The relationship between audit firm industry expertise, audit production and audit fees.

In the first chapter, we empirically examine the relationship between audit office industry expertise , audit production as proxied by audit hours and audit fees. Furthermore, we examine whether the relationship between efficiency gains resulting from office industry expertise and auditfees is contingent on the audit firms market power. Prior research on industry expertise and audit pricing base their inferences solely on audit fees (Francis et al., 2005; Ferguson and Stokes, 2002; Craswell et al., 1995). This is problematic since the observed fee is jointly determined by audit production and the pricing policy (OKeefe et al., 1994). Hence, prior research is unable to distinguish between both. By introducing audit hours into the analysis, we are able to contribute to the existing literature by first examining the direct effect of audit office expertise on audit production and subsequently the secondary effect on audit fees contingent on audit firm market power. The results indicate statistical and economical significant efficiency gains resulting from audit office industry expertise. In client industries where the audit office devotes the most of its resources to, audit engagements are performed with less audit hours. The results indicate that efficiency gains are realized both for the audit partner as well as the audit staff level. In addition, the efficiency gains result in a decrease of audit fees, suggesting that realized efficiencies are passed on to clients. However, the extentof efficiency pass-on depends on the audit firms industry market powermeasured by the distance to the closest competitor (Numan and Willekens, 2012). The higher the firms market power the less realized efficiencies are passed-on. 
            In the second chapter, we examine whether audit partners financial incentives (inputs) caused by partner compensation and partner wealth influence audit quality. More specifically, we are interested in fee-based compensation, i.e. the association between a partners compensation and the total amount of fees derived from his clients, and the partners wealth subject to reputation and litigation loss. Prior research has documented some results suggesting that audit quality might be affected by partner compensation or incentives (Knechel et al.,2013; Trompeter, 1994). However, progress on this important topic is slow because of the proprietary nature of the required information. We make use of an unique feature of the Belgian environment to retrieve information on partner wealth and partner debt. Our results show that fee-based compensation negatively affects audit quality, although not under all circumstances. The extent of fee-based compensation affects income-increasing discretionary accruals but only for clients for which the risk of reputation loss is low. For the high reputation risk clients the potential costs associated with reputation loss exceed the benefit of compromising auditor independence. For those clients, we find no statistical significant result for fee-based compensation in the discretionary accruals model and the going concern opinion model. We were unable to document a statistical significant relationship between partner wealth and audit quality
                        The third chapter deals with tacit collusion between audit firms and the local industry leaders reputation damage following a restatement on audit market instability, i.e. the market share transfers betweenaudit firms and the resulting variation in relative rankings of firms within the market. We characterize the audit market as a quality-differentiated oligopoly (Numan and Willekens, 2012). In an oligopoly, supplierscan have incentives for tacit collusion as each supplier has, by definition, some impact on the  price. By cooperating firms can increase prices in a jointly profit-maximizing way, thus restricting competition. However, tacit collusion is only an equilibrium outcome when for each market participant the benefits of collusion exceed the costs from unilaterally deviating from the collusive strategy (Motta, 2004). In the this chapter we examine two factors influencing the relative net benefitof collusion. First, competing with rivals in multiple markets within the same geographical area increase collusion incentives when asymmetriesacross the different markets exist (Bernheim and Whinston, 1990). Theseasymmetries can consist of differences in market shares across the two markets, asymmetries in cost structures of the suppliers, etcetera. Second, client concentration can deter collusion as it increases the relative gain of deviating from the collusive outcome and at the same time decreases the impact of future punishments by the other oligopolists (Kato and Honjo, 2007; Caves and Porter, 1978). Third, we additionally investigate the effect of  damage to the market leaders reputation onaudit market instability. We find that multimarket contact, i.e. the number of industries in which rival audit firms compete with each other within a Metropolitan Statistical Area, decreases market instability. Multimarket contact increases market share mobility and decreases the likelihood of leader dethronement. In contrast, client concentration, i.e. theconcentration of fees paid by clients, increases market instability. Inmarkets with highly concentrated clients the likelihood of leader dethronement increases and market share mobility decreases. Hence, concentrated clients are able to use their bargaining power to break the oligopolistic consensus. Furthermore, damage to the reputation of the market leader resulting from the leaders clients restating their financial statements increases the likelihood of leader dethronement. However, we are unable to document an effect on market share mobility. 

Keywords:Economies of scale, Audit fees, Efficiency pass-through, Audit production, industry expertise

Disciplines:Applied economics

Project type:PhD project