Fixed Costs, Audit Production, and Audit Markets: Theory and Evidence

Abstract

We analyze the role of discretionary fixed costs in audit production. Such costs are common (or joint) across a set of clients serviced by an accounting firm during a period. Our motivation is to better understand the implications of common discretionary fixed costs for the production and supply of audit services and audit market outcomes, such as the assurance level provided (audit quality) and audit costs and pricing, we conjecture that discretionary fixed costs are associated with the technology and other types of investments used by the auditor to transform audit effort (hours) into assurance for a portfolio of clients. We assume that such investments (and resulting costs) influence production primarily through the efficiency of audit effort (process improvements). We formally analyze the audit production problem in the context of auditor profit maximization and a more simple expected cost minimization formulation, and use examples, simulation methods, as well as explanatory figures to understand the implications of these models. Also, we use monotone comparative statics (Milgrom and Shannon [1994] to show the implications of client-specific losses (the auditor’s loss function) and the number of clients in an auditor’s portfolio on the level of fixed investments and audit assurance. The assumption that discretionary fixed costs are an important feature of audit service production yields a rich mix of interesting insights into the audit service market that are not found in the existing literature. Based on these analyses, we develop four testable hypotheses concerning the relations between audit quality and (1) the magnitude of client-specific possible losses from servicing a client; (2) the average client losses in an audit firm’s portfolio; (3) the number of clients in an audit firm’s portfolio; and (4) the variability of client losses in an audit firm’s portfolio. Using the absolute value of discretionary accruals as the proxy for audit quality and client size as the proxy for auditor losses, we find evidence consistent with the four hypotheses. In addition, using restatements as the measure of audit quality, we find some (weaker) evidence consistent with hypotheses 3 and 4.