Determinants and Consequences of Audit-Firm Profitability: Evidence from Key Audit Matters

• In Event: Other Issues in Auditing

Abstract

We use a novel dataset that links audit-firm and client-firm financial statement information from the U.K.’s largest audit firms to examine drivers of audit-firm profitability and its implications for audit outcomes conveyed by Key Audit Matter (KAM) disclosures. We first explore the determinants of audit-firm profitability and conclude that Big-4 and non-Big-4 audit firms have fundamentally different profitability structures. Big-4 firms earn higher profit margins than non-Big-4 firms. Furthermore, Big-4 profitability increases with client size and complexity, while non-Big-4 profitability is higher for smaller clients and clients with losses. Next, we examine the relation between audit-firm profitability and KAM reporting. We find that more profitable audit firms address more KAMs. However, audit-firm profitability is less likely to affect audit outcomes for loss-making clients (i.e., when auditors are exposed to more litigation risk). Our findings are robust to endogeneity controls, out-of-sample analyses, and alternative outcome measures.

Authors

• Zeyun (Jeff) Chen, Texas Christian University

• Anastasios Elemes, Essec Business School

• Ole-Kristian Hope, University of Toronto - Rotman School of Management

• Aaron Yoon, Northwestern University