Profit sharing in audit partnerships

Academics call the problem that arises when individuals in a partnership take actions inconsistent with the partnership's collective interest the “moral hazard problem”. This thesis examines how an audit partnership (i.e., partners as a whole) uses profit sharing rules to induce optimal partner behavior in performing various tasks, and thereby maximize the welfare of the partnership.

The analysis is undertaken in different market structures: a competitive market and an oligopolistic market, which are intended to capture the different markets for the non-Big Five audit firms and the Big Five audit firms. Non-cooperative game theory is used to analyze the strategic interaction of partners within a partnership, as well as the strategic interaction of firms when the market is an oligopoly.

In the oligopolistic market setting, it is assumed that clients are different in that the efficient audits of different types of clients require different effort profiles (i.e., different mix of auditors' effort-inputs); however, it is too costly, if not impossible, for an independent party like a court to verify each client's type, and thus client type cannot be used for partner compensation purposes. Under this assumption, I derive conditions under which there exists an equilibrium where audit firms strategically choose different profit sharing rules to specialize in different types of clients, and thereby earn positive economic profits. As a result of specialization, firms have different clienteles, and may provide audits of different quality and charge different audit fees for the same type of client. The analytical results help explain the observed differences in compensation plans among the Big Five audit firms, and provide insights into the differences in the audit services provided by the Big Five firms. This thesis also provides some empirical evidence consistent with the theory developed in this study.