Earnings quality, internal control weaknesses and industry-specialist audits

Abstract

Previous studies demonstrate that the quality of audit services provided by industry specialist auditors is higher than that of non-specialist auditors (e.g., Reichelt and Wang in J Account Res 48(3):647–686, 2010; Gul et al. in J Account Econ 47:265–287, 2009; Payne in Audit J Pract Theory 27(2):109–136, 2008; Balsam et al. in Audit J Pract Theory 22(2):71–97, 2003; Krishnan in Account Horizons (Supplement):1–16, 2003). Implementation of Section 404 of the Sarbanes–Oxley Act (SOX) presents special challenges to auditors to maintain the credibility of audit services when their clients have internal control weaknesses (ICW). This study examines whether audits of ICW firms by industry-specialists reflect a better earnings quality compared to audits by non-specialists in the post-SOX period. We use the matched pair sample constructed on the basis of propensity score matching process that controls for endogeneity and auditor’s self-selection bias and evaluate earnings quality measured in terms of performance-adjusted discretionary accruals and accruals quality. Our multivariate regression analyses produce evidence that earnings quality of the ICW firms audited by Big 4 industry specialists is higher than that of the ICW firms audited by Big 4 non-specialists. The superior specialist effect is, however, mainly confined to the firms having pervasive company-level control weaknesses. We find inconsequential difference between earnings quality of the firms with account-specific ICW regardless of whether they are audited by specialist and non-specialist auditors. Our additional analyses further show that any earnings quality difference between Big 4 and non-Big 4 clients is mainly attributed to specialist audit services provided by Big 4 auditors. We do not find any earnings quality difference between Big 4 non-specialists and non-Big 4 clients. Collectively, our study shows that in the enhanced regulatory post-SOX period, Big 4 auditors still provide higher quality audits if they have industry expertise, especially in a situation where companies have pervasive company-level control weaknesses.