The Dark Side of Audit Market Competition

Abstract

This paper examines the relation between audit market competition and audit quality. We use the staggered introduction of bullet trains in China as shocks to travel time between audit clients and prospective audit firms, which increases the threat of competition for incumbent audit firms. Using a generalized difference-in-differences design, we find that the increased threat of competition induced by the opening of a bullet train route in a city leads to a 6.1 percentage point (pp) increase in the probability of GAAP violations and a 2.5 pp decrease in the probability of modified audit opinions for clients headquartered in the city. We also find that bullet train connectivity leads to a 1.7 pp decrease in income-decreasing adjustments to earnings during year-end audits but no change in income-increasing audit adjustments. The negative relation between bullet train connectivity and audit quality is 1) stronger when bullet trains put greater competitive pressure on incumbent auditors and 2) weaker when clients exhibit an ex ante preference for high-quality audits. Our paper contributes to the literature by providing plausibly causal evidence that competition lowers audit quality.