Watching the Watchers – A Timeline

Before his appointment as Comptroller General of the United States, the head of the General Accounting Office, David M. Walker had extensive executive level experience in both government and private industry. Between 1989 and 1998, Mr. Walker worked at Arthur Andersen LLP, where he was a partner and global managing director of the human capital services practice based in Atlanta, Georgia.

From the July 2003 GAO Report entitled,
“PUBLIC ACCOUNTING FIRMS, Mandated Study on Consolidation and Competition.”

The audit market for large public companies is an oligopoly, with the largest firms auditing the vast majority of public companies and smaller firms facing significant barriers to entry into the market. Mergers among the largest firms in the 1980s and 1990s and the dissolution of Arthur Andersen in 2002 significantly increased concentration among the largest firms, known as the “Big 4.” These four firms currently audit over 78 percent of all U.S. public companies and 99 percent of all public company sales. This consolidation and the resulting concentration have raised a number of concerns. To address them, the Sarbanes-Oxley Act of 2002 mandated that GAO study:

1) the factors contributing to the mergers;
2) the implications of consolidation on competition and client choice, audit fees, audit quality, and auditor independence;
3) the impact of consolidation on capital formation and securities markets; and
4) barriers to entry faced by smaller accounting firms in competing with the largest firms for large public company audits.

Domestically and globally, there are only a few large firms capable of auditing large public companies, which raises potential choice, price, quality, and concentration risk concerns. A common concentration measure used in antitrust analysis, the Hirschman-Herfindahl Index (HHI) indicates that the largest firms have the potential for significant market power following mergers among the largest firms and the dissolution of Arthur Andersen .

Although GAO found no evidence of impaired competition to date, the significant changes that have occurred in the profession may have implications for competition and public company choice, especially in certain industries, in the future.

Existing research on audit fees did not conclusively identify a direct correlation with consolidation. GAO found that fees have started to increase, and most experts expect the trend to continue as the audit environment responds to recent and ongoing changes in the audit market. Research on quality and independence did not link audit quality and auditor independence to consolidation and generally was inconclusive. Likewise, GAO was unable to draw clear linkages between consolidation and capital formation but did observe potential impacts for some smaller companies seeking to raise capital. However, given the unprecedented changes occurring in the audit market, GAO observes that past behavior may not be indicative of future behavior, and these potential implications may warrant additional study in the future, including preventing further consolidation and maintaining competition.

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

In September 2003, the Government Accounting Office issued a report entitled,
“Report to the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services, Accounting Firm Consolidation, Selected Large Public Company Views on Audit Fees, Quality, Independence, and Choice.”

During 2003, the Public Company Accounting Oversight Board conducted inspections of public accounting firms for the first time. The Board inaugurated its inspection program (as required by Sarbanes-Oxley) with limited inspections of the four largest U.S. public accounting firms. In those inspections, the Board identified significant audit and accounting issues that were missed by the firms, and identified concerns about significant aspects of each firm’s quality controls systems. The Board’s inspection reports describe those issues. Because Board inspections and inspection reports are new, however, the Board offers a few remarks by way of providing readers with a context for the observations described in this report. The reports were issued to the four firms on August 26, 2004.

In April 29, 2005, KPMG issued a report on its Peer Review of the General Accounting Office (GAO) for the year 2004.

To The Comptroller General of the United States:
We have reviewed the system of quality control for the accounting and auditing practice of the Financial Management and Assurance Team of the United States Government Accountability Office (GAO FMA) in effect for the year ended December 31, 2004. A system of quality control encompasses the audit entity’s organizational structure and the policies and procedures established to provide it with reasonable assurance of conforming with professional standards. The elements of quality control are described in the Statements on Quality Control Standards issued by the American Institute of Certified Public Accountants (AICPA) and which are comparable with those in Government Auditing Standards. The GAO FMA is responsible for designing a system of quality control and complying with it to provide the GAO FMA reasonable assurance of conforming to professional standards in all material respects. Our responsibility is to express an opinion on the design of the system of quality control, and GAO FMA’s compliance with its system of quality control based on our review.

On August 29, 2005, KPMG agreed to the delayed prosecution agreement with the IRS and Justice Department related to the tax shelter case that began with a Senate investigation in 2003 that led to, the United States member firm of KPMG International, KPMG LLP being accused by the United States Department of Justice in early 2005 of fraud in marketing abusive tax shelters.

WASHINGTON — KPMG LLP (KPMG) has admitted to criminal wrongdoing and agreed to pay $456 million in fines, restitution and penalties as part of an agreement to defer prosecution of the firm, the Justice Department and the Internal Revenue Service announced today.

In December 2005 an article in the Financial Times entitled, “How more players can join the audit quartet,” stated:

Last week Christopher Cox, chairman of the US Securities and Exchange Commission, told the US accounting profession he thought the “intense concentration” of the Big Four firms in the marketplace was a bad thing and the rules that acted as a barrier to entry should be changed.

Certainly, this is the view of Paul Boyle, chief executive of the Financial Reporting Council, which regulates accounting firms in the UK. Instead of trying to encourage reluctant firms to grow into the space, he wants to create new firms from a different mould altogether. The large accounting firms are all partnerships and although for the past 20 years it has been legally possible for them to have 49 per cent ownership by outsiders, in practice they have remained partnerships.

For Mr Boyle, this means they have a different structure from more usual commercial organisations, which conform to a model of three constituent parts – the shareholders, the management and the people responsible for governance. In an accounting firm, he argues, these three are “bunched together”. The people who provide the capital for the accounting firm, the partners, are the same people who provide the governance and the management of the business.

PCAOB Leadership
Mark W. Olson became Chairman of the Public Company Accounting Oversight Board on July 3, 2006. From 1988 to 1999, Mr. Olson served as a partner with Ernst & Young LLP and its predecessor, Arthur Young & Company. At Ernst and Young, he was National Director of the firm’s Regulatory Consulting Practice for the financial services industry.

Prior to Mark Wilson was William J. McDonough a career banker, and before that the short reign of William Webster, former CIA Director, the PCAOB’s first Chairman. Appointed by Harvey Pitt, the then SEC Chairman, Pitt ran into trouble with this nomination and was forced to resign as SEC Chairman.

Oct. 9, 2002: Democratic leaders ask President Bush to remove Pitt, saying he is caving in to the accounting industry by opposing John H. Biggs as head of a new accounting oversight board.
Oct. 31, 2002: The SEC orders an investigation into the selection of William Webster to head the accounting board after reports that Pitt withheld information from other SEC commissioners about Webster’s involvement with a company facing fraud charges.

On November 12, 2002, less than two months after taking the position, William Webster resigned.