Dan A. Simunic

The Pricing Of Audit Services - Theory And Evidence

The question of the existence of competition among auditors has been the subject of considerable discussion in recent years. More specifically, the Big Eight firms as a group have been accused of monopolizing the market for audits {Staff Study of the Subcommittee on Reports, Accounting and Management of the Senate Committee on Government Operations [1977]). However, evidence on the issue is scanty and typically anecdotal (e.g., Bernstein [1978]). The evidence of the Staff Study itself is limited to concentration statistics, with the allegations relying on what has come to be called the concentration doctrine (Demsetz [1973]). According to this doctrine, supplier concentration is a reliable indicator of supplier behavior and performance. In this paper, I provide evidence from a test of the hypothesis that price competition prevails throughout the market for the audits of publicly held companies, irrespective of the share of a market segment which is serviced by the Big Eight firms. The evidence is based on an examination of a sample cross-section of audit fees.

Auditing, Consulting, And Auditor Independence

The question of whether an auditor should also provide management advisory services (MAS) to an audit client has been extensively debated. On the one hand, the Metcalf Committee Staff Study [1976, pp. 50-52] suggested that supplying both services can create a conflict of interests, particularly when a CPA firm recruits a clients executives and is interested in assuring their success, or when it installs a management information system and subsequently audits the reliability and accuracy of its own work. In these situations, a CPA firm acting as both auditor and consultant may be motivated not to report consulting deficiencies observed during the audit, thereby avoiding erosion of its consulting brand name. In general, any situation which increases the probability that an auditor will not truthfully report the results of his audit investigation can be viewed as a threat to independence.1 An opposing view of potential threats to truthful reporting by auditors engaged in MAS was taken by the Cohen Commission [1978, p. 97],

The Production of Audit Services: Evidence from a Major Public Accounting Firm

In this research, we examine the empirical relation between client characteristics and the nature and mix of labor resources used by an international CPA firm to obtain a desired level of assurance that clients financial statements are free of material misstatement. The level of assurance is the output of an audit, while the input resources measure the effort required to produce that output, under varying client circumstances. We use disaggregated labor hours by rank within the firm (partner, manager, senior, and staff) as the measure of inputs, in order to examine how client characteristics affect both the amount and mix of labor used. To the extent that client characteristics have differential effects on the various types of labor, only disaggregated data can reveal changes in labor mix and may also provide a more powerful test (relative to tests

Empirical assessment of the impact of auditor quality on the valuation of new issues

Abstract This paper reports empirical tests of an hypothesized positive relation between audit quality and firm-specific risk that is predicted by Datar, Feltham, and Hughes (1991) theoretical analysis of auditor choice when firms go public. Three types of proxies for ex ante firm-specific risk are used to test this relation: regression coefficients that theory relates to the firm-specific risk, ex ante proxies available from prospecti, and ex post variances in returns. Results from the first are moderately consistent with our hypothesis, while those from the latter two are either mixed or contrary.

The association between audit quality, retained ownership, and firm-specific risk in U.S. vs. Canadian IPO markets

Abstract This paper tests the demand-side prediction of Datar, Feltham, and Hughes (1991) that new issuers of securities are more likely to choose a high-quality auditor and retain a lower level of ownership as the firm-specific riskiness of future cash flows increases. Previous tests of this hypothesis using U.S. data have generally been inconclusive, perhaps because an increase in the riskiness of client cash flows simultaneously increases an auditors litigation risk and supply price. Our results using data from a significantly different legal environment (Canada) are consistent with the predictions of Datar, Feltham, and Hughes.

Voluntary Audits and the Cost of Debt Capital for Privately Held Firms: Korean Evidence

Using a large sample of privately held Korean companies that are not required to obtain an external audit, this paper examines the informational value of voluntary external audits of financial statements with respect to the cost of debt. We find that private companies with an external audit pay a significantly lower interest rate on their debt than do private companies without an audit. Further, the interest rate on borrowing is significantly lower for Big 4-audited companies than for non-Big 4-audited companies. Finally, we find that a change in a companys status from no audit to being audited - either voluntarily or because the audit became mandatory - leads to significant savings in the cost of borrowing.

Production Efficiency and the Pricing of Audit Services

In this paper, we examine the relative efficiency of audit production by one of the then Big 6 public accounting firms for a sample of 247 geographically dispersed audits of U.S. companies performed in 1989. To test the relative efficiency of audit production, we use both stochastic frontier estimation (SFE) and data envelopment analysis (DEA). A feature of our research is that we also test whether any apparent inefficiencies in production, identified using SFE and DEA, are correlated with audit pricing. That is, do apparent inefficiencies cause the public accounting firm to reduce its unit price (billing rate) per hour of labor utilized on an engagement? With respect to results, we do not find any evidence of relative (within-sample) inefficiencies in the use of partner, manager, senior, or staff labor hours using SFE. This suggests that the SFE model may not be sufficiently powerful to detect inefficiencies, even with our reasonably large sample size. However, we do find apparent inefficiencies using the DEA model. Audits range from about 74 percent to 100 percent relative efficiency in production, while the average audit is produced at about an 88 percent efficiency level, relative to the most efficient audits in the sample. Moreover, the inefficiencies identified using DEA are correlated with the firms realization rate. That is, average billing rates per hour fall as the amount of inefficiency increases. Our results suggest that there are moderate inefficiencies in the production of many of the subject public accounting firms audits, and that such inefficiencies are economically costly to the firm.

China-Related Research in Auditing: A Review and Directions for Future Research

1.Introduction Academic research concerning independent audits of financial statements,including the economic incentives and relations surrounding audit contracts and audit processes,is relatively new.Prior to the mid-1970’s,auditing was viewed as a purely practical activity,governed by technical rules largely set by the profession itself.But of course,auditing is

The Economics of Setting Auditing Standards

This paper develops a theory of the negotiating positions, or preferences over auditing standards, of the interest groups that may set such standards. Specifically, we consider how the preferences of auditors as standard setters may differ from the preferences of investors. We represent auditing standards by two properties: toughness and vagueness. Toughness is the level of audit effort required by the standards. Vagueness is the uncertainty of audit effort levels that could be considered by different parties as “in compliance” with the standards. Our model predicts that auditors and investors would consider both toughness and vagueness in influencing or setting auditing standards, since preferences over vagueness depend on the level of toughness. We model the market as composed of auditors with different wealth levels and investors with various investment projects and optimal standards will vary across these parties. We show that as a result of such tensions, auditing standards with a degree of vagueness are preferred. By analyzing the economic incentives of different potential standard setters, we help explain how auditing standards have developed in the real world and lay out the foundation for future research on the standards.

Do Joint Audits Improve or Impair Audit Quality

Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision because “Two heads are better than one.” Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free‐riding problem between audit firms and reduce audit evidence precision. We further derive a set of empirically testable predictions comparing audit evidence precision and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.