Auditors diversified experience and audit characteristics. Bill Francis Lally School of Management Rensselaer Polytechnic Institute

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1 Auditors diversified experience and audit characteristics Bill Francis Lally School of Management Rensselaer Polytechnic Institute Qiang Wu Lally School of Management Rensselaer Polytechnic Institute Ibrahim Siraj College of Management Long Island University Post 1

2 Diversified auditors: Audit fees and audit characteristics of the conglomerates Abstract While existing literature considers industry specialization of the auditors as one of the important factors in explaining audit fees and audit quality, we argue that generalized experience of auditors in serving firms from different industries should also matter, particularly for the multi-segment firms. We find that an auditor with a diversified experience of auditing in industries in which a client-diversified firm operates is likely to charge a significant fee premium. Further evidence suggests that such premium is not the result of more auditing effort but greater level of diversified experience. Additionally, we find that conglomerates audited by more generalized auditors are likely to have lower level of discretionary accruals, and lower likelihood of restatements. Our results are robust to the use of audit fees of conglomerates comparing with comparable portfolio of audits fess of standalone firms, and to the concern of endogenous process of auditor selection. 2

3 Diversified auditors: Audit fees and characteristics of the conglomerates 1. Introduction Two major reasons the auditors tend to specialize in particular industries are to improve audit quality and to lower the average cost of collecting and processing of information through transferring knowledge across homogeneous clients (e.g., Cairney and Young, 2006; Reichelt and Wang, 2010). But empirical evidence on whether industry specialization lowers the audit fee is conflicting. Evidence of a large number of studies suggests that specialists might charge a specialization fee premium because of their ability of providing quality differentiated services (e.g., Francis et al., 2005; Numan and Willekens, 2012). On the other hand, economies of scale generated from focusing on certain industries might lead the specialist auditors to charge a fee discount (Cahan et al., 2011; Fung et al., 2012). Further such industry expertise are presumed to improve audit quality (e.g., Simunic and Stein, 1987; Balsam et al., 2003; Lim and Tan, 2010). But there is a gap in the literature in examining how auditors experience of serving different industries as well as multi-segment firms affect the corresponding firms audit fees and audit quality. Unlike single-segment firms that are focused on a single-industry, diversified firms operating in multiple industries might highly value the auditors experience of serving in different industries. In other words, non-specialized auditing experience could be more valuable for diversified firms than focused firms. If serving of clients from different industries create a unique knowledge-scope for the auditors, then non-specialist would likely to charge higher audit fees. In addition to this argument, literature suggests that scope and incentives of earnings manipulation for diversified firms are much different than focused firms (Chen and Zhang, 2007; You, 2014; 3

4 Chen et al., 2016). Also there are some agency problems specific to diversified firms that destroy value (e.g., Berger and Ofek, 1995; Rajan et al., 2000), which could create managerial incentives of disclosing manipulated information. Auditors who have experience of dealing with diversified firms can easily detect such incentives specific to organizational forms. Therefore we can predict that, regardless of industries in which the auditors serve, the experience of complex organizational forms such as diversified firms would help the auditors transfer the knowledge across complicated clients and thus charge higher audit fees. We predict higher audit fees because the scope of economies of scale associated with serving in different industries should be much limited compared to scale for specialized auditors. Moreover, prior studies suggest that the auditor s industry specialization improve ability of error detection (Solomon, Shields, and Whittington, 1999; Owhoso, Messier, and Lynch, 2002), increase the auditor s quality of risk assessment (Taylor, 2000; Low, 2004). Therefore, as the auditor s experience of serving segment industries and serving diversified firms make them better at assessing multi-segment firms, such experience would likely to improve the quality of audit. Consistent with our predictions, using a sample of 43,973 firm-year observations from 2000 to 2014, we find that auditors experience of serving in different industries is significantly and positively associated with audit fees of the diversified firms. Also we find that auditors devoted to auditing conglomerates charge significantly higher audit fees for multi-segment firms. Then we try to explore whether such auditors charge higher audit fees because of the requirement of high auditing effort. While we find that in general diversified firms require high auditing effort, auditors with diversified experience need to put low efforts in auditing of diversified firms. We also check how the auditors experience of number of year auditing in diversified industries affect audit fees. We find that auditors with more than median number of years of 4

5 experience in the diversified industries are highly to charge diversification premium. Further we examine how such diversified experience could affect the earnings quality of the diversified firms. We find that auditors both diversified experience and conglomerate experience significant increase the earnings quality of the conglomerates. We also find evidence of negative relationship between experience and likelihood of earnings restatement. We use a propensity score methodology to rule out the influence of endogenous relationship between auditor choice and audit fees. Our paper contributes to the literature of financial accounting that focuses on how industry expertise affects audit quality and audit fees. While conventional literature is largely focused on different measures of industry specialization and how it affects pricing and quality of audits (e.g., Cairney and Young, 2006; Fung et al., 2012), we are the first to recognize that auditors nonspecialized or diversified expertise also does matter. Essentially for the case of conglomerates, experience of auditing firms from different industries and experience of serving conglomerates lead to a significant differential pricing and quality of the audits for diversified firms. While audit fees represent the equilibrium point of supply and demand audit market that is subject to subject to a number of constraints (Causholli et al., 2010), prior literature on audit fees implicitly assume that effect of industry characteristics is homogenous in the market pricing of audit. A recent paper of Bills et al. (2015) directly examine how industry characteristics might play role in industry expertise effect on audit fees. In this paper, we argue that industry specific expertise should not provide much help in the auditing of complicated or multi-segment firms. While existing studies are mainly focused on industry specialization, we show that non-specialization also matter for the client-firms that are diversified into multiple industries. 5

6 Our paper also contributes to a large body of literature on agency problems associated with corporate diversified firms. Since diversified firms are complicated form of organization and provide greater opportunities and incentive to undertake corporate decision that could be suboptimal for the shareholders (see Maksimovik and Phillips (2013) for an excellent review on this regard), external monitors need to put greater effort to effectively oversee managerial actions inside the conglomerates. Literature in audit also provides evidence that there is a positive relationship between diversification and audit fees. Our results imply that certain type of experience, such as auditing of different industries, rather than specialization to a single industry, could be an effective mechanism in overseeing a diversified firm. The rest of the paper is organized as follows. Section 2 focuses on relevant literature and hypotheses development. Section 3 discusses on the data and methodology. Section 4 discusses the empirical findings. Section 5 concludes the paper. 2. Relevant literature and hypotheses development 2.1. Industry specialization versus diversified experience of the auditors A common conclusion of the literature of auditor specialization is the industry expertise of the auditors helps improve performance and quality of audit (e.g., Solomon and Shields, 1999; Low, 2004). But whether such auditor specialization and resulted high quality audit should be associated with fee premium or discount is still an empirical question. Theoretically, audit firms could expect to obtain a strong base of knowledge and a consequential economies of scale and greater efficiency because of their industry expertise, which could lead a fee discount. On the other hand, 6

7 Auditors might achieve a number of benefits from specializing in certain industries. As effective audit planning and risk evaluations require industry information, industry specialization should lead to a better planning of audit and understanding of risk (e.g., Winograd et al., 2000). Industry expertise help auditors increase audit quality and reduce average costs by sharing knowledge about the procedures and risks associated with audits across homogeneous firms (e.g., Cairney and Young, 2006; Reichelt and Wang, 2010). A large number of studies that examine the auditor specialization effect on audit fees find evidence of a fee premium for the specialists (e.g., Ferguson et al. 2003; Francis et al. 2005; Carson, 2009; Cahan et al. 2011; Fung et al. 2012). However, further evidence suggests that such fee premium might be only applicable for clients with certain type of sizes (Casterella et al., 2004; Carson and Fargher, 2007), or for specific periods (Huang et al., 2007). On the other hand, we can argue that specialist auditor could charge a fee discount because of the economies of scale achieved from specialization (Cahan et al., 2011; Fung et al., 2012). Unlike the evidence of the relationship between audit specialization and audit fees, literature is to some extent consistent in providing evidence for the argument that industry expertise of the auditors increase audit quality. Theory suggests that specialization in various industries help auditors obtain product differentiation and serve with high quality audits (Simunic and Stein 1987; Dunn and Mayhew 2004). Auditors become more able in detecting accounting irregularities and false representation when they devote physical and human capital to gain industry expertise. Because of improved auditing ability, a large number of papers argue that auditors industry specialization increases earnings quality through limiting the scope of earnings management for the client firms. For example, several empirical papers find evidence of lower discretionary accruals for the firms served by specialist auditors (e.g., Balsam et al., 2003; Lim 7

8 and Tan, 2010). Further evidence suggests that auditors industry specialization is associated with better quality of disclosure (Dunn and Mayhew, 2004), higher earnings response coefficient (e.g., Balsam et al., 2003), lower occurrence of financial fraud (Carcello and Nagy, 2004), lower incentives of meeting or beating analysts forecasts through earnings manipulation, and higher likelihood of receiving going concern opinion if necessary (Reichelt and Wang, 2010). Conventional literature on industry specialization that we discuss above is focused on within-industry expertise, which is more applicable for the single-segment firms that operate in a single industry. On the other hand, since multi-segment firms operate in multiple industries, an auditor specialized into a single industry might not utilize the expertise and benefits associated with specialization. In this case, we can argue that the auditors experience of serving firms from different industries would be more useful in auditing of diversified firms operating in different industries. Since the score of economies of scales is much lower in the case of auditing firms from different industries than firms within a single industry, auditors are likely charge an experience premium for the diversified firms. Moreover, beside the experience of serving firms from different industries, we can argue that experience of auditing muti-segment firms itself can help auditors more capable of auditing the diversified firms. Why such experience matters because both scope and incentives of earnings management for diversified firms can be different from focused firms. A large number of papers documents that diversification destroys firm value because of severe agency problems (e.g., Berger and Ofek, 1995; Rajan et al., 2000; Ozbas and Scharfstein, 2010). Diversified firms can have incentives to manage earnings because of agency problems. Managers tend to hide inefficient allocation of capital through manipulating earnings at the segment level. 8

9 For example, Chen and Zhang (2007) present a theory arguing diversified firms have incentives of manipulate earnings at segment-level and thus such firms would suffer from misevaluations. In an empirical paper, You (2014) shows that diversified firms tend to transfer profits from segments with low valuation multiples to segments with high valuation multiples. Furthermore, unlike firm level earnings, segment level earnings are likely to be subject to greater managerial discretion and less monitoring by the auditors (e.g., Berger and Hann, 2003). A recent paper of Chen et al. (2016) show how the facility of operating in different industries provide the diversified firms a unique opportunity of conducting real earnings management. As the Securities and Exchange Commission requires that each conglomerate define a primary industry segment based on the segment holding the highest proportion of sales, diversified firms have the opportunity of placing their favorable industry segments as the primary segments by manipulating sales. Essentially Chen et al. (2016) find that segments in favorable industries experience a jump at the 50% cutoff points of sales and thereby becomes the primary segments. Therefore, we predict that - H1: There would be a positive association between auditors extent of diversified experience of serving clients segment-industries and audit fees. In terms of audit quality, we can further predict a - H2: Negative association between auditors extent of diversified experience of serving clients segment-industries and discretionary accruals. H3: Negative association between auditors extent of diversified experience of serving clients segment-industries and the likelihood of earnings restatements. 9

10 3. Data and methodology We start with a sample that is the intersection of Audit Analytics and Compustat Business Segment for the period of 2000 to Additionally, we need non-missing observations for the control variables used Compustat Annual database. We exclude firm-years that have any segment operating in financial (SIC ) or utility (SIC ) industry. Our final sample consists of 43,973 observations with 7,051 unique firms, where 6,202 firms are focused and 1,732 firms are diversified Measures of experience Industry experience To measures an auditor s experience of serving in different industries, first we calculate the auditor s market share in each industry it serves in a fiscal year. Then we distribute the market share in industry i for the segments that also operate in industry i. Finally, we calculate the firm level IND_EXP as the weighted average of market shares, whereas weight is a segment s sales over total firm s sales. For example, IND_EXP is as follows - n IND_EXP = ω it MARKET SHARE it i=1 ω it = sales of segment in indusry i over total firm sales MARKET SHARE it = Auditor s market share of audit fees in industry i 10

11 3.2. Measure of diversification We define a firm-year as diversified if it has operations in more than one industry. We define our industry based on 2-digit SIC. While conventional literature on diversification uses 4- digit SIC in measuring of diversification status, note that our 2-digit based measure coincide with the definition of unrelated industry diversification, which is more relevant for our research objective because we want to focus on experience of auditors in terms of auditing in different industries. 4. Empirical results 4.1. Descriptive statistics Table 1 provides summary statistics of the key variables for focused and diversified firms. We observe that the mean value of IND_EXP for diversified firms is significantly higher than focused firms, which implies that auditors of diversified firms have more diversified experience of serving different industries than auditors of focused firms. Also auditors of diversified firms show significantly higher mean value for CONG_EXP or experience in serving conglomerates than focused, which is not surprising as auditors who serve conglomerates may find it optimal or efficient to devote more resources in serving of conglomerates. Mean value of LAFEES or natural logarithm of audit fees is significantly higher for diversified firms than focused firms, which is consistent with prior literature arguing that auditors are likely to charge high fees when they need to put more effort in dealing with organizationally complex firms. Furthermore, we can observe that diversified firms, on average, are larger, more tangible, more profitable, less loss incurring, and older than focused firms. In terms of audit 11

12 characteristics, conglomerates, on average, are more likely to be audited by Big 4 auditors, experience longer auditor-client relationship, less likely to change auditors than single-segment firms. Also mean values of other variables indicate that focused firms, on average, are less likely to restate their earnings in financial statement, more likely to experience a higher lag in audit reporting, and receive going concern opinion than diversified firms. [Insert Table 1 here] Table 2 shows sample distribution and market share by industry at segment level. Our purpose is to find out whether there are any observable differences between most diversified and least diversified auditors in the market share of clients and audit fees in different industries. Each year we construct a quintile ranking of the measure of diversified experience, IND_EXP, and define the auditors at the top of rank as the most diversified auditors and at the bottom of rank as the least diversified auditors. In columns (2) and (3) we observe that for most of the industries majority of the segments are from single-segment firms. For instance, focused firms share in total number of segments in Healthcare, Business Equipment, and Energy industries are around 84%, 78%, and 69%, respectively. One the other hand, Diversified firms show considerable share in segments in Manufacturing, Chemicals, and Consumer Durable industries, which are 50%, 49%, and 45%, respectively. Further in table 2 we show market share in total number of clients and total audit fees for the least and most diversified auditors. In column (5) we observe that least diversified auditors are more active in Health, Chemicals, and Business Equipment with at least 17% market share of clients in each of those industries. But their share in the total audit fees generated from industries seem trivial compared to their share in total number of clients they serve, which we can observe in column (6). For instance, least diversified auditors serve around 13% of total segments in 12

13 Telecommunication industry, but they only earn 1.2% of total fees generated form that industry. Their maximum share in audit fees are in Health industry, in which they also hold maximum share of clients compared to other industries. Contrary to the least diversified auditors, columns (7) and (8) show that the most diversified auditors tend to have a moderate share in client-segments in each industry but have considerably larger share in audit fees generated from each of these industries. For example, in the Consumer Nondurable industry, the most diversified auditors capture around 27% of client-segments, where they earn around 46% of total audit fees generated from that industry. In general, in each industry, the market share of the most of diversified auditors in audit fees are almost double of market share in total number of clients. It suggests that highly diversified auditors tend to generate disproportionately high revenues compared to number of clients they serve, while the least diversified auditors generate a trivial amount of audit fees compared to their share clients in the industries. This might be a good indicator of plausible diversification premium earned by the highly diversified auditors in the market. [Insert Table 2 here] Next, we analyze the trend in market share in clients and audit fees of the least and most diversified auditor over the sample period. In figure 2 we observe that the highly diversified auditors show slightly upward trend in capturing client-segments, the market share is around 20% from the beginning of sample period to around 24% at the end of The least diversified auditors show more volatile trend that tends to decrease slightly from 15% in 2009 to around 10% in But their market share in audit fees stay in the vicinity of 1% to 2% in the most of the period, which is considerably lower compared to their market share in clients. On the other hand, the most diversified auditors show a upward movement of their market share in audit fees from 13

14 around 31% to 40% over the sample period. Again, the figure provide further support to our findings in table 2 that the most diversified auditors generate disproportionately high audit fees by serving moderate portion of clients in the market, whereas the least diversified auditors capture very small share of audit fees from the market by serving a considerable number of clients in the industries. [Insert Figure 1 here] In table 3, we observe that audit fees are significantly correlated with the measures of diversification and the measures of auditors experiences of serving firms from different industries (IND_EXP). Also we observe that Big4 auditors are highly likely to be much more experienced than other firms. Furthermore, we find a significant negative relationship between auditor change (AU_CH) and diversified industry experience, and conglomerate experience. We also find a negative relationship between auditor reporting lag (LAG_RP) and industry experience, which suggests that auditors with diversified experience need to exert less effort in auditing the clients. [Insert Table 3 here] 4.2. Regression results 4.1. Industry experience and audit fees Table 4 shows results from the relationship between auditors diversified experience and audit fees. Consistent with prior papers, column (1) shows that the coefficient of diversification dummy (DIV) is significant and positive. Once we include experience variable (IND_EXP) in column (2), the coefficient of diversification dummy becomes much smaller but remains 14

15 statistically significant. More importantly, we observe that both industry experience and the interaction between diversification dummy and industry experience is positive and highly significant. It implies that industry experienced auditors charge significantly higher audit fees to diversified firms than focused firms. In columns (3) and (4) of table 3 we use a continuous measure of diversification, which is the number of segments in different 2-digit SIC industries. Again, we expect to observe some nonspecialization premium for the increase of number of segments. First, column (3) show that audit fees are increasing with number of different industry a firm-year has operation in, which is consistent with the prior literature. In column (4), we interacted the number of segments with the measure of non-specialized industry experience, where we observe that firms involved in more diversifying operations experience higher audit charges. Overall our results in table 3 suggests that while auditors specialized in a single industry tend to charge a specialization on the firms, auditors with diversified industry experience tends to charge a diversification premium to diversified firms. [Insert Table 4 here] 4.2. Auditor switching effect In this section, we examine the effect of switching to new auditors with different extent of diversified experience. Thus, we only focus on the years in which the firms change their auditors. In column (1) we observe that the interaction term between diversification dummy and measure of auditor s diversified experience, IND_EXP, is significant and positive, which implies that new auditors tend to charge significantly high audit fees that is increasing with their diversified 15

16 experience. Next, in column (2), we examine the effect on audit fees when the newly hired auditors are at the top of the quintile of experience. The coefficient of the interaction between diversification and MOST_DIV is positive and statistically significant at 10% level. It suggests that newly hired auditors with a higher level of diversified experience tend to change high audit fees. It could be the case that the level of experience of new auditors could be similar to that of replaced auditors. In column (3), we examine what happens when replaces auditors were not the most diversified but the new auditors are. We observe that hiring of better experienced auditors lead to higher audit fees. Firms often change their organizational form. A focused firm could diversify its operation into new segments and might change current auditor to accommodate to changing demand of audit services. We create a dummy variable FC_DIV, which equals one if a focused firm becomes diversified in the current year. In columns (4), (5), and (6) we observe that the coefficient of FC_DIV is negative, even though not significant. It could seem unusual to some extent since we might rather predict that auditors should charge higher audit fees when the firms become diversified. But we have to keep in mind that this is subsample based analysis that only includes the sample years in which the firms change their auditors. Since firms might have various incentive in working when deciding of auditor changes, we cannot necessarily predict what happens to audit fees when the firms switch to new auditors. In column (4), we find that the coefficient of interaction between diversification dummy and continuous measure of auditor s diversified experience is positive but not significant. The coefficient of the interaction term is positive and significant at 10% level when we use indicator variable for the most diversified auditors, as shown in column (5). When we use dummy variable for the focused-to-diversified firms that replace low diversified auditors with the most diversified auditors, we find that the interaction term is positive and 16

17 significant at 1% level. It suggests that newly diversifying firms are tend to be charged with higher audit fees when they hire better experienced auditors. [Insert Table 5 here] 4.3. Auditor s non-specialized experience and auditing effort We argue that auditor s experience of auditing firms from industries could make them well capable of servicing the conglomerates, for which the auditors could charge a premium. On the other hand, prior literature also argues that auditors can charge higher fees for auditing of conglomerates since investigating multi-segment firms needs greater effort. Thus one can argue that our finding could simply be the result of more effort that auditors put for their conglomerate clients. Our main finding of significantly positive coefficient for the term of interaction between conglomerates and diversified-experiences of auditors suggest that while, on average, the auditor charge a higher fee for conglomerates, as the coefficient of diversification dummy indicates, there is an additional fee associated with their experience of auditing of firms from different industries. To figure out whether the higher fees are the results of experience premium, or greater effort, first, we examine the effects of experience on reporting lag. If the auditors have to put considerably higher effort in auditing diversified firms, then we could expect to observe a higher reporting lag days to same extent. In panel A of table 6, the coefficient of the interactions between diversification dummy and different measures of auditors experience are all negative from columns (1) to (6). Second, in a further test of finding our whether it is actually the experience that drives charging of higher audit fees, we investigate the relationship for the auditors who are new in industries and for the auditors who has been servicing in segment-industries for a longer period 17

18 compared to their peers. We can predict a higher audits fees to be charged by the latter type of auditors if there is market premium for experience. Essentially in constructing of the variables, first, we identify the number of years an auditor has been servicing in each segment-industry. Then we calculate the median number of years of auditors servicing for each year for each 2-digit SIC industry. An audit firm is specialized for a conglomerate if number of years it is active in each segment industry is greater than median number of years the auditors are active in those industries. We capture this characteristics by the dummy variable EXPERIENCED. On the other hand, an audit firm is completely new for a conglomerate if it has not prior experience of working in any of the industries in which the conglomerate operates, which is captured by the dummy variable BEGINNER. In panel B of table 6 we present the results using the variables EXPERIENCED, and BEGINNER. In column (1), first, we observe that the coefficient of BEGINNER is negative and significant at 1% level, which implies that, on average, the inexperienced auditors charge considerably low audit fees. Further the interaction term between diversification dummy and BEGINNER is positive but not significant. The results suggest that newly entrant auditors in the industries where conglomerate operate do not charge higher audit fees, even though they usually need to put greater effort of auditing clients from industries where they lack experience. On the other hand, in column (2), we find that the coefficient of the variable EXPERIENCED is positive and significant at 1% level. This is not surprising since auditors with diversified experience could be effective in audit service and charge higher fees. More importantly, the interaction term between diversification and EXPERIENCED is positive and statistically significant at 1% level. The results indicate that even though experienced auditors do no need to 18

19 put higher effort in auditing conglomerates compared to the non-experienced auditors, their specialization in diversified experience is highly likely to lead to a higher charging of audit fees. [Insert Table 6 here] 4.4. Auditors non-specialized experience and discretionary accruals As it become evident that non-specialized auditors charge higher audit fees for the diversified firms, next we try to observe how such experience help diversified firm improve audit quality. While auditors diversifying experience and conglomerate experience need to put lower effort in auditing diversified firms, we can assume that their experience should also lead to more accuracy in measuring earnings quality. Next Jones (1995) measure of discretionary accruals as dependent variable to investigate how auditors diversified experience affect earnings quality of conglomerates. Since diversified firms tend to have segments with uncorrelated nature of business that could cancel out each other s use of accruals management, overalls the use of accruals should be lower for the conglomerates. Therefore, rather than comparing the accruals of diversified firms against focused and to get a more clear and unbiased picture, we carry our test only on the sample of diversified firms. In table 7, in column (1) we observe that the continuous measure of diversified experience, IND_EXP, is negative and significant at 5% level. The coefficients of other measures of diversified experience in columns (2), (3), and (4) are also negative but not significant. In columns (5) and (6) we examine on the sample of diversified firms that change their auditors. We can observe in column (6) that the coefficient of CH_AU_MOST_DIV, indicator variable for the first that replace low-experienced auditors with the most experienced auditors, is negative and significant at 1% 19

20 level. Overall our results in table 7 suggest that auditors with diversified experience are better at auditing of conglomerates and could help disclose high quality financial reports. [Insert Table 7 here] 4.5. Auditors diversified experience and likelihood of earnings restatement Next we examine how auditors diversified experience might affect the propensity of earnings restatement of the conglomerates. In table 9, in a logit model using dependent variable RESTATEMET indicating whether earnings are restated in a year, we find that the coefficient of measures of diversification are negative, which are significant for the case of ordinal measure of experience as shown from column (2) to (4) Overall the results in table 8 indicate that the nonspecialized auditors could improve reporting quality and constrain earnings management for their conglomerate clients. [Insert Table 8 here] 4.8. Excess audit fees Throughout in our analyses, while measuring the effect of auditors diversified experience, we compare the audit fees of the conglomerates with the focused firms. Our argument is that such non-specialized experience should be more effective in the auditing of the diversified firms. Since different diversified firms have different industry combination, pooling all diversified and focused firms together and then compare their audit fees with each other could result in some dubious results. Thus, following the methodology of Berger and Ofek (1995), we construct a measure of 20

21 excess fees that compare the audit fees of a diversified firm with a comparable portfolio of specialized firms. Results in table 9 show that excess fees are increasing with the auditors diversified experience. Essentially it provides further empirical support for our argument that non-specialized experience in the auditing of the conglomerates. [Insert Table 9 here] 4.6. Endogeneity in the selection of auditors Recent literature argues that there are factors that could determine what type of auditors the firms might choose, or the process of auditor selection is not random (e.g., Eshleman and Guo, 2014; Francis and Gunn, 2015). Specially one can argue that a diversified is more likely to select an auditor with diversified industry than a focused firms. Thus we use a propensity score methodology to overcome the endogenous relationship between auditor choice and audit fees. In table 10, we use propensity score matching methodology to deal with this issue of endogenetiy and find that our results still persist. [Insert Table 10 here] 5. Conclusion Our paper provides the first evidence in audit literature that auditors diversified experience does matter in affecting audit fees and quality of diversified firms. We argue that the finding of conventional literature that industry specialization of the auditors might increase or decrease audit fees and affect audit quality should be more applicable for the single-segment firms, as these firms 21

22 operate in a single industry. But for the case of diversified firms, rather than experience of specialization to a single industry, what skill should matter the most is the auditors experience of auditing firms from different industries, as a diversified firm is a combination of segments in multiple industries. We find that auditors experience of auditing firms from different industries is significantly and positively associated with audit fees. Similarly we find that auditors who have rich experience serving conglomerates also charge higher audit fees for the diversified firms. Our further results imply that auditors such experience help reduce auditing effort and increase audit quality. It implies that while auditors with diversified industry experience charge higher audit fees to diversified firms, such higher fees are associated with greater skill and more accuracy in auditing. Overall our results provides an important implication of the literature of auditing that auditors diversified experience matter in affecting fees and quality of audits. 22

23 Appendix A: Variable Description Variable Definition Auditor Experiences IND_EXP MOST_DIV CH_MOST_DIV CH_AU_MOST_DIV BEGINNER EXPERIENCED An auditors industry experience, measured as the weighted average of market share in different industries the auditor has operation in a fiscal year. Each segment s proportion of total firm sales defines the weight. For instance, IND_EXP of firm i in a fiscal year t is n IND_EXP it = j=1 ω jt SHARE jt ; where ω jt is proportion of sales generated by segment j of firm i, SHARE jt is auditor s market share in audit fees generated in industry j. Indicator variable for a firm s auditor at the top of yearly quintile ranking of IND_EXP. Indicator variable for a firm that switches to an auditor at the top of quintile ranking of IND_EXP. Indicator variable for a firm s switching from auditors not at the top of yearly quintile ranking of IND_EXP to auditors who are at the top of ranking. Indicator variable for the auditors who are in the first year of serving in each industry where the client firms operate. Indicator variable for the auditors whose years of experience of serving in each industry the client firms operate in are more than median years of experience of the auditors in the corresponding industry. Source: Compustat Segment and Audit Analytics. Diversification Characteristics DIV NSEG FC_DIV Indicator variable for firm-years that operate in more than one industry defined by 2-digit SIC. Indicator variable for number of different 2-digit industries a firm-year is operating in. Indicator variable for the firms switching from focused in the previous year to diversified in the current year. Source: Compustat Segment. Audit Characteristics LAFEES LNAFEES BIG4 TENURE AU_ CH The natural logarithm of audit fees. Fees paid to primary external auditor for audit services are defined as the audit fees. The natural logarithm of nonaudit fees. Fees paid to primary external auditor for nonaudit services are defined as the nonaudit fees. BIG4 is an indicator variable for the firm-years audited by one of the Big 4 auditors. The number of years a firm is audited by its current auditor. Indicator variable for a firm that switch to a new auditor in a fiscal year. 23

24 SPEC FY_END UNQUAL RESTAT REPORT LAG GC Indicator variable for a firm audited by an industry specialist in a fiscal year. An auditor is a specialist if at least 30% of its fees are generated from a single 3-digit SIC industry. Source: Audit Analytics and Compustat Segment. Indicator variable for a firm of which fiscal year ends in December. Source: Compustat. Indicator variable for a firm for which the auditor issue an unqualified opinion without any additional language (AUOP=1) in a fiscal year. Source: Compustat. Indicator variable for the presence of a restatement of a firm s financial statement in a fiscal year. Source: Audit Analytics. Lag between the signature date of the audit opinion (SIG_DATE_OF_OP_S) and the date of the fiscal year-end (FISCAL_YEAR_END_OP). Source: Audit Analytics. Indicator variable for a firm for which the auditor issues a going concern modified report. Source: Audit Analytics. Firm Characteristics SIZE LEV TANG ROA LOSS AGE The natural logarithm of total assets of a firm. Source: Compustat. Leverage is defined as long-term debt (DLTT)/total assets (AT). Source: Compustat. Tangibility is defined as property, plant, and equipment (PPENT)/total assets (AT). Source: Compustat. Return on assets is defined as net income (EBITDA)/total assets (AT). Source: Compustat. Indicator variable for the firm-years with negative ROA. Source: Compustat. The number of years a firm is in Compustat. Source: Compustat. RECINV Receivable and inventory ratio, which is defined as (accounts receivable (RECT) + inventory (INVT))/total assets (AT). Source: Compustat. LITIGATION EXCHANGE NSEG FOREIGN ABS_ACCR Indicator variable for the firm operating in high-litigation industry. High-litigation industries are those with SIC codes , , , , , and Source: Compustat. Indicator variable for the firms included in a major exchange (STKO=0). Firms coded with 0 are either subsidiaries of the public firms or are not present in any one of the major exchanges. Source: Compustat. Number of business segments of a firm. A business segment is defined by unique 4-digit SIC industry a firm is operating in. Source: Compustat Segment Files. Proportion of sales generated by foreign segments. Source: Compustat Segment Files. Absolute value of discretionary accruals management, measured as the deviations from the predicted values from the following SIC 2-digit level industry-year regression using at least previous 10-years observations TA t A t 1 = α 0 + α 1 (1 A t 1 ) + α 2 ( S t A t 1 ) + α 3 (PPE t A t 1 ) + α 4 (Net Inocme t A t 1 ) + ε t where TA t is total accruals in current year t, A t 1 is total assets (AT) in previous year t-1, S t is change in total sales (SALE) in t, PPE is total net property, plant and equipment (PPENT), and Net Inocme is net income (NI). TA t is measured using following definition 24

25 TA t = ACT t CHE t ( LCT t DLC t ) DP t where ACT t is change in current assets (ACT) in t, CHE t is change in cash (CHE), LCT t is change in total current liabilities (LCT), DLC t is change in debt in current liabilities (DLC), and DP t is change in depreciation and amortization (DP). LAG(ABS_ACCR) GROWTH_SALE LAG(ROA) ALTMAN Prior year s ABS_ACCR Total sales (SALE) growth Prior year s ROA Following Zhang (2012), a modified Altman s Z-score (1968, 2000) is calculated using following methodology ZSCORE t = 0.3 ( NI t ) ( SALE t ) ( RE t ) ( WC t ) ( MCAP t ) AT t AT t AT t AT t LT t where RE t is retained earnings (RE), WC t is working capital as the difference between current assets (ACT) and current liabilities (LCT), and MCAP t is market value of equity calculated by multiplying total shares outstanding (CSHO) by fiscal year-end stock price (PRCC_F). CFO EXCESS FEES Ratio of net cash flow from operating activities (OANCF) to total assets (AT) Natural logarithm of the ratio of total audit fees to imputed audits fees of a firm. Following a modified version of Berger and Ofek (1995), it is calculated as follows EXCESS FEES i = Log( FEES i ifees i ) where FEES it is total audit fees of firm i in a year, ifees it is value weighted average of imputed audit fees of a firm s segments, which is calculated as follows n ifees i = imv ik n ifees imv ik ik k=1 k=1 where n it total number of segments of a firm, ifees ik is imputed audit fess of segment k, which is median audit fees of single-segment in industry k. Similarly, imv ik is imputed market value of segment k, which is calculated by multiplying the median ratio of market value to sales of single segment firms in industry k by segment k s sales. To calculate industry median for each industry, we require at least five single segment firms in a 2-digit SIC industry. Other Control Variables Industry indicators Year indicators Indicator variables for Fama-French 12 industries. Source: Compustat. Indicator variables for fiscal-years. Source: Compustat. 25

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