Are auditors becoming too big to fail? For over a decade, there have been articles and op-eds in the popular and business press arguing that the auditing industry, currently dominated by Deloitte & Touche, Ernst & Young, KPMG, and PwC, is a tightening oligopoly, increasingly insulated from the risks of failure.
Adding to this concern is that even as the number of mega audit firms has contracted from eight in the 1980s to four today, their combined market share remains formidable, especially in the United States. The Government Accountability Office, the investigative arm of Congress, periodically raises concerns about audit-industry concentration and suggests ways to boost growth of smaller firms. The consolidation raises the issue of how the surviving big auditors and the nation's accounting regulators will manage their relationship and what the effects will be on accounting rules and thus on capital markets, observes Karthik Ramanna, an associate professor and Henry B. Arthur Fellow in the Accounting and Management unit at Harvard Business School, where he studies the political economy of corporate accountability and financial reporting.
Several scenarios are possible.
"There are important implications for the quality of accounting information in corporations and in capital markets"
"We could imagine that as the audit industry becomes more concentrated, the big auditors would become increasingly secure in their position vis-à-vis regulators," Ramanna says. "Thus, they may become more negligent in their duties or more prone to enabling big risks in accounting. They wouldn't be as worried about the consequences. This is basically the argument behind concerns that the Big Four are too big to fail. "
On the other hand, they could become less likely to take risks. The audit giants might decide that their dwindling numbers make them increasingly visible targets for regulatory interventions and litigation, and they might become more risk averse. Additionally, with just a few major players in the market, the big firms might feel less need to compete with each other to satisfy client demands; this could reinforce their focus on playing it safe by mitigating potential regulatory and litigation costs.
"In either case," Ramanna says, "there are important implications for the quality of accounting information in corporations and in capital markets, and thus for the ability of managers and markets to effectively allocate resources across competing projects."
What they say
To determine which of these possibilities have actually borne out during the audit industry consolidation over the last few decades, Ramanna and colleagues measured how the big firms lobbied on proposed accounting regulations. His paper, coauthored with HBS doctoral student Abigail M. Allen and Boston College accounting professor Sugata Roychowdhury,
As it happens, new standards are proposed fairly often by the Financial Accounting Standards Board. The researchers made the first year of their study 1973 because that is when the FASB came into operation. They looked at four distinct eras of contraction: the Big Eight era (1973-1989), the Big Six era (1990-1998), the Big Five era (1999-2002), and the Big Four era (2003-2006). All but the final consolidation were due to mergers and acquisitions; the last contraction was due to the collapse of Arthur Andersen.
The researchers studied how often and in what contexts over time the decreasing number of big audit firms expressed concerns about decreased "reliability" (a key component of "verifiability," auditing's touchstone) in proposed standards. To benchmark the auditors' assessments of decreased accounting reliability, the researchers relied on independent evaluations of the proposed standards by two experienced accounting professionals who were blind to the study's objectives.
Overall, the results fail to support the proposition that the biggest auditors increasingly consider themselves too big to fail. Rather, the data show firms in the tightening oligopoly are more concerned about decreased reliability over time and sensitive to their growing visibility to regulators and to potential litigation. This result is robust to numerous alternative explanations such as the changing composition of regulators, the growth of fair-value-based accounting, broad macroeconomic trends, and aggregate stock market performance.
"What this study tell us is that contrary to the claims made in the press that the big auditors are too big or too few to fail, there is evidence of the audit firms becoming more concerned about taking risks," says Ramanna.
It makes sense that firms in an oligopoly would not want to make waves. There is an argument in the political science literature, Ramanna explains, about the "political costs" from size—that larger firms bear greater regulatory scrutiny. "It is easier for a politician or prosecutor to go after 'big fish' because voters know who the big fish are. That is why when there are fewer audit firms there could be a greater concern on the firms' part about such political costs."
Good for the industry?
There is a potential danger in this approach, Ramanna cautions. If audit firms' focus on reporting verifiability over flexibility goes too far, it could stifle innovation in accounting methodologies. This would have a negative impact on the ability of accounting information to facilitate effective capital allocation decisions in the economy.
"What we are seeing could also suggest that auditors are socializing or collectivizing the potential costs of exercising their professional judgment. Some risk-taking is needed in any professional activity; it is from such risks that innovation and growth emerge."
For client-managers, this means that the biggest audit firms are less likely to strive to meet their preferences for reporting flexibility, such as customized accounting methods that best reflect clients' business models. Instead audit firms are playing it safe by concentrating on verifiability.
A 'thin' world
Mindful of this tension amid concerns about too big to fail, Ramanna is also intrigued by the unusually esoteric world of accounting standard-setting.
Unlike major government programs such as Social Security and Medicare, which attract large, general-interest groups to rally, debate, and participate in the political process whenever changes are proposed, accounting regulation involves a relatively small pool of big participants.
For a start, few people understand the complexities underlying accounting measurements. Further, the most influential participants are usually powerful players—major audit firms, large industrial companies, big investment banks, and top investment management firms. Among this assemblage, the audit giants are the only group to systematically and consistently participate across various accounting issues.
Given the "thin" nature of this political process, it is particularly important to understand how increasing concentration in the audit firms affects the nature of accounting regulation, Ramanna says.
Future research, the authors hope, will continue to probe the changing audit oligopoly and its consequences amid increasing globalization, improvements in information technology, and the rise of the financial services sector in the US economy.
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