The effect of concentration and regulation on audit fees: An application of panel data techniques

• We examine the effect of regulation and market concentration on audit fees.
• We use panel data methods not previously used in the literature.
• Concentration has no effect on small firms and a very small effect on large firms.
• Regulation increases fees and places a large burden on small clients.

The financial audit – which is mandatory for publically traded companies – plays an important role in the transparency and efficiency of global capital markets. Yet, the cost of complying with the laws and regulations requiring financial statement review by external auditors can be substantial. Moreover, the supply-side of the audit market is dominated by a few firms. As a result, policymakers in many countries have an interest in considering the cost of additional regulation as well as ensuring that the concentrated nature of the audit market does not result in anti-competitive pricing. The goal of this paper is to provide new estimates of the extent to which regulation and market concentration have contributed to higher audit fees using a panel data approach. To accomplish this we use U.S. data from 2000 to 2010, a period that includes a large change in market concentration as a result of the collapse of the third largest auditor in 2002. In addition, the passage of the Sarbanes–Oxley Act (SOX) in 2002 in response to a series of accounting scandals, allows us to exploit an abrupt change in the regulatory environment. We find that the cost of additional regulation has been substantial and persistent. In addition, our results support the notion that the burden is larger for smaller firms. This was the rationale for exempting the smallest firms from the most costly provisions of SOX by the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd Frank). However, our results suggest that greater market concentration has only a very small impact on the fees of large clients, suggesting that fears that market power would generate higher fees are largely unwarranted.