Updated from 7:17 a.m. EDT

Have the Big Four become too big to fail?

That's the question accounting experts and policymakers arepondering as the Department of Justice reportedly mulls whether toindict accounting giant

KPMG

over alleged solicitation of illegaltax shelters.

Such an indictment could inevitably lead to a meltdown at KPMG akin to what happened to

Arthur Andersen

after its own indictment -- the loss of thousands of jobs, a major upheaval in auditing relationships and a further narrowing of a market that many analysts believe already lacks sufficient competition.

"It's an awkward spot," says Jack Ciesielski, publisher of the

Analyst's Accounting Observer

, an industry newsletter. If thegovernment

lets KPMG off with a light punishment, it might encourage more bad behavior by the company or other audit firms. On the other hand, he adds, "If they go ahead and gut it, I'm not surethey've done anyone any favors."

But the debate over how to deal with KPMG hasbroader implications as well. Since the Enron and WorldCom scandals earlier this decade, the federal government and other regulators haveput in place a series of reforms, including the landmark Sarbanes-OxleyAct, that have stepped up the scrutiny of accounting firms and theaudits they conduct.

The question is whether those reforms go far enough. Some accounting analysts don't believe they do. They want new rules to ensure even greatertransparency and independence at the Big Four -- or a forced breakupthat would ensure more competition.

"People are not focusing on what the real issue is: That you don'thave enough

competition at the four," says Lynn Turner, former chiefaccountant at the

Securities and Exchange Commission

and the head ofresearch at proxy adviser Glass Lewis. "If the firms get to thinkingthey are untouchable, what will be the quality of their work goingforward?"

The Final Four

The concerns about competition in the accounting space and how todeal with bad actors follows a consolidation over the last 20 years that narrowed the number of top firms from eightto five -- and then down to four after

Arthur Andersen's indictment.

As the competition narrowed, each of the remaining firms --KPMG,

Ernst & Young

,

Deloitte Touche Tohmatsu

and

PricewaterhouseCoopers

-- has assumed responsibility forauditing a large chunk of the universe of public companies.

For instance, Glass Lewis collected data on 482 publiccompanies in the

S&P 500

and found that in 2004 only four companies used an auditor outside of the Big Four, marking them as "a very powerful oligopoly at this point," according to Itzhak Sharav, a professor of accounting at Columbia University.

(Representatives for Deloitte and KPMG declined to comment for thisstory. Representatives for PricewaterhouseCoopers and Ernst & Young didnot return calls seeking comment. A Justice Department representative declined to comment on the KPMG case.)

Beyond their market dominance, the importance of the Big Four hasbeen magnified by recent reforms. Audits are now a crucial tool for uncovering corporate fraud, and regulators have steppedup scrutiny of them, which increases the demand for more thorough audits.

And accounting firms' responsibilities have broadened, thanks to aSarbanes-Oxley provision that makes them responsible for assessing andreporting on the state of companies' internal controls -- essentially,

sets of checks and balances intended to prevent corporate fraud.

Compounding the problem is that recent scandals havetarnished the reputations of all the major firms, not just KPMG. Ernst& Young, for instance, was

HealthSouth's

auditor during its accounting scandal. PricewaterhouseCoopers was auditing

Tyco

(TYC)

while Dennis Kozlowski was looting the company of hundreds of millions of dollars.

Executives at the Italian unit of Deloitte are facing trial on charges related to

the

Parmalat

scandal. Even

Grant Thornton

-- the fifth-biggestaccounting firm, but a relative shrimp in the industry -- has been hit,with executives indicted in the Parmalat matter.

No Nukes

But a criminal indictment, particularly in the accountingindustry, is a blunt tool, analysts say. If convicted, a firm could nolonger certify the accounting statements of public companies,effectively putting it out of business, notes Jeff Brotman, managing partner of the Ledgewood law firm and an accounting professor at the University ofPennsylvania Law School.

An indictment alone was enough to bring down Arthur Andersen, leading clients toabandon the company en masse.

Given the Big Four's prominence, and resulting loss of jobs and accountingrelationships if one of the companies were dissolved, many accounting experts argue against pursuing a criminal indictment against KPMG or any other firm.

Indicting an accounting firm is a "nuclear option" because of thedamage it would cause, says Brotman.

"I think the nuclear option should be taken off the tableentirely," Brotman says, adding that "the

Big Four firms are too big,and their importance is too profound and affects too many people" touse that option.

Even Grant Thornton, which would presumably pick up business ifKPMG dissolved, thinks the government should avoid thatscenario, says Cono Fusco, managing partner in charge of strategicrelationships at the firm.

"One fewer firm reduces the number of choices," says Fusco. "Ithink we need more choices, not fewer choices."

Even if an indictment is off the table, prosecutors are notpowerless to constrain auditors' behavior, accounting experts say. Thenew regulations created the Public Company Accounting Oversight Board,which replaced a largely toothless organization and is charged with keeping a close eye on auditors.

Additionally, prosecutors can indict individual partnersinvolved in fraudulent actions, fine firms or even bar them fromtaking on new clients, they note.

Even if the firms themselves are too big to fail, that doesn't meanthat their partners "can run off and do what they want," says CharlesMulford, an accounting professor at Georgia Tech's College ofManagement. "There's plenty of penalties that can be used to make surethese accounting firms -- or partners within them -- act within thelaw."

As for competition in the industry, while few accounting expertsare happy with the current situation, even fewer think much can orshould be done about it. And some think that the market will sortitself out.

Brotman, for instance, believes that some Big Four partnerswill split off and form niche firms in coming years that will cater toindividual sectors, such as the financial services industry.

But Glass Lewis' Turner thinks such forecasts are "pipe dreams." The bigpublic companies need auditors that have international offices, whichgenerally only the Big Four have. Setting up that internationalpresence would be prohibitively expensive for any of the smallerplayers -- or for niche firms, he says.

Still, Turner says regulators shouldn't let the present lack ofcompetition limit their options in dealing with accounting firms thatgo astray, arguing that prosecutors should remain open to indictingaccounting firms when needed. Regulators could force the breakup ofthe Big Four to introduce more competition, he notes.

In addition, Turner says individual indictments can make it difficult to secure a conviction, as seen recently in the case against formerHealthSouth CEO Richard Scrushy, he says. Meanwhile, currentregulations don't go far enough to ensure that accounting firmswill act in the public interest, Turner says.

Because the accounting firms are private partnerships, they don't have to adhere to many public-company rules, which include having a majority of independent directors. But because of their status as regulated companies, they could be required to do so, Turner says.

"It's only when you get that outside board that you get a change inculture at these firms," he says. "Without that, you won't have it."

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