The effect of audit market structure on audit quality and audit pricing in the private‐client market

• DOI: http://doi.org/10.1111/jbfa.12414
• Author: Caren Schelleman,Roger Meuwissen,Jeroen Raak,Erik Peek
• Published date: 01 March 2020
• Date: 01 March 2020

DOI: 10.1111/jbfa.12414

The effect of audit market structure on audit

quality and audit pricing in the private-client

market

Jeroen van Raak1Erik Peek2Roger Meuwissen3

Caren Schelleman3

1University of Amsterdam

2Rotterdam School of Management, Erasmus

University

3Maastricht University

Correspondence

Jeroenvan Raak, Amsterdam Business School,

Universityof Amsterdam, Plantage Muidergracht

12,1018 TV Amsterdam, The Netherlands.

Email:j.j.f.vanraak@uva.nl

Abstract

This study examines whether audit market structure affects audit

quality and audit pricing. We analyze two conceptually distinct

dimensions of market structure: audit market concentration and

client mobility. Focusing on the private-client segment of the Bel-

gian audit market,we compare the pricing and quality effects of mar-

ketstructure between the segment of small and medium-sized (SME)

clients and the segment of large clients to test how audit complexity

moderates such effects. We find that market concentration impairs

price and quality competition in the SME-client segment. Market

concentration is unrelated to audit quality in the large-client seg-

ment, where we argue that concentration is endogenous to audit

complexity. Furthermore, we find that client mobility stimulates

pricecompetition in both segments but improves audit quality only in

the large-client segment. We interpret our findings as evidence that

(a) audit market concentration impairs competition especially when

audits have low complexity and that (b) the large-client marketseg-

ment, characterized by higher audit complexity and higher market

concentration, can also be price and quality competitive if clients are

sufficiently mobile, and change auditors relatively frequently.

KEYWORDS

audit fees, audit quality, competition, market structure

JEL CLASSIFICATION

L11, L13, M42

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits

use and distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or

adaptations are made.

c

2019 The Authors. Journal of Business Finance & Accounting published by John Wiley & Sons Ltd

456 wileyonlinelibrary.com/journal/jbfa JBus Fin Acc. 2020;47:456–488.

VAN RAAK 457

1INTRODUCTION

This study examinesthe effect of audit market structure on audit quality and audit pricing in the private-client segment

of the audit market in Belgium. Regulators worldwide haveexpressed concerns that the current structure of the audit

market restricts effective competition among audit firms and, in turn, may lead to noncompetitive pricing or impair

audit quality (European Commission, 2010; Financial Reporting Council [FRC], 2018; US Government Accountability

Office [GAO], 2003, 2008). Most recently, the UK Competition & Markets Authority (CMA, 2019) argued that high

audit market concentration is a “deep-seatedproblem” that creates “limited choice and a market that is not resilient”

(p. 6), and proposed to open up the market for challenger audit firms through mandating joint audits. The CMA’s con-

clusion and proposal are based, at least in part, on the premise that high market concentration has led to low audit

quality,more in particular to recent accounting scandals such as those at BHS and Carillion. In making this premise, the

CMA adheres to the UK Labour Party’sview that c hangingthe audit market structure is an indispensable step towards

improving audit quality (Sikka et al., 2018). This view is, however, neither unequivocallysupported by academic evi-

dence nor the shared consensus amongst practitioners (see e.g., CMA, 2019, p. 46).1

The debate on the effect of audit market structure on competition and audit quality seemingly revolves around

two different viewpoints (see, e.g., GAO, 2008; House of Lords, 2011). One viewpoint is that high concentration of

audit firms’ market shares reflects a lack of competition and a potential threat to high-quality audits at efficient prices.

Another viewpoint is that an audit market’s degree of concentration has arisen as a natural response to client firms’

demand for audit quality. In particular, some have argued that high concentration in large-client audit markets is

a necessity that ensures that audit firms achieve economies of scale and have the audit technology and resources

required to undertake complex large-client audits (e.g., Danos & Eichenseher,1982; Dopuch & Simunic, 1980; Pound

& Francis, 1981; Sirois & Simunic, 2011).2Better alignment of audit firms’ resources with large clients’ needs can, in

turn, help audit firms to charge premium fees (e.g., Numan and Willekens,2012; Shapiro, 1989). Both viewpoints imply

different consequences for the relationship between audit market structure, audit quality,and audit fees. The former

viewpoint suggests that concentration reduces audit quality and increases audit firms’ pricing power; the latter view-

point predicts that concentration is at least partly endogenous to client firms’ audit demands and thus affects audit

quality and audit fees conditional on the complexityof the audit.3This study empirically contrasts these views, thereby

addressing two related questions: (1) Is audit market concentration associated with price or quality competition, after

controlling for audit complexity? (2) Do audit firms compete on price or quality also in marketsegments where higher

audit complexity stimulates higher levelsof concentration?

One hurdle in examining whether market structure’s effect on audit quality and pricing is conditional on audit

complexity is the need for a large sample of mandatory audits of sufficiently varying degrees of complexity,including

audits in which scale economies are of low importance. A sample of public-client audits tends to be biased toward

audits of higher complexity, as potentially evidenced by the worldwide dominance of Big Four audit firms in the

public-client segment of the audit market. Toovercome this issue, we focus our analysis on segments of the private-

client audit market in Belgium, where audits are mandatory and there is a comparatively large variation in audit

complexity and marketstructure. While defining audit market segments by geographical area—a key driver of market

segmentation—and client size—an observable measure of audit complexity—we examine two conceptually distinct

1For example,some auditors indicated to the Competition & Markets Authority that its view that low audit quality is widespread is “more perception than

reality”(Deloitte, 2019) and derives more from the experience of a few accounting scandals than from systematic evidence (see e.g., CMA, 2019, p. 46; Institute

of Chartered Accountants of Scotland, 2019; KPMG, 2019; PricewaterhouseCoopers, 2019). Furthermore, audit clients responding to the CMA indicated

that they “didnot have concerns about the quality of their audit process or did not think that the evidence [the CMA] presented indicated that there was a

systematicproblem with audit quality in the UK” (CMA, 2019, p. 46).

2Inaccordance with this idea, audit committee members interviewed by the UK Competition & Markets Authority (CMA, 2019) argued that challenger (non-

BigFour) audit firms are less capable of performing complex audits because of their smaller international networks, smaller audit teams, and lower investments

intechnology (p. 90).

3Throughoutthe paper we use the term “audit complexity” to describe a wide range of factors that contribute to the complexity level of the audit. Such factors

include,for example, organizational and operational complexity as well as the level of audit quality desired by the client firm (and its stakeholders).

458 VAN RAAK

but related dimensions of audit market structure: audit market concentration (cf. Francis, Michas, & Seavey, 2013;

Pearson & Trompeter, 1994; Simunic, 1980) and client mobility, as captured by the instability of audit firms’ market

shares (Buijink, Maijoor,& Meuwissen, 1998; Caves & Porter, 1978).

We focus on the Belgian private-client audit market, as this is one of the very few marketsthat has (1) a sufficiently

long time series of accounting and audit fee data and (2) detailed data on audit partner identity and location, which

we need to construct audit market segments. The Belgian audit market for private clients is also of more conceptual

interest. Past regulatory constraints on Belgian audit firms’ growth have created an exogenoussource of variation in

the structures of market segments as well as caused the Belgian audit market to havea comparatively low degree of

concentration (Boone, Meuwissen, & van Witteloostuijn, 2009). Further,the Belgian private-client market has a high

degree of fee transparency that is comparable to the degrees of transparency observed in public-client markets.This

high degree of transparency presumably strengthens the relationship between audit effort and audit fees, discourages

low balling, and stimulates audit firms in the private-client market to explicitly trade off price against quality compe-

tition, similar to their peers in public-client markets. We therefore examine both dimensions of competition. Finally,

understanding the effect of marketstructure on competition i n the audit marketfor private clients is of practical inter-

est because of private firms’ importance to the economy as well as their economic relevance to the audit sector in

Europe (Langli & Svanström, 2014; Wymenga, Spanikova,Barker, Konings, & Canton, 2011).

We argue that market concentrationmust be close to exogenous to audit complexity in the SME-client segment of

the audit market because SME-clients’ demand for technology- and resource-intensiveaudits is generally low. For this

reason we focus the first part of the analysis on the SME-client segment, where we find that market concentration is

positively associated with audit fees and negativelyassociated with audit quality.We interpret this finding as evidence

ofmarket concentration’s adverse effects on price and quality competition—evidence that is, by construction, robust to

the influence of audit complexity.Turning to the sample of large-client audits, we find that market concentrationi snot

significantly associated with audit quality, supporting the notion that in segments where audit complexityis relevant,

market concentration is a consequence of demand-driven resource optimization rather than the creation of market

power. In the second part of the analysis, we examine the question of whether price or quality competition existsin

the large-client segment of the audit market, despite the hypothesized need for concentration. Using client mobility

as an alternative, dynamic measure of market structure that is not endogenous to audit complexity,we find that the

negative relationship between client mobility and audit fees is not less pronounced in the large-client segment than in

the SME-client segment of the audit market.Further, we find that the positive relationship between client mobility and

audit quality is even more pronounced for large-client audits than for SME-client audits. These findings indicate that,

in spite of high levels of concentration, price and quality competition do exist in the large-client segment of the audit

market. In sum, the empirical evidence confirms regulators’ fears that audit market concentration impairs price and

quality competition, but only in a setting where audits havelow complexity. In a setting where audits are more complex

and audit firms’ search for scale economies necessitates some degree of concentration, we find that client mobility

stimulates price competition and improves audit quality.

Our study contributes to the literature on audit market structure in various ways. First, this study makes a first

attempt to account for the endogeneity of audit market concentration to audit complexity when examining the

relationship between concentration, audit pricing, and audit quality. Specifically,in contrast to prior studies, we test

the effect of market concentration in a setting where concentrationis plausibly exogenous. Further, we show that the

effect of marketconcentration on audit quality is a function of audit complexity: negative for SME clients but negligible

for large clients. This finding is of importance to regulators as it confirms that audit market concentration can have

net benefits if it allows audit firms to obtain scale economies in the investments required for complex audits. Second,

we examine the competition effects of client mobility, which better captures dynamics in audit marketsthan market

concentration measures. Doing so not only counters some of the limitations of market concentration measures that

we discuss in this study,but also shows that more concentrated market segments, such as that for large clients, can still

be competitive if clients are mobile. As such, our study potentially contributes to a broadening of the debate on what

determines competition in audit markets. Third, we focus our analysis on private-client audits. Despite the importance