Donald J. Stokes

Brand name audit pricing, industry specialization, and leadership premiums post-big 8 and big 6 mergers

This paper investigates brand name, industry specialization, and leadership audit pricing in the wake of the mergers that created the Big 6 and the Big 5 accounting firms. For samples of Australian listed public companies in each of the postmerger years 1990, 1992, 1994, and 1998, we estimate national audit fee premiums for the Big 6/5 auditors and the industry specialists and leaders. We find limited support for the ability of the Big 6/5 to obtain fee premiums over non†Big 6/5 for those industries not having specialist auditors. Nonspecialist Big 6/5 auditors are able to obtain fee premiums over nonspecialist non†Big 6/5 auditors for those industries having specialist auditors. However, this result only holds among the smaller half of our sample. We do not find strong support for the presence of industry specialist premiums in the postmerger years, especially after 1990, using various definitions of industry specialist. We find, at best, limited support for the presence of industry leadership premiums. The evidence suggests that after the Big 8/6 audit firm mergers, some caution is required in generalizing the Craswell, Francis, and Taylor 1995 finding of national market industry specialist premiums. More generally, the study raises questions about the tenuous link between the concept of specialization and national market†share statistics.

Auditing, directorships and the demand for monitoring

Abstract Three monitoring mechanisms used for corporate governance are external auditing, internal auditing, and directorships. We consider the three mechanisms as endogenous to the firm and that each firm has an optimal set of monitoring mechanisms the specific mix of which is conditioned by the firms production-investment attributes. Production-investment attributes are proxied by the degree to which firm value is determined by growth options versus assets-in-place. Empirical predictions are then made and tested concerning the total demand for monitoring from all three mechanisms, and substitutions or tradeoffs between 1) auditing and directorships and 2) external and internal auditing. The results support the hypotheses that overall monitoring expenditures decrease as the firm has relatively more assets-in-place, that relatively more auditing (compared to directorships) occurs for firms with greater assets-in-place, and that relatively more internal auditing (compared to external auditing) also occurs for firms with greater assets-in-place. Predictions are also made and tested concerning the general effect of firm size on the demand for auditing and directorships. The study helps to better understand the economic rationale for each monitoring mechanism and the role it plays in the efficient corporate governance of the firm.

City Markets as a Unit of Analysis in Audit Research and the Re‐Examination of Big 6 Market Shares

Big 6 market shares based on aggregate national data have been used in prior research to infer market leadership and industry expertise, and to differentiate Big 6 accounting firms from one another. In this study it is demonstrated that further differences exist with respect to city-specific audit markets, both between firms and within the same firm across different city markets. The specific finding is that the national market leader is not the city-specific market leader the vast majority of time. Usefulness of the city-level unit of analysis is further demonstrated by re-examining the 1989 mergers creating Ernst & Young and Deloitte Touche. The primary effect of the Ernst & Young merger was to increase market shares in cities in which the pre-merger firms already had significant market shares, resulting in an increase in the number of cities in which the merged firm achieved top ranking. In contrast, the primary effect of the Deloitte Touche merger was an expansionof the number of city-level markets in which the merged firm had significant (though not leading) market shares. The findings of this study suggest that, in order to move beyond our current understanding, important audit research questions such as the reason for particular auditor–client alignments, the competitive nature of markets, audit pricing of reputations, and auditor reporting and independence issues should be investigated in city-level markets where audit contracting occurs and where Big 6 market shares (and presumably reputations) vary widely from city to city.

What matters in audit pricing: industry specialization or overall market leadership?

Ferguson et al. (2003) report that audit industry fee premia primarily reside with joint national and city-specific industry leadership as opposed to merely firm-wide (national) industry expertise, suggesting auditor choice among the Big 5 is best conceptualized on joint industry specialization in city-specific markets and nationally. The present study examines whether the prior results could be confounded by the presence of city-specific overall market leadership effects. Our findings reaffirm that joint local and national auditor industry expertise is valued by audit clients. Furthermore, overall city-specific leadership, by itself, also matters in fee determination and results in higher fees, although at a slightly weaker level of statistical significance.

Is the audit services market competitive following Arthur Andersen's collapse?

This study investigates whether audit markets remain competitive in the wake of Arthur Andersens demise and merger with Ernst & Young to create the Big Four. We conduct the study estimating audit fee models using Australian audit market data from both 2000 and 2003 to determine whether there is any evidence of cartel pricing either before, or subsequent to, the merger. In both years, we find evidence of a Big N price premium when estimating an audit fee model across all clients, and when we estimate the model separately across large and small client market segments. This evidence is consistent with product differentiation by Big N auditors and competitive markets.

Audit Quality and Information Asymmetry Between Traders

In this study, we investigate the association between audit quality and information asymmetry between informed and uninformed traders. We employ three proxies for information asymmetry – absolute price differences, absolute volatility differences, and absolute differences in the long/short ratio of trades – between US stock and options markets and represent audit quality through the appointment of Big n and industry specialist auditors. For a sample of 4062 firm-years between 2002 to 2005, our results indicate that the appointment of Big n and industry specialist auditors is associated with lower information asymmetry measures. Our results are consistent with audit quality playing a role in the quality of financial reporting information and flowing through to the allocation of information among traders.

Strategic pricing by Big 4 audit firms in private client segments

We examine how Big 4 auditors compete for new private clients. We find evidence suggesting that Big 4 auditors offer fee discounts to attract non‐Big 4 private clients to experience attributes of their brand name audit services. We also find that to attract clients from competing Big 4 suppliers, Big 4 auditors target fee discounts at clients in industries where they are the market leader. Our results further indicate that the Big 4 industry leaders target fee discounts to fast‐growing clients and are able to charge these clients significant price fee increases in the second mandate period (after 3 years).

Incorporating prior domain knowledge into a kernel based feature selection algorithm

This paper proposes a new method of incorporating prior domain knowledge into a kernel based feature selection algorithm. The proposed feature selection algorithm combines the Fast Correlation-Based Filter (FCBF) and the kernel methods in order to uncover an optimal subset of features for the support vector regression. In the proposed algorithm, the Kernel Canonical Correlation Analysis (KCCA) is employed as a measurement of mutual information between feature candidates. Domain knowledge in forms of constraints is used to guide the tuning of the KCCA. In the second experiments, the audit quality research carried by Yang Li and Donald Stokes [1] provides the domain knowledge, and the result extends the original subset of features.