Does Big 6 Auditor Industry Expertise Constrain Earnings Management?

Abstract

SYNOPSIS: Earnings management remains a popular topic of debate and discussion among investors, regulators, analysts, and the public. One mechanism that might mitigate earnings management is auditors' industry expertise. Using a large sample of clients of Big 6 auditors, this research examines the association between auditor industry expertise, measured in terms of both auditor market share in an industry and an industry's share in the auditor's portfolio of client industries, and a client's level of absolute discretionary accruals, a common proxy for earnings management. Clients of nonspecialist auditors report absolute discretionary accruals that are, on average, 1.2 percent of total assets higher than the discretionary accruals reported by clients of specialist auditors. This finding is consistent with the notion that specialist auditors mitigate accruals-based earnings management more than nonspecialist auditors and, therefore, influence the quality of earnings. Keywords: industry specialization; Big 6; specialist firms; earnings management; discretionary accruals; audit quality. Data Availability: The data used in this study are publicly available from the sources indicated in the text. INTRODUCTION Earnings management is a concern for investors, regulators, analysts, and the public. In a review of the earnings management literature, Healy and Wahlen (1999) call for research on factors that limit earnings management. This study is a response that provides empirical evidence on one mitigating factor: auditors' industry expertise. Specifically, I examine the association between Big 6 auditor industry expertise and the level of firms' absolute discretionary accruals--a common proxy for earnings management. Bonner and Lewis (1990) find that, on average, more experienced auditors outperform less experienced auditors. Similarly, Bedard and Biggs (1991) observe that auditors with more manufacturing experience are better able to identify errors in a manufacturing client's data than auditors with less manufacturing experience. This is consistent with the findings of Johnson et al. (1991) that industry experience is associated with enhanced ability to detect fraud. Wright and Wright (1997) conclude that significant experience in the retailing industry enhances hypothesis generation in identifying material errors. Specialist auditors are likely to invest more in staff recruitment and training, information technology, and state-of-the art audit technologies than nonspecialist auditors (Dopuch and Simunic 1982). Solomon et al. (1999) find that specialist auditors have more accurate nonerror frequency knowledge than nonspecialists. This finding is important because it is not unusual that client firms suggest nonerror explanations for ratio fluctuations. Audit effectiveness thus depends on the accuracy of auditors' nonerror frequency knowledge. All these findings support the conclusion that auditors' industry-specific knowledge is associated with audit effectiveness. How does an auditor's specialized industry knowledge help in detecting earnings management? Maletta and Wright (1996) observe fundamental differences in error characteristics and methods of detection across industries. This suggests that auditors who have a more comprehensive understanding of an industry's characteristics and trends will be more effective in auditing than auditors without such industry knowledge. Auditors who specialize in the banking industry can assess the adequacy of loan loss provisions better than nonspecialist auditors and, therefore, can improve the credibility of reported earnings. Auditors with expertise in manufacturing can evaluate whether the client's provision for warranty obligations is in line with industry standards better than an auditor without this expertise. Specialist auditors are also likely to develop databases detailing industry-specific best practices, industry-specific risks and errors, and unusual transactions, all of which serve to enhance overall audit effectiveness. …