The Effects of Audit-Firm Monopolies within Local Audit Markets

Abstract

This study identifies auditors who have 100% market shares in a city-industry audit market (hereinafter, monopolist auditors) and examines their pricing strategy. I document that monopolist auditors charge lower fees than do industry specialist auditors. This result is consistent with a monopolists’ pricing strategy (i.e., limit pricing) to deter new entrants but contrasts with regulators’ concerns about monopoly pricing. I further find that monopolist auditors more often fail to detect misstatements than do industry specialist auditors. This is consistent with regulators’ concerns about market-dominating auditors’ complacency. In cross-sectional tests, limit pricing is predominantly evident in homogenous operation industries where more profits are at stake. On the other hand, limit pricing is moderated when clients’ proprietary costs are high, which lowers auditor switching risk. In addition, I find that monopolist auditors’ audit failures are more pronounced when the current market competition within a city is low. These findings suggest that auditors exhibit distinctive incentives when they lack the closest competitor.