Product Market Competition’s Effect on Earnings Management When Audit Quality Is Endogenous: Theory and Evidence

Samuel Andrew () and Schwartz Jeremy ()
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Samuel Andrew: Department of Economics, Loyola University Maryland, 4501 N. Charles Street, Baltimore, MD 21210, USA
Schwartz Jeremy: Department of Economics, Loyola University Maryland, 4501 N. Charles Street, Baltimore, MD 21210, USA

Review of Law & Economics, 2019, vol. 15, issue 3, 35

Abstract: A long standing question is whether product market competition disciplines a firm’s incentive to engage in earnings management. This paper argues that this question cannot be investigated adequately without accounting for the quality of firms’ auditors, because auditors affect the probability of discovering earnings management. Since firms choose their auditor, a non-compliant firm can alter its own probability of being detected. Consequently, a firm’s decision to manage earnings is a function of its auditor’s quality, which is itself endogenously chosen by the firm. To study this issue we develop a game-theoretic model that captures the potential inter-relationship between industry competition, the firms’ choice of audit quality, and compliance with accounting regulations (or the degree of earnings manipulation). We show that the link between financial compliance and product market competition is affected by the endogenously chosen audit quality. We estimate this model’s structural parameters and find that greater competition reduces both compliance and the demand for high quality audits.

Keywords: Oligopoly; Cournot; auditing; earnings management (search for similar items in EconPapers)
JEL-codes: K42 L13 L15 (search for similar items in EconPapers)
Date: 2019
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DOI: 10.1515/rle-2018-0044

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