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Audit Commitee Essay

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Audit Market Competition and Audit Quality

Sanjay Kallapur Indian School of Business Gachibowli, Hyderabad 500032 Phone: +91 40 2318 7138 sanjay_kallapur@isb.edu Srinivasan Sankaraguruswamy National University of Singapore Singapore Phone: +65 6516 4473 bizsrini@nus.edu.sg Yoonseok Zang Singapore Management University Singapore yszang@smu.edu.sg

Current draft: September 2008

We thank Clive Lennox, Andy Rose, and seminar participants at the Chinese University of Hong Kong, Hong Kong Polytechnic University, and Hong Kong University of Science and Technology for helpful comments.

Audit Market Competition and Audit Quality

Abstract Policy makers have been interested in the impact of audit market competition (concentration) on audit quality. In this paper we study the relation between audit market competition at the MSA level (Herfindahl index of concentration) and audit quality (measured by discretionary accruals and the Dechow-Dichev (2002) measure of accrual quality). We find that higher audit market competition is associated with lower audit quality. We control for fixed year effects, therefore our results are unlikely to be affected by the decrease in competition due to Andersen’s demise contemporaneous with an increase in audit quality because of regulatory measures such as SOX. Our results are robust to several sensitivity tests we perform in an attempt to rule out omitted variables correlated with client firms’ MSA location. Our results are also robust to controls for endogeneity between audit market concentration and audit quality. Keywords: Audit market competition, audit market concentration, audit quality.

Audit Market Competition and Audit Quality

1

Introduction
The effect of audit market competition on audit quality is central to the formulation

of public policy regulating auditors and client firms (Hackenbrack, Jensen, and Payne 2000). This issue has received much attention in recent times, as the number of big audit firms has decreased from...

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