Independence, low balling and learning effects

Independent auditors serve as gatekeepers of public securities markets, but ongoing competition among audit firms could harm auditors’ independence. For instance, a Green Paper of the European Union finds that especially audits of large and prestigious clients are hard-fought in terms of price competition. Major concerns are related to a pricing behavior called low balling. Here, the auditor sets the first period’s fee below the audit costs -incurring a loss for the initial audit- in order to win the client. However, as a quasimonopoly emerges for the incumbent auditor, he expects to offset this loss in the future. Mainly, this offset occurs due to reduced audit costs in subsequent periods. Recent management publications highlight that learning effects influence the cost behavior over time in two ways. On the one hand, cost reductions emerge from experience due to performing jobs repeatedly. Thus, learning is supposed to be an important strategic factor in lowautomation industries, like auditing. On the other hand, learning effects can be fostered by investments in learning, i.e., learning is manageable. Bundling non-audit services, like risk advisory- or performance measurement-related assurance services, with audits could be interpreted as audit-quality improving investments in learning about a client’s business. Accordingly, the goal of our paper is to analyze how learning effects according to the theory of learning curves affect competition on the audit market and thus the low-balling problem. Our analysis proceeds in several steps: In the first step, we model-endogenously identify conditions for the existence of price competition in audit markets. This step of analysis is important, because in most low-balling models competition is assumed to exist, although empirical evidence is mixed. In the second step, we analyze how different types of learning influence fee setting over time. Here, we assume auditors to have identical learning rates. This means competition in a given segment is considered, e.g., between Big-4 auditors or between National Majors. In the third step, we regard auditors with different learning abilities. Thus, auditors of different size -measured in number of clients- occur. In this step we capture the fact that empirically size is an important competition factor. Our results give hints to regulators under which conditions low balling might be a threat to auditor independence. Further, some recently introduced regulations, which aim at improving auditor independence, can be evaluated using the framework of our analysis.