Narrow diversification, wide diversification, and audit quality, evidence from China

Abstract

Purpose Audit firm diversification can take many forms. Strategic management theory suggests that if the diversification has a narrow focus, it can have a positive effect on performance through knowledge spillover. However, if the diversification is too wide, the lack of economies of scope may cause an even negative impact on performance. The purpose of this paper is to examine the effect of an audit firm’s diversification strategy on audit quality. Design/methodology/approach Specifically, the authors test whether auditors can benefit from knowledge spillover in their area of specialization. Findings The authors find that the magnitude of discretionary accruals and the balance of below-the-line item are significant lower for clients from narrowly diversified area than those from a widely diversified area, suggesting a higher audit quality due to possible knowledge spillover. In addition, the authors find such benefits are more pronounced with clients with high earnings volatility. Originality/value This study extends the studies on auditor industry specialization by examining the effect of audit firms’ diversification on audit quality and assessing potential differences on audit quality between narrow and wide diversification.