Audit Market Competition and Client Portfolio Risk

Abstract

This study investigates whether audit market competition influences the risk profile of audit offices’ client portfolios and whether an audit office’s client risk profile affects 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 how audit market competition affects audit offices’ client portfolio composition. Two streams of prior research have documented that auditors make portfolio management decisions based on risk avoidance, and that audit market competition affects audit quality, although the results are mixed. We suggest that audit market competition influences audit offices’ acceptance of risky clients by reducing the set of available acceptable clients. The increased riskiness of audit offices’ client portfolio, in turn, affects audit quality provided by the audit office. We find that audit market competition at both the MSA and MSA-industry levels increases the riskiness of audit offices’ client portfolios. Furthermore, results suggest that audit market competition through increases in the audit office’s 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 how audit offices manage their client portfolio risk and how audit market competition affects that ability and ultimately affects audit quality.