Audit-Firm Profitability: Determinants and Implications for Audit Outcomes
74 Pages Posted: 23 May 2021 Last revised: 20 Oct 2022
Date Written: October 19, 2022
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. 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 have 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, private-firm clients. Next, we examine the relation between audit-firm profitability and audit outcomes. Using a battery of alternative outcome measures (proxies for financial reporting quality, the propensity to issue a qualified auditor opinion, accounting restatements, and the level of unexpected KAM disclosures), we find that more profitable audit firms deliver higher audit quality. In supplemental analyses we show that the positive relation between audit-firm profitability and audit outcomes is generally stronger for more influential and illiquid clients (i.e., when auditors are exposed to more litigation risk). Our results are robust to several endogeneity controls such as using an instrumental variables approach, controlling for client-firm and audit-firm fixed effects, employing lead-lag and changes specifications, and assessing bias from correlated omitted variables. 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
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