ABSTRACT We examine how compensation policies of audit firms are associated with audit quality. Specifically, we investigate the effects of the ratio of variable to fixed compensation and the size of the basis for profit sharing (i.e., whether partners share profits in a small or in a large profit pool). For our analyses, we use detailed mandatory disclosure of the compensation policies in German audit firms. We document that compensation policies vary considerably across audit firms. We find that profit sharing in a small profit pool and high variable compensation are two characteristics of auditor compensation associated with lower audit quality. We also find some evidence suggesting that audit quality may be most at risk in cases in which partners rely more heavily on variable compensation to divide a relatively small profit pool. In additional analyses, we find that these associations are more pronounced in medium‐sized audit firms. We argue that this finding may result from these firms being too large for audit partners to directly monitor each other effectively, yet simultaneously too small to have sophisticated centralized monitoring systems in place. Finally, we find that integrating partner‐specific, nonprofit‐related performance metrics into the compensation structure mitigates the adverse effects of small profit pools and high variable compensation.

ABSTRACT This paper examines how auditors' judgments about accounting policies may differ when experiencing different levels of affinity for client management and facing different levels of pressure from client management. The theory of motivated reasoning is employed to analyze the effects of these two factors that should lead individual auditors to adopt as a directional goal the acceptance of client management's aggressive accounting. Accordingly, we predict and find that auditors experiencing greater client affinity and facing explicit client pressure suggest lower adjustments to clients' aggressive accounting, consistent with motivated reasoning's goal-related predictions. But our study goes further and investigates also how auditors react when motivated reasoning theory's “reasonableness constraint” is potentially violated by auditors who perceive excessive client pressure. We predict and find, consistent with the individual auditor's “reasonable constraint” being triggered in at least some auditors, that perception of client pressure intensity leads those auditors to propose larger adjustments to client accounting. To support our findings, we re-analyze the data from a prior motivated reasoning audit experiment, replicate that study's reported directional goal results employing methods used in this study and, in addition, find similar results to those found in this study for increased client pressure intensity on auditor judgment.

This study investigates who makes partner in Big 4 audit firms. Building on prior qualitative research, we conduct the first large scale study using archival data to examine the incremental importance of different individual auditor characteristics for making partner. For our analyses, we collect information on German auditors from a business-oriented social network site. We conduct a longitudinal analysis for a cohort of Big 4 senior managers and directors to identify determinants of making partner. We find that economic capital, social capital, and institutionalized cultural capital matter for making partner. Further, we find that female and foreign auditors are less likely to become partner than their counterparts. In addition, we perform a cross-sectional analysis using a larger sample of auditors to identify the distinct characteristics of Big 4 partners compared to Big 4 senior managers, Big 4 directors, and non-Big 4 partners, and find results consistent with the longitudinal analysis.

This study investigates the determinants and consequences of forming dyads at the top level of audit teams, i.e., dyads between concurring and lead auditor. We apply the sociological theory of homophily, i.e., the implicit preference for similar others, to hierarchically structured auditor dyads. Our regression analyses reveal that sharing the same gender and the same ethnicity, measured by dialect, increases the likelihood of dyad formation beyond what one would expect based on the characteristics of the pool of available auditors. Further, we observe that forming auditor dyads sharing the same age is avoided, suggesting that the need to establish a legitimate hierarchical relationship through social differentiation represents a boundary condition for homophily. Testing for the consequences of auditor dyad formation using an instrumental variable approach, we find that auditor dyads sharing the same dialect provide lower audit quality. We conclude that homophily matters in auditor dyad formation with potentially adverse consequences for audit quality.

ABSTRACT This study provides novel evidence on the magnitude of switching costs in auditing. Using a discrete choice approach, we infer switching costs from clients’ audit firm choices. The demand estimation reveals that switching costs are significant and vary by direction, with the highest costs associated with switching from non-Big 4 to Big 4 audit firms. Counterfactual analyses of forced switches suggest that switching costs are substantial, ranging from 0.7 billion U.S. dollars (14.2 percent of audit fees) to 1.2 billion U.S. dollars (24.0 percent of audit fees) when aggregated across all clients. Counterfactual analyses of voluntary switching show that the audit market would become highly dynamic and more concentrated if switching costs were removed. Additionally, clients would gain consumer surplus of up to 306 million U.S. dollars (5.4 percent of audit fees) in such a scenario. Overall, our study documents the importance of switching costs for understanding audit market dynamics. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: M42; M48; L11; L84.

ABSTRACT This study investigates the value of auditor industry specialization. In the first step, we use a discrete choice model to derive the first-order demand for auditor industry specialization. Our results reveal that clients have a general preference for auditor industry specialization, relating to both audit firm and audit office specialization. We observe that specializations at the audit firm and audit office level are substitutes. We also find that larger, more complex clients have a stronger demand for industry specialization at the audit office level. In the second step, we use the results from the discrete choice model to quantify the value of auditor industry specialists for clients. We find the overall value of industry specialization aggregated across all clients is 5.2 million USD (0.36 percent of audit fees) and that industry specialization at the firm (office) level is decisive for auditor choice in 4 percent (6 percent) of all cases. JEL Classifications: M42; M48; L11; L84.