Do Audit Clients Prefer Watchdogs or Lapdogs? The Effect of Strictness on Audit Offices’ Market Shares

Abstract

Regulators frequently interpret a high audit market concentration as a threat to audit quality and want to foster competition. However, both the direction and the sign of the link between quality and concentration are unclear. This paper investigates the link between audit offices’ market shares and two dimensions of their strictness: The probability to issue going concern opinions and the tolerance for earnings management. We develop an analytical model in which the information content of the audit outcome for the addressees of financial statements and the financial statements preparers’ preferences drive the client firms’ demand for audit services of a certain strictness. The model predicts an inverse u-shaped relation between an office’s strictness and its market share. In the empirical part of the paper, we use U.S. data from 2000 to 2016 to test the model’s prediction. For the Big 6 as well as for the non-Big 6 market and according to both dimensions of strictness, we find lower market shares for the strictest offices compared to offices with average levels of strictness. Moreover, relative to Big 6 offices with average strictness, we find lower market shares of Big 6 offices that are lenient in their going concern decisions, but not if they are lenient in terms of discretionary accruals. In contrast, non-Big 6 offices that allow for high levels of discretionary accruals have lower market shares, but not if they issue going concern opinions only rarely.