nach oben

Review of Quantitative Finance and Accounting

Erschienen in:

27.04.2016 | Original Research

Diversification by the audit offices in the US and its impact on audit quality

verfasst von: Sharad Asthana

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2017

Einloggen

Aktivieren Sie unsere intelligente Suche, um passende Fachinhalte oder Patente zu finden.

search-config

KI-gestützte Suche

Aus

Abstract

Audit offices in the US exhibit a wide variation in the number of industries they service. Strategic management theory suggests that diversification can affect the quality of output, depending on the nature and circumstances of diversification. This paper examines the effect of diversification at the audit office level on audit quality. Five proxies of audit quality are examined, mainly, absolute discretionary accruals, propensity to meet-or-beat earnings expectations by a cent, propensity to restate financial statements, propensity to receive a comment letter after an SEC review and propensity to issue a going concern opinion. Results suggest that diversification has detrimental effects on audit quality. On the other hand, when the diversification is part of the audit firm level strategy, the detrimental effects on audit quality are dampened. Moreover, when the diversification at the office level is part of a revenue expansion strategy, the audit quality is adversely affected. However, there is no detrimental effect on the audit quality when revenue expansion is not the objective. Also, diversification across dissimilar industries leads to more adverse effect on audit quality than diversification to similar industries. Results also suggest that when the audit office is located in a market with more (less) diversified client base, the adverse effects of diversification on audit quality are weaker (stronger). Finally, the offices of big-4 audit firms handle diversification better with less adverse effect on audit quality. The findings are important since they identify additional factors that explain audit quality at the audit office level.

Vorheriger Artikel Retrieving risk neutral moments and expected quadratic variation from option prices

Nächster Artikel Diversification of pre-IPO ownership and foreign IPO performance

Sie haben noch keine Lizenz? Dann Informieren Sie sich jetzt über unsere Produkte:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

Jetzt informieren

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

Jetzt informieren

For example, the Cleveland and San Diego offices of Ernst & Young both had 17 clients in 2009. However, The Cleveland office had clients from 10 industries while the San Diego office only had clients from 5 industries.

According to Asthana and Boone (2012), only 26.23 % of clients are audited by national-level industry experts.

Deltas and Doogar (2003) examine diversification strategy of Big N audit firms in the context of mergers.

Growth leads to larger audit offices. Larger audit offices are known to have better audit quality (Francis and Yu 2009; Choi et al. 2010; Francis et al. 2013). Larger audit offices may also be more diversified (Palepu 1985). However, holding office size constant, the role of diversification in defining audit quality is unknown.

Hiring an industry specialist auditor is not without risks, though. Ettredge et al. (2009) cautions that clients could shy away from industry specialists due to the risk of loss of competitive advantage through information leaks.

Offices could add new clients from existing industries only without diversifying. However, this would limit the number of target clients. A more likely approach would be to sacrifice concentration in limited industries and attract clients from a broader spectrum of industries.

Lustgarten and Shon (2013) show that large positive (negative) abnormal accruals lead to a higher likelihood of auditors (clients) terminating the engagement.

Data for this variable is obtained from the Comment Letter database in Audit Analytics.

Using Eq. 2 instead of Eq. 3 to define the diversification measure does not affect the conclusions. Results with Eq. 2 measure are reported in Panel A of Table 7. The two measures are very similar and the means (1.7209 vs 1.7044) are not significantly different and the Pearson Correlation is 0.86, significant at <1 % level. However, since the Eq. 3 measure is more intuitive and easier to interpret, I report that in the main tables.

Velury et al. (2003) and Lim et al. (2013) show that institutional ownership affects audit quality and the choice of industry specialist auditors. Institutional ownership data is not available in this paper. However, Lim et al. (2013) show (Table 2, page 353) that institutional ownership is highly correlated to client size (67 %), non-audit fees (47 %), cash flow from operations (30 %), and market-to-book ratio (30 %). Since all these 4 variables are used as control variables in this paper, the effect of institutional holdings should be adequately controlled.

Myers et al. (2014) show that in the post-SOX period, the propensity to issue a going concern opinion depends on auditor size (big-4 versus non-big 4). Inclusion of BIG-4 as an independent variable will control for this.

Kim et al. (2013) show that auditor size and tenure are both incremental risk-reducing factors. These two variables are included as independent variables to control for this effect.

Jaggi et al. (2015) provide empirical evidence that presence of internal control weaknesses affects the audit quality of industry specialist and non-specialist auditors differentially. The inclusion of ICOPINION controls for this effect.

Krishnan (2003) suggests that industry expertise can be measured in two ways: the market share approach and the portfolio share approach. In the market share approach, the audit fees from clients in the industry at the office level is deflated by the total audit fees in that industry for all audit offices in that city. In the portfolio share approach, the audit fees from clients in the industry at the office level is deflated by the total audit fees of the office. Both measures of CITYEXPERT yield very similar results. The two measures are highly correlated (Pearson correlation coefficient = 0.78; p = 0.01). Since most recent research (Francis and Yu 2009; Asthana and Boone 2012), uses the market share approach, for the sake of brevity, I report that measure only.

Replacing LOFFICE with the natural log of total clients at the office does not alter conclusions.

Including these industries does not alter the conclusions.

The results are qualitatively similar for the period 2000–2012 and for 2000–2012 sans 2002 (the year of SOX implementation).

The sample selection process requires the client to be available on 4 data bases. This results in a large size bias. This is typical in such research. For example, Asthana and Boone (2012) have similar data requirements and have an average LMV of 6.15, compared to our LMV of 6.25. To the extent the results are specific to large clients only; they should be applied to smaller clients with caution.

According to Chatterjee and Price (1977), VIFs under 10 imply that the model does not have significant multicollinearity problem.

The audit firm can diversify into industries not serviced by an audit office. To check if this affects the conclusions, I add the natural log of the total 2-digit SIC at the national firm level into my regressions and it loads insignificantly and all conclusions remain unchanged.

Choi et al. (2012) show that for a typical office, more than 90 % of the clients are local. Thus, there is a tendency among clients to hire the local auditor, rather than a distant one.

On the contrary, Table 8 shows that a larger office does not always have to be more diversified.

Andrews K (1980) The concept of corporate strategy. Richard D. Irwin, Homewood

Antle R, Gordon E, Narayanamoorthy G, Zhou L (2006) The joint determination of audit fees, non-audit fees, and abnormal accruals. Rev Quant Financ Acc 27:235–266CrossRef

Arnould RJ (1969) Conglomerate growth and public policy. Economics of conglomerate growth. Oregon State University Department of Agricultural Economics, pp 72–80

Arrunada B (1999) The provision of non-audit services by auditors: let the market evolve and decide. Int Rev Law Econ 19(4):513–531CrossRef

Ashbaugh H, LaFond R, Mayhew B (2003) Do nonaudit services compromise auditor independence? Further evidence. Acc Rev 78(3):611–639CrossRef

Asthana S, Boone J (2012) Abnormal audit fee and audit quality. Audit: J Pract Theory 31(3):1–22CrossRef

Balsam S, Krishnan J, Yang J (2003) Auditor industry specialization and earnings quality. Audit: J Pract Theory 22(2):71–97CrossRef

Barney JB (1991) Firm resources and sustained competitive advantage. J Manag 17:99–120

Berg G, Ofek E (1995) Diversification effects on firm value. J Financ Econ 37:39–65CrossRef

Boone C, Brocheler V, Carroll G (2000) Custom service: application and test of resources-partitioning theory among Dutch auditing firms from 1896 to 1992. Org Stud 21(2):355–381CrossRef

Butler M, Leone AJ, Willenborg M (2004) An empirical analysis of auditor reporting and its association with abnormal accruals. J Acc Econ 37(June):139–165CrossRef

Carcello J, Nagy A (2002) Auditor industry specialization and fraudulent financial reporting. Working paper, University of Tennessee and John Carrol University, Cleveland, Ohio

Carrera M, Gutierrez I, Carmona S (2003) Specialization and diversification in audit firms: a test of firm’s strategies in the Spanish audit market. Working paper, The University of Manchester, UK

Cassell C, Dreher L, Myers L (2013) Reviewing the SEC’s review process: 10-k comment letters and the cost of remediation. Acc Rev 88(6):1875–1908CrossRef

Chatterjee S, Price B (1977) Regression analysis by example. Wiley, New York

Cheng LTW, Leung TY (2012) The effects of management demography on auditor choice and earnings quality: evidence from China. Rev Pac Basin Financ Mark Policies 15(2):1–37CrossRef

Choi J, Kim C, Kim J, Zang Y (2010) Audit office size, audit quality and audit pricing. Audit: J Pract Theory 29(1):73–97CrossRef

Choi J, Kim J, Qiu A, Zang Y (2012) Geographic proximity between auditor and client: how does it impact audit quality? Audit: J Pract Theory 31(2):43–72CrossRef

Christensen H, Montgomery C (1981) Corporate economic performance: diversification strategy versus market structure. Strateg Manag J 2:327–343CrossRef

Chung H, Kallapur S (2003) Client importance, nonaudit services, and abnormal accruals. Acc Rev 78(4):931–955CrossRef

Cohen JR, Hoitash U, Krishnamoorthy G, Wright AM (2014) The effect of audit committee industry expertise on monitoring the financial reporting process. Acc Rev 89(1):243–273CrossRef

Davis L, Soo B, Trompeter G (2009) Auditor tenure and the ability to meet or beat earnings forecasts. Contemp Acc Res 26(2):517–548CrossRef

Dechow P, Sloan R, Sweeney A (1995) Detecting earnings management. Acc Rev 70(2):193–225

DeFond ML, Jiambalvo J (1994) Debt covenant violation and manipulation of accruals. J Acc Econ 17(January):145–176CrossRef

DeFond ML, Zhang J (2014) A review of archival auditing research. J Acc Econ 58(2):275–326CrossRef

Deltas G, Doogar R (2003) Practice diversification by large audit firms. Working paper, University of Illinois, UC

Dunn K, Mayhew B (2004) Audit firm industry specialization and client disclosure quality. Rev Acc Stud 9:35–58CrossRef

Durtschi C, Easton P (2005) Earnings management? The shapes of the frequency distributions of earnings metrics are not evidence ipso facto. J Acc Res 43:557–592CrossRef

Durtschi C, Easton P (2009) Earnings management? Erroneous inferences based on earnings frequency distributions. J Acc Res 47(5):1249–1281CrossRef

Etgar M, Rachman-Moore D (2010) Market and product diversification: the evidence from retailing. J Mark Channels 17:119–135CrossRef

Ettredge M, Young KS, Chee Yeow L (2009) Client, industry, and country factors affecting choice of big-4 industry expert auditors. J Acc Audit Finance 24(3):433–467

Fama EF, French KR (1997) Industry costs of equity. J Financ Econ 43:153–193CrossRef

Francis J, Yu M (2009) Big 4 office size and audit quality. Acc Rev 84(5):1521–1552CrossRef

Francis J, Michas P, Yu M (2013) Office size of big 4 auditors and client restatements. Contemp Acc Res 30(4):1626–1661CrossRef

Frankel R, Johnson M, Nelson K (2002) The relation between auditors’ fees of nonaudit services and earnings management. Acc Rev 77(Supplement):71–105CrossRef

Geiger MA, North DS (2006) Does hiring a new CFO change things? An investigation of changes in discretionary accruals. The Accounting Review 81(4):781–809CrossRef

Geringer JM, Tallman S, Olsen DM (2000) Product and international diversification among Japanese multinational firms. Strateg Manag J 21:51–80CrossRef

Gluck F (1985) A fresh look at strategic management. J Bus Strategy 6(2/Fall):4–17CrossRef

Gort M (1962) Diversification and integration in American industry. Princeton University Press, Princeton

Greenwood R, Li SX, Prakash R, Deephouse DL (2005) Reputation, diversification, and explanations of performance in professional firms. Organ Sci 16(5):661–673CrossRef

Higgs JL, Skantz TR (2006) Audit and nonaudit fees and the market’s reaction to earnings announcements. Audit: J Pract Theory 25(1):1–26CrossRef

Hitt M, Ireland R (1994) A mid-range theory of the interactive effects of international and product diversification on innovation and performance. J Manag 20(2):297–326

Hitt M, Hoskisson R, Kim H (1997) International diversification: effects on innovation and firm performance in product-diversified firms. Acad Manag J 40(4):767–798CrossRef

Hribar P, Collins DW (2002) Errors in estimating accruals: implications for empirical research. J Acc Res 40(March):105–134CrossRef

Hribar P, Nichols D (2007) The use of unsigned earnings quality measures in tests of earnings management. J Acc Res 45(5):1017–1053CrossRef

Jacquemin A, Berry C (1979) Entropy measure of diversification and corporate growth. J Ind Econ 27(4):359–369CrossRef

Jaggi B, Mitra S, Hossain M (2015) Earnings quality, internal control weaknesses and industry-specialist audits. Rev Quant Financ Acc 45:1–32CrossRef

Jensen M (1986) Agency cost of free cash flow, corporate finance and takeovers. Am Econ Rev Pap Proc 76:323–329

Jensen K, Kim JM, Yi H (2015) The geography of US auditors: information quality and monitoring costs by local versus non-local auditors. Rev Quant Financ Acc 44:513–549CrossRef

Jones J (1991) Earnings management during import relief investigations. J Acc Res 29(Fall):193–228CrossRef

Jones F, Raghunandan K (1998) Client risk and recent changes in the market for audit services. J Acc Public Policy 17:169–181CrossRef

Kim JB, Song BY, Tsui JSL (2013) Auditor size, tenure, and bank loan pricing. Rev Quant Financ Acc 40:75–99CrossRef

Kogut B (1985) Designing global strategies: profiting from operating flexibility. Sloan Manag Rev 27(1):27–38

Kothari K, Leone A, Wasley C (2005) Performance matched discretionary accruals. J Acc Econ 39(1):163–197CrossRef

Krishnan G (2003) Does big 6 auditor industry expertise constrain earnings management? Acc Horiz 17(Supplement):1–16CrossRef

Lim C, Tan H (2008) Non-audit service fees and audit quality: the impact of auditor specialization. J Acc Res 46(1):199–246CrossRef

Lim CY, Ding DK, Charoenwong C (2013) Non-audit fees, institutional monitoring, and audit quality. Rev Quant Financ Acc 41:343–384CrossRef

Lustgarten S, Shon J (2013) Do abnormal accruals affect the life expectancy of audit engagements? Rev Quant Financ Acc 40:443–466CrossRef

Mahoney JT, Pandian JR (1992) The resource-based view within the conversation of strategic management. Strateg Manag J 13(5):363–380CrossRef

Markham JW (1973) Conglomerate enterprise and economic performance. Harvard University Press, Cambridge

Menon K, Williams DD (2004) Former audit partners and abnormal accruals. Acc Rev 79(October):1095–1118CrossRef

Montgomery C (1982) The measurement of firm diversification: some new empirical evidence. Acad Manag J 25(2):299–307CrossRef

Myers JN, Myers LA, Omer TC (2003) Exploring the term of the auditor-client relationship and the quality of earnings: a case for mandatory auditor rotation? Acc Rev 78(3):779–800CrossRef

Myers LA, Schmidt J, Wilkins M (2014) An investigation of recent changes in going concern reporting decisions among Big N and non-Big N auditors. Rev Quant Financ Acc 43:155–172CrossRef

Palepu K (1985) Diversification strategy, profit performance and the entropy measure. Strateg Manag J 6:239–255CrossRef

Palich L, Cardinal L, Miller C (2000) Curvilinearity in the diversification-performance linkage: an examination of over three decades of research. Strateg Manag J 21:155–174CrossRef

Peel M (1997) UK auditor concentration: a descriptive note. Acc Bus Res 27(4):311–322CrossRef

Pennings J, Barkema H, Douma S (1994) Organizational learning and diversification. Acad Manag J 37(3):608–640CrossRef

Peteraf M (1993) The cornerstones of competitive advantage: a resource-based view. Strateg Manag J 14(3):179–191CrossRef

Porter M (1976) Interbrand choice, strategy, and bilateral market power. Harvard Economic Studies, Cambridge, MA

Reichelt K, Wang D (2010) National and office-specific measures of auditor industry expertise and effects on audit quality. J Acc Res 48(3):647–686CrossRef

Reynolds J, Francis J (2001) Does size matter? The influence of large clients on office-level auditor reporting decisions. J Acc Econ 30:375–400CrossRef

Robins JA, Wiersema MF (2003) The measurement of corporate portfolio strategy: analysis of the content validity of related diversification indexes. Strateg Manag J 24:39–59CrossRef

Rumelt RP (1974) Strategy, structure and economic performance. Harvard University Press, Cambridge

Rumelt RP (1982) Diversification strategy and profitability: summary. Strateg Manag J 3(4):359–369CrossRef

Shu PG, Chen TK, Hung WJ, Chiang TL (2013) Economic dependence and reputation concern for the audit firm, audit groups, and individual auditors—the case of Taiwan. Rev Pac Basin Financ Mark Policies 16(2):1–28CrossRef

Teece DJ (1982) Towards an economic theory of the multiproduct firm. J Econ Behav Organ 3:39–63CrossRef

Teece DJ, Pisano G, Shuen A (1997) Dynamic capabilities and strategic management. Strateg Manag J 18(7):509–534CrossRef

Velury U, Reisch JT, O’Reilly DM (2003) Institutional ownership and the selection of industry specialist auditors. Rev Quant Financ Acc 21:35–48CrossRef

Wernerfelt B, Montgomery C (1988) Tobin’s q and the importance of focus in firm performance. Am Econ Rev 78(1):246–250

Titel: Diversification by the audit offices in the US and its impact on audit quality
verfasst von: Sharad Asthana
Publikationsdatum: 27.04.2016
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2017
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-016-0576-y

Springer Professional

Abstract

Bitte loggen Sie sich ein, um Zugang zu Ihrer Lizenz zu erhalten.

Sie haben noch keine Lizenz? Dann Informieren Sie sich jetzt über unsere Produkte:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Weitere Artikel der Ausgabe 4/2017

Management earnings forecasts and IPO performance: evidence of a regime change

Corporate financing and anticipated credit rating changes

How important is the financial sector to price indices in an inflation targeting regime? An empirical analysis of the UK and the US

Volatility forecasting in the Chinese commodity futures market with intraday data

The impact of nominal stock price on ex-dividend price responses

Retrieving risk neutral moments and expected quadratic variation from option prices