GAO Admits The Big 4 Audit Competition Problem, But Fails To Suggest Any Remedies

January 2008

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The U.S. Government Accountability Office (GAO) survey released last week by found that the concentration within the audit firms was a problem, but then failed to suggest a single suggestion to deal with the problem. The GAO’s conclusion (report GAO-08-163) conflicts with other reports by private-sector groups (including the U.S. Chamber of Commerce), and UK and EU regulators.

Insufficient competition is indisputable

The GAO reports that the four largest accounting firms (aka the Big 4) audit 98 percent of the more than 1500 largest public companies with revenues in excess of $1 billion. This has been the case for years. Not surprisingly, with this concentration, the GAO’s survey shows that 60 percent of large public companies say that competition is insufficient.

This lack of sufficient competition is ratified by the GAO’s presentation of the Hirschman-Herfindahl index (HHI), which measures market concentration. The HHI is used by government agencies, including the Department of Justice and the Federal Trade Commission, when assessing concentration to enforce U.S. antitrust laws. The HHI for audit services to companies with over $1 billion of revenues is approximately 2500, and is modeled to increase to approximately 3300 should even the smallest of the Big 4 firms were to cease operating. According to Department of Justice standards, any number over 1800 is highly concentrated.

If any of the Big 4 firms were hit with one large (or a combination of smaller) adverse litigation results, their large clients and the capital markets would be scrambling for alternatives. Hank Paulson, Treasury Secretary describes the situation as:

“There are legitimate questions about the sustainability of the auditing profession’s business model and concern about the high degree of auditor concentration among the largest public companies.”

The entire subject arises because of the removal of Arthur Andersen by federal prosecutors in Houston because of destruction of evidence charges by a handful of rogue partners. This conviction was overturned by a unanimous Supreme Court (Arthur Andersen vs. United States, 544 U.S. 696 (2005)), but the firm was long-destroyed at that point. As a result of the desire to not have this concentration made worse, KPMG avoided facing Andersen’s fate for illegal tax shelter conduct, even though the scope of KPMG’s wrongdoing was substantially larger than Andersen’s.

Normally, concentrated markets raise concerns about adequate price competition. In this case, audit fees have grown significantly in recent years. But the GAO found that the increase in fees was not due to inadequate competition and instead could be entirely attributed to (i) increased work from additional regulatory requirements, and (ii) increased costs for personnel.

Despite the current and potential future competitive problems identified by the GAO, they nonetheless concluded:

“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.”

In defending this conclusion to the Financial Times, David Walker (the U.S. Comptroller General, and head of the GAO) said:

“Part of the question should be ‘What form would any action take?’ There are not that many actions that the government could take in this regard.”

Since the GAO can’t figure out anything to do, we provide a suggestion below.

The Big 4 firms will remain dominant without government involvement

The Big 4’s power, and the likelihood of anything lessening this concentration, are unchanged from a GAO 2003 study (GAO-03-864) performed as a Sarbanes-Oxley requirement. Then, and now, large companies say that they do not even consider a non-Big 4 firm to provide a viable alternative because of:

a) Ability to handle size and complexity of company operations (92% of respondents)
b) Technical capability with accounting principles and auditing standards (80% of respondents)
c) Industry specialization and expertise (68% of respondents)
d) Geographical presence (66% of respondents)
e) Reputation or name recognition (65% of respondents)
f) Expectations or requirements of the shareholders, banks, lenders or underwriters (54% of respondents)

The above six reasons would cumulatively appear to be an overwhelming obstacle, since each of the six reasons has an over 50% rate. Firms other than the Big Four thus have the “chicken and egg” problem of needing enormously greater size before the larger audit clients consider them to be capable of handling the job.

To put the size issue in perspective, the combined size of the fifth, sixth, seventh, and eighth largest audit firms is still substantially smaller than the smallest of the Big 4 firms. The Big 4 firms really are big, as demonstrated by the following revenue amounts for fiscal 2007:

PwC $25.2 billion

Deloitte $23.1 billion

E&Y $21.1 billion

KPMG $19.8 billion

Total $89.2 billion

This is made worse by how infrequently large companies consider making an auditor change. In 2003, the GAO reported the extremely long tenure of the audit relationships. According to the GAO, Fortune 1000 companies have used the same audit firm for an average of 22 years. This 22-year average is dramatically lower because of Andersen’s failure, which required all of Andersen’s clients to seek a new audit firm. Unfortunately, the GAO fails to report the average without the Andersen-related changes. However, the GAO does report that, even with the auditor turnover caused by the Andersen failure, approximately ten percent of public companies had the same audit firm for more than 50 years, with an average tenure of more than 75 years. Again, Andersen’s failure made these statistics artificially smaller.

In contrast, most small companies now think that there are adequate choices and competition. The GAO’s HHI calculation for the smaller company market (those with $100 million or less in revenues) confirmed this survey result. This represents a change since the passage of the Sarbanes-Oxley Act (SOX). This occurred in large part because the large firms resigned from these smaller (and less profitable) clients because of resource constraints, or raised their fees higher than some smaller companies were willing to pay.

Audit rotation of audit firms should be mandated

The GAO bases its report too much on what others are saying, and not enough on creating its own creative and proactive answer. The first alternative that the GAO considered (but then rejected) was a mandatory auditor rotation.

Mandatory rotation of audit firms (not just individual partners within the firm, as exists now) would do much to remove the inbred relationship that exists between the auditors and management. Management and auditors would realize that a new set of eyes would see any questionable judgments at the beginning of each rotation period. The Big Four firms and their larger clients have steadfastly resisted this notion.

It is difficult for the auditor to replace large clients after taking a hard line on the propriety of financial reporting. With the extremely low turnover of audit relationships, no wonder the Big 4 firms are slow to upset their relationship with management. This is especially true since the vast majority of audit partners serving the largest companies have only one client. If that one client is lost, the individual audit partner faces likely employment termination because there is little chance of obtaining sufficient new work to replace the lost client. This places intense pressure on an individual audit partner whose entire livelihood depends on serving his only client.

Perhaps the easiest way to kill a legislative idea is to have it loose momentum by having government bureaucrats perform a study. SOX drafters specifically considered mandatory auditor rotation to reform the public accounting profession. However, because of effective lobbying by accounting and business interests, rotation proponents settled for SOX Section 207, which requires a study “of the potential effects of requiring the mandatory rotation of registered public accounting firms”.

In 2003, the GAO issued its report required by SOX Section 207. However, instead of performing any semblance of an independent study, the GAO limited its work to a survey of the same accounting and business interests that were successful in keeping audit firm rotation out of SOX. Not surprisingly, the “study” simply repeats the one-sided interests that were surveyed.

In the current study on audit competition, the GAO mentions auditor rotation as the first possible improvement to the audit competition challenge. The GAO correctly notes that rotation alone will not increase the number of competitors. However, the GAO reports that rotation would provide (i) experience with changing from a single audit provider, and (ii) additional opportunities for midsize audit firms to propose (and win) clients where there would otherwise not be a change.

Unfortunately, the GAO relies on its 2003 failed study by stating that the Big 4 audit firms and the large audit clients do not want to implement auditor rotation. Humorously (although the GAO was not trying to be funny), the GAO said that one of the reasons for not implementing auditor rotation was that “audit firms could incur higher marketing costs as the increased efforts to acquire or retain clients.” Yes, that’s right. The audit firms would have to compete, but that was supposed to be the focus of the GAO study.

Audit rotation is a good idea that will not come until a major crisis forces change. Unfortunately, neither the GAO, the Securities and Exchange Commission, nor Congress have the backbone to make this controversial suggestion. Too bad.

Fulcrum Inquiry is a licensed CPA firm that performs forensic accounting, financial investigations, and operates SOX-compliant whistleblower complaint systems.

PwC	$25.2 billion
Deloitte	$23.1 billion
E&Y	$21.1 billion
KPMG	$19.8 billion
Total	$89.2 billion