Determinants of the profitability of audit engagements : an empirical study

Abstract

This study reports the results of an investigation into the profitability of audit engagements. The study is motivated by the frequently expressed concern regarding the lack of competitiveness on the audit market, based on trends of increasing concentration of suppliers in this market. The argument is that increasing concentration facilitates collusion and monopoly behavior, allowing firms to raise price above cost. A direct test of this argument would be to test the effect of elements of market structure on the ratio between price and costs (i.e. profitability). Industrial organization and industrial economics research has seen studies on this issue for a multitude of industries, but not for the audit industry. Due to unavailability of data particularly on audit costs, audit market research has attempted investigate the competitiveness of the market mainly by examining audit fees and audit production data. The current study attempts to investigate directly whether higher market concentration allows firms to raise price above cost. Based on insights from the audit fee and production literature, the economics of industrial organization, and the relatively recent studies on local (rather than national) audit markets, a model for explaining audit engagement profitability is constructed. This model is tested empirically on a sample of 114 audit engagements conducted by one of the (then) Big 6 audit firms. The results show that the audit market structure differs across local audit markets, and that this local structure has a significant influence on audit engagement profitability. In addition, some factors that have shown to be important determinants in prior audit fee and production studies are also significant in this study’s profitability model. These relate to client risk and financial distress, the length of the relationship between the auditor and the client, and client complexity. The results for local audit market structure suggest that, as expected, higher market share in local markets allows the audit firm to raise price above cost. This can be interpreted as a sign of market power. However, some alternative explanations for the empirical results of the paper are also suggested.