February 19, 2013

Big Four Audit Model Produces Surprising Results

University of Nebraska-Lincoln Assistant Professor of Accountancy Scott Seavey and colleagues study the Big Four auditing firms and the effect of the concentration of market power has on the quality of audits.
All publicly traded companies in the U.S. are required by the Securities and Exchange Commission to file periodic financial statements that have been certified by an independent auditor. With the demise of Arthur Andersen in 2002 in the aftermath of the Enron crisis there remains, practically, only four auditing firms for large companies to choose from. The four firms are commonly referred to collectively as the “Big Four.” In fact over 98 percent of all assets of Fortune 500 companies are audited by just those four accounting firms. Regulators in the U.S. and Europe have expressed great concern at the concentration of market power by the Big Four and what effect it may have on the quality of audits. As a result, U.S. regulators have recently suggested requiring that companies switch auditors every few years and European regulators have actually suggested breaking up the Big Four into a greater number of smaller firms. Yet in light of these heightened concerns, there is very little actual evidence about what effect, if any, the increased concentration in the audit market has had on audit quality.
The study finds that the concentration of market power among the Big Four audit firms in fact does not harm audit quality as regulators suggest. Gathering and analyzing evidence from 42 countries, Seavey and colleagues somewhat surprisingly “find just the opposite; countries with a higher concentration of audits performed by the Big Four have better overall audit quality.” The authors attribute this to the strong reputation of these firms (and the incentive to keep those reputations), their hiring and training practices, and the large network of experts and specialists available to Big Four firms that are not available to smaller audit firms. 
They also find that there is a “trickle-down” effect to smaller audit firms. In those countries with greater Big Four dominance, audit quality is higher not just for clients of the Big Four firms, but also for clients of all other auditors. They suggest that clients in these markets as a whole demand higher quality audits, and that lower quality auditors are driven out of the market.
In contrast, their study also finds that should only one or two of the Big Four firms dominate a country, then audit quality suffers. Their conclusion is that, “concentration among the Big Four is not the problem as regulators suggest, but concentration within the Big Four (in other words, domination by one or two firms) is problematic.” Thus their results suggest that regulators should focus their attention not on breaking apart the perceived oligopoly of the Big Four, but on ensuring that no one Big Four firm dominates a local market or industry.

In analyzing evidence from multiple countries, their findings have implications not just for U.S. markets but also for European, Australian and Asian markets, where many of the same concerns over audit market concentration have been raised by respective regulators.
This study was published in June 2012 in the early view version of Contemporary Accounting Research (forthcoming in an issue). Coauthors of the study include Jere Francis at University of Missouri and Paul Michas at University of Arizona.

Research located at http://onlinelibrary.wiley.com/doi/10.1111/j.1911-3846.2012.01156.x/full