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The paper (Simunic and Stein 1996, henceforth, S&S) presented here is an important area of audit research. The methodology combines economic theory with econometric analysis of data available on the accounting profession's market for audit services. This approach allows one to study such issues as the extent of competition and product differentiation among audit firms, and problems of low balling within the profession. S&S have chosen to focus on the effects of litigation on audit pricing and conclude that "auditors from the Big 6 firms in our sample appear to have anticipated actual litigation costs over the firm's client portfolio when pricing their services, at least when these costs were at their levels in the early 1990s -some 10 percent of accounting and auditing revenues" (S&S, 132-133).
In other words, there is no out-of-control liability crisis despite complaints to the contrary by the profession; although S&S do acknowledge litigation costs may have risen sharply since collecting their data, and evidence from market studies indicates mispricing of audit services can occur.
The question of the existence of a liability crisis obviously interests practitioners. However, is the S&S analysis already out-of-date relative to today's litigious environment? Are the various assumptions and estimates plausible from the practitioner's perspective? Is there evidence that has not been considered? For example, Jensen (1993) suggests that product and factor markets, presumably including markets for services such as auditing, are not efficient and considerable resources can be wasted before market mechanisms bring needed changes to an industry. In fact, Jensen (1993) alone would appear to provide substantial grounds for skepticism, especially in rapidly changing environments, concerning the S&S interpretation of market prices for audit services. Clearly if further progress is to be made, we must learn to communicate better with the profession, especially in this type of research where S&S (1995) have noted "the gap between academic research and public practice is unusually narrow."
S&S base their conclusion on a creative synthesis of related prior research and fresh evidence from a more extended analysis of their IPO study. While I find their analysis interesting given the data and models used, nevertheless, I feel their overall conclusion is at best only weakly supported, even for the legal climate of 1989-1990 when they collected their...