COMPETING FOR EMERGING CORPORATE CLIENTS: A STUDY OF INDEPENDENT AUDITOR CONCENTRATION.

Fisher, Steven A.

Abstract

In recent years competition among the largest public accounting firms has intensified as the so-called Big 8 CPA firms have consolidated into the "Big 5" firms. With audit fees being dependent to a large extent on client size and profitability, growth minded independent auditors are engaged in competition for the largest corporate clients as well as emerging corporate clients. The purpose of this research effort is to generate an understanding of independent auditor competition for emerging corporate clients represented by "Forbes 200 Best Small Companies in America" and for major corporations listed in the "Fortune 500."

The study provides and analyzes independent auditor market shares utilizing a series of market concentration ratios. The results indicate that market concentration has increased in both the "Forbes 200" and "Fortune 500" audit markets. As a consequence, the differences between the "Big 5" and smaller independent auditors are being accentuated. The smaller independent auditors are increasingly unable to compete with the largest firms for the largest and most desirable corporate clients.

Competing for Emerging Corporate Clients: A Study of Independent Auditor Concentration

Several thousand certified public accounting (CPA) firms operate in the United States. These firms range in size from sole practitioners to international organizations employing thousands of professionals and generating several billion dollars of revenue. The market for independent audits is highly stratified with large CPA firms auditing the largest clients and local firms servicing smaller clients. In general, smaller CPA firms are unable to compete with large firms' vast resources of personnel and technical capabilities.

In recent years, the accounting profession has experienced a wave of merger activity which has consolidated the so-called Big-8 public accounting firms into a group of mega-firms termed the Big-5. As competition intensifies, the Big-5 firms continue to dominate the market for major corporate clients. These firms have gained their market positions by offering a broad array of accounting and related services.

To maintain their individual positions in today's competitive audit market, Big-5 firms are engaged in intense marketing efforts, price competition, and are seeking to expand their client bases (Sommer, 1989). As many of their major audit clients begin to experience slower rates of growth, Big-5 firms are actively courting emerging corporate clients. With audit fees being dependent to a large extent upon client size and profitability, growth-minded Big 5 firms are engaged in intense competition for emerging corporate clients with outstanding growth potential. The independent audit oftentimes opens the door for the CPA firm to market other more profitable services, such as management consulting, to newly acquired client. This competition for emerging corporate clients pits the Big-5 firms against smaller accounting firms as well as against one another (Minyard & Tabor, 1991).

The purpose of this article is to generate an understanding of the extent of independent auditor competition for emerging corporate clients. Through the use of market concentration ratios, a comparative analysis is made of the trends in independent auditor competition in the markets for emerging corporate clients represented by the "Forbes 200 Best Small Companies in America" and for major corporations listed on the "Fortune 500." Analysis is made of independent-auditor concentration at five-year intervals, including 1981, 1986, 1991, and 1996. Additionally, concentration measures are presented for subsequent to the recent merger of Price Waterhouse and Coopers and Lybrand. The study's results highlight competition between the Big-8/Big-6/Big-5 and other accounting firms over the past two decades. The results should be useful to independent auditors, clients, and financial statement users in understanding the changing nature of competition in the audit industry.

Measuring Market Concentration

Market concentration is a measure of the extent of competition (or non-competition) in a particular market. When competition is high and individual firms have relatively low market shares, it is likely that firms will be price-takers rather than price-setters. In concentrated markets characterized by few firms with large market shares competition is likely to be imperfect and firms will engage in joint rather than independent actions (Wootton, Tonge, and Wolk, 1994).

Economists have developed various measures for determining the degree of market concentration. Common measures include the two-firm and four-firm concentration ratios and the Herfindahl Index. The two-firm and four-firm concentration ratios represent the total audit market share held by the dominant two or four independent auditors.

The Herfindahl Index provides a useful way to include all firms in an assessment of the degree of market concentration (Theil, 1972). It is calculated by summing the squares of the relative market shares of the individual independent auditors. This means that higher relative market shares receive a greater weighting than lower relative market shares. Therefore, the Herfindahl Index increases with greater market shares held by one or a limited number of independent auditors. In this effort market share represents the proportion of the Forbes 200 or Fortune 500 firms that are clients of a particular independent auditor.

To illustrate the use of the Herfindahl Index, let us assume that an audit market consists of one hundred client corporations and two independent auditors--A and B. In year one, 50 of the corporations use independent auditor A and the other 50 use B. In the second year, A is the choice of 90 corporations while the remaining 10 use B. Finally, in year three, A is used by all 100 of the corporations and none selects B. The relative frequencies and the calculated Herfindahl Indices for each year are presented as follows:

Year A B Herfindahl Index

1 0.5 0.5 [0.5.sup.2] + [0.5.sup.2] = 0.50
2 0.9 0.1 [0.9.sup.2] + [0.1.sup.2] = 0.82
3 1.0 0.0 [1.0.sup.2] + [0.0.sup.2] = 1.00

This example demonstrates that the Herfindahl Index increases with greater market dominance by one or a limited number of firms. The Index varies between zero (no market concentration and an infinite number of independent auditors with the same market shares) and one (one independent auditor for the entire market). Although simple, the Herfindahl Index provides a universal means that can be used to measure and compare the degree of concentration in various markets.

Results and Data Analysis

While the annual Fortune listing contains the 500 largest industrial corporations in terms of sales, the "Forbes 200 Best Small Companies in America" consists of publicly traded United States-based corporations with annual sales between $5 million and $350 million. Equity must be in the form of common shares which excludes limited partnership units, real estate investment trusts, and closed-end mutual funds. According to Forbes, these firms must show consistent increases in sales, earnings, and return on equity during the previous five years. Firms with declining sales and/or earnings were automatically screened out, as were stocks priced under $5. To ensure reasonable liquidity, corporations with fewer than 1 million shares outstanding or an average daily trading volume of under 1,000 shares were eliminated from the list. Similar criteria were used to compile the 1981, 1986, 1991, 1996, and 1998 Forbes 200 listings.

Companies are ranked by their five-year average return on equity. Furthermore, no company can have a net loss in the previous five years and must have a net income of at least $1 million in the most recent year. Information on the independent auditors for each of the corporations listed on the Forbes 200 and the Fortune 500 was gained primarily from Who Audits America and Moody's Industrials.

The results which are presented in Tables 1 and 2 indicate that the Big 8/6/5 firms continue to have an overwhelming presence in the Fortune 500 audit market. In recent years the Big 5 share of the Fortune 500 audit market has risen to slightly over 99 percent. In fact, only two non-Big 5 public accounting firms--BDO Seidman and Grant Thornton-- together have three Fortune 500 clients.

Table 1 Profile of the Fortune 500 Audit Market

 1981 1986 1991 1996 1998

Concentration ratios:

2-Firm Ratio 0.340 0.377 0.409 0.402 0.512
4-Firm Ratio 0.589 0.661 0.733 0.720 0.870
Herfindahl Index 0.129 0.137 0.169 0.163 0.212
Equally Distributed Shares 0.111 0.111 0.143 0.143 0.167

Aggregate Market Shares:

Big 8/6/5 96.8% 95.8% 98.2% 97.0% 99.4%
Non-Big 8/6/5 3.2 4.2 1.8 3.0 0.6

Individual Big 8/6/5
Firm Market Shares:

Arthur Andersen 15.0% 17.6% 18.6% 18.2% 19.0%
Deloitte, Haskins
 & Sells(*) 11.7 7.8
Touche Ross(*) 5.1 5.3
Deloitte & Touche(*) 12.6 16.2 16.7
Ersnt & Whinney(**) 13.2 14.2
Arthur Young(**) 10.9 7.4
Ernst & Young(**) 21.7 22.0 22.7
KPMG Peat Marwick 11.5 12.1 13.8 12.8 12.4
Price Waterhouse(***) 19.0 20.1 19.2 15.6
Coopers & Lybrand(***) 10.3 11.2 12.3 12.2
PricewaterhouseCoopers(***) 28.5

(*) Deloitte, Haskins, & Sells and Touche Ross merged to form Deloitte & Touche in 1990.

(**) Ernst & Whinney and Arthur Young merged to form Ernst & Young in 1990.

(***) Price Waterhouse and Coopers & Lybrand merged to form PricewaterhouseCoopers in 1998.

Table 2 Profile of the Forbes 200 Audit Market

 1981 1986 1991

Consentration Ratios:

2-Firm Ratio 0.253 0.253 0.425
4-Firm Ratio 0.465 0.474 0.749
Herfindahl Index 0.081 0.094 0.166
Equally Distributed Shares 0.111 0.111 0.143

Aggregate Market Shares:

Big 8/6/5 75.1% 83.0% 93.3%
Non-Big 8/6/5 24.9 17.0 6.7

Individual Big 8/6/5 Firm
Market Shares:

Arthur Andersen 13.2% 12.9% 21.5%
Deloitte, Haskins, & Sells(*) 8.4 7.7
Touche Ross(*) 6.2 10.2
Deloitte & Touche(*) 13.3
Ernst & Whinney 12.1 12.4
Arthur Young(**) 6.2 9.8
Ernst & Young(**) 21.0
KPMG Peat Marwick 11.4 7.7 19.0
Price Waterhouse(**) 7.70 10.8 7.7
Coopers & Lybrand(***) 9.9 11.3 10.8
PricewaterhouseCoopers(***)

 1996 1998

Consentration Ratios:

2-Firm Ratio 0.400 0.470
4-Firm Ratio 0.710 0.800
Herfindahl Index 0.153 0.192
Equally Distributed Shares 0.143 0.167

Aggregate Market Shares:

Big 8/6/5 92.5% 95.5%
Non-Big 8/6/5 7.5 4.5

Individual Big 8/6/5 Firm
Market Shares:

Arthur Andersen 20.0% 25.5%
Deloitte, Haskins, & Sells(*)
Touche Ross(*)
Deloitte & Touche(*) 18.0 16.0
Ernst & Whinney
Arthur Young(**)
Ernst & Young(**) 20.0 17.0
KPMG Peat Marwick 13.0 15.5
Price Waterhouse(**) 11.5
Coopers & Lybrand(***) 10.0
PricewaterhouseCoopers(***) 21.5

(*) Deloitte, Haskins, & Sells and Touche Ross merged to form Deloitte & Touche in 1990.

(**) Ernst & Whinney and Arthur Young merged to form Ernst & Young in 1990.

(***) Price Waterhouse and Coopers & Lybrand merged to form PricewaterhouseCoopers in 1998.

The results also indicate the Big-5 has gained a similar degree of dominance in the Forbes 200 audit market. The Big 5 share of the Forbes 200 audit market has increased from 75 percent in 1981 to 95 percent in 1998.

The two-firm and four-firm ratios indicate that both the Fortune 500 and Forbes 200 audit markets have become increasingly concentrated in recent years. However, both the two-firm and four-firm ratios indicate slightly greater concentration in the Fortune 500 audit market. During the 1981-1998 period, the two-firm ratio increased from 0.340 to 0.512 in the Fortune 500 market, while the change in the Forbes 200 market was from 0.253 to 0.470. The four-firm ratio reflects a change from 0.589 to 0.870 in the Fortune 500 market and an increase in the Forbes 200 market from 0.465 to 0.800.

These results are supported by the Herfindahl Index which takes into account the market shares of all auditors in the market. Over the 1981-1998 period, the Index increased to 0.212 from 0.129 in the Fortune 500 market, while the Index changed from 0.081 to 0.192 in the Forbes 200 market.

From the results it is obvious that there is increased concentration in both markets. However, this does not mean that both markets are necessarily concentrated with little or no competition among auditors. The Herfindahl Index results must be compared with a measure of equally distributed market shares. For example, an equally distributed audit market consisting of the Big-8 plus the non-Big-8 treated as a single firm would have a 0.111 (1/n) Herfindahl Index. An equally distributed Index for the Big-6 would be 0.143 and for the Big-5 market 0.167 (Stigler, 1950; Grossack, 1965).

The results indicate that prior to the merger of Price Waterhouse and Coopers and Lybrand the Big-8 and Big-6 had Herfindahl Indices approximating the measures for equally distributed market shares. However, subsequent to the merger of Price Waterhouse and Coopers and Lybrand there is a pronounced difference between the Herfindahl Index and the equally distributed market share.

The recent auditor merger activity has affected individual firm market shares in both the Fortune 500 and Forbes 200 audit market. In 1981 Price Waterhouse lead the Fortune 500 market while Arthur Andersen had the greatest share of the Forbes 200 market.

In 1998 the merged firm of PriceWaterhouseCoopers lead in the Fortune 500 market while Arthur Andersen is dominant in the Forbes 200 market.

Conclusion

The results indicate that the Big-5 firms continue to be powerful competitors for both Fortune 500 and emerging corporate clients. The recent merger activity is intensifying the Big-5's strength in offering a broad range of accounting, tax, and management consulting services. As a consequence, the differences between the Big-5 and smaller accounting firms are being accentuated (Lamarre, 1989).

Smaller accounting firms are unable to directly compete in all areas with the Big-5 firms. To survive and prosper smaller firms will have to develop specialties and carve out niches in the market (Nelson, 1990). For example, smaller firms may develop and emphasize industry specialties, such as real estate or technical expertise in areas of information systems. However, over the long run, smaller firms may possess certain economies of scale advantages over the Big-5 in servicing medium and small sized clients.

References

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Wootton, C. W. and S. D. Tonge, and C. M. Wolk (1994). Pre and post big 8 mergers: comparison of auditor concentration. Accounting Horizons. September, 58-74.

Steven A. Fisher Professor, Department of Accountancy California State University Long Beach, CA 90840-8504