The Hidden Risk of Auditor Industry Specialization: Evidence from the Financial Crisis

Abstract

Using a measure of office-level industry concentration/specialization (as opposed to a market-based measure), we identify situations in which auditor industry specialization could be detrimental for audit outcomes. In stable environments, industry specialist auditors should be able to apply their unique experience and knowledge in ways that yield better audit outcomes. However, during periods of heightened industry-specific risk, specialist auditors from the affected industry could struggle to secure and allocate sufficient resources to mitigate the heightened risk in the affected industry because, by construction, specialists in the affected industry have a client portfolio that is concentrated in the affected industry (i.e., there is insufficient resource slack). We test our predictions by investigating the effects of the recent financial crisis on audits of clients from the banking industry. We find that, during the period before the financial crisis, banking auditor industry specialization is associated with higher audit quality and more timely audits. However, during the financial crisis, the results indicate that banking auditor industry specialization is associated with lower audit quality and less timely audits. Collectively, our results suggest that auditor office-level industry specialization can be detrimental in certain circumstances and that audit firms and audit regulators should consider whether the audit market, audit firms, or audit offices have become too specialized to handle the resource allocation problems that crisis situations present.