United States Government Accountability Office Report to Congressional Addressees 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 January 2008 AUDITS OF PUBLIC COMPANIES Accountability Integrity Reliability Continued Concentration in Audit Market for Large Highlights Public Companies Does Not Call for Immediate Action Highlights of GAO-08-163, a report to congressional addressees Why GAO Did This Study What GAO Found GAO has prepared this report While the small public company audit market is much less concentrated, the under the Comptroller General’s four largest accounting firms continue to audit almost all large public authority as part of a continued companies. According to GAO’s survey, 82 percent of large public effort to assist Congress in companies—the Fortune 1000—saw their choice of auditor as limited to three reviewing concentration in the or fewer firms, and about 60 percent viewed competition in their audit market market for public company audits. as insufficient. Most small public companies reported being satisfied with the The small number of large auditor choices available to them. international accounting firms performing audits of almost all large public companies raises Percentage of Companies Audited by Four Largest Accounting Firms, by Company Size Percentage interest in potential effects on (Number of companies) 98%98% competition and the choices 100 95% 92% available to large companies 90% needing an auditor. This report 80 71% examines (1) concentration in the 60 market for public company audits, 44% (2) the potential for smaller 40 22% accounting firms’ growth to ease 20 market concentration, and (3) (1,606) (794) (1,190) (907) (498) (516) (1,211) (1,513) 0 proposals that have been offered 2002 2006 2002 2006 2002 2006 2002 2006 by others for easing concentration <$100 million $100 million - >$500 million - >$1 billion and the barriers facing smaller $500 million $1 billion firms in expanding their market Company revenue shares. Source: GAO analysis of Audit Analytics data. GAO surveyed a random sample of Although audit fees rose significantly in recent years, market participants almost 600 large, medium, and attributed these increases to expanding accounting and auditing requirements small public companies on their and higher costs for accounting firm personnel. GAO’s model also found that experiences with their auditors. factors other than concentration appeared to explain audit fee levels. Public GAO also interviewed the four company officials generally acknowledged that audit quality had increased. largest accounting firms and Although current concentration does not appear to be having a significant surveyed all other U.S. accounting adverse effect, the loss of another large firm would further reduce large firms that audit at least one public companies’ auditor choice and could affect audit fee competitiveness. company. GAO also developed an econometric model that analyzed Smaller accounting firms face various challenges in expanding to audit more the extent to which various factors, public companies, although most are not interested in these clients. As a including concentration and new result, concentration in the audit market for large public companies is likely auditing requirements, affected fee to continue. Large public companies that GAO surveyed said that smaller levels. To supplement this work, GAO interviewed market firms lacked the capacity and technical expertise they wanted in an auditor. participants, including public Audit firms that GAO surveyed said that adding qualified staff and increasing companies, investors, accounting their name recognition were the most significant challenges they faced in firms, academics, and regulators. expanding their public company audit practices. Some have taken steps to increase their capacity by joining networks with other firms. This report makes no recommendations. 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 To view the full product, including the scope expertise. Market participants raised questions about the overall and methodology, click on GAO-08-163. effectiveness, feasibility, and benefit of these proposals, and none were widely To view the results of GAO's surveys to public supported. Given the lack of significant adverse effect of concentration in the companies and accounting firms, click on GAO-08-164SP. For more information, contact current environment and that no clear consensus exists on how to reduce Orice Williams at (202) 512-8678 or concentration, no compelling need for immediate action appears to exist. [email protected]. United States Government Accountability Office 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 Page i GAO-08-163 Public Companies 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 Page ii GAO-08-163 Public Companies 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 This is a work of the U.S. government and is not subject to copyright protection in the United States. The published product may be reproduced and distributed in its entirety without further permission from GAO. However, because this work may contain copyrighted images or other material, permission from the copyright holder may be necessary if you wish to reproduce this material separately. Page iii GAO-08-163 Public Companies 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.