Reconceptualizing Audit Production: the Importance of Capital Investments and Joint Fixed Costs
51 Pages Posted: 27 Jul 2017 Last revised: 29 Jul 2021
Date Written: January 1, 2019
We reformulate audit production by incorporating the role of capital investments that affect the audits of multiple clients. Given such investments and their associated joint fixed costs, the investment and audit production decisions must be analyzed over a client portfolio. Our analyses are relevant both to researchers and practitioners since the Big 4 firms are currently making large investments in information technologies that could transform audit practice, and have profound implications for the structure of the industry. We use numerical methods that allow for a wide variety of specifications to derive solutions, and illustrate these solutions graphically. One implication of our research is that audit quality within a portfolio can be expected to vary systematically with the characteristics of clients in the portfolio. Therefore, the audit quality difference between Big 4 and non-Big 4 firms likely reflects an average upward shift in the array of audit quality within the portfolios of these two classes of firms, associated with a strong clientele effect and a weaker audit firm effect. Another implication is that large capital investments will tend to drive the auditing industry toward a natural monopoly equilibrium. To support the relevance of our analyses, we test several hypotheses concerning the relations between audit quality and the characteristics of auditors’ client portfolios and, using discretionary accruals, find evidence consistent with these hypotheses. Overall, our research demonstrates the importance of conceptualizing audit production as involving both labor and capital investments – not simply labor, as is the case with most existing auditing literature.
Keywords: Audit Services, Client Portfolios, Production, Investments, Discretionary Common Fixed Costs
JEL Classification: A10, M42
Suggested Citation: Suggested Citation