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    Audit Market Concentration, Audit Fees, and Audit Quality:...
    research summary posted July 18, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 11.0 Audit Quality and Quality Control 
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    Title:
    Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China
    Practical Implications:

    This study is important given the continued concerns expressed by global regulators about the potential harm to audit quality caused by concentrated audit markets. The separation of offsetting direct and indirect effects of concentration on audit quality enhances the understanding of how concentration influences audit quality and could explain why the previous studies document mixed evidences. The study also provides evidence on how audit fees play an important role in the association between concentration and audit quality and that regulatory interventions changing one of the offsetting effects could produce potential unintended consequences. 

    Citation:

    Huang, T., Chang, H., and Chiou, J. 2016. Audit Market Concentration, Audit Fees, and Audit Quality: Evidence from China. Auditing: A Journal of Practice and Theory 35 (2): 121-145.

    Keywords:
    audit market concentration, audit fees, audit quality, and China
    Purpose of the Study:

    The potential effects of recent audit market concentration on audit fees and audit quality have been a point of concern for policy makers. The primary concern is that this concentration reduces clients’ choice of audit service suppliers, strengthens auditor’s market power, and encourages complacency among auditors, resulting in higher audit fees but lower audit quality. Despite the concern, the extant literature provides mixed evidence on the consequences of audit market concentration. The situation between developed countries where audit markets are dominated by the Big 4 audit firms, and the Chinese Ministry of Finance (MOF) is starkly different. As a result, the MOF has expressed concern about the competitive and immature Chinese audit market characterized by many small-seized audit firms, which increases auditors; incentives to compete for clients by providing fee discounts, resulting in low audit quality. The difference in attitudes toward concentration between the developed countries and China as well as the fact that China is a setting where competition is thriving, while most of the developed countries are more concerned about lack of competition is the primary motivation behind the authors examination of the Chinese audit market. The objective of the paper is to investigate the effect of concentration on audit quality in a setting with significant competition a relatively weak legal environment. 

    Design/Method/ Approach:

    The authors employ path analysis to further examine the indirect effects of concentration on audit quality through audit fees. The sample consists of 12,334 Chinese firm-year observations from 2001-2011. Audit market concentration is measured at the city level as the market shares of the local top 4 audit firms and two Herfindahl indexes of audit fees earned from listed clients of the local top 4 and all audit firms in a city-year grouping, respectively.

    Findings:
    • The authors’ findings support the claim that concentration influences audit fees; furthermore, the positive effects of concentration on audit fees is consistent with clients having a limited choice of audit service suppliers and audit firms having greater market power in concentrated audit markets. The increased market power reduces auditors’ fear of client loss and allows them to charge higher fees.
    • The authors’ findings suggest that audit market concentration has no significant overall effect on client earnings quality.
    • The authors’ findings support the notion that concentration results in poor audit quality through auditor overconfidence and complacency.
    • The authors find that concentration increases audit fees and such increases in turn improve earnings quality, suggesting that when the audit market becomes more concentrated, auditors with increased market power become less lenient with clients and charge higher fees to devote more resources and effort to audit tasks, leading to higher audit quality.
    • The authors’ findings suggest that auditors are less likely to issue modified audit opinions when the market becomes more concentrated.
    • The authors find that in concentrated audit markets auditors have greater market power and lower cost of tell the truth and can charge higher audit fees to devote more resources and efforts to the audits that they carry out.
    Category:
    Audit Quality & Quality Control, Client Acceptance and Continuance
    Sub-category:
    Audit Fee Decisions