Auditor concentration and audit fees

Structural theory asserts that high supplier concentration is an indication of a lack of competition. As a result, high concentration of an audit market should result in higher audit fees. Weiss (1989) claims that in a high-concentration market, the market leaders use their market power to fix fees in a monopolistic fashion. Pearson and Trompeter (1994) also argue that product differentiation could also lead to a positive association between industry concentration and audit fees. That is, if the market leaders are perceived to be experts that provide a higher-quality service, then the fees charged for those services may be higher. Pearson and Trompeter further argue it is possible that high concentration may result in lower audit fees because market leaders’ specific expertise leads to significant economic scale.

Pearson and Trompeter find empirical evidence that the audit fees are negatively associated with market concentration. They conclude that the concentration measures may not be appropriate metrics for the assessment of price competition since they do not account for the possibility of intense competition for clients among the market leaders. Bandyopadhyay and Kao (2004) find that production efficiency does not explain the lack of a positive relationship between audit market concentration and audit fees.

Numan and Willekens (2012) argue that auditor competition within a market cannot be measured by market concentration because it fails to distinguish audit firms’ differential competitive power within the market. They suggest that the competition measure must be able to reflect each auditor’s unique competitive power within the market. Zhang et al. (2019) suggest that the audit fees in a market are affected by both the auditors’ market power over the auditees and the competition among the auditors. When a market concentration increases, the pricing power is controlled by fewer audit firms since the probability of collusive pricing is more likely. That is, the auditor’s market power measured by the market concentration increases the prices of the audit services.

The within-market competition, on the other hand, may make the audit fees auditorspecific. Based on the competitive pricing theory in DeAngelo (1981a), Chu et al. (2018) propose that the transaction costs determine the relative competitive positions of the audit firms in a market. For a given audit firm, the audit costs to a client must not be greater than the lowest audit costs in the bidding from other audit firms in the market. Since the larger audit firm in the market has more resources to handle demand shocks, the transaction costs associated with the audit firm are lower. When a small firm is the incumbent auditor, the audit firm must price to a point that its clients are not better off to switch to the largest audit firm in the market. Consequently, the smaller audit firm will price their services using the largest audit firm as a reference. Chu et al. (2018) provide evidence that the audit fees within a market are a decreasing function of the size difference between the largest audit firm in the market and the incumbent audit firm. Chu et al. also show that the effect of the Numan and Willekens (2012) measure goes away after the size difference between the largest audit firm in the market and the incumbent audit firm is included in the fee model, suggesting Chu et al. improve the measure of Numan and Willekens for within-market competition. The empirical evidence documented in Chu et al. confirms that the competition intensity in an audit market is not uniform to all audit firms; rather, it is audit firm-specific.

Zhang et al. (2019) argue that the auditors’ market power and the within-market competition are intertwined. That is, when the concentration is high, it is likely that the disparity of competitive powers among auditors is also large. They suggest that the market concentration can load effects of both the market power and the within-market competition if the within-market is not controlled for in the audit fee model. Consequently, the effect of the concentration on the audit fees can be positive or negative, depending on the audit market compositions in the estimation sample.

Zhang et al. (2019) provide empirical support for their arguments and document a positive relationship between market concentration and audit fees when within-competition is separately controlled. Furthermore, they also show' that the concentration does not provide all auditors in a market with the same market power. In particular, market concentration mainly represents the large auditors’ market pow'er over the large clients in the market.