LAWRENCE — In the U.S. public company audit market, regulators often assume that the absence of competition may lead to lower quality audits. However, a new article reveals competition is often overrated.
“We don’t find any evidence that a lack of competition is problematic. It turns out that auditors who appear to be operating in less competitive markets are more efficient and more effective,” said Will Ciconte, assistant professor of finance at the University of Kansas.
His working paper, titled “Profit persistence in the U.S. audit market,” investigates the relation between audit competition, quality and labor hours. Using proprietary data on auditor realization rates, the findings suggest that lower competition may reflect differentiation and that auditors use market power to deliver high audit quality.
The paper has been accepted to the Journal of Accounting Research.
“More providers should mean more fierce competition, where the provider should then try to differentiate based on their quality, and that should drive quality up and ensure prices stay at a fair price. Unfortunately, that ignores a few things unique about the audit market,” said Ciconte, who co-wrote the article with Andrew Kitto of the University of Massachusetts Amherst.
Their study focuses on profit persistence (i.e., profits are “sticky” over time). They find certain audit offices have abnormal profits and there does not seem to be enough competitive pressure to drive down those profits over time. This provides evidence supporting concerns expressed by the audit regulator that the audit market lacks competition.
“We interpret the evidence as suggesting auditors with persistent profits are just providing better audits,” he said.
For the main analysis, Ciconte and Kitto measure competition using regressions of abnormal profitability in the current year on abnormal profitability in the prior year. (Abnormal profitability refers to the difference between the profitability for a given audit engagement compared to all engagements in the same year.)
Ciconte said, “We use this measure to explore whether higher profit persistence, which we use as a measure for low competition, is related to auditor effort and quality. We test this by regressing auditor hours, financial statement restatements, PCAOB inspection findings and discretionary accruals on our competition measure.”
Most larger companies rely on one of the Big Four firms — Deloitte, PwC (PricewaterhouseCoopers), EY (Ernst & Young) and KPMG — for their accounting and auditing. But that comes with its own set of baggage.
“For many of these companies, they can’t get an auditor that’s outside of the Big Four because there’s a need to invest in technology and knowledge and skills to serve the client,” Ciconte said.
“There’s this concern, ‘We only have these four firms that can serve this pool of clients. They don’t have an incentive to do a good job.’ We say, ‘Let’s see what competition looks like inside these markets. And then if we are detecting that there appears to be less competition, what are the implications for stakeholders?’”
Given that Ciconte found a lack of competition wasn’t problematic, then wouldn’t the audit quality be the same if a company were to switch to any of the other Big Four?
“Because these auditors are able to develop skill and expertise which they can then exploit, this creates a barrier so another firm can’t just come in and say, ‘Hey, you should come with us.’ Because switching off that auditor will be costly to the clients. The clients are willing to stick with them because they figured out a way to develop their processes, to get the right people in place to do good work and to get to a quality answer that is not replicable by a competitor,” he said.
The Delaware native started at KU this fall. He considers his expertise a “weird hybrid” of audit research and tax research.
Ciconte said, “I know from my talks with rank-and-file partners in major firms, they’re always monitoring these concerns. They understand what’s going on in the regulatory environment, and so they’re concerned about potential changes. Our study suggests any changes should be done very cautiously. It’s not good to solve a problem that doesn’t exist.”