Working Paper: Do Entry Barriers to the Public Company Audit Market Deter Low Quality Audit Firms?

Paper Authors:  Andrew Kitto, Phillip T. Lamoreaux, and Devin Williams

Abstract:  Many legal jurisdictions, including the U.S. and U.K., have passed regulations to address the potential negative impacts of a lack of competition and high concentration in public company audit markets. One consequence of increased regulations, desired or not, is that they have presumably increased barriers to enter the public company audit market. An alternative view is that high barriers prevent the entry of low-quality entrants (von Weizsacker, 1980; Grossman and Horn, 1988). This study investigates the supply of, and demand for, first time public company audit firms in the U.S., firms that presumably overcame these barriers to enter the market. We document that since 2004, 275 unique audit firms have entered the U.S. public company audit market. We find evidence that these first time auditors provide lower quality audits as measured by a higher likelihood of client restatements, PCAOB-identified audit deficiencies, PCAOB enforcement actions, and lower auditor effort as measured by audit engagement hours. We also find evidence that these firms receive lower fees and that clients are significantly more likely to subsequently switch away from first time audit firms. Collectively, our results suggest that existing barriers to entry to the public company audit market do not prevent the entry of low-quality auditors, and clients do not fully infer quality based on first timers’ pre-entry quality signals.