When bigger is not better.

A common corporate argument against Big Six mergers--one that regulators have to examine--is that the reduced number of large accounting firms means less competition and perhaps higher fees as a result. In fact, regulators worldwide put so much pressure on two of the merging firms--KPMG Peat Marwick and Ernst & Young--that they called off the venture. Nevertheless, the Coopers & Lybrand/Price Waterhouse merger was still on at Journal press time, and no agency has ruled out any future mergers. So the question remains for regulators from Canberra, Australia, to Washington, D.C.: How do you quantify competition? What if in any one industry there are only two major competitors because two firms dominate before the merger and those same two firms dominate after the merger--will competition have changed? It depends how one views the data. Although regulators did not necessarily base their opposition on the data presented below, the results of one study help explain why two giants were forced apart.

Paul L. Walker, CPA, PhD, and Malcolm H. Lathan, CPA, PhD, both of the University of Virginia, did a study of 5,288 companies in 177 four-digit standard industrial classification (SIC) codes in an attempt to analyze the nature of changes in competition before and after the E&Y/KPMG (now defunct) and C&L/PW mergers. Arguments that mergers reduce competition via a loss of a Big 6 firm assume that each Big 6 firm has a significant practice in all industries. In fact, that is simply not the case. It takes economies of scale to be able to audit an industry efficiently and to compete effectively. In many industries there aren't six real competitors but sometimes only two or three.

Consider four specific industries as examples (see exhibit 1). Assume that to have a reduction in competition you must have a reduction in the number of major competitors. Furthermore, measure a major competitor as any auditor that audits at least an equal share in an industry (one-sixth premerger and one-fourth afterward). Using this approach for SIC category "transportation equipment," only two Big 6 firms are major competitors before the merger and there would have been only two afterward. That is, before the merger C&L and D&T dominate the industry with almost 70% of the market. After the merger these same two firms (now C&L/PW and D&T) would audit over 70% of the market. What is the impact on competition? Very little. SIC category "department/ retail stores" shows a similar conclusion. "Pharmaceutical preparation" shows a decrease in competition but "grocery stores" shows an increase. The mixed results show the difficulties of reaching a final conclusion.

Exhibit 1: Big Firm Competitors in
Selected Industries

                        Major            Major
                        Big 6          Proposed Big
                      Competitors      4 Competitors

Transportation
equipment                 2                 2
(cars and trucks)

Department/retail         2                 2
stores

Pharmaceutical            3                 1
preparation

Grocery stores            1                 2

How often does competition change in the 177 industries examined (which represent $7.4 trillion in sales)? Exhibit 2 shows the percentage of 177 industries in which there would have been a change in the number of accounting firms that were major competitors, as the national firms shifted from the Big 6 to the Big 4. It assumes a Big 4 firm would still have needed an equal share--now at 25%--to make it a major competitor. This calculation leads to a drastic change: nearly half (43%) of all industries would have had fewer major competitors to choose from for audit services if the Big 6 had become the Big 4.

Exhibit 2: Competition Change--25%
Share Is Competitor Threshold

Decrease         43%
Increase          1%
No change        56%

Walker and Lathan assumed that a Big 6 firm having an equal share (one-sixth, or approximately 17%), or greater, of audit clients in any industry was a "major competitor." If the firms had become the Big 4, would it still have been appropriate to consider that a 17%-threshold share made a firm a major competitor? That is, would a firm with a 17% share of an industry have been able to compete and survive over the long run? Or should a firm need a 25% share in an industry to consider itself a major competitor and compete effectively? The threshold used radically changes the number of competitors. Exhibit 3 is identical to exhibit 2, except it assumes the 17% figure remains constant: if a one-sixth share makes a major competitor before the merger, one-sixth would still make a major competitor after. This shows that only 16% of all industries would have had fewer major competitors to choose from and that 13% of the industries would have had an increase in competition.

Exhibit 3: Competition Change--17% Share Is
Competitor Threshold

Decrease         16%
Increase         13%
No change        71%

The mere 8-point (25% - 17%) difference in threshold results in a 27-point (43% - 16%) difference in the "decreased competition" figure. In fact, the 17% threshold may imply that the mergers would not have greatly reduced competition. Note that in both exhibits 1 and 2, the majority of the industries would have had no change in number of major competitors to choose from. And Walker and Lathan point out that these figures represent only one method of measuring competition; there are others. Obviously, the firms attempting to merge would argue for the 17% threshold.

The differing projected results for the Big 4 show not only that there was enough hard data to split up one merger but also that regulators now and in the future will have their work cut out for them in reaching a rational decision.