Are the Big Four Audit Firms Too Big to Fail?

Although the number of audit firms has decreased over the past few decades, concerns that the "Big Four" survivors have become too big to fail may be a stretch. Research by professor Karthik Ramanna and colleagues suggests instead that audit firms are more concerned about taking risks.
by Martha Lagace

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, 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 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.

About the Author

Martha Lagace is senior editor of Working Knowledge.

    • Mike Flanagan
    • Purch Mgr
    Nobody is too big to fail.
    • Mark F. O'Connor
    • CEO, Monadnock Research
    In today's post-Andersen world, "too big to fail" seems to be the approach taken by most global regulators, including those in the US. More aggressive regulatory reforms will likely come first in the European Union.

    My firm has done some research over the last several years on the risks posed by increasing diversification of the books of business of large firms that we think-of as auditors, but who actually have large books of business in consulting and other advisory areas. As these firms have grown in recent years, that growth has not come from audit.

    The collective risks posed by this increasing conflict of interest becomes more difficult to police and mitigate by the firms themselves and by regulators crafting effective reforms that ensure audit integrity without excessively burdening clients and the auditors that serve them.

    The point on complexity making it one of the least scrutinized areas is a good one, in my view. A guest post I did almost two years ago, "Honest Services Crisis", highlights many of the key issues. It can be found at Francine McKenna's Re:TheAuditors Big Four watchdog Weblog. I'm in the middle of putting together our annual update on this now, and you can assume the collective risk exposure highlighted in that piece has continued to rapidly increase at all firms.
    • Anonymous
    Risk is not of whether Big 4 is too big too fail. Risk is that individuals in Big 4 are failing.
    • Lesley
    • Audit Manager
    Yes - I believe that failure may be approaching for the mere fact that audit firms comprise a lot on quality and client service and are focused on chasing revenue.
    • Harlyn Sianturi
    • Manager Risk & Asset, PT Kaltim Prima Coal
    Moral hazard is the center of this issue; therefore, moral standard and application by persons in the big four makes the difference, to fail or not.
    • Estee Lim
    • Financial Controller
    Very interesting article.
    • Anonymous
    The paragraph "Good for Industry" is to me a prime example of professorial bulldust - full of speculation and supported by little factual evidence. Auditors audit financial reports and accountants prepare them in businesses that matter. That the auditor should focus on "verifiability" and not provide enough "flexibility" seems to be addressing the wrong priorities. What the oligopolistic auditors need to guard against is excessive "innovation" by the businesses being audited which distort financial reports (usually to the benefit of those preparing them). "Verifiability" is not enough to describe the attitudes, processes and procedures auditors need to adopt in countering manipulation and deceit.
    • Anonymous
    Does anyone remember Arthur Andersen?
    • Michael Moshiri
    • Speaker, Author, Big 4 Management Consulting Expert
    Great article. I would suggest the following additional reasons for the risk-averse stance the Big 4 are taking:

    The partners in a Big 4 firm contribute a much larger portion of their income to hedge liabilities associated with the audit functions of the firm (compared to other similarly large firms in other industries, e.g., law firms). So the personal monetary impact of risky business practices is already quite high.

    Plus, the majority of the Big 4 partners either witnessed the demise of Arthur Anderson with great concern, or experienced it first-hand. So the sour taste of the consequences is still fresh.

    Self-preservation is indeed a more powerful motivator than greed. And having served with EY, PwC, and Deloitte, I can say that every partner, director, and sr. manager I worked with in those firms is keenly aware of the need for persistent vigilance to avoid unnecessary risks.
    • Bill Magrogan
    • Biz Prof, U of South Carolina
    Perhaps the key here is to independeny audiit Final Four independent audits on a proven sampling size basis. And, publish the results!
    • Kapil Kumar Sopory
    • Company Secretary, SMEC(India) Private Limited
    The definite continuation of any firm - of auditors as well - depends on the quality of service it renders. Auditors' role is well defined and it can be performed without any ambiguity. However, it is a matter for the concerned auditor to be extremely watchful and vigilant to keenly go into everything deeply and call a spade a spade without fear or favour. Let the truth prevail under all circumstances.
    There is one lacuna in all this- that the auditor is paid by the firm itself which factor at times plays a vicious role of making the auditor give some concession(s) in the reporting to favour the paymaster. This is a trap which must be avoided. If discovered, stringent action needs to be immediately initiated against the concerned person and the relevant portions of the audit report got reexamined. Continued laxity on the part of the audit firm to shield the wrongdoer leads to tarnishing the firm's image leading to its decay.
    • Anonymous
    Look at the size of the pensions retired and retiring partners receive. Then look at how much outsourcing there is. Ther are few associates and seniors left. Every job is way too thin. The cost cutting implies that the partners' salaries, bonuses and pensions are not sustainable
    • Yaw Opoku
    Well, just as Arthur Andersen failed, so could the other big four.