Small is big ! e role of ‘ small ’ audits for studying the audit market

Studying history will not be complete if the focus lies only on the most powerful and rich segments of society. In order to fully understand historical facts, it is crucial to gather data on and analyze ordinary people, which constitute the vast majority of the population. Something similar is true for studying the audit services market. If we only focus on the so-called Big N audit rms and their large, listed, clients, we do not have an in-depth understanding of the market. By 2014, in the 28 countries of the European Union (EU), 92.98% of the enterprises were microenterprises, i.e. they had less than 10 employees. If we restrict our attention to the ‘accounting, bookkeeping, auditing, and tax services’ market, the percentage grows up to 95.63% (Eurostat, 2017). In other jurisdictions, the percentages are similar or even higher. It is a fact, therefore, that the vast majority of audit rms and their current and potential clients are small and medium-sized enterprises (SMEs). Despite the importance of SMEs for the audit market, only quite recently the academic literature has given the attention they deserve. Lack of accessible and reliable data is likely to be one of the reasons why many studies in the past have neglected this segment of the market and have focused on large audit rms. In this Editorial we focus on the insights generated by recent literature examining SMEs in the audit market, both from the supply and demand side. We highlight how this strand of the literature has improved our understanding of how the audit services market works and how it provides many opportunities for further research.


INTRODUCTION
Studying history will not be complete if the focus lies only on the most powerful and rich segments of society.In order to fully understand historical facts, it is crucial to gather data on and analyze ordinary people, which constitute the vast majority of the population.Something similar is true for studying the audit services market.If we only focus on the so-called Big N audit rms and their large, listed, clients, we do not have an in-depth understanding of the market.By 2014, in the 28 countries of the European Union (EU), 92.98% of the enterprises were microenterprises, i.e. they had less than 10 employees.If we restrict our attention to the 'accounting, bookkeeping, auditing, and tax services' market, the percentage grows up to 95.63% (Eurostat, 2017).In other jurisdictions, the percentages are similar or even higher.It is a fact, therefore, that the vast majority of audit rms and their current and potential clients are small and medium-sized enterprises (SMEs).
Despite the importance of SMEs for the audit market, only quite recently the academic literature has given the attention they deserve.Lack of accessible and reliable data is likely to be one of the reasons why many studies in the past have neglected this segment of the market and have focused on large audit rms.In this Editorial we focus on the insights generated by recent literature examining SMEs in the audit market, both from the supply and demand side.We highlight how this strand of the literature has improved our understanding of how the audit services market works and how it provides many opportunities for further research.

THE SUPPLY SIDE: IS THE AUDIT MARKET COMPETITIVE?
e high level of concentration and the possible lack of competition in the audit market have been a matter of concern to regulators for a long time.In his seminal paper, Simunic (1980, p. 161) started with the following phrase: e question of the existence of competition among auditors has been the subject of considerable discussion in recent years.More speci cally, the "Big Eight" rms as a group have been accused of monopolizing the market for audit.
More than 30 years later, Numan and Willekens (2012, p. 451) opened the 'Motivation and Contribution' section of their paper stating that: The audit market is characterized by a high level of concentration, regulated demand for audits by listed rms, and high barriers to entry due to reputation e ects and the need for specialized knowledge.Regulators in di erent countries o en express concerns about whether the degree of competition in the audit market is su cient.
At a rst glance, we could have the impression that our understanding of the audit market's competitive dynamics has not improved much within these three decades, if scholars are still tackling the same core question: is the audit services market su ciently competitive in order to guarantee an adequate level of quality at an acceptable price?Perhaps, this pessimistic view is not justi ed.During thirty years, the academic literature has accumulated a great deal of empirical evidence about the audit market's competitive dynamics.However, such empirical evidence Small is big!The role of 'small' audits for studying the audit market have not been able to establish any clear regularity about the relationship between market concentration and audit fees and audit quality -for references on audit fees, see Eshleman and Lawson (2017); for references on audit quality, see DeFond and Zhang (2014).
According to Simunic (1980), prior studies generally assume that Big N and non-Big N audit rms operate in two separate segments of the market that very rarely intersect.However, recent literature puts this assumption into question and analyzes the interactions between these two segments and their implications for audit fees and audit quality (Bills & Stephens, 2016;Keune, Mayhew, & Schmidt, 2016).
From a theoretical viewpoint, this recent strand of the literature refers to the notion of 'spatial competition' (Hotelling, 1929;Tirole, 1988).In a perfectly competitive market, price competition should lead to a unique equilibrium price equal to marginal cost.However, in real life, we observe di erent equilibrium prices in the same market that do not necessarily equate marginal cost.
is outcome may be attributed to product di erentiation.Before competing in prices, rms choose where to locate in the product space.e further they locate in the product space at the rst stage, the weaker is price competition at the second stage.
Somehow surprisingly, it is not until recently that this theoretical framework has been applied to studying competition in the audit market.Chan (1999) adapts the classic horizontal spatial competition model to the audit services market.Two stylized features of this market are inserted in the model: industry specialization and setup costs, i.e. the fact that the rst audit of a new client is more costly than subsequent audits, because of the initial investments required to become familiar with the client's accounting system.In this setting, three major e ects should be taken into account by an audit rm in choosing its optimal specialization strategy.e rst is the 'market share' e ect.In order to gain market share, audit rms need to reduce diversi cation, while choosing industry specialization.By doing this, they become more attractive for a larger share of potential clients.e second is the 'strategic' e ect.In order to relax price competition, rms need to di erentiate as much as possible and choose an extreme level of industry specialization.e third is the 'cost reduction' e ect.e closer the audit rm gets to a client in terms of industry specialization, the lower is its cost to perform an audit.If only the rst two e ects are considered, then the 'strategic' e ect dominates and, in equilibrium, rms di erentiate as much as possible and locate as far as possible from each other.However, if the 'cost reduction' e ect is introduced, the 'market share' e ect dominates and rms locate fairly close to each other in terms of specialization.Hence, according to this model, we expect audit rms to o er fairly similar products and have fairly similar market shares.Chan (1999) claims that this model provides a good description of competition between Big N rms and that such a competition could be quite erce, despite the concentration.Numan and Willekens (2012) were the rst authors applying this framework to an empirical study of real audit markets.As a proxy for the 'cost reduction' e ect, Numan and Willekens (2012) use the percentage of total revenue generated by an audit rm in a speci c sector, i.e. the degree of industry specialization in terms of revenue.
e higher the level of general industry specialization, the higher audit fees are expected to be in equilibrium.To verify whether the 'market share' e ect or the 'strategic' e ect dominates, the authors use the di erence between the market shares of the incumbent auditor and the closest competitor in the same market.ey adopt Metropolitan Statistical Areas (MSAs) in the United States of America (USA) as separate local markets, in which their hypotheses are tested and both the 'market share' e ect and the 'strategic' e ect are observed.Audit fees are increasing in both general industry specialization and market shares distance from the closest competitor in the same industry, showing predominance of the 'strategic' e ect.Numan and Willekens (2012) focus on Big N rms and follow Simunic (1980) and Chan (1999) in assuming that competition between Big N and non-Big N audit rms takes place in two separate markets, which do not in uence each other.Both Bills and Stephens (2016) and Keune, Mayhew and Schmidt (2016) challenge this critical assumption while keeping spatial competition as the underlying theoretical framework.When we move away from the audit market for multinational listed companies and focus on local markets for audits of private clients, casual observation shows that, in these local markets, the leading auditor is not necessarily a Big N rm.Again, it is quite surprising that this fact has triggered rigorous empirical analysis only very recently.Keune, Mayhew and Schmidt (2016) choose for their empirical analysis the same markets as Numan and Willekens (2012), i.e.MSAs in the USA.Using local rankings of auditors, the authors show that in markets where the leader is a non-Big Four rm, the overall level of audit fees is lower.Bills and Stephens (2016) also address MSAs in the USA.ey focus on the absolute di erence in market shares between 2 competing audit rms and nd that the distance between Big Four rms and the closest Nieves Carreta & Marco Trombetta non-Big Four rm is more important in determining the general level of audit fees than the distance between Big Four competitors only.Moreover, the closer a non-Big Four rm gets to its closest Big Four competitor, the lower the level of audit fees.Both studies show that the role played by non-Big Four rms is crucial in determining the overall level of competitiveness in local markets for audit services and the level of audit fees in these markets.
So, let us go back to the original question: is the audit services market su ciently competitive?Now, we can say that this question cannot be properly addressed by focusing exclusively on an audit market for listed clients dominated by the Big Four audit rms (the 'large' audit market).We need to extend our analysis to local markets where private businesses of various sizes, including SMEs, demand audit services.In these markets, Big Four and non-Big Four rms do compete and interact (the 'small' audit market).Empirical evidence gathered recently show that, at this extended level of analysis, the audit market competitiveness is high and the market dynamics is complex, putting into question the need for regulatory intervention aimed at increasing competition.

THE DEMAND SIDE: DO PRIVATE SMES DEMAND AUDIT?
Listed companies are required to have their annual report audited.Consequently, in the 'large' audit market dominated by the Big Four, an economically signi cant demand is guaranteed by regulatory requirements.When we move to local, small, audit markets, we need to take into account the demand for audits of private SMEs -which are not always required to undergo an audit.Vanstraelen and Schelleman (2017) provide a comprehensive literature review of auditing in private rms.
e policies for compulsory audits vary signi cantly from country to country (Minis & Shro , 2017).In the USA and Canada, private companies are generally not required to have an audit of nancial statements, regardless of their size.Under the EU regulation, audit exemptions for private companies are based on rm size proxied by number of employees, assets, and annual turnover.In many jurisdictions, the decision to audit their nancial statements is voluntary.Why do they consider that the bene ts of an external audit overcome its costs?What are the bene ts of voluntary audits?A relatively small, but increasing number of studies have investigated these issues (e.g.Dedman, Kausar, & Lennox, 2014;Minnis & Shro , 2017).
Managers of SMEs may use an external audit as an internal control mechanism when organizational complexity increases -e.g. to compensate for the hierarchical loss of control over employees when a company increases in size (Abdel-Khalik, 1993;Senkow et al., 2001;Seow, 2001).SMEs may also demand voluntary audits expecting to get from auditors skills and resources not available within them.Empirical evidence suggest that SMEs value the business advice provided by external auditors in areas such as taxation and accounting (e.g.Niemi, Kinnunen, Ojala, & Troberg, 2012;Bianchi, in press;Collin, Ahlberg, Berg, Broberg, & Karlsson, 2017).Furthermore, SMEs see that auditors may play a role in supporting management decisions, as well as help improving operational e ciency and e ectiveness (Collis, 2012;Ojala, Collis, Kinnunen, Niemi, & Troberg, 2016).
Finally, recent studies have examined the in uence of institutions and macroeconomic factors on the voluntary demand of audits.Voluntary audits may be seen as a substitute for weak institutional environments (Francis, Khurana, Martin, & Pereira, 2011).Moreover, within periods of economic growth, there is a decrease in the use of audited nancial statements by banks, leading to lower demand for audits (Lisowsky, Minnis, & Sutherland, 2017).
To sum up, recent literature indicates that voluntary audits demanded by SMEs may be a response to their agency con icts; they could also be a powerful management Small is big!The role of 'small' audits for studying the audit market tool for solving internal issues and/or to compensate for the lack of strong institutional protection.What about the consequences of voluntary audits for SMEs?So far, prior research examining the potential bene ts derived from voluntary audits has been restricted to its impact on debt contracting and on nancial information quality (Kim, Simunic, Stein, & Yi, 2011;Minnis, 2011;Clatworthy & Peel, 2013;Kausar, Shro , & White, 2016).Voluntary audits facilitate debt contracting for two reasons.First, they may alleviate information uncertainty faced by lenders; second, the assurance provided by an audit may reduce debt monitoring and negotiation costs (Blackwell, Noland, & Winters, 1998;Kim et al., 2011).Empirical research from Korea, the United Kingdom (UK) and the USA supports these arguments (Blackwell, Noland, & Winters, 1998;Minnis, 2011;Kim et al., 2011;Lennox & Pittman, 2011;Dedman & Kausar, 2012;Kausar, Shro , & White, 2016).Hope, omas and Vyas (2011), using a 68-country sample, nd similar results.
e second potential bene t of voluntary audits is higher nancial reporting quality.It is argued that an external audit improves the quality and credibility of the accounts, thereby the informative value of nancial statements for third parties.While this argument is generally taken for granted, there is limited empirical evidence of the bene cial e ect of voluntary audits on accounting quality, where Dedman and Kausar (2012) and Clatworthy and Peel (2013) constitute two major exceptions.Dedman and Kausar (2012) show that voluntary audits are associated with less conservative nancial reporting.Clatworthy and Peel (2013) found out that audited nancial statements of private rms are nearly half as likely as unaudited accounts to contain accounting errors.
In sum, prior studies provide empirical evidence of a demand for voluntary audits and the positive consequences that purchasing these voluntary audits brings for SMEs, both in terms of debt contracting and accounting quality.

SUGGESTIONS FOR FURTHER RESEARCH
As highlighted by Cassar (2011), the setting of private rms o ers many opportunities to understand key accounting issues.e previous sections summarize what we have learnt from the existing literature.Where can we go from here?
Further research exploring the heterogeneity of regulations and environments where private SMEs operate is needed.Mandatory audits constitute a policy used by governments to regulate nancial reporting quality.ere is a rich variety of regulatory regimes regarding mandatory audits for private SMEs. is empirical variation can provide fruitful insights into the role of auditing in society.Prior research has examined companies' reaction to changes in the regulatory regime, to better understand the bene ts of voluntary audits (e.g.Lennox & Pittman, 2011;Kausar, Shro , & White, 2016).Further research on threshold changes, exempting certain companies from mandatory audits, may contribute to current debate on the costs and bene ts of auditing SMEs.Such investigation may also assess the validity of thresholds based on metrics such as size, revenues, and employees for audit exemptions.Minnis and Shro (2017) provide interesting ideas for further studies.For instance, these authors claim there is a need for research providing evidence about the extent to which privately contracted auditors act as compliance monitors in various countries.is is particularly relevant in the case of developing countries, given the role of SMEs and the weak institutional environments that typically characterize these settings.
As prior research suggests (e.g.Minnis, 2011), client rm characteristics have a signi cant in uence on audit costs and bene ts.A promising area for further research consists in exploring the heterogeneity within private SMEs, as an attempt to better understand the dynamics of the audit demand.For instance, studies may examine potential costs and bene ts of voluntary audits for family rms, start-ups, or fast-growing companies.
More research is also needed to better understand the relationship between SMEs and small and medium audit practices and their 'key' individuals (CEOs/owners, managers, and audit partners).For instance, it may be worth exploring the role of individual traits (human capital, social capital, age, or experience) in the audit process -from engagement to audit report issuance.Prior research has shown that, in the case of mandatory audits, individual attributes in uence auditors' compensation, both in large and small-sized audit rms (e.g.Knechel, Niemi, Zerni, 2013;Bianchi, Carrera, & Trombetta, 2017).As far as we know, no studies have simultaneously considered the individual traits of business owners and auditors.Questions remain regarding the extent to which individual skills may in uence a rm's nancial reporting quality.Exploring the role of individual attributes of both owners/managers (e.g.Allee & Yohn, 2009) and auditor in the audit rm selection process may provide interesting insights into the factors for success in the 'small audit market.' According to DeFond and Zhang (2014, p. 304), the audit process "is a black box to archival auditing researchers, primarily due to data limitations." Further research on audit processes with a speci c focus on SMEs may provide insights into how auditors deal with heterogeneity in critical input quality during the audit process, i.e. preaudit nancial statements.Furthermore, there is virtually no research exploring fraud risk assessment and audit procedures for detecting fraud.Using proprietary data from SMEs could provide interesting insights into this critical stage of the audit process.Furthermore, auditors in this setting provide much more than assurance of nancial statements.Studies such as Niemi et al. (2012), Ojala et al. (2016), andCollin et al. (2017) bring insights into the added value provided by external auditors in areas such as taxation, accounting, and decision making.Questions remain regarding the extent to which the implicit provision of these additional services in audit engagement may a ect auditor independence (Vanstraelen & Schelleman, 2017).Further research may also explore the potential impact of auditors on performance metrics, as well as the social impact of audits on SMEs.
ere is also a need for revisiting the concept of audit quality and its relationship with nancial reporting quality (Gaynor, Kelton, Mercer, & Yohn, 2016) in the speci c context of SMEs.Further studies should consider alternative metrics for audit quality and accounting quality, better tted to the context of private SMEs.ese metrics may take into account, e.g.how auditors in uence the nancial reporting process, including the potential e ect of auditors' individual traits, as previously noticed.Another factor to consider is the stakeholders' perception of 'accounting quality' (e.g.creditors and suppliers) in the case of SMEs, which may di er signi cantly from the perception of shareholders and stakeholders from large, public, companies.More research is also needed in the quality control area, as little is known about the e ects of regulatory intervention on audit quality provided by small and medium practices in the 'small' audit market.
It is quite surprising how little the audit literature has bene ted from the theoretical and empirical industrial organization literature, in order to address competition in the audit market.Even in a 'mature' textbook, such as Tirole (1988), we can nd much more competition models with product di erentiation other than the classic horizontal 'spatial competition' model used by recent audit studies.For instance, vertical product di erentiation models and minimum quality standards may be useful in describing competitive interaction between rms of various sizes o ering di erent levels of audit quality under di erent quality regulation regimes -see Trombetta (2003) for an example of international regulation of audit quality and auditors' liability.Using distance between market shares in the same industry as a proxy for spatial location has been inspired by empirical analysis applied to the banking sector.Studies examining other sectors, where the competition degree constitutes a matter of concern (e.g.phone and data services or airlines) could stimulate alternative approaches that may lead to highlight speci c features of the audit market dynamics neglected by prior research.
Interestingly, the recent literature has shown how important local markets are. is conclusion calls for further studies from smaller countries and/or speci c regions within a certain country.is is a big opportunity for non-USA based research projects to play a leading role in the academic and policy making debate.Moreover, most of the suggestions for further research above require access to proprietary data and/or information gathered through interviews, questionnaires, and surveys.Proprietary data and working papers may help getting closer to the 'reality' of the audit process.Interviews may allow researchers to gain critical information about the interaction between business owners, managers, and auditors, as well as about the accounting system and the audit process (e.g.Cohen, Krishnamoorthy, & Wright, 2017).Surveys and questionnaires may be used to collect information on individual traits.While behavioral research and eld studies have a comparative advantage in this regard, archival researchers should use "creative settings and research designs to open up the 'black box'" (DeFond & Zhang, 2014, p. 304).e opportunity is here!