Pricing of Initial Audit Engagements by Large and Small Audit Firms

We investigate the extent to which auditors of U.S. companies reduce fees on initial audit engagements (termed 'fee discounting'). We hypothesize that rivalry among sellers, in terms of client turnover and price competition, is more intense among smaller audit firms. The data support this hypothesis. New clients account for 34% of all clients for small audit firms, but only 9% of all clients of larger audit firms. We theorize that the different client turnover rates between large and small audit firms can be explained by the market structure of the audit industry, which consists of an oligopolistic segment dominated by a few large audit firms and an atomistic segment comprised of many small audit firms. Further, we hypothesize and confirm that fee discounting is more extensive in the atomistic sector. The analysis of audit fee changes indicates that clients switching auditors within the atomistic sector get a 24% average discount over the prior auditor's fee. However, clients switching within the oligopolistic sector, receive a discount of only 4%. Since price competition is known to be less intense in oligopolistic compared to atomistic markets, we believe that market structure theory can explain why fee discounting is lower when larger audit firms compete for clients.