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Efficient allocation of capital requires both competition and accurate information on firm performance. However, producing credible financial information is not costless, nor is the independent verification of its accuracy. Firms in more competitive industries may try to avoid these costs and misrepresent their financial performance to investors, a practice known as earnings management. This paper develops a game theoretic model, that captures the potential relationship between industry competition, compliance with accounting regulations and the quality of independent audits. The theoretical model shows that whether compliance and audit quality increases or decreases with competition, depends on two offsetting considerations: (1) the product market effect, where firms in more competitive industries, with narrow profits margins may evade regulation in order to increase their profits; and (2) the audit market effect, where firms facing more competition may wish to increase their demand for a quality audit in order to signal the reliability of their financial statements and access capital markets at a lower cost. By estimating the structural parameters of this model using a Full Information Maximum Likelihood approach we find that firms in industries with greater competition have both lower levels of compliance, and employ lower quality audits, suggesting the product market effect is dominant. These results both help settle the academic debate on the role competition plays in firms' compliance with accounting regulations as well as serve as a guide to policymakers seeking to increase enforcement.
