The Association between Client‐specific Investment Opportunities and Audit Fees of Industry Specialists and Non‐Specialists

Abstract

Audit clients' investment opportunity sets (IOS) include firm‐specific opportunities that are unique to the client, as well as opportunities generalizable to the client's industry and opportunities even more generically available to all firms. Prior research does not examine the variation in audit fees related to firm‐specific IOS nor how firm‐specific IOS affects the premiums charged by industry specialist auditors. We find that firm‐specific IOS plays a distinct role in the pricing of audit services, leading to higher fees as the auditor demands compensation for increased audit risk. Further, we find that the ability of an industry specialist auditor to charge fee premiums is reduced in the case of clients that are highly differentiated based on firm‐specific IOS, as the knowledge gleaned in auditing other clients within the industry is often not applicable to clients in more unique IOS environments. We contribute to the literature by showing that industry specialist premiums are not constant for firms in the same industry; rather, they reflect a trade‐off between firm‐ and industry‐specific knowledge.

Impact of Partner Change on Audit Quality: An Analysis of Partner and Firm Specialisation Effects

“…It is argued that as industry specialist audit firms possess more industry‐specific knowledge (e.g., Cahan et al. ), they are better able to assess audit risk and are more likely to be able to detect errors (Solomon et al. ; Owhoso et al.…”

A taxing audit—On the association between auditor workload compression and tax avoidance

“…In addition to the variables above, we control for characteristics of the audit firm related to its ability to curtail aggressive financial reporting and perform an effective audit. Prior studies show that larger local audit practices ( OFFICE_SIZE ), Big 4 accounting firms ( BIG4 ), longer auditor‐client relations ( TENURE ), the economic significance of a client to its auditors ( INFLUENCE ), the length of the audit report lag ( REPORT_LAG ), whether the auditor issues a going concern report ( GCREPORT ), industry expert auditors ( AUD_EXPERT ) and tax expert firms ( TAX_EXPERT ) all contribute to the success of an audit (Cahan et al, 2015; Choi, Kim, Kim, & Zang, 2010; DeAngelo, 1981; Dunn & Mayhew, 2004; Francis & Yu, 2009; Knechel & Payne, 2001; Lopez & Peters, 2012; McGuire et al, 2012; Myers et al, 2003; Reichelt & Wang, 2010; St. Pierre & Anderson, 1984).…”

Narrative disclosures, firm life cycle, and audit fees

“…Based on prior audit fee research (e.g., Hay et al, ; Hackenbrack & Hogan, ; Cahan, Godfrey, Hamilton, & Jeter, ; Cahan, Godfrey, & Jeter, ; Jiang & Son, ; Casterella, Francis, Lewis, & Walker, ; Francis, LaFond, Olsson, & Schipper, ; Hay et al, ; Hogan & Wilkins, ; Larcker & Richardson, : Mitra, Hossain, & Deis, ), we control for various firm‐specific attributes that could impact audit fees. We control for firm size ( Size ), market‐to‐book ratio ( Market‐Book ), indicator of operating loss ( Loss ), debt to total assets ( Leverage ), net income over total assets ( ROA ), investment opportunity set ( IOS ), mergers or acquisitions ( M&A ), inventory and receivables to total assets ( Inventory_Receivable ), client firm's involvement in foreign operations ( Foreign ), client firm's reporting of extraordinary items in annual reports ( Extraordinary ), an indicator variable for clients with discontinued operations ( Discontinued ), material weaknesses in internal controls ( Material‐weakness ), auditor change indicator variable ( Auditor‐Change ), Big 4 audit firms ( Big4 ), audit industry specialization ( Specialist ), earnings restatement indicator variable ( Restatement ), and clients with material weakness ( Material‐weakness ) .…”

“…Based on prior audit fee research (e.g., Hay et al, 2006;Hackenbrack & Hogan, 2005;Cahan, Godfrey, Hamilton, & Jeter, 2015;Cahan, Godfrey, & Jeter, 2008;Jiang & Son, 2014;Casterella, Francis, Lewis, & Walker, 2004;Francis, LaFond, Olsson, & Schipper, 2005;Hay et al, 2006;Hogan & Wilkins, 2008;Larcker & Richardson, 2004: Mitra, Hossain, & Deis, 2007, we control for various firm-specific attributes that could impact audit fees. We…”