Multimarket Contact and Mutual Forbearance in Audit Markets

Abstract

ABSTRACTCompetition in audit markets is an important topic but direct tests of market competition have been limited. In this paper, we examine how audit firms behave when they are confronted with competition from another firm in a wide range of industry segments in a local market. Sharing a large number of market segments can lead to mutual forbearance among audit rivals. Such mutual forbearance is likely to manifest as higher audit fees in a market because rivals are hesitant to aggressively compete in the face of potential competitive retaliation. Using a sample of 25,662 observations from 2004 to 2015, we find evidence that supports this argument as proxied by the extent that audit firms compete in the same industries in the same locations. This result persists after controlling for several tight fixed‐effects specifications based on time, location, industry, and market segments. In supplementary tests, we also find that the likelihood of client switching is negatively associated with the multi‐industry contact of the incumbent, but clients that do switch are more likely to choose an alternative audit firm that confronts the predecessor auditor in fewer market segments. Our evidence is consistent with mutual forbearance among rival audit firms when confronted with the same competitor in different market segments.