Competition in the Audit Market: Policy Implications

• Date: 01 September 2015
• DOI: http://doi.org/10.1111/1475-679X.12087
• Published date: 01 September 2015
• Author: JOSEPH GERAKOS,CHAD SYVERSON

DOI: 10.1111/1475-679X.12087

Journal of Accounting Research

Vol. 53 No. 4 September 2015

Printed in U.S.A.

Competition in the Audit Market:

Policy Implications

JOSEPH GERAKOS

∗AND CHAD SYVERSON

∗,†

Received 23 January 2014; accepted 17 March 2015

ABSTRACT

The audit market’s unique combination of features—its role in capital mar-

ket transparency, mandated demand, and concentrated supply—means it re-

ceives considerable attention from policy makers. We explore the effects of

two market scenarios that have been the focus of policy discussions: manda-

tory audit firm rotation and further supply concentration due to the exit of a

“Big 4” audit firm. To do so, we first estimate publicly traded firms’ demand

for auditing services, allowing the services provided by each of the Big 4 to be

differentiated products. We then use those estimates to calculate how each

scenario would affect client firms’ consumer surplus. We estimate that, for

U.S. publicly trade firms, mandatory audit firm rotation would induce con-

sumer surplus losses of approximately $2.7 billion if rotation were required

after 10 years and $4.7–5.0 billion if after only four years. We find similarly

that exit by one of the Big 4 would reduce client firms’ surplus by $1.4–1.8

billion. These estimates reflect only the value of firms’ lost options to hire the

exiting audit firm; they do not include likely fee increases resulting from less

∗University of Chicago Booth School of Business; †NBER.

Accepted by Phil Berger. Wethank Ray Ball, Mary Barth, Pradeep Chintagunta, J.P. Dub´

e,

David Erkens, Rich Frankel, Ron Goettler,Bobby Gramacy, G¨

unter Hitsch, Ali Hortac¸su,Karim

Jamal, Bill Kinney, Robert Knechel, Dave Larcker, Christian Leuz, Doug Shackelford, Jesse

Shapiro, Doug Skinner, Stephen Taylor, Anne Vanstraelen, Mike Willenborg, Stephen Zeff,

two anonymous reviewers, and workshop participants at Maastricht University, Ohio State

University, Stanford University, University of Chicago, University of Connecticut, University

of Melbourne, University of North Carolina, University of Southern California, University of

Technology–Sydney, Washington University at St. Louis, the 2012 Illinois Audit Symposium,

the 2014 Winter Marketing Economics Conference, and the 2014 International Symposium

for Audit Research for their comments.

725

Copyright C,University of Chicago on behalf of the Accounting Research Center, 2015

726 J.GERAKOS AND C.SYVERSON

competition among audit firms. The latter could result in audit fee increases

between $0.75–1.3 billion per year for mandatory rotation and $0.47–0.58

billion per year for the disappearance of a Big 4 audit firm. Such losses are

substantial; by comparison, total audit fees for public firms were $11 billion

in 2010.

JEL codes: L84; M41; M42; M48

Keywords: auditing; mandatory rotation; competition

1. Introduction

The market for financial audits exhibits a set of features that distinguish

it from other markets for business services (and for that matter, many

other goods more broadly). First, it is seen by many to play an important

and, in some ways, unique role in preserving transparency and improving

the functioning of capital markets (e.g., Watts and Zimmerman [1983],

Black [2000–2001], Ball [2001]). Relatedly, failures of auditors to catch and

report improprieties are often highly—and occasionally spectacularly—

visible.

Second, a substantial portion of demand in the market is mandated. Pub-

licly traded firms are compelled to purchase audit services, and there are

no services from outside the industry that can legally serve as substitutes.

Third, the market’s supply side is highly concentrated. Among publicly

traded companies in the United States, for example, the majority of audit

engagements and almost all audit fees involve just four audit firms (the

“Big 4”: Ernst & Young, Deloitte, KPMG, and PricewaterhouseCoopers). In

2010, the Big 4 handled 67% of audit engagements and collected over 94%

of audit fees.1As discussed by Velte and Stiglbauer [2012], audit markets in

many other developed economies exhibit similar concentration.

The combination of these features has resulted in the audit industry be-

ing the subject of frequent policy debates. In this paper, we explore two

oft-recurring discussions in this vein. The first regards the consequences

of imposing a mandatory audit firm rotation policy. The second involves

the effects of further concentration in supply due to one of the Big 4 audit

firms exiting the market.

Both of these scenarios have already colored policy toward the industry.

The Public Company Accounting Oversight Board (the “PCAOB”) is in ac-

tive discussions about implementing a mandatory audit firm rotation policy

for publicly traded firms. During the PCAOB’s hearings in March 2012 on

mandatory audit firm rotation, panelists voiced opposing views about the

costs and benefits of a mandate. For example, the executive director of the

AICPA’s Center for Audit Quality stated that mandatory audit firm rotation

would hinder audit committees in their oversight of external auditors, while

former SEC chairman Arthur Levitt supported mandatory rotation because

1For a breakdown of market shares and fees over the recent decade, see tables 1 and 2.

COMPETITION IN THE AUDIT MARKET:POLICY IMPLICATIONS 727

“investors deserve the perspectives of different professionals every so often,

particularly when an auditor’s independence can be reasonably called into

question” (Tysiac [2012]). Moreover, Congress has moved to address the

issue of mandatory audit firm rotation. In June 2013, the U.S. House over-

whelmingly passed a bill to prohibit the PCAOB from mandating audit firm

rotation (Cohn [2013]), though the Senate has yet to take corresponding

action.

With regard to the disappearance of a Big 4 firm, there have been several

recent cases in which a Big 4 audit firm could arguably have been criminally

indicted but the Department of Justice decided to not file charges, probably

because of concerns about further increasing concentration.2For example,

in 2005 KPMG admitted criminal wrongdoing by creating tax shelters that

helped clients evade $2.5 billion in taxes. Nevertheless, the Department of

Justice did not indict KPMG and instead entered into a deferred prose-

cution agreement (Johnson [2010]). Moreover, according to the Lehman

Brothers bankruptcy examiner’s report (Valukas[2010]), Ernst & Young as-

sisted Lehman Brothers in implementing its Repo 105 transactions, which

allowed Lehman to temporarily reduce its leverage when preparing its fi-

nancial statements. Nonetheless, the Department of Justice did not pursue

criminal charges against Ernst & Young.3

We seek to explore how the fruition of these two scenarios—the imposi-

tion of mandatory audit firm rotation and the disappearance of one of the

Big 4—would affect the audit market, and in particular the consequences

for publicly traded firms, its primary customers. Addressing these questions

satisfactorily requires, at the very least, measurements of the willingness of

firms to substitute among individual audit firms and the value firms place

(if any) on extended relationships with audit firms. However,prior research

on the structure of the audit market has focused on other questions, pri-

marily on either correlations between audit fees and firm characteristics or

substitutability between the Big 4 and non–Big 4 groups.4While this work

has offered insights into several questions, its focus on separate issues has

left a gap that we seek to begin to fill with this study.

To obtain the necessary measures of firms’ willingness to substitute

among specific audit firms and the value firms place on extended relation-

ships with audit firms, we estimate the demand for audit services among

publicly listed firms. We conceptualize firms seeking audit services as choos-

ing from among several producers of those services (i.e., the audit firms),

2A criminal conviction prohibits an audit firm from carrying out audits of SEC registrants.

3In contrast, the New York attorney general Andrew Cuomo sued Ernst & Young, claiming

that the audit firm helped Lehman “engage in a massive accounting fraud” (Public Accounting

Report [2011]).

4For a review of studies that examine the association between audit fees and client char-

acteristics, see Causholli et al. [2011]. For examples of studies that examine substitutability

between the Big 4 and non–Big 4 groups, see Willenborg [1999], Ettredge, Kwon, and Lim

[2009], Lennox, Francis, and Wang [2012], and Guedhami, Pittman, and Saffar [2014].