The jury is still out regarding the long-term implications of accounting scandals, new regs and the demise of Andersen. But one thing is certain: Audits will cost more.

Eight, six, five, four ... Where will the consolidation of large public accounting firms cease? And what does the dwindling choice mean for public companies and their corporate finance functions? The short-term answers are that consolidation needs to end right here and that audits will become more expensive. These are the issues attracting the most attention from corporate finance executives. The long-term implications of auditor consolidation remain less certain and more troubling, particularly for the Big Four firms.

Rick Antle, senior associate dean and the William S. Beinecke professor of accounting at the Yale School of Management in New Haven, Conn., compares the accounting industry's interlocking structure to the complex power grid that delivers electricity to the Northeast. When systems threaten to fail, tensions among those who work on the grid mount. Put a CFO, a financial analyst, an auditor and a plaintiff's attorney in a room, Antle suggests, and watch the blame fly. "Each of those individuals feels unique pressures as a result of the way the entire system is orchestrated," he explains. "When you push on one part of that system, other parts of the system adapt."

Finance pros, auditors and academics agree on one projection, however: Further consolidation is unlikely and unwelcome. "Heaven forbid that something unfolds at HealthSouth or somewhere else that puts any one of the Big Four at risk of an Andersen-like demise," says Mike Head, managing director of corporate audit for Ameritrade Holding Corp. in Omaha, Neb. "That would make me very nervous as a purchaser of audit services and internal control services."

Nicholas Moore, the retired CEO of PricewaterhouseCoopers, does not believe another large firm will follow in Andersen's footsteps. Not exactly, anyway. "I think the regulators have awakened to the fact that they made a big mistake in letting Andersen implode," he says. "It was one of those situations where it was politically expedient to indict the firm." Moore expects any regulatory actions that take place in the near future to focus more on individuals than on institutions. "But the regulators don't hold all the cards," he adds. "All of the firms face civil liability." The Big Four have successfully managed that risk to date, but "any one lawsuit, if successfully exploited, can mortally wound them," he says.

A Healthy Convergence

The transformation of the Big Eight into the Big Five was motivated by radically different factors than the five-to-four transition. In 1987, Klynveld Main Goerdeler (KMG) merged with Peat Marwick Mitchell to create KPMG Peat Marwick. Arthur Andersen, Coopers & Lybrand, Ernst & Whinney, Price Waterhouse, Arthur Young, Deloitte Haskins & Sells, Touche Ross, and the new KPMG composed the Big Eight. Two years later, the formations of Ernst & Young and Deloitte & Touche resulted in the Big Six. In 1998, PricewaterhouseCoopers made it the Big Five.

The primary motivation behind each consolidation was economic. According to a July report from the U.S. General Accounting Office (GAO) on competition in the accounting industry, the mergers of the '80s and '90s occurred for three reasons: The largest firms needed to keep pace with the growing size, complexity and global reach of their customers. They felt pressure to achieve greater economies of scale. And they needed to expand their industry-specific and technical expertise.

Their customers benefited from the changes. The competition among the big firms kept audit fees in check, and technological developments such as databases and data-interrogation tools improved the quality and efficiency of audits. "We had more access to better tools at competitive prices with plenty of thought-leadership resources available," Head explains. "It was a very healthy convergence and consolidation."

These changes did create competitive barriers for service providers outside the Big Five. "Every change in the past decade or two seems to have made the biggest accounting firms even bigger," says Antle. The GAO report repeatedly emphasizes that smaller public accounting firms face formidable obstacles to entering the top tier. The gap between the largest accounting firms and the next four firms widened significantly between 1988 and 2002 (see Gap Analysis, below).

However, the GAO report confirms that audit fees, when adjusted for inflation, remained flat or decreased slightly between 1989 and the mid-1990s. Fees have increased slightly since the late '90s, although the GAO attributes that rise to the increase in the scope of audits rather than to consolidation. In fact, the report finds that the consolidation of the large public accounting firms did not increase audit fees, decrease auditor independence, or produce any direct effects on capital formation or the securities markets.

Someone Has To Pay

Since Andersen's dissolution, fees have swung upward more dramatically. As soon as the firm fell, many large public companies became concerned about the impact this involuntary consolidation of the accounting services market might have on their audit and risk management costs. Still, audit fees began to rise only after Sarbanes-Oxley took effect.

Some CFOs are now complaining about footing the bill for compliance with the law when their dollars are pouring into the Big Four. But Antle, who recently co-authored the textbook "Financial Accounting" (South-Western College/West, 2003) and who has studied the dynamics and structure of public accounting firms for 20 years, says someone has to pay for improvements in governance.

"I've done a lot of research on the compensation of executives in the industry," Antle says. "Suffice it to say, I didn't find any evidence that our society is supporting a whole bunch of overpaid accountants." He says that unless accounting firms were making abnormally high profits prior to Sarbanes-Oxley -- and the widespread treatment of audit services as a commodity suggests that they weren't -- the firms can be expected to pass on the cost of additional audit requirements to their customers.

Whether justified or not, these rising costs amplify concerns about audit firm size and selection. Ameritrade's Head believes that the move from the Big Five to the Big Four was in some ways a necessary -- or at least understandable -- step, but he emphasizes that a Big Three scenario would substantially raise the price of audits and reduce the availability of audit services. Why? Because fewer choices means fewer resources, particularly in certain geographic areas. Sarbanes-Oxley has effectively done away with the auditing off-season, so "those periods when auditors previously may have had some excess capacity have been absorbed with additional work on auditing internal controls, certifications and other requirements in the new law," he points out. "Here in Omaha, Union Pacific, ConAgra, Commercial Federal Bank and Ameritrade all draw on Deloitte's resources throughout the year. That's draining the talent pool."

Moore believes the conservative stance many companies have adopted in dealing with their auditors is also placing upward pressure on audit prices. "I've seen audit committees behave in a highly risk-averse way," he says. He points to the inefficiencies that arise when a company hires multiple firms to provide the services that a single firm provided in the past.

"There exists a bit of a pious attitude about not using auditors for anything other than the audit work," Moore says. "I think that attitude is an overreaction, and it isn't in the best interest of the company. I think it's appropriate to create some constructive tension around those issues, but I don't think it's a black and white world we live in. I think there are a lot of services these firms can provide that they should continue to be able to provide, particularly in the tax area."

He notes that good audits demand that auditors fully understand their customers' tax issues. "Now people and audit committees are suggesting you don't want [your external audit firm] to do the tax work," he says. "I think that's wrong. In an age [in which] people are becoming more and more productive, this is not making companies more productive. This is encumbering companies, and it is encumbering the firms."

Prospects for The Smaller Players

As businesses strive to separate audit from nonaudit work, some non-Big Four firms are seeing an opportunity. "Doing the internal control work under Section 404 has been a tremendous opportunity for us with nonaudit clients," says Ed Nusbaum, CEO of Chicago-based Grant Thornton LLP, the fifth-largest accounting firm in the United States. "And more of the larger companies are now interested in using other firms for tax work."

Although Grant Thornton absorbed 60 partners and roughly 500 employees from Andersen, a chasm still separates it from the Big Four. "The most observable impact of consolidation among accounting firms," according to the GAO report, "appeared to be the limited number of auditor choices for most large national and multinational public companies if they voluntarily switched auditors or were required to do so, such as through mandatory firm rotation." The GAO surveyed 147 large public companies as part of its research; 88 percent indicated that they would not consider using a non-Big Four company for audit and attestation services. That attitude is borne out by the audit-partner selections of Andersen's former clients (see Where Did Andersen's Clients Go? below).

But Nusbaum is seeing a shift. He says that investment bankers and analysts used to routinely steer large and midsize companies to the "glitter and glamour" of the biggest firms. "Today we've seen that investment bankers, analysts and the marketplace in general have a much greater acceptance of Grant Thornton," he says.

Nonaudit service firms, such as Protiviti, have also benefited. ACL Services Ltd., a Vancouver, British Columbia-based business-assurance software and services firm, reports that it has experienced more than 100 percent compound annual growth in its services group during the past three years. ACL's software helps companies and accounting firms identify areas of concern in financial statements. ACL practice leader Steven J. Figner says Big Four firms and their customers look to his company "to help them bring down the cost of data analysis" and, by extension, the cost of audit engagements.

Where Did Andersen's Clients Go?

Potential Brain Drain

Moore sees real challenges for the Big Four in the near future. "The business model for the accounting firms is being substantially eroded by the constant focus on what they can do and cannot do," he says. Big Four partners and accountants now have an unshakable focus on risk. Although regulatory and civil liability risks have always been concerns, the swift dismantling of Andersen redefined the dangers. Moore uses terms like "career-ending" and "traumatic" when he discusses his former competitor's demise.

"For a long time, accountants had been alleging that their liability burden was too high," says Antle. "Yet I don't think many of them thought that their existence could be threatened in the way Andersen's was. The risk accountants bear has been made much more real to them since Andersen's collapse."

If they were Big Four executives right now, both Moore and Antle say, they would be deeply concerned about the effects that the current regulatory environment will have on the talent pipeline. In the past, large accounting firms would bring new employees, culled from top undergraduate accounting and business programs, up to speed slowly. During Moore's public accounting career, he says, PwC "could have people on our payroll for two or three years in which they weren't all that productive. We could educate them to the point where they could be productive. Auditing complex companies requires intelligence, energy and integrity. You develop people over decades to do that type of work. In pure economic terms, the risk/reward ratio [of becoming a Big Four auditor] has changed dramatically. The best and the brightest are going to see that, and they're going to be reticent to pursue that kind of career."

Antle is not convinced that the best and brightest have made that decision -- yet. Earlier this year, while promoting his new textbook in meetings with accounting professors, he encountered a surge of interest in accounting. "The message I heard all over the country from different professors was the same," he says. "Their students were far more interested in accounting on the whole than they had been before. Now, again, if I were the chairman of a big accounting firm, I would be very concerned [about] whether this interest was going to translate into people going into the accounting profession."

Like so many other factors surrounding public accounting, the future of recruiting into the profession remains unknown. For observers and teachers, that uncertainty makes for an interesting study. For public companies and the Big Four, it could lead to additional cost and risk. "It was interesting before because of the consolidation," Antle says. "The debacles and new regulations create even more uncertainty. The only thing that's certain is that audits are going to cost more."