NEW YORK (CNN/Money) - Embattled accounting firm Arthur Andersen LLP, which is searching for a merger partner as it nears collapse, suffered a setback Wednesday as rival Big Five firm Ernst & Young opted out of negotiations.

New York-based Ernst said that as long as Enron and other Andersen litigation is unresolved, the accounting firm will not pursue a merger.

Andersen is looking to merge or sell all or parts of its operations and has held talks with other Big Five accounting firms including KPMG and Deloitte & Touche. It hopes to settle on a deal this week, a source with knowledge of the discussions told CNN/Money.

Chicago-based Andersen, the smallest of the Big Five accounting firms, has lost many large audit clients recently as the Enron scandal continues to cause companies to switch auditors and dump Andersen. So far, FedEx Corp. (FDX: Research, Estimates), Merck & Co. (MRK: Research, Estimates) and Freddie Mac (FRE: Research, Estimates) all have dropped Andersen.

Also on Wednesday, consumer finance firm Household International (HI: Research, Estimates) became the latest company to drop Andersen as its auditor. The company is appointing KPMG as its auditor for 2002.

In a statement Household International said, "Household has valued the quality of work and excellent service provided by Arthur Andersen during the course of the company's relationship with the firm. However, due to the current uncertainty about the future direction of Arthur Andersen, Household's Board of Directors felt that it was in the best interest of the company to make this change."

But now that Ernst is out, merger candidates are dwindling. Andersen also is presently not in talks with PricewaterhouseCoopers, the largest U.S. accounting firm, the source said.

Only Deloitte & Touche has admitted to holding discussions while KPMG has remained mum. Sources close to Andersen, once the most powerful accounting firm in the world, continue to insist that negotiations could result in deal.

"There are robust discussions going on," a person with knowledge of the talks said.

Andersen is currently trying to resolve possible criminal charges with the Department of Justice over its role in the collapse of Enron Corp. The firm has admitted that some of its staff shredded Enron documents. Andersen is also trying to settle shareholder lawsuits against the firm.

Art Bowman, of Bowman's Accounting Report, discounted the firm's chances of combining with any of its rivals. "No one will touch Andersen as long as the DOJ issue is out there and no one knows how to handle the liability issue," he said. "I don't think it will merge for now."

Andersen's actions this week represent a rapid about-face for the firm, which was once one the most powerful and ferocious in the accounting industry. Two years ago the firm lost its first place ranking when it split with Andersen Consulting (now known as Accenture) and now ranks as the smallest of the Big Five, with 85,000 employees and $9.3 billion in global revenue for the fiscal year ended Aug. 31.

"Andersen has gone into bunker mentality and is acting like a beaten dog," Bowman said.

Ernst & Young was seen as the least likely merger candidate for Andersen due to its conflicting culture, while Deloitte is the most likely partner, industry observers said. KPMG is more interested in the firm's European operations, observers said.

A merger of Andersen and Deloitte would make the combined company the largest U.S. based accounting firm, surpassing PricewaterhouseCoopers, with $9.5 billion in revenue. A merged Andersen-KPMG also would rank as the top accounting firm in the nation and would have revenue of $9.3 billion in the United States. An Andersen-Ernst merger would place the company second to PwC with $8 billion in revenue, according to Art Bowman of Bowman's Accounting Report.

KPMG and Andersen declined to comment. PwC could not be reached for comment.

Andersen is currently in talks with both the DOJ and the Securities and Exchange Commission to secure a settlement. The accounting firm is scrambling to meet a Thursday deadline to resolve possible criminal charges with the DOJ and could plead to lesser charges or face a criminal indictment.

However, the firm hopes to avoid any guilty pleas stemming from its role in Enron's collapse.

Andersen has admitted it shredded Enron documents but has tried to place the blame solely on dismissed partner David Duncan, who said he was advised by an in-house Andersen lawyer to destroy the documents.

On Monday, CNN/Money reported that the firm could reach a settlement with the DOJ this week.

Andersen also is trying to reach a resolution with the SEC, which likely will not come before Friday, the source said. The SEC talks are not directly related to the firm's negotiations with the DOJ, another source familiar with the negotiations told CNN/Money. Any deal with the SEC would seek to get some form of financial restitution for individual investors, the person said.

Press reports have said the SEC deal calls for Andersen to pay more than $100 million in fines and set up a fund to compensate Enron shareholders. The $100 million fine would represent the largest civil penalty levied against an accounting firm and greatly trumps Andersen's last pay out to the SEC.

Last summer, Andersen was fined $7 million to settle civil charges against it by the SEC. The agency said in June that Andersen's audits of Waste Management's financial statements were false and misleading but the accounting firm did not admit or deny any wrongdoing.

Andersen would be less eager to settle with the SEC if it is indicted by the DOJ. "Right now the Justice Department has a big, huge hammer," a source said.

The SEC faces a delicate enforcement issue if the Justice Dept. indicts Andersen on an obstruction of justice charge or if Andersen pleads guilty to such a felony.

SEC rule 102-E calls for the Commission to ban Andersen from signing off on public filings, including quarterly and annual financial reports.

"Any person who has been convicted of a felony or a misdemeanor involving moral turpitude shall be forthwith suspended from appearing or practicing before the commission," states the rule.

Experts in securities law say the SEC will have to be flexible since Andersen is auditor for more than 2,000 corporations.

"The rules would quite possibly prevent their consent to an audit from qualifying if they have a criminal issue," said Richard Breeden, former SEC Commissioner.

"But the Commission itself would be able to waive that, and in this kind of a situation, might well provide some kind of a relief," Breeden added.

"The SEC would have to give them a waiver," said Ira Sorkin, former director of the Commission's New York office.

But a guilty plea from Andersen to either the DOJ or SEC doesn't necessarily mean the end of the 89-year old firm. The SEC can prevent Andersen from conducting any public audits of firms here in the United States but neither agency regulates the practice of accounting, which is governed on a state level.

"Each state would have to take action and either suspend or revoke Andersen's license," Bowman said.  

-- additional reporting from CNNfn's Alan Chernoff