Audit Market Competition and Audit Offices' Client Portfolio Risk

Abstract

This study investigates whether audit market competition influences the risk profile of audit offices' client portfolios and whether audit offices' client risk profiles affect the association between audit market competition and audit quality. Economic theory suggests that market competition can affect a company's risk-taking, but there is limited evidence on whether audit market competition affects audit offices' client portfolio management. Two streams of prior research separately investigate whether risk avoidance affects auditors’ portfolio management decisions and whether audit market competition affects audit quality. We suggest that audit market competition influences audit offices' acceptance or continuation of risky clients by reducing the available acceptable clients. The increased riskiness of audit offices' client portfolios, in turn, affects the audit quality provided by audit offices. We find that audit market competition at both the MSA and MSA-industry levels increases the riskiness of audit offices' client portfolios. Furthermore, results from path analysis suggest that audit market competition through increases in audit offices' client portfolio risk explains a significant amount of the total effect of audit market competition on audit quality. This study contributes to the prior literature examining audit offices' management of client portfolio risk and whether audit market competition affects client portfolio risk and, ultimately, audit quality. It also sheds light on the regulatory concern over the concentrated audit market by suggesting one potential negative effect of high audit market competition.

Keywords: Audit market competition, risk-taking, audit offices, client portfolio, audit quality

JEL Classification: M40, M41, M42, M48