Audit Markets and Legal Environments: An International Investigation

Abstract

This study uses a set of firm-level data from Worldscope to examine the impact of national legal environments on audit markets across 39 countries. Our auditor choice and audit fee results support the legal cost hypothesis that Big Five auditors charge a higher risk premium and are more likely to turn away risky clients in strong legal environments than in weak legal environments. We also find that the complementary effect outweighs the legal cost effect in that strong legal environments do not reduce the market share of high quality auditors, but they enhance the development of capital markets, which in turn creates a higher demand for quality audit service. Our general sample results show that firms in strong legal environments, ceteris paribus, are more likely to hire Big Five auditors than their counterparts operating in weak legal environments. However, among the large firms in the sample, which are more likely to have international investors, we document evidence supporting the substitution effect hypothesis that firms in weak legal environments are more likely to hire Big Five auditors than firms in strong legal environments because external auditors may serve as a substitute for legal protection to mitigate agency conflicts.