Are the Big Four Audit Companies Way too Massive to Are unsuccessful?

Are auditors turning into way too major to fail? For more than a decade, there have been article content and op-eds within the well-known and business enterprise push arguing the auditing sector, at the moment 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 companies has contracted from eight inside the 1980s to four today, their combined market share remains formidable, especially within 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 companies. The consolidation raises the issue of how the surviving huge 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 inside the Accounting and Management unit at Harvard Enterprise 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 market 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 major risks in accounting. They wouldn’t be as worried about the consequences. This is basically the argument behind concerns that the Big Four are much too significant to are unsuccessful. ”

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 large corporations 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 business consolidation in excess of the last few decades, Ramanna and colleagues measured how the large companies lobbied on proposed accounting regulations. His paper, coauthored with HBS doctoral student Abigail M. Allen and Boston College accounting professor Sugata Roychowdhury, is titled The Auditing Oligopoly and Lobbying on Accounting Standards.

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 4 distinct eras of contraction: the big Eight era (1973-1989), the large Six era (1990-1998), the massive Five era (1999-2002), and the big 4 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 around time the decreasing number of large audit corporations 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 fall short to support the proposition the biggest auditors increasingly consider themselves much too significant to fall short. Rather, the data show firms inside the tightening oligopoly are more concerned about decreased reliability about 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 large auditors are much too big or way too few to fall short, there is evidence of the audit companies becoming more concerned about taking risks,” says Ramanna.

It makes sense that companies 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 corporations bear greater regulatory scrutiny. “It is easier for a politician or prosecutor to go after ‘big fish’ because voters know who the large 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
marketplace?

There is a potential danger in this approach, Ramanna cautions. If audit firms’ focus on reporting verifiability about flexibility goes also 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 which the biggest audit companies are less likely to strive to meet their preferences for reporting flexibility, such as customized accounting methods that best reflect clients’ enterprise models. Instead audit companies are playing it safe by concentrating on verifiability.
A ‘thin’ world

Mindful of this tension amid concerns about as well massive to fall short, 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 while in the political process whenever changes are proposed, accounting regulation involves a relatively small pool of significant participants.

For a start, few people understand the complexities underlying accounting measurements. Further, the most influential participants are usually powerful players-major audit corporations, large industrial companies, significant investment banks, and top investment management companies. Among this assemblage, the audit giants are definitely 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.