Diversification by the Audit Office in the US and Its Impact on Audit Quality
38 Pages Posted: 6 Oct 2012 Last revised: 10 Jun 2014
Date Written: May 2014
In the past six years, the average number of industries (2-digit SIC) serviced by audit offices in the United States has grown by 20% and the number of industries where the office has specialization has fallen by 40% (Data Source: Audit Analytics). This suggests a trend away from specialization towards diversification. 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.
Four proxies of audit quality are examined, mainly, discretionary accruals, propensity to meet-or-beat earnings expectations by a cent, propensity to restate financial statements, and propensity to receive a comment letter after an SEC review. Results suggest that, holding audit office and client attributes constant, diversification has detrimental effects on audit quality, possibly because such diverse audit engagements strain the resources of the audit office. On the other hand, when the diversification is part of the audit firm level strategy, the detrimental effects on audit quality are dampened, probably due to larger inter-office resources available to the audit team. Moreover, when the diversification at the office level is a part of a revenue expansion strategy, the audit quality is adversely affected; while under a portfolio rebalancing strategy, there is no detrimental effect on the audit quality, probably because under the expansion strategy, the office is more likely to face resource shortage. Also, unrelated diversification leads to more adverse effect on audit quality than related diversification.
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). One reason for this effect could be that audit offices located in diversified markets are better adapted to deal with diversification. Finally, the offices of big-4 audit firms handle diversification better with less adverse effect on audit quality, possibly due to more resources at their disposal. These results are robust to various controls from extant research. The findings of this paper are important since they identify additional factors that explain audit quality at the audit office level.
Keywords: Audit office, diversification, audit quality
JEL Classification: D46, G12, G14, M41, M42
Suggested Citation: Suggested Citation