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08-08-2019

A hidden risk of auditor industry specialization: evidence from the financial crisis

Authors: Cory Cassell, Emily Hunt, Gans Narayanamoorthy, Stephen P. Rowe

Published in: Review of Accounting Studies | Issue 3/2019

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Abstract

We identify situations in which auditor industry specialization could be detrimental for audit outcomes. We predict that during periods of heightened industry-specific risk, specialist auditors from the affected industry could struggle to secure and allocate sufficient resources to mitigate the heightened risk because they have client portfolios concentrated in the affected industry. Using a measure of office-level industry concentration/specialization (as opposed to a market-based measure), we find that banking auditor industry specialization is associated with higher audit quality and more timely audits during the period before the financial crisis. However, during the financial crisis, banking industry specialization is associated with lower audit quality and less timely audits. Collectively, our results suggest that auditor industry specialization can be detrimental in certain circumstances and that audit firms and audit regulators should consider whether the audit markets have become too specialized to handle the resource allocation problems that crisis situations present.

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Footnotes
1
In 2015, the PCAOB cited auditor industry specialization on its list of 28 audit quality indicators (PCAOB 2015).
 
2
While the financial crisis of 2008 was a very significant event for banks, bank crises are not uncommon. Previous crises include the savings and loan crisis (late 1980s and early 1990s), the inflation crisis (late 1970s and early 1980s), and many others. See Bordo and Haubrich (2009) for a detailed history.
 
3
Conversations with bank auditors suggest that audit resources were significantly reallocated during the financial crisis, with more resources being committed to bank clients. One manager we spoke with was reassigned during the financial crisis to focus on a large banking client.
 
4
This problem is particularly acute in industries that are concentrated geographically because auditor industry specialization measures that rely on a market-based benchmark do not adequately consider the makeup of the clientele in a particular city. Consider the expected number of specialist audit firms in a very large banking center (e.g., New York City), compared to a smaller banking center (e.g., San Antonio). According to the PCAOB’s audit quality indicator, New York City would be expected to have many more auditors that are classified as specialists than San Antonio. However, market-based measures of specialization do not allow for such variance in the distribution of specialists across cities because they essentially cap the number of auditors that can be classified as specialists in a city where there would otherwise be many specialists and elevate nonspecialists to specialist status in cities where there would otherwise be no or few specialists. We acknowledge that these problems are likely far less acute in industries that are more geographically dispersed.
 
5
Although not directly related to the motivation and contribution of our study, Minutti-Meza (2013) and Audousset-Coulier et al. (2016) provide additional evidence suggesting problems with market-based measures of auditor industry specialization.
 
6
Similarly, Beardsley et al. (2018) find that misstatements are negatively associated with audit office industry diversification, except for clients that cluster within a specific industry within the office. Beardsley et al. (2018) do not investigate the effects of audit office industry diversification during times of industry specific crisis.
 
7
For example, a diversified company can transfer funds from a cash surplus unit to a cash deficit unit (without taxes or transaction fees), thereby reducing the variability of operating cash flows (Bhide 1990).
 
8
Public Company Accounting Oversight Board, Auditing Standard No. 8 and Auditing Standard No. 13.
 
9
“Bear Stearns Big Bailout.” Bloomberg, 2008. Matthew Goldstein.
 
10
“FDIC Establishes IndyMac Federal Bank, FSB as Successor to IndyMac Bank, F.S.B., Pasadena, California.” FDIC Press Release, 2008.
 
11
“Bailed Out Banks.” CNN Money Special Report.
 
12
Michael Young, a lawyer at Willkie Farr & Gallagher who specializes in cases involving accounting irregularities, states: “Auditors have actually been pretty tough during the crisis in forcing companies to justify their valuation methods, a move which has resulted in many banks having to write down the value of their assets.” See “Role of Auditor in Crisis Gets Look.” Wall Street Journal, 2010. Michael Rapaport.
 
13
A number of factors provide tension for our hypothesis. First, offices (or firms) with a large number of banking clients may have been better equipped to respond to the implications of the crisis (e.g., with training, distribution of best practices, etc.) such that banking specialization became more beneficial for audit outcomes in the crisis period despite constrained personnel resources. Second, to the extent that crisis-related increases in risk were gradual or anticipatable, auditors could likely secure additional resources to mitigate the heightened risk. Finally, audit offices could request and secure resources from affiliated offices (i.e., within the operating region of the firm). We discuss tests that address this possibility in Section 4.3.1.
 
14
DeAngelo (1981) defines audit quality as the probability of detecting material errors and misstatements in the client’s financial statements and reporting the detected errors and misstatements. Misstatements represent a verifiable occurrence of poor financial reporting quality (DeFond 2010) and are a major focus of regulator and investor concerns about the quality of audits (Myers et al. 2003). Similarly, Palmrose and Scholz (2004) argue that financial statement restatements provide direct evidence of inferior audit quality and indicate the auditor’s failure to enforce the appropriate application of GAAP.
 
15
According to the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Concepts No. 2, “Timeliness alone cannot make information relevant, but a lack of information timeliness can rob information of relevance it might otherwise have had.”
 
16
In 2002, the Securities and Exchange Commission (SEC) expressed concerns about equal access to information among investors and required CEOs to personally vouch for the timeliness and fairness of public information disclosures (see https://​www.​sec.​gov/​news/​press/​2002-88.​htm). The Dodd Frank Act further increases enforcement of equal access to information by imposing monetary penalties and sanctions for insider trading.
 
17
In this quasi-experimental design, we use the financial crisis as a treatment condition, whereby we examine the difference in the effects of banking auditor industry specialization during the financial crisis and the period before the crisis.
 
18
Following Shipman et al. (2017), we use a linear probability model to estimate Equation (1) because this allows us to preserve sample observations, compare average treatment effects, and interpret the interaction term as a difference-in-differences test. Statistical inferences are similar for both LATE_FILE and MISSTATE when we use a probit model and estimate the interaction effect following Norton et al. (2004).
 
19
To facilitate the interpretation of coefficients, we tabulate results for raw (untransformed) DELAY. However, because raw DELAY does not meet the normal distribution assumption required by OLS (Knechel and Sharma 2012), we also perform tests using the natural log of DELAY and using a negative binomial model. Inferences from the (untabulated) results are similar. All untabulated analyses are available from the authors upon request.
 
20
LATE_FILE is constructed using the Audit Analytics non-timely filer database.
 
21
We designate 2008 and 2009 as crisis years; however, there is substantial divergence of opinion as to what the financial crisis years were. Cullen et al. (2018) use bankruptcies to indicate that the crisis began in late 2007, a perspective shared by the National Bureau of Economic Research. (http://​www.​nber.​org/​cycles.​html). Other bank auditing research (Doogar et al. 2015) highlights 2007 as the “lead-up” to the financial crisis. Regardless of differences in opinions about when the financial crisis began, most research supports 2008 and 2009 as crisis periods.
 
22
All continuous control variables are winsorized at the first and 99th percentiles.
 
23
The (untabulated) results are similar if we exclude year and MSA fixed effects or cluster standard errors at the audit-office level.
 
24
Our sample size is larger than that of bank studies that restrict their analyses to bank holding companies (i.e., those that use regulatory reporting data sets). A limitation of the expanded sample is that we cannot control for certain bank characteristics (e.g., securitizations) that are available in the regulatory reporting data sets.
 
25
We calculate BANK_SPEC using the full Audit Analytics audit fees dataset (before merging with Compustat). As discussed in Section 4.3.5, we find similar results if we calculate BANK_SPEC using the final sample.
 
26
In (untabulated) analyses, we perform tests using a less restrictive measure of MISSTATE that captures both big R and little r misstatements. By definition, little r restatements are less severe, as they are not required to be reported through an 8-K filing and do not require revision or withdrawal of the audit opinion (Tan and Young 2015). In these tests, we find insignificant coefficients on both BANK_SPEC and the interaction between BANK_SPEC and CRISIS.
 
27
The percentage of banks audited by Big 4 firms was 45% during the pre-crisis period (consistent with previous banking literature; Doogar et al. 2015) and decreased to 35% during the crisis. Untabulated analysis of Big 4 versus non-Big 4 clients from 2007 to 2009 reveals that, while a similar proportion of non-Big 4 banks dropped out of the sample, non-Big 4 firms attracted a larger proportion of banks that switched auditors.
 
28
As discussed in Section 4.3.5, we find similar results if we drop offices with fewer than 10 public clients or more than 75 public clients and when we drop the five largest banking cities.
 
29
In untabulated analyses, we perform similar tests where the dependent variable is LATE_FILE. Here, the coefficient on the interaction between BANK_SPEC and CRISIS is positive and significant for offices with high ROA banks and positive and insignificant for offices with low ROA banks. The test contrasting the coefficients on the interaction terms for high and low ROA offices is insignificant.
 
30
We do not make a prediction about the association between audit outcomes and banking auditor specialization in the pre-crisis period (main effects) because we have no reason to expect offices with banking specialization to be better or worse at conducting nonbanking engagements during normal times. That is, having banking expertise does not preclude an office from having expertise in other industries. Our predictions about the differential effects of banking audit industry specialization for OICs during the crisis (i.e., the interaction effects) are identical to those for banking clients because the impacts flow from the same source—heightened office-level (banking clients and OICs) resource constraints among offices with a high concentration of banking clients.
 
31
We include industry-crisis fixed effects in our OIC tests because the impact of the financial crisis likely varied across industries. We exclude industry-crisis fixed effects from our main tests because the sample is limited to banks.
 
32
Following Dechow and Sloan (1995), we use the modified Jones model (including prior year return on assets) to estimate the absolute value of discretionary accruals (ACCRUALS). Tests where ACCRUALS is the dependent variable use a smaller sample due to data constraints. We do not use ACCRUALS as a dependent variable in our analyses of bank audits because there are no widely accepted discretionary accrual models for banks.
 
33
In untabulated analyses, we perform (separate) tests for OICs with estimated positive and negative discretionary accruals. Here, the signs on the coefficients on the interaction terms between BANK_SPEC and CRISIS are consistent with expectations. However, the coefficients are not statistically significant.
 
34
Consistent with this, our discussions with a partner and a manager who conducted bank audits during the financial crisis at a Big 4 firm indicated that they frequently lead audits of bank clients from another office within the same region. They also mentioned that sharing manager and partner resources across offices within a region was common in the banking practice because of industry expertise.
 
35
Audit Analytics reports six “auditor region” classifications in the United States: Mid-Atlantic, Midwest, New England, Southeast, Southwest, and West. In our discussions with an audit manager from a Big 4 firm, the regional designations from Audit Analytics generally aligned with how the firm divided up the regions.
 
36
Our predicted crisis effect will moderate when auditors believe the risks are no longer relevant and reduce resources committed to those risks or hire and train additional audit personnel sufficient to mitigate sustained risk.
 
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Metadata
Title
A hidden risk of auditor industry specialization: evidence from the financial crisis
Authors
Cory Cassell
Emily Hunt
Gans Narayanamoorthy
Stephen P. Rowe
Publication date
08-08-2019
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 3/2019
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-019-09508-w

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