Research on the auditing sector has traditionally analyzed large audit firms and their clients—in other words, it has primarily focused on listed companies. The reason for this is simple: data on this market segment were available to be analyzed. However, over 95% of the audit services market is made up of small and medium-sized enterprises (SMEs).
Research has shown a high level of concentration and a possible lack of competition, suggesting that the audit services market is, in fact, an oligopoly requiring the intervention of regulators in order to prevent price fixing and correct imbalances. It also suggests that large and small audit firms operate in differentiated market segments that rarely overlap.
Over time, as more information has become available and the scope of research has expanded to include small audit firms, doubts have been raised about these earlier conclusions. The reality of the sector has started to come into focus.
In real life, rather than entering into a price war, companies seek to differentiate their products.
Is the auditing market competitive enough?
To answer this question, we need to extend our analysis to local markets, where businesses of various sizes demand audit services and the Big Four firms compete and interact with smaller audit services providers.
From a theoretical perspective, in a perfectly competitive market, competition should lead to an equilibrium price equal to the marginal cost of the service. However, in real life, rather than entering into a price war, companies seek to differentiate their products—and auditing firms are no exception.
It turns out that large audit firms are specialized in providing services to listed clients; given their structure and size, they are not always competitive in the “small” audit market. Meanwhile, small audit firms sometimes compete with the major firms for medium-sized clients.
An analysis that extends to local markets—and, therefore, audit services for private companies and SMEs—shows that the sector is not necessarily dominated by the Big Four firms and reveals that small audit practices play a fundamental role. As some authors have noted, this means that audit prices tend more towards the equilibrium of a competitive market.
A study entitled “Small is big! The role of ‘small’ audits for studying the audit market” found a considerable degree of industry specialization and product differentiation in the small audit market, which is reflected in the revenue generated by small and medium-sized audit firms. This finding shows that it is essential to include these smaller players in any analysis of competition in local markets.
SMEs value the business advice provided by external auditors, who in some cases play an important role in supporting management decisions.
Different clients, different needs
Listed companies are required by law to have their accounts audited. In some countries, private companies are exempt from this requirement, so the decision to undergo an audit is voluntary. In some jurisdictions, audit requirements are based on firm size, turnover, number of employees, or other factors.
Studies have shown that companies may voluntarily choose to undergo an audit for various reasons. A firm is more likely to undergo a voluntary audit when there are conflicts between different owners. The level of shareholder-debtholder agency costs and contractual constraints imposed by creditors are also key factors in the demand for voluntary audits.
Other business characteristics, such as size, age, and complexity, also influence this decision. Executives use audits as internal control instruments and even as problem-solving mechanisms. Moreover, SMEs value the business advice provided by external auditors, who in some cases play an important role in supporting management decisions. Moreover, companies that operate in weak institutional environments are more likely to undergo voluntary audits. In short, audit firms have to deal with a variety of clients, motivations, and needs.
A study of Italian audit firms found that, in addition to large firms and SMEs, the audit market also includes freelance auditors, who accounted for 36% of the study sample.
For a freelance auditor, the decision to remain independent is not economic: associating with other auditors would result in almost no difference in terms of compensation. Freelance work does, however, provide greater flexibility, freedom, and work-life balance.
Many small companies rely on freelance auditors, who play a key role at the local scale. Beyond their strictly audit-related duties, they also perform advisory functions for SME clients. The Italian study therefore shows that social capital—the set of relationships and tangible assets involved in interactions of this sort—is a key factor in the decision to hire an auditor and in the price paid for these services.
Freelance auditors and micro, small, and medium-sized audit firms face a challenge: in order to keep meeting their clients’ needs, they must advance in tandem with them. It used to be possible for small audit businesses to cater solely to a local clientele. Nowadays, they might find themselves having to audit the accounts of a small business whose clients are scattered across the globe—a considerably more complex service.
For small audit firms, the key to offering a higher-quality service while remaining independent is to associate with other practitioners on issues such as training and new technologies. Sticking strictly to the local market is no longer an option.
© IE Insights.