Unintended and Intended Consequences of the Audit Reform in European Union Countries
Abstract The 2014 Audit Reform in the European Union (EU) aimed to improve the independence of audit firms and to increase auditor choice in the Public Interest Entity (PIE) audit market. One vehicle through which the European regulators wanted to achieve these aims is by promoting the involvement of small audit firms in the PIE segment of the audit market. However, regulatory interventions also have unintended consequences due to stricter disclosure and compliance requirements can accompany new regulations, as evidenced by prior studies in the case of SOX and IFRS implementation (DeFond and Lennox 2011; Kim et al. 2012). In this study we enrich this stream of literature by providing new insights on the unintended consequences of the EU Audit Reform. Specifically, we document the number of audit firm exits from (and entries to) the PIE market after the Audit Reform was introduced and the potential implications that this change in market structure may have had on audit quality supplied by and price competition among successor audit firms. We use data for 4 EU countries for which we have the entire population of PIEs in the market, namely Denmark, Germany, Sweden and the United Kingdom (UK). We find that from the 367 audit firms active in these four member states in the period 2014-2020, 162 (44%) small audit firms exited the PIE audit market segment whereas only 49 (13%) audit firms entered the PIE market segment. These statistics suggest that the strict regulatory requirements included in the EU Audit Reform forced small audit firms out of PIE market segment. Next, we derive two hypotheses about the unintended consequences of this large amount of exits on audit quality and price competition in the PIE market. We predict that successor auditors provide similar audit quality (H1) and charge similar audit fees (H2) as compared to the auditors that exit the PIE market. The results show that the exiting audit firms supplied lower audit quality as compared to the successor audit firms, but as to the effect of exits on fees we do not find significant differences between exiting and successor audit firms. These findings suggest that the EU Reform may have improved the audit quality by forcing lower quality small audit firms out of the PIE market. The findings of this study are relevant for academics as well as informative for regulators, who are concerned with the departure of small auditors from the PIE market and the barriers to entry for new auditors.
