diversification by the audit office and its impact on audit quality

DIVERSIFICATION BY THE AUDIT OFFICE AND ITS IMPACT ON AUDIT

QUALITY

Sharad AsthanaProfessor, Department of Accounting

College of BusinessUniversity of Texas at San Antonio

One UTSA CircleSan Antonio, TX, USA 78249

Phone: (210) 458-5232E-mail: sharad.asthana@utsa.edu

September 28, 2012

HISTORY OF THE PAPER….

OCTOBER 2010 ARTICLE ON “COMMUTING STRESS” AND “WORK QUALITY”

OCTOBER 2010-FEBRUARY 2011 AUDIT OFFICE CLIENT HQ AUDIT QUALITY

MARCH 2011 CHOI ET AL. APRIL 2011 DIVERSIFY TO “DIVERSIFICATION” JANUARY 2012 VERSION 1 COMPETED MARCH 2012 USED FOR COMPS SEPTEMBER 2012 PAPER PRESENTED

DISTANCE

RESEARCH QUESTION

OFFICE SIZE

DIVERSIFICATION

AUDIT QUALI

TY

BACKGROUND: AUDITING LITERATURE FRANCIS & YU (2009)

Relation of Office Size with Accruals; Small positive Earnings; Small increase in Earnings; GC opinion

CHOI ET AL. (2010) Relation of Office Size with Audit fees; Accruals

FRANCIS ET AL. (2012) Relation of Office Size with Restatements

CONCLUSION: Larger Audit Offices have better Audit Quality:

More engagement hours / in-house experience Less economically bonded to clients More collective Human Capital

BACKGROUND: DIVERSIFICATION LITERATURE RUMELT (1974) PALEPU (1985) HITT ET AL. (1997) GREENWOOD ET AL. (2005) ETGAR & RACHMAN-MOORE (2010)

Diversification Leads to Sales Expansion If Auditors are rational creatures then

Audit Offices must diversify to reduce risk; increase revenue; maximize profits; and gain market dominance

TWO TYPES OF DIVERSIFICATION RELATED DIVERSIFICATION (NARROW FOCUS)

Economies of Scope/Scale: Benefit from use of the same resources across diverse markets and products

Economies of Experience: Benefit from coordination of resource flow across diverse markets

Results in Improved Output (Quality/Quantity)Kogut (1985) Wernerfelt & Montgomery (1988)

TWO TYPES OF DIVERSIFICATION UNRELATED DIVERSIFICATION (WIDE

FOCUS) Sacrifice “Depth” for “Width” Spread available resources too “thin”

across diverse engagements.

Results in Reduced Output (Quality/Quantity) Palepu (1985)

TO SUM UP .........

PROXIES FOR DIVERSIFICATIONUNRELATED DIVERSIFICATION (WIDE

FOCUS) INDUSTRY DIVERSIFICATION CLIENT DIVERSIFICATION GEOGRAPHIC DIVERSIFICATION

RELATED DIVERSIFICATION (NARROW FOCUS)

SERVICE DIVERSIFICATION

PROXIES FOR AUDIT QUALITY AUDIT FEES

o Francis et al. (2005)o Choi et al. (2008 & 2010)

DISCRETIONARY ACCRUALS MEET OR BEAT EARNINGS

EXPECTATIONSo Francis and Yu (2009)o Reichelt and Wang (2010)o Choi et al. (2012)

MAIN FINDINGS…Industry diversification, client diversification, and geographic diversification have adverse effects on audit quality.

Service diversification has beneficial effect on audit quality.

HYPOTHESES… H1a: Ceteris paribus, diversification at the audit

office level leads to client and sales expansion. H2a: Ceteris paribus, audit quality will be

negatively associated with industry diversification at the audit office level.

H3a: Ceteris paribus, audit quality will be negatively associated with diversification of client-size at the audit office level.

H4a: Ceteris paribus, audit quality will be negatively associated with diversification to distantly located clients.

H5a: Ceteris paribus, audit quality will be positively associated with diversification across services provided by the audit office.

RESEARCH DESIGN…

RESEARCH DESIGN…

SUMMARY OF RESULTS

CONCLUSIONS… Industry diversification, client

diversification, and geographic diversification have adverse effects on audit quality, possibly because such diverse audit engagements strain the resources of the audit office.

Service diversification has beneficial effect on audit quality, possibly due to knowledge spill-over effect from providing multiple services to the same client.

CONTRIBUTIONS… The findings of this paper are important

since they identify additional factors that explain audit quality at the audit office level and extend the recent research on audit office performance in the local audit market.

As a consequence of these results, future researchers are advised to control for diversification at the audit office level, in addition to controls for office attributes suggested by extant research.

IF WE KNEW WHAT IT WAS WE WERE DOING, IT WOULD NOT BE CALLED RESEARCH, WOULD IT? ~ALBERT EINSTEIN