Multimarket Contact and Mutual Forbearance in Audit Markets

Abstract

Competition in audit markets is an important topic but direct tests of market competition have been limited. In this paper, we examine how audit firms behave when they are confronted with competition from another firm in a wide range of industry segments in a local market. Sharing a large number of market segments can lead to mutual forbearance among audit rivals. Such mutual forbearance is likely to manifest as higher audit fees in a market because rivals are hesitant to aggressively compete in the face of potential competitive retaliation. Using a sample of 25,662 observations from 2004 to 2015, we find evidence that supports this argument as proxied by the extent that audit firms compete in the same industries in the same locations. This result persists after controlling for several tight fixed‐effects specifications based on time, location, industry, and market segments. In supplementary tests, we also find that the likelihood of client switching is negatively associated with the multi‐industry contact of the incumbent, but clients that do switch are more likely to choose an alternative audit firm that confronts the predecessor auditor in fewer market segments. Our evidence is consistent with mutual forbearance among rival audit firms when confronted with the same competitor in different market segments.

Using and Interpreting Fixed Effects Models

“…In robustness tests, they substitute the country and industry FE with firm FE, which are finer partitions of (or nested in) countries and industries. In a similar vein, Dekeyser et al [2021] use location, industry, and year FE in their main specification. To assess robustness to finer FE, they also report specifications with combinations of those FE (e.g., location-industry or location-industry-year FE).…”

The Effect of Client Industry Agglomerations on Auditor Industry Specialization

“…However, this argument assumes a price competitive market. Audit research examining different “types” of auditors has validated the assumption that the audit market is a quality‐differentiated market wherein each engagement‐auditor pair has a unique production function leading to cost and quality differentiation that is often positively associated with price (Francis [2004], Francis [2011], Dekeyser, Gaeremynck, Knechel, Willekens [2021], Francis, Golshan, and Hallman [2022]). As such, competitors may find it difficult to bid away the specialization price premium.…”

Would regional competition pressure affect audit quality? Evidence from a spatial distribution of the audit market

“…Ettredge et al (2020) derived the Office-Client Balance in a metropolitan area as a proxy variable for audit market competition and found that greater metro-level competition among auditors was associated with higher audit quality. Dekeyser et al (2021) found that competing with the same audit firms across different industries within a geographic region leads to mutual forbearance among auditors and less price competition.…”