Exploring Market Reactions to a High-Quality Auditor and Managerial Preference for Audit Quality

Abstract

We explore the entry of a high-quality (HQ) auditor, who provides independent and high-quality audits, into existing audit markets. U.S. and EU regulatory bodies have signaled dissatisfaction with audit quality through audit inspection reports as well as proposed and enacted reforms. Our experimental markets explore whether increased quality competition leads to increased audit quality, effort, and managerial demand for audit quality. We find that the addition of an HQ auditor does not increase other auditors’ effort and quality. Instead other auditors reduce their audit effort thereby providing lower quality. It appears that this behavior is a result of differing managerial demand for audit quality, as we find strong evidence that the HQ auditor does not dominate the market, despite investors placing a premium on High/Agree reports issued by the HQ auditor. That is, while holding costs constant, managers forego an earnings premium associated with the HQ auditor, suggesting that other forces beyond economic considerations impact the demand for audit quality. Additional analysis suggests loss aversion as a potential explanation; managers appear to forego higher payoffs to receive fewer disagree reports thereby smoothing their earnings. This evidence, along with the price premium for HQ auditor reports, suggests a gap between investors and managers with respect to the value of monitoring. Our findings indicate a need for additional theoretical and empirical investigation to develop a more comprehensive theory of the demand for auditing.