The American Antitrust Institute

AAI Working Paper No. 08-03

ABSTRACT

Title: THE AUDIT INDUSTRY: WORLDS WEAKEST OLIGOPOLY?

Author: Bernard Ascher, Research Fellow, American Antitrust Institute

The worlds audit oligopoly is composed of four accounting firms: PricewaterhouseCoopers,

KPMG, Ernst & Young, and Deloitte Touche Komatsu (the Big 4). These firms are in a strong
position in that they audit the financial statements of nearly all the global public companies in the
world and, arguably, are the only audit firms able to do so. They are huge, privately-owned,
international networks with robust revenues, vast resources, and expertise. Yet they are heavily
regulated by governments, and they are subject to massive lawsuits when investors and creditors
suffer large losses due to fraud or error; these are their major weaknesses. Since the dual shocks
of the collapse of Arthur Andersen (reducing the Big 5 to 4) and the enactment of stringent
regulations by the U.S. Congress in 2002 in reaction to corporate accounting scandals, there is
great concern in the financial community that another company in the oligopoly could be forced
out of business, further reducing the choice of auditors for multinational corporations and
causing disruptions in the marketplace.

This paper reviews the effects of concentration on competition in the market for audits of major
multinational corporations, as well as the effects on audit fees, audit quality, and the regulatory
environment. It observes that competition is far less intense than in earlier years and that
regulatory authorities are reluctant to take severe disciplinary actions against audit firms, but that
the industry remains vulnerable to legal challenge. Global public companies will continue to
face limited choice of auditors until smaller competitors or new competitors can build viable
networks and reputations for high quality audits. The paper examines barriers to market entry
and comments on proposals to promote greater competition, including liability limitations. It
also reports on anticompetitive practices of major accounting firms in the past and the need for
regulatory authorities to maintain constant vigilance to avoid any recurrence. Finally,
responding to the question posed in the title, the paper concludes that considering the industrys
market dominance, the relaxation of punitive actions by regulatory authorities and the
availability of some forms of liability limitation, the audit industry may not be the ideal
candidate for weakest oligopoly in the world.

Date: August 2008

Electronic copy available at: http://ssrn.com/abstract=1337105

Keywords: competition, oligopoly, antitrust, business organization, accounting firms, audit fees,
corporate governance, corporate fraud, liability limitations, Sarbanes-Oxley compliance, capital
markets, globalization, international accounting standards, international financial reporting
standards, regulation, professional services, business schools

JEL Classifications:
D2 Production and Organizations
D4 Market Structure and Pricing
F2 International Factor Movements and International Business
K2 Regulation and Business Law
L1 Market Structure, Firm Strategy, and Market Performance
L2 Firm Objectives, Organization, and Behavior
L4 Antitrust Policy
L8 Industry Studies: Services

Author Contact: bascher@antitrustinstitute.org

AAI Working Papers are works in progress that will eventually be revised and published
elsewhere. They do not necessarily represent the position of the American Antitrust Institute.

Electronic copy available at: http://ssrn.com/abstract=1337105

 THEAUDITINDUSTRY:WORLDSWEAKESTOLIGOPOLY?
ByBernardAscher
ResearchFellow,AmericanAntitrustInstitute


EXECUTIVESUMMARY

Onlyfourfirmsintheworldarecapableofpreparingauditsofthemajorglobalcorporations.This
oligopolyislessfearedforitsmarketdominancethanforitssmallnumberoffirms,whichleavesclients
withlittlechoiceinselectinganauditingcompany.DespiteheavygovernmentregulationintheUnited
States,manyfearthatfurtherconcentrationintheaccountingindustrythroughmergerorbusiness
failurewouldresultinchaosandlossofinvestorconfidenceinthefinancialcommunity.Regulatory
authoritiesappeartobeinhibitedinlevyingseverepenaltiesonthesefirms.Thefirmsaretoobigto
fail.Atthesametime,theBig4arevulnerabletomassivelawsuitswithmultimilliondollarclaimsthat
couldbankruptthem.

ArecentreportbytheU.S.GovernmentAccountabilityOffice(GAO)reviewedthesituationandawide
rangeofproposals(includingliabilitylimitations),butmadenorecommendationforactionatthistime
becauseeachoftheproposedsolutionshasdistinctdisadvantages.

Thispaperreviewsthecompetitiveeffectsofconcentrationintheauditindustry,theproblemsthat
arisefromconcentration,therecentsharpincreaseinauditfees,theindustrysvulnerabilitytomega
lawsuits,andtheproposedsolutions,especiallyliabilitylimitation.Itconcludeswithsomecomments
andconcernsaboutthelackofgreaterchoiceandcompetition.Thepapersuggeststhatmorework
needstobedonetofindwaysofencouragingmidsizeandsmallerfirmstodevelopthecapacityand
reputationtoconductmultinationalauditsandtoreduceimpedimentstotheentryofnewfirmsinto
thefield.

PartIofthepaper(FourAreTooFew)introducestheproblemsandsetsthestagefordiscussionofthe
issues.Thereisgeneralagreementthatthesmallnumberofauditfirmslimitstheabilityofglobal
corporationstoselectorchangeauditorsandthatfurtherdeclineinthenumberwouldcreateserious
problemsinthefinancialcommunity.Canthelevelofcompetitionbeincreasedand,ifso,how?How
cantheU.S.governmentregulateanddisciplinetheauditindustryeffectivelywithoutfurtherweakening
it?Shouldthegovernmentenactlegislationtolimittheindustrysliability?Whatcanbedoneto
removebarrierstotheentryofadditionalglobalauditfirms?

PartII(TheCastofCharacters)describesthenatureoftheoligopoly,itsorigins,size,andstructure.
TheauditoligopolyconsistsoffourgiantaccountingfirmsPricewaterhouseCoopers,Ernst&Young,
KPMG,andDeloitteToucheTohmatsu(TheBig4).Thesefirmsaretheresultofaseriesofmergers,
alongwiththedemiseofArthurAndersen(oneoftheBig5).Theauditindustryisheavilyconcentrated,
consideringthattheBig4accountingfirmscurrentlyauditthevastmajorityofallU.S.publiccompanies
(78percentbasedonthenumberofcompanies;99percentonthebasisoftotalsalesofpublic

3
companies).Collectively,theBig4earnedalmost$90billionworldwidein2007andemployedmore
thanahalfmillionpersons.Inadditiontoaudits,revenuescomefromtaxservicesandbusiness
consulting.EachoftheBig4isnotmonolithicandcentrallyoperated,butratheralooseconfederation
ofindividualmembercompaniesprivatelyownedpartnershipsconnectedbyacommonbrandand
networkofcommunications.Eachfirmhassuccessfullyprojectedtheimageofaglobalorganization,
ratherthanonetiedtoaparticularnationality.

PartIII(TheEffectsofConcentration)discussestheeffectsofconcentrationoncompetitioninthe
industry,thesharpriseinauditfeesinrecentyearsandreasonsfortheincrease.Theauditindustryhas
beenconcentratedformanyyears,butsince2002themarketissharedbyonlyfourfirmsinsteadof
eight,asinthe1970s.Competitionisfarlessintensenowthaninearlieryearsandglobalpublic
companiesfacealimitedchoiceofauditfirms.Auditfees,thoughmuchhigherthanbefore,reflect
costsmorefullyandrealistically.InitsstudyoftheBig4,GAOfoundthatthereisnoclear,definitive
linkbetweenaccountingmarketstructureandanticompetitivebehavior.Thereappearstobegeneral
agreementthatthehigherfeesareattributablemoretonewregulatoryrequirementsthantoindustry
concentration.ClientsoftheBig4large,sophisticatedmultinationalcorporationswithhuge
resourcesarecomplainingabouttheburdenofregulatoryrequirements(whichcontributetothecost
ofaudits),butnotthecostoftheauditsthemselves.Smallpublicfirmscomplainaboutthe
requirementsandthedisproportionatelyhighcostsofaudits.Actionsbyregulatoryauthoritiesare
constrainedbythefearofdrivinganothermajoraccountingfirmoutofbusinessandthereby
compoundingthelackofchoiceproblemsofglobalpubliccompaniesinselectinganauditfirm.There
appearstobenoevidenceofanticompetitivebehaviorinrecentpublicliteratureandtherearenocases
reflectingantitrustviolationsbymajoraccountingfirmsintheUnitedStates.However,in2000,the
thenBig6werefinedforanticompetitivepracticesinItaly,whichservesasareminderforregulatory
authoritiestoremainvigilantsothatsimilaranticompetitiveactivitiesdonotoccurinthefuture.
(Becauseofthefundamentalunderlyingimportanceofaccountingstandardsintheauditbusiness,Part
IIItakesnoteoftherecentstepstakenbytheU.S.Securities&ExchangeCommissiontomovetoward
adoptionofinternationalfinancialreportingstandardsandAppendixIII4providesinformationonthe
developmentandstatusofinternationalstandards.)

PartIV(DeepPocketsandExposuretoLiability)examinesinformationonmegalawsuitsfiledagainst
theBig4andotherlargeaccountingfirms.DetailedinformationonlawsuitsisassembledinAppendixes
IV1thruIV4.Thegreatestweaknessoftheoligopolyappearstobeitsexposuretopotentiallyruinous
legalchallenges.Despiteadominantmarketpositionandaboomingbusiness,theoligopolyandits
clientsareintheanomaloussituationofseekinggovernmentprotectionagainstmassivelawsuitsby
disgruntledinvestors,creditorsandothers.PartIVdescribesgovernmentconsiderationofliability
limitationsandtheextenttowhichsuchlimitationsalreadyexistintheUnitedStatesandother
countries.Italsoaddressestheneedforauditqualitytoprotectthepublicinterestandtoavoid
litigation.Consideringtheliabilitylimitationsthatcurrentlyexistandthepotentialforadoptionof
limitationsbymorejurisdictions,aswellastheinherentdifficultyofprosecutinglegalchallenges,the
levelofexposureofauditfirmstomassivelawsuitsthegreatestweaknessoftheauditoligopoly
maybeonthevergeofdecline.

PartV(RecountingtheRemedies)discussesvariousproposalscurrentlyunderconsiderationtoreduce
therisksofcurrentandfutureauditmarketconcentration,toincreasecompetition,andtoimprove
auditqualityandindependence.Eachhasdisadvantages.Proposalstosetmonetarycapsonliability,
forexample,couldeliminateausefulincentiveforauditorstobeperspicaciousindetectingcorporate
fraudandwrongdoingandwoulddepriveinjuredpartiesofamechanismtoobtainadequaterelief.In

4
theUnitedStatessomelimitationsalreadyexistintheformofproportionateliabilityandcontractual
agreements.TheEuropeanCommissionrecentlyrecommendedthatits27memberstatesadopt
measurestolimitliability,consistentwiththeirownlegalsystems.Fivememberstatesalreadyhave
monetarycapsonliabilityandfiveothersallowauditfirmstolimitliabilitythroughcontractual
agreements.ProposalstobreakuptheBig4ortorequireoneormoreofthemtospinoffaportionof
theiroperationstocreateadditionalfirmswiththecapacitytoauditlargepubliccompanieswouldhave
disruptiveconsequencesforexistingauditfirmsandtheiremployees.Proposalstoremovemarket
barriersmaybecostlyandineffective,butofferthemostpragmaticapproach.Removalofrestrictions
onoutsideownershipofaccountingfirms,however,couldhelptoattractnew,wellfinanced
entrepreneurswithmanagementexpertisetoacquireandcombinesmallercompaniesintolarger
networksandenhancetheirreputations.Safeguardswouldbenecessarytoavoidconflictsofinterest
withotherbusinessesownedbytheentrepreneurs.Proposalstoimprovethequalityofauditsinclude
educationandtrainingprograms,strictlicensingandcertificationrequirements,continuingeducationto
keepaccountantsuptodateonnewdevelopments,creationofcoordinationandcommunication
programswithparticipationofmidtierandsmallerauditfirms.Thesealsomayprovetobecostlyand
ineffective.Radicalproposals,suchasnationalizationorthirdparty(e.g.,insurancecompany)payment,
arewellintentionedandmayremoveabasicconflictofinterestinthecurrentsystembywhichaudit
firmsarepaid,buttheyraisequestionsconcerningoperation,costandefficiencyofthesystemandhow
thedrasticchangewouldaffectthebusinesscommunity.

PartVI(MakingtheWorldSafeforAuditingMultinationalCorporations)analyzestheavailable
informationandpresentsconclusions,partlythroughresponsestoquestionsposedintheintroduction
tothispaper.Thesituationwithrespecttothesmallnumberofauditfirmsremainsprecarious.The
needformonetarycapsonliabilityforauditfirmsintheUnitedStates,however,maybelessenedby
alreadyexistinglimitationsintheformofproportionateliabilityandcontractualagreements.
Competitionhaspracticallyslowedtoacrawl,butcouldbeincreasedoverthelongtermbyremoving
barrierstoentryofnewfirmsandgrowthofmidtierandsmallerauditfirms.Becausetheprocessof
barrierremovalrequireslongleadtime,thepapersuggeststhatstepsneedtobetakensoontobuild
morecapacityandavoidafuturecrisis.AppendixVI1providesideasforaprocompetitiveprogramto
developadditionalauditfirmscapableofconductingauditsofglobalpubliccompanies.Inthe
meantime,regulatoryauthoritiesneedtoremainvigilanttoavoidrepetitionofanticompetitivepractices
ofthepast.Finally,respondingtothefacetiousquestioninthetitle,thepaperconcludesthattheaudit
industrymaynotbetheidealcandidateforweakestoligopolyintheworld.

THEAUDITINDUSTRY:WORLDSWEAKESTOLIGOPOLY?
ByBernardAscher
ResearchFellow,AmericanAntitrustInstitute

Preface

Recentcorporatescandalsandturmoilintheaccountingsectorinspiredthispaper.Itisastorythatis
stillunfoldingascompaniesandauditorsadjusttonewregulatoryconditions,imposedmainlyasa
reactiontothosescandals.Auditfirmsandlargepubliccompaniesalsofaceaworldofglobalization,
wherecompetitionforlistingsamongnewandexistingstockmarketsismountingandnewstandardsfor
internationalfinancialreportingarebecomingmoreacceptable.Itisaworldfilledwithfinancial
innovations(someofwhichgaverisetothecorporatescandals)amidstgrowingtechnicalcomplexity,
whichislittleunderstoodbythevastmajorityofindividualinvestors.Althoughcompetitionin
internationalcapitalmarketsandadoptionofinternationalaccountingstandardsgobeyondthescope
ofthispaper,theycontinuetounderliethecompetitioninahighlyconcentratedauditindustry,an
oligopolywhichisthesubjectofthispaper.

Theworldslargestcorporationsessentiallydependuponfourprivatelyheldaccountingfirmstosupply
theirannualauditswhicharerequiredbylaw.Theauditindustryisheavilyregulatedbygovernments
andissusceptibletomassivelawsuitswhentheirclientsareinvolvedinfraudulentactivitiesorsuffer
severefinanciallosses.Auditorsareexpectedtodetectfraudorquestionablepracticesinreviewing
financialstatements.Onemajoraccountingfirmwasdrivenfrombusinessbecauseofcorporatescandal
andthereisgreatfearthattheindustrymayshrinkfurtherthroughgovernmentorprivatelegalaction.
Becauseofthehistoryofmultimilliondollarlitigation,theindustryisunabletoobtainliabilityinsurance.
Thesituationissoseriousthatthefourremainingmajorauditfirmsandtheirclientsarepetitioning
governmentstoimposemonetarylimitsonliability.Isthistheworldsweakestoligopoly?

Virtuallyalloftheinformationinthispapercomesfrompublishedsources.Theauthorwishesto
acknowledgethosewhoassistedinidentifyingandsuggestingpertinentsourcesofinformationforthis
report,particularlyOrriceWilliamsoftheGeneralAccountabilityOffice,VirgilWebboftheAmerican
InstituteofCertifiedPublicAccountants,LouiseHabermanoftheNationalCouncilofStateBoardsof
Accounting,ProfessorRoySuddaby,DepartmentofStrategicManagement&Organization,Alberta
SchoolofBusiness,andRichardLarm.Theauthoralsoappreciatesthecommentsandsuggestions
receivedfrommembersoftheAdvisoryBoardoftheAmericanAntitrustInstitute(AAI),especially
LawrenceJ.White,ProfessorofEconomics,SternSchoolofBusiness,NewYorkUniversity.Anymistakes
ormisjudgments,however,arethesoleresponsibilityoftheauthorandtheopinionsexpressedinthe
papermaynotnecessarilyreflecttheviewsoftheAAI.

August2008

TABLEOFCONTENTS


Abstract 1
ExecutiveSummary 3
Preface 6
TableofContents 7
PartI Introduction:FourAreTooFew 8
PartII TheCastofCharacters,SizeandStructureoftheOligopoly 10
PartIII EffectsofConcentration 16
PartIV DeepPocketsandExposuretoLiability 30
PartV RecountingtheRemedies 40
PartVI MakingtheWorldSafeforAuditingMultinationalCorporations 45

Appendixes
I1AuditIndustrySelectedStudies 49
II1BriefHistoryoftheBig4AccountingFirms50
II2MarketSharesofMajorAccountingFirms 51
II3AuditFirmSpinoffsandSalesofConsultingArms52
II4ListofSelectedTightOligopolies53
III1CommentsontheRisksofFurtherConcentration54
III2NonauditCompetition56
III3AuditFeeIncreasesLargestCompaniesinIllinois58
III4DevelopmentandStatusofInternationalFinancialReportingStandards59
IV1GrowthofLawsuitsAgainstAuditFirms(1967Present)61
IV2OutofCourtSettlementsbyBigEightAccountingFirms(198085)64
IV3TopTenShareholderSettlementsbyAccountingFirms(19972004)65
IV4CasesAgainstAccountingFirms,Settlements,Fines,PendingCases(1992Present)66
IV5EUCommissionerFritsBolkestein:FourReasonsforNotLimitingLiability68
VI1IncreasingtheSupplyofGlobalAuditFirms 69

SelectedReferences 70

PARTI

INTRODUCTION:FOURARETOOFEW

EnactedduringtheGreatDepressionofthe1930s,U.S.lawsrequirethatfinancialstatementsofpublic
companiesmustbeauditedbyanindependentpublicaccountant.Aspubliccompaniesgrewand
expandedinternationally,particularlyinthesecondhalfofthe20thcentury,publicaccountingfirmsalso
grewandfollowedtheirclientstoservetheminforeignmarkets.

ConcentrationhaslongbeencharacteristicoftheU.S.accountingindustry.Eveninthe1960s,the
largestaccountingfirmscontrolledroughly7580percentoftheauditsofpubliccompanies.Atthat
time,though,eightfirmssharedthebusiness.Overtheyears,throughmergersandconsolidations,the
firmsgrewfarlarger,butthenumberoffirmsshranktofiveand,withtheclosureofArthurAndersenin
2002,theBig5becametheBig4.

TheBig4aregiantorganizationswithsubstantialhumanresources,technicalcapabilities,hugeearnings
and market power. These four firms dominate the industry and conduct nearly all the audits of the
worldslargestcorporations.Theaccountingbusinessiscurrentlybooming,revenuesaresurging,and
audit fees are rising. Paradoxically, despite this enviable position, the audit oligopoly suffers the
weakness of vulnerability to massive lawsuits and fears that court cases could cause the collapse of
anotherbigaccountingfirm.

Largepubliccompaniesarenowconcernedabouttheshortsupplyoffirmsavailableforauditing,
particularlyiftheydesiretochange,orifoneoftheBig4weretogooutofbusiness.Regulatorsinthe
UnitedStatesandothercountriesalsoareconcernedaboutthelackofadditionalcompetitorsandthe
possiblefailureofanotherbigfirmasaconsequenceofregulatoryactionsormassivelawsuits.

Asanintegralpartoftheglobalfinancialsystem,whichdependsuponintegrityinfinancialreportingand
investorconfidence,accountingfirmsarenowthefocusofseveralstudiesonwaystofacilitatethe
operationofcapitalmarketsandtoregulatetheindustrywithoutstiflingit.Forexample,arecent
reportbytheU.S.GovernmentAccountabilityOffice(GAO)reviewedthesituationandawiderangeof
proposals(includingliabilitylimitations),butmadenorecommendationforactionatthistimebecause
eachoftheproposedsolutionshasdistinctdisadvantages.SeeAppendixI1foralistofGAOstudiesand
otherstudies.

WhileclientsoftheBig4auditfirmsareconcernedabouttheirlackofchoice,theyarealsoconcerned
thatmajorlawsuitscouldbringaboutfailuresofindividualauditfirms.Thisconcernissharedby
regulatoryauthorities.Theshortsupplyofaccountingfirmscapableofauditingmajormultinational
corporationsappearstobeinhibitingdisciplinaryactionsbyregulatoryauthorities.

Thispaperassemblesandorganizesinformationonthestatusoftheauditindustrywithemphasison
theeffectsofconcentrationonauditfees,competition,regulation,andauditqualityaswellasthe
vulnerabilityofaccountingfirmstomassivelawsuits.Inaddressingthecurrentcompetitivesituation,
thepaperseeksanswerstofourbasicquestions:(1)Canthelevelofcompetitionbeincreasedand,if

8
so,how?(2)HowcantheU.S.governmentregulateanddisciplinetheauditindustryeffectivelywithout
furtherweakeningit?(3)Shouldthegovernmentenactlegislationtolimittheindustrysliability?(4)
Whatcanbedonetoremovebarrierstotheentryofadditionalglobalauditfirms?

Thepaperisorganizedasfollows.Followingthisintroduction,PartIIdescribesthenatureofthe
oligopolyandtheBig4accountingfirms.PartIIIfocusesontheeffectsofconcentrationonlimited
choiceofauditors,auditfees,competition,andregulation.PartIVexaminesthethreatofmega
lawsuitsfiledagainstlargeaccountingfirmsandthequalityofaudits.PartVexploresthevarious
proposalstoresolvethesituation.PartVIattemptstoanswerthefourquestionsposedaboveinthis
introduction.

PARTII

THECASTOFCHARACTERS,SIZEANDSTRUCTUREOFTHEOLIGOPOLY

OligopolySizeandScope

Theauditoligopolyiscomposedoffouraccountingfirms(theBig4)PricewaterhouseCoopers(PwC),
Ernst&Young(EY),KPMG,andDeloitteToucheKomatsu(DT).Eachofthesefirmsgenerateshefty
annualrevenuesofabout$20billionormore,roughlythesizeofCostaRicasgrossdomesticproduct
($22billion).Theoligopolyisglobalinreachandhasgrownrapidlyinrecentyears.Eachfirmhasa
presenceinmorethan140countries,backedbyextensivecommunicationnetworks,technical
knowledgeandindustryexpertise,andeachemploysover100,000employeesworldwide.

Collectively,theBig4earnedalmost$90billionin2007andemployedmorethanahalfmillionpersons,
equivalenttotheentirepopulationofNewOrleans(2000Census).TheInternationalFederationof
Accountants(IFAC)estimatesaworldpopulationofover2.5millionaccountants.1

Worldwiderevenues,employees,andnumberofcountriesofoperationforeachfirmin2007areshown
below.(AncestryoftheBig4firmsgoesbacktothe1800sorearly1900s.AppendixII1presentsabrief
history,tracingtheevolutionofeachofthefirms.)

Firm(2007FYdata) Revenues Employees Countries

PricewaterhouseCoopers $25.2bn 146,700 150

DeloitteToucheTohmatsu $23.1bn 150,000 142
Ernst&Young $21.1bn 130,000 140
KPMG $19.8bn 123,000 145

Source:Wikipedia,CompanyWebsites

MarketShare

Fromtherevenuedatashownabove,itisclearthatnosinglefirmisdominantintheindustry.The
globalmarketissharedalmostequallybytheBig4.Themarketsharepercentagesrangefrom22to28
percentbasedon2007revenues;twoofthefirmshadalmostequalsharesofabout25percent.Over
thelastfiveyears,thespreadhasbecomemoreequalizedastheshareofPricewaterhouseCoopers(the

1
IFACiscomprisedof157membersandassociatesin123countriesandjurisdictions,representingover2.5million
accountants.AccessedonIFACwebsitewww.ifac.orgAugust16,2008

10
largestintermsofrevenue)declinedfrom34percentin2002to28percentin2007andtheshareof
KPMG(thesmallestofthefour)increasedfrom18percentto22percentinthesameperiod.Appendix
II2containsatableonmarketshare/concentrationratiosforselectedyearsintheperiod19882005.

RevenuebyGeographicRegion

Europe is the largest source of revenue for the Big 4, generating $41.4 billion or 46 percent of total
revenue in 2007, about 19 percent more than the previous year. For KPMG, Europe produces more than
half its revenue. In the same period, revenue from the Americas increased by only 10 percent to $36.7
billion or 41 percent of total revenue. Revenue from Asia (mostly China, India and Southeast Asia) grew
the fastest, by 22 percent, but remained the smallest regional segment at 13 percent of total revenues.

StructureofGlobalOrganization(Global,ButNotMonolithic)

Asglobalorganizations,theBig4varyintheirlevelsofintegration.Ratherthancentrallyoperatedand
controlledparentsubsidiaryrelationships,themajoraccountingandauditfirmsareorganizedas
confederationsofindividualmembercompaniesconnectedbyacommonbrandandnetworkof
communications.Generally,themembercompaniesareseparateandindependentlegalentitieswhose
representativesparticipateinglobalcommitteesthatworktosetandmeethighqualityoperating
standardsandconsistencyofqualityatalllocations.Inthisrespect,theorganizationsaresimilarto
franchiseoperations.Somerefertotheseaffiliationsasacollectionofmemberfirmsorindividual
firmsoperatingunderanumbrellaoraseriesofnationalpartnershipsor(asinarecentdocumentof
theEuropeanCommission2)theBig4auditnetworks.

Ofthemajorfirms,EYappearstobewelladvancedintheprocessofintegratingitsregional
organizations:87countrypracticesinWesternandEasternEurope,theMiddleEast,IndiaandAfrica
organizedintoasinglearea;asimilarEYintegrationisunderwayamong700partnersin15countriesin
theFarEast.3Alongthesamelines,PwCrecentlyannouncedareorganizationtobringitsnational
partnershipsclosertogetherandKPMGisintheprocessofmergingsomeofitsEuropeanpractices.4
Theonlytrueinternationalpartnershipwithstrongcentralcontroloveraccountingstandardsand
procedureswasthenowdefunctArthurAndersen.5

TheBig4havesuccessfullyprojectedtheirimagesasglobalcompanies,nottiedtoanyindividual
country.Thecompanynamesandreputationsarerecognizedthroughouttheworld.Asanexample,
StevenG.Butler,ChairmanofKPMG,inapublicappearancein2001,describedhiscompanyasfollows:
"KPMGisaglobalprofessionalservicesfirm,andtherearetwoelementsthatservetodefinewhowe
are...First,we'reaknowledgebusiness...Second,KPMGisastatelessorganization.Wepracticein
morethan150countriesaroundtheworld,employmorethan100,000peopleThemembershipofour

2
EUPressReleaseIP/08/897June6,2008,"Auditing:CommissionissuesRecommendationonlimitingauditfirms'
liability"(seeMEMO/08/366)
3
BusinessWirePressRelease,Ernst&YoungAnnouncesSignificantGlobalizationMoves,Forbes,April21,2008

4
Hughes,Jennifer,PwCtoshakeupnationalpartnershipnetwork,FinancialTimes,Aug.19,2008;Hughes,
Jennifer,Forasinglelanguage,auditregulatorsmustgoglobaltoo,FinancialTimes,Aug.20,2008.

5
Aharoni,Yair,CoalitionsandCompetition:TheGlobalizationofProfessionalBusinessServices,1993,p.139

11
executiveteamandourBoardofDirectorsiscomprisedofamultinationalmixofprofessionalswho
togethersymbolizethetremendousdiversitywithinourfirm.6

Consolidation

Theauditoligopolyexistedinthe1970sand1980s,butitconsistedofeightfirmsatthattime.
Beginningin1987,internationalaccountingfirmsconsolidatedtheirresourcesthroughaseriesof
mergers,creatingtheBig5fromtheBig8,whichhadalsoresultedfromseveralmergers.TheBig
5cameaboutthroughthefollowingmergers:
PeatMarwickandKMGbecameKPMG(1987);
Ernst&ErnstandArthurYoungbecameErnst&Young(1989);
DeloitteHaskins&SellsandToucheRossbecameDeloitte&Touche(1989);
PriceWaterhouseandCoopers&LybrandbecamePricewaterhouseCoopers(1998).

Also,in1998,aproposedmergerbetweenErnst&YoungandKPMG,whichwouldhavecreatedaneven
largerfirm,failedbecauseofEuropeanregulatoryandantitrustconcernsincertaincountriesforsome
businesssectors.7ArthurAndersen,thesmallestoftheBig5participatedinseveralmergerdiscussions
withotherfirms,butwasnotinvolvedinamergerduringtheperiod.

Bycombiningresources,mergersenabledthefirmstotakeadvantageofgreatereconomiesofscale,to
followtheirclientsaroundtheworldastheybecameglobalized,andtoinvestinthelatestcomputer,
communicationandinformationtechnology.Inthe1980s,themajoraccountingfirmshadaspirations
ofbecomingprofessionalservicefirmsormultidisciplinarypracticesglobalconsultingfirms,
includinglegalservices,withonestopshopping.8

TheBig5becametheBig4in2002withthedemiseofArthurAndersen.Thefirmwasindictedfor
obstructionofjusticeforshreddingdocumentsrelatedtotheauditinthe2001Enronscandal.The
resultingconviction,sinceoverturned,stilleffectivelymeanttheendforArthurAndersen.Mostofits
countrypracticesaroundtheworldweresoldtomembersofwhatisnowtheBigFour,notablyErnst&
YounggloballyandDeloitte&ToucheintheUK.9(SeePartIIIforfurtherdetailsoncompetitionforAAs
formerclients.)

6
Butler,StephenG.,ChairmanofKPMG,speakingonApril23,2001attheInternationalHonoreeLuncheoninNew
YorkCity.ButlerreceivedtheBetaGammaSigmaInternationalHonoreeAward,theSociety'stophonor,following
hisspeech.ReportedinBetaGammaSigmaNews,Summer2001,page1.
7
[T]hereisevidencethatKarelVanMiert,theEUcompetitioncommissioner,wasindeedgearinguptostop,orat
leastseriouslychallenge,theKPMGandE&Ymerger.Inaconfidential18pageletterMr.VanMiertconcludesof
theKPMGandE&Ymerger,onthebasisofaninitialinquiry,thatthereisstronglikelihoodthatthenotified
operationwillcreateorstrengthenadominantposition,whethersingleoroligopolistic,inthemarketofauditand
accountingservices,withintheEU.Kelly,Jim,E&YKPMG:RiseandDeclineofaMerger,FinancialTimes,Feb.
19,1998.
8
Forexample,in1998,PwCexpectedtobeoneofthetopsixlawfirmsineverycountryinwhichitoperated,
includingAmerica;DeloitteToucheTohmatsustatedsimilarintentions;andErnst&Young'sstatedaimwasto
haveagloballawfirmwith4,000staffby2003or2004.Economist,Nov.13,2003.Alsosee:Ascher,Bernard,"The
ThreattoU.S.LawyersfromCompetitionbyMultidisciplinaryPractices(MDPs):IsItGone?"AmericanAntitrust
Institute,WorkingPaper0606,November29,2006,availableathttp://antitrustinstitute.org/Archives/557.ashx
9
Gullapalli,Diva,GrantThorntonBattlesItsImage;No.5AccountingFirmStrugglesToAttractMajorAudit
Clients,DespiteMisfortunesofBigFour,WallStreetJournal.,June9,2005.pg.C.1

12

SecondTierandSmallerFirms

Asecondtierofmidsizedfirmshavemultinationalclientsandnetworkswithpotentialforinternational
growth.Withover350publiclytradedcompaniesasclients,BDOSeidman,LLPistheU.S.memberfirm
ofBDOInternational,theworld'sfifthlargestaccountingandconsultingorganizationwithover621
memberfirmofficesin110countriesandapproximately30,000partnersandstaff.In2007,BDO
Internationalhadrevenuesof$3.911billion.10Anothersecondtierfirm,GrantThornton,has
internationalreachandexpertise.Itsinternationalnetworkoperatesinmorethan100countries,with
recentrevenuesof$2.8billionandtotalpersonnel(includingpartners)ofover25,000.Morethan700
smallerfirmsalsoauditpubliccompaniesintheUnitedStates,buttheygenerallylackthestaff,
resourcesandexpertisetoauditmajormultinationalcorporations.

LevelofConcentration

TheBig4accountingfirmsdominatethemarketforauditsoflargepubliccompanies.In2006,they
audited98percentofthe1500largestpubliccompanieswithannualrevenuesover$1billionand92
percentofpubliccompanieswithannualrevenuesbetween$500millionand$1billion.In2002,they
auditedover78percentofallU.S.publiccompanies(thoselistedonstockexchanges)and99percentof
allpubliccompanysales,accordingtoreportsoftheU.S.GovernmentAccountabilityOffice(GAO)11.

Thelevelofconcentrationisevenmorepronouncedwhenconsideringtheindustryoftheclients.In
someindustries,suchaspetroleumandcoal,andsecurityandcommoditybrokers,thelevelof
concentrationin2002bythetoptwoauditingfirmswasabout94percent(basedonindustryassets).
Otherindustriesinwhichthelevelsofconcentrationforthetoptwoauditingfirmsweregreaterthan
80percentincludemetalandmining;generalbuildingcontractors,airtransportation,nondepository
(loanandcredit)institutions;oilandgas;andtransportationequipment.Becausepubliccompanies
generallypreferauditorswithestablishedrecordsofindustryexpertiseandrequisitecapacity,their
viablechoicesintheseindustriesareevenmorelimitedthantheBig4.12

WorldwideDominance

TheBig4accountingfirmsdominateinternationally,withnearly$90billionintotalglobalnetrevenues
for200713,upfrom$47billionin2002.14Asexamples,theBig4audited:
virtuallyallmajorlistedcompaniesintheUnitedKingdomin200215(allbutoneoftheUKs
biggestcompaniesand98percentoftheFTSE35016;

10
NotethatBDOSeidmanissubjecttoa$521millionjuryverdict.Thecaseisunderappeal.SeeAppendixIV4of
thispaperandOsterland,Andrew,"Jurysfraudpenaltystunsauditor:$521millionjudgmentseenaslargest
evercouldswampBDOSeidman,"FinancialWeek,Aug.20,2007.
11
U.S.GovernmentAccountabilityOffice(GAO03864),"PublicAccountingFirms:MandatedStudyon
ConsolidationandCompetition,"ReporttotheSenateCommitteeonBanking,Housing,andUrbanAffairsandthe
HouseCommitteeonFinancialServices,July2003.
12
Ibid.
13
Wikipedia,availableathttp://en.wikipedia.org/wiki/Big_Four_auditors,accessedAugust16,2008
14
Ibid;February2003PublicAccountingReport
15
GAO,op.cit..,fn11
16
Jopson,Barney,Topauditfirms'dominancestudied,FinancialTimes,Apr.10,2006;OligopolyWatch,

13
 over80percentofallpubliccompaniesinJapanin2002;17
atleast90percentintheNetherlandsin2002;18and
morethan80percentoflistedcompaniesinItalyin2001(thenBig5).19

AuditandOtherRevenues

Whileauditingisakeyservicewhichliesatthecoreofthebusiness,itisnottheonlysourceofrevenue
forthesefirms.Otherservicesincludetaxadviceandbusinessconsultingservices.Theproportionof
auditrevenuetototalrevenuefluctuates.Inthe1980sand90s,themajoraccountingfirmssought
moreconsultingbusiness,whichwasseenasmorelucrativethanauditing.Inthelate1990s,however,
theBig4facedharshcriticismforputtingcommercialinterestsaheadofthepublicinterest.Facing
strongpressurestospinofftheirconsultingarms,threeofthefourfirmssplitorsoldtheirconsulting
armsby2002;onlyDeloitteretaineditsconsultingservices.(Fordetailsofthespinoffsandsubsequent
revivalseeAppendixesII3andIII2.)Priortothedivestiture,auditrevenueasapercentageoftotal
revenuedeclinedtoconsiderablylessthan50percent,20butafterthespinoffoftheconsultingarmsof
majoraccountingfirmsin1998andtheissuanceofregulationsunderSarbanesOxleylegislation,the
percentageincreasedtoatleast51percent.21However,morerecently,theBig4haverevivedtheir
consultingbusinesses22andoneBritishstudyindicatesthatauditfeesnowrepresentonlyonethirdof
Big4income.23Forfurtherdiscussionofcompetitionfornonauditbusiness,seePartIIIandAppendix
III2.

NatureoftheOligopoly:TightwithSignificantMarketPower

Theauditindustryisanoligopoly,thatis,itconsistsofasmallnumberoffirmsthatcontrolsthesupply
ofauditservicestomajorcorporations.Italsomeetsthedefinitionofatightoligopoly,meaningthat
itisamarketstructureinwhichthetopfourproviderscontrolatleast60percentofthemarketand
otherentitiesfacesignificantbarrierstoentryintothemarket.Inthelargepubliccompanyaudit

Thelatestmaneuversofthenewoligopoliesandwhattheymean:BigFourauditorsanddivestment,Aug.10,
2006.
17
GAO,op.cit.,fn11
18
Ibid.
19
Ibid.
20
Auditfeesdeclinedfrom70percentofaccountingfirmsrevenuesin1976tojust31percentin1998,as
consultingfeesexpanded.Stuart,AlixNyberg,CFOMagazine,Oct.1,2002;alsoquotedinFuturecastsonline
magazineinreviewofArthurLevittsbook,TakeontheStreet,Vol.5No.3,Mar.1,2003.
21
Asurveyof23DowJonesIndustrialsshowedthatauditfeesin2004represented65percentoftotalfeesof$821
millionin2004;prior,theauditfeeswereonly30percentofthetotal.Gullapalli,Diva,AuditFeesAreonRiseAs
CompaniesPonyUp;PaymentsforConsultingAndOtherServicesShrink,InBigChangeFrom2000,WallStreet
Journal,Mar.25,2005.pg.C.3;Taub,Stephen,AuditFeesSurgedin2004;Withcompaniesreportedlywillingto
payupfortopnotchauditingwork,accountingfirmsaremakinghay,CFO.com,Mar.28,2005
22
Hughes,Jennifer, Auditfirmsonceagainmaking'consultinghay'FinancialTimes,Nov.19,2007.p.4;Byrnes,
Nanette,ConsultingPaysOffforAccountantsAgain;Deloitte&Toucheresistedsplittingwithitsconsultingarm,
andnowthemultibilliondollarsegmenthasinspiredotherauditfirmstorebuildtheirs,BusinessWeek,Aug.20,
2007
23
Hughes,Jennifer,Andersen'scollapseresultsinafeebonusforBigFourrivals,FinancialTimes,Apr.29,2008.
p.19

14
market,theBig4nowauditover99percentofallpubliccompanieswithsalesover$250million,and
otherfirmsfacesignificantbarrierstoentryintothemarket.24

TheauditindustryalsoqualifiesasatightoligopolybyanothermeasuretheHerfindahlHirschman
(HHI)Index.Asageneralrule,anHHIbelow1,000indicatesamarketpredisposedtoperform
competitivelyandonethatisunlikelytohaveadversecompetitiveeffects.A1,0001,800value
generallyindicatesmoderateconcentration.Anythingover1,800isregardedasasignofacute
concentration.AnHHIabove1,800indicatesahighlyconcentratedmarketinwhichfirmshavea
potentialforsignificantmarketpowertheabilitytoprofitablymaintainpricesabovecompetitive
levelsforasignificantperiodoftime.From1990to1997,thefourfirmindexwasfairlysteadyand
belowthe1800mark,butfollowingthemergerofPriceWaterhouseandCoopers&Lybrand,theindex
jumpedoverthethresholdandincreasedfrom1998to2002withthedemiseofArthurAndersen,when
theindexhit2566,wellabovethethresholdforsignificantmarketpower.25Numerousothermarkets
intheUnitedStatesqualifyastightoligopolies(seeAppendixII4).

Thus,theresultofconsolidationthroughaseriesofmergers(andthedissolutionofArthurAndersen)isa
moreheavilyconcentratedauditindustry,consistingoffourhugefirmswithsignificantmarketpower.
PartIIIdiscussestheproblemsassociatedwithconcentration.

24
GAO,op.cit.,fn11
25
Ibid.

15


PARTIII

EFFECTSOFCONCENTRATION

Themostobviousandperhapsthemostsignificanteffectofconcentrationintheindustryisthelimited
choiceofauditsuppliersforpubliccompanies.Concentrationalsoaffectsauditfees,competition,audit
quality,andtheregulatoryenvironment.Marketpowerresultingfromconcentrationsometimesleads
toanticompetitivebehavior.ThesesubjectsareaddressedinturninPartIII.

LimitedChoice

Largepubliccompanieshavefewerchoicesinselectinganauditfirm.TheBig4havefew,ifany,
competitorsamongmidtierfirmsinthemarketforlargepubliccompanyaudits.GAOfoundthat
specialization,potentialconflictsofinterest,andindependencerulescanfurtherlimitauditchoices.
Thesignificantchangesthathaveoccurredintheprofessionmayhaveimplicationsforcompetitionand
publiccompanychoice,especiallyincertainindustries,inthefuture,GAOreported.Thegreatfear
amonglargepubliccompaniesisthatchoicescouldbefurtherreducedifanotheroftheBig4accounting
firmsgoesoutofbusiness.26Largepubliccompaniesaremoreconcernedaboutavailabilityofaudit
firmsthanaboutprice.27

EvenbeforetheBig5shranktotheBig4,therewasconcernaboutthesmallnumberofmajoraudit
firms.In1998,onereportstatedthatareductionfromfivetofourwouldnotbetoleratedandtwo
CompetitionCommissionersoftheEuropeanUnionbelievedthatfiveistheminimumrequiredto
ensureenoughcompetition.28Accordingtoavarietyofreports,nowthatthereareonlyfourfirms,
furthershrinkagewouldbeacatastropheforfinancialmarkets,aglobaleconomicconcern,athreat
tocontinuedexistenceoftheprofessionandcouldcallintoquestionviabilityofthesurvivors.
Reductiontothreefirmscouldcauseparalysisinfinancialmarketsandleavetheindustrytoosmallto
maintainauditqualityandindependence.SeeAppendixIII1foracompilationofcommentsand
referencesonfurtherconcentrationoftheauditindustry.Theseriousnessandcomplexityofthe
situationishighlightedbyastatementoftheoutgoingChairmanoftheU.S.PublicCompanyAccounting
OversightBoard,whosaidin2005:regulatorsdonothaveacluehowtorespondifoneofthebigfour
accountingfirmsweretocollapse.29

26
GAO,op.cit.fn11
27
FinancialTimes,March29,2008,op.cit.fn20
28
Guerrera,Francesco,andSpiegel,Peter,DeloitteofferwouldfacereluctantEUcompetitionhurdle,Financial
Times,March12,2002
29
WilliamMcDonough,ChairmanoftheU.S.PublicCompanyAccountingOversightBoard,expressingreliefthat
theDepartmentofJusticereachedasettlementwithKPMGoveritssalesoftaxavoidanceschemestoclients,
quotedinParker,Andrew,USauditwatchdogwarnsaboutindustry,FinancialTimes,September27,2005

16
ClientConflicts

Partoftheproblemwithlackofauditorchoiceisthefearofpossiblemisuseofcompanyinformation
businessstrategies,secretrecipes,andothertradesecrets.Ifaclientperceivesthepossibilityof
conflictswitharivalcompaniesusingaparticularauditingfirmitmightruleoutselectingthatauditfirm,
thusreducingthenumberofpracticalchoices.Forexample,CocaCola,fearingthatcompanysecrets
wouldbecomevulnerable,madeErnst&YoungdropPepsiafterArthurYoungmergedwithErnst&
Whinneyin1989.(PepsiCohadbeenanArthurYoungclientsince1965;CocaColahadbeenanErnst&
Whinneyclientsince1924andpaidhigherauditfeesthanPepsiCo.)30InFebruary1998,EYandKPMG
citedclientoppositionasoneofthereasonsforabandoningmergerplans(althoughtherewerea
numberofotherreasons,e.g.,antitrustissues,costproblems,andthedifficultyofmergingtwodiverse
companiesandcultures).31Alongwithfearsthattherelativelackofchoicewouldencouragearisein
prices,therewerefearsamongclientsthatthecombinedfirmswouldmakecompanysecretsvulnerable
torivalsusingthesamefirm.32

Ontheotherhand,eachoftheBig4hasclientswhocompeteinthesameindustryandtherearefew,if
any,reportedinstancesinwhichauditfirmpersonnelmayhaverevealedcompanysecretstoanother
client.Theaccountantsarguethattheyhaveabetterrecordofkeepingcompanysecretsthan,say,
advertisingmen;theyalsosaythatinsomeindustriesexperienceisessentialtonavigateclientsthrough
specialregulatoryprovisions,includingtaxrules.33

AuditFees

Auditfeesareprobablyathistoricallyhighlevels.Theincreasesince2002isgenerallyattributedtonew
regulatoryrequirementsratherthantoindustryconcentration.Auditclientsarecomplainingaboutthe
highcostofcompliancewiththerequirementsofSarbanesOxleylegislation,nothighauditfees.34
Ironically,thelegislationenactedasabacklashtocorporateandaccountingscandalshascreatedahuge
bonanzaforauditfirms.Businessisboomingtotheextentthatsomeoftheoverloadisflowingfromthe
Big4tosmalleraccountingfirms35andtoIndiathroughoutsourcing.36

30
HooverProfile:ErnstandYoungGlobalLtd.,LastupdatedJune24,2004,obtainedonlinefromAnswers.com,
accessJuly20,2008
31
Ibid.Therewerefearsthatthemergerwouldhavefurtheredtheconsolidationofthemajoraccountingfirms
intotheBigFour,anoutcomedisturbingtomanyindustryanalysts.(Seefn7supra.)Alongwithfearsthatthe
relativelackofchoicewouldencourageariseinprices,therewerefearsamongclientsthatthecombinedfirms
wouldmakecompanysecretsvulnerabletorivalsusingthesamefirm.
32
Ibid.Therewasaconflictatthetimeofthemergerovereachfirm's"cola"clients.Aconflictofinterestexisted
inthatPepsiCohadbeenanArthurYoungclientsince1965,whileCocaColahadbeenanErnst&Whinneyclient
since1924.CocaColaforcedthefirmtodumpPepsiCo,asErnst&YoungnotedthatCocaColahadbeenaclient
foralongertimeandthatCoke'sannualauditfeewas$14million,amuchhigherfigurethanPepsi's$8.8million
auditfee.
33
Economist,BeanCountersUnite,Oct.25,1997
34
Ciesielski,JackT.andWeirich,ThomasR.,"UpsandDownsofAuditFeesSincetheSarbanesOxleyAct:ACloser
LookattheEffectsofCompliance,CPAJournal,Oct.2006
35
Reilly,David,"OutsideAudit:MidtierAuditorsGainTractionInQuestforLargeCapClients,"WallStreetJournal,
Nov.14,2006,p.C3
36
Bellman,Eric,ACostofSarbanesOxley:OutsourcingtoIndia,WallStreetJournal,July14,2005;US
accountingworkforIndianBPOs,RediffNews,July14,2005
http://www.rediff.com///money/2005/jul/14bpo.htm,accessedJune26,2008.

17

Becauseaccountingfirmsarenotrequiredtorevealinformationonrateschargedtoindividualclients,
determiningthepreciselevelofauditfeesandthechangesovertimearedifficulttasks.IntheUnited
States,however,publiccompaniesarenowrequiredtodisclosetheamountpaidinauditfees.Fees
varyamongclientfirmsdependingupontheamountofworkinvolved,whichisaffectedbythesizeof
thecompanyandtheextentofitsbusinessactivities(includingmergersandacquisitions).

Tradeliteratureaboundswithdescriptionsoftheincreasebasedonvariousstudies.Forexample,
accordingtotheCPAJournal,37between2001and2004auditandauditrelatedfeesincreasedby103
percentfor496oftheS&P500.AreportbytheCorporateLibrarystatedthattheaggregatedata
presentedsomefairlyoutstandingfigureswithanaverageincreaseinauditfeesof756percent
between2001and2006.38Otherarticles(basedonvarioustimeperiodsanddifferentgroupsof
companies)indicatethatauditfees:havetripled39;doubled40;andskyrocketed41.Thesituationhas
beendescribedasarevolutioninfees,andadramaticchangeinthemarket.42

Majorcorporationsarespendingtensofmillionsofdollarsonaudits.AccordingtotheWallStreet
Journal,in2004,basedonproxydisclosures,23ofthe30DowJonesIndustrialspaidatotalof$533
millionforauditfees.GeneralElectric,forexample,paid$78millionin2004;UnitedTechnologies,$32
million;IBM,$22million;andJohnson&Johnson,$20million.43Companiesarewillingtopayupfor
topnotchauditingwork,andtheaccountingfirmshavemilkedthechangingauditingenvironmentby
chargingmuchhigherfees.44AccordingtoArthurBowman,editorofBowmansAccountingReport,the
feesofsmalleraccountingfirmswere35to40percentlowerthantheBig4s.45Forfurtherinformation
onincreasesinauditfees,seeAppendixIII3.

Auditfeesarenolonger(astheyoncewere)alossleadertoattractconsultingbusiness;theyreflect
morerealisticallytheactualcostofaudits.Clientsdonotchangeauditfirmsoften.Itismanifestly
costlytochangeauditors,largelybecausechangingauditorsisareportableevent,andthemarketmay
beskepticalaboutthereasoningbehindachangeofauditorsanddiscountthecompanysstockprice.
Auditorstendtobechangedveryinfrequently.Intheextreme,GeneralElectric,forexample,hasused
KPMGanditspredecessorsforoverahundredyears.46Becauseswitchingcostsarehigh,competitive

37
CPAJournal,Oct.2006,,op.cit.fn34
38
CorporateLibraryPressRelease,"BigFourAuditFirmsFeeltheEffectsofPostSOXInroadsasAuditFees
Skyrocket,"PostedSept.17,2007
39
Grant,Jeremy,"PilingonthepressureasSarbanescostshit,"FinancialTimes,May22,2006.pg.27
40
Hughes,Jennifer,"RisingauditfeesemboldencriticsofBigFouraccountancyfirms,"FinancialTimes,Sep.10,
2007.p.19;Hughes,Jennifer,"RisingauditfeesemboldencriticsofBigFouraccountancyfirms,"FinancialTimes,
Sep.10,2007.p.19;Hughes,Jennifer,"Andersen'scollapseresultsinafeebonusforBigFourrivals,"Financial
Times,Apr29,2008,p.19; Countryman,Andrew,"SarbanesOxleymandatessendcorporateauditexpenses
soaring,"ChicagoTribune,June5,2005
41
Wallison,PeterJ.,"TheSorcerer,theApprentice,andtheBroom:WhattoDoaboutPrivateSecuritiesClass
Actions,"AEIOnline,Posted:Thursday,Mar.8,2007,accessedJuly20,2008;CorporateLibrary,Sept.17,2007,op.
cit.fn34;ChicagoTribune,June5,2005,op.cit.fn40
42
CorporateLibrary,Sept.17,2007,op.cit.fn38
43
Gullapalli,Diva,Mar.25,2005,op.cit.fn21;Taub,Stephen,Mar.28,2005,op.cit.fn21
44
Taub,Stephen,Mar.28,2005,op.cit.fn21
45
Stuart,AlixNyberg,Oct.1,2002,op.cit.fn20
46
Brown,JohnPrather,"AreFourBigAuditingFirmsEnough?,"ColumbiaLawandEconomicsSeminar,March6,
2006,p.3

18
tenderingseldomoccursthesedays,butsomebargainingoccursduringthereappointmentprocess.47
Asnotedbyatradejournal,Auditfeeshadtoincrease,tohelpminimizelitigationthroughsturdier
auditsortopayforlitigationexpenseswhenasturdierauditwasntenough.48Withfewerbusiness
opportunitiesattheirexistingauditclients,auditorsseemtobedevotingmoretimetotheaudit,and
justifyingtheirhigherfees.Theevidenceshowsthataccountingfirmsarebeingpaidbetterforaudit
engagementsthantheyusedtobe,andthismaybeasufficientincentivetokeepthemfocusedonthe
taskofauditing.49Manybelievethatthesmallnumberoffirmsandthelackofalternativesuppliers
underliehighfeesandadditionalcostcomesfromtheneedforthebig4tobuildreservestodefend
againstpotentiallyruinouslawsuits.50

Withrespecttocausesfortheincreaseinauditfees,theGAOfoundthattherewasnoclear,definitive
linkbetweenaccountingmarketstructureandanticompetitivebehavior.Moreover,GAOfound(after
usingvariousauditfeemeasures)thatitsresearchdidnotprovideconclusiveevidenceofanyeffects
ofconsolidation.51Someevidencedidsuggestthatauditfeeswerelossleadersduringthe1980sand
1990s.GAOconcluded,howeverthat2002marketstructurewasnotnecessarilyinconsistentwitha
competitiveenvironment.52RecentstudiesintheUnitedKingdomfoundalinkbetweenconcentration
andauditfees.53

Competition

Themarketforauditingisatwotiermarket:(1)themarketforlargepubliccompaniesinwhichtheBig
4competeamongthemselves;and(2)themarketforauditsofallothercompaniesinwhichtheBig4
competealongwithallotherauditingfirms.

BarrierstoEntry

GAOfoundthatmidtierandsmalleraccountingfirmsfacesignificantbarrierstoenteringthelarge
publiccompanyauditmarket.Theseincludelackofadequatestaff,technicalexpertise,accesstocapital
andglobalreach.TheGAOreportitemizesthebarriersasfollows:reputation,size/capacity
constraints,limitedaccesstocapital,litigationrisks,lackofexpertise,lackofglobalnetworksand

47
CompetitionandChoiceintheUKAuditMarket,OxeraConsultingLtd.,April2006,availableat
http://www.oxera.com,accessedJuly13,2008.Bargainingpowerbetweenauditfirmandclientisreasonably
symmetrical.Highswitchingcostsmakeaclientreluctanttochangefirms.Atthesametime,lossofamajorclient
canbeharmfulnotonlytorevenuebuttoreputationandcancausesubstantialinternalshakeupsattheauditfirm,
whichaccountmanagershaveastronginterestinavoiding.
48
CPAJournal,Oct.2006,,op.cit.fn34
49
Ibid.
50
Ibid.
51
GAO,op.cit.,fn11
52
Ibid
53
ArecentstudybytheLondonSchoolofEconomicsfortheaccountingfirmBDOfoundalink(althoughtherewas
nolinkpriortocollapseofAAin2002)betweenconcentrationandauditfees,maintainingthattheimpactis
quantifiable.Alsoastudyin2006byOxeraConsultingLtd.foundalinkbetweenconcentrationandaudit
fees:CompetitionandChoiceintheUKAuditMarket,preparedbyOxeraConsultingLtd.FortheUKDepartment
ofTrade&IndustryandFinancialReportingCouncil,April2006,availableat:http://www.oxera.com,accessedJuly
13,2008.

19
alliances,varyingstatelicensingrequirementsandotherregulations,SarbanesOxleyandindependence
requirements.Asaresult,intheshortrun,themidtierandsmallerfirmsarenotexpectedtoreachthe
sizeofthelargeaccountingfirms.ThebarriersarediscussedfurtherinthesectionsbelowandinPartV
ofthispaper.

CompetitionAmongtheMajorFirms

Competitionamongthemajoraccountingfirmswasmuchkeenerinyearspriortoconsolidationofthe
industryintofourfirms.Intheearly1980s,auditfirmscameundertremendouspressuretolowertheir
auditfees.Clientsactivelyplayedtheeightmajorauditfirmsagainstoneanothertolowertheiraudit
feesinbiddingwars.Asaresult,auditfeesbecamealossleaderandwerenotselfsupporting.54
AWallStreetJournalarticleatthattimecitedtworeasonsfortheincreasedcompetitionamong
certifiedpublicaccountingfirms.First,morebigcompaniesarerequestingmultiplebidsfortheir
outsideauditstocutcosts,andsecond,thelargerCPAfirms,inanefforttoexpand,arecompeting
moreaggressivelywithsmalleraccountingfirmsforthebusinessofmidsizedandcloselyheld
companies.55ArthurW.Bowman,editorofthePublicAccountingReport,pointedoutthatarecent
rashof[corporate]mergersisspurringauditfeecompetitionasnewparentcompaniesdropthe
auditorsofoneofthemergedconcerns.Feeswerebeingdiscountedto70%ofthebasefeesand,in
somecases,50percent,comparedto8090%twoyearsprior.56

AccordingtoYaleUniversityprofessorShyamSunder,theauditorsrespondedtocompetitivepressures
byloweringtheirauditfees,loweringthequalityofauditservicestheyprovided,andbyturningto
morelucrativeconsultingservices.Auditsbecameatoolforattractingclientsbusinessfor
managementconsulting,informationtechnology,taxadviceandotherservices.57Itwasnot
uncommonforthemajoraccountingfirmstounderprice(lowball)theirauditservicestogainother
businessfromclients.58

Thisfiercecompetitioncouldhavecontributedtoconsolidationoftheindustry.[A]ccountingis
turningintoanintenselycompetitiveandnottoogenteelbusinessinwhichcomputersarecuttingcosts,
clientsareraidedandanincreasingshareofrevenuescomesfromsuchnonauditingservicesas
managementconsultingandtaxplanning,observedBusinessWeekmagazine.TocompetePWand
DH&SarepreparingtotrythefirstmergeramongBigEightfirms.59Between1991and1997,KPMG
lostapproximately60auditclientsintheUStoE&Y.AsstatedinaWashingtonPostreport,price
competitionforcorporateauditsishurtingaccountingfirmssomuchthattheyareseekingnewsources
ofrevenueandinsomecasesmergerpartners.60

54
Berton,Lee,"AuditFeesFallAsCPAFirmsJockeyforBids,"WallStreetJournal,Jan28,1985,p.1
55
Ibid.
56
Ibid.
57
CollapseofAccounting:CausesandCures,ShyamSunder,YaleUniversity,PowerPointslidesaccessedMay31,
2008
58
Bazerman,MaxH.,Morgan,KimberlyP.andLoewenstein,GeorgeF.,"TheImpossibilityofAuditor
Independence,"Vol.38,No.4,SloanManagementReview,MassachusettsInstituteofTechnology,Summer1997
59
BusinessWeek,TheBigEightCouldSoonBetheBigSeven,Sept.24,1984,p.37
60
Ross,Nancy,CompetitionStingingBigAccountants,WashingtonPost,Sept.1,1984,p.D9

20
CompetitionforArthurAndersenClients

IncompetingforArthurAndersensformerclientsin2002,theBig4garnered87percentofthe
business.61 Andersenhadreviewedthebooksof1,300publiccompanies.62E&Ymergedwithmanyex
AApracticesaroundtheworld,butnotintheUnitedStates,UnitedKingdom,andNetherlands.Deloitte
absorbedtheUKbusinessofAA.63

Interestingly,notalloftheBig4gainedmarketsharewhenArthurAndersenwentoutoftheaudit
business.From1988to2005,basedonsalesrevenueaudited,Ernst&Younggained7percentmarket
share;DeloitteTouchealsogained7percent;KPMGgained3.6percent.PricewaterhouseCooperslost
3.8percent.ArthurAndersenhadaccountedfor14percentin1988.SeeAppendixII2.

AMilderFormofCompetition

Nowthatthereareessentiallyonlyfourmajorsuppliers,thenatureofcompetitionisquitedifferent.
Competitionstillexists,butitisfarlessvigorous.Inadditiontoindustryconcentration,however,a
numberofotherfactorshavechanged.Beginninginthelate1980s,themajorfirmswerepressuredinto
divestingthemselvesoftheirmanagementconsultingactivitiesbecauseofthepossibilityofconflictof
interestwithauditbusiness.Moreover,theenactmentofnewregulatoryrequirementsintheSarbanes
OxleyActof2002madeauditsmorecomplicatedandburdensome.Ineffect,since2002,anauditisa
differentproductthananauditinprioryears.Also,auditfirmsnolongerarepermittedtoprovide
consultingservicestotheirauditclients(althoughtheycanprovidesuchservicestononauditclients).
Theycanprovidetaxservicestoauditclients(subjecttocertainrestrictions)andtononauditclients.64

Thus,itisdifficulttoconcludethatindustryconcentrationbyitselfisresponsibleforlessvigorous
competitionsince2002.Infact,theGAOconcludedthatthe2002marketstructurewasnotnecessarily
inconsistentwithacompetitiveenvironment.65AlthoughGAOfoundnoempiricalevidenceof
impairedcompetitiontodate,itobservedthattheincreaseddegreeofconcentrationcoupledwith
restrictionsontheprovisionofnonauditservicestoauditclientsmayhaveimplicationsforcompetition
orexerciseofmarketpowerinthefuture.66

Pricecompetitionisasecondaryconsideration.Big4auditclientsaresophisticatedcompanieswith
greatresourcesandexpertise,unlikepurchasersofconsumerproductswholacksuchknowledgeand
canbehurtmorebypricefixingandotheranticompetitivebehavior.Eventhoughauditcostscanrun
intomillionsofdollarsinabsoluteterms,thepriceeffectsaresmallinrelationtostockmarketvalueand
intermsofthecostsoftheproductssoldtoultimateconsumers.Otherfactorsconsideredbyaudit
clientsinselectinganauditfirmarereputation(seediscussionbelow),sectorspecificskills,
internationalcoverage,andqualityofstaff.

61
Gullapalli,Diya,"GrantThorntonBattlesItsImage;No.5AccountingFirmStrugglesToAttractMajorAudit
Clients,DespiteMisfortunesofBigFour,"WallStreetJournal,Jun9,2005.p.C1
62
Economist,Nov.13,2003;andAscher,op.cit.fn6
63
Gullapalli,op.cit.,fn21
64
Byrnes,Aug.20,2007,op.cit.fn22
65
GAO2003,op.cit.fn11
66
Ibid.

21
MidTierandSmallerAuditFirms

TheBig4auditfirmscontinuetodominatethemarketforauditsofmajormultinationalcorporations,
althoughmidtierfirms,suchasGrantThorntonandBDOhavetriedtomakeinroadsinthatmarket.
GrantThorntonsCEO,EdwardE.Nussbaum,inCongressionaltestimonyandinspeeches,hasasserted
thattherealreadyaremorethanfourfirmscapableofperforminginternationalaudits.Hecontends
thatGrantisanexcellentfifthchoice,hasofficesinanumberofcountries,andcandevotemore
attentiontoclientsthantheBig4.Grantembarkedonacampaign,advocatingrightsizing.Backin
2001,GrantevenstoleaBigFiveemployeetohelpitwinBigFivebusiness:EdRuss,whomGrant
executivescametoknowasheresearchedapossibleacquisitionofGrantbyhisemployer,
PricewaterhouseCoopers.67

GrantThorntonandBDOaregrowing,buttheyhavealongwaytogotojointheranksoftheBig4.For
example,therevenueofErnst&Youngis23timesthatofGrantThornton,thefifthlargestfirm.Evenif
thenumber5through8firmswererolledintoone,therewouldnotbeenoughbusinesstomatchthe
capabilitiesoftheBig4.68

AsaresultoftheworkgeneratedbySarbanesOxleyrequirements,theBig4areoverloaded;theyhave
becomemoreselectiveinacceptingclientsandhaveletsomeofthesmallerclientsgo.Midtierand
smallerauditfirmshavegainedfromtheoverload.69Intheyears2003to2005,4,000companies(one
thirdofallpubliccompanies)switchedtoNonBig4auditors70andtheproportionofsmallercompanies
usingBig4auditorsfellbyhalfbetween2002and2006.71Anothersurveyof3,140companiesshowed
thatthenumberofnonBig4auditfirmsservicingthesecompaniesincreasedfromnonein2001to91
in2006(anincreaseof1,000percent).Inaddition,thenonBig4firmsmorethandoubledtheirmarket
shareoverthisperiod.Thisgrowthmayinpartbeduetotheenormousincreaseinrevenue
opportunitiesforauditservices.72

Indeed,concentrationinthesmallandmidsizepubliccompanyauditmarkethaseasedduringthepast
fiveyears.TheBig4shareinauditingsmallpubliccompanieswithannualrevenuesunder$100million
hasdeclinedfrom44percentin2002to22percentin2006;andinauditingmidsizepubliccompanies
withannualrevenuebetween$100millionand$500millionfrom90percentin2002to71percentin
2006,accordingtotheGAO.73

GAOfoundthatthemarketforsmallerpubliccompanyauditswasmuchmorecompetitivethanthe
overallorlargecompanymarket.74Smallerpubliccompaniesarechangingauditorsmorefrequently.
Apparently,thestigmaofusinganonBig4auditorisfading.WhileGAOrecognizedthatsmaller

67
Gullapalli,June9,2005,op.cit.fn61
68
McDonough,William,ChairmanPublicCompanyAccountingOversightBoard,quotedinAccountingObserver
Website(accessedMay14,1998},"NiceWorkIfYouCanGetIt,PartII,"postedbyJackCiesielski,Sept.29,2005.
69
Reilly,Nov.14,2006,op.cit.fn34
70
Ibid.
71
Chasen,Emily,"USwatchdogsays'Big4'auditfirmsenoughfornow,"Reuters,Jan.10,2008
72
CorporateLibraryPressRelease,Sept.17,2007,op.cit.fn38
73
U.S.GeneralAccountabilityOffice,(GAO08163):"AuditsofPublicCompanies:ContinuedConcentrationin
AuditMarketforLargePublicCompaniesDoesNotCallforImmediateAction,"ReporttoCongressional
Addressees,Jan.2008
74
Ibid.

22
companiesseemorechoicesofauditfirms,itssurveyneverthelessfoundthat82percentoflargepublic
companiesseetheirchoiceofauditorslimitedtothreefirms.75

Reputation

Reputationisanimportantfactorincompetition.BanksrecommendtheBig4tolargeborrower
companies.Inadditiontoreputation,strengthsoftheBig4includeexpertise,communicationnetworks
capitalandhumanresources,geographicreach,anddeeppocketstowithstandlargelawsuits.Investors
oftenquestionwhyasmallpublicaccountingfirmhasbeenselectedtoperformaudits,butreadily
acceptaBig4firmwithoutquestion.76

TheAmericanAssembly,aninfluentialpublicpolicyforum(associatedwithColumbiaUniversity),noted
theeffectofamorediffusesnobberyinareportlastMaythatsaidapatinaofauthorityand
confidencesurroundedthebigfour:Analystsandinvestmentbankersareoftenconcernedthatthe
presenceofamidtierfirmasauditorwillnegativelyimpactacompany'smarketability,eitherby
creatingtheperceptionthatthecompanywasshedbyabigfourbecauseofhighrisk,orraisinga
spectreofdoubtaboutthevalidityofitsfinancialstatements."77Midtierandsmallerauditfirmshave
attemptedtorefutethisperceptionbiasinCongressionaltestimonyandpublicappearances,
especiallyEdwardNussbaum,CEOofGrantThornton.78

Midtierfirmsbelievethesituationhaschangedsincetheaccountingscandalsofthepastdecade.There
isnolongerastigmaassociatedwithauditorchanges,aspointedoutbyConoFusco,managingpartner
forstrategicrelationshipsatGrantThornton."Basedontheinquirieswewouldhavegotteninthe
past,hesaid,therewassomelevelofconcernamongcompaniesthatthemarketplacedahigher
valueonhavingoneoftheBigFour.Buttoday,changingfromoneofthefourlargefirmsisnotseenas
asellsignal."79

SwitchingfromaBig4toasmallerauditfirmmaynolongerbeseenasasellsignalandbanksmayno
longerbeplacinghighervalueonaBig4audit.80AstudycommissionedbyBDOfoundthat244public
companieswhichdroppedaBig4auditorhadnoeffectonstockprices.81

OtherNetworks

InOctober2006,BakerTilly,oneofthebiggestaccountingfirmsintheUnitedKingdom,createdBaker
TillyUSA,anetworkof22midsizedUSaccountingfirmstocompetewiththeBig4.82Atpresent,the
BakerTillyInternationalNetworkhas144memberfirmsaroundtheworld.83Threeotheraccounting

75
Ibid.andChasen,Sept.17,2007,op.cit.fn71
76
Jopson,Barney,"Thestrangleholdofleadingauditorshaspromptedcallsforradicalmeasurestoreduce
concentration.ButtherearelimitstowhattheUKcanachievealone,"FinancialTimes,Mar27,2006,p.15
77
Ibid.
78
Ibid.
79
Reilly,Nov.14,2006,op.cit.fn34
80
Ibid.
81
Ibid.
82
Vault,Hightimesforaccountants,Vault.com,accessedApr.20,2008
83
Virchow,Krause&Co.,thelargestU.S.memberoftheBakerTillyInternationalNetwork,isseekingtochangeits
nametoBakerTillyLLP.The77yearoldaccountingfirmisindiscussionswiththeBakerTillyinternationalgroup

23
firmnetworksMooresRowlandNorthAmerica,theLeadingEdgeAllianceandMooreStephensNorth
Americaarehopingtocreatedemandfortheirrespectiveservicesbycombiningaccountingfirmsto
rivalthepoweroftheBig4.84

Thisisclearlyinresponsetotheconsolidationoftheaccountingprofessioninrecentyears,whichhas
narrowedthechoiceofauditorsandaccountantsforcorporateAmerica.Thesenetworksrecognizethe
marketopportunitiesforauditservices.AsstatedbyGeoffBarnes,ChiefExecutiveandPresidentof
BakerTillyInternational,Weareatatimewhenthebusinessmarketiscryingoutforalternativestothe
Big4,andwebelievethatourstructurecanfillthatvoid.85

OtherCompetition

Incompetitionforbusinessandtaxadvisoryservices(nonauditservices),theBig4competenotonly
againsteachotherbutagainsttheirformersubsidiaries,suchasAccentureandBearingPoint,aswell
aslawfirmsandotherbusinessconsultingfirms,suchasMcKinsey&CompanyandBoozAllen.They
alsocompetewitheachotherinrecruitingtopaccountinggraduatesfromleadinguniversities,andin
governmentlobbying.NonauditcompetitionisdescribedfurtherinAppendixIII2,showingrevenues
forconsultingservicesforeachoftheBig4in2006acombinedtotalofover$20billion.

RegulatoryEnvironment:Soft

Until2002,theauditindustryintheUnitedStateswasselfregulatedthroughitstradeassociation,the
AmericanInstituteofCertifiedPublicAccountants(AICPA),subjecttooversightbytheSecurities&
ExchangeCommission(SEC),anindependentagencyoftheU.S.governmentwithabout3,400
employees.In2002,theSarbanesOxleyActcreatedthePublicCompanyAccountingOversightBoard
(PCAOB),aprivate,nonprofitcorporation,tooverseetheauditorsofpubliccompanies.86ThePCAOB
wascreatedtoprotectinvestorsandthepublicinterestbypromotinginformative,fair,andindependent
auditreports.(Theauditindustryalsoissubjecttolawsandregulationsofstategovernments.)

ThePCAOBBoardconsistsoffivememberswhoareappointedbytheSecuritiesandExchange
Commission.AlthoughthePCAOBisaprivatesectorentity,theActgivestheSECoversightauthority

aboutbecomingtheflagshipfirmintheU.S.andisalsopursuingapprovalfromstateregulatorsinthefour
Midwesternstateswhereitoperates,aswellasfromtheirstateboardsofaccountancy.Undertheproposal,allof
theotherU.S.firmsinthenetworkwouldremainindependentmemberfirmswiththesameabilitytousethe
brandnameastheynowuseit,butonlyVirchow,KrausewoulduseBakerTillyasitsfirmname.Over60ofBaker
Tilly's144memberfirmsacrosstheglobehaveBakerTillyaspartoftheirname.VirchowKrausehasofficesin
Chicago,Detroit,MinneapolisandWisconsin,andastaffofover1,300.Thefirmhopestogainregulatoryapproval
aroundtheendof2008.VirchowKrauseWantsBakerTillyNamingRights,WebCPAwebsite(accessedAug.21,
2008)
84
Vault,op.cit.fn82
85
BakerTillywebsite:www.bakertillyinternational.com,accessedJuly16,2008
86
Recently,athreejudgepanelontheU.S.AppealsCourtfortheDistrictofColumbiaCircuitruledina21decision
thatthemakeupofthePCAOBundertheSarbanesOxleyActdoesnotviolatetheappointmentsclauseand
separationofpowersintheConstitution.Theplaintiffs,theFreeEnterpriseFundandauditfirmBeckstead&
Watts,mayappeal,eithertothefullappealscourtoreventheU.S.SupremeCourt.Cohn,Michael,"HowWould
theSupremeCourtRuleonthePCAOB?"WebCPA,Aug.27,2008(accessedAug.28,2008)

24
overtheBoard.InadditiontoappointingmembersoftheBoard,theSEC,amongotherthings,must
approvethePCAOBsbudgetandrules,includingauditingstandards,andmayreviewappealsofadverse
Boardinspectionreportsanddisciplinaryactionsagainstregisteredfirms.Withastaffofabout500,
PCAOBhasabudgetofroughly$140million(financedbyfeesfromissuersofstock).

TheActgivesthePCAOBfourprimaryresponsibilities:registrationofaccountingfirmsthatauditpublic
companiestradinginU.S.securitiesmarkets;inspectionsofregisteredpublicaccountingfirms;
establishmentofauditingandrelatedattestation,qualitycontrol,ethics,andindependencestandards
forregisteredpublicaccountingfirms;andinvestigationanddisciplineofregisteredpublicaccounting
firmsandtheirassociatedpersonsforviolationsofspecifiedlawsorprofessionalstandards.87

PCAOBconductsperiodicinspectionsofauditfirmsandreleasespartoftheinformationtothepublic,
subjecttolimitationsofconfidentiality.Criticscontendthatthepublicreportsaretoovagueand
releasedoneyeartoolatetotellthepublicwhatkindofjobthelargeauditfirmsaredoing.88PCAOB
spokesmenindicatethattheinspectionreportsareintendedtobeadialogbetweenPCAOBandthefirm
andthatthereportsserveasaconstructivetooltoimproveauditquality.89

Manybelievethatregulatoryauthoritiesarereluctanttotakeactionagainstmajoraccountingfirmsfor
fearthatanotheroftheBig4mightcollapseandthrowthefinancialworldintoturmoil.90Notingthe
mildSECpunishmenthandedouttoauditfirmsfortheirrolesinaccountingscandals,in2003,amajor
businesspublicationraisedthequestion:AretheBig4accountingfirmsnowtoofewtobeallowedto
failandeffectivelybeyondregulatorsreach?Regulatorsfaceaconundrum.Theymustcarryabig
stickbutnotuseittodriveanyoftheremainingbigplayersoutofbusiness.91Regulatorsfeel
constrainedtosanctiontheBig4whenitcomestonewevidenceofunprofessionalbehavior.After
Andersen,noonewantstobeblamedforcausinganotherfirmtocollapse.92Morerecently,aNew
YorkTimesarticleobservedthattheappetiteforprosecutingaccountingfirmshasdiminishedsince
ArthurAndersenwasconvictedofobstructionofjusticeaspartoftheEnroninvestigation,accordingto
analystsWithonlyfourlargeaccountingfirmsleft,thegovernmentisunlikelytopushanyofthemtoo
hard,expertssay.93

87
PCAOBStrategicPlan,20082013,Mar.31,2008;pcaob.com(accessedJuly20,2008;sec.gov(accessedJuly20,
2008)Inaddition,notethatcombatingsecuritiesandcommoditiesfraudsisalsoapriorityfortheFBI'sWhite
CollarCrimeProgram.Thesefrauds,however,aremuchbroaderinscopebecausetheyincludepyramidandPonzi
schemes,marketmanipulation,brokerembezzlementandforeignexchangefraudandnotsimplywrongdoingin
preparationofcorporatefinancialreportsandaudits.FBIwebsite,(accessedJuly20,2008).
88
Johnson,Sarah,WhytheBig4AreStillaBigMystery,CFO.com,Jan.26,2007.Seealso:Johnson,Sarah,
PCAOBFindsSlipupsinE&YAudits,CFO.com,May3,2007;PCAOB:DeloitteFailsonFairvalueTesting,
CFO.com,June18,2007;AllenRappeport,PCAOBCitesDeficienciesatPwC,CFO.com,July1,2008;Kim,Jim,
PCAOBTakesPwCtoTask,CFO.com,July3,2008;Leone,Marie,FailingGradesforE&Y,KPMG,CFO.com,Jan
12,2007.
89
Johnson,Sarah,Q&A:ThePCAOB'sCharlesNiemeier,CFO.com,Jan.26,2007
90
Cray,Charlie,andDrutman,Lee,CorporationsandthePublicPurpose:RestoringtheBalance,SeattleJournal
forSocialJustice,Fall/Winter2005Issue:Volume4,Issue1
91
Dwyer,Paula,TheBigFour:TooFewtoFail?,BusinessWeek,Sept.1,2003,p.30
92
Cray,Fall/Winter2005,op.cit.,fn90
93
Bajaj,Vikas,andCreswell,Julie,ALenderFailed.DidItsAuditor?,NewYorkTimes,Apr13,2008

25
InternationalAccountingStandards

Whiletheissuesassociatedwithinternationalaccountingstandardsandcapitalmarketsextendbeyond
thescopeofthispaper,itisappropriatetonotethesignificanceofconvergenceofnationalaccounting
standardsintoharmonizedinternationalstandards,especiallyinviewofthestepsrecentlytakenbythe
U.S.Securities&ExchangeCommissiontomovetowardadoptionofsuchstandardsinthecoming
years.94

Duetoincreasingeconomicintegrationandchangesinindustrialstructure,theworldhasoutgrownthe
existingsystemofvaryingnationalaccountingstandards.Universallyacceptableaccountingstandards
areimportanttoinvestorsandtocompaniesengagedincrossbordertransactions,includingcross
borderstockofferingsandlistingsofcompanysharesonstockexchangesoutsidetheirhomecountries.
Adoptionofglobalstandardswillrelievelargecompaniesoftheneedtokeepseparateaccounts
accordingtodifferingstandardsortheneedtoreconciletheirfinancialstatementstothestandardsof
anothercountry.Itwillmakeiteasiertocomparefinancialresultsofreportingcompaniesfrom
differentcountries.Thus,thedevelopmentofglobalstandardswillloweradministrativecostsandcosts
ofraisingcapitalforlargecompanies.Initially,however,itmayraisethecostofauditsbecauseofthe
addedtimeneededtoconvertfromonestandardtoanother,atleastforsomeperiodoftime.95

Theworldslargestaccountingfirmshavebeenintimatelyengagedinthedevelopmentandpromotion
ofinternationalfinancialreportingstandardsand,throughtheiradvancedknowledgeandexpertise,will
gainanadvantageoversmalleraccountingfirmsthroughadoptionofthesestandardsinternationally.In
effect,smallerauditfirmswithoutuptodateknowledgeoftheIFRSsystemcouldbefacedwithanother
barriertocompetitionforlargepubliccompanyaudits.96ForfurtherdetailsonthestatusofIFRS,see
AppendixIII4.

AuditQualityandIndependence

Incompetitionforclients,qualityandreputationarestrongpointsoftheBig4auditfirms.Despitethe
numerous,highlypublicizedaccountingscandals,theBig4performthousandsmoresuccessfulaudits.
Basedontheirresources,theirexpertise,andtheirtrackrecords,theBig4cancommandapremiumfor
theirauditfees,aspreviouslystated.Qualityandindependence,therefore,canbecountedasstrengths
oftheoligopoly.Atthesametime,however,inviewoftheliabilityrisksandthenatureofthesystem
(particularlytheconflictbetweenthepublicinterestandtheinterestofthepayingclient),qualityand
independencecanalsoberegardedasweaknesses.ThisisdiscussedfurtherinPartIVofthispaper.

AnticompetitiveBehavior

InMarch1977(priortoconsolidationoftheeightmajoraccountingfirms),theFederalTrade
Commission(FTC)openedaninvestigationofrestrictionsoncompetitioninaccountancy.The

94
SECProposesRoadmapTowardGlobalAccountingStandardstoHelpInvestorsCompareFinancialInformation
MoreEasily,PressRelease2008184,Aug.27,2008
95
Hughes,Jennifer,"FarreachingchangesforUS,"FinancialTimes,Aug.27,2008
96
Johnson,Sarah,andLeone,Marie,"BigFour:GetaHeadStartonIFRS:TheSEC'sproposedtimelinegives
credencetoacallbyauditorsforcompaniestostartpayingattentiontointernationalaccountingrules,"CFO.com,
Aug.28,2008(accessedAug.31,2008).

26
Commissionwastostudytheeffectsofstaterestrictionsonadvertisingbyaccountants(allstatesexcept
Nevada);prohibitionsonthoseinotheroccupations(e.g.,lawyers,realestateagents)alsopracticingas
accountants(46states);andprohibitionsonaccountantsbiddingcompetitivelyforaccounting
engagements(19states,includingMassachusetts,Michigan,PennsylvaniaandOhio).Thestudyalso
wastoincludethedegreeofpossiblecontrolbymajoraccountingfirmsovertheaccountingindustry,
thereasonsforsuchdominance,anditspossibleeffects.97Theinvestigationwaspromptedbycollapse
ofthePennCentralRailroad,theEquityCorporationofAmericascandal,andaSenatesubcommittee
staffreportchargingthatbigaccountingfirmstendtoservetheircorporateclientsratherthanthe
investingpublic.98

Ataboutthesametime,theDOJchallengedTexasregulationsthatprohibitedcompetitivebiddingby
accountantsinthestate.Ifsuccessfulthedecisioncouldapplyinotherstates.99In1978,aU.S.District
CourtinTexasruledthatTexasregulationsconstitutedaviolationoftheShermanActwiththepurpose
oreffectofsuppressingoreliminatingpricecompetitionandthatthestateboardofaccountancywas
notimmunefromfederalantitrustlaw.100Thisoverturnedtheprevailingdoctrinethatprice
competitionwasunethical,underminedprofessionalintegrityandwouldnotdeliverthedesiredtype
andqualityofservicestothecustomer.Thedecisionwasaffirmed,butmodified,in1979bytheU.S.
CourtofAppeals.101

Subsequently,in1980,theFTCcloseditscasebecausetheCommissionfoundthatmanyofthe
restraintshadbeendroppedvoluntarilyandthatsincethecasewasopened,SupremeCourtdecisions
favoringcompetitionamongprofessionalshadcausedasignificantnumberofstatesandassociations
tocancelorreduceaccountingrestrictions.102TheFTCwastocontinuemonitoringthesituation,
includingstaterulesagainstencroachment,thepracticeofoneaccountingfirmsolicitinganother
firmsclients.103

TheseandvariousothercourtdecisionsintheUnitedStateshelpedtounleashvigorousprice
competitionamongthemajoraccountingfirmsinthe1980sand1990s,especiallyasauditfeesbecame
usedaslossleaderstoattractmorelucrativeconsultingbusiness.

Morerecently,theItaliangovernmenttookactionagainstanticompetitivebehaviorofaccounting
companies.In2000,theItaliangovernmentleviedfinesontheItalianAssociationofPublicAccountants
(ASSIREVI)anditsmembers,theBig6globalaccountingfirms.Atthetime.thesixfirmsArthur
Andersen,Coopers&Lybrand,Deloitte&Touche,KPMG,PriceWaterhouse,andRecontaErnst&
Younghandledroughly90percentofthebusinessofthoseentitiesinItalywhicharerequiredtohave
outsideaccountants.ThefirmsviolatedItalianantitrustlawbyconcludingagreementsthatcovered
virtuallyeveryaspectofcompetitionbetweentheauditingfirms.Theviolationswereoftwodistinct

97
WallStreetJournal,FTCtoStudyStateAccountancyBoards,GroupsforPossibleCurbsonCompetition,Mar.
25,1977,p.7
98
Ibid.
99
Ibid.
100
UnitedStatesv.TexasStateBoardofPublicAccountancy,U.S.DistrictCourt,WesternDistrictofTexas,Austin
Division.CivilNo.A76CA219,filedMay5,1978;CommerceClearingHouseTradeRegulationReports,62039
101
UnitedStatesv.TexasStateBoardofPublicAccountancy,U.S.CourtofAppeals,FifthCircuitNo.782205,
datedApr.9,1979;CommerceClearingHouseTradeRegulationReports,62,546
102
WallStreetJournal,FTCClosesProbeofAccountingRulesLimitingCompetition,Sept.17,1980,p.4
103
Ibid.

27
types:settingpricesfortheservicesofferedonthemarketbythemembersofASSIREVI;and,more
generally,coordinatingcompetitivebehavior.104

Theagreementssetthefeesforauditingbasedoncirculationofanannualbenchmarkauditfeeand
workinghourstableaccordingtothesizeandthesectorofactivityoftheclientfirms.Theagreement
alsolaiddownrulestobefollowedwhenacquiringnewclientsinordertoprotectthemarketpositions
ofeachfirm.Inparticulartheserulesprohibitedanyformofcompetitioninrelationtoeachauditfirm's
clientportfolio.Byapplyingtheserules,theauditingfirmswereabletoagree,forexample,onhowto
respondtorequestsfordiscountsfromclientcompanies,andtoestablishinadvancethefirmthat
wouldbeawardedauditingcontracts,inmanycasesmakingcompetitivetenderingamereformality.105

Inviewoftheseriousnatureoftheseoffenses,theAuthorityimposedfinesonthesixfirmstotaling
4.5billionlire(about$2.3million):1.223million($0.63million)onArthurAndersen,840million($0.43
million)onCoopers&Lybrand,788million($0.41million)onRecontaErnst&Young,687million($0.35
million)onKPMG,539million($0.28million)onPriceWaterhouseand470million($0.24million)on
Deloitte&Touche.)106Thefineswereequivalenttobetween1.15percentand1.4percentoftheir
revenuesfromauditingservices.107

Inits2003reportonconcentrationintheauditindustry,theU.S.GeneralAccountabilityOfficefound,
withrespecttoauditfees,thereisnocleardefinitivelinkbetweenaccountingmarketstructureand
anticompetitivebehavior.108

InShort

Since2002theBig4accountingfirmshavebeenengagedinamilderformofcompetitionforaudit
clientsthanoccurredinthe1980sand1990s.Midtierandsmalleraccountingfirmsfaceformidable
barrierstoentryinthemarketforauditsofglobalpubliccompanies,althoughtheyaregainingmarket
shareintheauditsofsmallercompanies.Auditfeesaremuchhigherthanbefore,reflectingcostsmore
fullyandrealistically.InitsstudyoftheBig4,GAOfoundthatthereisnoclear,definitivelinkbetween
accountingmarketstructureandanticompetitivebehavior.Thereappearstobegeneralagreement
thatthehigherfeesareattributablemoretonewregulatoryrequirementsthantoindustry
concentration.ClientsoftheBig4large,sophisticatedmultinationalcorporationswithhuge
resourcesarecomplainingabouttheburdenofregulatoryrequirements(whichcontributetothecost
ofaudits),butnotthecostoftheauditsthemselves.Smallpublicfirmscomplainaboutthe
requirementsandthedisproportionatelyhighcostsofaudits.Actionsbyregulatoryauthoritiesare
constrainedbythefearofdrivinganothermajoraccountingfirmoutofbusinessandthereby
compoundingthelackofchoiceproblemsofglobalpubliccompaniesinselectinganauditfirm.There
appearstobenoevidenceofanticompetitivebehaviorinrecentpublicliteratureandtherearenocases
reflectingantitrustviolationsbymajoraccountingfirmsintheUnitedStates.Nevertheless,recallingthe

104
ItalianAuthorityPressRelease,ProceedingReference1266,Number4,February21,2000;alsoProceeding
Reference97,November25,1998
105
Ibid.
106
Ibid.
107
OECDAnnualReportonCompetitionPolicyDevelopmentsinItaly,1999,pars.7273
108
GAO,op.cit.fn11

28
exampleoftheindustrysanticompetitivepracticesinItalyinrecentyears,regulatoryauthoritieswould
bewelladvisedtoremainvigilantsothatsimilaranticompetitiveactivitiesdonotoccurinthefuture.

PartsIIandIIIhavefocusedonthestrengthsoftheoligopoly.PartIVfocusesonitsweaknesses,
especiallyitsexposuretomassivelawsuits.Moreover,itfocusesontheissueofliabilitylimitationsand
questionsonhowtomaintainconsistenthighqualityauditsinthelightofconflictsofinterestbuiltinto
theauditsystem.

29


PARTIV

DEEPPOCKETSANDEXPOSURETOLIABILITY

Thegreatestweaknessoftheauditoligopolyappearstobeitsexposuretopotentiallyruinouslegal
challenges.Despiteadominantmarketpositionandaboomingbusiness,theoligopolyanditsclients
areintheanomaloussituationofseekinggovernmentprotectionagainstmassivelawsuitsby
disgruntledinvestors,creditorsandothers.

MassiveLawsuits

Massivelawsuitsareeverpresentrisksandsourcesofweaknessforeachofthemajorauditand
accountingfirms.Thisisnotanewphenomenon,buttheclaimshavegrowninsizethroughtheyears,
whiletheindustryhasconsolidatedintofourhugefirms.Duringa5yearperiodinthe1980s,thecost
ofsettlementstomajorauditfirmsamountedtolessthan$200million;109whereasin19982006,the
Big4auditfirmsfaceddozensofclaimsinexcessof$1billion.110

Auditfirmsarevulnerable,partlybecausetheyhavedeeppocketsandpartlybecauseofthenatureof
thebusiness.Whencorporationssuddenlyfailorsufferseveredeclinesinstockprices,disgruntled
investors,creditorsandemployeesarepronetosuetheauditorsaswellasthecorporatemanagement.
Claimsagainsttheauditorsarebasedonallegationsoffraudorfailuretoidentifyerrorsorwrongdoings
thatledtomassivelosses.Withpendingclaimstotalingbillionsofdollars,theBig4auditfirmsface
seriousthreatstotheirsurvival.

AppendixIV1tracesthegrowthoflawsuitclaimsfrom1967tothepresentthroughreportsthat
appearedinthepopularpressandtradejournals.111AppendixIV2liststhelargestsettlementsin1980
85;AppendixIV3liststhetoptencasesin19992004;andAppendixIV4providesanextensive(butnot
exhaustive)listofcasesfrom1992topresent,involvingeachoftheBig4.Becausemediareportsoften
combinethevalueoftheclaimsagainsttheclientwiththoseagainsttheauditors,themagnitudeofthe
claimsastheyapplytotheBig4maybesomewhatoverstated.Also,theamountunderconsideration
maychangeovertimeandoutofcourtsettlementsmaybeagreedonaconfidential(undisclosed)basis.
Legalchallengesarecomplex,takeyearsbeforereachingcourtorsettlement,andareusuallysettledfor
smalleramountsthanthoseoriginallysought.112

109
HouseSubcommitteeonOversightandInvestigations;citedinSmallCPAFirms'LiabilityRatesSoarPlight
TiedtoMalpracticeSuitsAgainstBigEight,Burton,Lee,WallStreetJournal,Nov19,1985.pg.1
110
Holstein,WilliamJ.,WhatIfOneofTheBigFourFails?TryingtoavoidanArthurAndersentypedisruption,
Directorship,Sept.2006
111
PublicationsareidentifiedinfootnotesinAppendixIV1.
112
Buck,Tobias,"Brusselssuggestslegalshieldforbigauditfirms,"FinancialTimes,Jan.18,2007

30
Auditors,insomeinstances,actuallywincases(asintheEquitableLifecaseintheUnitedKingdom).113
WhilethebodyofinformationonsettlementsbytheBig4isextensive,itshouldberecognizedthatthe
numberofcasesinwhichtheauditorsperformtheirtaskswellarehardlyreportedandpublicized;they
arefarmorenumerousandcertainlynotasnewsworthyasthescandals.

LawsuitsinOtherCountries

LawsuitsagainsttheBig4arenotlimitedtotheUnitedStates.Examplesofothercountriescases
includeItaly(Parmalat),UnitedKingdom(EquitableLife),Canada(PhilipServices),Ireland(SmartForce)
andJapan(Kanebo).ThesecasesareincludedinthelistinAppendixIV4.Nationallawsapplyineach
country.TheEuropeanUnionconsideredlimitsforauditfirmliabilityandrecentlyissued
recommendationsforits27membercountriesratherthanimposingEuropeanwideregulations(see
below).

AvailabilityofInsurance

Inthe1980s,thethenBig6auditfirmswerecoveredbyliabilityinsurance,mainlyfromLloyd'sof
London.In1993,however,Lloyd'ssharplyraiseddeductibles,orportionsofnegligencesettlementsthe
firmmustpaybeforegettinganycoverage.Likewise,otherinsurershadraisedpremiumratesand
imposeddeductiblesof$10millionandlimitedcoverageto$100million.Lloyd'slimitedcoverageto
$50millionforallannualsettlements,ratherthan$50millionpernegligenceaward.114Becauseoftheir
inabilitytoobtainliabilityinsuranceforcatastrophiccases,themajoraccountingfirmstoalargeextent
arenowselfinsured.115

TheAmericanInstituteforCertifiedPublicAccountants(AICPA)offersaninsuranceprogramthrough
CNAandAonInsuranceServicesforfirmsbillinginexcessof$10million,butnotfortheBig4.The
programaffordsCPAfirmsextensiveresourcesandexperience,includingtailoredriskmanagement
servicesandhighlyresponsiveclaimsmanagement.TheBig4auditfirmsarespecificallyexcluded.116

EffectonSmallAuditFirms

Asliabilityinsurancebecamemoreexpensiveorunavailable,smallauditfirmsfaceddifficultiesdeciding
whethertocontinueauditingpubliccompanies.Severalseverelycurtailedorabandonedthebusiness
ofauditingpubliccompanies,focusinginsteadonprivateclients,taxes,consulting,andotherkindsof
workthatfacefewergovernmentrestrictions.Manyofthedroppedclientswerethesmallestpublic
companies,oftentheleastlucrativeclientswhocouldnotaffordorhadbeenrejectedbytheBig4.117

113
IntheEquitableLifecaseintheUnitedKingdom,Equitablesuedfor$4.77billion,butlatercutthatamountto
about$1.5billion,thendroppedthecaseinSeptember2005,andpaidforthelegalcostsincurredbyErnst&
Young.Ernst&Young,Jun.9,2007,Wikipedia.com,accessedJuly20,2008;BBCNews,Equitableslashes
auditorclaim,July18,2005
114
Lochner,PhilipRJr.,"BlackDaysforAccountingFirms,"WallStreetJournal,May22,1992,p.A10
115
Weil,Jonathan,andSpurgeon,Devon,"ArthurAndersenInsurerIsRenderedInsolventFundsFromBermuda
FirmWereGoingtoBeUsedToSettleHostofClaims,"WallStreetJournal,Apr1,2002,p.C1
116
SeeAICPAProfessionalLiabilityInsurancePlanforRegionalFirmsathttp://www.cpai.com/business
insurance/professionalliability/lgfirm.isp,accessedMay21,2008
117
Johnson,Carrie,EffectonSmallAuditFirms:SeeSmallAccountingFirmsExitAuditing,WashingtonPost,Aug
27,2003,p.E01

31

LawsuitsasaBarriertoNewEntrants

Exposuretomassiveclaimsinlawsuitsisalsoanimportantelementinauditindustrycompetition.
Fearsofbankruptcyduetocostsofcourtcasesarerealand,toacertainextent,threatentoreduce
furtherthenumberofglobalauditfirms.Althoughithasnothappenedthusfarforamajorfirm,118the
possibilityweighsheavilyontheauditindustry.Becauseliabilityinsurancehasbecomevirtually
unobtainable,theBig4firmsmustsetasidereservestoselfinsureagainstpotentialcatastrophicclaims.
ThisisaheavyburdenthatcanbebornebetterbytheBig4thanbysmallerauditfirms.Indeed,therisk
ofmassivelawsuitstendstodiscouragemarketentryofnewauditfirmsandconstitutesaformidable
barriertocompetition(seePartV).Ironically,exposuretolitigationissomewhatofadoubleedged
swordfortheBig4.Itisathreattotheirsurvival,butatthesametimeithelpstosolidifytheirmarket
positionbydiscouragingcompetitorsfromenteringthemarket.

CampaignforLiabilityLimits

Theunavailabilityofliabilityinsuranceandthethreatofruinouslawsuitsdrivetheauditfirmsandtheir
clientstopressgovernmentsforliabilitylimitations.Withbillionsofdollarsofclaimspending,the
liabilityexposuresubstantiallyexceedsthecombinedpartnercapitaloftheBig4firms.119Thus,the
majorauditfirmsandtheirclientscontendthatliabilitylimitsarenecessarytopreventthelossof
anotherBig4firm,whichwouldthrowtheglobalfinancialsystemintochaos.120

ThedisappearanceofanyoneoftheBig4firmswouldbeatruecatastropheforfinancialmarketsas
wellasforpubliccompaniesworldwide.CollapseofanotherBig4firmcouldcauseparalysisin
financialmarkets.121Thechoiceofauditorswouldbesubstantiallyreduced,andtherequirementsfor
auditorindependencemightmakeitimpossibleforsomecompaniestofindasufficientlyskilled
independentauditor.122[I]tcouldleaveinternationalbusinessesstrugglingtofindanauditortosign
offontheiraccounts.123Inaddition,accountingandauditingcosts,alreadyskyhigh,wouldbecomean
evenmorecostlyburdenonpubliccompanies,reducingprofitsanddrivingsmallercompanieswhich
bearadisproportionateshareofthecoststoprivatization.124Theprospectoflosinganothermajor
accountingfirmandthenegativespiralingeffectthatwouldoccuracrosstheotherfirmsandinour
financialmarketsmustberecognizedasaglobaleconomicconcern.125

118
In1990,Laventhol&Horwath,atthetimetheseventhlargestauditingfirmintheUnitedStates,filedfor
bankruptcyprotectiondueinparttoafailureintheprovisionofnonauditservices,andsubsequentclassaction
litigation,lossofreputation,andinabilitytoattractandretainclients.See:Cunningham,LawrenceA.,"TooBigto
Fail:MoralHazardinAuditingandtheNeedtoRestructuretheIndustryBeforeitUnravels,BostonCollegeLaw
SchoolFacultyPapers,Year2006Paper165
119
Wallison,Mar.8,2007,op.cit.fn41
120
CommitteeonCapitalMarketsRegulation,InterimReport,87,citedinWallison,op.cit.fn41
121
Cray,Fall/Winter2005,op.cit,fn90
122
Wallison,op.cit.fn41
123
Buck,Tobias,Jan.18,2007,op.cit.fn112
124
Wallison,Mar.8,2007,op.cit.fn41
125
Ernst&YoungCEOJamesS.TurleyinaspeechinDecember2005,citedinHolstein,Sept.2006,op.cit.fn110

32
ThreerecentreportsontheconditionoftheU.S.capitalmarketsrecognizedthatanyoneofthefour
globalaccountingandauditingfirmscouldbedestroyedatanytimebyalargejuryawardinaprivate
securitiesclassaction.126

OneoftheBig4CEOscalledforthegovernmenttocaptheliabilityofmajoraccountingfirms,
suggestingacapof$100to$200million."Somelevelofaccountabilityinthecourtsisgoodforus,"he
said."Butwhenyoustarttalkingabout...havingbillionsofdollarsinliabilityonasingleaudit...itjust
doesn'tmakesense."127

OppositiontoLiabilityLimits

Opponentsofliabilitylimitationspointoutthattheglobalfinancialsystemoperateslargelyontrust.
Credibilityisessentialtomaintainingconfidenceinthesystem.Certifiedpublicaccountantsserveinthe
publicinterestandareexpectedtospotanduncoverirregularitiesinthecorporatebookswhenthey
occur.Toooftenauditorstendtoprotecttheirclientsortheirfirmratherthanthepublic.Alongwith
regulationandenforcement,lawsuitsserveasadeterrenttoimproperaccounting,thusprotectingthe
publicinterest.Atthesametime,theyhelptoredressharmtoinvestorscausedbyinappropriate
corporategovernanceandquestionableaccountingpractices.

SomeclaimthatsecuritieslawsintheUnitedStatesaffordauditorswithampleprotection,mainly
throughthePrivateSecuritiesLitigationReformActof1995,whichlimitsliabilitytoproportionatefault,
imposeslitigationrequirementsthatmakeitlesslikelyforauditorstobesued,andweedsoutfrivolous
cases.128(Underproportionateliability,anauditorisliableonlyforthepartoftheclaimforwhichitis
responsible,takingintoaccountthefaultofotherparties.Forexample,iftheauditfirmisresponsible
for20percentofthedamage,itwouldpayonlythatportionofthedamages.Incasesofjointand
severalclaims,auditfirmshavebeenresponsiblefortheentireamountwhentheclientisbankruptor
otherwiseunabletopay.)

Auditorliabilityisalsolimitedbycontractualarrangementswithclients(althoughthiswontprotectthe
auditoragainstclientsshareholders);andbypunitivedamagewaiversinauditclientcontracts.As

126
Thethreegroupsare:theU.S.ChamberofCommerce;agroupofacademicsandmarketprofessionalscalled
theCommitteeonCapitalMarketsRegulation;andNewYorkCitymayorMichaelBloombergandSenatorCharles
Schumer(DN.Y.),citedinWallison,PeterJ.,"HostagestoFortune:AChangeintheAuditCertificationCanReduce
Auditors'Risks,"Posted:Apr.6,2007,AEIOnline,accessedJuly20,2008.CommitteeonCapitalMarkets
Regulation,InterimReport,Nov.30,2006,14,availableat
www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf(accessedMar.5,2007);andMichaelR.
BloombergandCharlesE.Schumer,SustainingNewYork'sandtheUS'GlobalServicesLeadership,Jan.22,2007,
102,availableat
www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf
(accessedMarch5,2007).
127
DeloitteCEOJamesCopeland,citedinSolomon,CalebandBerton,Lee,DeloitteIsHitByJuryAwardof$77
MillionPunitiveDamageIsLeviedInCaseofTaxReturnsForCattlePartnership,WallStreetJournal,Nov.11,
1993,p.A4
128
Coffee,JohnP.,"Troublewithacaponliability:Protectingauditorsweakenscorporateaccountability,"Pensions
&Investments,May12,2008

33
LimitedLiabilityCompanies(arelativelynewbusinessstructure),theindividualpartnersinauditfirms
arenotresponsiblefortheliabilitiesofotherpartners.129

Somecontendthatclaimsofcatastrophicliabilityexposureareexaggeratedandthatauditorshavepaid
onlyasmallportionofwhatmajorpubliccompanieshavepaid.130Legalchallengesarecomplex,take
yearsbeforereachingcourtorsettlement,andareusuallysettledforsmalleramountsthanthose
originallysought.131Withregulatorsreluctanttotakestrongactionsagainstthefourremaining
accountingfirms(asnotedinPartIIIofthispaper),civillawsuitsareleftasthemosteffectivediscipline
forauditingfirms.132

"Theissueissimplyoneoftrust.Underthelaw,wehaveadutytoassurethatpublicauditorsand
accountantsupholdthepublictrustinherentintheirpermit...Publicauditorshaveadutytoprotectthe
public.Whentheyfailinthatduty,thepublicmustbeprotectedfromtheauditors."133

LiabilityLimitsinOtherCountries

Currently,intheEuropeanUnion,liabilitycapsexistinonlyfivememberstates:Germany,Austria,
Belgium,GreeceandSlovenia.InGermany,auditorexposureiscappedat4millionEuros(about$6
million).134InGreece,thelimitsarebasedonamultipleoffeessecuredbyanaccountingfirmwithan
auditclient.135Britain,meanwhile,isintroducingtheconceptof"proportionateliability."Australia
alreadyhasaproportionateliabilityregime.Denmark,Netherlands,Luxembourg,Spain,andtheUnited
Kingdom136allowauditfirmstolimitliabilitythroughcontractualagreementswithclients(asinthe
UnitedStates).

In2003,inaspeechinLondon,FritsBolkestein,EUCommissionerofInternalMarketandTaxation,
expressedoppositiontoliabilitylimits.TheCommissionconsidersauditorliabilityprimarilyasadriver
ofauditqualityanddoesnotbelievethatharmonisationorcappingofauditorliabilityingeneralis
necessary,hesaidandwentontoaddthattherearefourclearreasonsfornotlimitingauditor
liability.137InJune2008,however,theEuropeanCommissionformallyrecommendedthatthemember

129
TheBig4accountingfirmsareLimitedLiabilityCompanies(LLCs),arelativelynewbusinessstructureinthe
UnitedStates,allowedbystatestatute.LLCsarepopularbecause,similartoacorporation,ownershavelimited
personalliabilityforthedebtsandactionsoftheLLC.OtherfeaturesofLLCsaremorelikeapartnership,providing
managementflexibilityandthebenefitofpassthroughtaxation.Theseentitiesofferabusinessthelimited
liabilityofacorporationbutaregenerallytreatedaspartnershipsfortaxpurposes(thatis,thereisnotaxatthe
entitylevelandthereforeno"doubletaxation").IRSwebsite,www.irs.govaccessedAug.20,2008
130
Coffee,May12,2008,op.cit.fn128
131
Buck,Tobias,Jan.18,2007,op.cit.fn112
132
Bajaj,Apr.13,2008,op.cit.fn93
133
ConnecticutAttorneyGeneralRichardBlumenthal,announcinganinvestigationoftheroleofArthurAndersen
intheEnronscandal,PressRelease,January17,2002
134
Economist,"Thefutureofauditing:Calledtoaccount,Nov.18,2004
135
Michaels,AdrinaandParker,Andrew,"Governmentsareconsideringwaystoshelteraccountingfirmsfrom
ruinouslawsuitsbutlawyersspecialisinginclassactionsuit,"FinancialTimes,May21,2004
136
Heaton,Nicholas,"OneSizeFitsAll?ThemanydifferentapproachestoauditorsliabilityamongtheEUs27
memberstatesmakeharmonisationathornysubject,"AccountancyAge,Feb.22,2007
137
Bolkestein, Frits, Auditor Liability: An EU Perspective, Address at The London Underwriting Centre, Mar 24, 2003;
(http://europa.eu.int/rapid/pressReleasesAction.do?reference=SPEECH/03/151&format=HTML&aged=0&language=EN&guiLanguage=en)
Forexcerptsfromthespeech,seeAppendixIv5ofthispaper.

34
statesenacttheirownliabilitylimitations,pointingoutthatthecombinationofunlimitedliabilityand
insufficientinsurancecoveragemakesthecurrentsituationnolongertenable(seefurtherdetails
below).

In2004,BritainsOfficeofFairTradinghadconsideredandrejectedauditorcaps,statingthatitfound
littleevidencethatcapsencouragedcompetitionorwoulddoanythingtoreducetheriskofthecollapse
ofaBig4firm.Indeed,capsmightmakeconcentrationworse,sincetheywouldhelptheBig4,whoare
alreadymostexposed,morethansmalleroutfits138

Alsoin2004,itappearedthatBritainwasleaningtowardadoptionofproportionateliability.Asstated
byPeterMontagnon,headofinvestmentaffairsattheAssociationofBritishInsurers,"Investorshave
beenreadytosupportaproperlyelaboratedregimeforproportionateliabilitybecausethismakesthe
auditorsclearlyresponsiblefortheirownmistakesbutabsolvesthemfromresponsibilityforthefailings
ofothers.Butinvestorshavealwaysbeenhighlyskepticalofanyotherformofliabilitycapbecausethey
perceiveaseriousrisktoqualityandconfidenceintheaudit."139

In2005,WilliamMcDonough,thenChairmanofthePublicCompanyAccountingOversightBoard,told
theFinancialTimesthatauditorscouldnotexpectlawmakersintheUnitedStatestoconsiderproviding
themwithliabilityprotectionuntiltheyhadwonbackpublicconfidence.140

EuropeanUnionConsiderations

In2006,theEuropeanCommissionissuedareportandinitiatedaconsultationonauditorsliability.The
reportofferedfourwaystoimproveprotectionfortheauditindustry:(1)imposeafixedmonetarycap
forauditorliabilityatEuropeanlevelthroughEUlegislation;(2)introduceacapbasedonthemarket
capitalizationoftheauditedcompany;(3)proposeacapbasedonamultipleoftheauditfeescharged
bytheauditortotheclient;or(4)introducetheprincipleof"proportionateliability",meaningthat
auditorswouldonlybeliabletopaydamagesthatwerecausedbytheirownmistakes,butnottheir
clients'.141FollowingconsultationswithEUmemberstates,regulatorsandtheprivatesector,inJune
2008theEUCommissionissuedrecommendationsforaction.

EURecommendationsforMemberStates

Initsrecommendations,theEuropeanCommissionendorsedtheconceptofliabilitylimitations,but
avoidedadoptionofasinglemethodoflimitationforallMemberStates.Instead,MemberStatesmay
chooseamethodthatbestsuitstheirlegalenvironment,butisinlinewithcertainprinciples.Itsaimis
toprotectEuropeancapitalmarketsbyensuringthatauditfirmsremainavailabletocarryoutauditson
companieslistedintheEU.Limitationscanalsobeadoptedforauditsofunlistedcompanies.Three
methodscaps,proportionateliability,oracontractuallimitationareofferedaspossibleexamples,
butanyotherequivalentmethodmightbeused.Limitationmustbeconsistentwiththefollowing
principles:(1)thelimitationofliabilityshouldnotapplyinthecaseofintentionalmisconductonthepart

138
Economist,Nov.18,2004op.cit.fn134
139
Ibid.
140
Parker,Andrew,"Accountingheadwarnsoncappingliabilities,"FinancialTimes,Sept.24,2005
141
EUPressReleaseIP/08/897June6,2008,"Auditing:CommissionissuesRecommendationonlimitingaudit
firms'liability"(seeMEMO/08/366)availableat
http://ec.europa.eu/internal_market/auditing/liability/index_en.htm

35
oftheauditor;(2)alimitationwouldbeinefficientifitdoesnotalsocoverthirdparties;and(3)
damagedpartieshavetherighttobefairlycompensated.

UponintroductionoftheEUrecommendations,InternalMarketandServicesCommissionerCharlie
McCreevysaid:Afterindepthresearchandextensiveconsultation,wehaveconcludedthatunlimited
liabilitycombinedwithinsufficientinsurancecoverisnolongertenable.Itisapotentiallyhugeproblem
forourcapitalmarketsandforauditorsworkingonaninternationalscale.Thecurrentconditionsare
notonlypreventingtheentryofnewplayersintheinternationalauditmarket,butarealsothreatening
existingfirms.Inacontextofhighconcentrationandlimitedchoiceofauditfirms,thissituationcould
leadtodamagingconsequencesforEuropeancapitalmarkets.142

Themajorauditnetworkswillnotreceiveimmunityfromtheirauditfailureandtheywillcontinuetopay
compensationtodamagedparties,butclaimsagainstthemwillnotbeunlimited.Damagedpartieswill
retaintherighttobefairlycompensatedforinjury,butsubjecttothelimitsofthemethodchosenby
theirMemberStates.Aliabilitylimitationshouldbenefitnewmarketentrantsandespeciallymidtier
auditfirms,asthesefirmsmaynothavethesameabilitytoestablishselfinsurance,whichwas
establishedbytheBig4morethanadecadeago.Lowerliabilityriskswouldprovidestrongerincentive
fornewinvestmentintomidtierauditfirms,whichcouldhelpthemcompetewiththemajoraudit
networks.143

Therecommendationswerewelcomedbysomeauditfirmsandtheirtradeassociations.144Someofthe
memberstatesalreadyhavelimitationsineffect.Now,itisamatteroftimebeforetheotherstateswill
decidewhat,ifany,limitationstoadopt.TheEuropeanactionsmaywellencouragecountriesinother
regionstofollowtheirexamples.

AuditQualityandIndependence

Theinvestingpublicatlargedependsontheauditsystemoperatingwithcompleteintegrity.Auditing
criticscontendthatdecliningqualityofauditsisacauseoflawsuitsandthatconsistentlyhighquality
auditswouldeliminatetheriskofliabilityexposure.145Therisingnumberofliabilitylawsuitsisaresult
oftheseriesofhighlypublicizedaccountingscandalsinrecentdecades.Eventhoughthesescandals
mayinvolvearelativelysmallnumberofcases,thereisgreatpublicconcernregardingthepotentialfor
corporatefraudandabuse.Thereisevenskepticismoverthequalityofauditsandtheabilityofauditors
todetecterrorsandinaccuraciesinfinancialstatements.

U.S.lawsrequirethatfinancialstatementsofpubliccompaniesmustbeauditedbyanindependent
publicaccountant.Inattestingtofinancialstatements,therefore,theauditorisexpectedtoplaythe

142
Ibid.,PressRelease
143
Ibid.,Q&A
144
Forexample,seeDeloittePressRelease,Jun13,2008,IASPLUSMonthlyNews,www.iasplus.com,accessed
Aug.20,2008;Heaphy,S,InstituteofCharteredAccountantsinIreland,"ICAIwelcomesEUCommission
recommendationonAuditorLiability,"ICAIwebsite,www.accountingnet.ie,Jun.15,2008accessedAug20,2008;
InstituteofCharteredAccountantsinEnglandandWales,"AuditorLiabilityLimitation,"undatedICAEWwebsite,
www.icaew.com,accessedAug.20,2008
145
Forexample,seeBolkestein,op.cit.,fn137.Unlimitedauditorliabilityisaqualitydriver.Iftheauditordelivers
permanentlyhighqualityhehasnoliabilityexposure.Thereisnomoreeffectiveliabilityriskmanagementthan
deliveringhighqualityaudits.

36
roleofapublicwatchdog.TheAmericanInstituteofCertifiedPublicAccountants(AICPA)statesinits
CodeofProfessionalEthics:Intheperformanceofanyprofessionalservice,amembershallmaintain
integrity,shallbefreeofconflictsofinterest,andshallnotknowinglymisrepresentfactsorsubordinate
hisorherjudgmenttoothers....Membersshouldaccepttheobligationtoactinawaythatwillserve
thepublicinterest,honorthepublictrust,anddemonstratecommitmenttoprofessionalism.146

ConflictsofInterest

Conflictsofinterest,however,arebuiltintothesystemasauditfirmsarepaidbythecorporations
whosebookstheyreview.ThisconflictwasaddressedinaSupremeCourtcasein1984.147TheCourt
heldthatbycertifyingthepublicreportsthatdepictacorporation'sfinancialstatus,theindependent
auditorassumesapublicresponsibilitytranscendinganyemploymentrelationshipwiththeclientand
owesultimateallegiancetothecorporation'screditorsandstockholdersandtotheinvestingpublic.148
Inthedecision,ChiefJusticeWarrenBurgerwrote:"This'publicwatchdog'functiondemandsthatthe
accountantmaintaintotalindependencefromtheclientatalltimesandrequirescompletefidelityto
thepublictrust."149

"Thefactthatauditfeesarepaidbythecompanyauditedposesabasicconflictofinterestbuiltintothe
SecuritiesActs,"asoneaccountancyprofessornoted.150AccordingtobillionaireinvestorWarren
Buffett,auditorstendtokowtowtothemanagerswhochoosethemanddoleouttheirpay.151Inthe
pasttheseconflictscouldbemanagedbetter.However,inmorerecentyears,theaudithaslostits
statureandisnolongertheprimaryfocusofaccountingfirms.152Auditsbecamecommoditized
productsandclientswerepayingmoreforconsultingthanforaudits.153Asaccountingfirmsshiftedto
somethingmoreakintomarketingorganizationsobsessedwithcrossselling[additional]servicesto
auditclients,theconflictbetweenservingcorporatemanagersandprotectingthepublicinterestwas
magnified.154

Someobserversevensubmitthatcompleteimpartialityandobjectivitymaybepsychologically
impossiblebecauseofsubconsciouspersonalbiasesofwhichindividualauditorsmaybeunaware.
Psychologicalresearchpointstoaninescapableconclusion:suchimpartialityisimpossibleunder
currentinstitutionalarrangementsDespitetheauditorsbesteffortstoplacetheexternalusers
interestsabovetheclientsandtomaintainobjectivity,theymaybeunabletoovercomecognitiveor

146
QuotedinBazerman,Summer1997,op.cit.fn58
147
U.S.SupremeCourt:1984,UnitedStatesv.ArthurYoung&Co.,U.S.SupremeCourtReports,26April1984
148
Steinberg,William,"CookedBooks:ShoddyandinsomecasessharppracticesbytheBigSixaccountingfirms
arethehiddenelementlinkingthefinancialscandalsofthe1980sand1990s,"AtlanticMonthly,Jan.1992
149
W.Burger,U.S.SupremeCourt:1984,UnitedStatesv.ArthurYoung&Co.,U.S.SupremeCourtReports,26April
1984,79LEd2d,826838.
150
AndrewD.BaileyJr.,theErnst&YoungprofessorofaccountancyattheUniversityofIllinoisatUrbana
Champaign,quotedinReutter,Mark,"Accounting:Changeinauditingfirms'dutiesgaverisetoconflictsof
interest,"UniversityofIllinoisatUrbanaChampaignNewsBureau,May1,2002
151
QuotedinHilzenrath,DavidS.,"AfterEnron,NewDoubtsAboutAuditors,"WashingtonPost,Dec.5,2001,p.
A01
152
Reutter,May1,2002,op.cit.fn150
153
Weil,Jonathan,"MissingNumbersBehindWaveofCorporateFraud:AChangeinHowAuditorsWork;'Risk
Based'ModelNarrowedFocusofTheirProcedures,LeavingRoomforTrouble;A$239MillionStickyNote,"Wall
StreetJournal,Mar.25,2004,p.A1
154
Reutter,May1,2002,op.cit.fn150

37
psychologicalbiasesthatmakethemarriveatmarginaldecisionsintheclientsfavorThelarger
problemfacingsocietyisthatthereisgoodreasontobelievethatauditorswillunknowingly
misrepresentfactsandwillunknowinglysubordinatetheirjudgmentduetocognitivelimitations.155

''Nochangetothelawonfinancialliabilitycouldprotectoneofanauditor'sgreatestassets,its
reputation,''saidPatriciaHewitt,Britain'ssecretaryofstatefortradeandindustry.''Thatresponsibility
restswiththeprofessionalismofauditorsthemselves.''156

Somecriticscontendthatfiercepricecompetitioncontributedtothedeclineinauditquality.Afterthe
federalgovernmentruledthatbansonadvertising,uninvitedsolicitations,andparticipationinbidding
contestsareanticompetitive,biddingwarsensued.157Inordertocutcosts,auditfirmsputfewer
resourcesintoaudits,usingjuniororinexperiencedstafforskimpingonrecordchecks.158Reduced
hoursonthejobtendedtodiscourageauditorsfromlookingforfraud.Oneoftheshortcutsusedbythe
majoraccountingfirmswasadoptionofariskbasedapproach,whichfocusedonriskyclientsandrisky
areasofcompanyfinancialreports,thosepronetoerrororfraud.Onlycursoryreviewsweremadeof
themorestable,lowriskitems,suchascashonthebalancesheet.Ratherthancheckingall
componentsofthefinancialstatementadetailsorientedapproach,theauditorstriedtoidentify
areasinwhichmisstatementsweremostlikelytooccur.159

EffortstoImproveAuditQuality

TheBig4accountingfirmshavespenttensofmillionsofdollarstoimprovetheirauditingtechniques.
KPMG'sinvestigativedivisionhasdoubledto280itsforceofforensicspecialists,somehailingfromthe
FederalBureauofInvestigation.PricewaterhouseCoopersLLPauditorsattendseminarsrunbyformer
CentralIntelligenceAgencyoperativesonhowtospotdeceitfulmanagersbyscrutinizingbodylanguage
andverbalcues.Roleplayingexercisesteachhowtostanduptoacompany'smanagement.160

AdditionaleffortstoimproveauditqualityincludetheestablishmentofaCenterforAuditQualityanda
thinktank,TheDeloitteForensicCenter,tofocusonissuesfacingauditorsinatimeofgrowingfinancial
complexityandmarketglobalization.InJanuary2007,theAICPAandeightpubliccompanyaccounting
firmsestablishedTheCenterforAuditQuality,anautonomous,nonpartisan,nonprofitgroupaffiliated
withtheAICPAandbasedinWashington,D.C.TheCentersmissionistofosterconfidenceintheaudit
processandtoaidinvestorsandthecapitalmarketsbyadvancingconstructivesuggestionsforchange
rootedintheprofessionscorevaluesofintegrity,objectivity,honestyandtrust.TheCenterforAudit
Qualityaimstobecomeanexpertresourceandcatalystforpubliceducationanddiscussion.161InJune
2007,Deloitteestablishedathinktank(DeloitteForensicCenter)toexploreapproachesformitigating

155
Bazerman,Summer1997,op.cit.fn58
156
Norris,Floyd,"BritainRefusestoPutCapOnLiabilityofBigAuditors,"NewYorkTimes,Sep.9,2004,p.W1
157
Weil,Mar.25,2004,op.cit.fn153
158
Hilzenrath,Dec.5,2001,op.cit.fn151
159
Weil,Mar.25,2004,op.cit.fn153
160
Ibid.
161
CAQPressRelease,Jan.30,2007.Theeightpubliccompanyaccountingfirmsare:BDOSeidmanLLP,Crowe
ChizekandCompanyLLC,Deloitte&ToucheUSALLP,Ernst&YoungLLP,GrantThorntonLLP,KPMGLLP,
McGladrey&PullenLLP,andPricewaterhouseCoopersLLP.MembershipisopentoallU.S.publiccompany
auditingfirmsregisteredwiththePublicCompanyAccountingOversightBoard.Associatemembershipisavailable
forU.S.accountingfirmsnotregisteredwiththePCAOB.

38
costs,risksandeffectsofcorporatefraudandcorruption.Thethinktankwillfocusontheuseof
technologytodetectandpreventfraud.162

Indevelopingitsrecommendationstomemberstatesonliabilitylimitation,theEuropeanCommission
wasmindfulthatauditqualityisfundamentalandthatinvestorsshouldhavefullconfidenceinthe
auditor.Inamemoaccompanyingtherecommendations,theCommissionemphasizedthatthe
limitationsshouldnotapplyincaseofintentionalbreachofauditorduties,suchascollusivebehavior
withmanagementincommittingfraud.Thelimitationshouldapplyonlyincaseofnegligentbehaviorby
theauditor.Also,theCommissionpointedoutthat,duringthepublicconsultationperiod,respondents
fromcountrieswherealiabilitycapalreadyexists(e.g.,Germany,Austria,Belgium),didnotbelievethat
theirdomesticcaphadhadadverseeffectsonauditquality.163

Maintainingconsistenthighqualityauditscanminimizetheriskofmassivelawsuits.

InShort

Tosummarize,PartIVidentifiesexposuretopotentiallyruinouslegalchallengesasthegreatest
weaknessoftheauditoligopoly.Despiteadominantmarketpositionandaboomingbusiness,the
oligopolyanditsclientsareintheanomaloussituationofseekinggovernmentprotectionagainst
massivelawsuitsbydisgruntledinvestors,creditorsandothers.Liabilitylimitationsalreadyexistto
someextentintheUnitedStates,particularlyintheformofproportionateliability.Liabilitycapsexistin
afewEuropeancountries,butcanbeexpectedtospreadtoothersinlightoftherecent
recommendationsbytheEuropeanCommission.Thepursuitorthreatoflawsuitscanstillserveasa
deterrenttofraudulentbehaviorandasaspurtoauditqualityandcanbringcompensationtoinvestors
andcreditorswheninjuryoccursbecauseoffraudornegligence.However,legalchallengesgenerally
arecomplexanddifficulttoprove,takeyearsbeforereachingcourtorsettlement,andareusually
settledforsmalleramountsthanthoseoriginallysought.Auditqualityandindependencearea
fundamentalconcernoftheglobalfinancialsystem.Thepublicinterestneedstobeprotectedfrom
conflictsofinterestwhicharebuiltintothesystem,particularlypaymenttotheauditorbytheclient
whosebooksareaudited.Consideringtheliabilitylimitationsthatcurrentlyexistandthepotential
trendtowardthespreadoflimitationstoadditionaljurisdictions,aswellastheinherentdifficultyof
prosecutinglegalchallenges,thelevelofexposuretomassivelawsuitsthegreatestweaknessofthe
auditoligopolymaybeonthevergeofdecline.

162
SmartPros,DeloitteFormsThinkTankForensicCenter,June22,2007accessedAug.13,2008
163
EUPressReleaseIP/08/897June6,2008,op.cit.fn2

39
 PartV

RECOUNTINGTHEREMEDIES

Thereisnoshortageofproposalstoremedytheproblemsassociatedwithauditindustryconcentration.
Theproposalsarecenteredmainlyonthreeobjectives:(1)preventfurtherconcentration;(2)promote
increasedcompetition;and(3)improveauditqualityandindependence.

PreventFurtherConcentration

Largepubliccompaniesalreadyarefacedwithalimitedchoiceofauditfirmsandfurtherconcentration
throughmergerorbusinessfailurewouldexacerbatethesituation.Inthecaseofamergeroftwo
Big4firms,U.S.antitrustandsecuritiesregulatorssurelywouldreviewtheproposalcarefullyinviewof
thecurrentshortsupplyofauditfirms.BusinessfailureofaBig4firmisnotlikelytooccur,giventhe
financialhealthofthesefirms,exceptforthepossibilityofruinouslawsuits.

RiskReduction

Reductionoftheriskoflitigation(discussedindetailinPartIV)canbeaccomplishedbymaintaining
consistenthighqualityaudits(seebelow)orthroughstatutorylimitsonauditfirmliability.Thereis
greatpubliccontroversyoversettingstatutorylimitations.Thelevelofamonetarycaponliabilitycan
alsobeafactor.Forexample,alimitintherangeoftensofmillionsofdollarswould,inmanycases,
denyinvestorsandlendersfromreceivingadequatecompensationwhereauditfirmsareatfault;alimit
ofonehundredmilliondollars,insomecases,mightalsobeunfairtoshareholdersandcreditors,while
beingregardedasaninsufficientsafeguardbypubliccompaniesandauditfirms.Opponentsofliability
capsarenotinterestedinprovidingsecurityfortheauditoligopolyanditscorporateclients.They
objectoutrighttoanystatutorylimitongroundsthatitwouldeliminateausefulincentiveforauditors
tobeperspicaciousindetectingcorporatefraudandwrongdoingandwoulddepriveinjuredpartiesofa
mechanismtoobtainadequaterelief.

PromoteIncreasedCompetition

AuditfirmsandtheentirefinancialcommunityarestilladjustingtotherequirementsofSarbanesOxley
legislation.Pricecompetition(asnotedinPartIII)isasecondaryconsiderationforlargepublic
companiesinselectinganauditfirm.Otherconsiderationsincludereputation,sectorspecificskills,
internationalcoverage,andqualityofstaff.However,atsomefuturetime,whencompliancewiththe
newregulationsbecomesmoreroutine,corporationsmayagainseektoreduceauditcostsaggressively,
astheydidinthe1980s.ThiswouldgeneratemorecompetitionamongtheBig4auditfirms.

40
ManyProposals

Proposalstocreatealargerfieldofcompetitorsandincreasethechoicesavailabletolargepublic
companiesinclude:requiringdivestmentofauditorsbyoneormoreoftheBig4;removebarriersto
growthofmidtierandsmallerauditfirmsandtonewentrants;allowoutsideownershipofauditfirms;
buildadditionalnetworksandreputations;andchangetheperceptionbiasagainstthenonBig4firms.

Divestiture

ThemostradicaloftheseproposalsisdivestiturebreakinguponeormoreoftheBig4intosmaller
piecestocreatealargernumberoffirmsforauditselection.Theproblemswiththisapproachare
many:decidingwhichfirm(s)tosplitup,howtosplitthem,howtofinancethem,whowillmanage
them;avoidingdisruptionofannualauditsofclientcompanies;andavoidingviolationofthelegalrights
oftheowners(partners)oftheBig4firms.Breakingupthefourfirmsintosmaller,morecompetitive
unitsisregardedasanextrememeasure,whichinitselfcouldbedisruptiveandmightevendilutethe
resourcesnecessaryforauditfirmstodefendagainstmassivelawsuits.Similarproposalsinclude
forcingBig4firmstodivestsomeoftheirlargepubliccompanyclients,aproposalthatwasunder
considerationinBritain,butlaterwasdismissed.164Incidentally,itisnotinconceivablethatdisaffected
partnersinaBig4firmcouldleavethatfirmandbringtheirclientswiththem,formingthenucleusofa
newcompetitiveauditfirm.Itisdoubtfulthatgovernmentscoulddeviseeffectivemeasuresto
encouragepartnerstodoso,evenifthisweredeterminedtobedesirable.

BarrierRemoval

Themostpragmaticapproachistofindwaystoremovethebarrierstogrowthofmidtierandsmaller
firmsandtonewentrants.Mergersamongthesefirmscouldbeencouraged.Itwilltakealongtime,
though,todevelopfirmsornetworkstoreachthesizeandcapabilitiesoftheBig4.Somenetworks
alreadyareatworktobuildexpertiseandreputationsinternationally(seePartIII).Also,someworkis
underwaytopublicizethecapabilitiesofmidtierfirmsandtochangethestigmaattachedtotheuseof
nonBig4auditfirmsbylargepubliccompanies.Governmentpurchasingpowercouldbeusedaswell
toencouragehiringmidtierorsmallerfirmsthroughcontractsforauditsofgovernmentagenciesor
programs.

OutsideOwnershipofAccountingFirms

Oneofthebarriers,whoseremovalcouldshowpromisingresults,isthelimitationonoutsideownership
ofauditfirms.Atpresent,theUnitedStatesandothercountriesrequirethataccountingfirmsbe
ownedentirely,orbyamajorityof,certifiedpublicaccountants.Ifthisrequirementwereremovedor
modified,itcouldperhapsattractentrepreneurswithamplefinancialresourcesandtalented
management,whorecognizetheopportunitiesinthisfieldandarewillingtotakeonthechallengeof
buildingnewauditentities.Suchentrepreneurscouldincludecorporateconglomeratesorprivate
equityfirms,notonlywithcapital,butwithmanagementtalentandexperienceinconsolidatingsmall
firmsandbuildinglargerbusinesses.Thenewentitiescouldbecreatedbyacquiringexistingsmallfirms
andcombiningthemintolargenationalandinternationalfirms.Anentrepreneurwithaninternationally
recognizedbrandnamewouldbehelpfulinestablishingareputationforqualitywork.Thenewentities

164
Jopson,Feb.5,2007,op.cit.fn16

41
probablywouldhavetostartwithsmallcompanyclientsanddemonstratetheircapabilitiesoverseveral
yearsbeforetheycouldattractglobalcorporationseveniftheyofferlowerauditfees.Thenew
entitieswouldnothavetocopewiththeriskofmegalawsuitsuntiltheyactuallysolicittheaudit
businessofglobalcorporations.

OpponentsofoutsideownershipareconcernedthatwithoutCPAsasmajorityowners,external
shareholdersmightmakebusinessdecisionsinafirmseconomicintereststhatcompromiseits
independenceforpurposesofperformingaudits.Appropriatesafeguardswouldbeneededtoensure
independenceandauditquality.165Anotherproblemfornewentitiescouldbeashortageofqualified
accountantsinthelabormarket,whichsomecompaniesindicatedmaybemoreofanimpedimentto
growththanlimitedaccesstocapital.166

ImproveAuditQuality

Asnotedearlier,consistenthighqualityauditscouldminimizetheneedforliabilitylimitations.
ImprovementsinauditqualitywouldhelptosustaintheBig4andreducethethreatoffurthershrinkage
ofthenumberoffirmscapableofauditinglargepublicglobalcompanies.AdraftreportbytheU.S.
TreasurysAdvisoryCommitteeontheAuditingProfession(May5,2008)recommendsaseriesof
proposalstoimprovethequalityofauditsthrougheducationandtrainingprograms,strictlicensingand
certificationrequirements,continuingeducationtokeepaccountantsuptodateonnewdevelopments,
creationofcoordinationandcommunicationprogramswithparticipationofmidtierandsmalleraudit
firms.

Qualitycontrol,ethics,andindependencestandardsforregisteredpublicaccountingfirmsalreadyare
responsibilitiesofthePCAOB(seePartIII).Regulatoryauthoritiesshouldbewaryofrecommendations
thatwouldduplicateexistingprogramsatthecostofgovernmentsandtaxpayers.Theauditindustry
andindividualBig4firmshavealsotakenstepstoimprovetheabilityofauditorstodetectfraudand
misstatements.

Someradicalproposalswoulddirectlyaddresstheinherentconflictofinterestinthesystem,where
auditorsarepaidbythecompanieswhosebookstheyaudit.Theseproposalsincludechangingtheaudit
paymentsystembynationalizingtheauditindustryortheprocessofauditorselection,orbycreatinga
newentitytohireandpaytheauditorsforexample,insurancecompanies.

Nationalization

Fordecadespubliccompanieshavepaidaccountingfirmstoaudittheirbooks.Forthosewhobelieve
thissystemisbasicallyflawed,adirectsolutionwouldmeanthatsomeoneotherthantheauditedpublic
companyshouldpayfortheaudit.Ifthegovernmentconductedaudits,accordingtothistheory,
auditorindependenceandhenceauditqualitywouldbeimproved.Thisisnotanewidea.President
FranklinD.Rooseveltthoughtofitfollowingthemarketcrashof1929,whenheconsideredhavingthe
FederalTradeCommissionauditpubliclytradedcompanies.Aftervigorouslobbyingfromtheaccounting
profession,RooseveltandCongressallowedtheindustrytoregulateitself.167

165
GAO(2003),op.cit.fn11
166
Ibid.
167
Pizzo,StephenP.,MakingAccountingAddUp,Forbes.com,Feb.26,2002

42

Theideaaroseagainin2002inthemidstofcorporatescandals,whenRepresentativeDennisKucinich
introducedlegislation(TheShareholderandEmployeeProtectionActof2002)168tocreateaFederal
BureauofAudits(FBA)withintheSecuritiesandExchangeCommissiontoprotecttheAmerican
shareholderfromcorporatecriminals.169Underthisapproach,theroleoftheFBAwouldbetoassign
governmentemployedaccountantstoperformauditsforpubliccompanies,ineffectnationalizingthe
auditindustry.Theproposalraisedmanyquestions.Forexample,whatwouldhappentothemajor
accountingfirmswhoserevenuesconsistoftensofmillionsofdollarsofauditfeesannually?Wouldall
thecertifiedpublicaccountants,whoconductannualauditsofsome17,000publiccompanies,become
governmentemployees?Howwouldthetransitionbemanaged?Couldthegovernmentconductthe
servicefreeofpoliticalinfluenceandmoreefficientlythantheprivatesector?Wouldthegovernment
beabletoattracthighqualityaccountantstoserveasauditors?Thecostoftheprogramcouldbe
neutralifitwerefundedbyauditfees.Thebilldidnotadvance,butitcalledattentiontotheinherent
conflictofinterestbuiltintotheauditsystemandItservesasareminderthatinextremecircumstances,
Congresscouldchangethesystem.

AnInsuranceSolution

Ataboutthesametime,aPrincetonUniversityprofessorproposedasystemwherebypubliclytraded
companieswouldberequiredtopurchase"auditinsurance."170Thesamecompaniesthatprovide
directorsandofficerliabilityinsurancecouldprovidethesepolicies.Eachpublicfirmwouldbefreeto
buy(ornotbuy)anyamountoffinancialmisrepresentationinsurance,andindicatetheamountof
coverageboughtinitsreport.Theinsurerwouldexaminethefinancialreportsandchargeapremium.
Underthisproposal,theinsurancecompanywouldberesponsibleformonitoringauditqualityand
wouldbearthefinancialliabilityforproperaudits.Thiswouldbeaprivateenterprisesolutionrather
thannationalization,butsomeofthesamequestionsremainregardingmanagementofthetransition,
thefateoftheauditfirmsandtheiremployees,andtheeffectivenessoftheprogram.Problemsalso
couldariseinsettingtheratesinasmuchasauditfirmsandtheirclientswouldhavelittleleveragein
negotiatingforlowerrates.171

AprofessorofaccountingatNYU172makesastrongcaseforfinancialstatementinsuranceunderwhich
insurancecarrierswouldappointandpayauditorsinsteadofthecompaniesbeingaudited.Thiswould
aligntheinterestsoftheauditorwithinvestorsratherthanthecompanies.Companieswouldpurchase
financialstatementinsurancetocoverinvestorslossesarisingfrommisrepresentationoromissionin
financialreports.Thepremium(tobedeterminedbyriskassessors)wouldcoverboththeinsuranceand
theaudit.Theamountofcoverageandthepremiumwouldbemadepublictoprovideincentivesto
improvethequalityoffinancialstatements.Thesystemisintendedasafreemarketapproachwithno
legislationrequired,butatemporaryregulatoryinitiativemaybenecessarytogetthesystemstarted.

168
HR3795,107thCongress2dSessionH.R.3795February26,2002
169
CongresstoConsiderFederalTakeoverofExternalAuditing,CAEBulletin,InstituteofInternalAuditors,Feb.
28,2002
170
Ibid.DanPalmon,theChairmanoftheAccountingDepartmentatRutgersUniversity
171
Pizzo,Feb.26,2002,op.cit.fn156;CAEBulletin,Feb.28,2002,op.cit.fn167
172
JoshuaRonen,ResearchProfessorofAccountingattheSternSchoolofBusiness,NewYorkUniversity.

43
TheSECcouldmandateminimumcoverageforafederalinsurer,whowouldcollectthepremiums.In
time,marketinstitutionswouldreplacethegovernmentastherequiredinfrastructureisestablished.
Thisapproachwouldrequirespecialinitiativeandcoordinationbetweentheprivatesectorandthe
governmentinthestartupperiod.Completereplacementofthecurrentauditsystemwithouta
governmentmandatewouldrequirethemarkettooperateinsuchawaythatcompanieseagerlyswitch
fromhiringauditorstobuyingfinancialstatementinsurancebecausetheyclearlyrecognizethe
economicandcorporategovernancebenefitsofthenewsystem.173

InShort

Variousproposalsareunderconsiderationtoreducetherisksofcurrentandfutureauditmarket
concentration.Eachproposalhasdisadvantages.Proposalstopreventfurtherconcentrationinclude
settingmonetarycapsonliabilitytoreducetheriskoflitigation,ahighlycontroversialmeasure.
Opponentsobjecttomonetarylimitsongroundsthatitwouldeliminateausefulincentiveforauditors
tobeperspicaciousindetectingcorporatefraudandwrongdoingandwoulddepriveinjuredpartiesofa
mechanismtoobtainadequaterelief.Moreover,intheUnitedStatessomelimitationsalreadyexistin
theformofproportionateliabilityandcontractualagreementsonliabilityand,inEurope,fivecountries
alreadyhavemonetarycapsonliability.Proposalstopromotegreatercompetitionincludebreakingup
theBig4orrequiringoneormoreofthemtospinoffaportionoftheiroperationstocreateadditional
firmswiththecapacitytoauditlargepubliccompanies.Theseproposalsraisequestionsregardingthe
consequencesforexistingauditfirmsandtheiremployees,aswellasmajordisruptionsforthebusiness
community.Otherproposalstopromotegreatercompetitionincluderemovingbarrierstonewentrants
andtogrowthofmidtierandsmallerfirms.Removalofrestrictionsonoutsideownershipofaccounting
firmscouldhelptoattractnew,wellfinanced,managementtalentedentrepreneurstoacquireand
combinesmallercompaniesintolargernetworks,butsafeguardswouldbenecessarytoavoidconflicts
ofinterestwithotherbusinessesownedbytheentrepreneurs.Proposalstoimprovethequalityof
auditsincludeeducationandtrainingprograms,strictlicensingandcertificationrequirements,
continuingeducationtokeepaccountantsuptodateonnewdevelopments,creationofcoordination
andcommunicationprogramswithparticipationofmidtierandsmallerauditfirms.Otherproposals
includemeasuresdesignedtoremoveabasicconflictofinterestbychangingtheauditsystemsothat
auditorsgetpaidbythegovernment(nationalization)orbyathirdparty(e.g.,aninsurancecompany)
ratherthantheclientwhosebooksarebeingreviewed.Thesemeasures,consideredquiteradical,raise
questionsabouttheconsequencesforexistingcompaniesandtheiremployeesanddisruptive
conditionsforthebusinesscommunityinthetransition.

173
Ronen,Joshua,PostEnronReform:FinancialStatementInsuranceandGAAPRevisited,StanfordJournalof
Law,Business&Finance,Autumn2002,Volume8Number1,pp.3968.Ronen,Joshua,FinancialStatement
InsuranceWillBestEnsureAuditorIndependence,GuestColumn,DowJonesNewsletter,Aug.18,2004.
DoleAsksSECtoRequireFinancialStatementinsurance,CorporateFinancingWeek.com,Feb.9,2003
(accessedAug.31,2008).

44


PARTVI

MAKINGTHEWORLDSAFEFORAUDITINGMULTINATIONALCORPORATIONS

Auditingisanimportantelementintheworldfinancialsystem.Investorsdependonthereliabilityof
corporatefinancialstatements.Thepoweroftheauditoligopolyisdemonstratedbythefactthatits
fourfirmsarepracticallytheonlyonesintheworldthatarecapableofauditinglargemultinational
corporations.Althoughthismarketissharedfairlyevenlyamongthefourmajoraccountingfirms,the
situationisviewedasprecariousbylargeauditclients,notsomuchbecauseofhighauditfees,but
becauseoflackofchoiceinselectinganauditfirm.Thesmallnumberofchoicesalsopresentsa
problemforregulatoryauthorities,whoappeartobeinhibitedfromtakingstrongdisciplinaryactionfor
fearthatitcouldputanotherauditcompanyoutofbusinessandcreatechaosinthefinancialmarkets.

StrengthsandWeaknesses

Thestrengthoftheoligopolyisoffsetsomewhatbyexposuretomassivelawsuits.Fearfulthataseries
ofmultimilliondollarlawsuitscouldsinkanothermajorauditingfirm,theclientcompaniesare
advocatinglegislationtolimittheliabilityofauditfirms.Itisanomalousthattheclientcompanies
wouldbeseekingtomaketheoligopolyevenmorepowerfulbyreducingthethreatoflawsuits,rather
thanseekingrelieffromhighauditfees.However,regulatoryrequirements(namelycompliancewith
theSarbanesOxleylaw)areseenasthecauseofhighauditfees,notthelackofcompetition.Client
companiesareindeedseekingremovalorrelaxationofcertainoftheserequirements.

Pricecompetitionhasvirtuallyslowedtoacrawlascomparedtothe1980sand90s,priorto
consolidationoftheindustryintofourfirmsinsteadofeight.Inthoseearlieryears,pricecompetition
wasimportanttotheclientcompanies,whichsoughttoreducecostsbygeneratingbiddingwarsamong
theeightfirms.Auditfeesareprobablyatrecordhighs.Atthemoment,however,theprimeconcerns
ofpubliccompaniesaretheheavyburdenofregulatoryrequirements,thelackofchoiceofauditor
firms,andthethreatoffurtherconcentration.

Intheformoffourhugefirms,theauditoligopolynowhassurvivedforsixyearssincethedemiseof
ArthurAndersenandtheenactmentofSarbanesOxleylegislation.Inspiteofmortgageandcredit
crises,theworldsfinancialauditandreportingsystemappearstobeonevenkeel,raisingtheinevitable
question:doesthelevelofconcentrationmatter?Theanswerisaresounding:YES.Outward
appearancescanbedeceptive.Limitedavailabilityofmajorauditfirmsremainsaproblem.Thesystem
isinverydelicatebalanceorfragileatbest.Thethreatoffailureofanothermajorauditfirmisstillan
importantfactorincapitalmarketsandinregulationofsecurities.

45

FourQuestions

Theintroductiontothispaperposesfourquestions:
(1) Canthelevelofcompetitionbeincreasedand,ifso,how?
(2) HowcantheU.S.governmentregulateanddisciplinetheauditindustryeffectivelywithout
furtherweakeningit?
(3) Shouldthegovernmentenactlegislationtolimittheindustrysliability?
(4) Whatcanbedonetoremovebarrierstotheentryofadditionalglobalauditfirms?

Competition

Withrespecttothefirstquestion,thelevelofcompetitioncanbeincreasedbyencouragingnewlarge
firmstoenterthemarket.This,ofcourse,cannotbedoneovernight.AsnotedinPartIII,midtierfirms
arestrivingtogainnewglobalclientsaslowprocessandsmallerauditfirmshavejoined
internationalnetworks,whichcouldhelpbuildtheircapabilitiesofservingglobalcorporationsalsoa
slowprocess.AsnotedinPartV,itmightbehelpfultoattractnew,cashrich,managementtalented
entrepreneurstotheindustrytoacquiremidtierandsmallerfirmsandcombinethemintointernational
networkswithcapabilitiesofauditinglargeglobalpubliccompanies.Todoso,barrierstomarketentry
wouldhavetoberemovedorrelaxed,suchasrequirementsintheUnitedStatesandothercountries
thataccountingcompaniesmustbeownedentirely,orbyamajorityof,certifiedpublicaccountants.
Safeguardsalsomayhavetobeinstalledtoavoidconflictsofinterestwithotherbusinessesofthe
entrepreneur.AsdiscussedinPartV,manyproposalshavebeenoffered,butnonewouldprovidean
immediatesolution.Whilesomeopportunitycurrentlyexistsforgreatercompetition,stepsneedtobe
takensoontocreateadditionalincentivesformorefirmstobuildcapacitytoauditmultinational
corporationssoastoavoidafuturecrisis.

Regulation

Withrespecttothesecondquestion,theU.S.Governmentwillhavetowalkafinelineindisciplining
auditfirmsincasesoffraudorwrongdoing.Prosecutingindividualaccountantsratherthantheirfirm
appearstobeanappropriatemeasure,althoughsomecriticscontendthatlimitingenforcementinthis
waydeniesregulatoryauthoritiesofanimportantdisciplinarytool.Forthetimebeing,however,itmay
benecessaryforregulatorstolimittheirenforcementactionstomaintainthepresentnumberofaudit
firmsforglobalcorporations.Continuedmonitoringandsurveillancemustbeusedasadeterrentto
improperactions.RecallingtheexperienceofItalyin2000(withauditfeepricefixing,clientallocation
andotheranticompetitivepracticesofthethenBig6),authoritiesmustremainvigilantofpossible
anticompetitivepracticesbytheoligopolyaswellasfraudulentauditing.Thevastmajorityof
accountantsarestrictlyprofessionalandethical.Yet,itisthefewaccountantsinvolvedinhighprofile
fraudcaseswhoarousenegativepublicity,tainttheindustryimageandprompttheneedfordisciplinary
actions.

MonetaryLimits

Withregardtothethirdquestion,althoughthethreatoflawsuitsisanimportantcheckonmisconduct
bycorporateexecutivesandtheirauditors,someofthesettlementshavebeenexceptionallylarge.

46
Withliabilityinsurancelargelyunavailabletoauditfirms,thethreatposesaneconomicconcerntothe
Big4,whomustsetasidereservestoprotectthemselvesagainstmassivelawsuits.AsdiscussedinPart
IV,somemeasureshavealreadybeenadoptedtolimitliabilityofauditfirmsintheUnitedStates,such
asproportionateliabilityandallowingcontractualagreementswithclients.TheEuropeanUnion
recentlyrecommendedtoitsmemberstatesadoptionofsomeformsofliabilitylimitation,subjectto
certainconditions.Fivememberstatesalreadyhavemonetarylimitsonliabilityandfiveotherspermit
auditfirmstolimitliabilitybycontractualarrangement.Tosomeextent,thelackofliabilitylimitations
actsasabarriertonewentrantsaswellastogrowthofmidtierandsmallerfirms.Smallerfirmsare
reluctanttoentertheglobalmarketbecauseoftherisksofliability.Whilethethreatisnotsoimminent
anddangerousastorequireimmediategovernmentaction,considerationofliabilitylimitsinthenear
futurecannotbesummarilydismissed.Enactmentofsuchameasuremightbefoundtobedesirableas
partofaprogramtoencourageanddevelopadditionalauditfirmswithcapabilitiessuitableforglobal
corporations.IdeasforaprocompetitiveactionplanareshowninAppendixVI1.

Barriers

Withregardtothefourthquestion,removingbarrierstoentryoffersapromising,butslow,solutionto
attractingnewfirmsintothebusiness.Asnotedabove,thelackofliabilitylimitationsactsasa
deterrentfornewandexistingfirmstoenterthemarketforglobalclients.Aprocompetitiveprogram
toremovebarrierstoentryandgrowthcouldincludesomeliabilitylimitationsaspartofanactionplan
(seeAppendixVI1).Underthisprogram,inreturnforthebenefitsofmonetarycapsonliability,the
auditindustrywouldberequiredtoestablishandfundaneducationcenterforaccountants.Withthe
expectedconversiontointernationalfinancialreportingstandards,educationwillassumeanevenmore
vitalroleinthehealthandstandingofauditfirmsandfortheaccountingprofession.

AsdiscussedinPartV,theremovalorrelaxationofownershiprestrictionscouldhelptoattractnew
entrepreneurswithaccesstocapitalandmanagementknowhow,whocouldworktowardbuilding
networkscapableofservingglobalpubliccompanies.Througheducationprogramsandgreater
communicationandcoordinationwithintheauditindustry,participationbymidtierandsmallerfirms
canenhancetheirexpertiseandreputationssoastodispelperceptionsinthefinancialcommunitythat
createabiasagainstnonBig4auditfirmsintheglobalmarket.U.S.TreasurysAdvisoryCommitteeon
theAuditingProfessionrecommendsaseriesofeducationandtrainingprogramstoimproveaudit
quality.

InShort

Thesmallnumberofauditfirmscapableofperforminginternationalauditsforlargepubliccompanies
remainsaprecarioussituation.AsconcludedbytheGAO,noneoftheproposedsolutionsappeartobe
justifiedatpresent.Ittookmanyyearsfortheindustrytoconsolidateintofourmajorfirms.Itwilltake
manyyearsfortheindustrytogainnewentrants.Someproposalstodevelopgreatercompetitionby
midsizeandsmallerfirmsmayhelptobuildmoreauditcapacity(althoughtheGAOreportedthat
marketparticipantsgenerallysawtheseproposalsashavinglimitedeffectiveness,feasibilityand
benefit).Theproposalsincludeallowingoutsideownershipofaccountingfirmsinordertoprovide
capitaltoexpandtheiroperations,creatingagroupofaccountingandauditingexpertstoprovide
neededexpertisetosmallerauditingfirms,andestablishingaprofessionwideaccreditationprogramto
helpthesefirmsovercomesomeofthenamerecognitionandreputationchallengestheyface.While
someopportunitycurrentlyexistsforgreatercompetition,consideringthelongleadtimeneeded,steps

47
needtobetakensoontocreateadditionalincentivesformorefirmstobuildcapacitytoaudit
multinationalcorporationssoastoavoidafuturecrisis.

Withrespecttotherisksofliability,theneedformonetarycapsmaybelessthanoriginallyexpected,
consideringthatsomeformsofprotectionalreadyhavebeenadoptedtolimitliabilityofauditfirmsin
theUnitedStates(throughlawsforproportionateliabilityandforallowingcontractualagreementswith
clients).The27nationEuropeanUnionhasrecommendedthatitsmemberstatesadoptsomeformof
liabilitylimitation.Fivememberstatesalreadyhavemonetarylimitsandfiveotherspermitauditfirms
tolimitliabilitythroughcontractualagreements.Withregardtoregulationanddisciplineoftheaudit
industry,limitingenforcementactionstoresponsiblepartnersorotheremployeesratherthanthefirm
asawholewoulddenyregulatoryauthoritiesofanimportantdiscipline.Forthetimebeing,however,it
maybenecessaryforregulatorstolimittheirenforcementactionstomaintainthepresentnumberof
auditfirmsforglobalcorporations.Continuedmonitoringandsurveillancemustbeusedasadeterrent
toimproperactions.RecallingtheexperienceofItalyin2000(withauditfeepricefixing,client
allocationandotheranticompetitivepracticesofthethenBig6),authoritiesmustremainvigilantof
possibleanticompetitivepracticesbytheoligopolyaswellasfraudulentauditing.

FinalWords

Finally, it is time to respond to the question posed in the title of the paper: Is the audit industry the
worldsweakestoligopoly?Consideringtheindustrysmarketdominance,thehighlevelofauditfees,
theboomingauditbusinessofrecentyears,therelaxationofpunitiveactionsbyregulatoryauthorities,
and the availability of some forms of liability limitation, the audit industry may not be the ideal
candidateforweakestoligopolyintheworld.Afacetiousquestiondeservesafacetiousanswer.

48
 AppendixI1

AUDITINDUSTRYSELECTEDSTUDIES

UnitedStatesGovernmentAccountabilityOffice

(GAO03864),"PublicAccountingFirms:MandatedStudyonConsolidationandCompetition,"Reportto
theSenateCommitteeonBanking,Housing,andUrbanAffairsandtheHouseCommitteeonFinancial
Services,July2003

(GAO031158),"AccountingFirmConsolidation,"SelectedLargePublicCompanyViewsonAuditFees,
Quality,Independence,andChoice,ReporttotheSenateCommitteeonBanking,Housing,andUrban
AffairsandtheHouseCommitteeonFinancialServices,September2003

(GAO04216),"PublicAccountingFirms:RequiredStudyonthePotentialEffectsofMandatoryAudit
FirmRotation,Report,November21,2003.

(GAO04217),"MandatoryAuditFirmRotationStudy:StudyQuestionnaires,Responses,andSummary
ofRespondents'Comments,"ReportFebruary26,2004.

(GAO06361),"SarbanesOxleyAct:ConsiderationofKeyPrinciplesNeededinAddressing
ImplementationforSmallerPublicCompanies,"ReportMay8,2006.

(GAO08163):"AuditsofPublicCompanies:ContinuedConcentrationinAuditMarketforLargePublic
CompaniesDoesNotCallforImmediateAction,"ReporttoCongressionalAddressees,January2008

U.S.ChamberofCommerce,CommitteeontheRegulationoftheU.S.CapitalMarketsinthe21st
Century,ReportandRecommendations,March2007,17072,availableat
www.uschamber.com/publications/reports/0703capmarketscomm.htm(accessedApril2,2007).

CommitteeonCapitalMarketsRegulation,InterimReport,November30,2006,14,availableat
www.capmktsreg.org/pdfs/11.30Committee_Interim_ReportREV2.pdf(accessedMarch5,2007);and
MichaelR.BloombergandCharlesE.Schumer,SustainingNewYork'sandtheUS'GlobalServices
Leadership,January22,2007,102,availableat
www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.
pdf(accessedMarch5,2007).

The103rdAmericanAssembly,TheFutureoftheAccountingProfession(NewYork:ColumbiaUniversity,
November2003),8,availableat
www.americanassembly.org/programs.dir/prog_display_ind_pg.php?this_filename_prefix=accounting&
this_ind_prog_pg_filename=report(accessedApril2,2007).

EUPressReleaseIP/08/897June6,2008,"Auditing:CommissionissuesRecommendationonlimiting
auditfirms'liability"(seeMEMO/08/366)availableat
http://ec.europa.eu/internal_market/auditing/liability/index_en.htm

Foradditionalstudiesandotherreferences,seeListofSelectedReferences

49
 AppendixII1

BRIEFHISTORIESOFTHEBIG4ACCOUNTINGFIRMS

PricewaterhouseCoopers(PwC).SamuelLowellPrice,anaccountant,startedhis
practiceinLondonin1849.In1865PricewentintopartnershipwithWilliamHopkinsHolyland
andEdwinWaterhouse.AfterHolylandleftthefirm,itbecameknownasPrice,Waterhouse&
Coin1874.PriceWaterhouseopenedanofficeinNewYorkin1890.In1854WilliamCooper
establishedhisownpracticeinLondon,whichbecameCooperBrotherssevenyearslaterwhen
histhreebrothersjoined.MeanwhileintheUnitedStates,in1898,RobertH.Montgomery,
WilliamM.Lybrand,AdamA.RossJr.andhisbrotherT.EdwardRossformedLybrand,Ross
BrothersandMontgomery.Coopers&Lybrandistheresultofamergerin1957amongCooper
Brothers&Co;Lybrand,RossBros&MontgomeryandaCanadianfirmMcDonald,Currieand
Co.In1998,Coopers&LybrandmergedwithPriceWaterhousetoform
PricewaterhouseCoopers.

Ernst&Young(E&Y).ArthurYoung,borninGlasgow,Scotland,movedtotheUnited
Statestopursuehiscareerinaccounting,andformedanaccountingfirm,ArthurYoung&
Company,withhisbrotherStanleyin1906.AlwinCErnst,borninCleveland,startedasmall
publicaccountingfirmwithhisbrotherin1903.In1989,thetwofirmswerecombinedtoform
Ernst&Young.

KPMG.KstandsforKlynveld,anaccountingfirm(KlynveldKraayenhof&Co.)founded
byPietKlynveldinAmsterdamin1917.PisforPeat,fromtheaccountingfirmWilliamBarclay
Peat&Co.,whichwasfoundedinLondonin1870.MstandsforMarwick.JamesMarwick,
togetherwithRogerMitchellfoundedtheaccountingfirmMarwick,Mitchell&Co.inNewYork
Cityin1897.GisforGoerdeler.Dr.ReinhardGoerdelerwasformanyyearschairmanofthe
GermanDeutscheTreuhandGesellschaft(DTG)andlaterchairmanofKPMG.Heiscredited
withlayingmuchofthegroundworkfortheKMGmerger.KMGandPeatMarwickbecameKPMG
in1987.

DeloitteToucheTomatsu(Deloitte).In1845WilliamWelchDeloitteopenedanoffice
inLondonandwasthefirstpersontobeappointedanindependentauditorofapublic
company.In1880,heopenedanofficeinNewYork.In1895CharlesWaldoHaskinsandEijah
WattSellsformedHaskins&SellsinNewYork.In1898GeorgeToucheestablishedanofficein
Londonandthenin1900joinedJohnBallantineNiveninestablishingthefirmofToucheNiven
inNewYork.Afterseveralnamechangesfrom1947to1960,thefirmemergedasToucheRoss
in1969.Meanwhile,in1952,DeloittemergedwithHaskins&SellstoformDeloitte,Haskins&
Sellsandin1968,NobuzoTohmatsuformedTohmatsuAwoki&Co,afirmbasedinJapanthat
wastobecomepartoftheToucheRossnetworkin1975.In1989,ToucheRossmergedwith
DeloitteHaskinsSellstoformDeloitte&Touche.TheinternationalfirmwasrenamedDeloitte
ToucheTohmatsuin1993toreflectthecontributionfromtheJapanesefirm.

50

APPENDIXII2

MARKETSHARESOFMAJORACCOUNTINGFIRMS
BASEDONREVENUES,SELECTEDYEARS,INPERCENT

1988 2002 2004 2005

PW&CL 35.0
PWC 34.0 31.4 31.2
EW&AY 18.0
EY 23.0 25.1 25.3
DHS&TR 17.0
DT 24.0 24.1 24.3
KPMG 14.0 18.0 17.5 17.6
AA 14.0
Other 2.0 1.0 1.9 1.5

PW&CL=PriceWaterhouseLLPandCoopers&LybrandLLP
PWC=PricewaterhouseCoopersLLP
EW&EY=Ernst&WhinneyLLPandArthurYoungLLP
EY=Ernst&YoungLLP
DHS&TR=DeloitteHaskins&SellsLLPandToucheRossLLP
DT=DeloitteToucheLLP
KPMG=KPMGPeatMarwickLLP(priortoFebruary1995)
AA=ArthurAndersenLLP

Source:GAO2003Report:ConcentrationRatios,PublicCompanyRevenues(Sales)Audited,1988and2002,
updatedto2004and2005

51
 AppendixII3

AuditFirmSpinoffsandSalesofConsultingArms

March2000:
Ernst&YoungsolditsconsultingoperationtoParisbasedCapGeminifor$11billion.

February2001
KPMGsNorthAmericanoperation,KPMGConsulting(subsequentlyrebrandedas
BearingPoint)splitfromitsparentcompanyandfloatedontheNewYorkStock
Exchange.

July2001
ArthurAndersensAndersenConsultingsplitfromitsparentcompany,havingchanged
itsnametoAccenture.

October2002
PwCsoldPwCConsultingtoIBMfor$3.5billion.

March2003
DeloitteConsulting,ontheotherhand,abandoneditsplannedspinoff(tobenamed
Braxton,originallyannouncedinFebruary2002)anddecidedtomaintainits
consultingarm,assuringtheregulatorsandthepublicthatitwouldcomplywithrulesto
avoidconflictsofinterest.174

174
Inresponsetocriticismoverperceivedconflictsofinterest,Deloitteinsisteditwillcontinuetofullycomplywiththeform
andsubstanceoftheSarbanesOxleyActandtheSecuritiesExchangeCommission'sindependencerulesintheUnitedStates
andwithallregulatoryandlegislativerequirementsinothercountries.JamesCopeland,chiefexecutiveofDeloitteTouche
Tohmatsu,said:WereallyalreadyhavefocusedourDeloitteConsultingpracticeonthe75%ofthemarketthatwedon't
alreadyaudit.Zea,Adriana,DeloitteinconsultancyUturn,AccountancyAge,Mar.31,2003

52
 AppendixII4

LISTOFSELECTEDTIGHTOLIGOPOLIES

Cereals: Kellogg,GeneralMills,GeneralFoods
Beer: AnheuserBusch,Miller,Coors
Airlines: American,United,Northwest,Delta,USAir
Garbagedisposal: WasteManagement,BrowningFerris
Automobiles: GeneralMotors,Ford,Chrysler,Toyota
Locomotives: GeneralElectric,GeneralMotors
Carbonateddrinks: CocaCola,PepsiCo
Recordings: Warner,Sony,BMG,Polygram,EMI,MCA
Expressdelivery: FederalExpress,UPS,AirborneFreight
Soapsanddetergents: Procter&Gamble,Colgate,Lever
Meatpacking: IowaBeefPackers,Cargill,ConAgra
Automobilerentals: Hertz(Ford),Avis,Budget(Ford),Alamo,National(GM)
Athleticshoes: Nike,Reebok,Adidas
Toys: Mattel,Hasbro

Source:W.Shepherd,TheEconomicsofIndustrialOrganization,4thed.(London:PrenticeHall,1997)citedinTable
2,GAOReport2003:ListofSelectedTightOligopolies,asof1996,MarketLeadingcompanies
Notes: This list includes a variety of tight oligopolies, and it does not attempt to compare or infer similarities aside from market
concentration. It includes leading companies from the U.S. market perspective. The companies in certain markets may have also
changed since 1996.

AdditionalNote:WhilethereisindustryspecializationbytheBig4firms(seeLevelofConcentrationinPartIIof
thispaper(p.12)),thereisnoclearpatternofconcentrationbyauditfirmsinthetightoligopolieslistedabove.
Forexample,incereals,PwCauditsKelloggsandKPMGauditsGeneralMills;inautomobiles;Deloitteaudits
GeneralMotors;PwCauditsFordandToyota,andKPMGauditsChrysler;inlocomotives,DeloitteauditsGeneral
MotorsandKPMGauditsGeneralElectric;andincarbonatedbeverages,EYauditsCocaColaandKPMGaudits
PepsiCo.Inthesecases,noneoftheBig4hasamonopolyinauditingallthecompaniesinthetightoligopoly.
Quitetothecontrary,itappearsthatcompetingcompaniesconsciouslyselectdifferentauditorsinorderto
safeguardcompanysecretsandstrategies.Inthecaseofcarbonatedbeverages,whenErnst&Whinneymerged
withArthurYoung,CocaColaforcedthecombinedfirmtodumpPepsiCoasaclient(seeClientConflictsinPart
IIIofthispaper(page12andespeciallyfootnotes27and28).

53




AppendixIII1


COMMENTSONTHERISKSOFFURTHERCONCENTRATION

EvenbeforetheBig5shranktotheBig4,therewasconcernaboutthesmallnumberofmajoraudit
firms.In1998,onereportstatedthatareductionfromfivetofourwouldnotbetolerated.
LessonsfromtheAccountancyMergers,LexeconLtd.,CRACompetitionMemo:Sept.1998

In2002,EUCompetitionCommissionerKarelvanMiertexpressedhisopinionthatfiveistheminimum
requiredtoensureenoughcompetition,aviewsharedbyhispredecessor,MarioMonte.
DeloitteofferwouldfacereluctantEUcompetitionhurdle,Guerrera,Francesco,andSpiegel,
Peter,FinancialTimes,March12,2002

"ThecurrentdegreeofconcentrationintheprofessionraisesthespecterthatthecollapseofaBigFour
firmwouldbeathreattothecontinuedexistenceoftheprofession.Anauditenvironmentwithonly
threelargefirmsmaybetoosmallanumbertomaintainauditqualityandindependence,andanyevent
thatcausesanotherfirm'scollapsewouldautomaticallycallintoquestiontheviabilityofthesurvivors."
AmericanAssemblyreport(2005)TheFutureoftheAccountingProfession:Auditor
Concentration

TheconcentrationoftheaccountingindustryhasraisedconcernsthatthecollapseofanotherBigFour
firmcouldcauseparalysisinfinancialmarketsin the event that only three big accounting firms remained, it
would be difficult for the client companies to juggle the relationships necessary to comply with conflict of interest
rules.
CorporationsandthePublicPurpose:RestoringtheBalance,CharlieCrayandLeeDrutman,
SeattleJournalforSocialJustice,Fall/Winter2005Issue:Volume4,Issue1

Fewindustryobserversbelievethatanyofthenextlargestfirmscouldhandlethekindofgiant,multi
nationalaccountsthattheglobalaccountingfirmsareequippedtoservice.
TheFutureofAuditing:CalledtoAccount,TheEconomist,Nov.20,2004,quotedin
CorporationsandthePublicPurpose:RestoringtheBalance,CharlieCrayandLeeDrutman,Seattle
JournalforSocialJustice,Fall/Winter2005Issue:Volume4,Issue1

Becauseoftheinterconnectednessofinternationalmarkets,thelossofanotherbigfirmalsoisaglobal
economicconcern.Theprospectoflosinganothermajoraccountingfirmandthenegativespiraling
effectthatwouldoccuracrosstheotherfirmsandinourfinancialmarketsmustberecognizedasa
globaleconomicconcern.

54
Ernst&YoungCEOJamesS.Turleyspeech,December2005,quotedinWhatIfOneofTheBig
FourFails?TryingtoavoidanArthurAndersentypedisruption,Holstein,WilliamJ.,Directorship,
September2006

ThedisappearanceofanyoneoftheBigFourfirmswouldbeatruecatastropheforfinancialmarkets
aswellasforpubliccompaniesworldwide.Thechoiceofauditorswouldbesubstantiallyreduced,and
therequirementsforauditorindependencemightmakeitimpossibleforsomecompaniestofinda
sufficientlyskilledindependentauditor.Inaddition,accountingandauditingcosts,alreadyskyhigh,
wouldbecomeanevenmorecostlyburdenonpubliccompanies,reducingprofitsanddrivingsmaller
companieswhichbearadisproportionateshareofthecoststoprivatization.
TheSorcerer,theApprentice,andtheBroom,WhattoDoaboutPrivateSecuritiesClass
Actions,Wallison,PeterJ.,AmericanEnterpriseInstituteOnline,Posted:Thursday,March8,2007

Afurtherreductioninthenumberoffirmswithglobalreachisseenasproblematicbecauseitcould
leaveinternationalbusinessesstrugglingtofindanauditortosignoffontheiraccounts.
Brusselssuggestslegalshieldforbigauditfirms,Buck,Tobias,FinancialTimes,January18,
2007,FT.comsite.

"Insomecases,becauseofgeographicdemandsorindustryspecialization,acompanymayevenhave
onlyonerealisticchoice."
ChristopherCox,ChairmanoftheSecuritiesandExchangeCommission,quotedinNumber
crunch:whythedominanceofthebigfourisalarmingregulators,Jopson,Barney,FinancialTimes.Mar
27,2006.p.15.

ThecomplexityandseriousnessofthesituationarefurtherillustratedbyastatementoftheChairmanof
theU.S.PublicCompanyAccountingOversightBoard,whosaidin2005:Regulatorsdonothaveaclue
howtorespondifoneofthebigfouraccountingfirmsweretocollapse.
WilliamMcDonough,ChairmanoftheU.S.PublicCompanyAccountingOversightBoard,
expressingreliefthattheDepartmentofJusticereachedasettlementwithKPMGoveritssalesoftax
avoidanceschemestoclients;quotedinParker,Andrew,USauditwatchdogwarnsaboutindustry,
FinancialTimes,Sep27,2005

55
 AppendixIII2

NonauditCompetition

Duringthat1980s,theBig5boldlyannouncedtheirplanstobecomeintegratedprofessionalservice
firmsbyexpandingtheirlegalservicesandotherconsultingservices.Throughtheirconsultingaffiliates,
theybegantofillclientsneedsformanagementadvice,informationtechnologysystems,taxandlegal
advice.Infact,thesebusinessservicesparticularlyinformationtechnologybecamemoreprofitable
thanthebasicauditbusinessandauditingwasseenasafootinthedoorameansofgainingmore
nonauditbusiness.175

Themarketingofconsultingservicestoauditclientsduringthe1980sand1990sgaverisetocomplaints
aboutpotentialconflictsofinterest.Regulators,lawmakersandshareholderactivistsallegedthatafirm
offeringbothconsultancyandauditservicestothesameclientcouldleadtoquestionableaccounting
practices.176Harshlycriticizedforputtingcommercialinterestsaheadoftheirroleasindependent
auditorssafeguardingthepublicinterest,accountingfirmsfacedstrongpressurestospinofftheir
consultingarms.

TheSarbanesOxleyActof2002bannedaccountingfirmsfromprovidingconsultingservicestoaudit
clients.177UnderSarbanesOxleyspecifiednonauditservicescannotbeprovidedtoauditclients,
includingfinancialinformationsystemsdesignandimplementation;investment,management,and
securitiesservices;andlegalandexpertservicesunrelatedtotheaudit.Taxservicesmaybeprovided.
178

Between2000and2002,threeoftheBig4splitorsoldofftheirconsultingarms.Thus,evenpriorto
enactmentoftheSarbanesOxleylaw,someoftheBig5hadalreadydivestedtheirconsultingarms.
Onlyoneofthemajoraccountingfirms(Deloitte)retaineditsconsultingarm,assuringregulatorsand
thepublicthatitwouldcomplywithrulestoavoidconflictsofinterest.179Forfurtherdetailsofspinoffs,
seeAppendixII3.

In2007,thenoncompeteagreementsrelatedtothespinoffsaleshaveallpassed,andaccordingto
AccountancyAge,alloftheBig4arebackinthetop10ofUKconsultingfeeearners.Thereturnees
postedexceptionalgrowth:25percent,14percentand11percentrespectivelyatPwC,E&Yand

175
Forexample,in1998,PwCexpectedtobeoneofthetopsixlawfirmsineverycountryinwhichitoperated,
includingAmerica;DeloitteToucheTohmatsustatedsimilarintentions;andErnst&Young'sstatedaimwasto
haveagloballawfirmwith4,000staffby2003or2004.Economist,Nov.13,2003.Alsosee:Ascher,Bernard,"The
ThreattoU.S.LawyersfromCompetitionbyMultidisciplinaryPractices(MDPs):IsItGone?"AmericanAntitrust
Institute,WorkingPaper0606,November29,2006,availableathttp://antitrustinstitute.org/Archives/557.ashx
176
Zea,Adriana,Deloitteinconsultancyuturn,AccountancyAgeMar.31,2003
177
PresidentGeorgeW.BushsignedtheSarbanesOxleyActof2002(PublicLaw107204)onTuesday,July30,
2002.CongresspresentedtheacttothePresidentonJuly26,2002,afterpassageintheSenatebya990voteand
intheHousebya4233margin.
178
Benston,GeorgeJ.,SarbanesOxley:ABenefitsCostAnalysis,May5,2004,availableonlineat
www.aei.org/docLib/20040505_Benston.pdf,accessedJuly20,2008
179
Ibid.

56
KPMG,and10percentforDeloitte.Thegrowthpictureislittledifferentworldwide;thishasbeena
bumperyearfortheirconsultingarms.180

Thenewerconsultingwork,however,isnolongerfocusedoninformationsystems(whichisnow
consideredlowmargin,commoditywork,butratheroncombiningavarietyofservicestoprovide
adviceonbusinessstrategies."Nowwe'reworkingwithourclientstofigureoutwhatisthebest
businesssolutionforthem,"saysAidanBrennan,headoftheadvisorybusinessatKPMGEurope."The
marketissayingwewantadviceindependentofthesolutionthere'sbeenarealdemandforusto
providethat."181AlloftheBig4arenowengagedinconsultingandadvisoryservices,aswellasin
auditing.TobeconsistentwiththelimitationsoftheSarbanesOxleylaw,theseservicesgenerallyare
performedfornonauditclientsonly.Deloitteusesateamapproachsothatauditorsarenotpaid
directlyfornonauditwork;theyshareapoolofprofitswithtaxexpertsandconsultants.182

In2006,revenuesforconsultingservicesoftheBig4amountedto$20.3billion,ofwhichDeloitte
earned$8.9billion;KPMG,$5.3billion;PwC,$3.7billion;andE&Y$2.4billion.183

180
AccountancyAge,AccountancyAge.com,Jan.5,2005;Hughes,Jennifer,Auditfirmsonceagainmaking
'consultinghay'FinancialTimes,November19,2007.p.4;Byrnes,Nanette,ConsultingPaysOffforAccountants
Again;Deloitte&Toucheresistedsplittingwithitsconsultingarm,andnowthemultibilliondollarsegmenthas
inspiredotherauditfirmstorebuildtheirs,BusinessWeek,Aug.20,2007
181
Ibid.
182
Byrnes,Aug.20,2007,op.cit.fn180
183
Ibid.

57
 AppendixIII3


AUDITFEEINCREASESLARGESTCOMPANIESINILLINOIS

Overall,auditfeespaidin2004bythe25largestcompaniesinIllinoisroseawhopping64
percentintheirmostrecentfiscalyear,tomorethan$220million,oranaverageofnearly$9
million,accordingtoaChicagoTribuneanalysisoftheauditfees.Since2001,theyearbefore
SarbanesOxleycameintoexistence,auditfeesforthosecompanieshavemorethandoubled,
fromanaverageof$3.8million.

COMPANY AUDITFEES2003 AUDITFEES2004 PCT.CHANGE

Boeing $16,300,000$30,900,000 89.6%

Caterpillar $10,200,000$18,700,000 83.3%
Aon $10,000,000 $15,300,000 53.0%
KraftFoods $10,700,000 $14,500,000 35.5%
Motorola $7,300,000 $13,900,000 90.4%
CNAFinancial $8,000,000 $12,300,000 53.8%
BaxterInternational $5,585,000 $11,713,000 109.7%
AbbottLaboratories $6,725,000 $11,257,000 67.4%
R.R.Donnelley* $1,469,855 $11,047,926 651.6%
SaraLee $8,900,000 $9,500,000 6.7%

*IncreaseinR.R.DonnelleyfeescameinpartfromexpensesassociatedwithMooreWallacemerger.

Source:ChicagoTribune,June5,2005

AstudybyprofessorsattheUniversityofNebraskaatOmahaof633companiesintheFortune
1000showedtheirauditfeesrose,onaverage,nearly64percent,atotalincreaseofmorethan
$1.4billion.

Source:ChicagoTribune,June5,2005

58
 AppendixIII4

DEVELOPMENTANDSTATUSOF

INTERNATIONALFINANCIALREPORTINGSTANDARDS

Eachnationhasitsownstandardsforreportingthefinancialconditionsofpubliccompanies.Theseare
rulesandprinciplestoguideaccountantsandtoprovideaconsistentmethodbywhichcompanieskeep
theirbooksandreporttheirincome,profitsandlosses.Forexample,thestandardshelpdeterminethe
mannerinwhichaccountantstreatthevalueoftangibleandintangibleassets,includingthevalueof
buildingsandrealestate,goodwill,intellectualpropertyrights,pensionliabilities,andderivatives.

FinancialreportsofU.S.companiescurrentlyarepreparedinaccordancewithnationalstandardsthe
GenerallyAcceptedAccountingPrinciples(GAAP),formulatedbytheFinancialAccountingStandards
Board(FASB),aprivatelyfunded,nonprofitorganization.

Effortstoestablishinternationalaccountingstandardsgobackatleastasfaras1967.TheLondon
basedInternationalAccountingStandardsCommittee(IASC)begandevelopingandissuingstandardsin
conjunctionwithexpertsfromthepublicandprivatesectorsandorganizations,suchastheInternational
FederationofAccountants(IFAC)andtheInternationalOrganizationofSecuritiesCommissions(IOSCO).
In2000,theIASCwasrestructuredintotheIASB(InternationalAccountingStandardsBoard),aprivate,
nonprofitorganization,whichissuesinternationalstandardsthatcomplementorreplacethoseofthe
IASC.TrusteesareheadedbyPaulVolker,formerChairmanoftheU.S.FederalReserveBoard.

InApril2001,theIASBadoptedallIASandcontinuedtheirdevelopment,callingthenewstandards
InternationalFinancialReportingStandards(IFRS).In2002,theEuropeanUnionannouncedplansto
adoptIFRSforallEUcompaniesbeginningin2005.TheIASBandtheFASB,itsU.S.counterpart,issued
theNorwalkAgreement,(namedforNorwalk,Connecticut)pledgingtocoordinateworktoconverge
IFRSandUSGAAP.Australia,NewZealandandHongKongcommittedtoadoptingIFRSin2003.
Significantly,IFRSbecameeffectiveinallmemberstatesoftheEUin2005.Thefollowingyear,China
adoptedaccountingstandardsbroadlyinlinewithIFRSandIASB.Alsoin2006,IASBandFASBworked
outdetailedplanstoconvergeIFRSandUSGAAP.In2007,Canada,India,JapanandKoreaagreedon
planstoadoptorconvergeaccountingstandardswithIFRS.Alsointhatyear,theU.S.SECallowed
foreignusersofIFRStostopreconcilingtheiraccountstoUSGAAP,aspreviouslyrequiredseenasa
strongsignalthattheregulatorwasplanningtoallowUScompaniestoreportinIFRS.

Thestandardsareinusebymorethan12,000companiesinabout100countries.Australiaissuedits
equivalentofIFRSinJune2006,replacingthepreviousAustraliangenerallyacceptedaccounting
principlessinceJune2006.TheAccountingStandardsBoardofJapanplansconvergencewithIFRSby
2011.CanadawillrequiretheuseofIFRSin2011forCanadianpubliclyaccountableprofitoriented
enterprises.Russiahasbeenimplementingaprogramtoharmonizeitsnationalaccountingstandards
withIFRSsince1998.Despitetheseefforts,essentialdifferencesbetweenthenationalstandardsand
IFRSremain.Since2004allcommercialbankshavebeenobligedtopreparefinancialstatementsin
accordancewithbothandinternationalstandards.FulltransitiontoIFRSisthusdelayedandisexpected
totakeplacebeginningin2011.InTurkey,since2006TurkishcompanieslistedinIstanbulStock

59
ExchangearerequiredtoprepareIFRSreports.InSingapore,reportingstandardsarecloselymodeled
onIFRS,withappropriatechangesmadetosuittheSingaporecontext.Asmentionedabove,the27
memberstatesoftheEUhavebeenrequiredtouseIFRSsince2005.TheUnitedStatesisthelastmajor
countrytocommittotheinternationalstandards.

ConsideringthatthousandsofU.S.companiesareengagedinbusinessinforeigncountrieswhichhave
adoptedinternationalstandardsandtwothirdsofU.S.investorscurrentlyownsecuritiesofforeign
companies,inAugust2008,theSECannouncedaneightyearplantoadoptIFRS.Theplanremains
subjecttoreview.Publiccommentshavebeenrequested.Somelargercompaniescouldchooseto
beginusingIFRStoreportfinancialresultsstartingin2010.TheSECestimatesatleast110U.S.
companieswouldqualifybasedontheirmarketcapitalization,amongotherfactors.TheSECwilldecide
in2011whethertorequireallofitsregistrantstouseIFRS.Theexpecteddeadlinesformandatoryuse
are:2014forlargecompaniesand2016forallU.S.publiclytradedcompanies.

Themajoraccountingfirmshavebroadlyendorsedthemove,sayingthattheUnitedStatesshouldnot
isolateitselfasmostcountriesmovetointernationalstandards.

ConversiontoIFRSwillbeacostly,timeconsumingprocess,affectingnotonlythebookkeepingof
publiccompanies,butmanyoftheirmanagementandcontrolsystemsaswell.Itwillrequirebroad
changesintheeducationofaccountantswithcurrenttextbooksbasedalmostentirelyonUSGAAPand
withUSGAAPfirmlyetchedinthemindsofpracticingaccountants.TheIFRSdivergesdistinctlyfrom
GAAPandwillbringdifferentresultstoprofitandlossstatements.USaccountingrules,guidanceand
officialinterpretationstotalsome25,000pages.IFRS,whichhastriedtorelyonprinciplesandhas
avoidedaddingmuchinterpretation,ismoreontheorderof2,500pages.Conversionwillrequireyears
ofgreatefforttomakethenecessarychanges,butultimatelyadoptionoftheinternationalstandards
shouldcutoperationalcostsforcompaniesandmakeiteasiertoaccomplishcrossborderinvesting.

Source:CompiledbytheauthorfromSECPressRelease,Wikipedia,andvariousnewspapersandbusiness
publications

60
 AppendixIV1

GrowthofLawsuitsAgainstAuditFirms(1967Present)

Auditfirmshavelongbeentargetsoflawsuits.Thisisnotanewphenomenon.In1967,forexample,
ForbesMagazinereportedthatfiftylawsuitswerependingagainstpublicaccountingfirms.184In1992,
TimeMagazinereportedthataccountantsface4,000liabilitylawsuits,doublethenumberin1985,
coveringmorethan$15billionindamages;in1991,theBig6paid$300milliontosettlelawsuits.185In
1995,theEconomistMagazinereportedthatthethenBig6forkedoutover$3billiontosettle
negligenceclaimssince1990.186Thesamereportindicatedthatoutstandinglegalclaimsagainstthe
firmsinAmericatotaledabout$30billionandthatinLondon,aclaimfor$11billionwaspendingagainst
PwCandE&YovertheauditofBankofCreditandCommerceInternational.187Atthattime,Philip
Laskawy,thechairmanofErnst&Young,estimatedthatlegalcostsnowswallowafifthoftheBigSix's
revenuefromauditandtaxwork.188

Auditfirmshavelongbeentargetsoflawsuits,partlybecausetheyhavedeeppocketsandpartly
becauseofthenatureofthebusiness.Whencorporationssuddenlyfailorsufferseveredeclinesin
stockprices,disaffectedinvestors,creditorsandemployeesarepronetosuetheauditorsaswellasthe
corporatemanagement.Claimsagainsttheauditorsarebasedonallegationsoffraudorfailureto
identifyerrorsorwrongdoingsthatleadtomassivelosses.

GrowthofLitigation

Thenumberandsizeoflawsuitsagainstauditfirmshavegrowninrecentyears.In19982006,theBig4
auditfirmsfaceddozensofclaimsinexcessof$1billion,189whereasin198085,forexample,thecostof
outofcourtsettlementsformalpracticebytheBig8amountedtolessthan$180million,ofwhich$137
millionwaspaidbynowdefunctArthurAndersen.190The198085casesarelistedinAppendixIV2.

Between1999and2004,fivecasesbroughtsettlementsinexcessof$100million.E&Ywasinvolvedin
thelargestpayout,$335million,intheCendantcase.NowdefunctArthurAndersenwasinvolvedin
twocases:BaptistFundsofArizona($217million)andSunbeam($110million).KPMGwasinvolvedin

184
Forbes.com,WhatAreEarnings?TheGrowingCredibilityGap,May15,1967
185
McCarroll,Thomas,AccountingWho'sCounting?Time,Apr.13,1992
186
Economist,Accountancyfirms:Aglimmerofhope,Apr.1,1995,p.62
187
Ibid.
188
Ibid.
189
Holstein,WilliamJ.,WhatIfOneofTheBigFourFails?TryingtoavoidanArthurAndersentypedisruption,
Directorship,Sept.2006
190
HouseSubcommitteeonOversightandInvestigations,citedinBerton,Lee,SmallCPAFirms'LiabilityRates
SoarPlightTiedtoMalpracticeSuitsAgainstBigEight,WallStreetJournal,Nov19,1985,p.1

61
theothertwocases:RiteAid($125million)andLernout&Hauspie($115million).191AppendixIV3lists
thetoptencasesinthatperiod.

Asof2004,federalagencieshadcollected$2billionfromaccountants,lawyersandotherprofessionals
fromtheS.&L.debaclehalffromfourbigaccountingfirms...Andtheprogramisstillyoung,a
Governmentspokesmansaid,withhope.Thepaymentsarefunneledtoinstitutionsmadeinsolventby
theS&Lcrisis.192

Bigpensionfundsandlawfirmsarenowpressingcasesmoreaggressivelywhencorporationslose
moneyorwhenstockpricesdrop,causingharmtopensionfundportfolios.Auditfirmsgetdrawninto
thecasesongroundsthattheyshouldhavespottedtheproblems.193Thus,dozensofbilliondollar
lawsuitswerependingagainsttheBig4from1998to2006.194In2006,theEuropeanCommission
reportedthatauditfirmsfacedfiveclaimsworthmorethan$1bnand11claimsintherangeof$250m
to$1bninEuropealone195andin2007,accordingtotheCommitteeonCapitalMarketsRegulation,
morethanthreedozensuitswerepending,involvingtensofbillionsofdollarsofclaimedpotential
damages.196

InMay2007,TycoInternationalandPwCagreedtopayatotalof$3.2billiontosettleaclassaction
lawsuitbroughtbyTycosshareholdersoveramultibilliondollaraccountingfraudthatendedwith
Tycostopexecutivesgoingtoprison(CEOL.DennisKozlowskiandCFOMarkH.Swartz).Ofthetotal,
PwCpaid$225millionandTycopaid$2.975billiontoconcludeafouryearlegalbattle.197SeeAppendix
IV4fordetailedlistofcases.

InApril2008,PwCreportedanincreaseinfederalclassactionshareholderlawsuitswith163casesfiled
(comparedto163in2006;169in2005;206in2004)Ofthese,accountingrelatedcasesfellin
proportiontototalcasesto50%in2007(comparedto61%in2006).198TheFederalBureauof
Investigationhas17continuinginvestigationsofpossiblecorporateandaccountingfraudrelatedto
subprimelending.Thatnumber,theF.B.Ihassaid,islikelytoincrease.199

191
Economist,CalledtoAccount,Nov.18,2004

192
Flaherty,Francis,"BusinessDiary,"NewYorkTimes,Aug14,1994,p.A2
193
Holstein,WilliamJ.,WhatIfOneofTheBigFourFails?TryingtoavoidanArthurAndersentypedisruption,
Directorship,Sept.2006
194
Ibid.
195
Buck,Tobias,"Brusselssuggestslegalshieldforbigauditfirms,"FinancialTimes,Jan.18,2007
196
Wallison,PeterJ.,"TheSorcerer,theApprentice,andtheBroom:WhattoDoaboutPrivateSecuritiesClass
Actions,"AEIOnline,Posted:Thursday,Mar.8,2007,accessedJuly20,2008
197
InternationalHeraldTribune,Lawyersget14.5percentinTycocase,$29millioninexpenses,AssociatedPress,
Dec.20,2007
198
Thefullfalloutofsubprimerelatedcasesisexpectedtobeseenin2008.PwCSeesSecuritiesLitigationonthe
Rise,WebCPA,NewYork,April11,2008

199
Bajaj,Vikas,andCreswell,Julie,ALenderFailed.DidItsAuditor?NewYorkTimes,Apr13,2008

62
CasesontheHorizon

Severalpotentiallyhighvaluecasesarecurrentlypending.Examplesinclude:ashareholdersuitagainst
NewCenturyFinancialanditsauditorKPMG;severallawsuitsagainstBearStearns,itsauditor(Deloitte)
anditspurchaser(JPMorganChase);andalawsuitbyshareholdersagainstDellanditsauditor,PwC(a
casewhichwasexpandedtoincludeIntelsallegedsecretrebateprogramof$1billionperyearto
Dell)..Thedeclineof$19billioninBearStearns'smarketcapitalizationsinceJanuary2007isonegauge
ofthepotentiallossesinvestorsmaytrytorecoup.200

200
Gerstein,Josh,"AmidBearStearnsRubble,LawyersSwoopIn,"NewYorkSun,Mar.18,2008,
http://www.nysun.com/business/amidbearstearnsrubblelawyersswoop/73076/accessedAug.13,2008

63
 AppendixIV2

OutofcourtSettlementsbyBigEightAccountingFirms

MalpracticeLawsuits(198085)

Firm AmountPaid

ArthurAndersen $137,089,359

PeatMarwickMitchell 19,400,000

Ernst&Whinney 6,020,500

DeloitteHaskins&Sells 4,997,585

Coopers&Lybrand 4,375,850

PriceWaterhouse 3,500,000

ToucheRoss 2,250,000

ArthurYoung 1,490,000


Source:HouseSubcommitteeonOversightandInvestigations;citedinSmallCPAFirms'LiabilityRatesSoar
PlightTiedtoMalpracticeSuitsAgainstBigEight,Burton,Lee,WallStreetJournal,Nov19,1985.pg.1

64
 AppendixIV3

TopTenShareholderSettlementsbyAccountingFirms(19972004)

Auditor CompanySettlement($millions) Date

E&Y Cendant 335 Dec1999

Andersen BaptistFundsofArizona 217 Mar2002
KPMG RiteAid 125 Mar2003
KPMG Lernout&Hauspie 115 Oct2004
Andersen Sunbeam 110 May2001
Andersen ColonialRealty 90 Jul1997
KPMG OxfordHealthPlans 75 Mar2003
Andersen WasteManagement 75 Dec1998
PwC MicroStrategy 55 May2001
E&Y Informix 34 Jun1999

Source:PublicAccountingReport,citedinThefutureofauditing:calledtoaccount,TheEconomist,Nov.18,
2004

65
 AppendixIV4

CasesAgainstAccountingFirms
Settlements,Fines,PendingCases(1992Present)

Thislistofcasesisintendedtobeillustrativeandnotexhaustive.Sometimesdifferentreportsofthe
sameclaimvaryintheamountscited.Insomecases,thefiguresincludenotonlytheportionofthesuit
againsttheauditor,butdamageclaimsagainsttheentireauditedcorporation.Thus,mediareportsmay
overstatethemagnitudeofthecasesagainsttheauditors.Also,theamountunderconsiderationmay
changeovertimeandoutofcourtsettlementmaybeagreedonaconfidential(undisclosed)basis.

Auditor Client $Millions Date Comments

Deloitte

(FinancialInstitutions) 312. Mar1994

Umbrellasettlementw/fedlgovtforallegedlyfaultyauditsofcollapsedfinancialinstitutionsduringthepastdecade
FortressRe 2000. Nov2004
Delphi 38.25 Feb2008
PhilipServices(Canada) 50.5 Mar2007
Parmalat(Italy) 149. Jan2007,Apr2007? (originallysought$!0billion)
AdelphiaCommunications167.5 Aug2007
(paid$50mtosettleAdelphia4/26/05;paid$167.5mtoAdelphiaAugust2007)
Ligand N/A Dec2007
(PCAOBfine$1million,PCAOBRelease105200700512/10/07
KogerProperties(FL) 81.3N/A
BearStearns 1000. April2008
UnitedCompaniesFinancialN/AN/A
Navistar N/A July2005
GeneralMotors 26 Aug2008
(Total$303m:GMpaid$277m,$200mreportedlycoveredbyGMsinsurancecarrier;casefiledSept.2005)

PwC

Miniscribe 95 1993 C&L

AmericanMutual 24 1996 C&LCourtrejected$3.75million
MicroStrategy 55 May2001
SafetyKleen 87.5 Jan2005
Raytheon 50May2004
AmercoInc.(UHaulIntl) 50 N/A (suedfor$2.5bn)
Texarkana(travel) 54.5N/A
Refco 2000 Aug2007 (PwC/E&Y/GrantThornton)
Tyco 225 May2007
BCCI(BankCredit/Commerce)200 1995 (sought$11bn)
MiniScribe 92 Feb1992 (200mjury2/5/92C&L)
Maxwell N/A 1996 (C&L)
AHERF(AlleghenyHealthEducationandResearchFoundation) (C&L2001)
AIG N/A 2007
Dell 1,000. Jan2007 Amountnotyetspecified
OAOYukos 0.48 Mar2007

66
KPMG
BankAmericaCorp. 75 Dec1992 PeatMarwick
(FinancialInstitutions) 186.5 1994 (PaidtoUSGovtFailedS&L)
OrangeCounty 75 May1998 Originalclaim$3billionfiledSept.2005
RiteAid 125 Mar2003
Columbia/HCA 9 Oct2001 filedin1999
Lernout&Hauspie Speech 115 Oct2004
OxfordHealthPlans 75 Mar2003
Xerox 22.4April2005 (paidtoSEC)
(TaxShelters) 456 Aug2005 (paidtoDOJ)
GemstarTVGuide 25 N/A (plus10mfine11/05)
TenetHealthcare N/A Mar2006
FannieMay 2.000Dec2006

E&Y
(FailedSavings&Loans)400 1992 (PaidtoUSGovernment)
Cendant 335 Dec1999
Informix 34 Jun1999
BankofNewEngland 84 1998 (collected$44m)
EquitableLife(UK) 4.770 Sep2005
(cutto750mBP,thendroppedinSep2005;EquitablepaidEYslegalcosts)
MerryGoRound4.000 1997
CharlesKeatingS&L63 1993 (paidlargelybyinsurance)
SmartForce(Ireland) 0.725N/A
HealthSouth 445. Feb2006 (HSouthpd,suingEY)
Refco 2.000 Aug2007 (PwC/E&Y/GrantThornton)
AOLTimeWarnerN/AN/A
BanqueCantonaledeGeneveN/AN/A
JDSUniphaseN/AN/A
SuperiorBankN/AN/A
PNC 9 Apr2007

GrantThornton
Refco 2000 Aug2007 (PwC/E&Y/GrantThornton)
Carnegie N/AN/A

BDOSeidman
Bankest(FL) 521 June2007 (Underappeal)
(Floridajuryverdict:$170millioncompensatorydamages,$351millionpunitivedamages)

Andersen
(FinancialInstitutions) 65 Dec1993 UmbrellasettlementUSG
BaptistFundsofArizona217 Mar2002
WorldCom 6100. Sep2005
QwestCommunicationIntl N/A Oct2004
GlobalCrossingLtd. N/A Nov2005
Dynegy 1N/A
Sunbeam 110 May2001
ColonialRealty 90 Jul1997
WasteManagement 75 Dec1998
PeregrineSystemsN/AN/A
Enron 300 Apr2002

Source:Compiledbytheauthorfromvariouspublications.(N/A=notavailablepriortopublication)
Lastupdate:8/31/08

67
 AppendixIV5

EUCommissionerFritsBolkestein
FourReasonsforNotLimitingLiability

FollowingareexcerptsfromaspeechinLondonbyFritsBolkestein,EUCommissionerofInternal
MarketandTaxation,onMarch24,2003.

TheCommissionconsidersauditorliabilityprimarilyasadriverofauditqualityanddoesnotbelieve
thatharmonisationorcappingofauditorliabilityingeneralisnecessaryTherearefourclearreasons
fornotlimitingauditorliability.

Unlimitedauditorliabilityisaqualitydriver.Iftheauditordeliverspermanentlyhighqualityhehasno
liabilityexposure.Thereisnomoreeffectiveliabilityriskmanagementthandeliveringhighquality
audits.

Liabilitysystemsexistfortheprotectionofthepersonswhosuffereddamagenotfortheconvenience
ofthosewhomaybeatfault.Therefore,the"deeppocket"approachisprincipallysoundbecause
someonewhohassuffereddamageshouldnothavetoshouldertheburdenofsuingseparatelyall
partieswhichhaveapartialresponsibilityforproperfinancialstatements.Inanycase,allMember
Stateshavetheconceptofjointandseveralliabilityasafundamentalelementintheircivilliability
systems.

Increasedauditorliabilityispartlyaselfcreatedproblem.Here,therearetwoconsiderations.

Thegrowthofauditfirmsandthebrandingofonenameonefirmworldwidehassignificantlyincreased
thepotentialdamagetothewholenetworkincaseofapotentialauditfailurecommittedbyoneofthe
localfirms.Thisdrivesthewillingnessofnetworksofauditfirmstosettleforhigheramounts.Trendsin
liabilityclaimsshouldnotbeconsideredinabsolutetermsbutrelativetotheincreasedturnoverand
profitofauditfirms,figuresthatarenoteasilyavailableworldwide.

ClaimsfrompotentialauditfailureshavebeensettledtooeasilyoutofCourt.Asaconsequencethereis
verylittlecaselawclarifyingtheboundariesofauditorliability.Anunansweredquestionformeis
whetheroutofCourtsettlementsareinitiatedbytheauditfirms'desiretolimitthedamagetothe
brandnameorbytheriskjudgementofinsurancecompanies.

Audit is by its very nature a function which is carried out in the public interest. This implies that 3rd
partiesshouldbeabletorelyonthecorrectnessofcompanies'financialstatementsandbeinaposition
toclaimdamagesincaseoffraudulentfinancialreporting.EUcompanylawspecificallyrecognisesthe
protection of third parties such as creditors as one of its major objectives. In this context the
Commission is somewhat concerned about the recent modification to some UK audit reports which
seem,inresponsetotherulingintheBannermancase,totrytolimitauditorliabilitytothirdpartiesvia
wordingintheauditreport.

Source: Bolkestein, Frits, Auditor Liability: An EU Perspective, Address at The London Underwriting Centre, Mar. 24, 2003;
(http://europa.eu.int/rapid/pressReleasesAction.do?reference=SPEECH/03/151&format=HTML&aged=0&language=EN&guiLanguage=en)

68
 AppendixVI1

IncreasingtheSupplyofGlobalAuditFirms

AProCompetitiveActionPlan

ThevariousproposalsdiscussedinPartVarebasicallylongtermsolutionstotheneedsfor
greatercompetitionandgreaterchoiceofauditorsformultinationalclients.Forthosewhoare
anxioustomovemorequicklyanddecisively,itwouldbeprudenttogiveseriousconsideration
toaplantopreventfurthershrinkageandfurtherconcentrationoftheauditindustry.The
mostpragmaticapproachistofocusonremovingbarrierstonewentrantsandthegrowthof
existingfirms.SomeofthebarriersidentifiedbyGAO(seePartIII)consistofshortcomingsof
thefirmsduetotheirlackofsize,i.e.,reputation,capacity,lackofexpertiseandglobal
networks.Theseshortcomingscanonlybeovercomewithtimeandbythefirmitself,but
actionsonotherbarrierscouldfacilitateandacceleratetheprocess.Barriers,suchaslackof
accesstocapital,litigationrisks,andstateregulations,canbedealtwiththroughgovernment
action.

Litigationriskscouldbeaddressedbyadoptinglimitsonliability.Perhaps,acapcouldbeplaced
onpunitivedamages(butnotcompensatorydamages)againstauditorsbasedonamultipleof
theauditorsfee.Forinstance,ifthefeeis$10millionandthecapisfivetimesthefee,the
auditorwouldbeliableforamaximumof$50million.Suchalimitshouldbecontingentonthe
auditindustryswillingnesstocontributetothedevelopmentofalargernumberofcompetitors
fortheauditsofmultinationalclients.Asaquidproquoforthisbenefit,theauditindustry
wouldberequiredtoestablishandfundaneducationcentertohelpkeepaccountantsfrom
smallercompaniesuptodateonaccountingregulationsandespeciallyontheinternational
financialreportingstandardswhichareexpectedtobecomeeffectiveworldwideinafewyears.
Collegestudentsinaccountingandbusinessmanagementcoursescouldalsohaveaccessto
suchafacilityorgroupoffacilities,whichwouldbenefitallauditfirms.

Lackofaccesstocapitalcouldbeaddressedthroughremovalofstaterestrictionsonoutside
ownershipofaccountingfirms.This,ofcourse,wouldrequireamendmentstostatelaws,which
couldperhapsbestimulatedbysomefederalumbrellalegislation.Safeguardswouldneedtobe
builtintosuchlegislationtoassureagainstconflictsofinterestwherenewauditfirmowners
maybeengagedinotherenterprises.Statelawsareespeciallysensitiveforlocalfirmswhich
maynotwishtoattractnewcompetitorsornewowners.Soitwillbenecessarytobuilda
consensusandrallysupportersforsuchchanges.

Whilethisplanmayappearoverlyambitious,itdoesprovidesomeideasforconsideration.The
costoftheplan,ofcourse,mustbeweighedagainstthecostofinaction.

69
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