Determinants of Audit-Firm Profitability and Implications for Key Audit Matter Reporting

Abstract

We use a novel dataset that links audit-firm and client-firm financial statement information from the U.K.’s largest audit firms to examine drivers of audit-firm profitability and its implications for audit outcomes conveyed by Key Audit Matter (KAM) disclosures. We first explore the determinants of audit-firm profitability and conclude that Big-4 and non-Big-4 audit firms have fundamentally different profitability structures. Big-4 firms earn higher profit margins than non-Big-4 firms. Furthermore, Big-4 profitability increases with client size and complexity, while non-Big-4 profitability is higher for smaller clients and clients with losses. Next, we examine the relation between audit-firm profitability and KAM reporting. We find that more profitable audit firms address more KAMs. However, audit-firm profitability is less likely to affect audit outcomes for loss-making clients (i.e., when auditors are exposed to more litigation risk). Our results are robust to several endogeneity controls such as controlling for client-firm and/or audit-firm fixed effects, employing changes specifications, and using an instrumental variables approach, as well as to examining the external validity of our findings and using alternative outcome measures. Our study contributes to the literature by being the first to provide insights into audit-firm profitability and examine in detail its implications for audit quality and audit effort.