Strategic entry deterrence in the audit industry: Evidence from the merger of professional accounting bodies

Studies show that incumbents reduce prices in response to higher entry threats in consumer industries. We provide new insights on the importance of an incumbent firm's reputation to the limit‐pricing decision by examining a professional service industry where the supplier's reputation serves as an existing barrier. The recent staggered passage of mergers of three Canadian accounting certification bodies exogenously increases the probability of future entry to incumbent audit firms. Employing difference‐in‐differences analyses and a strict fixed‐effects structure (client‐firm, audit‐firm, province and year‐month fixed effects), we find that incumbent audit firms reduce audit fees in response to a higher entry threat induced by the merger. The microstructure of the audit industry provides further insights—non‐Big‐4 audit firms reduce fees after the merger, while Big‐4 audit firms can withstand higher entry threats and do not adjust fees.