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    Auditor Specialization, Auditor Dominance, and Audit Fees:...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 03.0 Auditor Selection and Auditor Changes, 03.01 Auditor Qualifications 
    Auditor Specialization, Auditor Dominance, and Audit Fees: The Role of Investment Opportunities
    Practical Implications:

    The results may be useful to practitioners in developing a client portfolio and in determining bids for audit fees, as they provide empirical evidence on the consequences of investing in industry expertise under certain conditions.  For example, these results show that high industry IOS and high IOS homogeneity are associated with higher audit fees, which implies that auditors can benefit from investments to develop industry expertise in industries with such conditions.  However, these results also imply that it is more difficult to dominate industries with high IOS homogeneity, since companies in these industries have high incentives to protect proprietary information from other auditor clients. 

    The results of this study may also be relevant for company managers and audit committees in that they provide evidence on the determinants of audit fees and the possible within-industry transfer of proprietary knowledge to competitor firms through the firms' auditor.


    Cahan, S. F., J. M. Godfrey, J. Hamilton, and D. C. Jeter. 2008. Auditor Specialization, Auditor Dominance, and Audit Fees: The Role of Investment Opportunities. The Accounting Review 83 (6): 1393-1423.

    auditor selection, auditor changes, auditor dominance, audit fees, investment opportunities, auditor concentration
    Purpose of the Study:

    The authors note that the GAO has expressed concerns related to audit firm competition in certain industries.  Namely, certain industries are dominated by few audit firms, resulting in reduced competition.  The authors investigate whether industry “investment opportunity set” (i.e., levels of growth options) explains why auditors choose to specialize in certain industries.  The authors suggest that when an industry investment opportunity set (IOS) is high, audit firms are willing to make costly investments in industry-specific knowledge.  In addition, when IOS is relatively homogeneous across clients in an industry, then auditors can easily transfer the knowledge they invested in across clients.  Below are three objectives that the authors address in their study: 

    • To investigate the impact of the investment opportunity set (IOS) in an industry on auditor industry specialization.
    • To investigate the effect of different levels of homogeneity of industry IOS on auditor industry specialization.
    • To investigate the effect of the industry IOS on audit fees.
    Design/Method/ Approach:

    The authors use a sample that includes 3,443 industry-years of data to determine whether auditor industry specialization is associated with audit clients’ Investment Opportunity Set (IOS) and/or the homogeneity of the IOS within an industry (HIOS).  The authors measure IOS for each industry using four firm-level variables: investment intensity (prior 2 years), growth in the market value of assets (prior 2 years), ratio of market value of assets to book value of assets, and the ratio of R&D expenditures to book value of assets. Further, the authors measure IOS homogeneity (HIOS) as the within-industry standard deviation of the IOS for all firms.  Finally, the authors measure auditor  industry specialization as the market share of client assets audited by the two largest auditors in an industry (defined using 3-digit SIC codes). 

    • Overall, industry IOS affects the structure of industry audit markets and the fees charged by auditors in these markets.
    • Auditors invest more in industry-specific specialization when the within-industry IOS is higher (to create barriers to entry for other auditors) and the IOS is more homogeneous (as auditors are able to transfer the expertise across client firms within the industry more easily).
    • However, auditor dominance (i.e. having one auditor dominate the industry) is negatively associated with IOS homogeneity as client firms will not want proprietary information to be transferred by the auditor to other client firms in the industry.
    • Industry IOS level and homogeneity are both positively associated with audit fees, either as payment for the investment in the IOS or as a premium for hiring the industry expert auditor.
    Auditor Selection and Auditor Changes
    Auditor Qualifications (e.g. size - industry expertise)
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