From the article The Validity of Auditor Industry Specialization Measures by Sophie Audousset-Coulier (Concordia University), Anne Jeny (ESSEC), and Like Jiang (Melbourne University), published in Auditing: A Journal of Practice and Theory, 2016. This article was shortlisted for the ConsultInFrance (Syntec) “Prix Académique de la Recherche en Management”.
Industry specialist auditors are defined as auditors who’ve developed industry expertise, thanks to which they are able to provide higher quality audits and more efficient services to their clients. However, defining what constitutes industry specialization is a major topic of debate amongst academics as well as practitioners, since an auditor’s degree of industry specialization can be an important deciding factor for firms selecting an auditor (GAO 2008).
Over the years, researchers have developed a variety of methods to assess an auditor’s degree of industry specialization (ISP). These methods fall into two main categories: measures based on market share, and measures based on client portfolio size. Both types of approach depend on what data is available (for example, audit fees, customer size, number of customers ...).
Are specialized auditors really better?
In order to test the internal and external validity of these measures, our research compares 30 different methods used by previous researchers to measure an auditor’s industry specialization, using a sample of US data covering the 10 year period from 2000-2010. First, we analyzed the level of internal associations between the 30 ISP measurement methods to see if they refer to the same auditors as industry specialists. We then tested the level of external associations between these 30 methods by estimating their propensity to produce the same results regarding audit fees and audit quality.
Our results show that using these different measures to identify auditors as industry specialists produced important inconsistencies. They also show that these inconsistencies have a significant effect on the conclusions drawn regarding audit fees and audit quality.
Indeed, we conclude that industry specialization measures have weak internal and external validity. This result represents a real challenge for researchers and questions the strength of previous empirical results which have relied on an auditor’s degree of industry specialization as an accurate gage of audit quality.
Our contributions to academic literature
First, by systematically comparing 30 industry specialization measures within a large sample (35,288 observations), and over an extended period of time (10 years), our analysis provides a large-scale classification of the inconsistencies produced by the various methodologies used to designate auditors as industry specialists.
Second, since audit fee information isn’t always available, our analysis is highly relevant to researchers who don’t take audit fees into account when measuring an auditor’s degree of specialization. Indeed, one of the major take-aways from our research is that the use of client size-based ISP measures as surrogates for audit fee-based ISP measures produces significantly different results and casts doubts on the validity of such a substitution.
Indeed, approaches based on market share are positively associated with audit fee premiums, certainly because they measure greater audit quality and reputation, or the bargaining power of the auditor. In contrast the approaches based on the client portfolio are associated with reductions of fees, presumably because they measure economies of scale.
Finally, our research shows that deviations between the 30 methods are important and large enough to influence the statistical results that estimate of the effects of industry specialization on audit fees and audit quality.
Helping various actors with important managerial decisions
Our results can help various stakeholders in their management decisions. First, they can help audit firms in choosing their portfolio of clients, developing an industry-specific strategy, and positioning themselves within the market. Second, our results suggest that refining the way we measure industry specialization can help customers in their choice of auditor. Finally, our results may help regulatory bodies use more appropriate measures when analyzing the risk of a monopoly and understand how small and medium-sized audit firms could reach certain levels of industryspecialization.
The concept of industry specialization is an important, yet highly complex concept. Further research may help to better understand this issue by looking more closely at how industry specialization is put into practiceand its effects on the quality and cost of an audit. Access to quantitative and qualitative data on audit firms and their clients would be greatly beneficial for researchers interested in the subject of auditor industry specialization.