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Diversification by the Audit Offices in the U.S. and Its Impact on Audit Quality

Sat, January 17, 3:45 to 5:15pm, TBA

Abstract

Audit offices in the US exhibit a wide variation in the number of industries they service. Strategic management theory suggests that diversification can affect the quality of output, depending on the nature and circumstances of diversification. This paper examines the effect of diversification at the audit office level on audit quality. Four proxies of audit quality are examined, mainly, discretionary accruals, propensity to meet-or-beat earnings expectations by a cent, propensity to restate financial statements, and propensity to receive a comment letter after an SEC review. Results suggest that, holding audit office and client attributes constant, diversification has detrimental effects on audit quality. On the other hand, when the diversification is part of the audit firm level strategy, the detrimental effects on audit quality are dampened. Moreover, when the diversification at the office level is a part of a revenue expansion strategy, the audit quality is adversely affected; while under a portfolio rebalancing strategy, there is no detrimental effect on the audit quality. Also, unrelated diversification leads to more adverse effect on audit quality than related diversification. Results also suggest that when the audit office is located in a market with more (less) diversified client base, the adverse effects of diversification on audit quality are weaker (stronger). Finally, the offices of big-4 audit firms handle diversification better with less adverse effect on audit quality. These results are robust to various controls from extant research. The findings of this paper are important since they identify additional factors that explain audit quality at the audit office level.

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