washington, D.C.: Sept. 30, 2003).

^32Appendix II contains more information on concentration by industry
sector.

^33The difference in the percentage of large domestic and large
multinational companies indicating that the choice of accounting firms was
inadequate was not significant.

             Midsize and Small Public Companies and Auditor Choices

           Although many midsize public companies reported that their choice
           of auditors was limited, smaller companies generally reported
           having more choices than larger companies, if they had to change
           auditors. For example, among midsize companies, 59 percent of
           multinational and 52 percent of domestic companies reported that
           their choices were limited to three or fewer firms (fig. 4). In
           contrast, only about one-third (34 percent) of small companies
           indicated that they were restricted to three or fewer accounting
           firms and over 40 percent said that they had six or more choices.
			  
^34The data on auditor changes indicate that large companies change
auditors less frequently than midsize and smaller companies. Between 2003
and 2006, there were approximately 28 changes per year per 1000 companies
among large companies, 84 changes per year per 1000 companies among
midsize companies, and 264 changes per year per 1000 companies among small
companies.

           Figure 4: Percentage of Midsize and Small Companies That Reported
           Having Three or Fewer Choices for Auditor

           Note: The estimate for small multinational companies is subject to
           a sampling error of +/- 16 percentage points.

           Based on our survey, midsize and small public companies were more
           likely than large companies to consider using midsize or smaller
           accounting firms if they had to choose a new auditor. About half
           (51 percent) of midsize companies would consider using midsize
           firms and 16 percent would consider using smaller firms. Further,
           74 percent of small public companies would consider using smaller
           firms.

           In addition, compared with large companies, more midsize and small
           companies were satisfied with the number of choices they had for
           possible auditors. As shown in figure 5, about half of midsize and
           less than a fifth of small companies reported that the number of
           choices they had was not enough.

           Figure 5: Percentage of Small and Midsize Companies Reporting They
           Did Not Have Enough Choices for Auditor

           Note: The estimate for small multinational companies is subject to
           a sampling error of +/- 14 percentage points.

           However, about 60 percent of midsize multinational companies
           reported that they would have three or fewer choices if they had
           to change auditors and about half said the number of choices was
           not enough.

           Our analysis also showed that many midsize and small public
           companies have moved to midsize or smaller auditors. Since 2003,
           over 1,400 midsize and small companies that had been audited by
           one of the largest firms have changed auditors. Of these, almost
           1,100 (about 74 percent) engaged midsize or smaller firms as their
           new auditors and about 360 (about 25 percent) chose another one of
           the largest auditors (fig. 6). In contrast, only 13 percent of
           midsize and small companies that left midsize auditors and 3
           percent of midsize and small companies that left smaller auditors
           subsequently engaged one of the largest firms.

Figure 6: Changes in Auditors among Small and Midsize Public Companies

Although Opinions on the Impact of Concentration in the Large Public Company
Market Varied, Other Factors Appeared to Account for Recent Fee Increases

Opinions varied on the effect of concentration on competition and on the
sufficiency of competition in the market for public company audits. Many
of the market participants we interviewed felt that competition was quite
strong and not significantly affected by concentration. For example,
representatives of the largest firms told us that they competed intensely
with each other. Some of the public company officials we spoke with also
saw the audit market as competitive. For example, the audit committee
chair of one large public company said that although a major competitor
was lost when Arthur Andersen dissolved, the market had adjusted and was
still competitive. However, several companies we surveyed commented that,
with few firms to choose from, the market did not have enough competition.
For example, the CFO of a midsize company said that consolidation in the
market had led to a decline of value-added services by auditors and an
escalation of audit pricing. Another company official that responded to
our survey stated that the audit market was an oligopoly with little price
competition and too little concern for service. The CFO for another
company commented on our survey that something needed to be done to force
more competition, while a different CFO commented that although more
competition was desirable, action to break up the largest firms was not
warranted.

Based on the results of our survey, 57 percent of public companies thought
that the level of competition for audit services for their company was
sufficient. However, while about 70 percent of small companies saw the
level of competition as adequate, only about 40 percent of large Fortune
1000 companies shared this view (fig. 7). About half of midsize companies
saw the level of competition as adequate.

Figure 7: Percentage of Public Companies Indicating That the Level of
Audit Market Competition Was Sufficient

Note: Of the 6,906 companies in our survey population, 12.6 percent were
large, 46.5 percent were midsize, and 40.9 percent were small.

  Factors Increasing Audit Fees

Although highly concentrated markets typically raise concerns about price
competition, our analysis indicated that other factors appeared to explain
the increases in audit fees in recent years. Data on audit fees paid by
public companies show that these fees have increased substantially since
2000, a period that included the dissolution of Arthur Andersen and the
passage of the Sarbanes-Oxley Act. Audit fees have risen for companies of
all sizes and across industries and regions. However, the fee increases,
as a percentage of client company assets, were most dramatic for smaller
companies. Between 2000 and 2006, median fees as a percent of assets more
than quadrupled (a 334 percent increase) for companies with less than $100
million in revenue, more than tripled (a 239 percent increase) for
companies with revenue between $100 million and $1 billion, and almost
tripled (a 190 percent increase) for companies with revenue over $1
billion. After these increases, median fees were about $111,000 for
companies with less than $100 million in revenue, $900,000 for companies
with revenue between $100 million and $1 billion, and $3,156,000 for
companies with revenue greater than $1 billion. Although audit fees
increased significantly on average for all sizes of firms, the amount that
companies spend on audit fees generally remains a small portion of their
overall revenues.

Market participants and others cited various factors that had contributed
to recent fee increases. The most significant factors that staff from the
largest firms cited in interviews were the increasing complexity of
accounting and financial reporting standards and the additional
requirements of new auditing standards that had increased the amount of
work involved in audits and the need for technical expertise. For example,
one of the largest firms noted that the number of experts on staff at the
firm more than doubled between 2003 and 2007. Many market participants
noted similar factors as impacting fees. The largest firms also cited the
increased costs of attracting and retaining talented staff and
specialists. Similarly, midsize and smaller firms reported on our survey
that the top four factors increasing their costs since 2003 were
complexity of accounting principles and auditing standards, additional
requirements of new standards, the time and effort necessary to prepare
for PCAOB inspections, and the costs incurred to hire and train staff.

In particular, the Sarbanes-Oxley Act, which increased the amount of audit
work performed at public companies, was frequently cited as one of the
major factors in the recent fee increases. This legislation introduced a
number of new requirements for audits of public companies, and many market
participants told us that the new requirements accounted for much of the
fee increases since 2002. Representatives from some audit firms we spoke
to said that section 404 of the act had, where implemented, substantially
increased their workload and costs for implementing new methodologies and
staff training. (Section 404 requires the accounting firm to attest to,
and report on, management's assessment of the effectiveness of its
internal control over financial reporting.) In addition, 84 percent of
companies reporting that their audit fees had increased since 2003
indicated on our survey that the audit of internal control over financial
reporting was one of the reasons for the increase. To date, only larger
public companies--which SEC calls accelerated filers--have had to comply
with the new requirements for assessing these internal controls. Smaller
public companies--those considered nonaccelerated filers--are scheduled to
fully comply with the new audit requirements in annual filings after
December 15, 2008, potentially resulting in further increases in these
companies' audit fees.

Independence requirements may also have changed the way some firms price
audits, resulting in rising fees. DOJ officials and others stated that
audit firms were now less likely to price audits as a loss leader in order
to sell nonaudit services because of these requirements in the
Sarbanes-Oxley Act.

  Effects of Concentration on Fee Increases

The results of an econometric model we developed to assess the extent to
which various factors could be influencing audit fees in recent years also
indicated that factors other than concentration appear to explain audit
fees.^35 Our model analyzes the extent to which audit fees paid by public
companies appear to be explained by a variety of factors that could affect
those fees. For example, our model included such variables as the
concentration within the audit market for a particular industry (as
measured by HHI), the size of the company, whether the company's fiscal
year ends during a busy period, whether the company completed a
Sarbanes-Oxley Section 404 internal control audit, the number of times the
company changed auditors, and other factors that could affect the
company's audit fees. Appendix V explains our model in detail.

The results of our model suggested that higher audit market concentration
across individual industries was not associated with higher audit fees.
Specifically, our model found that, in general, public companies operating
in industrial sectors with more concentrated audit markets were not paying
higher audit fees than companies in sectors with less concentrated audit
markets. However, for the largest companies we found some evidence that
audit market concentration within an industry did have a very small effect
on fees.^36 More precisely, after isolating the effect of other factors,
our model results indicated that large companies in industries with audit
markets that were 10 percent more concentrated than the average industry
sector (as measured by HHI) paid on average about half a percent more in
audit fees than other large companies. By comparison, the model results
also indicated, after controlling for other factors, that companies that
completed the Sarbanes-Oxley section 404 internal control audit, which
increased the amount of work done by auditors, paid roughly 45 percent
more in audit fees than companies that did not complete the internal
control audit. This finding was consistent with estimates from other
studies that examined the effect of the implementation of this
requirement. Although factors other than concentration appeared to explain
audit fee levels, the available data did not allow us to conclude that
audit fees were competitive overall or to determine whether individual
companies were charged competitive fees.^37

^35Our analysis is based on a panel data set compiled for over 12,000
companies from 2000 through 2006. The panel data set allowed us to exploit
a number of techniques to increase the validity of the results, including
estimating "random-effect" and "fixed-effect" model specifications. The
fixed-effects model helps to control for the potentially large number of
unmeasured forces that might explain the differences in the audit fees
paid across public companies. As a result, the fixed-effects models were
able to account for over 90 percent of the variation in audit fees. Time
period fixed effects were added to help control for Sarbanes-Oxley and
other factors that have impacted the fees paid by all public companies.
See appendix V for a more complete discussion of our econometric approach,
including model specification, variables used, data sources, estimation
techniques, and limitations.

^36We ran a model with small and large companies and included a variable
that allowed us to differentiate the effect of concentration from larger
companies.When the smallest companies were excluded from the analysis, we
did not find an effect of concentration on fees for the remaining
companies. See appendix V for limitations.

In addition, the analysis we conducted with our model indicated that
individual accounting firms appeared to charge higher fees when they
controlled a large portion of the audit market within a particular
industry, but this finding did not appear to be the result of
anticompetitive pricing. Rather, it appeared that these firms may have
been charging a premium for their industry expertise. We found that the
price premiums received by accounting firms that collected a large share
of the revenues from audits conducted within an industry sector were
similar across all sizes of companies, including those small companies
that typically have many accounting firms to choose from. This suggests
that higher fees are more likely the result of these firms being able to
charge premiums as the result of their industry expertise rather than of
anticompetitive pricing.^38 For example, a firm with industry expertise
may develop and market audit services that are specific to clients in the
industry and that provide a level of service exceeding that provided by
other firms in the same industry. If this is the case, the higher fees
these firms may charge could reflect the specialized service they offer
rather than anticompetitive pricing.

  Other Potential Effects of Concentration

While some market participants expressed concern that concentration in the
audit market could negatively affect audit quality, others said that the
quality of audits had improved in recent years. According to DOJ and FTC
guidance on analyzing market competitiveness, sellers with market power
may lessen competition on dimensions other than price, such as product
quality, service, or innovation. However, even in highly concentrated
markets, including oligopolies, competition among sellers may lead to
innovation and high-quality products. The effect of concentration on audit
quality is difficult to measure empirically. However, we asked market
participants about their views on several aspects of audit quality,
including the experience and technical capability of their accounting
firm's partners and staff, the firm's ability to efficiently respond to
client needs, and its ability and willingness to appropriately identify
and surface material reporting issues in financial reports. Most market
participants who commented on audit quality in our interviews and many on
our survey said that audit quality had improved, which some attributed to
the Sarbanes-Oxley Act.^39 However, four others, including some academics,
a former regulatory official, and an industry consultant with whom we
spoke, expressed concerns that concentration was affecting the quality of
audits. For example, one said that that having only four firms in the
market resulted in low-quality audits that harmed investors. Appendix IV
provides more information on trends in audit costs and quality.

^37Appendix V includes the various limitations of our data and the model
we developed.

^38Since price competition is assumed to prevail in the small client
segment of the audit market because of its low concentration, any premium
from the effect of market power should be competed away. However, premiums
that exist due to brand name reputation or quality-differentiated services
will not be. A number of academic studies on publicly traded U.S. firms
also explained sizeable premiums for the big accounting firms as the
result of product differentiation and brand-name reputation and not of
market power. For a summary see, David Hay, W. Robert Knechel, and Norman
Wong, "Audit Fees: A Meta-analysis of the Effect of Supply and Demand
Attributes," Contemporary Accounting Research, vol. 23, no. 1 (spring
2006).

High concentration may also diminish competition because dominant sellers,
in this case accounting firms, may be more likely or more able to engage
in coordinated interaction in ways that can affect auditing practices or
prices. Some market participants we interviewed expressed concern that the
prevalence of the largest firms on advisory panels or standard-setting
bodies enabled them to coordinate actions to influence the development of
new standards in a way that hampered competition or otherwise
disadvantaged public company audit clients. However, most market
participants we spoke to did not express such concerns.

Further Concentration Could Adversely Affect Audit Fees and Limit Choices

Although the current level of concentration does not appear to be having
significant adverse effect, the potential for further concentration in the
audit market did raise concerns. Further concentration could arise as a
result of several events. For example, audit firms face the risk that
civil litigation could result in their insolvency or inability to continue
operations. Since 1998, audit firms may have paid at least ten settlements
or awards of $100 million or more that have resulted from private
litigation.^40 In addition, a jury recently found BDO Seidman, the
sixth-largest accounting firm, liable for $521.7 million in damages,
although BDO Seidman plans to appeal the verdict. Several officials we
spoke with commented that litigation increases during periods of high
market volatility. As a result, litigation-related costs to auditors could
increase in the case of an economic downturn. Officials from the largest
firms told us that litigation costs have significantly increased since
2003. Some officials we interviewed from the largest firms and the
insurance industry told us that the largest firms do not have insurance
coverage to protect against the largest claims, both because insurance at
that level is not available and because of fear that having more insurance
could induce plaintiffs to seek higher awards. However, full information
on litigation risk and costs and accounting firms' insurance coverage is
not publicly available, so we could not identify the magnitude of the risk
that litigation poses to these firms. Some officials we spoke with also
suggested that litigation could damage a firm's reputation, causing the
firm to fail if its clients began seeking other firms for their audits.
For example, according to some academics, Laventhol & Horwath, the
seventh-largest accounting firm in 1990, declared bankruptcy that year in
part due to a series of class action lawsuits that resulted in a loss of
reputation and the firm's inability to attract new work.^41

^39One objective of the Sarbanes-Oxley Act was to improve auditor
independence and audit quality through stricter limitation on nonaudit
services, the establishment of the PCAOB and its inspection program, and
requirements that auditors assess and report on internal controls over
financial reporting at public companies.

^40Six cases were reported in Aon Professional Risks, "Awards/Settlements:
Analysis of a Selection of Publicly Known Matters Involving Auditors,"
(Montreal, Canada: March 2006.) Some of the reported settlements might not
have been approved by the courts, and some of the reported awards may have
been appealed. Four other cases, the Andersen settlement in the Sunbeam
case, KPMG settlements involving Rite Aid and Lernout & Hauspie, and a
PricewaterhouseCoopers settlement in the Tyco International case, were
widely reported. For these cases, see In re Sunbeam Securities Litigation,
Case No. 98-8258-CIV-Middlebrooks, USDC SDNY, Order Approving Settlement
(Nov. 29, 2001); In re Rite Aid Securities Litigation, 146 F. Supp. 2d 706
(E.D. Pa. 2001); In re Lernout and Hauspie Securities Litigation, Civ.
Act. No. 00-CV-11589 (PBS), USDC Mass, Order and Final Judgment; In re
Tyco Securities Litigation, Stipulation of Settlement, MDL Docket
02-1335-PB, Civ. Case No. 02-866-PB (July 6, 2007). One research
organization examined class action securities fraud filings against
companies in general and noted that new filings, including those that
allege specific accounting allegations (to the extent they could be
identified in complaints and/or press releases), have generally declined
since 2004. See Cornerstone Research, Securities Class Action Case
Filings, 2007 Mid-Year Assessment (July 2007) and Cornerstone's previous
yearly reports.

^41See, for example, Lawrence A. Cunningham, "Too Big to Fail: Moral
Hazard in Auditing and the Need to Restructure the Industry Before It
Unravels," 106 Columbia Law Review 1698 (2006).

Firms also face the risk of failure from federal or state regulatory
action and criminal prosecution, among other reasons. State Boards of
Accountancy can revoke accounting firms' licenses to practice in their
state for violating board rules or for other reasons. Under SEC rules,
convicted felons shall be suspended from practicing before the SEC, so an
accounting firm convicted of a felony could not continue to audit its
SEC-registered clients and would likely fail. Further, an indictment for a
felony could contribute to a firm's failure if clients began leaving in
anticipation of a potential conviction. For example, many of Arthur
Andersen's clients had changed to a different auditor even before Arthur
Andersen was convicted of obstruction of justice for destroying
Enron-related documents in 2002. The market for public company audits
could also become significantly more concentrated if any of the existing
largest or midsize firms chose to discontinue operations for other
reasons. Mismanagement of a firm's financial obligations could also lead
to its bankruptcy.

As has happened in the past, a merger could also lead to further
concentration in the market. DOJ and the Federal Trade Commission
published Horizontal Merger Guidelines for use in determining whether a
merger is likely substantially to lessen competition. The guidelines
include steps for assessing whether the merger would significantly
increase concentration, the potential for any of the firms to exercise
market power after the merger, and the difficulty of entry into the market
for new firms. Concerns that DOJ raised about a proposed merger of
accounting firms in the late 1990s suggest that the agency would be less
likely to approve any future mergers among the largest accounting firms.
In 1997, shortly after two of the six largest firms at the time,
PriceWaterhouse and Coopers & Lybrand, announced their intention to merge,
two of the other six largest firms, KPMG Peat Marwick and Ernst & Young,
also announced plans to combine their operations. According to the DOJ
Antitrust Division's 1999 Annual Report, these two firms abandoned their
plans to merge after DOJ raised concerns that this merger would have
"adversely affected competition by reducing the already limited number of
firms providing auditing services to Fortune 1000 companies."^42

The loss of another large accounting firm from the audit market could
significantly increase the level of concentration. If one of the largest
firms failed or left the market, concentration would increase if many of
this firm's public company clients engaged one of the remaining three
largest audit firms. To illustrate the effect of such an event, we
simulated the effect of the failure or exit of the smallest of the largest
firms. To redistribute the clients of this firm, we assigned them to other
firms in the same proportion as the clients of Arthur Andersen were
distributed after that firm dissolved.^43 Under this scenario, the
resulting HHI of the overall audit market would rise from 2,300 to roughly
3,000, substantially above what DOJ considers to be a highly concentrated
market. The increase in HHI would likely be even greater in the large
public company market. Higher concentration could increase the risk that
the remaining large accounting firms would exercise market power to raise
prices and coordinate their actions among themselves to the detriment of
their clients. Appendix II contains more information on our simulations of
the result of the loss of one of the largest firms through a failure or a
merger.

^42Regulators from outside the United States, including those from
Australia, Canada, and the European Union, had also begun investigations
of the proposed merger.

Further concentration could have various other negative effects on public
companies and their investors. While many public companies and other
market participants indicated that there were enough auditors to choose
from, further concentration would leave large companies with potentially
only one or two choices for a new auditor, as our survey indicated that 86
percent of large companies would likely only use one of the largest
auditors if they had to switch auditors. Many interviewees said that this
would not be enough choices. As in the current market, independence rules
that prevent companies from using as their auditor firms that provide them
with certain nonaudit services could further limit these choices. Also,
companies in specialized industries could have fewer choices if some
accounting firms do not operate in those industries. Many we interviewed
also suggested that further concentration would reduce competition and
potentially increase the cost of an audit.

Further, public company officials stated that changing auditors could be
costly for the companies involved. According to our survey results, 44
percent of large companies that had not recently changed auditors reported
that the burdens of time, effort, and cost were of great or very great
importance in their decision not to change auditors. In addition, only 102
large (Fortune 1000) public company auditor changes occurred between
January 2003 and June 2007, suggesting that large companies preferred to
use the same auditor from year to year. If the market were further
concentrated among three large firms, the affected companies would need to
change auditors and incur the associated costs. Similarly, to the extent
the remaining largest firms resigned as auditors for smaller clients as
they absorbed the failed firm's larger clients, these small companies
would incur the costs of finding a new auditor. Finally, the market
disruption caused by a firm failure or exit from the market could affect
companies' abilities to obtain timely audits of their financial
statements, reducing the audited financial information available to
investors.

^43In this simulation, we assumed that surviving firms would keep all of
their current clients even after picking up clients from the failed firm.
If some firms would shed clients to midsize or smaller firms as they add
clients from the failed firm, the effect on concentration could be lower.

Regulators Could Act to Mitigate the Effects of Further Concentration

If the number of large accounting firms were to decrease, the
organizations with oversight responsibility for the public company audit
market could act to mitigate the effects on the market. The organizations
that have a role in overseeing aspects of the public company audit market
include SEC, PCAOB, and DOJ. SEC is responsible for protecting investors,
maintaining efficient markets, and facilitating capital formation and also
oversees PCAOB. Similarly, PCAOB is responsible for overseeing the
auditors of public companies in order to protect the interests of
investors and further the public interest in the preparation of
informative, fair, and independent audit reports. In the event of the loss
of one of the largest firms, the agencies' actions could vary according to
the facts and circumstances of the situation, such as the size of the
affected firm, the reason the firm left the market, or the degree to which
an orderly transition of audit services was available. For example, in
order to support its mission and address temporary market disruptions and
difficulties companies had in meeting financial reporting deadlines when
Arthur Andersen was indicted in 2002, SEC issued a number of measures
providing guidance and regulatory relief to Arthur Andersen's clients.
This rulemaking provided Arthur Andersen clients with extended deadlines
to submit audited financial statements and hotline numbers for companies
and investors to call with questions.^44 Through the International
Organization of Securities Commissions (IOSCO), SEC is also working with
other securities regulators around the world to identify possible actions
regulators could consider in responding to events affecting the
availability of audit services and to develop information for regulators
to consider in contingency planning and crisis management.

^44SEC Release No. 33-8070, Requirements for Arthur Andersen LLP Auditing
Clients, 67 Fed. Reg. 13518 (Mar. 22, 2002).

Although it does not have a direct role in addressing the loss of a large
accounting firm from the market, DOJ would have a role in reviewing
proposed mergers involving accounting firms. As part of ensuring
competition in the U.S. economy, the Antitrust Division of DOJ is
responsible for enforcing antitrust laws. Under DOJ merger guidelines, the
division would challenge any merger likely to substantially lessen
competition. DOJ officials explained that action on their part would only
occur if a merger among current competitors was proposed or if an
antitrust or criminal case was brought against one of the firms. As a
result, the division has not been formally reviewing trends in the market.
When asked whether the Antitrust Division might review the competitiveness
of the market if one of the largest firms exited the market for reasons
other than a merger, an official stated that the division might analyze
the market using publicly available information and offer its expertise
and advice to other regulators. However, the division does not have the
authority to formally investigate the market or request proprietary
information from firms or companies in such a situation.

Midsize and Smaller Firms Face Challenges Auditing Public Companies, and Growth
in These Firms Is Unlikely to Ease Concentration in the Large Public Company
Audit Market

Growth in the capacity of midsize and smaller audit firms is unlikely to
reduce concentration in the large company audit market, at least in the
near term, for two reasons. First, our survey and interviews with
representatives of these firms suggest that over 70 percent of midsize and
smaller firms are not interested in expanding their market share by adding
additional large public company audit clients because they would face
additional risks and give up existing profitable activities to do so.
Second, firms that do want to audit large public companies continue to
face challenges to expanding their public company practices. Chief among
these challenges are having adequate capacity (e.g., staff and geographic
coverage) to audit large public companies, acquiring the needed technical
capability and industry specialization, and developing name recognition
and a reputation for this kind of work. Similar challenges also affect
midsize and smaller firms that audit small and midsize public companies.
Some firms are taking actions to reduce certain challenges, such as
increasing their geographic reach by joining networks and affiliations.
But many firms and market participants we interviewed also said that the
growth of smaller firms was unlikely to ease concentration in the market
for auditors of large public companies.

Midsize and Smaller Firms Face Several Disincentives and Challenges to Entering
the Large Public Company Audit Market

While most midsize and smaller audit firms expect to grow in the next five
years, only a small number want to enter or expand their share of the
large company audit market, in part because they would face additional
risks and forego currently profitable nonaudit activities to do so.
According to our survey of the 118 accounting firms with at least 5 public
company clients, the 4 midsize firms and 79 percent of the smaller firms
that responded expected to increase the number of public companies they
audited in the next 5 years.^45 However, when asked if they would consider
expanding their market share if they had the opportunity to add acceptable
clients, 74 percent of both midsize and smaller firms said that they were
not interested in serving as auditor for additional large public
companies.^46 Some firms and market participants told us that the
possibility of being sued created a disincentive against entering or
expanding in the audit market for large companies because the failure of
one large client could jeopardize the audit firm. Large companies can pose
a greater financial risk to their auditors than smaller clients. The
amount shareholders recovered in settlements of class action lawsuits
against public companies and their auditors tends to increase in
proportion to the company's market capitalization. Midsize and smaller
firms also may not be seeking to perform audits of large public companies,
because they have had new opportunities to provide companies of all sizes
with nonaudit services, such as consulting, since 2003. The Sarbanes-Oxley
Act's independence standards prohibit firms from providing clients whose
financial statements they audit with some of the nonaudit services that
they were accustomed to providing. As a result, many smaller firms have
moved into this area. However, 21 percent of midsize and smaller firms
said that they would be willing to enter or expand their share of market
for auditing large companies, given the opportunity and acceptable
potential clients, but emphasized the challenges they faced in doing so.

  Firm Capacity to Audit Larger Companies

According to midsize and smaller firms responding to our survey, their
capacity to audit large public companies poses the greatest challenge to
them entering this market and reducing its concentration. According to our
survey, the firms' capacity is the top reason that large public companies
give to explain why they would not consider using a midsize or smaller
firm. Specifically, 92 percent of those companies said that the inability
of midsize and smaller firms to handle their company's size and complexity
was of great or very great importance in their unwillingness to consider
them (fig. 8).^47 For example, the audit committee chairman of a large
technology manufacturing company we interviewed said that an auditor
smaller than the company's current large firm could not audit a business
of his company's size. Similarly, the audit committee chair for a large
automobile manufacturer told us that large companies did not consider
using midsize firms because those firms did not have the number of
experienced staff that the firms had.

^45Accounting firm survey data in this report does not include the
responses of the largest firms, or firms with four or fewer audit clients
unless otherwise noted. Also, data for smaller firms refer to survey
respondents only and cannot be generalized to all smaller firms because of
low response rates for this group.

^46Fifty percent of midsize firms and 75 percent of smaller firms we
surveyed said that they were not interested in serving as auditor for
additional large public companies.

Figure 8: Firms' Challenges in Auditing Large Public Companies

To meaningfully reduce concentration in the large public company market,
then, midsize and smaller firms would need to staff audit teams that were
large enough to serve multiple large public companies. However, these
firms face challenges recruiting and retaining staff. As we reported in
2003, it is not uncommon for an audit of a large national or multinational
public company to require hundreds of staff, and most midsize and smaller
firms do not have the staff resources necessary to commit hundreds of
employees to a single client. As table 2 illustrates, the largest firms
have significantly more capacity, in terms of staff and partners than
midsize and smaller firms.

^47Public company survey statistics are accurate within 12 percentage
points, unless otherwise noted.

Table 2: Largest, Midsize, and Smaller Accounting Firm Capacity, 2006

                                                                       Public 
                                                 Professional         company 
Firm                               Partners^a      staff^b Offices clients 
Largest                                                                    
Deloitte & Touche LLP                   2,654       26,960      98   1,377 
Ernst & Young LLP                       2,100       17,200      83   1,743 
PricewaterhouseCoopers LLP              2,069       21,409      84   1,347 
KPMG LLP                                1,664       14,038      89   1,210 
Midsize                                                                    
McGladrey and Pullen LLP^c                775        4,567     125     103 
Grant Thornton LLP                        444        3,575      48     411 
BDO Seidman LLP                           240        1,803      34     301 
Crowe Chizek & Company                    129        1,458      20     104 
Smaller^d                                                                  
Average of sample of smaller firms         46          332       8      20 

Source: Public Accounting Report, 2006-2007.

^aEquity partners, including those who do not work on audits.

^bNonequity partners and professionals.

^cRSM McGladrey and McGladrey & Pullen are affiliated through an
alternative practice structure. The number of offices includes those for
RSM McGladrey, which is a subsidiary of H&R Block and performs tax and
consulting services and for McGladrey & Pullen, which performs audit
services.

^dSample of smaller firms that audit at least one public company.

To approach the capacity of the largest firms, midsize and smaller firms
would have to grow substantially. The gap between the largest and midsize
firms is significant, however. Combined, the four midsize firms still have
over 2,600 fewer professional staff than the smallest of the largest
firms, KPMG. The midsize firms also have significantly fewer public
company clients. But midsize and smaller firms told us that obtaining
additional staff to expand their audit practices was difficult.
Specifically, 58 percent of midsize and smaller firms responding to our
survey that want to audit large public companies said that the ability to
recruit and retain qualified staff was a great or very great impediment to
expansion. While the representatives from the largest firms told us that
they also faced this challenge, one smaller firm representative said
obtaining sufficient numbers of staff was particularly difficult for
smaller firms, which have fewer resources (salaries and benefits) to use
in competing for talent with the largest firms, the public companies
themselves, and others needing public accountants. According to many
market participants we interviewed, the demand for qualified accountants
has increased significantly in recent years because accounting firms,
including the largest firms, need additional staff to conduct the audits
of internal controls required in section 404 of the Sarbanes-Oxley Act.
Firms are not only competing with each other for staff, but also with
public companies that need additional accounting staff to comply with
certain requirements of Sarbanes-Oxley. In addition, firms are competing
with regulators who need more staff to oversee the accounting profession.
In the face of this increased demand, hiring such staff has become more
expensive.

Constraints on midsize and smaller firms' geographic reach also reduced
the likelihood that the growth of these firms will reduce concentration in
the large company market. As table 2 shows, midsize and smaller firms
generally have fewer offices than the largest firms. Accounting firm
representatives also told us that these firms have a smaller presence in
foreign countries than the largest firms. According to our survey, 66
percent of large companies that would not consider using a midsize or
smaller firm said that these firms' geographic presence was of great or
very great importance in explaining their unwillingness to do so. Large
multinational companies in particular need auditors that have a presence
in all of the countries in which they operate. While many midsize and
smaller firms partner with other independent firms to expand their
geographic reach, a few company officials we interviewed said that most of
the international networks these firms belong to are not extensive enough
to meet their companies' needs. In addition, many market participants we
interviewed were concerned that the quality standards, practices, and
internal controls of these networks and affiliations might be less uniform
than those prevailing in the international networks of the largest firms.

Accounting firm representatives we interviewed had mixed views on the
global capabilities of midsize and smaller firms. In spite of companies'
views on the importance of firms' abilities to provide global services,
only one-third of midsize and smaller firms responding to our survey that
want to audit large public companies said that their firms' international
reach was a great or very great impediment to expansion. For example, one
accounting firm official told us that midsize firms and affiliations had
good global capabilities and global operations. However, another
accounting firm official told us that the global networks used by midsize
and smaller firms needed to add standardized quality controls in order to
improve.

  Technical Capability and Industry Specialization

The technical capabilities and specialized industry knowledge of midsize
and smaller firms that want to enter the large public company market can
also limit these firms' ability to enter this market and reduce its
concentration. According to our survey, 80 percent of large public
companies that would not consider using a midsize or smaller firm said
that such firms' technical capabilities with accounting principles and
auditing standards was a great or very great reason why they would not do
so. One official from a large public company whom we interviewed said that
accounting firms' technical capabilities differentiate the largest and
smaller firms and that smaller firms did not have the resources to keep up
with changing auditing standards and increasingly complex accounting rules
around the world. Other company officials we interviewed also said that
technical capabilities were an important reason why large and complex
companies do not use midsize and smaller firms.

Several representatives of smaller accounting firms also told us that
their firms had difficulty maintaining their technical capabilities. For
example, one representative of a smaller firm noted that his firm had less
depth in terms of technical expertise than larger firms especially when it
came to complex transactions. Other firms said that maintaining technical
expertise was time-consuming and costly. Two representatives of smaller
firms noted that keeping up with new standards and guidance from multiple
sources was also difficult, requiring the firms to revise guidance for
their staff as new standards were implemented or to purchase costly
prepared guidance materials from external sources. However, firms see this
as less of an issue than do their clients. Only 21 percent of accounting
firms responding to our survey that want to audit large companies said
that the complexity of accounting principles and auditing standards were a
great or very great impediment to expansion, compared to 80 percent of
clients.

In addition, having sufficient industry expertise can be challenging for
firms that want to audit large public companies. According to our survey,
67 percent of large public companies that would not consider using midsize
and smaller firms said that such firms' industry specialization or
expertise was of great or very great importance in their unwillingness to
do so. Some large public companies told us that they needed this kind of
industry expertise in their auditor. For example, the audit committee
chairman for a large insurance company told us that when he chooses an
audit firm, industry expertise was the most important factor he
considered. He said that his company's audit firm must have experience
with other companies in the insurance industry and doubted that midsize or
smaller firms could meet these requirements.

Several representatives of smaller accounting firms whom we interviewed
said that industry expertise was a significant barrier to auditing large
public companies. For instance, a representative of one smaller accounting
firm noted that before accepting a new client, her firm was very careful
to ensure that it has the right expertise to do the audit. She said that
since the firm's expertise was in distribution and manufacturing, the firm
would not accept a financial institution client. An official from another
midsize firm told us that industry specialization was important because
audits were not commodities. Instead, these accounting firms specialized
in certain industries and had particular areas of expertise. This emphasis
on industry expertise can limit midsize and smaller firms' ability to
expand their businesses to serve companies that operate in industries
outside of their specialty. However, only 17 percent of accounting firms
responding to our survey that want to audit large companies said that
specialized technical or industry expertise was a great or very great
impediment to expansion.

  Accounting Firm Reputation

Another major barrier to midsize and smaller firms' ability to obtain
large company clients is that these auditors do not have the reputations
the largest firms enjoy. According to our survey, 65 percent of large
companies that would not consider using a midsize or smaller firm said
that reputation or name recognition were great or very great reasons that
they were unwilling to do so. In addition, company officials told us that
they were confident that the largest firms could meet their companies'
audit needs because these auditors had well-established reputations for
quality. These officials were less familiar with the smaller firms' work
and thus were uncertain about the ability of such a firm to adequately
serve their companies. Market participants told us that conducting due
diligence on unfamiliar firms was time-consuming, in part because
information was not readily available. Furthermore, although PCAOB has
begun inspecting accounting firms' audit work, many market participants we
interviewed said that the information currently available from the PCAOB
inspection reports was not sufficient to judge a firm's audit
capabilities. For example, some noted that part of the inspection results
were not published, inspection reports were not always timely, and PCAOB
did not make an overall judgment on a firm's quality.^48

Companies are also responding to their perceptions of investors'
preferences when they choose one of the largest auditors. According to our
survey, 54 percent of large companies that would not consider using a
midsize or smaller firm said that the expectations or requirements of
shareholders, banks, lenders, or the underwriters that help the company
raise capital were of great or very great importance in their
unwillingness to do so. Institutional investors and investment banks often
use a company's financial statements and audits as the starting point in
an investment decision and want to have confidence in the auditor that
reviewed the financial statements. Similarly, representatives from an
investment bank and an institutional investor told us that they preferred
auditors with established reputations because of a lack of familiarity
with capabilities of most midsize and smaller firms. One company official
we interviewed said that she did not know why a larger company would not
want to use one of the largest firms, given that these firms' name
recognition provided underwriters with a certain comfort level. In
addition, investment bank representatives told us that they want companies
to use auditors with sufficient financial resources to withstand a
liability judgment against them. For example, if an investment deal
falters, the investment bank or underwriter may have to assume more of the
settlement costs if the audit firm cannot bear its share. Furthermore, one
investor told us that the largest firms' greater financial resources made
them better able to survive a large client's failure.

^48We did not evaluate PCAOB's inspection program for this report.

Midsize and smaller firms agree that name recognition and reputation pose
a challenge to entering the audit market for large companies. Fifty
percent of accounting firms responding to our survey that want to audit
large companies said that name recognition or reputation with potential
clients was a great or very great impediment to expansion. Similarly, 54
percent of these firms cited name recognition or credibility with
financial markets and investment bankers as a great or very great
impediment to expansion. In addition, some accounting firm representatives
we interviewed said that midsize and smaller firms have had fewer
opportunities to compete with the largest firms for large companies'
business and do not have well-established reputations. However, one
midsize firm representative noted that reputation should become less of an
impediment as more companies moved from the largest firms to smaller firms
and these firms' work became better known.

An analysis of data on firms that audit initial public offerings (IPOs)
illustrates investors' preferences for the largest firms in certain
situations. While midsize and smaller firms' combined share of the IPO
market has grown progressively, rising from 18 percent to 40 percent since
2003, the largest firms have consistently audited the majority of IPOs
(fig. 9). Staff from some investment firms that underwrite stock issuances
for public companies told us that in the past they generally had expected
the companies for which they raised capital to use one of the largest
firms for IPOs but that now these organizations were more willing to
accept smaller audit firms. For example, an official from one investment
firm told us that the firm now generally accepted two of the midsize audit
firms for IPOs or securities issuances. However, as figure 9 shows, most
of the companies that went public with a midsize or smaller auditor were
smaller. In addition, these firms' share of IPOs of larger companies
(those with revenues greater than $150 million) rose from none in 2003 to
about 13 percent in 2007.

Figure 9: IPOs, 2003-2007

Note: Changes in the business environment and audit market during this
period make judgments based on year-to-year comparisons difficult.

Midsize and smaller firms responding to our survey indicated that they had
had mixed experiences assisting clients with IPOs. All of the midsize
firms and 82 percent of smaller firms responding to our survey had
assisted new and existing clients with an IPO or subsequent securities
issuance. However, two of the four midsize firms, as well as 36 percent of
the smaller firms, reported losing clients that wanted another firm, often
one of the largest firms, to help them prepare for an IPO or subsequent
securities issuance.

Similar Challenges Affect Midsize and Smaller Accounting Firms in the Market for
Small and Midsize Companies

Midsize and smaller accounting firms responding to our survey said that
they faced challenges even in competing in the market for smaller public
company audits. Our survey respondents in this market generally reported
that the challenges they faced were significant impediments to increasing
the number of public companies they served. As shown in figure 10, these
challenges, such as firms' capacity, global reach, and technical
capability or expertise, are similar to those facing midsize and smaller
firms that want to audit large companies.

Figure 10: Midsize and Smaller Firms' Challenges in Auditing Small and
Midsize Companies

To increase their capacity and geographic reach, accounting firms need the
financial capital to hire new staff or acquire other audit firms, but
capital constraints and expansion costs pose an impediment to growth for
some midsize and smaller firms. While this constraint could affect firms
of all sizes, midsize and smaller firms have fewer partners from whom they
can obtain capital. Of the midsize and smaller firms responding to our
survey that focus on smaller companies, 65 percent said that the costs of
hiring and training additional staff were a great or very great impediment
to expansion. According to an accounting firm representative we
interviewed, some smaller firms can be constrained from raising capital to
expand their businesses because of the partnership structure, which
requires individual partners to pool their own assets or assume debt for
acquisitions and other growth activities, such as hiring new staff.
However, one midsize firm representative said that raising capital for
expansion was not an impediment for his firm.

Smaller firms responding to our survey also told us that complying with
the many different requirements individual states impose could hinder
their efforts to audit clients with operations in multiple states. Each of
the 50 states and 5 U.S. territories have state boards of accountancy that
have sole authority for establishing licensing requirements for certified
public accountants in their jurisdictions. If a company's business
operations extend across state lines, auditors may need to get temporary
certifications in each of the states where they will conduct audit work.
These requirements can range in complexity and cost among the several
states. Some firms we interviewed said that complying with multiple state
licensing requirements was difficult and often expensive. However, only 27
percent of midsize and smaller firms responding to our survey that focus
on smaller companies said that varied state licensing requirements were
great or very great impediments to expansion. Furthermore, some
representatives of accounting firms whom we interviewed said that multiple
state requirements did not stop them from competing for new clients.

Smaller Audit Firms Are Taking Actions to Expand Their Market Share, but
Challenges Remain

Many midsize and smaller firms have taken steps to reduce the challenges
that they face and have successfully expanded their share of the audit
market for small and midsize companies somewhat in recent years. In some
cases, these firms have expanded their audit practices in niches that
allow them to use their expertise, rather than attempting to serve clients
in new industries. Some midsize and smaller firms told us that, while
having staff with a certain type of expertise could be a barrier in trying
to serve all types of companies, it did not hinder them if they focused on
a more select set of industries. They said that this approach had allowed
them to build their reputations in specialty areas, which may enable them
to acquire progressively larger clients, and grow incrementally. Other
firms told us that they had expanded their practices through mergers and
acquisitions, adding new industry expertise, increasing their capacity,
and extending their geographic reach. Smaller firms that responded to our
survey generally viewed this approach as effective for increasing the
number of companies they audited, with 73 percent saying that it was at
least somewhat effective. Some representatives of midsize firms whom we
interviewed also said that acquisitions were an effective way to expand
into regions where they did not already have an office.

While funding for expanding midsize and smaller accounting firms typically
came from loans from financial institutions, merging with other accounting
firms, or the personal resources of the firm's partners, a small number of
firms are using a different method of increasing their access to capital.
These firms have established alternative practice structures, in which the
firm engaged in attest services is closely aligned with another
organization that performs other nonaudit services. One example is where
owners of the accounting firm sell the nonaudit portion of their practice
to a new entity, which may be publicly or privately owned. The work the
firm previously conducted is then essentially divided into two separately
controlled entities, one of which conducts most of the firm's nonaudit and
attest work, while the other conducts audits. Owners of the audit firm are
also employees of the nonaudit entity, and the audit firm generally leases
employees, office space, equipment, administrative support, and other
services from this entity. Audit firms gain additional access to capital
from the initial sale of the nonaudit entity or loans from the new entity
that they can use for acquisitions and other growth activities. However,
some firms with alternative practice structures told us that getting
approval for their organizations from some states was challenging and that
they were subject to additional scrutiny because their uncommon structure
raised concerns about independence.^49 In addition, 63 percent of midsize
and smaller firms responding to our survey said that alternative practice
structures would only be slightly or not at all effective in helping them
increase their market share.

Finally, according to representatives of two accounting firm networks and
affiliations of independent firms, these organizations help midsize and
smaller firms deal with some of the challenges they face. As we have seen,
some midsize and smaller firms join these networks in order to extend
their geographic reach. In two cases that we reviewed, we found that the
structure of these organizations varies widely. One organization was
described as having a focused mission and high standards that member firms
must continuously meet, while a representative from another said that the
organization functioned primarily as a vehicle to share best practices and
refer business to other member firms. All midsize firms and over 60
percent of smaller firms responding to our survey belonged to a network or
affiliation, generally to increase competitiveness with larger firms and
extend their national and international reach. One network representative
we spoke to told us that the network's main benefit was its ability to
serve clients that were expanding, especially internationally, by
partnering with other firms in the network. In interviews, officials from
two smaller firms also told us that networks and affiliations provided
opportunities to serve new clients either by partnering with other firms
or through referral services.

^49Auditor independence is a frequently cited concern about alternative
practice structures, and the American Institute of Certified Public
Accountants (AICPA) has established additional independence rules for them
to ensure that attest services can be performed with objectivity and will
protect the public interest.

Midsize and smaller firms that responded to our survey had mixed views
about the ability of these networks and affiliations to help increase
their market share. Some market participants thought that networks' value
could be limited because, unlike the global networks of the largest firms,
the member firms of these networks and affiliations did not share a common
set of methodologies or internal controls. In general, the firms in
networks wanted to maintain their individuality in order to avoid being
held liable for another firm's audit work. In addition, officials from two
smaller firms that are members of a network expressed concern that the
proposed independence standards of the International Federation of
Accountants--the global organization for the accounting profession that
develops international standards on ethics, auditing and assurance,
education, and public sector accounting standards--could present
additional challenges for networks because of the broad way that the
standards define networks.^50 Officials with the International Federation
of Accountants told us that the standards were still under consideration
and that comments and concerns from accounting firms on this issue were
still under review.

While the practices discussed above have helped smaller accounting firms
to reduce some of the challenges they face, certain barriers are likely to
persist, particularly in the market for large company audits. While
focusing on niche markets can deepen a firm's expertise, just as mergers,
acquisitions, and networks can increase firms' capacity and geographic
reach, midsize and smaller firms are still much smaller than their large
firm competitors and have much less experience in the large company audit
market. Some market participants think that building up smaller firms'
capacity, experience, and reputation to serve large companies is likely to
be a long-term process, thus their growth is unlikely to ease
concentration.

^50The International Ethics Standards Board for Accountants, an
independent standard-setting body within the International Federation of
Accountants released an exposure draft, Code of Ethics for Professional
Accountants, for comment in December 2006.

Proposals for Addressing Concentration and Increasing Market Share for Smaller
Auditors Have Significant Disadvantages

Over the years, academics, industry groups, and other market participants
have offered a range of proposals that are intended to reduce the risks of
current and further concentration, or address the expansion challenges
facing midsize and smaller audit firms. We considered a number of these
proposals and found that, while each could offer certain benefits, each
proposal also presents at least some significant disadvantages, and market
participants generally saw these proposals as having limited
effectiveness, feasibility, and benefit. Since the current level of
concentration does not appear to be having significant adverse effect, and
the proposals we reviewed were generally not seen as effective in
addressing the risks of concentration or challenges facing smaller firms
without serious drawbacks, we found no compelling need to take action.

Proposals Others Have Made for Reducing the Risks of the Current Level of
Concentration Involve Trade-offs

Several proposals have been offered to reduce the risks of the current
level of concentration, including mandatory audit firm rotation, audit
firm financial statement disclosure, and breaking up the largest firms
into more firms.

  Mandatory Audit Firm Rotation

Some academic and industry sources have suggested that requiring public
companies to periodically change auditors could reduce the current level
of concentration. Such mandatory audit firm rotation would limit the
period of years that an accounting firm could serve as the auditor for a
particular public company. Our survey results show that companies often
retain their auditors for long periods of time.^51 For example, according
to our survey results, approximately 40 percent of public companies had
used their current auditor for at least 5 years, and almost a quarter had
used their current auditor for at least 10 years.^52 While generally
proposed as a means of enhancing auditor independence by periodically
bringing in a new auditor for a "fresh look" at a company's financial
statements, mandatory rotation could potentially reduce concentration to
the extent that it provided more opportunities for midsize and smaller
firms to compete to provide audit services to public companies.

^51Unless otherwise noted, the margin of error for public company survey
results was less than 12 percentage points.

^52Large companies were more likely than small and midsize companies to
retain their auditor for at least 10 years (47 percent and 20 percent,
respectively).

Although mandatory auditor rotation would increase opportunities to
compete, it would not increase the number of viable competitors, and views
on its effectiveness as a means of reducing concentration were mixed. For
example, 44 percent of midsize and smaller firms responding to our survey
stated that mandatory rotation would be at least a somewhat effective way
for their firms to gain more public company clients, and 52 percent of
respondents thought that it would be only slightly or not at all
effective.^53 One person we interviewed noted that mandatory rotation
might not be feasible, since some companies had very limited choices due
in part to the restrictions of independence requirements. Another market
participant noted that mandatory rotation would not necessarily reduce
concentration because large public companies would likely just rotate to
another one of the largest firms. In a 2003 report on the potential
effects of mandatory audit firm rotation, we found similar results.^54
Based on surveys we conducted for that report, 83 percent of accounting
firms that audit 10 or more companies and 66 percent of Fortune 1000
public companies stated that under mandatory auditor rotation, the market
for public company audits would either become more concentrated or remain
about the same. Further, more than half of accounting firms that audit 10
or more companies felt that mandatory audit firm rotation would reduce the
number of firms willing and able to compete for public company audits.

In addition, market participants we spoke with raised other concerns about
mandatory audit firm rotation. Some said that mandatory rotation would
increase both audit firms' and public companies' costs. In our 2003
report, we found that many audit firms and large companies surveyed
believed that mandatory rotation would increase initial year audit-related
costs by more than 30 percent. For example, we reported that audit firms
could incur higher marketing costs as they increased efforts to acquire or
retain clients. With new auditors every few years, public companies also
would incur higher support costs for assisting the new audit firm in
understanding the companies' operations, systems, and financial reporting
practices. Others expressed concern that new audit firms would need a
period of time to become fully familiar with a client's operations.
Lacking knowledge, and the time that would be required to acquire it,
could increase the risk of an auditor not detecting financial reporting
issues that could materially affect the company's financial statements.

^53Accounting firm survey data in this report does not include the
responses of the largest firms, or firms with four or fewer audit clients
unless otherwise noted. Also, data for smaller firms refer to survey
respondents only and cannot be generalized to all smaller firms because of
low response rates for this group.

^54See GAO, Public Accounting Firms: Required Study on the Potential
Effects of Mandatory Audit Firm Rotation, [69]GAO-04-216 (Washington,
D.C.: Nov. 21, 2003).

Other recently implemented regulatory changes may have already provided at
least one of the benefits this proposal is designed to provide. The
Sarbanes-Oxley Act requires mandatory rotation of lead and reviewing audit
partners after they have provided audit services to a particular public
company for five consecutive years. Many market participants we
interviewed for our 2003 report suggested that this requirement, when
fully implemented, could achieve some of the independence benefits related
to a new auditor's having a fresh look at a company's financial
statements.^55

  Audit Firm Financial Statement Disclosure

Another proposal that has been offered would require public company
auditors to provide financial information that could also be used to
assess the competitiveness of audit fee levels. Some market participants
and others advocate requiring accounting firms that audit public companies
to disclose detailed financial information, such as their own revenues and
profits. They have noted that providing this information could increase
the transparency of the market and help participants evaluate its
profitability, and the information could also help market regulators and
others evaluate whether firms were charging prices above competitive
levels.

Jurisdictions outside the United States have begun requiring audit firms
to disclose some financial information, but the results have been unclear.
In the United Kingdom, audit firms are required to file financial
information. However, because U.K. accounting firms provide many services,
some find the consolidated financial statement to be of limited usefulness
in assessing the economics of the firms' audit services. As a result,
based on the advice of a group of market participants, the U.K. Financial
Reporting Council recommended that audit firms disclose the financial
results of their work on statutory audits and directly related services,
so that "clearer and more comparable information on the profitability of
audit work" would be available.^56 In addition, beginning in 2008, audit
firms that carry out statutory audits in the European Union are required
to file information on fees charged for audits and other services, as well
as data on the basis for partners' compensation.

^55The partner rotation requirements went into effect May 6, 2003.

Most market participants we interviewed on this proposal did not believe
that requiring audit firms to publicly disclose their financial results
would be very effective in reducing the risk of anticompetitive pricing
among the largest accounting firms. Some market participants we spoke with
indicated that such financial statements would not provide useful
information for evaluating whether firms were charging fees above
competitive levels. Others familiar with the accounting profession have
commented that regulators already had the authority to request certain
financial information from firms if needed. Therefore, this proposal might
not have any direct effect on market competition.

  Breaking Up the Largest Firms into More Firms

Some academics and former regulators have suggested that requiring one or
more of the largest firms to spin off a large portion of their operations
to create more than four firms with the capacity to audit large public
companies could ease current concentration. Breaking up the largest firms
would at least temporarily decrease concentration and mitigate the adverse
effect of one of the firms exiting the market or failing. Firms in other
markets have been split up in the past--for example, Standard Oil and the
American Tobacco Company in 1911; meatpacking firms in 1920; and AT&T,
which owned all regional operating telephone companies, in 1984. In some
of these cases, some of the resulting companies merged in later years
after market or technological changes.

Market participants we spoke with expressed concerns about the potential
adverse effects of forcing the largest firms to divest themselves of some
of their operations. For example, several indicated that splitting the
firms could entail significant costs and diminish the economies of scale
and depth of expertise that currently allow the largest firms to audit
large public companies with complex technical needs and worldwide
operations. The result could be increased audit costs and decreased
quality of audits performed. In the public company survey we conducted for
our 2003 report on accounting firm consolidation we found that 79 percent
of survey respondents opposed breaking up the largest firms.^57 Though a
few we interviewed thought that this proposal would be effective in
reducing concentration, those we interviewed on this topic generally
agreed that it was not very feasible and that it could be complicated,
difficult, and costly. These adverse results seem especially disruptive in
the absence of compelling evidence that current levels of concentration
were causing harm.

^56The Financial Reporting Council oversees the regulatory activities of
the professional accountancy and actuarial bodies in the United Kingdom.
In October 2006, the Market Participants Group was established to advise
the council on possible actions that market participants could take to
mitigate the risks arising from the characteristics of the market for
public company audits in the U.K.. In October, 2007, the group issued a
report, titled Choice in the UK Audit Market, Final Report of the Market
Participants Group, which contains 15 recommendations to increase auditor
choice in the United Kingdom.

Reducing the Impact or Risk of Litigation Could Prevent Further Concentration,
but Proposals to Achieve This Goal Have Been Questioned

The risk of being sued appears to reduce some audit firms' willingness to
seek out additional public company clients. We reported in 2003 that
litigation risk was a barrier for smaller firms seeking to audit larger
public companies because of the difficulty of managing this risk and of
obtaining affordable liability insurance.^58 In the survey we conducted
for this report, over half (61 percent) of midsize and smaller audit firms
reported that liability/tort reform would be at least somewhat effective
in helping them increase their market share. Further, litigation could
result in even more market concentration if firms that were sued
ultimately went out of business. Several proposals have been made to
reduce the potential for litigation to cause further concentration in the
market for audit services, including placing caps on auditors' liability
and targeting enforcement against responsible individuals, among others.

  Liability Caps

A number of market participants and academics, and a recent report
commissioned by Senator Charles Schumer and New York City Mayor Michael
Bloomberg have recently advocated placing caps on auditors' potential
liability as a means of reducing the risk of litigation that could lead to
the loss of another large audit firm.^59 Liability caps would limit the
overall amount that an audit firm would have to pay in connection with a
lawsuit involving the work it performed for one of its public company
clients. Some of the proposals have suggested caps that are fixed across
the entire market, while others would base caps on the fees the auditor
received or the client's market capitalization. Some have argued that caps
would not only decrease litigation risk but would also increase the
availability of insurance. Both of these developments could reduce the
risk of a firm failing because of litigation. In addition, some believe
liability caps could also lead to increased efficiencies if audit firms
could reduce the amount of time they spent protecting themselves against
lawsuits.

^57This survey was to a random sample of Fortune 1000 companies on their
experiences with their auditors of record. See GAO, Accounting Firm
Consolidation: Selected Large Public Company Views on Audit Fees, Quality,
Independence, and Choice, [70]GAO-03-1158 (Washington, D.C.: Sept. 30,
2003).

^58 [71]GAO-03-864 .

^59U.S. Senator Charles Schumer and New York City Mayor Michael Bloomberg
commissioned the management consulting firm McKinsey & Company to work
with the New York City Economic Development Corporation to develop the
report Sustaining New York's and the U.S.' Global Financial Services
Leadership (2006).

While some market participants thought that capping auditors' liability
would be beneficial, others pointed out that such caps could have negative
effects and would not protect firms against all risks that could lead to
failure. Some of the former regulators and a representative of investors
we spoke with were concerned that having less potential liability would
limit the extent to which audit firms were held responsible for their work
and could lead to lower audit quality. Others were concerned that caps
would limit investors' ability to recoup losses they incurred if an
auditor was found to have committed fraud. In addition, caps would not
reduce the risk that firms face from enforcement actions, which could also
lead to failure. Finally, a few questioned the fairness of capping
liability for auditors but not for others who faced similar risk, such as
public companies and investment banks.

  Targeting Enforcement Actions against Responsible Individuals

As we have noted, audit firms could also fail as a result of a regulatory
enforcement action, increasing market concentration. Some market
participants have suggested that having regulatory or enforcement agencies
target their efforts against responsible partners rather than entire
organizations would reduce the risk that an audit firm might fail for this
reason. DOJ has the authority to take criminal enforcement action against
individuals, corporations, or partnership entities. For example, DOJ
indicted Arthur Andersen as a firm for obstruction of justice in 2002, but
also indicted four current or former Ernst & Young partners in 2007 for
alleged tax fraud conspiracy and other charges related to marketing tax
shelters. In 2005, DOJ indicted 19 individuals, including 16 former KPMG
partners, on charges related to marketing fraudulent tax shelters but
recently entered into a deferred prosecution agreement with the firm
itself. As part of the agreement, charges would not be brought against
KPMG as long as the firm followed the terms and conditions of the
agreement, which included agreeing to pay $456 million in fines,
restitution, and penalties.^60 Advocates of targeting the responsible
individuals rather than the firm argue that DOJ should consider the
negative consequences for public companies of further consolidation
against the benefits of criminal indictment against a firm. DOJ guidance
states that prosecutors must consider, among other factors, whether an
indictment would cause "disproportionate harm" to employees who have not
been proven personally culpable and the effect of prosecution on the
public in determining whether to charge a firm. DOJ officials declined to
comment on whether they took the potential negative consequences of firm
failure into consideration when making decisions in the Ernst & Young and
KPMG cases or whether they would do so in similar cases in the future.

However, others did not think that the ability of regulatory or
enforcement agencies to take certain actions against audit firms should be
limited. Market participants generally agreed that the facts and
circumstances of each case should determine whether regulatory and
enforcement agencies should take action against responsible partners or
firms. One former regulator commented that removing the option of taking
criminal action against a firm would give those firms safe harbor to
commit fraud. Further, this proposal would not address the risk that firms
face from class-action lawsuits, which is thought to be a significant
portion of firms' total litigation risks

  Other Proposals to Reduce Auditors' Liability for Alleged Wrongdoing

One proposal would seek to reduce the potential for further concentration
due to the loss of an audit firm by changing how auditors attest to the
fairness of financial statements. Officials from the six largest
accounting firms and proponents of this proposal stated in a paper on
serving global markets that what auditors could reasonably uncover in an
audit was limited.^61 However, the attestation that auditors currently
make states, "In our opinion, the financial statements present fairly, in
all material respects, the financial position of the company ... and the
results of its cash flows" which one commenter said fails to convey the
uncertainty associated with financial statements and audits. The
accounting firm paper on serving global markets states that, in the
current environment, company managers, investors, and others may have
expectations for audits that are too high--for example, that an auditor
has detected all possible fraud in a company's financial statements. Thus,
some propose changing the format and wording of the auditor's attestation
to reflect the varying certainty that an auditor can give to different
parts of financial statements. Some market participants we interviewed
believed that including more descriptive information in the attestation
would be helpful, while several others thought such a change would not
make a difference in firms' liability risk and could make the attestation
complex and confusing.

^60In 2007, charges against 13 of the individuals were dismissed by the
court, and these dismissals have been appealed by the government.

^61Samuel A. DiPiazza and others, Global Capital Markets and The Global
Economy: A Vision From the CEOs of the International Audit Networks
(November 2006), available at http://www.globalpublicpolicysymposium.com.

Another proposal, this one involving financial statement insurance, has
also been suggested as a means of reducing auditors' litigation risk.
Instead of having companies appoint and pay for their own external
auditors, this proposal advocates creating financial statement insurance
that would be provided by insurance companies. This insurance would
provide coverage for investors in the public company against losses
suffered as a result of problems with the company's published financial
statements. Insurance companies, to lower their risk of such losses, would
then appoint and pay audit firms to attest to the accuracy of the
financial statements. The auditors' opinions would assist the insurance
companies in setting future premiums and coverage levels.

Such financial statement insurance may be a way of lowering the risk of
the loss of another large audit firm because auditors would be agents of
the insurance companies. Depending on how relevant laws regulating
financial statement insurance were structured, proponents note that
liability would generally be shifted to insurers and away from auditors.
Further, because each policy would be tailored to a particular audit
engagement, one proponent has argued that more insurance than is currently
available would be available under this proposal, although some risky
companies may not be able to obtain it. However, most of the market
participants we discussed this proposal with did not favor it, citing the
significant changes it would make to the current audit function and
federal securities laws and the fact that insurance companies themselves
might not be interested in insuring financial statements in this way or
qualified to do so.

Proposed Actions to Help Reduce the Challenges Facing Smaller Firms Would Offer
Limited Benefits

Various entities have made proposals intended to help smaller firms expand
their share of the audit market for public companies. These include
allowing outside ownership, creating a shared experts office,
standardizing licensing and registration standards, and establishing an
accounting firm accreditation program.

  Outside Ownership of Accounting Firms

Some market participants have suggested that allowing parties other than
the firm's partners to own or invest in audit firms could increase these
firms' financial resources and allow them to hire the additional staff
needed to serve larger companies. According to AICPA, under all states'
laws, certified public accountants (CPAs) must make up the majority
ownership of all accounting firms, and other owners must be active
participants in the firms.^62 These requirements were intended to preserve
audit quality by ensuring auditor independence according to one market
participant and an industry report.

Market participants pointed out the potential negative effects of allowing
outside ownership of accounting firms, and most of the accounting firms
responding to our survey agreed that being able to raise capital from such
sources would have little if any effect on their ability to expand their
market share.^63 Opponents of extending outside ownership argue that,
without CPAs as majority owners, external shareholders might make business
decisions in a firm's economic interests that compromise its independence
for purposes of performing audits. One report recommending consideration
of changing outside ownership rules indicated that appropriate safeguards
would be needed to ensure independence and audit quality. Several of the
midsize and smaller firms we interviewed said that access to capital did
not pose a significant impediment to expansion, because firms currently
raised sufficient capital through traditional channels such as loans
backed by the partnership and, in some cases, alternative practice
structures. In fact, 61 percent of midsize and smaller firm survey
respondents said that increasing their access to capital would be only
slightly effective or not at all effective in helping them increase the
number of audit clients they served. Firms told us that the shortage of
qualified accountants in the labor market rather than limited access to
capital was their primary impediment to growth.

^62According to AICPA and the National Association of State Boards of
Accountancy (NASBA), all 50 states and the District of Columbia have
adopted the Uniform Accountancy Act's ownership provisions, which require
CPAs to be the majority owners of audit firms, or stricter ownership
provisions. The Uniform Accountancy Act is a model for state board
legislation developed by the AICPA and NASBA. It is nonbinding, and states
may adopt it voluntarily, in whole or in part.

^63We asked firms for their views on the effectiveness of a list of
possible measures. Results showed that responses varied on whether the
following were at least somewhat effective: merger/acquisition (71
percent); access to specialized technical and industry expertise (63
percent); liability/tort reform (61 percent); participation in an
affiliation (56 percent); alternative practice structures (25 percent);
mandatory audit firm rotation (44 percent); ability to raise capital (32
percent); regulatory changes (25 percent). See also [72]GAO-08-164SP for
detailed survey results.

  Shared Experts Office

Creating a shared entity staffed with accounting experts with specialized
technical and industry expertise to supplement smaller firms' technical
capabilities for performing public company audits could provide midsize
and smaller firms with advice on accounting standards and audit
procedures. A shared experts office could be similar in concept to the
"national offices" maintained by larger firms to provide advice to their
staff auditors on complex and emerging issues. According to some market
participants, smaller audit firms can currently obtain assistance through
various technical support services offered by FASB, AICPA, SEC, and
networks or affiliations they may be a member of. But some market
participants told us that services such as those the SEC provides were not
heavily used, either because auditors and companies feared reprisals if
they alerted regulators to potential problems they might be facing or
because they did not expect a timely response.^64

Market participants we interviewed noted that creating a shared experts
office that many firms could use would have various advantages and
disadvantages. Several market participants said a shared experts office
that provided comprehensive support and guidance on complex accounting and
auditing issues could be effective, especially if it were established
within an appropriate organization. However, most did not think that
establishing such an office would be feasible. Some market participants
that we interviewed said that a shared office's effectiveness would be
limited. For instance, one participant noted that a shared experts office
would lack the "tone at the top" that a firm's national office provides.
Others noted that staff at an external office could find it difficult to
obtain all the needed facts from firms in order to make an accurate
determination. Also, market participants said that the shortage of
individuals with the required expertise could make establishing an
external office challenging. Finally, some market participants said that
such an office would face challenges because it could face legal liability
if its staff gave out erroneous guidance that resulted in criminal or
civil litigation. Furthermore, other organizations such as AICPA have
considered establishing similar offices in the past but did not because
they could not identify ways to overcome these challenges.^65

^64We did not evaluate the effectiveness of these programs for this report.

Finally, midsize and smaller firms responding to our survey had mixed
views on the effectiveness of this proposal as a means of expanding the
number of public companies they could audit. Only 8 percent of midsize and
smaller firms said that having access to specialized technical and
industry expertise would be very effective in helping them expand their
public company client base, and 55 percent said that it would be somewhat
or moderately effective.

  Uniform Licensing and Registration Standards

Easing restrictions that hindered their ability to operate in multiple
states could potentially increase the ability of smaller accounting firms
to serve more public company clients. Many accounting firm officials and
industry groups have said that differences in auditor licensing and
registration standards across states are costly and make operating in
multiple jurisdictions burdensome. AICPA and the National Association of
State Boards of Accountancy (NASBA) have developed the Uniform Accountancy
Act, a suggested model for state legislation that was recently amended to
provide a comprehensive system under which CPAs would have mobility to
practice in more than one state with minimal barriers. However, each state
will have to implement these changes identically to create the uniform
system, and some market participants we interviewed said that states are
unlikely to do so. The AICPA is working with NASBA and the state boards of
accountancy to develop uniform legislation and accountancy rules in each
state to eliminate some of the barriers that exist for CPAs who perform
work across state lines. If the current initiative is successful, the
regulatory burdens associated with licensing will be significantly
improved. However, such a system is not likely to help reduce
concentration because some firms we interviewed said that although
complying with varying state standards was challenging, it did not prevent
them from competing for new clients or entering new markets.

^65AICPA has several mechanisms to support CPAs and firms that audit
public companies, including the Accounting and Auditing hotline and the
Center for Audit Quality (CAQ). AICPA and the largest public accounting
firms established the CAQ, an autonomous public policy organization that
is affiliated with AICPA. The CAQ's mission is to foster confidence in the
audit process. To help fulfill that mission, the CAQ provides technical
support for public company auditing professionals through web casts,
conference calls, briefings, and alerts on public company auditing
developments and practices.

  Accounting Firm Accreditation

Finally, providing more information about the capabilities of midsize and
smaller firms could make public companies more aware of lesser-known firms
and potentially increase these companies' willingness to consider
additional firms as their auditor. Some market participants have suggested
that establishing an accounting firm accreditation program would help
establish midsize and smaller firms' reputations by providing companies
and investors with additional information about their audit capabilities.
An accreditation program could be similar to the programs used for
colleges and universities, which use nationally recognized accrediting
agencies to determine whether institutions meet established standards and
thus acceptable levels of quality. Accounting firm accreditation, whether
carried out by a government agency or approved private organization, could
use a similar approach to certify firms as being able to audit certain
types of companies.

Company officials and other market participants told us that having
additional information about unfamiliar firms could be beneficial. For
example, investors told us they tended to prefer firms with
well-established reputations and that conducting due diligence on the
unknown firms' qualifications required extra work. Several other market
participants thought that providing additional information about firms
through an accreditation program could be at least a moderately effective
and feasible way to establish firms' reputations. One accounting firm
official thought that having a credible organization endorsing firms as
qualified to conduct audits for companies of certain sizes would help
companies make informed decisions and increase their choices of auditors.

However, other market participants raised concerns about the costs and
burden that accreditation would impose on firms. For example, according to
Department of Education guidelines universities have to complete an
in-depth self-evaluation that measures their performance against the
established standards and undergo on-site evaluations in order to earn
accreditation. Following accreditation, the accrediting body monitors and
periodically reevaluates the universities' accreditation status. Some
participants thought that the burden of this process could outweigh any
benefits.

Agency Comments and Our Evaluation

We provided a draft of this report to the Chairman of the SEC, the
Chairman of the PCAOB, DOJ, and the Department of the Treasury for their
review and comment. We received technical comments from SEC, PCAOB, and
DOJ that were incorporated where appropriate. Treasury had no comments.

We are sending copies of this report to interested congressional
committees and subcommittees; the Chairman, SEC; the Chairman, PCAOB; DOJ;
and Treasury. We will also make copies available to others on request. In
addition, the report will be available at no charge on the GAO Web site at
[73]http://www.gao.gov .

If you have any questions concerning this report, please contact Orice M.
Williams at (202) 512-8678 or [74][email protected] , Jeanette M. Franzel
at (202) 512-9471 or [75][email protected] , or Thomas J. McCool at (202)
512-2642 or [email protected]. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this report. See appendix VI for a list of other staff who contributed
to the report.

Orice M. Williams
Director, Financial Markets and Community Investment

Jeanette M. Franzel
Director, Financial Management and Assurance

Thomas J. McCool Director, Center for Economics

List of Congressional Addressees

The Honorable Christopher J. Dodd: 
Chairman: 
The Honorable Richard C. Shelby: 
Ranking Member: 
Committee on Banking, Housing, and Urban Affairs: 
United States Senate: 

The Honorable Richard Durbin: 
Chairman: 
The Honorable Sam Brownback: 
Ranking Member: 
Subcommittee on Financial Services and General Government: 
Committee on Appropriations: 
United States Senate: 

The Honorable John F. Kerry: 
Chairman: 
The Honorable Olympia J. Snowe: 
Ranking Member: 
Committee on Small Business and Entrepreneurship: 
United States Senate: 

The Honorable Barney Frank: 
Chairman: 
The Honorable Spencer Bachus: 
Ranking Member: 
Committee on Financial Services: 
House of Representatives: 

The Honorable Michael K. Conaway: 
House of Representatives: 

[End of section] 

Appendix I: Objectives, Scope, and Methodology

This work was conducted under the Comptroller General's authority. Our
objectives were to study (1) the level of concentration among the market
for public company audits and the impact of this concentration, (2) the
potential for increased capacity among midsize and smaller accounting
firms to ease market concentration, and (3) proposals that have been
offered by others for easing concentration in the market for public
company audits and the barriers facing midsize and smaller firms in
expanding their market share for public company audits.

We conducted this performance audit in New York City and Washington, D.C.,
from October 2006 to January 2008 in accordance with generally accepted
government auditing standards. Those standards require that we plan and
perform the audit to obtain sufficient, appropriate evidence to provide a
reasonable basis for our findings and conclusions based on our audit
objectives. We believe that the evidence obtained provides a reasonable
basis for our findings and conclusions based on our audit objectives.

To determine the level of concentration among the market for public
company audits and its effect we collected data and calculated our own
descriptive statistics for analysis. Using audit market data from various
sources, we analyzed auditor changes and changes in audit fees, computed
concentration ratios and Hirschman-Herfindahl indexes, and conducted trend
analyses. We also developed and employed an econometric model to analyze
the relationship between concentration and fees. Appendix V contains more
details about this model. To augment these data, we interviewed academics,
private consultants, trade associations, accounting firms, public
companies, and Securities and Exchange Commission (SEC) and Public Company
Accounting Oversight Board (PCAOB) officials. We also reviewed relevant
academic literature. Most of the research studies citied in this report
have been published in academic journals. These studies were also reviewed
by our economists, who determined that they did not raise serious
methodological concerns and were reliable for our limited purpose.
However, the inclusion of these studies is purely for research purposes
and does not imply that we deem them definitive. Finally, we surveyed
public companies and accounting firms about their views on these topics.
Our work did not include evaluating the quality or viability of the
accounting firms that perform public company audits.

To determine the potential for the growth of midsize and smaller firms to
affect concentration in the market for public company audits we reviewed
relevant literature and included questions on this topic in our survey of
public companies and accounting firms. In addition, we obtained data on
the auditors chosen by initial public offerings (IPO) from SEC filings and
analyzed this data. We also analyzed data related to the size of the
largest, midsize, and smaller firms. We assessed the reliability of this
data and found that it was reasonably sufficient for our purposes. We also
interviewed representatives of accounting firms, public companies,
investment banks, institutional investors, venture capital firms, and
trade associations.

To determine what proposals have been offered to address further
concentration and the challenges midsize and smaller firms face we
reviewed academic literature, as well as government and industry papers,
and interviewed representatives of accounting firms, public companies, and
other industry participants. We obtained information about the
effectiveness, feasibility, and overall benefit of these proposals through
our survey results and individual and group interviews with
representatives from accounting firms, public companies, investment banks,
institutional investors, academics, insurance companies, and former SEC
officials. We also met with officials from SEC, PCAOB, and the Department
of Justice (DOJ) to obtain their views on the advantages and disadvantages
of these proposals. We obtained much of this information at a roundtable
discussion we held on July 10, 2007, that involved 18 market participants
from across all the sectors mentioned above. The overall objectives of the
roundtable were to provide an opportunity for the participants from
different sectors and viewpoints to engage in an in depth discussion of
the significance of concentration in the market, challenges facing midsize
and smaller firms, and the strengths and weaknesses of proposals
previously identified, as well as to identify additional proposals. To
encourage open and candid input from the various parties, we agreed not to
attribute any input from either our general data collection effort or the
roundtable to specific organizations or individuals.

Data Analysis

To address the structure of the audit market we computed concentration
ratios and Hirschman-Herfindahl indexes (HHI) for 2000 to 2006 using Audit
Analytics, an online market intelligence service maintained by Ives Group,
Incorporated. Audit Analytics provides, among other things, a database of
audit fees by company since 2000, along with demographic and financial
information. We also used the Audit Analytics database to analyze changes
in the audit fees companies have paid by various size categories. Audit
Analytics also provides a comprehensive listing of all reported auditor
changes that includes data on the date of change, departing auditor,
engaged auditor, nature of the change (dismissal or resignation), any
going concern flags or other accounting issues, and any fee disputes or
fee reductions. Using this database, we identified 5,867 auditor changes
from January 2003 through June 30, 2007. For our econometric model we also
used data on audit opinions (going concern opinions), restatements, 404
compliance (internal control), and late filers that were also maintained
by Ives Group in the Audit Analytics database. We used Public Accounting
Report (PAR) and other sources for the remaining trend and descriptive
analyses, including the analyses of the top and lower sizes of accounting
firms, contained in the report.

In addition to reviewing the data collection methods and management
controls over these databases that we conducted for a previous report, we
assessed the reliability of the current data in other ways. We performed
several checks to verify the reliability of the Audit Analytics databases.
For example, we crosschecked random samples from each of the Audit
Analytics databases with SEC proxy and annual filings and other publicly
available information. Additionally, we compared our HHI calculations
based on Audit Analytics data to HHI calculations based on 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 also spoke with other users
of the Audit Analytics data. While we determined that these data were
sufficiently reliable for the purpose of presenting trends in audit fees
and auditor changes, as we have previously reported, the descriptive
statistics on audit fees contained in the report should be viewed in light
of a number of data challenges. First, the Audit Analytics audit fee
database does not include fees for companies that did not disclose audit
fees paid to their independent auditor in an SEC filing.^1 Second, some
companies included in the database--especially small companies--did not
report complete financial data. We handled missing data by dropping
companies with incomplete financial data from any analysis involving the
use of such data. As a result, we are not dealing with the entire
population included in the Audit Analytics database but rather with a
large subset. Because of these issues, the results should be viewed as
estimates of audit fees and market concentration based on a large sample
rather than precise estimates based on the entire population. Moreover,
the sample we used to produce the estimates throughout the report does not
include funds, trusts, nonoperating companies, or subsidiaries of another
public company.

^1See appendix V for more details on audit fees and disclosure
requirements.

For a previous report we performed similar, albeit more limited, tests on
PAR data, and concluded that they were appropriate for its use in this
report. However, these data are self-reported by the accounting firms,
which are not subject to the same reporting and financial disclosure
requirements as SEC registrants. Moreover, while the data are suitable for
comparing the largest firms to midsize and smaller firms, caution should
be used in comparing midsize and smaller firms to each other.

To assess the market for new publicly traded companies we obtained data
using SEC's Electronic Data Gathering, Analysis and Retrieval (EDGAR)
system, a database that includes information on registered companies'
initial public offering (IPO) in the United States. SEC's EDGAR database
is the primary source for information on IPOs since all companies issuing
securities that list on the major exchanges, OTC Bulletin Board (OTCBB),
as well as those that meet certain criteria for listing on the Pink
Sheets, must register securities with the SEC. In a previous report, we
crosschecked these data with NASDAQ data on NASDAQ IPOs for consistency.
For our analysis of size of the companies going public and their auditor
of record, we dropped companies from our analysis that were missing the
requisite revenue data in the database. We looked at a sample of these
companies and concluded that companies dropped from our sample are largely
companies that used either pro forma or partial year revenues in their
preliminary filings, or were funds, trusts or banks. While funds and trust
have been eliminated in our empirical work in this report, some publicly
traded banks have also been excluded in our analysis of IPOs by size. As
dropping these companies still left a large sample from which we computed
the descriptive statistics contained in our report, this data limitation
is minor in the context of this report.

Survey Data

To augment our empirical analysis, we conducted two confidential surveys
to obtain information from accounting firms and their public company
clients. First, we surveyed a random sample of 595 publicly held
companies. We created this population from the Audit Analytics database.
Our initial population included over 6,900 U.S.-based public companies
that traded on major exchanges (NYSE, NASDAQ, AMEX, OTCBB), excluding
foreign filers, funds and trusts, and benefit plans. Our sample was
allocated across six strata: (1) large companies (Fortune 1000) that had
changed auditors since 2003, (2) medium-size companies (greater than $75
million in market capitalization, but not Fortune 1000) that had changed
auditors since 2003, (3) small companies (less than $75 million in market
capitalization) that had changed auditors since 2003, (4) large companies
that had not changed auditors since 2003, (5) medium-size companies that
had not changed auditors since 2003, and (6) small companies that had not
changed auditors since 2003. The survey included questions related to
companies' audit services and the selection and engagement of the
company's auditor. To develop the questionnaire, we consulted with
individuals knowledgeable about the accounting profession, including
representatives of Financial Executives International and public
companies. We also pretested our questionnaire with three public companies
of different sizes and industries. We directed our survey to the audit
committee chair--or other member of the audit committee--where available.
We obtained names and addresses for audit committee members from Audit
Analytics. If no audit committee information was available, we conducted
additional research and identified a member of the company's management,
typically the chief financial officer, as the recipient of the
questionnaire.

We mailed paper questionnaires on May 22, 2007. Those companies not
completing the questionnaire were sent a replacement questionnaire and
another reminder letter in June and July. On June 12 and 13, we also made
phone calls to the corporate headquarters of 210 companies whose audit
committee chair or other selected informant had not responded in an
attempt to reach that person to encourage response. After excluding 29
sampled companies that we found to be ineligible for the population, we
received 406 usable responses as of August 15, 2007 from the final sample
of 566 companies, for an overall response rate of 73 percent (table 3).
Again, the number of responses to individual questions may fluctuate,
depending on how many respondents answered each question.

Table 3: Disposition of Public Company Sample

            Companies that changed auditor since      Companies that have not changed              
                            2003                            auditor since 2003                     
                       Non-Fortune    Non-Fortune             Non-Fortune    Non-Fortune           
                        1000, with     1000, with              1000, with     1000, with           
                            market         market                  market         market           
                    capitalization capitalization          capitalization capitalization           
            Fortune of $75 million   of less than  Fortune of $75 million   of less than       All 
               1000     or greater    $75 million     1000     or greater    $75 million companies 
Initial                                                                                            
population       80            917          1,682      792          2,295          1,140     6,906 
Initial                                                                                            
sample           58             70            124       81            178             84       595 
Ineligibles                                                                                        
detected in                                                                                        
the sample        1              5             14        1              4              4        29 
Final                                                                                              
eligible                                                                                           
Population       78            832          1,405      778          2,228          1,061     6,383 
Final                                                                                              
eligible                                                                                           
sample           57             65            110       80            174             80       566 
Usable                                                                                             
responses        42             49             71       56            134             54       406 
Response                                                                                           
rate                                                                                               
(number of                                                                                         
responses                                                                                          
divided by                                                                                         
final                                                                                              
eligible                                                                                           
sample)         74%            77%            69%      70%            78%            69%       73% 

Source: GAO.

The public company survey results came from a random sample drawn from our
population of U.S. publicly traded companies and, thus, could be weighted
to statistically represent that larger group. We weighted our sample to
adjust for nonresponse by company size. In our analysis, we did detect a
small amount of nonresponse bias among small public companies traded over
the counter. We analyzed the result of this nonresponse on selected
estimates. We concluded that the nonresponse did not affect our findings
or conclusions. Unless otherwise noted, the margin of error for public
company survey results used in the report was less than 12 percentage
points.

Second, we surveyed representatives of a take-all sample of the entire
population--437 midsize and smaller U.S. accounting firms that audited at
least one public company in 2006 (as identified by information in the
Audit Analytics database) and were also registered with PCAOB. Each of the
midsize firms operates nationally and to some extent internationally,
audits more than 100 public companies, and has around $1 billion in
revenue or less. The smaller firms audit regional and local public
companies and have fewer than 100 public company clients. We used the
survey to obtain firms' views on their plans regarding engagements with
public companies, participation in associations, competition, audit costs
and quality, and related issues. We obtained name and address information
for the executives to be contacted from registration applications filed
with PCAOB.^2 To develop our questionnaire, we consulted a number of
experts knowledgeable about the accounting profession, including
representatives of PCAOB. We also pretested our questionnaire with one of
the four largest firms, a midsize firm, and two smaller firms.

We began our Web-based survey on May 16, 2007, and included all usable
responses as of August 15, 2007 to produce this report. After we removed
three firms found to be ineligible for the survey (merged out of
existence, or without at least one publicly held U.S. client), the final
eligible population we surveyed was 434 firms. See table 4 for the final
disposition of our sample, including the subset of firms with five or more
publicly held clients that we chose to report statistics for in this
product.

Table 4: Disposition of Accounting Firms Selected for Survey

                                               Five or more One to four       
                                                    clients     clients Total 
Initial sample                                       181         256   437 
Ineligibles outside the survey population              0           3     3 
Final eligible sample                                181         253   434 
Refusals                                               2           8    10 
Other nonresponse                                     61         112   173 
Usable responses                                     118         133   251 
Response rate (number of responses divided                                 
by final eligible sample)                            65%         53%   58% 

Source: GAO.

^2Firms' registration applications are publicly available at
[76]http://registrationapplications.pcaobus.org/ .

Those firms not completing the questionnaire were sent up to four emails
starting on June 1, 2007, and a sample of firms not responding were called
to attempt to gain their participation on June 13 and 14. A paper version
of the questionnaire was provided upon request, and firms could respond
using this questionnaire by fax or mail.

We received 251 usable responses from these 434 firms, for an overall
response rate of 58 percent. However, the number of responses to
individual questions may be fewer than 251, depending on how many
responding firms were eligible or chose to answer a particular question.
In addition, we determined during our pretests that many of the survey
questions were irrelevant for the largest firms, so we administered
selected survey questions orally to representatives of each of the largest
firms and conducted indepth individual interviews with representatives of
each of these firms. That information is reported separately from the firm
survey results.

While the accounting firm survey results came from a census of the
population, we limited our analysis in this report to the 118 responding
firms with 5 or more publicly held clients because the response rate of
firms with only 1-4 clients was significantly lower (53 percent) than for
the larger firms (65 percent). Our analysis suggested that those small
firms responding were different from those that did not, in terms of
geography and number of clients. We were concerned that some small firms
did not respond because the prospect of more auditing work for publicly
held clients did not appeal to them and, thus, they found the survey
request irrelevant. The small firms that responded could have answered the
survey questions differently than the nonresponding small firms would
have. As a result, reporting percentages based on responding small firms
with one to four clients could introduce bias into results if those
results were generalized to all accounting firms that audited at least one
publicly traded company.

In addition to potential nonresponse bias, there are other practical
difficulties in conducting any survey that may 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 firms and clients with letters, e-mails,
and telephone calls to encourage them to respond and offer assistance.
Before the surveys began, we mailed notification letters to both survey
samples, encouraging them to respond and asking them to correct improper
contact information. We also checked and edited the survey data and
programs used to produce our survey results. In addition to the survey
statistics cited in this report, all survey questions and the frequencies
of responses to each question are presented in a supplemental product that
can be found on our Web site at http://
[77]www.gao.gov/cgi-bin/getrpt?GAO-08-164SP .

Appendix II: Other Issues Related to Concentration in the Audit Market

Although having eased slightly recently, the overall market for public
company audits continues to be highly concentrated among the largest
accounting firms. In assessing the degree of concentration in a market,
the standard practice uses the proportion of each competing firm's share
of the overall revenue collected. By analyzing data from Audit Analytics,
which collects audit information from the filings public companies submit
to the Securities and Exchange Commission (SEC), we found that the overall
extent to which the largest firms dominate the amount of total audit fees
collected continues to be very high. As shown in table 5, 94 percent of
the total amount of audit fees paid by public companies went to the
largest firms in 2006.^1 This is slightly lower than the 96 percent of
audit fees the largest firms earned in 2002. As a result, the general
market can still be characterized as a tight oligopoly, which is a market
dominated by a small number of sellers with the risk that these firms
could greatly influence price and other market factors.^2

Table 5: Market Shares of Audit Fees by Accounting Firm Size

            2002  2004  2006 
Largest 96.2% 96.4% 94.4% 
Midsize  1.5%  1.7%  2.7% 
Smaller  2.3%  1.9%  2.9% 

Source: GAO analysis of Audit Analytics data.

Note: Data do not include trusts, mutual funds, blank check or
nonoperating entities. Companies paying audit fees to two different
auditors in one year are also excluded.

The largest firms are significantly larger than their nearest competitors.
According to data from the Public Accounting Report, which collects
self-reported financial information from accounting firms, the combined
audit revenue of the four midsize firms is slightly less than one-half the
audit revenue of the smallest of the largest firms.^3 Similarly, as shown
in figure 11, the market share as measured by audit fees of each of the
largest firms individually is much larger than the market share of the
other groups combined.

^1Market shares are generally calculated using the dollar value of sales -
in this case that would correspond to audit fees collected. The Federal
Trade Commission (FTC) and Department of Justice (DOJ) note that measures
such as sales, shipments, or production are the best indicators of future
competitive significance. In the absence of audit fees, which were not
publicly disclosed until recently, proxies are commonly used such as
client revenues (sales) or assets. For example, see GAO's 2003 report on
consolidation ( [78]GAO-03-864 ).

^2Markets are considered tight oligopolies if the top four firms' share of
the market exceeds 60 percent.

Figure 11: 2006 Market Shares of Each of the Largest Firms Compared to
Other Firms, as Measured by Audit Fees

Note: Figure does not include trusts, funds, blank check or nonoperating
entities. Companies paying audit fees to two different auditors in one
year are also excluded.

Overall Audit Market and Many Specific Industries Are Highly Concentrated

Another key statistical measure that is used to assess the degree to which
a market is dominated by relatively few firms also shows that the public
company audit market is highly concentrated. The Hirschman-Herfindahl
Index (HHI) is one of the concentration measures used by government
agencies, such as DOJ and the Federal Trade Commission, to aid in the
assessment of market structure and potential market power. An HHI for a
market is calculated using the various market shares of the firms
competing to offer goods or services within it.^4 According to merger
guidelines issued by DOJ, an HHI below 1,000 indicates a market that is
predisposed to perform competitively and one that is unlikely to have
adverse competitive effects. An HHI between 1,000 and 1,800 indicates a
moderately concentrated market, while an HHI above 1,800 indicates a
highly concentrated market.

^3Data on audit revenue from the Public Accounting Report include revenue
from audits of both public and private companies. Unless otherwise noted,
market shares and other concentration measures in this report are based on
audits of public companies only.

As shown in figure 12, the HHI in 2006 for the overall market for public
company audits--as determined based on the audit fees collected by
accounting firms auditing public companies--was 2,300, a level considered
to be significantly concentrated. This represents a slight decline since
2002, when the audit market's HHI was around 2,390 after it peaked
following the dissolution of Arthur Andersen.^5

^4HHI calculated based on Audit Analytics audit fee database by summing the
squares of the individual market shares of all the firms within a given
market. For example, a market consisting of five firms with market shares
of 35 percent, 30 percent, 20 percent, and 10 percent has an HHI of 2625
(352 + 302 + 202 + 102). The HHI reflects both the market shares of the
top firms and the composition of the market outside of the top firms,
whereas the four-firm concentration ratio does not.

^5A study by London Economics in 2006 for the European Commission found
that the audit market HHI in the UK and member countries of the European
Union varied widely but were generally higher than the HHI threshold of
2000 used by the European Union as indicating a market where a merger
could create competitive concerns. See London Economics in association
with Ralf Ewert, "Study on the Economic Impact of Auditors' Liability
Regimes," Final Report to EC-DG Internal Market and Services (Frankfurt am
Main, Germany, September 2006) and Official Journal of the European Union,
"Guidelines on the assessment of horizontal mergers under the Council
Regulation on the control of concentrations between undertakings,"
2004/C31/03 (May 2, 2004).

Figure 12: Hirschman-Herfindahl Indexes, 2000-2006

Note: HHI figures based on total audit fees.

We also found that analyzing the audit market by region and industry
reveals that many industries were similarly highly concentrated and that
concentration also exists across six major geographic regions of the
country.^6 We segmented the market into distinct economic sector
(industry) audits and distinct regional audits. As figure 13 illustrates,
all industries are above the threshold for significant market power and
have generally shown some improvement since 2002, but some sectors are
significantly more concentrated than others. A number of these
industry-specific markets would not only be considered tight oligopolies
but would also be considered dominant firm markets (one firm holding over
60 percent of the market with no significant competitors). For example,
Ernst & Young accounts for 77 percent of all audit fees collected in the
agricultural sector while, the second largest firm only holds 12 percent
of the market.

^6This does not imply GAO advocates defining the audit market this way,
rather this segmentation suggests some differences that might be relevant
for analyzing choice and other competition-related matters. Only if we can
define industry-specific markets and regional markets as unique audit
market sectors of the economy is such a characterization appropriate.
Evidence suggests that some sectors have particularly complex audits and
sector-specific expertise is an important determinant of auditor choice.
This should be viewed in light of the fact that many companies are
involved in activities that cut across multiple industries.

Figure 13: Hirschman-Herfindahl Indexes, Markets Segmented by Industry

Notes: Industries defined by two digit North American Industry
Classification System codes.

^aThe warehousing sector contains fewer than 15 companies.

^bThe agriculture sector has fewer than 30 companies.

Similarly, we found regional markets in the United States such the
Mid-Atlantic and the Midwest to be somewhat more concentrated than the
Western regions, although all were highly concentrated.^7

Loss of One of the Largest Firms Would Result in Even Higher Concentration

In the event of further mergers, acquisitions, or closures of large firms,
the market would become even more concentrated. To determine the effect of
further concentration, we simulated the effect of the failure or exit of
one of the largest firms and the effect of a merger between two of the
largest firms.^8 When simulating the effect of the failure or exit of the
smallest of the largest firms, we distributed the clients of the failed
firm among the remaining firms in the same proportion as the clients of
Arthur Andersen were distributed after that firm dissolved. Under this
scenario, the resulting HHI of the overall audit market would rise from
2,300 to roughly 3,000 which is considerably further above what DOJ
considers to be a concentrated market (fig. 14). Further, figure 14 shows
that if we segment the audit market by size, that the increase in HHI
would be greatest among large companies. Higher concentration could
increase the risk that the remaining large accounting firms could exercise
market power to raise prices and coordinate their actions among themselves
to the detriment of their clients.

^7According to some, local concentration measures may be more appropriate
than national measures because the availability of professional
accounting, advertising and law services depends on the location of
personnel.

^8The scenarios are based on simple assumptions and the estimates for the
increases in the HHI are for illustrative purposes only.

Figure 14: HHI with Simulated Firm Failure or Merger

The figure also shows that a merger between two of the largest firms could
significantly increase concentration for the overall audit market. To
identify the result of such a merger, we simulated the effect of a merger
between the two smallest of the largest firms and found that HHI for the
market as a whole would increase from 2,300 to 3,124, which is again well
above DOJ's threshold for a concentrated market and higher than in the
case of a firm failure. As with the case of a firm failure, segmenting the
audit market by size illustrates the biggest increase in HHI would occur
in the market for large public company audits, which according to our
simulation would rise from 2,558 to 3,476 (fig. 14).

Appendix III: Analysis of Auditor Changes

In the last few years, companies that changed their auditor switched to a
midsize or smaller accounting firm more frequently than to one of the
largest firms. We analyzed data from the Audit Analytics database of over
8,000 auditor changes among companies registered with the Securities and
Exchange Commission (SEC) and listed on major exchanges (NYSE, NASDAQ and
AMEX), as well as those traded through other exchanges such as OTCBB.
Through this analysis, we identified 5,867 total changes in auditors
between January 2003 and June 2007.^1 As shown in table 6, the largest
firms lost a net total of 1,149 clients, while the midsize and smaller
firms picked up a net total of 282 and 867 clients, respectively.

Table 6: Public Companies Changing Accounting Firms, January 2003 to June
2007

                          Accounting firm after change                        
                                                                        Total 
Accounting firm          Largest      Midsize     Smaller       departures 
Largest                                                                    
Number of                                                                  
companies                                                                  
leaving largest                                                            
firms                        561          560         742 1,863            
Average revenue                                                            
of largest                                                                 
firms' clients    $1,687,884,613 $170,386,590 $60,857,991                  
Average audit                                                              
fee paid by                                                                
largest firms'                                                             
clients               $2,013,663     $549,825    $227,901                  
Midsize                                                                    
Number of                                                                  
companies                                                                  
leaving midsize                                                            
firms                         52           45         342   439            
Average revenue                                                            
of midsize                                                                 
firms' clients      $581,263,262  $84,047,669 $34,511,234                  
Average audit                                                              
fee paid by                                                                
midsize firms'                                                             
clients                 $820,200     $300,287    $151,511                  
Smaller                                                                    
Number of                                                                  
companies                                                                  
leaving smaller                                                            
firms                        101          116       3,348 3,565            
Average revenue                                                            
of smaller                                                                 
firms' clients      $106,434,760  $40,328,634  $6,045,755                  
Average audit                                                              
fee paid by                                                                
clients                 $431,124     $213,265     $52,885                  
Total gains^a                153          676       1,084                  
Total losses^b           (1,302)        (394)       (217)                  
Net gain (loss)          (1,149)          282         867                  

Source: GAO analysis of Audit Analytics data.

Notes: Average revenue and average audit fee figures are based only on
those companies with available relevant financial data.

^aTotal gains represent the sum of companies that went to that particular
category of accounting firm (largest, midsize, or smaller) from another
category. For example, the largest accounting firms gained 153 companies
from 2003 to 2007 (52 from midsize firms and 101 from smaller firms).

^bTotal losses represent the sum of companies that left that particular
category of accounting firm (largest, midsize, or smaller) for another
category. For example, large accounting firms lost 1,302 companies from
2003 to 2007 (560 went to midsize firms and 742 went to smaller firms).

^1Foreign companies, benefit plans, pension, health, and welfare funds,
subsidiaries with parents already included, and fund and trust entities
are not included in this analysis.

Table 6 also shows that while midsize and smaller firms gained a larger
number of clients, the largest firms still retained the clients that, on
average, have higher revenues and pay larger audit fees than the companies
that switched to a midsize or smaller firm. Therefore, despite the largest
firms experiencing a net loss of over one thousand clients, most of these
were smaller companies with lower revenues and audit fees. Companies that
changed from one of the largest firms to another had average revenues of
over $1 billion, while companies that changed from one of the largest
firms to a smaller firm had average revenues of just over $60 million.

Within these changes, we also found that midsize firms gained clients in
particular regions and industries. Overall, as shown in table 7, the
largest firms lost clients in every region of the United States
(Mid-Atlantic, New England, Southeast, Midwest, Southwest, and West). In
contrast, the midsize firms experienced net gains in clients in all of
these regions, especially in the Midwest where they acquired 27 percent of
the companies that changed auditors. Smaller firms also added clients in
all regions, most notably in the West, where 329 additional companies
selected them to serve as the auditor of record. This represents 82
percent of the changes made in that region. Incidentally, the Western
region is also the area in which the largest firms suffered their worst
losses and the midsize firms generally experienced their weakest gains.

Table 7: Percentage and Number of Changes Public Companies Made in
Auditors, by Region

                 Percentage of companies changing auditors gained or lost
Engaged                    New                                             
Auditor   Mid-Atlantic England Southeast Midwest Southwest   West    Total 
                   14.11%  20.91%    10.44%  19.63%    10.36%  9.27%   12.16% 
                                                                              
Largest         (-261)   (-84)    (-179)  (-152)    (-110) (-360) (-1,149) 
                   13.49%  13.94%    11.38%  27.23%    11.18%  8.25%   12.29% 
                                                                              
Midsize           (75)    (11)      (49)    (88)      (28)   (31)    (282) 
                   72.41%  65.16%    78.18%  53.15%    78.44% 82.48%   75.54% 
                                                                              
Smaller          (186)    (73)     (130)    (64)      (82)  (329)    (867) 

Source: GAO analysis of Audit Analytics data.

Note: Changes in auditors where region was unknown were excluded.

Our analysis of companies that ultimately selected one of the largest
firms or a midsize firm shows that midsize firms have made inroads into
certain industry sectors. In sectors in which there were at least 30
changes, Grant Thornton captured more than 20 percent of the companies
that switched in mining; certain manufacturing; wholesale trade;
information; professional, scientific, and technical services; and
accommodation and food services. BDO Seidman also secured over 20 percent
of the changes in six sectors with at least 30 changes: certain
manufacturing; wholesale trade; information; professional, scientific, and
technical services; management of companies and enterprises; and
administrative, support, and waste management and remediation services.
Finally, Crowe Chizek was the only firm in the top eight to engage more
than 20 percent of the finance and insurance companies that switched to
one of the largest firms or a midsize firm.

Companies reported a number of different reasons for changing auditors.
According to our survey results, large companies that recently changed
auditors frequently reported that they did so to obtain better customer
service (69 percent). Many large companies also reported changing auditors
to obtain a better working relationship with their auditor (67 percent).
Others said they changed auditors to obtain lower fees (26 percent).

In interviews, representatives of public companies, accounting firms, and
other market participants attributed many of the midsize and small company
auditor changes to the aftermath of the Sarbanes-Oxley Act, which, among
other things, enhanced auditor independence and required increased reviews
of public companies' internal controls (which initially affected larger
public companies) and prompted the largest firms to focus on providing
those services to their large clients. This increased workload increased
the largest firms' costs and fees and necessitated that some smaller
public companies expand their options and look to midsize or smaller
firms. Officials from two of the largest firms told us that they did make
changes to their client portfolios in the period after Sarbanes-Oxley was
passed, including resigning as auditor of record from some clients for
risk or capacity constraint reasons. On our survey of the over 400 U.S.
accounting firms that audit public companies, midsize and smaller
accounting firms responding also reported resigning as auditor of record
for risk mitigation reasons, specific issues with the client, or fees
being insufficient to cover audit costs.^2 Midsize and small companies
that recently changed auditors indicated on our survey that they did so to
obtain better customer service, a better working relationship with their
auditor, lower fees or because their auditor resigned. In addition, some
companies commented that they changed because their auditor was too busy
and expensive for them or because their auditor wanted to focus on larger
clients. A few reported, however, that they changed auditors because the
auditor went out of business or merged with another firm.^3

^2See [79]http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP for full results
to this survey question.

^3We also reviewed the reasons for auditor changes in the Audit Analytics
auditor change database. Reasons such as independence issues, fee
reductions, accounting firm merging or exiting the market were also cited
in these data.

Appendix IV: Trends in Audit Costs and Quality

Various factors likely affected changes in audit fees and audit quality
since the demise of Enron and Arthur Andersen. According to our data
analysis, survey, and interviews, audit costs and quality seem to have
increased in recent years. Additional work associated with new and
increasingly complex accounting and auditing standards, cost increases
associated with auditor changes and with acquiring and retaining audit
staff, new costs associated with regulatory oversight of public company
audits and other requirements of the Sarbanes-Oxley Act (the Act), and
some firms' recovering more of their costs have likely contributed to
increases in audit fees. Similarly, while many of these factors have been
cited as reasons for why it has been increasingly hard for accounting
firms to maintain audit quality, market participants generally agreed that
these changes have contributed to improved audit quality.

Factors Influencing Audit Costs

To varying degrees, different factors likely contributed to increased
audit fees since 2001 including firms' performing additional audit work,
higher costs commonly associated with auditor changes and with acquiring
and retaining audit staff, increases associated with the new public
company audit oversight structure and auditors expanded interaction with
audit committees, and firms' recovering more of their costs through audit
fees. Many market participants have noted that the number and complexity
of requirements associated with accounting and auditing standards have
contributed to firms performing new and additional procedures to help
comply with the new requirements and reduce audit and litigation risk.
Since 2000, public companies and their auditor have, where applicable, had
to deal with new and expanded accounting standards dealing with hedge
activities, derivatives, other financial instruments, impaired assets, and
intangible assets including goodwill. In addition, firms have had to deal
with new and expanded audit standards related to fraud, audit
documentation, and fair value measurements and disclosures.

In response to the demise of Arthur Andersen in 2002, more than 1,000 of
its public company audit clients had to find new audit firms. In addition,
as firms and public companies adjust to market-related changes following
the 2002 Sarbanes-Oxley Act, auditor change has continued. Our analysis of
auditor changes found that between 2003 and 2007 almost 6,000 auditor
changes occurred. Echoing our 2003 study of audit firm rotation, some
market participants we spoke to said that changing auditors would increase
public company audit-related costs. As part of our 2003 study of audit
firm rotation, we surveyed large (Fortune 1000) public companies and firms
that audited more than 10 public companies and more than 67 percent of
companies and firms responded that a change in auditor would likely
increase firms' initial year audit costs and public company audit support
costs--taken together--by more than 30 percent. In addition, accounting
firms we have spoken to and surveyed cited increased costs of attracting
and retaining talented audit staff and specialists. Many of those
commenting on this factor linked the higher costs of attracting and
retaining talented staff to the increased capacity-related demands facing
the firms associated with implementing the Act.

Also, the Act established a new major audit requirement that has
significantly expanded the scope of financial audits for public companies
by requiring, among other things, that their auditor assess and report on
the effectiveness of their internal control over financial reporting
(Section 404b). Representatives from all sizes of accounting firms we
spoke to said that the new audit requirement related to internal controls,
which generally became effective for the 2004 audits of the largest public
companies, has resulted in a substantial increase in their workload and
related costs associated with additional audit staff and expertise, and
audit methodologies. Until 2008, auditors for only the largest public
companies, those considered to be accelerated filers, have had to comply
with the new internal control audit-related requirements. Firms that audit
smaller public companies, those considered nonaccelerated filers, are
scheduled to comply with the new audit requirement with annual filings
after December 15, 2008. When effective for smaller public companies, the
requirement is expected to further increase their audit fees.

The accounting firms that we have spoken to noted that, in addition to
requiring new internal control work; other requirements of the Act have
contributed to increased audit costs and the fees charged to public
companies. The Act established a new regulatory oversight structure for
firms that audit public companies with the creation of the Public Company
Accounting Oversight Board (PCAOB). To date, PCAOB has established firm
registration and inspection programs and has adopted auditing standards
that Securities and Exchange Commission (SEC) has approved that registered
firms must follow. Several firms we have spoken to since the PCAOB was
established noted that they have incurred additional costs to support
PCAOB-related activities, as well as respond to the audit documentation
standard and a shorter audit partner rotation period mandated by the Act.
In addition, since a key provision of the Act made public company audit
committees responsible for hiring the firm and overseeing the audit, some
firms we spoke to said they have seen a substantial increase in their
staffs' interaction with the audit committees members, which has added to
audit costs.

A number of firms we spoke to also noted that the Act's stricter
independence requirements may have contributed to higher audit fees by
causing some firms to change the way they price their audit service. The
stricter independence requirements were intended to significantly limit
the types of nonaudit services firms can sell to their audit clients
without impairing the firm's independence. Department of Justice (DOJ)
officials and others we spoke to stated that the significant limits on
firms' opportunities to sell audit clients nonaudit services make them
less likely to under price audits as a loss leader. To the extent that
firms in the past have underpriced their audits expecting to sell nonaudit
services which are now prohibited, it is reasonable to believe that these
firms have increased their audit fees to cover their audit cost.

The results of our survey of midsize and smaller firms and our discussions
with the largest firms generally confirmed the factors that have increased
the audit cost fees. All four of the largest firms reported in interviews
that the increasing complexity of accounting and auditing standards and
the additional requirements of new standards were factors having a
significant effect on the cost of audits. The largest firms and the other
firms differed only slightly on other factors that have significantly
affected audit cost. The largest firms noted costs to attract and retain
talented staff and costs related to litigation as the two other top
factors contributing to increased audit costs. In addition to the
requirements of new standards and the price of talent, the other firms
cited the time and effort to prepare for the PCAOB inspection and the
complexity of accounting principles and auditing standards as their top
factors.

The results of our survey of the audit committee chairs of over 500 public
companies also show that increases in audit hours and rates charged by
firms and other factors have led to increased audit fees. Public companies
that reported increasing audit fees reported that changes in the number of
hours by the audit engagement team (85 percent) and senior partners (73
percent), as well as changes in hourly rates of the audit team and senior
partners (76 percent), led to increased audit fees.^1 In addition, of
those public companies reporting that their audit costs had increased
since 2003, 84 percent reported that the additional requirement for an
audit of internal control over financial reporting was a factor in the
increase of their audit.

^1The results from our public company survey are representative of and
generalized to the larger public company population our sample was drawn
from. Unless otherwise noted, the margin of error for public company
survey results was less than 12 percentage points.

Factors Influencing Audit Quality

While management has the primary responsibility for the quality and
reliability of a public company's financial statements, the auditor is
responsible for providing reasonable assurance, through an independent
audit, about the reliability of the company's financial statements.
Investors need to know that the financial statements on which they make
investment decisions are reliable and the independent audit plays a vital
role in assuring their reliability. In a prior report, we defined a
quality audit as one conducted, in accordance with applicable auditing
standards to provide reasonable assurance about whether the audited
financial statements are presented in accordance with applicable
accounting principles and are free of material misstatements.^2 Audit
quality is often thought to include the experience and technical
capability of the auditing 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. When high quality public company audits are performed,
management and investors are more likely to rely on the financial
statements and the financial information they contain.

  Audit Oversight

For decades, the public accounting profession was, in practice,
self-regulated, taking responsibility for establishing auditing standards
and administering a program designed to oversee the activities of
independent public accounting firms that audit companies whose securities
are registered with the SEC. While given statutory authority for
establishing rules governing financial reports for publicly traded
companies in the 1930s, SEC permitted the accounting profession (American
Institute of Certified Public Accountants (AICPA)) to set auditing
standards, subject to SEC's oversight of the standard-setting process.
Concerns raised with the audits of public companies in the 1970s focused
attention on the need to improve the quality control mechanisms used by
firms to ensure that professional standards were being met. In response,
AICPA revised its approach to setting audit standards in 1979 by
establishing the Auditing Standards Board, which was designed to have a
more efficient standard-setting process through a body composed of
representatives from firms of all sizes and nonpublic accounting
organizations. In 1977, AICPA instituted two voluntary peer review
programs--one for firms performing audits of public companies and one for
those performing audits of private companies--designed to review the
systems of audit quality controls for participating firms' audits of
companies. Also, in 1977, AICPA created the Public Oversight Board to
represent the public interest by overseeing the audit standards-setting
process and the voluntary peer review program.

^2In our 2003 study on the potential effects of mandatory audit firm
rotation mandated by the Sarbanes-Oxley Act ( [80]GAO-04-216 ), we defined
a quality audit as one in which the auditor conducts the audit in
accordance with Generally Accepted Auditing Standards (GAAS) to provide
reasonable assurance that the audited financial statements and related
disclosures are (1) presented in accordance with Generally Accepted
Accounting Principles (GAAP) and (2) are not materially misstated whether
due to errors or fraud. This definition assumes that reasonable third
parties with knowledge of the relevant facts and circumstances would have
concluded that the audit was conducted in accordance with auditing
standards and, that within the requirements of those auditing standards,
the auditor appropriately detected and then dealt with known material
misstatements by (1) ensuring that appropriate adjustments, related
disclosures, and other changes were made to the financial statements to
prevent them from being materially misstated, (2) modifying the auditor's
opinion on the financial statements if appropriate changes or other
adjustments were not made, or (3) if warranted, resigning as the public
company's auditor of record and reporting the reasons for the resignation
to SEC.

The purpose of the peer review program AICPA established was to provide
the public with assurance that a firm performing auditing services for
companies registered with SEC had an effective quality control system that
provided reasonable assurance that its audits were in compliance with
generally accepted auditing standards. According to the AICPA, a number of
large accounting firms had been using peer reviews to enhance audit
quality as far back as the early 1960s. In 1988, AICPA made peer review
mandatory for all member firms performing auditing and accounting
services.

To enhance auditor independence, improve audit quality, and restore
investor confidence in response to the major accountability breakdowns at
Enron and WorldCom, the Congress, through the enactment of the
Sarbanes-Oxley Act, replaced the profession's longstanding self-regulatory
structure for public company audits with an independent regulatory
structure administered by PCAOB. Among its other responsibilities, the Act
made PCAOB responsible for establishing auditing and other professional
standards applicable to the audits of public companies by registered firms
and inspecting those firms which perform public company audits. Since its
establishment in 2002, PCAOB has designated certain existing auditing and
quality control standards issued by the Auditing Standards Board through
April 2003 as its interim standards, while focusing its attention on
issuing new and modifying certain interim auditing standards. As of
September 2007, PCAOB has not issued either new or modified quality
control standards.

In addition to its work on standards, PCAOB is responsible, through its
inspection program, for evaluating the auditor's application of existing
audit and related requirements standards to promote high quality audits.^3
The PCAOB inspection program replaced the AICPA's peer review program that
evaluated firms' public company auditing practices.^4

  Views on Audit Quality

Many factors can affect audit quality including auditing, accounting, and
quality control standards; accounting firm inspections; and audit staff
quality; and the availability of qualified audit staff. In asking
accounting firms about audit quality, we considered audit quality to
include the experience and technical capability of the audit firm partners
and staff as well as the capability to efficiently respond to a client's
needs and identify and communicate material reporting issues in financial
reports. All of the largest firms and over 80 percent of the midsize and 3
accounting firms responding to our survey said that, since 2003, it has
been harder to maintain audit quality.^5 This widely held view likely
reflects the significant changes in the auditing environment since 2003
and the capacity demands facing the profession as audits have become more
complex, requirements have expanded, and the PCAOB's inspection program
has been implemented. Together these changes have increased emphasis on
audit quality. Midsize and smaller accounting firms participating in our
survey indicated that several factors have made it harder to maintain
audit quality, with the most significant being the complexity of the
accounting principles and auditing standards (92 percent), staff
experience and technical capability with complex accounting principles and
auditing standards (90 percent), and availability of qualified staff (84
percent). The largest firms' views on audit quality were also in line with
those of the survey respondents. Representatives of all of the largest
firms indicated that the complexity of the accounting principles and
auditing standards and staff experience and technical capability with
complex accounting principles and auditing standards have made maintaining
audit quality harder. In addition, three of the four firms indicated the
availability of qualified staff has made maintaining audit quality harder.
During interviews, some representatives of the largest firms noted that
they have significantly increased the number of staff in their national
offices who provide technical consultations to the audit teams due to the
complexity of the accounting principles and auditing standards. Also,
during interviews, representatives of accounting firms mentioned that they
have faced stiffer competition in hiring due to companies expanding their
accounting and internal audit departments, SEC and PCAOB increasing their
staff, and consulting firms wanting experienced accountants to help their
clients implement section 404.

^3Section 104(d) (2) of the Sarbanes-Oxley Act.

^4The AICPA peer review program is still applicable for PCAOB inspected
firms' non-SEC issuer audit and accounting practices.

^5Accounting firm survey data in this report does not include the
responses of the largest firms, or firms with four or fewer audit clients
unless otherwise noted. Also, data for smaller firms refer to survey
respondents only and cannot be generalized to all smaller firms because of
low response rates for this group.

During our interviews, all of the largest firms and in replying to the
survey, all of the midsize firms who responded, indicated that the
increased role of the audit committee made maintaining audit quality
easier. Only 23 percent of the smaller survey respondents shared this
view.^6 Also, half of the largest and midsize firms responded that
complying with PCAOB inspections made maintaining audit quality easier as
compared with only 8 percent of the smaller firm survey respondents.

Despite the fact that accounting firms reported it was harder to maintain
audit quality, market participants we spoke to who commented on audit
quality generally noted that they thought audit quality had improved.
Similarly, public companies think several aspects of audit quality have
increased in recent years. In our survey to public companies, we asked
about specific aspects of audit quality and how those aspects have changed
since 2003.^7 While companies reported that several aspects of quality
have remained the same, the aspects the public company survey respondents
indicated increased most significantly were the amount of time spent by
audit engagement team (77 percent), the addition of audit of internal
control over financial reporting as required in the Sarbanes-Oxley Act (73
percent), and amount of time spent by senior partners and experts (72
percent). Company officials and others we interviewed also generally said
that overall audit quality had increased in recent years. One controller
we interviewed said that overall audit quality had become lax before the
Sarbanes-Oxley Act was passed. However, he thinks that quality has changed
significantly in recent years and auditors are much more rigorous. While
public companies we surveyed were generally satisfied with their auditor
of record considering the scope of the audit, the fees paid for audit
services and the quality they received, several respondents commented that
the requirements in Sarbanes-Oxley have led to significant increases in
audit work and fees. Some survey respondents also questioned whether these
higher costs exceeded the benefits of the additional requirements.

^6Section 301 of the Sarbanes-Oxley Act requires the audit committee to be
responsible for hiring, compensating, and overseeing the work of the
accounting firm.

^7The aspects of audit quality we asked about were (1) responsiveness to
client questions and needs, (2) technical capability with accounting
principles and auditing standards, (3) amount of time spent by audit
engagement team, (4) amount of time spent by senior partners and experts,
(5) appropriate time spent on issues based on risk areas, (6) experience
and capability of engagement partner, (7) experience and capability of
engagement staff, (8) addition of audit of internal control over financial
reporting, and (9) ability/willingness to identify and surface material
reporting issues.

Appendix V: Econometric Analysis of the Effect of Industry Concentration
on Audit Fees

The current structure of the market for audit services has raised concerns
about the potential for anticompetitive pricing, especially for the
largest public company clients. While the classic oligopoly theory
suggests that prices of goods and services are positively associated with
market concentration, the modern theory of industrial organization makes
no clear statement regarding the impact of concentration on competition.
Therefore, to investigate the relationship between concentration and audit
fees, we compiled a panel data set using Audit Analytics data. The data
initially contained observations on over 12,000 companies over a
seven-year period from 2000 to 2006 excluding funds, trusts, and
nonoperating entities. To analyze the relationship as validly as the data
constraints allowed, we employed various panel data modeling techniques.
While the results suggest that the increase in audit fees appears largely
unrelated to supplier concentration, in part because of all the
contemporaneous changes occurring in the market and other modeling and
data limitations, these findings should not necessarily be viewed as
definitive or as proof that that market for audit services is competitive.
This appendix provides additional information on the construction of our
database, econometric model, additional descriptive statistics and the
limitations of the analysis.

The Panel Data Sample Was Created by Compiling Several Audit Analytics Databases

To construct the database used to estimate the econometric model we
compiled audit fee and financial data and additional information on the
thousands of public companies audited by the largest, midsize, and other
public accounting firms. Audit Analytics, an online intelligence service
maintained by Ives Group, Incorporated provides, among other things, a
database of fees paid by public companies to their auditors back to 2000
with demographic and financial information. In addition, we added
information on these companies using the Late Filer, Internal Control,
Restatement, Auditor Change and Audit Opinion databases also maintained by
Audit Analytics. In this manner, we were able to include information on
the risk and auditing characteristics of the companies as additional
control variables in the resultant econometric model. Moreover, a panel
data set, that is data pooled across all companies over the 2000 to 2006
period, allowed us to account for variances in audit fees across companies
and over time as well as use techniques that enhance the validity of the
parameter estimates. We deleted from our sample various entities including
funds, plans and trusts, subsidiaries with parent data already included in
the database, blank check and nonoperating entities and duplicate entries.
Table 8 reports the descriptive statistics on the resultant panel data
set. Because some companies either did not exist until the later years,
merged with other companies, went private, entered into bankruptcy, or
otherwise failed to report at some point over the period, not all the
companies have the requisite data for each year. Moreover, companies were
not required to report audit fees until 2001.^1 As a result, the panel is
unbalanced. The public companies clients remaining in our sample were used
initially to investigate two related questions:

           o When other important factors influencing audit fees are
           accounted for, do companies operating in more concentrated sectors
           of the economy pay higher fees?

           o When other important factors influencing audit fees are
           accounted for, do companies audited by accounting firms with
           higher market shares in a certain sector pay higher fees?

Table 8: Descriptive Statistics of the Panel Data Set, 2000-2006

Dollars in millions
                         2000    2001    2002    2003    2004    2005    2006 
                                                                              
                      N=4,440 N=6,498 N=8,762 N=9,817 N=9,863 N=9,270 N=8,559 
Audit fees^a                                                               
Average             $0.651  $0.707  $0.931  $1.016  $1.431  $1.559  $1.711 
Median               0.186   0.187   0.186   0.187   0.243   0.304   0.349 
Standard deviation   2.134   2.341   3.673   3.671   5.158   5.022   5.395 
Revenue of firms                                                           
audited^a                                                                  
Average             $2,044  $1,918  $1,888  $1,984  $2,191  $2,292  $2,551 
Median                 130     122      84      70      68      71      80 
Standard deviation  10,295   9,209   9,024   9,946  11,444  12,044  13,154 
Assets of firms                                                            
audited^a                                                                  
Average             $5,582  $5,070  $5,983  $6,476  $7,244  $7,476  $8,404 
Median                 312     256     188     156     160     166     190 
Standard deviation  37,597  38,148  46,492  52,293  62,141  65,008  75,389 
Median fees                                                                
(percentage of                                                             
revenue)             0.14%   0.15%   0.22%   0.27%   0.37%   0.39%   0.36% 
Average fees                                                               
(percentage of                                                             
revenue)             0.04%   0.04%   0.06%   0.06%   0.08%   0.08%   0.08% 
Median fees                                                                
(percentage of                                                             
assets)              0.07%   0.09%   0.14%   0.19%   0.27%   0.31%   0.29% 

Source: GAO analysis of Audit Analytics data.

Notes: N is the number of observations in each year that have audit fees
reported.

^aDollars are converted to real terms using the chain weighted GDP price
index. Total audit fees include audit and audit-related fees.

^1The manner in which audit fees are categorized and reported has changed
since 2000 as well. As discussed below, companies were required to report
fees paid to their external auditor more uniformly in 2001.

Our panel data approach investigates industry (economic sector)
concentration (HHI) from 2000 to 2006 since there is variation in the
degree of concentration across industries and within industries over time.
We also investigate variation in audit firm market share of a particular
industry, and therefore, potential market power, over the 2000-2006 period
as well. Our econometric model is estimated to gauge whether or not audit
fees can be explained by changes in these concentration variables.
Sullivan (2007) takes a different approach in addressing anticompetitive
pricing, using auditor change (switching) data from 1988 to 2005 and
similarly attributes audit fee increases to the new regulatory environment
and increased effort on the part of auditors rather than anticompetitive
behavior.^2 Asthana, et al. (2004) examines audit fess from 2000 to 2002
and concludes that the increase in the fee premium charged by the largest
firms was the result of decreased competition in the audit market for
multinational companies due to the exit of Arthur Andersen. However, as
Sullivan (2007) points out, the authors cannot control for trends in
audits fees that predate the Arthur Andersen dismantlement.^3

Econometric Modeling Procedures for Handling Panel Data

Panel data provides potential advantages over pure cross sectional and
pure time series designs and allows us to factor out the time- and
space-invariant components of the data. As a result, panel data are able
to identify and measure effects that are not detectable in other designs.
There are two commonly accepted approaches to estimating panel data--the
random-effects model and the fixed-effects model. In the fixed effects
model individual effects are estimated, in this case, for each company to
reflect the assumption that special features specific to each
company--such as audit risk, management style, skill of internal auditors
or audit committee, or internal control processes--can be captured best
with a different, time-invariant intercept for each company. In a random
effects model, in this context, these individual effects are captured
through treating the intercept as a random variable with a unique error
term for each company. While each model has its advantages and
disadvantages, the random effects model is appropriate when we can
plausibly assume that the individual effects (which are unobserved and
unmeasured in the model) are uncorrelated with the explanatory variables
that are measured and included in the model. Otherwise the fixed effects
model is preferred, especially as a control for omitted variables bias, as
it is in this context (see discussion below).

^2Mary Sullivan, "Great Migration: How Recent Events Changed the Switching
Behavior of Top-Tier Audit Clients" (George Washington University working
paper, Washington, D.C., July 2007). While this approach allows for a
longer-term look at the audit market, it can only investigate whether
auditor switching changed as a result of Andersen's dismantlement relative
to other factors such as the Sarbanes-Oxley Act. Auditor switching
behavior may reasonably be interpreted as an indicator of pricing behavior
but it does not directly address whether audit fees are higher or lower
due to concentration.

^3See Sharad Asthana et al, "The Effect of Enron, Andersen, and
Sarbanes-Oxley on the Market for Audit Services" (SSRN Working Paper, June
2004), [81]http://ssrn.com/abstract=560963 . This is one of the reasons we
do not attempt a pure interrupted time series design using audit fees.
Audit fees data were not publicly available until recently, and, as a
result, our data source did not have fee data prior to 2000. Moreover, it
would be difficult to reach a valid conclusion since the dismantlement of
Andersen occurred around the same time as the passage of the
Sarbanes-Oxley Act.

Using panel data--data across companies and over time--the basic model
takes the form:
(1) yit = q + Xitb + Zid + eit: 

where y = the dependent variable (audit fees paid by the company to its 
auditor). 

X = a matrix of explanatory variables that varies across time and 
individual companies. These are variables that help capture the 
characteristics of the public company client, the characteristics of 
the auditing industry, the characteristics of the auditor, and the 
characteristics of the audit engagement as well as variables that for 
control the effect of Sarbanes-Oxley. 

Z = a matrix of variables that vary across companies but for each 
individual company are constant across the six years. The variables are 
essentially the variables that indicate the number of auditor changes 
over the period, indicate whether or not a company was a client of 
Arthur Andersen in 2002 as well as regional and industry dummy 
variables. 

q = constant term. 

i = 1, 2, . . ., 12,749 and represents the individual companies in the 
initial panel. 

t = 1, 2, . . ., 6 and represents the number of years (2000-2006). 

As is the typical case with panel data, we have a large number of cross-
sections (public companies) and a relatively small number of time 
periods. Therefore we specify the composite error structure for the 
disturbance term as follows: 

(2) eit = i + hit: 

where i = company-specific error component which captures the 
unobserved heterogeneity across companies (either as a fixed-or random- 
effect). 

E(Xithit) = 0 (there is no correlation between hit and Xit). 

The a[i] is the individual effect which can be treated as either fixed or
random. The fixed- and random-effect models which take account of the
repetition inherent in the data and allow us to use the individual
differences effectively. Correspondingly, if we treat the individual
effect as zero we can estimate the model using the simple ordinary least
squares (OLS) procedure. This is a pooled OLS regression model where we
assume the intercept and slope coefficients are constant across time and
space and the normal error term (y[it]) captures differences over time and
individual companies. However, when the true model is random-effects
model, pooling the observations in this manner using OLS produces biased
estimates that are also not efficient when compared to the more complex
generalized least squares (GLS) procedure (outlined below). Moreover, the
pooled OLS model is also susceptible to omitted variables bias. Likelihood
ratio tests strongly rejected the pooled OLS model in favor of the
fixed-effects and therefore OLS would be inappropriate in this regard as
well.

The random effects technique proceeds under the assumption that the
ignorance about the unobserved differences in audit fees across companies
is better captured through the disturbance term rather than the intercept.
The random effects model basically maintains that the public companies in
the sample have a common mean audit fee (represented by the constant term,
th) and that the individual differences in fees for each company are
captured in the error term a[i]^4 Given the composite nature of the new
disturbance term which incorporates the individual random effect of each
company, the appropriate method for producing estimates is GLS.^5 Feasible
GLS derives an estimate of the covariance matrix of the error term and
uses the information (heteroscedasticity from repeated observations of the
same crosssection unit) to estimate the coefficients in the model.

^4The random effects model can be thought of as a regression with a random
constant term. In other words, it is assumed that the intercept is a
random outcome variable that is a function of a mean value plus a random
error.

The drawback to this approach is that it forces one to make the strong
assumption that the unobserved random-effects are uncorrelated with the
explanatory variables in the model E(X[it]a[i]) = 0 in addition to the
standard assumption E(X[it]y[it]) = 0). As a result, the random effect
treatment of the panel data may also produce estimates that suffer from
the inconsistency due to omitted variables. Therefore, the validity of the
results would depend more heavily on the control variables included in the
model to capture differences across companies, unless the omitted
variables (unobserved heterogeneity across company) are uncorrelated with
the concentration variables. If this is the case, the random-effect model
may produce more appropriate estimates than the fixed-effects model. In
our case, the Hausman test, which formally tests whether the omitted
variables are correlated with the other regressors in the model, clearly
rejected the random-effect model in favor of the fixed-effects model.
Therefore, the results section of this appendix focuses primarily the
fixed effects models (see below).

In the case of the fixed effects model, a[i] is estimated uniquely for
each company as a fixed coefficient to be added to the intercept term. In
this way, we take into the account the individuality of each company (each
crosssectional unit) by letting the intercept vary by a fixed amount for
each company. The benefit of the fixed effects estimator is that it is
consistent in the presence of omitted variables. Because many variables
that affect audit fees across companies are difficult to measure or could
not be obtained this omission could bias the parameter estimates. With
panel data and a fixed effect specification it is possible to obtain
consistent estimates of the effect of concentration even when there are
correlated omitted effects. The differences that exist across companies
are essentially pulled out and accounted for explicitly, allowing for a
more valid estimation of the effect of industry concentration on company
audit fees. Moreover, in many cases the fixed effects estimates will still
produce consistent estimates even when the random effects model is valid.

^5Because a[i] is in the composite error for each time period t, the error
term (e[it] = a[i] + y[it]) is serially correlated across time,
invalidating OLS estimates.

Variables Included in the Model

SEC disclosure requirements now require companies to disclose audit fees
paid to the external auditor and that these fees paid be broken down into
the following categories: (1) audit fees, (2) audit-related fees, (3) tax
fees, and (4) all other fees.^6 Audit-related fees can include fees paid
to the external auditor for due diligence services, internal control
reviews or other work that is traditionally performed by the independent
accountant. The dependent variable in our econometric models is total
audit fees, which is composed of audit fees and audit-related fees. While
the results we report below use this measure of fees, we also used audit
fees (without audit-related fees) for each company in some models as a
sensitivity test. More importantly, because SEC disclosure requirements
were not in effect during 2000 and for a portion of 2001, some
observations are based on firm-specific practices for categorizing fees
rather than the more uniform categorization initiated by SEC regulations.
We deal with this econometrically by dropping 2000 and 2001 in some
specifications for sensitivity analysis, and, when these years are
included, time fixed-effects are used to control for potential difference
in the recording of audit fees.

The primary variables of interest are the industry concentration variables
defined by two-digit North American Industry Classification System (NAICS)
codes: (1) the share of the market held by a company's auditor of record
in a given year in a given industry sector (Sharef) and (2) the
Hirschman-Herfindahl Index (HHI1) for the industry sector in which the
company operates in a given year. Both concentration variables are based
on the total audit fees collected. The HHI is calculated by summing the
squared market shares of all the firms auditing public company clients in
a given industry. As table 9 illustrates, the HHI's computed for the
various sectors of the economy vary across sectors over time. We also
interacted the HHI variable with measures of company size, to allow for
distinct effects for large and small companies. We did not include
companies operating in the public administration sector in our econometric
analysis as there were an insufficient number of companies to reliably
determine concentration. Similarly, in some econometric specifications we
dropped Agricultural and Warehousing companies as the numbers fell below
30 and 15 companies respectively in most years.

^6In November 2000, the SEC adopted a rule requiring public companies to
disclose audit and audit-related fees paid to their outside auditors.
These requirements were later expanded to include a uniform categorization
of fees, among other things.

Table 9: Hirchman-Herfindahl Indexes by Sector, 2000-2006

NAICS Sector                      2000  2001  2002  2003  2004  2005  2006 
Agriculture^a                    2,970 3,164 6,268 4,844 4,894 5,312 6,092 
Mining                           2,908 2,668 2,866 2,651 2,653 2,342 2,466 
Utilities                        2,837 3,321 4,508 3,848 3,870 3,751 3,680 
Construction                     2,233 2,665 3,188 3,184 3,091 3,079 3,042 
Manufacturing: food processing                                             
and textiles                     2,177 2,464 2,913 2,640 2,632 2,778 2,720 
Manufacturing: wood, petroleum,                                            
minerals, chemical products      2,378 2,209 2,747 2,721 2,743 2,583 2,602 
Manufacturing: durable           2,216 2,266 2,454 2,434 2,483 2,388 2,347 
Wholesale trade                  1,800 2,111 2,238 2,258 2,198 2,177 2,144 
Traditional retail               1,767 2,483 2,553 2,497 2,431 2,559 2,558 
Miscellaneous retail             2,643 2,253 2,434 2,414 2,429 2,286 2,207 
Transportation                   2,699 2,461 2,555 2,791 2,786 2,534 2,477 
Warehousing^b                    4,036 3,154 3,364 3,273 3,567 3,259 3,601 
Information                      2,473 2,314 2,579 2,451 2,502 2,422 2,341 
Finance and insurance            1,958 2,145 2,382 2,403 2,368 2,355 2,347 
Real estate, rental and leasing  2,498 2,735 2,852 2,319 2,414 2,315 2,642 
Professional, scientific, and                                              
technical                        1,948 1,857 2,095 2,244 2,313 2,136 2,002 
Management of companies and                                                
enterprises^c                    2,089 2,220 2,644 3,033 2,447 2,221 2,115 
Administrative and support and                                             
waste management and remediation 5,215 2,923 2,372 2,417 2,352 2,343 2,201 
Educational services             5,034 2,897 4,374 4,108 5,188 4,589 3,675 
Health care and social                                                     
assistance                       3,654 2,701 3,920 3,163 2,872 2,786 2,689 
Arts, entertainment, and                                                   
recreation                       2,194 1,896 1,956 1,954 2,252 1,798 2,029 
Accommodation and food services  2,239 2,702 2,511 2,977 2,566 2,624 2,716 
Other services                   3,809 3,628 3,430 3,376 2,709 3,198 3,237 
Public administration^d          4,213 3,855 5,460 2,617 3,617 2,478 2,488 
All sectors                      1,999 2,034 2,392 2,393 2,413 2,333 2,300 

Source: GAO analysis of Audit Analytics data.

Notes: Based on total audit fees collected in industries defined by two
digit NAICS codes.

^aThe agriculture sector contains fewer than 30 companies.

^bThe warehousing sector contains fewer than 15 companies.

^cThe management of companies and enterprises sector comprises (1)
establishments that hold the securities of companies and enterprises for
the purpose of owning a controlling interest or influencing management
decisions or (2) establishments that administer, oversee, and manage
establishments of the company and that normally undertake the strategic or
organizational planning and decision making role of the company or
enterprise. Not included in any econometric specifications.

^dNot included in any econometric specifications due to an insufficient
number of companies.

While the HHI variable captures the impact of overall concentration on
audit fees, the market share variable can capture two distinct types of
effects. One the one hand, market share can be an indicator of a firm's
degree of monopoly power and large shares can give substantial market
power to the firm if there are no significant competitors. On the other
hand, high market share could result in economies of scale and lower costs
which are then passed on to clients in the form of lower audit fees. In
the case of the market for audit services the market share variable could
also proxy for industry expertise (quality-differentiated services), which
would justify higher fees. Therefore, a positive relationship between
market share and audit fees would be consistent with both market power and
an expertise or quality premium. We further explore this with a number of
models to determine whether individual market power (monopolistic pricing)
or industry expertise most likely explains the positive relationship we
find between market share and audit fees (see results section).

Although, the fixed effect model guards against time invariant omitted
variables bias, it is always advisable to explore possible causes of
heterogeneity. We included a number of control variables in an attempt to
capture the variation in audit fees across companies related to audit
effort (size), risk factors and complexity. Table 10 includes a listing of
the various variables included in the econometric models, ranging from
company size (assets) to indicators of a restatement, a going concern
opinion, negative earnings, late filings and controls for Sarbanes-Oxley
(SOX). Sarbanes-Oxley added new costs to the standard audit, especially
the Section 404 Report on internal controls in 2004.^7 Over the sample
there are some companies that complete the yearly internal control review
beginning in 2004 and other that do not. We controlled for this explicitly
with a dummy variable, as well as an additional dummy if the company was
found to have inadequate controls. As some of these variables may also be
related to the concentration variables, controlling for them also enhances
the internal validity of the parameter estimates.

^7Although compliance was not initially anticipated until 2004 for large
companies or 2005 for smaller companies (before being later delayed), it
is likely that 2003 fees include some Section 404 attestation costs in
preparation for full compliance.

Since accounting firms are now prohibited from providing services such as
financial information system implementation and design, internal auditing,
and a number of other services, any cross subsidization (or low-balling)
of the audit that potentially existed in the early years (2000 and 2001)
is less likely in the later years in our sample. Moreover, as indicated
above, the sample consists of fees reported under the old SEC rules for
2000 and 2001, and fees reported under the new rule for 2002 through 2006.
As a result, we also included time period fixed effects to control for
regulatory changes, changes in the scope and complexity of audit
engagements, changes in the manner in which, the audit was priced or audit
fees were categorized and recorded, and other forces that can be captured
by a company-invariant (consistent across companies) fixed effect.
Collectively the variables and techniques help capture the
characteristics, of the public company client (effect of the amount of
effort required by the auditor), of the auditing industry (e.g., pricing
differences across accounting firms), of the auditor (e.g., knowledge
advantages due to specialization) and of the engagement (e.g., busy
season) and help explain the variation in audit fees across companies. All
appropriate variables were adjusted for inflation.

Table 10: Primary Variables in the Econometric Analysis

Variable                Description                                        
TAFEESADJ               Total audit and audit-related fees paid by a       
                           company to its auditor in 2006 dollars             
ASSETSADJ               Assets of the audited company in 2006 dollars      
BIGCO3                  Indicates whether company has greater than $250    
                           million in assets (2006 dollars).                  
BIGCO1                  Indicates whether company has greater than $1      
                           billion in assets (2006 dollars).                  
BIGCO35                 Indicates whether company has greater than $3.5    
                           billion in assets (2006 dollars).                  
HHI1                    HHI (defined by total audit fees) for a sector     
                           defined by two-digit NAICS code                    
SHAREF                  Percentage of the market (defined by audit fees)   
                           held by a company's auditor of record              
LOSS                    Indicates whether company experienced a loss in a  
                           given year                                         
GC                      Indicates concern about a company's ability to     
                           continue as a going concern was raised             
RESTATDUM               Indicates whether a company filed restated         
                           financials during the year                         
LATE                    Indicates whether a company filed a notice of      
                           nontimely filing during the year                   
INTERNAL                Indicates whether a company completed the          
                           Sarbanes-Oxley Act Section 404 review              
INADEQ                  Indicates whether companies internal control were  
                           found inadequate                                   
POSTSOX                 Indicates audit year occurs after the passage of   
                           the Sarbanes-Oxley Act                             
BUSY                    Indicates whether the company's fiscal year end    
                           date occurs during the busy season (December)      
CI (Client Influence)^a Measured as the fees paid by the company to a      
                           given audit firm relative to total fees paid by    
                           all clients audited by that firm in a given        
                           industry sector                                    
EXPERT                  Indicates whether a given firm audits 10 percent   
                           or more of all company clients audit in a          
                           particular industry sector                         
BIG45                   Indicates whether a company is audited by one of   
                           the largest firms in a given year                  
MID4                    Indicates whether a company is audited by a        
                           midsize firm in a given year                       
SEPARAUDITOR            Indicates whether the company paid additional      
                           audit-related fees to a second auditor             
AUCH0006                Number of auditor switches for a given company     
                           over the 2000-2006 period                          
AACLIENT2002            Indicates whether a company switched from Andersen 
                           in 2002                                            
Firm                    Audit Firm specific dummy variables for the top    
                           eight firms                                        
Year                    Year dummy variables (period-fixed effects)        
Region                  Region dummy variables (Canada, Foreign and        
                           various section of the US)                         
Industry                Industry dummy variables (defined by two-digit     
                           NAICS codes)                                       

Source: GAO.

^aAs pointed out in S. Bandyopadhyay and J. Kao, "Market Structure and
Audit Fees: A Local Analysis," Contemporary Accounting Research, vol. 21,
issue 3 (fall 2004), one might expect a dominant auditor to restrain any
pricing behavior when faced with a powerful audit client, resulting in a
diminished positive relation between auditor market concentration and
audit fees. We include this variable to control for this possibility.
Since, in the regressions below it is typically positive when it is
significant--contrary to theoretical expectation--this variable could be a
proxy for complexity.

As table 11 shows there is a low degree of correlation between most of the
explanatory variables in the panel. However, there is a high degree of
correlation between the market share variable, the dummy indicating
whether a firm is an industry expert and the dummy variable which
indicates whether a company is audited by one of the largest accounting
firms (Big 4/5 dummy variable). In fact, principal components analysis
suggests the Big 4/5 dummy variable adds very little to a model once the
market share variable is included.^8 As a result the Big 4/5 is not
included in a given model if the market share variable is also being
estimated. We also drop the expert variable in some specifications for
sensitivity analysis in lieu of the somewhat high correlation with the
market share and the interaction variables. It should be noted however,
the correlation between HHI and market share is relatively low.

^8Principal components analysis involves a mathematical procedure that
transforms a number of possibly correlated variables into a small number
of uncorrelated variables called principal components. The first principal
component accounts for as much as the variability in the data as possible,
and each succeeding component accounts for as much as the remaining
variability as possible. In our case the market share variable accounts
for 96 percent of the variance in the factor space.

Table 11: Correlation Matrix, GAO Panel Data Set, Select Variables

                  1     2     3     4     5     6     7     8     9     10    11    12   13    14    15   
1. Log(ASSETSADJ)  1.00                                                                                   
2. LOSS           -0.43  1.00                                                                             
3. GC             -0.49  0.32  1.00                                                                       
4. POSTSOX        -0.03 -0.05  0.07  1.00                                                                 
5. BUSY            0.10 -0.02 -0.01  0.12  1.00                                                           
6. CI             -0.26  0.11  0.19  0.04 -0.01  1.00                                                     
7. EXPERT          0.53 -0.16 -0.31 -0.08  0.01 -0.36  1.00                                               
8. Log (HHI1)      0.07 -0.05 -0.03  0.20  0.01  0.02  0.08 1.00                                          
9.                 0.77 -0.38 -0.30  0.00  0.10 -0.21  0.40 0.06  1.00                                    
Log(HHI1)*BIGCO03                                                                                         
10. Log(SHAREF)    0.61 -0.20 -0.38 -0.10  0.02 -0.45  0.88 0.09  0.44  1.00                              
11. INTERNAL       0.29 -0.17 -0.18  0.24  0.11 -0.09  0.18 0.01  0.28  0.22  1.00                        
12. INADEQ         0.06  0.00 -0.04  0.07  0.02 -0.02  0.04 0.00  0.05  0.06  0.30  1.00                  
13. LATE           -035  0.20  0.40  0.15 -0.06  0.19 -0.29 -0.01 -0.24 -0.33 -0.05 0.12 1.00             
14. RESTATDUM     -0.02  0.05  0.07  0.07 -0.03  0.04 -0.03 0.01  -0.02 -0.02 0.05  0.13 0.25  1.00       
15. BIG45          0.56 -0.17 -0.32 -0.11  0.02 -0.38  0.94 0.10  0.43  0.92  0.18  0.04 -0.31 -0.03 1.00 

Source: GAO.

Results

We ran roughly 100 different models, including several pooled OLS,
random-effects and fixed-effects models with varied specifications as
sensitivity tests. Given the number of issues that plague the simple OLS
model and that formal tests strongly rejected the pooled OLS model in
favor of fixed-effects, we do not report the pooled OLS results in this
appendix. Moreover, since the Hausman test overwhelming rejected the
random-effects in favor of the fixed-effect model, we present the results
for the random-effects models for comparison only.^9 Note, also, that the
time invariant variables (Z[i]), such as number of auditor changes over
the period, and industry and region indicators appear in the
random-effects model but not in the fixed-effects models as these
variables are collinear with the unique fixed-effect estimated for each
company. The random and fixed-effects models run on 2002 through 2006 data
suggest that, in general, companies operating in more concentrated
industries do not pay higher fees when other important drivers of audit
fees are included (table 12). Moreover, focusing on the fixed-effect
results, we found this result to hold even when we included 2000 and 2001
in the analysis or if we include only the post Sarbanes-Oxley years
(2003-2006). In all cases, the HHI is positive but statistically
insignificant.

^9Additionally, the random effects model allows us to attempt to separate
out the partial effects of the time invariant variables.

Table 12: Random-Effects and Fixed-Effects Models Explaining Log of Fees

                    Random                                                                                                     
                    Effects                           Fixed Effects                                                            
                                                                                                                      $3.5     
                                                                                            $1 billion               billion   
                                                                                            interaction            interaction 
                                              $250 million interaction term                    term                   term     
                    2002 -                2000 -     2001 -     2002 -    2003 -                                               
                    2006^a                 2006       2006       2006      2006             2001 - 2006            2001 - 2006 
                   N= 34,688            N= 43,239  N= 39,905  N= 34,703  N= 28,238           N= 39,905              N= 39,905  
C                    8.5647**             7.5929**   7.4699**   7.5436**  7.9463**             7.7733**               7.7827** 
                    (16.8464)            (21.6481)  (14.5038)  (11.2777)  (9.3876)            (15.3838)              (15.6559) 
YEAR2001                 ----             0.1454**       ----       ----      ----                 ----                   ---- 
                                         (14.8267)                                                                             
YEAR2002                 ----             0.3175**   0.1689**       ----      ----             0.1686**               0.1724** 
                                         (18.8100)  (10.4579)                                 (10.4400)              (10.7074) 
YEAR2003             0.1280**             0.4642**   0.3127**   0.1357**      ----             0.3094**               0.3132** 
                    (16.2787)            (24.9257)  (17.6895)  (17.8404)                      (17.4808)              (17.7304) 
YEAR2004             0.3156**             0.6622**   0.5095**   0.3348**  0.1998**             0.5085**               0.5131** 
                    (36.2896)            (33.7899)  (27.4027)  (36.9703) (24.1626)            (27.3279)              (27.6594) 
YEAR2005             0.3722**             0.7426**   0.5861**   0.4088**  0.2724**             0.5850**               0.5906** 
                    (37.0582)            (37.1455)  (31.4034)  (37.0063) (26.4758)            (31.3368)              (31.7133) 
YEAR2006             0.3988**             0.7693**   0.6142**   0.4383**  0.3012**             0.6137**               0.6223** 
                    (36.8647)            (35.3901)  (30.0785)  (31.1552) (22.4383)            (30.0751)              (30.5558) 
LOG(ASSETSADJ)       0.2830**             0.2636**   0.2599**   0.2527**  0.2637**             0.2615**               0.2639** 
                   (122.2293)            (44.4466)  (42.3690)  (39.3751) (35.9253)            (44.2531)              (45.5836) 
LOSS                 0.0398**             0.0363**   0.0337**   0.0299**   0.0278*             0.0269**                0.0213* 
                     (5.2908)             (4.6571)   (4.0579)   (3.1582)  (2.2360)             (3.2108)               (2.5405) 
GC                   0.1689**             0.1396**   0.1279**   0.1004**  0.1198**             0.1264**               0.1297** 
                    (13.8142)             (8.7037)   (7.5207)   (5.3223)  (5.1789)             (7.4163)               (7.5889) 
POSTSOX              0.0823**             0.0697**   0.0685**   0.0691**      ----             0.0717**               0.0703** 
                     (5.1217)             (4.6988)   (4.5681)   (4.2092)                       (4.7615)               (4.6686) 
BUSY                 0.1085**             0.1314**   0.1362**   0.1302**  0.1184**             0.1346**               0.1339** 
                     (9.8573)             (4.3232)   (4.4531)   (4.1105)  (3.5753)             (4.4561)               (4.4427) 
CI                   0.9475**             0.9034**   0.8999**   0.9147**  0.8870**             0.8835**               0.8854** 
                    (47.8395)            (31.5599)  (29.1252)  (25.9041) (21.8819)            (28.9938)              (29.0351) 
EXPERT              -0.4333**            -0.3211**  -0.3357**  -0.3818** -0.3251**            -0.3375**  -0.3421**             
                   (-23.6342)           (-16.7375) (-15.7221) (-12.7964) (-9.3465)           (-15.9276) (-16.1688)             
SEPARAUDITOR           0.0114               0.0348     0.0452     0.0531    0.0358               0.0494     0.0545             
                     (0.2679)             (0.7225)   (0.9213)   (1.0520)  (0.6314)             (1.0056)   (1.1057)             
LOG(HHI1)             -0.0602               0.0199     0.0633     0.1001    0.0443               0.0295     0.0281             
                    (-0.9353)             (0.4521)   (0.9644)   (1.1852)  (0.4131)             (0.4595)   (0.4431)             
LOG(HHI1)*BIGCO3     0.0559**             0.0386**   0.0437**   0.0502**  0.0503**                 ----       ----             
                    (35.5015)            (15.2818)  (15.9620)  (15.9526) (13.3452)                                             
LOG(HHI1)*BIGCO1         ----                 ----       ----       ----      ----             0.0502**       ----             
                                                               (16.4422)                                                       
LOG(HHI1)*BIGCO35        ----                 ----       ----       ----      ----                 ----   0.0664**             
                                                               (15.9693)                                                       
LOG(SHAREF)          0.2753**             0.2577**   0.2610**   0.2757**  0.2722**             0.2611**   0.2636**             
                    (71.2752)            (47.1572)  (44.0156)  (37.6615) (32.4633)            (44.4352)  (44.5784)             
INTERNAL             0.3870**             0.3644**   0.3655**   0.3663**  0.3667**             0.3542**   0.3564**             
                    (45.3539)            (40.1350)  (40.0650)  (38.6133) (34.2462)            (38.7978)  (39.2137)             
INADEQ               0.2043**             0.2488**   0.2183**   0.1811**  0.1568**             0.2306**   0.2308**             
                    (12.6448)            (13.0846)  (11.4915)   (9.4094)  (7.9006)            (12.2212)  (12.2179)             
AACLIENT2002          -0.0203                 ----       ----       ----      ----                 ----       ----             
                    (-0.9367)                                                                                                  
LATE                 0.1003**                 ----       ----   0.0891**  0.0857**                 ----       ----             
                    (11.7026)             (8.6441)   (7.3398)                                                                  
RESTATDUM            0.0926**                 ----   0.1050**   0.0759**  0.0668**             0.1024**   0.1018**             
                     (9.6802)             (9.8963)   (6.6881)   (5.3366)           (9.6697)    (9.6201)                        
AUDCHS0006            -0.0014                 ----       ----       ----      ----                 ----       ----             
                    (-0.1862)                                                                                                  
Dummy variables                                                                                                                
Industry                  Yes                   No         No         No        No                   No         No             
Regional                  Yes                   No         No         No        No                   No         No             
Other statistics                                                                                                               
Hausman test of                                                                                                                
random effects                                                                                                                 
model                862.9703                 ----       ----       ----      ----                 ----       ----             
s[e                    0.4241               0.4271     0.4249     0.4264    0.4324               0.4242     0.4236             
]R^2 b                 0.8442               0.9345     0.9371     0.9397             0.9373      0.9375                        
 Public Companies F-statistic 3999.2990               63.4299    57.9157   47.9965              63.6369    63.8281             
 Public Companies                                                                                                              
65.6400 Public                                                                                                              
 Companies Public                                                                                                              
 Companies Public                                                                                                              
 Companies Public                                                                                                              
 Companies Public                                                                                                              
 Companies Public                                                                                                              
        Companies                                                                                                              
Durbin Watson                                                                                                                  
Statistic              1.4526               1.7779     1.8756     2.0300    2.3273               1.8755     1.8745             
Information                                                                                                                    
criterion                                                                                                                      
Akaike                   ----               1.3282     1.3307     1.3606    1.4210               1.3276     1.3247             
Schwarz                  ----               3.2417     3.3817     3.6741    4.1530               3.3786     3.3757             
Hannan-Quinn             ----               1.9316     1.9800     2.0978    2.3001               1.9769     1.9740             

Source: GAO.

Notes: T-statistics are in parentheses. * indicates significance at the 5
percent level and ** indicates significance at the 1 percent level.

^aWhites' stacked covariance matrix was not used. In all other cases the
covariance matrix was adjusted.

^bAdjusted R2 is reported.

To explore the differences between different size companies, we also
interacted the HHI variable with a dummy variable that indicates whether a
company exceeds $250 million in assets. This variable is both positive and
significant, indicating that larger firms operating in more concentrated
industries may pay higher fees, but we note that this effect is very
small. Because this was an arbitrary definition which would include a
number of companies considered small by other sources, we varied our
definition of large using various cut-off values. When we defined large as
$1 billion or $3.5 billion in assets the results remain the same.
Consistently the estimates suggest that a 10 percent increase in the HHI
for large companies results in an increase in audit fees around 0.5
percent. Since the dissolution of Andersen initiated an increase in the
HHI by about 18 percent, the model suggests that the result on audit fees
for the largest public companies would have been less than 1 percent.^10
By comparison the estimated effect of the 404 internal control
requirements resulted in roughly a 45 percent increase in audit fees,
while issuing a financial restatement is associated roughly with an 11
percent increase in fees. However, when we ran the models only on
companies with assets greater than $250 million in assets (or any other
sub-samples of large companies defined by assets) we found no relationship
between industry concentration and audit fees for these companies. When we
defined large by some measures we found a negative but statistically
insignificant relationship between HHI and audit fees. Further, when we
ran the model only on clients of the largest firms the coefficients on the
interaction term were either much smaller (substantively insignificant) or
statistically insignificant. As a result, this finding regarding the price
impact for larger companies may not be robust and should be interpreted
with caution.

^10For individual sectors this result could vary. For example, since the
dissolution of Arthur Andersen led to an increase in the HHI by about 36
percent in the utilities sector, the model suggests the resultant impact
on audit fees for large companies (with over $1 billion in assets or
revenue) in this sector would have been roughly 1.8 percent. Either way
this is a very small especially when viewed as a percentage of large
company assets or revenue.

Table 13: Fixed Models Explaining Log of Fees, by Market Segments,
2001-2006

                                     Fixed effects: 2001-2006
                                           >$500                                 
                      >$250      <$250   million      > $1       < $1     < $0.1 
                    million million in        in   billion billion in billion in 
                  in assets     assets   revenue in assets     assets     assets 
                  N= 19,351  N= 20,554 N= 11,815 N= 10,433  N= 29,472  N= 15,918 
C               3.4023**  10.2934**  6.1074**  5.3434**   9.4437**  10.3934** 
                   (4.4859)  (14.0739)  (6.5726)  (4.5316)  (16.1935)  (12.9132) 
YEAR2002        0.1111**   0.2056**  0.1379**  0.1472**   0.1881**   0.1914** 
                   (5.0155)   (9.3704)  (5.2792)  (4.4616)  (10.6026)   (7.5918) 
YEAR2003        0.2445**   0.3581**  0.2709**  0.2735**   0.3354**   0.3468** 
                  (10.2598)  (14.7338)  (9.5418)  (7.9036)  (17.0191)  (12.3685) 
YEAR2004        0.4148**   0.5687**  0.4201**  0.4205**   0.5475**   0.5556** 
                  (16.2569)  (22.5425) (13.5887) (11.2816)  (26.5975)  (19.0359) 
YEAR2005        0.4524**   0.6698**  0.4481**  0.4424**   0.6337**   0.6685** 
                  (17.4146)  (27.2448) (13.9584) (11.8177)  (30.9360)  (23.6873) 
YEAR2006        0.4488**   0.7138**  0.4386**  0.4417**   0.6721**   0.7147** 
                  (15.7695)  (26.5128) (12.4807) (10.9920)  (30.0593)  (23.2328) 
LOG(ASSETSADJ)  0.4650**   0.1589**      ----  0.4799**   0.2051**   0.1331** 
                  (29.3864)  (26.5241) (16.8403) (33.5556)  (22.5666)            
LOG(REVADJ)         ----       ----  0.4363**      ----       ----       ---- 
                             (17.8800)                                           
LOSS            0.0628**    0.0233*  0.0851**  0.0552**    0.0218*    0.0274* 
                   (5.4216)   (2.2515)  (6.3595)  (3.5098)   (2.3915)   (2.3546) 
GC               0.0958*   0.0518**   0.0982*    0.1042   0.0884**     0.0249 
                   (2.2106)   (3.0334)  (2.0738)  (1.8025)   (5.1790)   (1.4470) 
POSTSOX         0.1285**    -0.0038  0.1371**  0.1204**   0.0445**    -0.0178 
                   (6.2325)  (-0.1925)  (5.5588)  (4.0780)   (2.6985)  (-0.7790) 
BUSY             -0.0071   0.2142**  0.2570**    0.0198   0.1798**   0.2502** 
                  (-0.1238)   (5.0299)  (3.1510)  (0.1909)   (5.0642)   (5.4635) 
CI              1.5222**   0.8691**  2.3798**  2.1143**   0.8556**   0.9039** 
                  (18.0067)  (25.6574) (14.0979) (11.3065)  (27.4069)  (24.6155) 
EXPERT         -0.1889**  -0.6588** -0.1056** -0.1166**  -0.4559**  -0.8101** 
                  (-7.3891) (-18.8267) (-3.2930) (-3.5222) (-17.4709) (-18.9266) 
SEPARAUDITOR      0.0469     0.0098   -0.0082   -0.1107     0.0404    -0.0198 
                   (0.4328)   (0.1743) (-0.0422) (-0.4357)   (0.8328)  (-0.3128) 
LOG(HHI1)         0.0670    -0.0537   -0.1748   -0.2262    -0.0566    -0.0035 
                   (0.7349)  (-0.5658) (-1.8132) (-1.7274)  (-0.7589)  (-0.0339) 
LOG(SHAREF)     0.2540**   0.2913**  0.3430**  0.2686**   0.2714**   0.3105** 
                  (24.3212)  (36.5375) (15.1644) (15.6734)  (40.9955)  (33.9122) 
INTERNAL        0.3878**   0.4562**  0.3663**  0.3418**   0.4395**   0.4680** 
                  (33.6500)  (27.6471) (26.3227) (22.6297)  (38.7850)  (19.8015) 
INADEQ          0.1882**   0.2132**  0.2188**  0.1661**   0.2353**   0.1980** 
                   (8.9729)   (6.0029)  (9.0037)  (6.2371)  (10.4055)   (3.2663) 
RESTATDUM       0.1066**   0.1105**  0.0886**  0.0988**   0.1099**   0.1168** 
                   (7.9981)   (7.5543)  (5.8784)  (5.7273)   (9.0035)   (7.1903) 
Dummy                                                                         
variables                                                                     
Industry              No         No        No        No         No         No 
Region                No         No        No        No         No         No 
Other                                                                         
statistics                                                                    
s[e               0.3484     0.4110    0.3212    0.3193     0.4129     0.4041 
]R^2 a            0.9384     0.8879    0.9244    0.9365     0.9052     0.8762 
F-statistic      60.9300    28.0144   46.9472   54.9306    36.8678    23.5043 
Durbin Watson     1.8034     2.1176    1.8467    1.8216     2.0067     2.1538 
Statistic                                                                     
Information                                                                   
criterion                                                                     
Akaike            0.9443     1.2987    0.7896    0.7820     1.2917     1.2768 
Schwarz           2.9466     3.6239    2.7545    2.7668     3.4984     3.6906 
Hannan-Quinn      1.6005     2.0584    1.4492    1.4524     2.0003     2.0754 

Source: GAO.

Notes: T-statistics are in parentheses; * indicates significance at the 5
percent level and ** indicates significance at the 1 percent level.
Whites' stacked covariance matrix was used in all specifications.

^aAdjusted R^2 is reported.

The models also consistently show that accounting firms holding a larger
market share of the industry in which the public company operates are
found to charge higher fees (Sharef is statistically significant and
positive in each instance) but this leaves open the question as to whether
the empirical evidence is supportive of expertise-quality-differentiated
services or anticompetitive pricing. Unfortunately, these are extremely
difficult issues to address in a rigorous and comprehensive manner.
Similar to other studies, we investigated the audit fee-market share
relationship in various large and small client segments of the market. We
found that market share-related price premium also exists in the small
client segment of the market and these premiums were not statistically
different from those that existed in the large company segment of the
market (table 13).^11 Even when we ran the model on companies with assets
below 100 million, we still found a statistically significant and positive
relationship between the auditor's share of the market (Sharef) and audit
fees. It should be noted that the HHI for this sector was well below the
critical value of 1,000 in 2006. Therefore, the persistence of this
positive relationship between market share and audit fees in all segments
of the market--even those predisposed to perform competitively--suggest it
is more likely due to industry or technical expertise
(quality-differentiated service) and in the case of the larger firms,
brand-name reputation.^12 A firm with industry expertise may exploit its
specialization by developing and marketing audit-related services which
are specific to clients in the industry and provide a higher level of
assurance. If this is the case, such firms could earn a return on this
investment by charging higher audit fees than other firms and remain
competitive for the most relevant opportunities, even at a premium price.
It should be noted that Oxera (2006), using similar modeling techniques,
interpreted this association as an indicator of market power in U.K. audit
markets but did not acknowledge the presence of quality differentiated
services and industry expertise nor report any further investigation to
unpack the relationship.^13

^11Since price competition is assumed to prevail in the small client
segment of the audit market because of its low concentration, any premium
existing due to the effect of market power should be competed away but
premiums that exist due to brand name reputation or quality-differentiated
services will not.

^12This interpretation of the premium accruing to larger firms is
commonplace in the academic literature on audit fees.

^13"Competition and Choice in the UK Audit Market," Oxera (April 2006).

We conducted a number of sensitivity test to examine the robustness of our
findings. For example, we used the log of audit fees--net of audit-related
fees--as the dependent variable and obtained similar results. To
investigate whether multicollinearity was an issue, we ran a number of
models excluding the potentially collinear variables and obtained similar
results. We also altered the functional form, using market share instead
of logged market share, and obtained results which more strongly supported
our initial results. Because estimated coefficients of the fee
determinants could differ significantly for the largest and other
auditors, we also ran the model separately for these two classes of firms.
To address potential problems of endogeneity we estimated the
relationships using two-stage least squares. Finally, to investigate
whether the results were sensitive to unbalanced nature of the data--the
number of companies in the sample for each industry differs across the
years--we estimated the model using sample probability weights, where the
weights are based on the number of companies in a given industry (or
alternatively total revenues, fees paid or assets). In our case, this
amounted to de-meaning the data to obtain the fixed effects estimates and
then running weighted least squares. Consistently, we found no evidence of
a positive and significant relationship between industry concentration and
audit fees.

While our analysis suggests the increase in audit fees appears largely
unrelated to supplier concentration, it is difficult to determine the
extent to which audit pricing is consistent with competitive behavior with
the available data because of all the contemporaneous changes occurring in
the market. As a result these results should be interpreted with a
consideration of a number of limitations. First, this is an aggregate
analysis and, therefore, does not demonstrate that all companies receive a
competitive price (local markets may be important). Moreover, the absence
of evidence of uncompetitive pricing does not necessarily imply that we
can conclude that the market is competitive from a pricing perspective.
Second, our results are based on one battery of tests focused on industry
(economic sector) concentration and this does not imply that it is the
definitive way to examine the effect of concentration on prices. While
evidence suggests that some sectors have particularly complex audits and
sector-specific expertise is an important determinant of auditor choice
many companies are involved in activities that cut across multiple
industries raising some questions about characterizing industry-specific
markets as unique audit markets, especially for large firms. Our
investigation was undertaken because it appeared to be a useful way to
consider the effect of concentration given the available data. Additional
data may allow for analysis that may address the issue more completely or
more validly. Third, although the fixed effect estimator is robust to the
omission of any relevant time-invariant variables and we have explained
over 90 percent of the variation in fees, if there are time-varying
differences that have been omitted, the results could be biased. As
complexity and inherent risk of the individual client audits could vary
over time there is some concern that financial variables traditionally
included in the literature could not be included here (e.g. number of
subsidiaries, inventory and receivables). However, this threat should be
balanced against the power of the fixed-effects estimator which may
capture some of this effect.

Fourth, our conclusion that quality-differentiation and industry expertise
most likely better explains market dynamics than monopolistic pricing,
while standard in the academic literature, critically hinges on the
smaller company segment actually performing competitively. We, like
others, have made this assumption based on the low HHI statistics computed
for that segment of the market and other market indicators that suggest
competitive pricing for smaller companies. Users of this report should
note that our tests of individual market power were limited and the
results should be interpreted in light of this limitation. Fifth,
potential measurement error in the audit fee variable, assuming it is
random, would make it more likely that we would conclude that a
relationship does not exist when indeed it does. Given the large amount of
the variation in fees we have explained and the techniques we have used,
this (statistical validity) would not appear to be an issue.

Appendix VI: GAO Contacts and Staff Acknowledgments

GAO Contacts

Orice M. Williams, (202) 512-8678 or [email protected] Jeanette M.
Franzel, (202) 512-9471 or [email protected] Thomas J. McCool, (202)
512-2642 or [email protected]

Staff Acknowledgments

In addition to the contacts named above, Cody Goebel and John J. Reilly
Jr., Assistant Directors; William Bates; Tania Calhoun; Emily Chalmers;
William R. Chatlos; Bob Dacey; Francis Dymond; Lawrance Evans Jr.; Kristen
Kociolek; Annamarie Lopata; Kimberly McGatlin; Marc Molino; Jill M.
Naamane; Karen O'Conor; Carl Ramirez; Nicole Riggs; John Saylor; Jeremy
Schwartz; Estelle Tsay; Richard Vagnoni; Ethan Wozniak; and Tory Wudtke
also made key contributions to this report.

(250321)

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Highlights of [89]GAO-08-163 , a report to congressional addressees

January 2008

AUDITS OF PUBLIC COMPANIES

Continued Concentration in Audit Market for Large Public Companies Does
Not Call for Immediate Action

While the small public company audit market is much less concentrated, the
four largest accounting firms continue to audit almost all large public
companies. According to GAO's survey, 82 percent of large public
companies--the Fortune 1000--saw their choice of auditor as limited to
three or fewer firms, and about 60 percent viewed competition in their
audit market as insufficient. Most small public companies reported being
satisfied with the auditor choices available to them.

Percentage of Companies Audited by Four Largest Accounting Firms, by
Company Size

Although audit fees rose significantly in recent years, market
participants attributed these increases to expanding accounting and
auditing requirements and higher costs for accounting firm personnel.
GAO's model also found that factors other than concentration appeared to
explain audit fee levels. Public company officials generally acknowledged
that audit quality had increased. Although current concentration does not
appear to be having a significant adverse effect, the loss of another
large firm would further reduce large companies' auditor choice and could
affect audit fee competitiveness.

Smaller accounting firms face various challenges in expanding to audit
more public companies, although most are not interested in these clients.
As a result, concentration in the audit market for large public companies
is likely to continue. Large public companies that GAO surveyed said that
smaller firms lacked the capacity and technical expertise they wanted in
an auditor. Audit firms that GAO surveyed said that adding qualified staff
and increasing their name recognition were the most significant challenges
they faced in expanding their public company audit practices. Some have
taken steps to increase their capacity by joining networks with other
firms.

Academics and business groups have put forth proposals to reduce audit
market concentration and address challenges facing smaller accounting
firms, including capping auditors' liability and creating an office to
share technical expertise. Market participants raised questions about the
overall effectiveness, feasibility, and benefit of these proposals, and
none were widely supported. Given the lack of significant adverse effect
of concentration in the current environment and that no clear consensus
exists on how to reduce concentration, no compelling need for immediate
action appears to exist.

GAO has prepared this report under the Comptroller General's authority as
part of a continued effort to assist Congress in reviewing concentration
in the market for public company audits. The small number of large
international accounting firms performing audits of almost all large
public companies raises interest in potential effects on competition and
the choices available to large companies needing an auditor. This report
examines (1) concentration in the market for public company audits, (2)
the potential for smaller accounting firms' growth to ease market
concentration, and (3) proposals that have been offered by others for
easing concentration and the barriers facing smaller firms in expanding
their market shares.

GAO surveyed a random sample of almost 600 large, medium, and small public
companies on their experiences with their auditors. GAO also interviewed
the four largest accounting firms and surveyed all other U.S. accounting
firms that audit at least one public company. GAO also developed an
econometric model that analyzed the extent to which various factors,
including concentration and new auditing requirements, affected fee
levels. To supplement this work, GAO interviewed market participants,
including public companies, investors, accounting firms, academics, and
regulators.

This report makes no recommendations.

References

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  79. http://www.gao.gov/cgi-bin/getrpt?GAO-08-164SP
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