The Competitive Environment in the Audit Market and the Clarity of Accounting Standards

48 Pages Posted: 5 Sep 1997

Date Written: February 1998

Abstract

This paper studies the impact of a change in the competitive environment on the nature of the auditing standards preferred by the accounting profession, client switching and opinion shopping, and auditor independence. While standards can be characterized in many ways, a feature relevant to switching, opinion shopping and independence is the flexibility that the standard allows preparers. We model flexibility as the standard's clarity or the probability that two reasonable individuals, after examining the same set of facts about a client, conclude the same accounting treatment is appropriate. We look at a game where auditors collectively select the amount of flexibility that the standard allows and then compete for a client's business. The client has an ongoing relationship with his current auditor, the incumbent, but will entertain bids on the engagement from an outside or entrant auditor.

We demonstrate as the entrant can compete more directly with the incumbent, that is, as the entrant is able to meet with the client and discuss the appropriateness of specific accounting treatments, auditors jointly prefer less flexible standards, and auditor independence is an equilibrium outcome for a larger set of parameter values. If the entrant auditor has no contact with the client and cannot commit to any opinion, auditors jointly maximize their total expected profits by setting flexible or unclear standards which allows the incumbent to charge a high fee and retain the client by accommodating the client's wishes. If the entrant is able to contact the client and learn about the client's case, it is less profitable for the incumbent to accommodate the client. The auditors may honestly form different opinions, and possibly commit to client's desires, causing unprofitable "report" competition. To limit this competition, auditors select clear standards where the expected legal costs make it too costly for either auditor to sacrifice his independence.

Other results in the paper are independent of the competitive environment. First, if in equilibrium any auditor compromises his independence, it is the client's incumbent auditor and not the potential entrant auditor. This suggests a new testable implication, beyond the negative impact of a switch itself. Second, increased competition does not always mean equilibrium profits are reduced. Finally, the intuition that more clarity implies more independence may be overturned for some parameter values.

JEL Classification: G14, G10, M40, M49

Suggested Citation

Krishnan, Murugappa (Murgie) and Thoman, Lynda, The Competitive Environment in the Audit Market and the Clarity of Accounting Standards (February 1998). Available at SSRN: https://ssrn.com/abstract=10624 or http://dx.doi.org/10.2139/ssrn.10624

Murugappa (Murgie) Krishnan (Contact Author)

Yeshiva University ( email )

500 West 185th Street
New York, NY 10033
United States

Lynda Thoman

Purdue University ( email )

Krannert School of Management 1310 Krannert Bu
West Lafayette, IN 47907
United States
765-494-4489 (Phone)
765-494-9658 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
747
Abstract Views
3,830
rank
41,464
PlumX Metrics