An investigation of lowballing, quasi-rents, and initial start-up costs in the municipal audit market

Several accounting researchers identify conditions in which incumbent auditors have the possibility of receiving quasi-rents. In a competitive market, when such conditions are present, lowballing is expected on the initial contract.;No empirical research, other than laboratory experiments, has been conducted concerning the relationship between audit fees and costs across auditor tenure because cost information is not publicly available. Instead, archival researchers have attempted to find evidence of lowballing by examining the relationship between audit fee and auditor tenure. However, without information relating to audit production costs as well as fees, one is unable to draw a conclusion as to the presence of lowballing or quasi-rents.;A regional audit firm has made available fee and cost data for the governmental audits conducted by the firm between 1988 and 1993. Using this panel of data, a logistic regression is performed in which audits are found to be more frequently priced below avoidable costs in the early years of auditor tenure, suggesting initial audit lowballing. Additionally, regression analyses are performed in which the percentage of audit costs billed by the auditor, audit fee, and audit costs are regressed on auditor tenure and a number of control variables. The results indicate that the percentage of costs billed is positively associated with auditor tenure, providing additional evidence of initial audit lowballing and subsequent economic rents. No relationship is found between tenure and audit fee. Audit costs are found to be negatively associated with auditor tenure, providing evidence of initial audit start-up costs.;Both lowballing and quasi-rents have been theoretically linked with reduced auditor independence. The degree of impairment should depend upon the magnitude of the fee discounts and economic profits. The estimated regression equations are used to compute the "receivables" and/or quasi-rents generated on the audits of four representative clients, and the net present value of the auditor-auditee relationships. The results indicate that lowballing generally occurs on the initial audits of all entities except special districts. The initial fee discount(s) are generally fully recovered by the fifth year on audits of cities and counties, but are not completely recovered on school district audits.