Audit Market Competition and Audit Clients’ Use of Accrual-based versus Real Earnings Management

Abstract

This study investigates how the level of audit market competition influences audit clients’ use of earnings management tools. Specifically, this study examines whether clients use more or less accrual-based earnings management than real earnings management when the competition among auditors intensifies. We use 16,793 firm-year observations collected from Korean stock market for the empirical analyses, and the audit market competition is measured by the number of auditors providing audit service in a specific year and industry. The results are summarized as follows: First, clients use more accrual-based earnings management as audit market competition intensifies, suggesting that auditors allow clients’ aggressive earnings management to overcome intense competition. Because there is a substitutive relation between accrual-based and real earnings management, the magnitude of real earnings management decreases as the competition intensifies. Second, we find that the fierce audit market competition is more likely to decrease real earnings management and increase accrual-based earnings management when the client firms have strong incentive to manipulate earnings. The findings clearly show the detrimental role of intense audit market competition. Based on the findings of this study, regulators should be more careful to set up policies to promote more competition in the audit market.