Quality suffers for audit offices with clients from different industries, study shows

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Audit

Audit

The quality of audit services suffers when an audit firm has clients from many different industries, according to new research from the University of Notre Dame.

Erik Beardsley
Erik Beardsley

If an audit office has a diversified client portfolio, it is more difficult to audit a particular type of client, according to "Audit Office Industry Diversity and Audit Quality," forthcoming in the Journal of Accounting, Auditing and Finance from Erik Beardsley, assistant professor of accountancy at Notre Dame’s Mendoza College of Business, along with Nathan Goldman at North Carolina State University and Tom Omer at the University of Nebraska-Lincoln. 

The study examined financial statement restatement rates for clients of audit offices from 2002 to 2015. Each firm they examined had data from a varying number of years, for a total of 35,265 observations in the dataset. “When the financial statements must be restated because of a material error, this means the audit team missed the error before statements were issued, indicating lower audit quality,” Beardsley explained.

“Prior studies have examined different characteristics of audit firms or offices, but they have not considered the industry diversity of the client portfolio as a whole,” he said. “For example, even if an audit office has a lot of clients in one industry, the overall industry diversity of the portfolio can harm the audit quality of all clients in the portfolio. This is likely because auditing a lot of different industries forces the auditor to spread their resources to a variety of different engagements rather than focus on particular types.”

The study found that having an industry-diverse client base can harm audit quality for both small and large audit offices. Though a small office may not have many clients, if each is in a different industry, audit quality suffers. Likewise, even a large office with more resources is less effective at allocating those resources when the clients are more industry-diverse. 

The study also determined that having a diverse client base can harm audit quality for industry specialists and non-industry specialists, where specialization is based on market share.

“An office could have a large market share in one industry, often due to one or two high-profile clients,” Beardsley explained, “but still be considered industry-diverse if it also audits clients in a variety of other industries. We observed the adverse effect of industry diversity even among offices with large market share, meaning that having a large market share is not enough to counter balance the negative effects of industry diversity.

“However, we did not find the negative effect when there were clusters of three or more clients in the same industry,” he continued, “suggesting that sufficient industry knowledge can occur from clusters of three or more clients in an industry.”

The study could prove helpful for audit firms in making resource allocation and client retention decisions, as well as for audit committees to assess which auditor is their best fit.

 

Contact: Erik Beardsley, ebeardsl@nd.edu