Reconceptualizing Audit Production: the Importance of Capital Investments and Joint Fixed Costs

51 Pages Posted: 27 Jul 2017 Last revised: 29 Jul 2021

See all articles by Tracy Gu

Tracy Gu

The University of Hong Kong (HKU), Accounting Division, Faculty of Business and Economics

Dan A. Simunic

University of British Columbia (UBC) - Sauder School of Business

Michael T. Stein

Old Dominion University

Date Written: January 1, 2019

Abstract

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

Gu, Tracy (Ti) and Simunic, Dan A. and Stein, Michael T., Reconceptualizing Audit Production: the Importance of Capital Investments and Joint Fixed Costs (January 1, 2019). Available at SSRN: https://ssrn.com/abstract=2900389 or http://dx.doi.org/10.2139/ssrn.2900389

Tracy (Ti) Gu

The University of Hong Kong (HKU), Accounting Division, Faculty of Business and Economics ( email )

#1312, KK Leung Building
Pokfulam Road
Hong Kong
+852 3917-8345 (Phone)

Dan A. Simunic (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
416-486-5361 (Phone)
416-486-6158 (Fax)

Michael T. Stein

Old Dominion University ( email )

Strome College of Business
Norfolk, VA VA 23529
United States
17576835495 (Phone)

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