Market Reactions to a High-Quality Auditor and Managerial Preference for Audit Quality

Abstract

We insert an automated high-quality (HQ) auditor into established experimental audit markets to test the impact on the supply and demand for audit quality. Our approach allows us to investigate manager demand for audit quality and how other auditors respond to the increased competition from the HQ auditor. Theory predicts that managers will demand high levels of audit quality to avoid investors’ price-protecting behavior, resulting in the HQ auditor dominating the audit market. This demand for high-quality auditing should increase other auditors’ provision of high-quality audits to compete with the high-quality competitor. However, we find strong evidence that the HQ auditor does not dominate the audit market – despite holding audit costs constant and investors placing a premium on HQ auditor reports. We also find that adding an HQ auditor results in other auditors lowering audit quality. Our additional analyses indicate that some managers demand lower audit quality in an attempt to avoid negative audit reports. This evidence is consistent with loss aversion as a potential explanation for this behavior. Our findings indicate a need for additional theoretical and empirical investigation to develop a more comprehensive theory of the demand for auditing.

Keywords: audit quality, demand, manager preference, loss aversion, supply

JEL Classification: M42, M48