Does More Competition Improve the Incumbent’s Audit Quality? Evidence from the Emergence of Second-Tier Audit Firms in China

• In Event: Audit Quality and Institutional Factors

Abstract

This study examines the impact a shock to competition has on the incumbent accounting firms’ audit quality. Our setting is a quasi-natural experiment related to the government-supported emergence of second-tier domestic accounting firms in China. We use this shock to perform a difference-in-differences test focused on incumbent Big 4 response to new competition, which we instrument by the industry-level variation in second-tier firms’ market share change. We find that the audit fee and audit quality of Big 4 firms decrease in response to the increased competition from second-tier audit firms. The quality reduction is higher in industries with lower initial Big 4 dominance, i.e. industries with lower entry barriers for new entrants. Our results highlight that increased competition, as captured by a larger number of audit firms, can reduce average audit quality, which contrasts the frequent regulatory opinion that more competition in the audit market will improve audit quality.

Authors

• Xiaochi Ge, Cass Business School

• Pawel Bilinski, Cass Business School

• Arthur Kraft, Cass Business School, City, University of London