The signalling cost of hiring a large auditor: evidence from the fee differential between large and small auditors

Abstract

The market for financial auditing is highly concentrated. If large auditors audit with greater accuracy, hiring a large auditor signals the firm's financial report quality to investors. This study considers the competition between large and small auditors and analytically shows that the fee differential between them consists of their audit cost difference and the signalling cost of hiring the former. The negative signal associated with a downward auditor switch is a switching cost. Large auditors therefore cannot compete with small auditors if the former perform no signalling function. The analytical model is empirically estimated to show the magnitude of the signalling cost embedded in a large auditor's audit and non-audit fees. Findings suggest that non-audit fees contain a larger signalling cost component than audit fees do. Moreover, auditees with higher financial report quality are willing to pay a higher signalling cost to signal their financial report quality.