Andersen Is Toast. But Its
Progeny Can Still Flourish.

Arthur Andersen doesn't need a white knight. It needs a chain saw.

Mr. Volcker, the former Fed chairman now in charge of resuscitating the company, shouldn't stop with separating consulting from auditing. He should go further and break up the auditing business. Forget mergers. Andersen's strategic move should be in the opposite direction -- to split into three or four functionally oriented and invigorated audit firms.

A merger of Andersen with a Big Four accounting firm is, in my opinion, a worst-case scenario. Competition in the accounting industry is already at a dangerously low level. U.S. corporations can seldom find an auditor that is not also auditing their competitors -- a real concern for innovative companies trying to shield valuable intellectual assets from spying eyes. Another industry merger or a fire sale of Andersen's assets to a "big four" would only further erode efficiency and effectiveness.

The Enron/Andersen saga brings to the surface another vulnerability of the highly concentrated accounting industry as well: systemic risk. The failure of an accounting firm leaves thousands of public companies stranded without an effective auditor. Blue Chip, Merck, Delta and Federal Express, which recently dropped Andersen, will have no problems getting another auditor. But hundreds of smaller companies in depressed industries (e.g., telecom, biotech), may be seen as too risky and problematic to take on.

Those transition difficulties can have very real effects in the marketplace. Substantially higher audit fees and reporting delays, among other dislocations, can be expected. Investors, relying on a smooth flow of credible information, will be the ultimate losers. What's more, the systemic failure risk will increase with an Andersen merger. Industry concentration can do little but tank public efforts to enhance auditor efficiency and independence.

The last quarter century witnessed an unprecedented wave of "demergers" in the form of corporate spinoffs, breakups, and carveouts. Most conglomerates operating across industry boundaries split up by spinning off non-core operations and increasing focus on their unique competencies. Airlines spun off hotels and flight reservation activities (AMR spinning off Sabre), and chemical companies shed drug development and oil businesses (DuPont selling Conoco). AT&T's breakup, Merck's spinoff of Medco and General Electric's plan to sell its insurance operations are other examples.

In most cases, it was consumers that benefited. And not only in the form of competition, service and efficiency. Breakups also allowed investors to better monitor the companies and, recently, to alleviate accounting concerns. Tyco's proposed breakup is a case in point.

Auditing bucked the trend. Successive mergers, unchecked by regulators, decimated midsized auditors and resulted in the current Big Five. Those giants are engaged in auditing, but auditing, just like manufacturing or trading, isn't a core competency. Effectively auditing, for example, software producers or insurance providers or HMOs requires specialized skills. The industries are different enough to require specialized procedures and know-how.

This is where Andersen's breakup comes in. Extreme as it may sound, splitting the company into three or four new accounting firms structured along industry/technology lines could extricate Andersen from its predicament. Its current specialization is in energy (though, after Enron, some may doubt that), utilities, pharmaceuticals, financial services, certain technology sectors, media and communications. The new Baby Andersens could form along these sectors.

With new names and independent bona fides, they would also shed the taint of the beleaguered parent company. The result would be companies both more nimble and more cost efficient than the Big Four. The new breed of auditing firms would breathe life into the accounting industry.

Regulators both at the Securities and Exchange Commission and the state level can help by smoothing out red tape associated with the formation and certification of new firms and by expediting legal action against Andersen. Extension of reporting deadlines to Andersen's clients will also help. A favorable reaction by policy makers and the Justice Department will go a long way toward solving the problem.

Past mergers of audit firms were justified or excused by the economies-of-scale argument for serving global clients, There is, of course, some validity to this line of reasoning, but mammoth companies also see diseconomies of scale, weakened governance and loss of control. Evidence the current squabble about who in Andersen gave the order to shred documents -- Houston or Chicago headquarters.

With Andersen having 85,000 people world-wide (close to 28,000 in the U.S.) and almost 5,000 partners, a breakup will not exactly result in inefficient midgets. The proposed three or four Baby Andersens will still be large enterprises, with hundreds of partners and tens of thousands of employees each, capable of auditing large, multinational corporations. Even if they will not each have representation in every corner of the globe, alliances with local accountants can extend their reach. Dell, Cisco and Nike successfully outsource production and marketing; why shouldn't accounting firms?

Breakups are never easy, but this one could bring real and healthy change to the accounting industry. If that happens, all Enron's pain would not have been in vain.

Mr. Lev, an accounting and finance professor at New York University's Stern School of Business, is the author of "Intangibles: Management, Measurement, and Reporting" (Brookings, 2001).

Updated March 18, 2002