Audit-Firm Profitability: Determinants and Implications for Key Audit Matter Reporting

55 Pages Posted: 23 May 2021 Last revised: 23 Jul 2021

Date Written: July 22, 2021

Abstract

We use a novel dataset that links audit-firm and client-firm financial statement information from the U.K.’s largest audit firms to examine drivers of audit-firm profitability and its implications for audit outcomes conveyed by Key Audit Matter (KAM) disclosures. We first explore the determinants of audit-firm profitability and conclude that Big-4 and non-Big-4 audit firms have fundamentally different profitability structures. Big-4 firms earn higher profit margins than non-Big-4 firms. Furthermore, Big-4 profitability increases with client size and complexity, while non-Big-4 profitability is higher for smaller clients and clients with losses. Next, we examine the relation between audit-firm profitability and KAM reporting. We find that more profitable audit firms address more KAMs. However, audit-firm profitability is less likely to affect audit outcomes for loss-making clients (i.e., when auditors are exposed to more litigation risk). Our results are robust to several endogeneity controls such as controlling for client-firm and/or audit-firm fixed effects, employing changes specifications, and using an instrumental variables approach, as well as to examining the external validity of our findings and using alternative outcome measures. Our study contributes to the literature by being the first to provide insights into audit-firm profitability and examine in detail its implications for audit quality and audit effort.

Keywords: Auditing, Audit Firms, Audit-Firm Profitability, Key Audit Matters, Private Firms, Audit Quality, Audit Effort

JEL Classification: G30, M10, M40, M41, M42

Suggested Citation

Chen, Jeff Zeyun and Elemes, Anastasios and Hope, Ole-Kristian and Yoon, Aaron, Audit-Firm Profitability: Determinants and Implications for Key Audit Matter Reporting (July 22, 2021). Available at SSRN: https://ssrn.com/abstract=3848871 or http://dx.doi.org/10.2139/ssrn.3848871

Jeff Zeyun Chen

Texas Christian University ( email )

2900 Lubbock Ave
Fort Worth, TX 76109
United States

Anastasios Elemes

ESSEC Business School ( email )

3 Avenue Bernard Hirsch
CS 50105 CERGY
CERGY, CERGY PONTOISE CEDEX 95021
France

Ole-Kristian Hope (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

HOME PAGE: http://www.rotman.utoronto.ca/FacultyAndResearch/Faculty/FacultyBios/Hope.aspx

Aaron Yoon

Northwestern University - Department of Accounting Information & Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

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