The Big Five Beats a Final Four

Auditing firms' power is already so concentrated that little would be gained if Andersen closes shop. Still, new regulation is needed

By David Henry

The thought that auditing firm Arthur Andersen may soon collapse or be consumed by a rival is no doubt giving tens of thousands of investors a moment of joy. Their numbers include everyone who lost money by trusting the financial reports Andersen approved for Enron, Sunbeam, Waste Management, and Boston Chicken. Doesn't it seem like just deserts to see the firm that shredded Enron documents poised to go into the shredder itself?

Hold on. Truth is, the end of Andersen would likely provide only fleeting satisfaction for investors. If the Big Five accounting firms shrink to the Final Four, the concentration of power that permitted poor auditing in the first place would grow that much worse. Corporate executives could continue to persuade auditors to accept flawed financial reports as technically passable within generally accepted accounting principles. The auditors' work would continue to get mutually satisfactory scores through the industry's practice of what it calls "peer review." And the exaggerated numbers would suck in more investors -- before the inevitable restatements.


  "When you get down to the Final Four, we definitely will continue to have these types of problems, and maybe even more so, because they are so able to control what goes into the rules," says Lynn Turner, a former partner at Coopers & Lybrand (now PricewaterhouseCoopers) who fought bitterly with the big firms while chief accountant of the Securities & Exchange Commission. "Now the Big Five CEOs get together and decide what they are going to do," says Turner. "The Final Four will be able to do it on the golf course."

That's why Andersen's demise would make it all the more important for Washington to enact reforms to protect investors. Economies of scale concentrate power with the big firms, which do virtually all of the accounting work for major publicly traded corporations. The big auditors have the staff resources to draft rules and research issues taken up by industry committees. True, the committees do include representatives from smaller firms who might be more objective about the proper auditing of big companies. But they don't have the clout to back up their views. Smaller firms "struggle so much that the profession actually pays them for their time on these committees," says Turner.

Losing Andersen would also mean losing an opportunity to address the industry's shortcomings and construct a model auditing firm. Paul Volcker, the former chairman of the Federal Reserve and chairman of the industry-funded International Accounting Standards Board, is trying to achieve just those goals with Andersen. He heads a panel Andersen asked to recommend changes in its auditing practice.


  On Mar. 11, Volcker's panel made initial recommendations, including separating Andersen's auditors and consultants into independent partnerships, empowering a central group of partners with "unambiguous authority" on accounting judgements over partners at client offices, and prohibiting personal tax work for executives of firms Andersen audits.

The new rules would go a long way toward returning Andersen to its high professional standing and away from the days when it rewarded auditors for "cross-selling" products to the very executives they were supposed to oversee. If Andersen goes under, the remaining firms won't have to compete with Volcker's model of integrity -- even though integrity should be of prime concern right now to corporations eager to reassure nervous investors.

And don't hold out hope for a new-model accounting firm to emerge quickly and challenge the Big Four. The barrier to small entrants is enormous. To audit the global operations of major companies, a firm needs to be big and have international offices in place. It also needs capital and the ability to spread central costs over many clients. The average Big Five firm has 2,600 audit clients. The lack of companies with a similar base explains why no other firms ever moved into the vacated ranks of what used to be the Big Eight.


  With a Final Four, federal regulators and lawmakers would need to act decisively. An important step would be establishing an independently funded regulatory board, with subpoena power and with membership dominated by the public, but including a few certified public accountants not beholden to accounting firms. The current Public Oversight Board is weak and vulnerable. It had its funding cut off in spring, 2000, by the American Institute of Certified Public Accountants during a dispute with the big firms.

Companies also should be required to change auditors at least every seven years. Critics of rotation say auditors are most likely to be tricked the first year on the job. But the biggest investor losses have come years after firms started working for clients. Other simple steps would help, too. For example, Congress should specifically outlaw attempts by CEOs to coerce or mislead auditors.

Finally, the SEC should find ways to seed competition for the big firms. It could prod Wall Street to hire midsize firms for audits of young U.S. companies making initial public offerings. Other audit firms could serve investors well in that role, including BDO Siedman, McGladrey & Pullen, and Grant Thornton. But in the meantime, the best hope for investors lies in rehabilitating Andersen, not sending it to death row.

Henry covers accounting issues for BusinessWeek in New York

Edited by Douglas Harbrecht

Before it's here, it's on the Bloomberg Terminal.