Simunic 1980 - The Pricing of Audit Services (Theory and Evidence)

Accounting Research Center, Booth School of Business, University of Chicago
The Pricing of Audit Services: Theory and Evidence

Author(s): Dan A. Simunic
Source: Journal of Accounting Research, Vol. 18, No. 1 (Spring, 1980), pp. 161-190
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University of
Chicago
Stable URL: http://www.jstor.org/stable/2490397 .
Accessed: 28/09/2013 17:30
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp
.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.
Wiley and Accounting Research Center, Booth School of Business, University of Chicago are collaborating
with JSTOR to digitize, preserve and extend access to Journal of Accounting Research.
http://www.jstor.org
This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

All use subject to JSTOR Terms and Conditions
ofAccounting
Journal Research
Vol.18No. 1 Spring1980
Printed in U.S.A.
The Prici of Audt Nervices:

Theoryw-
and rEviden~ce
DAN A. SIMUNIC*
1. Introduction
The question of the existenceof competitionamong auditorshas been
the subject of considerablediscussionin recentyears. More specifically,
the "Big Eight" firmsas a grouphave been accused of monopolizingthe
marketforaudits (StaffStudyofthe Subcommitteeon Reports,Account-
ing and Management of the Senate Committeeon GovernmentOpera-
tions [1977]). However, evidence on the issue is scanty and typically
anecdotal (e.g., Bernstein[1978]). The evidence of the StaffStudy itself
is limitedto concentrationstatistics,withthe allegationsrelyingon what
has come to be called the "concentrationdoctrine" (Demsetz [1973]).
Accordingto this doctrine,supplierconcentrationis a reliable indicator
of supplier behavior and performance.In this paper, I provide evidence
froma test of the hypothesisthat price competitionprevailsthroughout
the marketforthe audits of publiclyheld companies,irrespectiveof the
share of a marketsegmentwhichis servicedby the Big Eight firms.The
evidence is based on an examinationof a sample cross-sectionof audit
fees.
In order to test the competitivenessof the audit industryusing fee
data, it is firstnecessary to develop a positive model of the process by
whichaudit fees are determined.Since an audit feeis the productofunit
price and the quantityof audit servicesdemanded by the managementof
the audited company (hereaftercalled the auditee), cross-sectionaldif-
* AssistantProfessor,UniversityofBritishColumbia. This paper is based on mydoctoral
dissertation(Universityof Chicago, 1979). I am indebtedto Yale Brozen,Sidney Davidson,
Nicholas Dopuch, Roger Kormendi,Shyam Sunder, and William Wecker for their com-
ments. I have also benefitedfromthe comments of participantsin various accounting
workshopsat whichthe resultsofmydissertationwerepresented.[Acceptedforpublication
November 1979.]
161
Copyright(, Institute
ofProfessional 1980
Accounting

162 JOURNAL OF ACCOUNTING RESEARCH, SPRING 1980
ferencesin fees can representeitherthe effectof quantitydifferencesor

price differences. A positivemodel of the determinantsof audit quantity
and price suggestsfactorswhich need to be controlledbeforeany infer-
ence about competitioncan be made fromobservedfee data.
Following Demski and Swieringa[1974], I considerthe externalaudit
to be a subsystemof an auditee's overall financialreportingsystem.In
this regard, the audit service is viewed as an economic good to the
auditee, which has substitutesand complementsin consumption.Thus
the quantity of auditing demanded by an auditee will result from a
conventionalequalization of marginalprivate benefitsand costs.' How-
ever, the nature of the benefitswhich an auditee derivesfromthe audit
service is still an open question. I hypothesizethat the potential legal
liability of an auditee and auditor to financialstatementusers (share-
holders, creditors,etc.) drives the design of externalfinancialreporting
systems.That is, the benefitsare in the natureofliabilityavoidance. The
implicationsof this sort of motivationare discussed later in this paper.
A second requirementfortestingcompetitionis the identificationof a
competitivebenchmark.The typical approach in the industrialorgani-
zation literature(see Weiss [1971]) is to make cross-sectionalinterindus-
trycomparisonsofmarketstructure(generallymeasured by a concentra-
tion ratio) with performance(generallymeasured by an average rate of
returnearned by firmswithinan industry).In such studies, industries
with "low" supplier concentrationserve as a benchmark.However, any
interindustry comparisonof rates of returninvolvesdifficult problemsof
controlforconfoundingdifferences, such as in risk.In thispaper,the test
for competition is an intraindustrycomparison of prices, where the
competitivebenchmarkis the market segment for "small" audits. An
intraindustrytest is possible because, as shown in table 1, the market
dominance of the Big Eight firmsincreases significantly withthe size of
the audited company.Thus, I assume that price competitionprevails in
the submarketforthe audits of "small" companiesand testforthe effects
of increasingBig Eight concentrationon prices paid by "large" auditees.
The data forthis paper consist of 397 observationson audit fees and
related variables obtained froma sample surveyof publiclyheld corpo-
rationsin the United States. The surveywas conductedduring1977.The
data were analyzed using a series of least-squares regressionswhere the
specificationof the regressionequations was derived fromthe model of
audit fee determination.Results includethe identification of a numberof
' The terms"audit" and "audit service"referto the process ofauditing,not the auditor's
certificatewhich is attached to a set of financialstatements.This distinctionis necessary
because the audit productionfunctionis clearlynot singlevalued-audit processes ofmany
differentspecificationscan result in the same observed outcome. Much confusioncan be
avoided if one is carefulto distinguishbetween these two elements. For example, while
owners may demand that financialstatementsprepared by managementbe accompanied
by an audit certificate,under existinginstitutionalarrangements,it is the auditee manage-
ment who demands the quantityof auditingwhich underliesthat certificate.

PRICING OF AUDIT SERVICES 163
TABLE 1
Big Eight Firm ConcentrationRatios in theMarket for
the Audits of Publicly Held Companies When Auditees
Are Classified bySize*
Auditee Size as Measured by Sales Big Eight Concentration
(in millions) Ratio
$1 to $25 .59
$26 to $50 .76
$51 to $100 .82
$101 to $250 .88
$251 to $500 .91
Sales > $500 .95
* These concentrationratios are constructedfrom the data
reportedby Harris [1976] whichconsistof information on auditor
identity,company size, etc. for 8,077 publiclyheld corporations.
The concentrationratio is simplythe numberof auditees in each
size class who were audited by one of the Big Eight firms,divided
by the total numberof companies in that class. Note that concen-
tration ratios are generallyconstructedusing the sales, assets,
value added, or number of employees or sellers; however,such
informationis not available forCPA firms.
significantaudit fee determinants,as well as failureto reject the hypoth-

esis that price competitionprevails throughoutthe marketforfinancial
audit services. The demand-based positive model of auditingdeveloped
in the paper also providesinsightsinto the economics of auditingunder
currentinstitutionalarrangements.
2. Assumptionsof the Fee DeterminationModel

I assume that both the auditee and auditorare riskneutraland seek to
maximizetheirown expected profitseach period.Thus, auditee manage-
ment seeks to maximize the expected profitsof the financialreporting
entity,while the auditor seeks to maximize the expected profitsof the
auditingfirm.Both parties can purchase resourcesin competitivefactor
markets.Further,let:
a = the quantity of resources utilized directlyby the auditee in

operatingthe internalaccountingsystem
q = the quantityof resourcesutilizedby the auditorin performing
the audit examination
v = the per-unitfactorcost ofinternalaccountingsystemresources
to the auditee
c = the per-unit factor cost of external audit resources to the
auditor,includingall opportunitycosts and thereforea provi-
sion fora normalprofit.
so that a and q not only
I assume that resources are utilized efficiently
denote inputs to the auditee's financialreportingsystembut also corre-
spond to unique quantities of output constructswhich may be called
internalaccountingcontroland externalaudit control,respectively.Thus,

164 DAN A. SIMUNIC
a financialreportingsystemis completelydescribedby the orderedpair

(a, q).
Assume that the auditee and auditorare jointlyand severallyliable to
financialstatementusers forlosses attributableto defectsin the audited
financialstatements.' Further,the benefitsfromthe financialreporting
system(a, q), derivesolelyfromreductionoflosses to financialstatement
users. Let the random variable, d, denote the presentvalue of possible
futurelosses which may arise fromthis period's audited financialstate-
ments. Thus, E(d) = f(a, q). Assume that the auditee and auditor
identicallyassess this functionwhich has first-and second-orderpartial
derivativeswhere:
dE(d) 2E(d) a2E(d)
<0 >0 >0.
aa da2 aaaq
dE(d) &2E(d) a2E(d)
<0 >0 >0.
aaq aqaa
And at any givenlevel of E(d):
da d2a
-<0 >0.
dq dq2
Since liabilityis joint and several,actual losses willsomehowbe divided

between the two parties.Let 6 denote the ex-postfractionoflosses borne
by the auditorwhere:
0 ' 0' 1.
At the timeofthe audit,thisloss apportionmentfactoris also a random

variable. Assume that the auditee and auditoridenticallyassess E(0) and
assume that d and 0 are independent.
Finally, let p denote the unit price of external audit services to the
auditee; that is, the price per unit of q purchasedby the auditee fromthe
auditor. The auditor's revenue derived from an audit engagement is
thereforepq, or the audit fee.
3. The Auditee's Problem When the Market forAudits Is

Competitive
An expected profit-maximizing auditee will seek to minimizethe ex-
pected periodic costs of operatinga financialreportingsystem.Let TC
2
Section 11(f)of the SecuritiesAct of 1933 and Section 18(b) ofthe SecuritiesExchange
Act of 1934provideforjoint and severalliabilityon the partofauditees and auditors.Under
these provisions,the entireamount of damages sufferedby a thirdpartycan be collected
fromany one of the liable persons,with that person generallyretainingrightsto collect
fromall otherpersonswho are also liable.

denote the total costs of the system.The auditee's problemcan initially

be expressed as an unconstrainedminimizationof expected total costs:
minE(TC) = va + pq + (d a, q)(I- (O)) (I)
In this problem, the choice variables are the systems design, (a, q),
whereas v is a marketparameter,E(8) is an unconditionalexpectation,
and E (d) is an expectationconditionalon the system'sdesign.The value
of p, on the other hand, will depend on the state of competitionin the
marketforaudit services.
An auditor's minimumsupply price per unit of q is marginal cost.
Alternatively,his minimumfee fordifferent levels of audit quantitywill
be equal to his incrementalexpected total cost, denoted E(C), where:
E(C) = cq + E(d I a, q)E(6). (2)
Note that the auditor's expected costs are a functionof the auditee's
financialreportingsystem.Since by definition,the parameterc includes
all costs of a unit of q, includinga normalreturn,3when the marketfor
audits is competitivepq = E(C), and the auditee's problembecomes:
minE(TC) = va + cq + E(dl a, q)E(6) + E(dl a, q)(1 - E(0)) (3)
or simply:
minE(TC) = va + eq + E(d I a, q). (4)
The necessaryconditionforthe expected cost minimizationis:
aE ( TC) aE(d) aE(d)

- + L =O or =V.
aa ace aa
E(T C) aE(d) aE(d)

- _ + C=O or C
aq dq aq
This conditionstates that the auditee will demand quantitiesof a and q
up to the point where the marginalreductionin expected liabilitylosses
is equal to the auditee's marginal resource cost. The solution to this
systemof equations under competitionis denoted (d, q ).
While the solution values (a, j) are obtained simultaneously,the
natureofinternalaccountingsystemsand externalauditingsuggeststhat
implementationof the solution by the auditee is sequential, that is, d is
followedby q. This is consistentwiththe normaltechnicalauditingmodel
wherein an auditor's audit programdesign is a functionof the internal
accounting system. However, to what extent does the model allow for
independentaction on the part of auditors in attainingthe solution (a,
4)? In other words, given that the auditee has computed (a, j) and
3 It is reasonable that an auditor's returnto capital be computed per unit of q rather
than per engagement,since an auditor's capital itselfis predominantlygeneralratherthan

engagementspecific.

166 DAN A. SIMUNIC
installedthe internalaccountingsystemd, what additionalconditionsare

necessaryforthe auditor to perceivethat an audit examinationof scope
q is in his own best interests?An agreementon the amount of the audit
fee,p4, insures only that q < q, since forlargervalues of q an auditor
would fail to earn a normal return.To insurethat audit scope is in fact
equal to j, it is necessary to assume (in a single-periodmodel) that the
auditee is able to evaluate q.
It is also worth noting that the solution (d, q) is invariant to the
incidence of third-party liability.Equation (3) willreduce to equation (4)
forall values where 0 c E(0) c 1. This resultholds because the auditee
expects to incur all systemscosts and is assumed to be indifferent about
whethercosts occur in the formofthe cost ofinternalaccountingsystems
(ud), the externalaudit fee (c4 + E(d Id, q)E(0)), or the expectedpresent
value of the auditee's share of residual liabilitylosses E (d Ild, ) (1 -
E(6)). However, attainmentof the competitivesolutionwhen E(6) > 0
requires that the auditee recognize that p is not a fixed value but a
function,p (a, q). In addition,when E (6) > 0, the auditee mustbe able to
analyze the componenttermsof equation (2). Thus, if one assumes that
analysis is costly,the impositionof third-party liabilityupon the auditee
alone is preferableto a regimeof joint and several liability,unless there
are sufficientoffsetting benefitsassociated withexistingarrangements.
4. The Auditee's Problem in a NoncompetitiveMarket

Setting
Suppose that a dominantsubset of auditors (e.g.,the Big Eight firms),
throughcollusion,agree to limitprice competitionso as to introducean
elementofmonopolyprofitinto audit prices.Let m representthe amount
of monopoly rent included in the unit price p.' The fee schedule of an
auditor who was a memberof the cartel would be:
pq = (c + m)q + E(d I a, q)E(6).
Substitutinginto equation (1) and simplifying,
an auditee would seek to:
minE(TC) = va + (c + m)q + E(d Ia, q).
And the necessaryconditionforthe minimizationwould be:
aE (d)
ha
aE (d)
- = c + m.
aq
In principle,a group of auditors acting as a cartel could be expected to compute and
incorporate into p, a joint profit-maximizing value of m. However, to demonstratethe
effectsof monopolypricing,determinationof the optimumm is not necessaryand I merely
assume that m > 0.

By inspection, the revised solution value of q, denoted qm, must
decrease relativeto q. In addition,since:
a2E (d)
-> 0,
aaaq
the reductionof q makes the value of aE(d)/aa more negativeat any a,
and thus the desired quantity of internalaccountingunder monopoly,
denoted an.smust be greaterthan d. However, because of diminishing
substitutabilitybetweeninternalaccountingand externalaudit resources
in controllingliabilitylosses, it must also be true that:
E(d amqm)>E(d Id,), and (5)
E(TC am,qn) > E(TC cd,. (6)

That is, monopolypricinginduces a substitutionaway fromq toward a
relativelyless productiveresource,a, whichresultsin an increase in the
desiredlevel of expectedresidual liabilitylosses (relation(5)). This effect
can be described as a decrease in the quality of the auditee's financial
reportingsystembecause financialstatementsare now more likelyto be
defective,resultingin largerexpected liabilitypaymentsto thirdparties.
In summary, auditor monopoly reduces the quantity demanded of exter-
nal auditingand resultsin lower-quality,higher-costfinancialreporting
systems.
By definition,monopoly pricingincreases the unit price of external
auditing,p. However, the effectupon observable audit fees is indetermi-
nate. That is:
pqm Z pv,
depending upon the price elasticityof demand implicitin the auditee's

cost minimizationproblemat the competitivesolutionpoint (a, q). If the
implicitdemand functionis inelastic in the vicinityof the point (c, q),
then forsmall values of m, the audit fee would increase,while ifdemand
was elastic in that vicinity,the audit fee would decrease.
While the increase inp has no clear implicationforthe audit fee itself,
I have shown that the auditee's total systemscosts must increase in a
monopolysetting.However, E(TC) includes an unobservablecost com-
ponent,E (d I a, q) (1 - E(6)), the share of residual losses expected to be
incurred directlyby the auditee. Unless the entire increase in E(TC)
occurs in this unobservable component,which is unlikely,5monopoly
pricingwill increase an auditee's observable systemscosts,or:
vamn + pqrn > Va + p4.
For this to occur,it is necessarythat E(8) = 0 and that the entireincrease in E( rC) be
in the expected residual loss component.

168 DAN A. SIMUNIC
5. The EffectsofAuditor Production Economies on

Financial ReportingSystems
While I assume that the factorcosts of resources are uniformto al
auditors,the productionfunctionsof audit firmsmay neverthelessdiffer.
In the model, productionis measured by reductionof expected liability
losses. Therefore,allowing for productionfunctiondifferencesimplies
that aE(d)/aq may vary across auditors.
If specificauditors enjoy unique economies in production,then these
firmswill earn economicrents,but the characteristicsofauditee financial
reportingsystems,includingaudit fees,will not be affected.Such econ-
omies are not of interesthere. Alternativelythere may exist sources of
economies which can be exploited,at least potentially,by more than one
auditor. If there is competitionamong the auditors who achieve the
economies,thenrentswould be bid away and audit priceswould decrease.
In addition, in equilibrium,auditees would only demand services from
those auditorswho fullyachieved the available economies.
The necessary conditionfor the minimizationof expected costs with
economies is:
aE(d)
aa
aE (d) aE(d) c
-X- =c or -
aq aaq X
where the parameter N _ 1 denotes an auditor's relative efficiencyin
reducingexpected losses. For auditors who achieve economies, N > 1. I
will denote the auditee's expected cost-minimizingsolution with econ-
omies as (ae q,). The characteristicsof this solution are the reverse of
the monopolyresults.That is, whilep decreases, the sign of the change
in audit fee is indeterminate,since the auditee is motivatedto substitute
q for a and the net change in pq depends on the price elasticityof the
implicitdemand functionforexternalauditing.As in the case of monop-
oly, unless the entire change occurs in the auditee's share of residual
losses, which is unlikely,then:
vae + pqe < vd + p4.
6. Effectsof Variations in Assessed Loss Functions

The loss function,E(d) = f(a, q), will vary across audit engagements.
The assessment of this functionby the auditee and auditor can be
includinghistoricloss expe-
expected to reflectall available information,
riences under similarcircumstances.The spatial location of the function
assessed for a specific engagementcan be influencedby many factors,
includingthe legal environmentand various internalcharacteristicsof
the engagement,which I call determinantsof loss exposure. Possible

variables which mightbe associated with such differencesare discussed
in a later section. At this point, I simplynote that a uniformupward
displacementofthe loss functionin the (E(d), a, q) space, that is, greater
loss exposureat any (a, q), increasesthe marginalbenefitsfromexpected
loss reductionand resultsin expansion of the cost-minimizing financial
reportingsystem.Note that thereis no change in relativeprices.Rather,
the expansionof a and q is complementary.As a result,each ofthe three
componentsof the auditee's expected total costs, namely, ua, pq, and
E (d I a, q) (1 - E (6)), can be expected to increase. Finally,this increase
in demand forboth controlresourceswill occur under any and all of the
three industryscenarios-competition, monopoly,and auditor econo-
mies-discussed in the previoussections.
7. SummaryoftheModel and Developmentofthe Test for

Competition
The implicationsof the model, in the formof directionalchanges in
the auditee's decisionvariables and relatedcosts,are summarizedin table
2. The changes described in the firsttwo columns of the table are
measured against the competitivesolution;the last two columnsdescribe
the effectsof differencesin assessed loss functionsand the loss-sharing
ratio. The characteristicsof auditee financial reportingsystems are
grouped into two categories,unobservable and observable. Included in
the formerare the auditee's share of residual losses, the price of audit
services,and the quantities of internalaccountingcontroland external
audit controlwhich the auditee demands.
TABLE 2
Implications of the Model withRespect to Cross-Sectional Differencesin the
CharacteristicsofAuditee Financial ReportingSystems
Monopoly Production Increase in Audi- Increase in

Pricing Economies tor's Share Loss Exposure
Losses LosEpur
Unobservable:
Auditee's share of residual
losses E(d I a, q)(1-E(0)) + - - +
Unit price of the audit service
(p) + - + none
Quantityofinternalaccounting
control (a) + - none +
Quantity of external audit con-
trol (q) ................... + none +
Observable:
Audit fee (pq) .............. Depends on implicit
price elasticityof de-
mand + +
Cost of internal accounting con-
trol ( ua) + - none +
Sum (va +pq) + - + +

170 DAN A. SIMUNIC
Recall fromthe assumptionsof the model that a and q eithercan be

thoughtof as generalized quantities of factorinputs or as output con-
structs.As outputs,these quantitiesare not observable.It is the output
construct,externalaudit control,which is priced in the marketforaudit
services and the price,p, is likewisenot observable.Rather,we can only
observe the fee, pq. In the case of internal accounting, there is no
interveningoutputmarketand thus no marketprice.However,assuming
efficiencyin resourceuse, va and pq are commensurable.
Based on the model, the hypothesisthat price competitionprevails
throughoutthe marketforaudit servicescan be tested using the sum of
observable systemscosts, va + pq. Before I develop the test,note that
while the Big Eight firmshave been accused of monopolizingthe market
foraudit services,these firmsare also the most likelyto have exploited
available economies of scale. Furthermore,scale economies can exist in
either a monopolisticor a competitivemarket setting.Note also that
audit servicesmay be differentiated. With respectto productdifferentia-
tion,the marketforaudits is a hedonic market(see Rosen [1974]). That
is, differentiated products are not observed directlybut rather are re-
vealed by differencesin prices which are associated with differencesin
observedproductcharacteristics.In auditing,the principaldifferentiating
characteristicof the service is likely to be the identityof the supplier,
and again it is the Big Eight firmswhichenjoy visibilityand brand-name
recognitionamong buyers. Thus, the pricingof audit services can be
expected to be complex, and any price differencesbetween Big Eight
firmsand otherauditorsmust be interpretedwithcare.
Given these considerations,to test the hypothesisof competitionit is
firstnecessary to controlforcost differencesarisingfromdifferencesin
loss exposure and the expected loss-sharingratio. Call the cost not
explained by these factorsthe cost residual. Next, classifyauditee cor-
porations into two size categories, "small" and "large,"'6and classify
auditorsas Big Eight or non-BigEight firms.The purpose ofthe auditee
size classificationis to partitionthe marketintoa segmentwhereauditees
can and do purchase servicesfroma large numberofsuppliersand which
can thereforebe assumed competitive,and a segment where the Big
Eight are highlydominantand may behave as a cartel.Differencesin the
average cost residuals between auditees using Big Eight and those using
non-Big Eight firmscan then be interpretedusingtable 3. Note that the
test requiresa joint comparisonofdifferences in average cost residualsin
both marketsegments;that is, resultsin the "large" auditee segmentcan
only be interpretedby referenceto the competitivebenchmark.Finally,
in interpretingpossible findings,I assume that if the Big Eight firms
collude to increase prices in the "large" auditee segment,theirnon-Big
Eight competitorswould seek to expand marketshare and price consist-
6
For the moment,the bound between these categoriesis not specified.

TABLE 3
Test for Competition:InterpretationofPossible Differencesin Average Residual Total
SystemsCosts ofAuditees Using Big Eight versusNon-Big Eight Auditors across
Market Segments
Results forthe "Small" Auditee Segment
Results forthe "Large"
Auditee Segment (CRE I8) > (CRE I8) = (CRE I8) <
(CREI8) (CREI8) (CRE 18)
(CRE | 8) > (CRE 8 .)* Competition with Monopoly pric Monopoly pric-
differentiated ing by the Big ing by the Big
product to the Eight Eight together
Big Eight withscale econ-
omies to the Big
Eight
(CRE | 8)- (CRE I8 ) Competition with Competition Monopoly pric-

differentiated without any scale ing by the Big
product to the economies to the Eight together
Big Eight to- Big Eight with scale econ-
gether with dis- omies to the Big
economies to Eight
non-Big Eight
with "large" au-
ditees* *
(CRE | 8) < (CRE 8 .) . Competition with Competition with Competition with

differentiated diseconomies to scale economies
product to the non-Big Eight to the Big Eight
Big Eight to- with "large" au-
gether with dis- ditees
economies to
non-Big Eight
with "large" au-
ditees
* (CRE I8) denotesthe average residualcosts ofauditees usinga big Eightfirmand (CRE I8) denotes
the average residual costs of auditees using a non-BigEight firm.
** The combinationswhereinthe costs of large auditees onlyare lowerwhen a Big Eight firmis the
auditor would be evidence of economies to the Big Eight or diseconomiesto the non-Big Eight when
performing large audits. Note that this is not evidence of economies to auditorsize, arising,forexample,
-fromstaffspecialization,since the effectis limitedto a certainaudit context.As a result,I wouldinterpret
such findingsas evidence of diseconomiesto smallerauditorswhen servicinglarge auditees.
ent with their own cost conditions,rather than to maintain the cartel
price.
8. Control Variables forDifferencesin Loss Exposure
Little is presentlyknown about sources of variationsin liabilityloss

exposure across audit engagements.To obtain some initial insights,I
discussed the question with Chicago-area representativesof each of the
Big Eight firmsand with representativesof a number of organizations

172 DAN A. SIMUNIC
writingprofessionalliabilityinsurance coverage foraccountants.7From

these discussions,the followinggeneralfactorswereidentifiedas possible
determinantsof loss exposure: (a) the size of the auditee, (b) the com-
plexityof the auditee's operations,(c) auditingproblemsassociated with
certain financial statement components,especially inventoriesand re-
ceivables, (d) the industryof the auditee, and (e) whetherthe auditee is
a publicly or closely held company. The data for this research were
obtained solely frompubliclyheld corporationsand thus were homoge-
neous with respect to the last factor.The variables and theirmeasures
used to control for the remainingfactors are described below. Each
variable is assigned a mnemonicname forease of furtherreference.
SIZE OF THE AUDITEE
I measured the size of the auditee by the entity'stotal year end assets
(variable name ASSETS). A priori,the stockofassets seems moreclosely
related to possible loss exposurethan would an accountingflowmeasure,
such as revenue,because defectivefinancialstatementswhichresultin a
lawsuitfrequentlyinvolvesome deficiencyin asset valuation.In addition,
externalauditorshave traditionallyapproachedthe audit processthrough
the endingbalance-sheet, relyingon the factthat verificationof balance
sheet componentsindirectlyverifiesreportedincome.Note also thatboth
internalaccountingand externalauditingare sampling-basedprocesses.
To the extentthat increases in measured total assets of auditees reflect
increases in the number of individual elements which comprise the
accounting populations of which total assets are composed, then the
sample size requiredto achieve a givenlevel of controlwill increase at a
decreasing rate. Thus, I hypothesized that the positive relationship
betweenASSETS and both q and a is nonlinear.
COMPLEXITY OF THE AUDITEE S OPERATIONS
Loss exposure can be expected to increase,the greaterthe decentrali-

zation and diversificationof the financialreportingentity.Both of these
aspects of complexityincrease the number of decision centers in an
organizationwhose activitiesneed to be monitored.The recent contro-
versy over illegal corporatepaymentsand the resultinginternalcontrol
requirementsimposed by the Foreign CorruptPractices Act reflectthe
overall problemof controllinglarge decentralizedorganizations.
In this study,I measured decentralizationby the number of consoli-
dated subsidiarieswhichare includedin the auditee's financialstatements
(variable name SUBS). The diversificationof the auditee is measured
using two variables: (1) the numberof Standard IndustrialClassification
System two-digitindustries in which the auditee operates, less one
7Information was obtained from the followinginsurers:American Home Assurance
Company,the St. Paul Companies,Chubb CustomMarket,Inc.,Crum& ForesterInsurance
Companies, and Lloyd's Underwriters'Non-MarineAssociation.

(variable narmeDIVERS), and (2) by the ratio of the auditee's foreignto

total assets at year-end(variable name FORGN).
RECEIVABLES AND INVENTORIES
Auditors have long recognized that certain accounting populations

involve potentially greater loss exposure through the loose notion of
"relativeaudit risk" (see, e.g.,Lenhart and Defliese [1957]).In thissense,
both receivables and inventoriesare "risky"balance sheet components.
Specific auditingprocedures (confirmationand observation)are recom-
mended forthese accounts. Moreover,the valuation of these items is a
complex task, requiringa forecastof futureevents.Liabilityexposure is
thus expectedto varycross-sectionally withtherelativesize ofreceivables
and inventoriesin different auditee balance sheets. To controlforthese
differences,I used the two ratio variables: receivables to total assets at
year-end (variable name RECV) and inventoriesto total assets at year-
end (variable name INV).
PRINCIPAL INDUSTRY OF THE AUDITEE
While loss exposure may well vary with the industry(ies)in which an
auditee operates, there is really no basis to hypothesize any specific
industryeffects.However,possible differences in q and a associated with
industryclassificationwere also investigatedin the sample data.
9. Control Variables forDifferencesin theAssessed Loss-

Sharing Ratio
A plausible, and probablythe only measurable,determinantofE (8) is
evidence of auditor or auditee financialdistress.Recall that the auditor
and auditee are assumed to assess identical distributionson 0. Evidence
of auditor financialdistressincreases the probabilitythat the realization
of 0 will be 0 = 0; that is, all losses must be paid by the auditee because
the auditoris insolvent.Thus E (0) would decrease. Conversely,evidence
of auditee financialdistressincreases the probabilitythat realized 0 = 1,
due to auditee insolvency,and E(6) would increase.
Because public accounting firmsare private partnerships,evidence
which mightbe used to assess possible financialdistress of auditors is
difficultto obtain. As a result,I did not controlforthis effect.
I used threevariables to controlforcross-sectionaldifferences in E(0)
arising from auditee financial difficulty. The firstis a. measure of the
auditee's accountingrate of returnin the currentyear, the ratio of net
income to total assets at year-end (variable name PROFI7-) E(0) is
expected to increase as thaerate of returndecreases. Note that rate of
return measures have been found useful in bankruptcystudies (e.g.,
Beaver [1968] and Altman [1968]) for discriminatingbetween "failed"
and "nonfailed." firms. Tlh second variable is a (0, 1-)variable which was

174 DAN A. SIMUNIC
assigned a value of one if an auditee had incurreda net loss duringany

one ofthe currentor twopriorfiscalyears (variablename LOSS). Finally,
I used another (0, 1) variable to identifythose auditees who received a
"subject to" qualified audit opinion in the currentyear (variable name
SUBJ). A "subject to" qualificationis givenwhen thereexistsignificant
uncertaintieswhich may result in futurelosses to the auditee. In the
United Kingdom,Firth[1978] foundthat the issuance ofan opinionform
equivalent to a "subject to" (namely,"asset valuation" and "going con-
cern" qualifications)by a U.K. auditorhad a significantnegativeimpact
on the marketpriceofthe auditee's securities.Thus, the conditionswhich
underlie the issuance of a "subject to" opinion were hypothesized.to
affectthe assessmentofE (6) such that E (6) increaseswhen SUBJ takes
on a value of one.
10. Differencesin Auditor Production Functions
There has been essentiallyno previousresearchin the area of auditor

productionfunctionsand sources of productioneconomies. In my study,
I did not investigatedirectlyany specificsources of economies to scale.
Rather I inferredthe presenceof some unspecifiedeconomiesto firmsize
if,as describedin table 3, the residualsystemscosts of "small" companies
usingBig Eight auditorswere,on average,lowerthan the costs of "small"
companies using non-BigEight auditors.8The argumentis analagous to
a test for scale economies based on the survivorprinciple (see Stigler
[1968]), in that the currentstate of the industrymightarise fromany
numberof factorswhichincrease the relativeefficiencyof the Big Eight
firms.
I did, however,controlforthe possible source of productionfunction
differencesacross engagementsbroughtabout by reductionsin q because
of auditor learningover time.The reductionof cumulativeaverage costs
through learning during successive performancesof a task has been
observedin severalphysicalproductionsituations.A similarphenomenon
can be expected in auditingif the auditee employsa given auditor fora
number of years. Normally,the effectsof learningwould be measured
using time series of productionand cost data. But, a learningeffectcan
also be observedin a cross-sectionof audit feesifthe effectis sufficiently
large and the lengthof auditee/auditorassociation varies in the sample.
To controlforpossible differencesin q fromthis source, I included as a
control variable the number of years an auditee has used its current
8 To inferthe presenceof scale economiesto the Big Eight,it is bothnecessaryand
that(CRE 18) < (CRE 18) in thecompetitive
sufficient marketsegment. Ofcourse,ifthe
Big Eightdo notpriceas a cartel,thenthe samerelationship wouldbe observedin the
marketsegment for"large"audits.

auditor (variable name TIME).9 The relationshipbetween TIME and q

was hypothesizedto be negative.
1iZ. Measurement of the Dependent Variables

The auditee's total observable systemscosts consist of-thetwo com-
ponents, va and pq. Since the audit fee is a paymentmade in a market
transaction, measurement of pq was relatively straightforward. This
element of total cost is denoted by the variable named FEE.
Identificationand measurementof the empiricalcounterpartof the va
componentwas substantiallymore difficult.From the model, note that
internalaccountingresourcesare only relevantto a test forcompetition
among externalauditorsifthe (a, q) resourcesare substitutable.In order
to obtain a relevant measure of va for purposes of this study,it was
sufficientto identifyand measure those elements of internal systems
costs which could reasonably be substitutedforexternalaudit services.
Based on this argument,I measured va using the salaries paid by the
auditee to its internalauditors.This element of total cost is denoted by
the variable named ICOST.
While the test forcompetitionis based on residual differencesin the
sum of FEE + ICOST, the individual componentsmay differin degree
ofmeasurementerrorand are each ofinterest.Therefore,in the analyses
which follow,I examine the behavior and determinantsof the separate
componentsas well as of the sum.
The variables, their measures, and hypothesized relationships are
summarized in table 4. The average residual differencein the systems
costs of auditees across the two auditor classes is measured by the
coefficientof a (0, 1) variable named AUDITOR which is assigned a
value of one when the auditoris a Big Eight firm.The questionnaireused
to obtain data on these variables is available on request.
12. Design and Results of the Survey

The basis forthe surveywas the list of publiclyheld corporationsand
theirauditorscomprisingthe 1976 editionof Who AuditsAmerica?This
list includes 8,077 companies classified by sales volume and auditor
identity.A stratifiedsample of 1,207 companies was contacted during
1977 througha questionnairemailed to a principalfinancialofficerofthe
corporation.The size ofthe sample was based on an informalassessment
of the marginalbenefits-costsof samplingand an expectedresponserate
of30 to 40 percent.'0The sample is stratifiedby size ofauditee (companies
9 As learningoccurs, an externalauditor becomes relativelymore efficient in reducing
losses and, from the model, the auditee is motivated to substitute q for a. However,
adjustinga controlsystemis probablycostly,and I do not expectto observenordo I control
forthis effectin the empiricalwork.
10The responserate to the Financial Executive Institute'saudit feesurveyofits members
was 41 percent (Hobgood and Sciarrino[1972]).

176 DAN A. SIMUNIC
TABLE 4
Summaryof Variables and HypothesizedRelationships
Relationshipto Auditee's Sys-
Name tems Cost Component
FEE ICOST
Control variables for differencesin loss
exposure:
1. Total assets at year-end ASSETS + +
2. Number of consolidatedsubsidiaries SUBS + +
3. Number of two-digitSIC industries DIVERS + +
in which auditee operates,less one
4. Foreignassets + total assets at year- FORGN + +
end
5. Accounts,loans, and notes receivable RECV + +
* total assets at year-end
6. Inventories . total assets at year-end INV + +
Control variables for differencesin the

assessed loss-sharingratio:
7. Net income + total assets PROFITS - N/A
8. (0, 1) variable where (1) if auditee LOSS +
incurredloss in any oflast threefiscal N/A
years
9. (0, 1) variable where (1) if auditee SUBJ + N/A
receiveda "subject to" qualifiedopin-
ion
Controlvariablefordifferences
in auditor
productionfunctions:
10. Number of years auditee has used TIME - N/A
currentauditor
Auditoridentity:
11. (0, 1) variable where (1) if auditor is AUDITOR any-see table 3
a Big Eight firm
Dependent variables:
12. Amountofcurrentyear'sexternalau- FEE
dit fee
13. Salaries paid to internalauditors in ICOST
currentyear
withsales less than $125 millionversusthose withsales greaterthan that

amount) and by auditor group (Big Eight firmversus non-Big Eight
firm).The "small" auditee segmentwas bounded at $125 million,since
the marginal Big Eight market share for clients of this size and larger
approaches 90 percent.Thus the hypothesisthat competitionprevails in
the marketforaudits of companies greaterthan about this size becomes
difficultto maintain,a priori."
" That is, a marketshare this large would surelybe sufficientevidence,to a believerin
the "concentrationdoctrine,"that the marketsegmentwas not competitive.Even a smaller

TABLE 5
Responses byStratum
SmallAuditees(sales LargeAuditees
less than $125 million) (sales greaterthan All Auditees
$125million)
Big Eight auditor:
Sample requests 333 425 758
Usable responses 117 172 289
Response rate 35% 40% 38%
Non-Big Eight auditor:

Response rate 21% 31% 24%
All auditors:
Response rate . 29% 37% 33%
Within each stratum,sample units were selected at random. Re-

sponse rates by stratumare shown in table 5. Follow-upsecond requests
were sent to approximately50 percentof initialnonrespondents, withan
emphasis on those strata witha low response rate.
13. Test forNonresponse Bias

I examined the possibilitythat respondentsand nonrespondentswere
not homogeneous with respect to relevantcharacteristicsby comparing
the values ofvariables reportedby earlyand late respondents,a standard
test fornonrespondentbiases (see Oppenheim [1966]). Means and stan-
dard deviations (whereapplicable) of the values ofreportedvariables for
the two groups are shown in table 6. The early respondentsare those
whose replies were received duringthe firstthree weeks (the declared
due date of the mailing),while the late respondentsconsistprimarilyof
those companies who replied to the second request.
Note fromtable 5 that nonresponsewas more frequentamong smaller
companies and those auditees using non-Big Eight auditors. Table 6
shows that whilethe size ofearlyand late respondentswas approximately
the same, a substantiallylarger proportionof late respondentsused a
non-BigEight auditor.This supportsthe argumentthatlate respondents
were good proxies for nonrespondents.Since the mean values of the
various othervariables were substantiallyidentical,the data obtained do
not seem to be biased. However, I still cannot explain the reluctanceof
companies using non-BigEight auditorsto respondto the survey.
marketshare mightbe sufficient
to supportan allegationofmonopoly,but thereis no basis
to determinea minimumrequiredshare. Thus the bound is necessarilysomewhatarbitrary.

178 DAN A. SIMUNIC
TABLE 6
Test forNonresponse Bias
188 Early Respon- 47 Late Respondents
dents
ASSETS: mean . $389,125M $384,682M

std. dev. (918,908) (756,725)
SUBS: mean 13 15
std. dev. . (20) (44)
DIVERS: mean .89 .91
std. dev. (1.32) (1.47)
FORGN: mean .07 .06
std. dev. (.17) (.13)
RECV: mean . .23 .24
std. dev. (.16) (.18)
INV: mean .23 .26
std. dev. (.18) (.28)
PROFIT: mean ... .06 .06
std. dev. (.07) (.05)
LOSS: percentof companies withnet losses . 20% 21%
SUBJ: percent of companies with a "subject
to" . 10% 10%
TIME: mean .. . 18 19
std. dev. (13) (16)
FEE: mean .$170M $193M
std. dev. (258) (337)
AUDITOR: percentof companies using a Big Eight
auditor ..71% 42%
14. Test of the DeterminantsofAudit Fees

Data received fromthe respondentsare summarizedin table 7, using
means and standard deviations (in parentheses)forthe arithmeticvari-
ables, and the percentageof observationswhen the variable takes on a
value of one forthe categoricalvariables.
The hypothesesabout the determinantsof the audit fee componentof
total observable costs were tested by obtainingleast-squares' estimates
of the coefficientsof the variables in the followinglinear regression
function:
ETSe bo + biSUBS + b2DIVERS + b3FORGN + b4RECV
+ b5INV + b6PROFIT + b7LOSS + b8SUBJ
+ b9TIME + b oAUDITOR + u
where the variables were constructedas describedin table 4, and where

the errorterm,ii, was assumed to have the standard properties.'2The
12
Examinationofvarious scatterplots ofresidualsindicatesthat the residualvarianceis
homogeneous when the square-roottransformation is used. However,with the cube-root
transformation, ofASSETS, whichwas also examined,
as well as witha log transformation
the errorvariance is correlatedwithASSETS. When the exponentis varied from.33 to .5,
the signs of significantcoefficientsare unchangedand thereare only small changes in the
t-valuesforall coefficients.

TABLE 7
DescriptiveStatistics for Variables
ByAuditeeSize ByAuditor
Group
397Total 187Auditees 210Auditees 108Auditees
Observations withSales withSales U28ng a Big Usinga Non-
Less Than GreaterThan EightAuditor BigEightAudi-
$125million $125million EgtAdor tor
FEE $206.6M $77.1M $322.0M $226.6M $153.0M
(277.1) (71.4) (355.0) (266.9) (297.2)
ICOST $112.OM $29.OM $202.8M $141.0 $ 45.5M
(271.0) (83.0) (361.8) (308.2) (134.2)
ASSETS $555.1MM $176.7MM $891.9MM $695.6MM $178.9MM
(1,194.5) (640.7) (1,147.7) (1,311.8) (672.8)
SUBS . 16.9 7.0 25.6 18.1 13.4
(30.5) (13.9) (37.8) (31.1) (28.8)
DIVERS .9 .6 1.3 1.0 .7
(1.4) (.9) (1.6) (1.4) (1.1)
FORGN .07 .05 .11 .08 .05
(.15) (.11) (.17) (.15) (.11)
RECV .23 .24 .18 .23 .23
(.17) (.18) (.1I1) (.17) (.14)
INV .23 .25 .23 .20 .29
(.19) (.21) (.17) (.17) (.23)
PROFIT .06 .06 .06 .06 .07
(.06) (.08) (.04) (.04) (.08)
LOSS 16.3% 25.7% 8.1% 13.8% 23.1%
SUBJ 8.0% 8.5% 7.6% 8.0% 9.3%
TIME 19.0 yrs. 13.7 yrs. 23.8 yrs. 19.9 yrs. 16.6 yrs.
(15.2) (12.0) (16.1) (15.8) (12.9)
A UDITOR 72.5% 62.0% 82.0% 100.0% 0.
dependent variable was deflatedby some power transformation of AS-

SETS, denoted ASSETSe, in orderto linearizethe FEE = g(ASSETS)
relationship.I used a power transformation because, in the absence of a
theory from which the form of the function,g, can be derived, the
exponentfora power transformation can readilybe estimated.Thus, if
FEE = wASSETSe6, then In FEE = In w + e(ln ASSETS) + In v,and
a least-squares estimateof the exponentis simplythe e in the regression
of In FEE on In ASSETS.
Note that by using size-deflatedaudit fees as the dependentvariable,
an implicitinteractionis assumed between ASSETS' and each of the
independent variables and the errorterm in the determinationof the
observed undeflated value of FEE. That is, the effectof each of the
independent variables in the regressionfunctionwas assumed to be
conditionalon auditee size.
Using this approach, the result of the firststep in the data analysis
yielded a regressionof In FEE on In ASSETS of:

180 DAN A. SIMUNIC
In FEE = 3.33 + .45(ln ASSETS)

t= 9.1 t= 22.7
2 = .57
n = 397 observations.
Taken alone, the variable ASSETS is a verysignificantdeterminantof

the audit fee, with a nonlinearrelationship,as hypothesized.While the
estimatedexponentforthe ASSETS transformation is .45,the test ofthe
determinantsof the ratio, FEE/ASSETSe, may be sensitive to the
specifictransformation which is used. Therefore,I fittedthe regression
functionusing both a somewhat larger exponentvalue of .5 (a square-
root transformation)and a somewhat lower value of .33 (a cube-root
transformation).The best resultswere obtained with a .5 exponentand
are shown in table 8. However, overall resultswere not sensitiveto this
variationin the exponent.13
Table 8 shows the regressioncoefficients,their standard errors (in
parentheses), and various regressionstatistics. Coefficientswhich are
significantat the .05 level in a one-tailor two-tailt-test(as appropriate)
are marked with an asterisk.The correlationmatrixof the variables is
displayedin table 9. Column 1 of table 8 includesall usable observations,
while the last three columns,which are relevantto the test forcompeti-
tion, exclude twenty-four responses received frombanks (SIC code 60).
Bank respondentswere excluded fromthe test both because none of the
banks in the sample was audited by a non-BigEight firm,and theywere
outlierswith uniformlyverylow values forthe dependentvariable. The
coefficientfor the variable BANK in column 1 is for a (0, 1) variable
(given assigned a value of one forthese twenty-four respondents).
Examinationof the data also revealed that the dependentvariable was
systematicallylow forpublic utilitycompanies (SIC code 49). However,
the twenty-twoutilitiesin the sample were audited both by Big Eight
and non-BigEight firms.Thus, I includedin the regressionanother(0, 1)
variable, denoted UTILITY, whose observationswere retained forthe
test of competition.In addition, a power transformation(using a .5
exponent) of the variable SUBS and a log transformation of the variable
TIME helped to linearizethe fittedfunction.
A finalmodificationofthe regressionfunction, made aftera preliminary
examinationofthe data, was to partition Big Eight firmsinto the two
the
groups,Price Waterhouse& Co. ((0, 1) variable named A UDITOR-PW)
and the remainingseven firms((0, 1) variable namedA UDITOR-7). This
was done because, as shown in table 10, the average value of the
dependent variable varied across the Big Eight, with Price Waterhouse
13 This is the hypothesizedspecificationof the function.As explained below, certainex-
post modificationsof the regressionfunctionwere made aftera preliminaryanalysis of the

data.

TABLE 8
Regression of (FEE/ASSETS5) on Explanatory Variables
ExcludingBanks
Hypothesized 397 Total .373Observa- 202 Auditees
Sign of tionsExcluding 171 Auditees withSales
Coefficient Observations Banks withSales Less GetrTa
Than $125MM GreterTha
SUBS.5 + .96* 1.01* 1.32* .93*

(.14) (.15) (.37) (.18)
DIVERS + 1.03* .99* 1.82* .72*
(.26) (.27) (.55) (.31)
FORGN + 14.88* 14.72* 14.37* 14.61 *
(2.45) (2.53) (5.27) (2.88)
RECV + 9.06* 9.72* 6.15* 18.93*
(2.29) (2.41) (3.06) (4.46)
INV + 7.26* 7.42* 6.46* 9.09*
(1.86) (1.90) (2.57) (2.98)
BANK none -9.79*
(1.63)
UTILITY none -2.97* -2.83* -1.64 -1.62
(1.59) (1.63) (4.01) (1.87)
PROFIT - 2.52 2.58 1.81 1.53
(5.52) (5.64) (6.74) (12.20)
LOSS + 1.83* 1.85* 2.12* .93
(.92) (.94) (1.20) (1.73)
SUBJ + 2.71* 2.84* 3.84* .81
(1.19) (1.23) (1.90) (1.73)
LOG(TIME) - -.43 -.23 1.18 -1.58
(.86) (.89) (1.34) (1.28)
AUDITOR-PW none .76 .94 .78 1.20
+ or - (1.14) (1.18) (1.88) (1.61)
A LDITOR-7 .1.66* -1.69* -1.84 -1.15
(.77) (.79) (1,08) (1.21)
Intercept 5.67 5.14 3.84 5.14
Std. error of the estimate 6.32 6.45 6.57 6.30
Adjusted R2 . .46 .42 .28 .51
F 26.79 23.6 6.5 18.4
FEE/ASSETS.5
mean . .13.0 13.61 12.61 14.54
std. dev. (8.58) (8.49) (7.74) (8.98)
* An asteriskindicatesthat the regressioncoefficient
is significantat the .05 level in a one-tailor two-
tail (as appropriate)t-test.Standard errorsof the regressioncoefficients are shown in parentheses.
a high-valueoutlierboth in average deflatedfees received and, as will be

shown,in auditees' average deflatedinternalcosts.?4
to note that the rankingof the Big Eight by average deflatedfees in
14 It is interesting
table 10 corresponds closely to the verbal descriptionof each firmrecently given by

Bernstein[1978]. QuotingBernstein,the firmsare describedin sequence: PW-"the premier
accountingfirm";AY-"not aggressive,super professional";E & W-"not on the competi-
tive edge"; DHS-"not aggressive, strong auditors"; AA-"aggressive... emphasize
growth";PMM-"very aggressive... price cutter";TR-"very aggressive... price cutter";
CL-"most aggressiveof the eight... price cutter."

182 DAN A. SIMUNIC
, c
co0Q 00 n -- C 1
'C c i- LO L
. . . . . . 0. . . 0. .
I It Ittq C
EN4
O LO LO. L-.
t~ ~~~L
?. LO "t--
?~~~~r-
EN. . q LO.C oII
C Lo II
Ill 'l -ii
cl~cl
cc...

TABLE 10
Average Fees Paid to Big Eight Auditors Deflated byASSETS5
(Excluding Bank Respondents)
Numberof FE en ASSETS5`Std.
Observations FEE Mean Dev.
Price Waterhouse & Co 44 16.4 9.1

ArthurYoung & Co. 16 15.0 7.7
Non-Big Eight firms 108 14.1 8.8
Ernst & Whinney 30 14 8.5
Deloitte Haskins & Sells 27 13 9.8
ArthurAndersen & Co . 57 12.7 8.8
Peat Marwick Mitchell & Co. 30 12.5 8.0
Touche Ross 20 11.8 5.6
Coopers & Lybrand 41 11.6 6.8
Note that the individual regressioncoefficientsacross the last three

columns of table 8 are similar.A formaltest of the homogeneityof the
"small" and "large" auditee segmentsyielded an F-statisticof 1.3 with
(13,347) degrees of freedomand resulted in failureto reject (at the .05
significancelevel) the null hypothesisthat the overallregressionrelation-
ship is homogeneous across the two auditee size categories.'5However,
homogeneityof the audit fee regressionacross auditee size classes is not,
test forcompetition,because possible auditee substi-
in itself,a sufficient
tutiontoward or away frominternalaccountingresourceshas not been
controlled.For the same reason, the uniformlynegative coefficientsof
A UDITOR-7 and the uniformlypositive coefficientsofA UDITOR-PW
cannot be interpretedat this point.
15. Test of the Determinantsof the Sum of ControlCosts

In order to interpretthe AUDITOR coefficients, it was necessary to
examine the behavior of total systemscosts. Of the 397 observations,333
respondentsprovided informationon the variable ICOST. Respondents
who failedto providethe information were typicallylarge,decentralized,
consolidatedentitiesforwhomthe cost ofcollectingthe data mightlikely
15 The test statistic(Johnston[1972])is:
(SSI - SS2 - SS3)k
F =
(SS2 + SS3)/(m2 + m3- 2k)
where
SS1 = residual sum of squares forthe total observations(excludingbanks) regression
SS2 = residual sum of squares forSales < $125MM regression
SS3 = residual sum of squares forSales > $125MM regression,and
k = 13(numberof variables); m2 = 171; m3 = 202.
Substituting:
F (14997 - 6824 - 7488)/13 52.7

1.3
(6824 + 7488)/(171 + 202 - 26) 41.2

184 DAN A. SIMUNIC
be high.Of the 333 completeresponses,nineteenwere frombanks,which

reduced the available observationsforthe test of competitionto 314.
Proceeding as in the analysis of the audit fee data, the regressionof
ln(F'EE + ICOST) on ln(ASSETS) yielded an estimatedslope coeffi-
close to one-halfto justifyuse of
cient,e, of .55. This value is sufficiently
the square-roottransformation ofASSETS as the size deflatorforeach
cost component,and thus fortheirsum.
The least-squares' estimates of the coefficientsof the variables in the
linear regressionfunction:
FEE + ICOST
- bo + b1SUBS + b2DIVERS
ASSETS '
+ b3FORGN + b4RECV + b5INV
+ b6PROFIT + b7LOSS + b8SUBJ
+ b9TIME + b1oAUDITOR-PW
+- bi1AUD)ITOR-7 + bl2UTILITY + 6
are displayedin table 11,togetherwithvariousregressionstatistics.As in

table 8, the standard errorsof the coefficientsare shown in parentheses,
while coefficientswhich are significantat the .05 level are marked with
are ofprincipal
an asterisk.In these results,the sets ofauditorcoefficients
interest,with the remainingvariables included solely for purposes of
control.
Finally,forcompleteness,I display in table 12 the least-squares' coef-
ficientestimates of the variables hypothesizedto be determinantsof
ICOST. The regressionfunctionis:
ICOST
bo+b1SUBS+bb2DIVERS+ b3FORGN
ASSETS 5
+ b4RECV + b5INV + b6AUDITOR-PW
+ b7AUDITOR-7 + b8UTILITY + 6.
Results are presentedusing the same formatas in table 11. Four obser-
vations were deleted fromcolumn 1 as outliers,representingverysmall
companies who used some internalauditorswithveryhighvalues forthe
constructeddependentvariable.
A scan of table 12 shows that the regressionresultsare, on the whole,
unsatisfactory.The low adjusted R2 and the lack of significanceand
inconsistentsigns of many of the control variables suggest that the
determinantsof ICOST are not correctlyspecifiedand/or that there is
significanterrorin the measurementof this variable.

TABLE 11
Regression of ((FEE + ICOST)/ASSETS5) on Explanatory Variables
4Observations 160 Auditees with 154 Auditees with

Banks Sales
Excludig Less Than Sales GreaterThan
Excluding $125MM $125MM
SUBS5 . .1.58* 1.34* 1.35*

(.21) (.43) (.28)
DIVERS . .1.70* 2.22* 1.35*
(.41) (.66) (.54)
FORGN . .12.88* 12.38* 12.09*
(3.41) (6.40) (4.12)
RECV ............... ........ 9.74* 7.39* 25.72*
(3.22) (3.67) (6.79)
INV ........................... 8.73* 9.16* 7.71*
(2.52) (3.03) (4.41)
UTILITY . .-2.75 -1.36 -2.32
(2.17) (4.60) (2.68)
PROFIT . ..57 -.63 .37
(7.26) (7.77) (18.11)
LOSS . ..56 .89 2.18
(1.22) (1.41) (2.53)
SUBJ .......................... 2.88* 4.49* .25
(1.63) (2.19) (2.57)
LOG (TIME) . 1.41 2.19 -1.54
(1.23) (1.63) (1.93)
5.71* 2.64 8.42*
AUDITOR-PW . (1.57) (2.23) (2.34)
-.82 -1.58 -.02
AUDITOR-7 . (1.04) (1.27) (1.79)
Intercept 4.16 3.35 6.89
Std. error of the estimate 8.00 7.48 8.23
Adjusted R2 . . .44 .26 .51
F ........................... 21.9 5.6 14.2
(FEE + ICOST)/ASSETS5
mean 17.14 14.1 20.33
std. dev . (10.75) (8.7) (11.75)
* An asteriskindicatesthat the regressioncoefficient
is significantat the .05 level in a one-tailor two-
tail (as appropriate)t-test.Standard errorsof the regressioncoefficients are shown in parentheses.
16. Discussion and InterpretationofResults

Findings with respect to the hypothesizedcontrolvariables are sum-
marized in table 13. The significancetests of the FEE determinantsare
fromcolumn2 oftable 8 (recall thatthese regressionresultsare generally
homogeneous across auditee size classes), while only those variables
whose coefficients are statisticallysignificantin both columnsoftable 12
are listed as significantdeterminantsof ICOST (these regressionresults
are not homogeneousacross the two columns).
The controlvariables fordifferences in loss exposure describe aspects
of the external audit and internalcontrol environment.Note that the
selection of specific aspects of the environmentas control variables

186 DAN A. SIMUNIC
TABLE 12
Regression of (ICOST/ASSETS 5) on Explanatory Variables
156 Auditees with 154 Auditees with
Sales Less Than Sales Greater
Than
$125MM $125MM
SUBS.5 .03* .04*
(.01) (.01)
DIVERS .25 .95*
(.19) (.31)
FORGN 4.55* -.11
(1.68) (2.37)
RECV .42 3.97
(1.01) (3.93)
INV . -.10 .07
(.84) (2.59)
UTILITY .75 -.88
(1.26) (1.47)
AUDITOR-PW .81 6.03*
(.61) (1.37)
A UDITOR-7 ................. -.24 1.57
(.35) (1.04)
Intercept ..................... .76 2.24
Std. errorof the estimates ...... 2.09 4.86
Adjusted R2 .................. .09 .25
F ......................... 2.8 7.5
Dependent variable
mean ...................... 1.34 6.77
std. dev. .................... (2.19) (5.63)
TABLE 13
SummaryofSignificance Tests on Hypothesized Control Variables
Significant (at .05level)
Relationship
with
AuditFees Internal
AuditCosts
in loss exposure:
Controlvariables fordifferences
ASSETS Yes Yes
SUBS Yes Yes
DIVERS .Yes No
FORGN .Yes No
RECV Yes No
INV Yes No
in expectedloss shar-
Controlvariablesfordifferences
ing ratio:
PROFIT. No Does
LOSS Yes not
SUBJ Yes apply
Controlvariable fordifferencesin auditor production Does

functionsover time: not
TIME .....No apply

followsfromthe hypothesisthat avoidance of third-party liabilitylosses

motivatesthe designofauditee controlsystems.The factthatall variables
in this group (namely,ASSETS, SUBS, DIVERS, FORGN, RECV, and
INV) are statisticallysignificantdeterminantsof audit fees supportsthe
descriptivevalidityof this hypothesiswithrespect to the externalaudit
component of the system. However, the same variables are far less
successfulin explainingcross-sectionalvariationin internalaudit costs.
The latter result may indicate either that liabilityavoidance is not a
primarymotivatorin the design of internalsystems,or the presence of
significantmeasurementproblems.
The quantityof internalaccountingcontrolrelevantto externalfinan-
cial reportingis a constructin the model whose empirical counterpart
can only be measured with substantial error. For example, internal
auditorsare likelyto be involvedboth in the verificationoffinancialdata
for external reportingand in monitoringoperating efficiencyand the
adherence to general managementpolicies. Since the principalbenefit
fromthese otheractivitiesis not liabilityavoidance, a failureto separate
these costs by various internalaudit activitiesleads to misspecificationof
the regressionfunctionforobservedinternalaudit costs.Althoughfurther
research on this problem is necessary,the overall resultsreportedhere
neverthelessdo not support a rejection of the hypothesisthat liability
avoidance drivesthe design of financialreportingsystems.
The controlvariables fordifferencesin the assessed loss-sharingratio
representalternativemeasures of auditee financialdistress.The insignif-
icance of the PROFIT variable and significanceof the two categorical
variables, LOSS and SUBJ, suggest that E(8) and thereforep do not
varycontinuouslywiththe profitability ofauditees. Rather,the auditor's
expected share of residual liabilitylosses seems to increase only with
evidence of significantdeteriorationin the auditee's operationsor pros-
pects.
The fact that audit fees were not found to vary systematicallywith
TIME could indicate eitherthat learningeffectswere "swamped" by the
noise in a cross-section,or that auditors pursue multi-periodpricing
policies,in that theyaverage the expectedcost reductionoflearningover
time. With such policies, learningeffectscould not be observed in fee
data.
For the test of competition,the test statistics are the AUDITOR
coefficientsin table 11, interpretedusing table 3. For both "large" and
"small" auditees and for the observations in total, the AUDITOR-7
coefficients are not significantly
differentfromzero. Thus, the hypothesis
that price competitionprevails throughoutthe market for audits of
publicly held companies cannot be rejected. Indeed, since average fees
for audits by seven of the dominant firmsare lower throughoutthe
marketthan the fees oftheirnon-BigEight competitors(table 8) and the
factthat coefficients ofA UDITOR-7 in table 11 stilltend to be negative,

188 DAN A. SIMUNIC
the resultssuggestthat the Big Eight firmsenjoy scale economieswhich

are passed on as lower prices to auditees. This is obviouslyan important
issue which deserves furtherresearch.
Finally,withrespectto Price Waterhouse& Co. (PW), the significantly
positive coefficientof A UDITOR-PW in column I of table 11, which is
consistentacross auditee size classes, indicates that the clients of this
firm,on average, use highercost controlsystems.However, this is not
evidence of monopolypricingby PW, since the obvious and best substi-
tute fora PW audit is not the employmentofadditionalinternalauditors,
but rather an external audit by some other Big Eight firm.Note that
both the separate audit fee (fromtable 8) and internalcost components
(fromtable 12) are differentially greaterforPW auditees. In the regres-
sions,the PW classificationvariable may be a proxyforomittedvariables
describingcertainunknowndifferentiating characteristicsof PW clients
which affectthe quantities (a, q) demanded by these companies. Thus,
auditees using PW may demand controlsystemsof greaterthan average
quality.Alternatively, the significantly
positivecoefficient ofA UJDITOR-
PW (relativeto A UDITOR-7) in table 8 may representa price difference
paid by auditees for a differentiated service. That is, a PW audit may
possess some utility-bearing characteristicsto auditees which command
a positive implicit price in the market. While it is not possible to
distinguishbetween the two interpretations, clearlyPW, PW clients,or
both are somehow differentiated fromotherclass members.
17. Concluding Comments

One of the impedimentsto understandingthe audit service is the
ambiguityof the relationshipbetween auditors,audited companies,and
externalfinancialstatementusers. Auditorsare exhorted,in theircodes
of ethics,forexample,to be independentand objective;yettheyare hired
and compensated by auditees. The findingof the Commissionon Audi-
tors' Responsibilities[1978] that "many users appear to misunderstand
the role ofthe auditorand the natureofthe servicehe offers"is therefore
not surprising.
In the positivemodel of auditingdeveloped in this paper, the essential
interdependence of the auditee's and auditor's economic interests is
recognized.The model allows forauditorindependencein the sense that
the auditor implementsq as a complementto the internalaccounting
system,a. An auditee demands a positive quantityof auditingbecause
external auditors have some advantage (relativeto internalsystems)in
certainaspects of control.In the model,therefore,an auditoris indepen-
dent in the same sense as is any supplierof a servicewho seeks compe-
tently to performa task demanded by a customer. The auditee and
auditor are not always adversaries. Although their economic interests
may diverge in ex-post litigation,as each tries to minimizelosses, the
hypothesisregarcingliabilityavoidance motivationimplies that, at the

time of the audit, there is a mutualityin the auditee's and auditor's

private interestsvis-a-visthe externalworld.
The question of whether the avoidance of third-partyliabilityis a
dominantsource of expected benefitswhich drivesthe design of auditee
financial reportingsystems is an importantone because of a possible
externalitywhich can thereby result. Expected liability losses are a
private cost, and the legal system is the screen throughwhich losses
sufferedby thirdpartiesare filtered.An alternativewould be to forcethe
auditee to internalizeexpected losses to users by relatingthe quality of
controlsystemdesign to the marketvaluation of the auditee's firm.In
that way, variationsin the quality of controlsystemsas perceivedby the
marketwould affectthe risk-returncharacteristicsofauditees' securities.
Note, however,that currentlyneitherinternalcontrolcosts nor external
audit fees are informationwhich is publiclyavailable to marketagents.
Thus, under currentarrangements,marketreaction to alternativesys-
tems designs can only be a tenuous auditee motivator,at best. The
Securitiesand Exchange Commissionrecentlydid propose a requirement
that managementdisclose and discuss weaknessesin its internalcontrols.
But in the finalversionof AccountingSeries Release No. 250, the SEC
withdrewa proposed rule that external audit fees be disclosed. One
argumentin support of required disclosure of audit fees could be the
avoidance of potential externalities,to the extentthat the audit fee is a
good measure of the quality of auditingpurchased.
Finally, the failure to reject the hypothesis that price competition
prevails throughoutthe market for audits of publicly held companies
suggeststhat observed differencesin Big Eight concentrationacross the
marketmay be essentiallyirrelevant.That is, concentrationstatistics,by
themselves,cannot support the allegation that the Big Eight firmsare
monopolizingthe marketforaudit services.
REFERENCES
ALTMAN, E. "Financial Ratios, Discriminant Analysis and the Prediction of Corporate

Bankruptcy."Journal ofFinance (September 1968): 589-609.
BEAVER, W. "Market Prices, Financial Ratios, and the Predictionof Failure." Journal of
AccountingResearch (Autumn 1968): 179-92.
BERNSTEIN,P. "CompetitionComes to Accounting.' Fortune(July17,1978): 89-96.
COMMISSION ON AUDITORS' RESPONSIBILITIES. Report,Conclusions, and Recommnenda-
tions. New York: Commissionon Auditors'Responsibilities,1978.
DEMSETZ, H. The Market ConcentrationDoctrine. Stanford,Calif.: AmericanEnterprise
Institute-HooverInstituteon War, Revolutionand Peace, 1973.
DEMSKI,J.,ANDR. SWIERINGA."A CooperativeFormulationofthe AuditChoice Problem."
The AccountingReuiew (July1974): 506-13.
FIRTH, M. "QualifiedAudit Reports:Their Impact on InvestmentDecisions." The Account-
ing Revieuw(July1978): 642-50.
HARRIS, S. P. WhVhoAuditsAmerica?Menlo Park, Calif.:Spencer P. Harris,1976.
HOBGOOD, C., AND J. SCIARRINO. "Management Looks at Audit Services." Financial
Executive (April 1972): 26-32.
JOHNSTON, J. Economnetric Methods. 2d ed. New York: McGraw-Hill,1972.

190 DAN A. SIMUNIC
LENHART, N., AND P. DEFLIESE. Montgomery'sAuditing.8th ed. New York: Ronald Press,
1957.
OPPENHIEIM, A. M. Questionnaire Design and AttitudeMeasurement. New York: Basic
Books, 1966.
in Pure Compe-
ROSEN, S. "Hedonic Prices and ImplicitMarkets: Product Differentiation
tition."Journal ofPolitical Economy (January1974): 34-55.
STIGLER, G. "The Economies of Scale." Reprinted in The Organization of Industry.
Homewood- Richard D. Irwin,1968.
SUBCOMMITTEE ON REPORTS, ACCOUNTING AND MANAGEMENT OF' THE COMMISSION ON
GOVERNMENT OPERATIONS, UNITED STATES SENATE. Establishment:
TheAccounting
A StaffStudy. Washington,D.C.: GovernmentPrintingOffice,1977.
UNITED STATES OFFICE OF MANAGEMENT AND BUDGET. StandardIndustrialClassifica-
tion Manual. Washington,D.C.: GovernmentPrintingOffice,1972.
WEISS, L. "Quantitative Studies in IndustrialOrganization."In Frontiersof Quantitative
Economics, edited by M. D. Intriligator.Amsterdam:North-Holland Publishing Co.,
1971.


Simunic 1980 - The Pricing of Audit Services (Theory and Evidence)

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Simunic 1980 - The Pricing of Audit Services (Theory and Evidence)

Uploaded by

Copyright:

Available Formats

Accounting Research Center, Booth School of Business, University of Chicago

The Pricing of Audit Services: Theory and Evidence

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

The Prici of Audt Nervices:

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

ferencesin fees can representeitherthe effectof quantitydifferencesor

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

significantaudit fee determinants,as well as failureto reject the hypoth-

2. Assumptionsof the Fee DeterminationModel

a = the quantity of resources utilized directlyby the auditee in

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

a financialreportingsystemis completelydescribedby the orderedpair

Since liabilityis joint and several,actual losses willsomehowbe divided

At the timeofthe audit,thisloss apportionmentfactoris also a random

3. The Auditee's Problem When the Market forAudits Is

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

denote the total costs of the system.The auditee's problemcan initially

aE ( TC) aE(d) aE(d)

E(T C) aE(d) aE(d)

than per engagement,since an auditor's capital itselfis predominantlygeneralratherthan

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

installedthe internalaccountingsystemd, what additionalconditionsare

4. The Auditee's Problem in a NoncompetitiveMarket

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

E(d amqm)>E(d Id,), and (5)

E(TC am,qn) > E(TC cd,. (6)

depending upon the price elasticityof demand implicitin the auditee's

vamn + pqrn > Va + p4.

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

5. The EffectsofAuditor Production Economies on

6. Effectsof Variations in Assessed Loss Functions

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

7. SummaryoftheModel and Developmentofthe Test for

Monopoly Production Increase in Audi- Increase in

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

Recall fromthe assumptionsof the model that a and q eithercan be

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

(CRE | 8)- (CRE I8 ) Competition with Competition Monopoly pric-

(CRE | 8) < (CRE 8 .) . Competition with Competition with Competition with

8. Control Variables forDifferencesin Loss Exposure

Little is presentlyknown about sources of variationsin liabilityloss

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

writingprofessionalliabilityinsurance coverage foraccountants.7From

SIZE OF THE AUDITEE

COMPLEXITY OF THE AUDITEE S OPERATIONS

Loss exposure can be expected to increase,the greaterthe decentrali-

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

(variable narmeDIVERS), and (2) by the ratio of the auditee's foreignto

RECEIVABLES AND INVENTORIES

Auditors have long recognized that certain accounting populations

PRINCIPAL INDUSTRY OF THE AUDITEE

9. Control Variables forDifferencesin theAssessed Loss-

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

assigned a value of one if an auditee had incurreda net loss duringany

10. Differencesin Auditor Production Functions

There has been essentiallyno previousresearchin the area of auditor

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

auditor (variable name TIME).9 The relationshipbetween TIME and q

1iZ. Measurement of the Dependent Variables

12. Design and Results of the Survey

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM

Control variables for differencesin the

withsales less than $125 millionversusthose withsales greaterthan that

This content downloaded from 130.15.241.167 on Sat, 28 Sep 2013 17:30:22 PM