Auditor size and audit pricing: evidence from small audit firms

Abstract

In a competitive market, audit prices can vary if the clients believe that the quality of audits varies. Previous research links auditor independence, a key element of audit quality, to auditor size and consequently suggests a positive association between audit quality and auditor size. Moreover, by using the dichotomy approach (Big Five/non-Big Five), numerous studies in many countries have found that the largest audit firms with international reputations earn fee premiums due to their perceived higher quality. Little is known, however, about pricing differences arising from product differentiation among small audit firms.

This study examines the relation between auditor size and audit prices by using the data on hourly billing rates and the auditor characteristics from 103 small Finnish audit firms. This study documents, after controlling for the auditor's technical capability, the positive association between auditor size and audit pricing. The results suggest that both size and technical capability have a positive impact on auditor remuneration, implying that product differentiation also takes place among these small audit firms.

Acknowledgements

An earlier version of this paper was entitled ‘Can small audit firms signal their quality?’. I am grateful to Ann Gaeremynck, Juha Kinnunen, Robert Knechel, Markku Koskela, Veijo Riistama, Stefan Sundgren, Stuart Turley, Peter Wysocki, participants of the Workshop on Auditing and Financial Accounting Research 2002, in Vaasa, the EAA 2002 Conference in Copenhagen, and the IAAER World Congress 2002 in Hong Kong for their helpful suggestions and remarks. I also owe thanks to the two anonymous referees whose comments and suggestions improved the quality of the paper. The financial assistance of the Helsinki School of Economics and the HSE Foundation, the Academy of Finland, and the Foundation of Jenny ja Antti Wihuri is gratefully acknowledged. I also wish to thank the Registered Association of Certified HTM auditors for access to the data, which made this study possible.

Notes

‘Big Five’ refers to the group of the following firms: Arthur Andersen, Ernst & Young, Deloitte & Touche, KPMG and PricewaterhouseCoopers. Before the merger of Coopers & Lybrand and Price Waterhouse this group of firms were referred as the ‘Big Six’. Today, after the collapse of Arthur Andersen, the remaining firms are known as the ‘Big Four’. For reasons of consistency, ‘Big Five’ is used throughout this paper to refer to these largest international audit firms.

There is also a certification (Julkishallinnon-ja talouden tilintarkastaja, JHTT) for auditors who specialize in public sector auditing.

In addition to the auditor size variables tested in the study, the number of offices an audit firm has may also affect fees (Deis and Giroux, 1996). The number of offices, however, is not controlled for in this study simply because the audit firms of interest, which were self-employed individual auditors, obviously do not have multiple offices. Even if some of them had, this would not be a problem at the empirical level because it can be assumed that the other two size variables, number of clients and net sales, contain information about number of offices.

It should be noted, however, that revenues as a measure of auditor size also require the assumption that at least some clients, at some point of time, are able to observe the size of the client base.

The assumption that the regression residuals are normally distributed was tested with the Jarque–Bera (1987) test. The results do not suggest violation of this assumption. To assess the possibility of the problem of multicollinearity among the independent variables, variance inflation factors (VIF) were calculated for independent variables in the regressions. As all the VIF values are less than two, the VIF values do not suggest that multicollinearity affects the results.

Following Moizer (1997), generic reputation refers in this context to the minimum professional standard that audit clients ‘automatically’ attribute to an auditor who holds a certification.