Recently, a system of audit firm rotation has been implemented for the audits of listed companies conducted in the European Union (EU). In the U.S., in contrast, the regulator decided against such rotation. Whereas proponents argue that rotation would strengthen independence and decrease audit market concentration, opponents stress the importance of auditors' learning effects, which would be eliminated by a change in auditors. In extending the market matching model of Salop (1979), we provide an analysis that integrates these contradictory views. We assume that both auditors' industry expertise and their experience in auditing a client decrease audit costs. We investigate the bidding strategies applied to re-acquire clients that were lost due to rotation, auditors' profit contributions, the equilibrium number of auditors (i.e., audit market concentration), and the economic importance of specific clients. Our findings indicate that the regulators' goals of simultaneously decreasing client importance and audit market concentration are in direct conflict and, therefore, the rotation system might have unintended consequences. Our model, thus, suggests how different institutional parameters give rise to economic forces that can support diverging decisions regarding the implementation of MAR.
In its recently published Green Paper, the European Commission 2010 discusses various methods to enhance the reliability of audits and to re-establish trust in the financial market. The Commission primarily focuses on increasing auditor independence and on reducing the high level of audit market concentration. Based on a model in the tradition of the circular market matching models introduced by Salop 1979, we show that prohibiting non-audit services as a measure intended to improve auditor independence can have counter-productive secondary effects on audit market concentration. In fact, our model demonstrates that incentives for independence and the structure of the audit market are simultaneously determined. Because market shares are endogenous in our model, it is not even clear that prohibiting non-audit services indeed increases an auditor's incentive to remain independent.
This paper addresses the effects of a prohibition of providing non-audit services (NAS) to audit clients. By combining a strategic auditor–client game with a circular market-matching model that has an endogenous number of auditors, we take into account the interdependence between the auditors’ and clients’ incentives, the market structure, and the quality of audited reports. We show that the regulation’s effects depend on the preexisting audit market concentration and the types of blacklisted NAS. In sharp contrast to the effects that regulators desire, a prohibition of providing NAS to audit clients can further increase audit market concentration and decrease the quality of audited reports if the fees that auditors previously earned from providing the blacklisted NAS were relatively high, compared to the reduction in audit costs that result from spillovers. In contrast, a prohibition of the NAS that generate intense spillovers and low NAS fees can have the unexpected—but desired—effect of decreasing market concentration; however, reporting quality also decreases.
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