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SUMMARY We investigate the effects of audit market concentration on audit fees and audit quality in China, where competition is intense and the legal environment is relatively weak compared with developed countries. Analyzing 12,334 firm-year observations for the period 2001 to 2011, we find a significant positive relation between concentration and audit fees. Path analysis shows that concentration improves client earnings quality and reduces the need for auditors to issue modified audit opinions through increased audit fees. Additional analysis indicates that the increased audit fees and client earnings quality resulting from increased concentration are associated with a lower likelihood of executives and auditors being sanctioned by regulators for audit failures. Together, our results suggest that concentration improves audit quality indirectly through increased audit fees and this positive indirect effect offsets the negative direct effect of concentration on audit quality. By separating the direct and the indirect effect of concentration on audit quality, our study would explain why previous studies that do not have a separation document mixed evidence. Our findings inform regulators that actions taken to eliminate the indirect effect of concentration, for example restricting the upper bound of audit fees, could produce unintended outcomes such as decreased audit quality.

We investigate whether audit committee members of the board prove to be better monitors if they are also on the compensation committee, as they would be more attuned to compensation related earnings management incentives. Analyzing data on a sample of S&P 500 firms over the period 2003-2005, we find that ceteris paribus, firms with overlapping audit and compensation committees have higher financial reporting quality, proxied for by discretionary accruals than those without such overlap. Further, we find that there is an inverted U shaped relationship between overlapping magnitude and financial reporting quality, with an optimum overlap of about 47%. Our findings are robust to controlling for the percentage of CEOs' incentive compensation and using accounting restatements as another proxy for financial reporting quality. Overall, our results suggest that there is knowledge spillover from the compensation committee to the audit committee, as reflected in higher financial reporting quality. We interpret this to suggest that some overlapping of the committee memberships may be beneficial to audit committee monitoring effectiveness.