Are Measures of an Audit Firm's Competitive Position in Local Markets Robust?

Abstract

Recent studies determining the effect of audit market competition on firm level audit fees have developed novel measures of an audit firm’s relative competitive position. Numan and Willekens (2012) find a relationship between audit fees and the ‘industry market share distance to the closest competitor’. Chu et al. (2018) provide evidence that suggests smaller incumbent auditors are pressured into offering lower fees when competing against a large local audit firm. These results are important to regulators and antitrust authorities that seek to understand the implications of a market dominated by a few large audit firms. We demonstrate that competition measures employed in these audit pricing studies are endogenous by construction and that their relationship with audit fees is due to ‘mathematical coupling’. A series of simulations demonstrate that the coefficients of local competitive position measures are subject to simultaneity bias. We employ the instrumental variable (IV) regression method to account for simultaneity bias. Using ‘strong’ instruments, our IV regression results indicate that local competition measures are unrelated to audit fees after controlling for simultaneity bias. Our findings have import for audit pricing studies where explanatory variables are constructed which contain contemporaneous audit fee components.