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Auditing, consulting, and audit market concentration

  • ZfB-Special Issue 5/2012
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Abstract

In its recently published Green Paper, the European Commission (Audit policy: lessons from the crisis. Brussels, 2010) discusses various methods to enhance the reliability of audits and to re-establish trust in the financial market. The Commission primarily focuses on increasing auditor independence and on reducing the high level of audit market concentration. Based on a model in the tradition of the circular market matching models introduced by Salop (Bell J Econ 10(1):141–156, 1979), we show that prohibiting non-audit services as a measure intended to improve auditor independence can have counter-productive secondary effects on audit market concentration. In fact, our model demonstrates that incentives for independence and the structure of the audit market are simultaneously determined. Because market shares are endogenous in our model, it is not even clear that prohibiting non-audit services indeed increases an auditor’s incentive to remain independent.

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Notes

  1. See Ewert (1990, p. 197 ff.), Dopuch (1988), and Graham (1988) for a critique.

  2. See, for example, GAO (2008) for the US, Ewert and London Economics (2006) Europe, Stefani (2006) for Switzerland, and Bigus and Zimmermann (2008), Petersen and Zwirner (2008), Köhler et al. (2010), and Quick and Sattler (2011b) for Germany.

  3. We derive the conditions that must be fulfilled for the assumptionm > n to emerge endogenously below.

  4. Our results from analyzing fee data from Switzerland and the USA show that clients of the (three and four) respective market leaders indeed demanded considerably more non-audit services than clients of the small audit firms. For the years 2002–2009, we observed an average ratio between non-audit fees and audit fees in Switzerland and in the USA of 30.57 and 21.67 % for clients of non-Big X audit firms, whereas this ratio was 67.84 and 35.55 % for clients of Big X auditors.

  5. The question of whether competition in the consulting market affects competition in the market for audit services is not the focus of this paper (for a formal analysis of this argument, see Wu2006).

  6. The large audit firms’ higher number of partners and assistants also contributes to the increased costs associated with acquiring and retaining audit staff and the higher expenses incurred for professional training. Chang et al. (2008) found empirical evidence that the number of training hours of partners and assistants is higher in big firms compared to middle-sized and small audit firms.

  7. Based on data for US audits performed by an international public accounting firm, O’Keefe et al. (1994) found that client characteristics explain more than 80 % of the cross-sectional variation in the quantity of professional labor input. Measures for the client characteristics used in this study (client size, complexity, and risk) were similar to those used in prior audit pricing studies. Fee studies also indicate that the characteristics of the client and the auditor-client relationship account for a large degree of the variance in audit fees (for a meta-analysis of the audit fee studies, see Hay et al.2006).

  8. The results we obtain would be qualitatively similar if we assumed a concave or a convex cost function.

  9. Not only do small accounting firms face severe challenges in obtaining audit contracts from large clients, but it also seems that they are not very interested in serving this market segment (see GAO2008). In addition, there is empirical evidence that the choice of the auditor depends on client characteristics (see Knechel et al.2008).

  10. See Simunic (1984), Simon (1985), DeBerg et al. (1991), and Bell et al. (2001) (US); Butterworth and Houghton (1995) and Craswell and Francis (1999) (Australia); and Ezzamel et al. (1996) (UK). Palmrose (1986), however, documented a positive relationship between audit fees charged by one supplier and non-audit fees paid to a different supplier that did not perform the audit, which contradicts the argument for knowledge spillovers.

  11. Using data on audit staff hours, O’Keefe et al. (1994) did not find evidence of knowledge spillovers from management consulting and/or tax consulting to audit services. Davis et al. (1993) found a weakly significantpositive relationship between tax services and different audit effort measures and between accounting-related consulting services and audit hours weighted by billing-rate ratios. If additional effort is required for audits of clients who also purchase non-audit services and the demand for auditing is inelastic (see Beck et al.1988, pp. 52–54), these results do not support the existence of audit production efficiencies arising from knowledge spillovers.

  12. Antle et al. (2006) also have used a simultaneous-equations specification to estimate audit and non-audit fee models, finding evidence consistent with the existence of knowledge spillovers. Their result thus stands in opposition to the findings of Whisenant et al. (2003). Their fee models, however, might be mis-specified, since important variables measuring audit effort are not included.

  13. Moreover, they showed that the significant coefficient of audit fees in a single-equation model with non-audit fees as a dependent variable (as documented in DeBerg et al.1991; Barkess and Simnett1994; Craswell1999) is also sensitive to simultaneous-equations bias.

  14. In fact, numbers of audit firms betweenm*/2 andm* would also be possible equilibria if we considered a sequential market entry decision. Since we do not focus on the auditors’ specialization decision, in the following sections we only consider the number of audit firms for which the zero-profit contribution is fulfilled.

  15. Anecdotal evidence suggests that the profession is seriously affected by decreasing hourly rates for auditing, which is seen as a springboard for attracting clients to buy higher-margin non-audit services (see, for example, Göggelmann2010). The reasoning for “dumping pricing” is related to the overcapacities of audit firms (see o.V.2009). There is, however, also evidence indicating that the decrease in revenues from non-audit services caused by the implementation of regulatory restrictions is being offset by a substantialincrease in audit fees and in higher profit margins for audit services (see Weil2004,2005; Gullapalli2005).

  16. Based on an empirical study, Quick and Sattler (2011b) make a similar argument regarding the interrelation between restricting the fee an audit firm is allowed to earn from a single audit client to a certain percentage (also viewed as a possible means to increase auditor independence) and the level of audit market concentration.

  17. Khurana and Raman (2006) and Quick and Warming-Rasmussen (2009), for example, document the fact that addressees of financial reports perceive auditor independence to be impaired if auditing and consulting services are acquired from the same supplier, and Frankel et al. (2002) report a positive relationship between non-audit fees and the magnitude of discretionary accruals. Larcker and Richardson (2004) and Lim and Tan (2008), in contrast, observe that audit quality increases with the level of non-audit services, and Jenkins and Krawczyk (2001) find a favorable effect on perceived auditor independence in appearance (or no effect). Quick and Sattler (2011a) demonstrate that attestation services and tax consulting services do not significantly affect earnings management, whereas consulting services from the category “miscellaneous” impair the quality of financial statements.

  18. The qualitative results of our analysis do not change if audit firmi audits clients it is specialized in and provides consulting services to clients outside this region: The profit contribution from consulting would not change, but the average consulting fees would increase byc C /2n. Which of these cases is more costly for the clients depends on the relation between\( \alpha \cdot {{c}_{A}}^{l} \) andc C .

  19. From fiscal years 2002–2009, the three largest audit firms (KPMG, PricewaterhouseCoopers, and Ernst & Young) audited on average 86 % of listed corporations headquartered in Switzerland (not including financial institutions and real estate or insurance companies; data fromThomson One,Audit Analytics, and from annual reports). Thus, the Swiss audit market can serve as an example of a separated audit market.

  20. Between 2002 and 2009, the largest four audit firms in the USA (KPMG, PricewaterhouseCoopers, Ernst & Young, and Deloitte) provided audit services to only 56 % of the listed companies headquartered in the USA, on average (data fromThomson One,Audit Analytics, and from annual reports). Thus, small audit firms had a non-negligible market share even in the market for listed companies, at least if the number of clients is used as a measure of calculating the concentration ratio.

  21. This result, however, is straightforward, since we did not assume that audit firms incur additional fixed costs for providing consulting services to their clients.

  22. For the case in which consulting also affects the costs for auditing small clients that are similar to the large clients consuming consulting services, our results are unaffected if the more restrictive restriction\( \gamma \cdot {{c}_{0}}^{l}>\sqrt{2\cdot {{c}_{A}}^{s}\cdot {{c}_{F}}^{s}} \) is fulfilled.

  23. If the assumption does not hold because the number of large audit firmsn is sufficiently high and\( {{c}_{0}}^{l} \) is sufficiently low, the large audit firmi effectively competes with the nearest other large audit firmi − 1 and could charge a fee of\( {{\textit{fee}}^{i}}(0)={{c}_{0}}^{l}+{{{c}_{A}}^{l}}/{n}\;. \)

  24. A similar result holds for the case in which not all small audit firms in between two large audit firms effectively compete with the large audit firms. If small audit firms in a relatively large distance to the nearest large audit firm compete with each other, these small audit firms can be investigated as in reference situation I. The analysis of the audit firms relatively near to the large audit firms’ positions is the same as described in this section.

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  1. Department of Economics, University of Konstanz, Box 142, 78457, Konstanz, Germany

    Christopher Bleibtreu &  Ulrike Stefani

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  1. Christopher Bleibtreu
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  2. Ulrike Stefani
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Correspondence to Christopher Bleibtreu.

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Bleibtreu, C., Stefani, U. Auditing, consulting, and audit market concentration. Z Betriebswirtsch 82 (Suppl 5), 41–70 (2012). https://doi.org/10.1007/s11573-012-0597-5

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