“Fixed Costs, Audit Production, and Audit Markets: Theory and Evidence” by Professor Dan A. Simunic
Professor Dan A. Simunic
Professor of Accounting Division
University of British Columbia
We analyze the role of fixed costs in audit production. Our motivation is to better understand the interaction of the production and supply of audit services and audit market outcomes. We conjecture that fixed costs are associated with the technology and other types of fixed investments used by the auditor to transform audit effort (hours) into assurance. We assume that such investments (and resulting fixed costs) influence production primarily through the efficiency of audit effort (process improvements). Efficiency increasing investments can result in either lower cost audits or higher assurance levels. We formally analyze the audit production problem from simple to more complex specifications, and use examples and simulation methods as well as explanatory figures to try to understand the pricing and market implications of various formulations. We rely on examples and simulation results, since the complexity of audit production with technology investments and fixed costs when an accounting firm has a portfolio of diverse clients doesn’t allow us, in general, to obtain closed‐form solutions. The assumption that fixed costs are an important feature of audit service production yields a rich mix of interesting insights into the audit service market that are not found in the existing auditing literature. Based on these analyses, we develop four testable hypotheses concerning the relations between audit quality and (1) the magnitude of client‐specific possible losses from servicing a client; (2) the average client losses in an audit firm’s portfolio; (3) the number of client’s in an audit firm’s portfolio; and (4) the variability of client losses in an audit firm’s portfolio. Using the absolute value of discretionary accruals as the proxy for audit quality, we find evidence supporting the four hypotheses.