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    Audit Market Concentration and Auditor Tolerance for...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management 
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    Title:
    Audit Market Concentration and Auditor Tolerance for Earnings Management.
    Practical Implications:

    Given that auditor concentration is an important topic that has seen relatively little empirical research, this study contributes to the literature by providing more complete evidence on the relation between auditor concentration and audit quality. Concentration reduced the opportunity for Big 4 clients to switch auditors particularly given the new auditor independence requirements following the 2002 Sarbanes-Oxley Act. Reduced choice is seen as increasing auditor entrenchment and complacency, and potentially contributing to a more lenient and less skeptical audit for clients.

    Citation:

    Boone, J. P., I. K. Khurana, and K.K. Raman. 2012. Audit Market Concentration and Auditor Tolerance for Earnings Management* Audit Market Concentration and Auditor Tolerance for Earnings Management. Contemporary Accounting Research 29 (4): 1171-1203. 

    Keywords:
    industrial concentration, earning management, auditor independence, auditing-quality control
    Purpose of the Study:

    The relation between market concentration and audit quality remains an important public policy issue. This study examines whether concentration in U.S. local audit markets affects the auditor’s tolerance for earnings management by audit clients. In recent years, policy makers have expressed concern about the risks posed by auditor concentration (i.e., the market dominance of the Big 4 audit firms) for audit quality. The concern is that market concentration limits a company’s choice of auditory, particularly if they are a large company. Having only four large auditors reduces a client’s opportunity to switch auditors and thereby entrenches the incumbent auditor. To the extent that auditor entrenchment contributes to auditory complacency and a more lenient and less skeptical approach to audits, auditor concentration could lower service quality. To the extent that audit entrenchment strengthens auditor independence and allows for greater “pushback” by the auditor, concentration could have a beneficial effect on audit quality. The authors examined a restrictive sample of observations based on clients that have the incentive and means to manage earnings to meet or beat earning benchmarks.

    Design/Method/ Approach:

    The sample is formed from the merged COMPUSTAT annual industrial files, including the primary, secondary, tertiary, and full coverage research files. The sample consists of 4,779 observations for which client’s nondiscretionary earnings fell short of analysts’ consensus earnings forecast from 2003-2009. The authors also examine a reduced sample of 2,988 observations where they exclude clients with nondiscretionary earnings that fall short of the analysts’ consensus earnings forecast by more than 5 percent of total assets.

    Findings:

    The results indicate that higher concentration (as measured by the Herfindahl index) is associated with an increased likelihood of the client having sufficient positive discretionary accruals that together with the nondiscretionary earnings is equal to or greater than the analysts’ consensus earnings forecast. Utilizing a more focused definition of earnings management, thefindings suggest that higher concentration is associated with lower audit quality. The results hold across alternative measures of the Herfindahl index based on all auditors or Big 4 auditors only, and based on audit fees, client size, or number of clients. However, the authors are unable to detect a relation between Big 4 market share and auditor tolerance for earnings management to meet or beat the earnings forecast. In a separate analysis the authors find evidence that clients in more concentrated audit markets are more likely to just beat (rather than just miss) the earnings benchmarks. Overall, the evidence is consistent with auditor concentration manifesting itself in increased auditor tolerance for earnings management by clients.

    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management, Impact of SEC Rules Changes/SarBox