Is There a Dark Side of Competition? Product Market Competition and Auditor-Client Contracting

Abstract

This study establishes the informational value of a firm’s product market competition, derived from narrative 10-K filing disclosures, in the audit contracting process. Greater product market competition could either serve as means of mitigating agency costs between managers and shareholders or heightening managerial rent seeking activities and the incentive to distort disclosures. Consequently, greater competition could either increase or decrease audit engagement risk. We find that greater product market competition is associated with greater engagement risk. Auditors respond to the higher risk by assessing greater audit fees. Although auditors respond by charging higher fees and dedicating greater effort to these engagements, we nonetheless find that audit quality is negatively affected by greater competition. Our findings are consistent with the dark side hypothesis of product market competition. Overall, our study provides evidence that firm-level competition effects convey valuable information to auditors and play a meaningful role in the contracting process.

Keywords: Product Market Competition, Audit Risk, audit quality, Agency Costs