Skip to main content
SpringerLink
Log in

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

  • Original Research
  • Published:
Review of Quantitative Finance and Accounting Aims and scope Submit manuscript

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.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Notes

  1. 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.

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

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

  4. 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.

  5. 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.

  6. 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.

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

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

  9. 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.

  10. 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.

  11. 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.

  12. 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.

  13. 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.

  14. 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.

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

  16. Including these industries does not alter the conclusions.

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

  18. 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.

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

  20. 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.

  21. 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.

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

References

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

    Google Scholar 

  • 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 27:235–266

    Article  Google Scholar 

  • 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):513–531

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

  • 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):355–381

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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):1875–1908

    Article  Google Scholar 

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

    Google Scholar 

  • 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):1–37

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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):43–72

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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):243–273

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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 9:35–58

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

  • 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 44:513–549

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

  • 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):779–800

    Article  Google Scholar 

  • 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 43:155–172

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

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

    Article  Google Scholar 

  • 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):1–28

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Article  Google Scholar 

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

    Google Scholar 

Download references

Acknowledgments

I am thankful to Henri Akono, Matt Behrend, Jeff Boone, Dana Forgione, Mark Greenwald, Jun (Maggie) Hao, Carlos Jiminez, Sarfraz Khan, Shiyou Li, Cheryl Linthicum, Emeka Nwaeze, Sung-Jin Park, Benedikt Quosigk, K. K. Raman, and Claire Veal, along with participants at the University of Texas at San Antonio workshop, the AAA Auditing Midyear Conference 2015 and the AAA Annual Conference 2015 for their helpful comments. I am also thankful to the UTSA College of Business for summer financial support for this project. This project supports the COB mission of creating and sharing knowledge.

Author information

Authors and Affiliations

  1. Department of Accounting, College of Business, University of Texas at San Antonio, One UTSA Circle, San Antonio, TX, 78249, USA

    Sharad Asthana

Authors
  1. Sharad Asthana
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Sharad Asthana.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Asthana, S. Diversification by the audit offices in the US and its impact on audit quality. Rev Quant Finan Acc 48, 1003–1030 (2017). https://doi.org/10.1007/s11156-016-0576-y

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11156-016-0576-y

Keywords

JEL Classification

Search

Navigation