“Transaction Costs and Competition among Audit Firms in Local Markets” by Professor Dan Anthony SIMUNIC
Professor Dan Anthony SIMUNIC
CGA Chair in Accounting
Sauder School of Business
University of British Columbia
A large body of academic literature interprets the dominant audit firms in audit markets – as defined by client companies operating in specific client industries – to be high quality, differentiated suppliers who command higher audit fees. The dominant audit firms are normally defined by their large client-industry market shares. However, in the industrial organization literature, dominant suppliers with large market shares are normally viewed as having market power, which can result in those firms earning economic rents. So the interpretation of any audit fee premium to dominant audit firms in a market is ambiguous. In this paper, we develop a measure for audit firm competition in local audit markets based on the transaction costs of changing audit firms included in DeAngelo’s (1981) multi-period audit pricing model. Our competition measure reflects the relative size difference between the largest audit firm in a market and the other audit firms operating in that market. We find that audit fees decrease as the size difference between the largest audit firm in a market and a client’s incumbent audit firm increases. The evidence suggests that dominant audit firms charge higher audit fees because of their significant local competitive advantage over smaller audit firms. Our study advances understanding of audit market competition and provides an alternative explanation for the excess audit fees earned by the largest audit firm(s) in local audit markets.