Audit Market Concentration and Auditor Tolerance for Earnings Management

Abstract:     
In recent years, policy makers have expressed concern about the risks posed by audit market concentration (i.e., high market shares for the dominant Big 4 audit firms) for audit quality. In this paper, we examine the relation between concentration at the local (i.e., metropolitan statistical area) level and auditor tolerance for earnings management during 2003-09. Specifically, we focus our analysis on clients that met (or beat) the analysts’ earnings forecast but would have missed the target in the absence of positive (i.e., income-increasing) discretionary accruals. Using a sample of clients whose earnings before performance-adjusted discretionary accruals are below the consensus analysts’ earnings forecast, we find higher concentration is associated with an increased likelihood of the client meeting or beating the earnings target. Our findings hold after accounting for the effects of concentration on audit fees, the potential endogeneity of concentration, and other variables identified in the prior literature to affect audit quality. A separate analysis of the earnings distributions for all companies covered by IBES during 2003-09 also suggests that higher concentration increases clients’ propensity to just beat (rather than just miss) the analysts’ earnings forecast. Collectively, our findings are consistent with the misgivings expressed by policy makers, i.e., that oligopolistic dominance of the audit market by the Big 4 fosters complacency among auditors resulting in a more lenient and less skeptical approach to audits and lowers service quality.

Keywords: Market concentration, Audit quality, Earnings management

JEL Classification: M41

Accepted Paper Series