We analyze the role of discretionary joint fixed costs in audit production. Given such costs, the investment decision and production of audit services must be analyzed over a client portfolio. We model this problem, and use monotone comparative statics (Milgrom and Shannon ) to show the implications of variations in client-specific losses and the number of clients for the optimum level of fixed investment and auditassurance. We develop four hypotheses concerning the relations between audit quality and (1) the magnitude of potential client-specific losses; (2) average client losses in a portfolio; (3) the number of clients in a portfolio; and (4) the variability of losses in a portfolio. Using discretionary accruals as the audit quality proxy, we find evidence consistent with these hypotheses. Using PCAOB inspection results and financial statement restatements as proxies for audit quality, we find weaker evidence consistent with hypotheses 2, 3 and 4.
Original Publication Citation
Gu, Tracy and Simunic, Dan A. and Stein, Michael T., Fixed Costs, Audit Production, and Audit Markets: Theory and Evidence (January 16, 2017). Available at SSRN: https://ssrn.com/abstract=2900389.
Gu, Tracy; Simunic, Dan A.; and Stein, Michael T., "Fixed Costs, Audit Production, and Audit Markets: Theory and Evidence" (2017). Accounting Faculty Publications. 6.