Imperfect Competition in Audit Markets and its Effect on the Demand for Audit-Related Services

We demonstrate that when cost differences among CPA firms serve as a source of economic rents to the incumbent auditor, the switching costs previously cited asthe sourceof the auditors' rents may actually reducethe auditors' economic rents to the benefit of the client. This result has implications for how switching costs affect the way audit engagements are structured and how clients invest in their relationships with auditors. While the resulting behavior may appear to be inefficient or of a "suspicious nature, it is a natural consequence of imperfect competition. This behavior includes (i) clients under-investing in their accounting systems, (ii) clients accepting their current auditor's management advisory services (MAS) bid, even though a rival CPA firm has submitted a lower bid for identical MAS, and (iii) inefficient same sourcing for MAS and audit services when CPA firms treat their audit and non-audit divisions as separate profit centers.