Profit Persistence in the U.S. Audit Market

Abstract

This paper investigates the competitiveness of the U.S. audit market and the effects of competition on audit quality. Using a proprietary database of auditor realization rates, we provide the first empirical assessment of abnormal profit persistence in the U.S. audit market following methodology from the industrial organization literature. We find consistent evidence that abnormal profits persist over time and are not quickly driven back to competitive returns by market forces. Our tests suggest that audit market concentration is a key determinant of persistence and that audit offices that achieve greater profit persistence are less likely to lose clients. Interestingly, we fail to find any evidence that profit persistence is associated with lower quality; rather, we document that it is negatively related to instances of financial restatements and discretionary accruals. Our results have significant policy implications and contribute to the longstanding debate in the academic literature on the consequences of high concentration. Although our findings support critics’ claims that audit markets lack sufficient competition, they are inconsistent with the notion that entrenchment leads to lower audit quality. In fact, our findings imply that auditors may use market power to constrain aggressive financial reporting decisions.