Specialization Through Client Commonality and Its Effect on Audit Production Costs

Abstract

Similarities among clients create commonalities across audit processes that provide an auditor with an opportunity to reduce production costs through increased knowledge spillover, changes in the labor mix, and the implementation of additional audit technology. Auditors that take advantage of the similarities across clients can specialize in a particular set of companies, potentially allowing increased audit efficiency and lower audit risk. I introduce client-level measures of company similarity that are based on both financial statements and narrative disclosures from the annual report. I use these measures to proxy for the opportunities to specialize that arise from greater client commonality, finding strong evidence that higher client overlap is associated with lower audit fees. This relationship is incrementally stronger in industries for which the auditor has greater economic incentives. Because the financial statements and narrative disclosures are distinct disclosure channels, I explore the effect on audit fees when the two channels portray inconsistent messages about the degree of client commonality. When the financial statements are relatively unusual compared to peer clients, but the narrative disclosures do not reflect this dissimilarity, I expect the auditor to assess higher audit risk. Consistent with this prediction, the auditor charges higher audit fees under this condition. On the other hand, when the narrative disclosures are more unique than the financial statements reflect, audit fees are lower, which I argue is due to the greater, more useful firm-specific information contained in the text relative to the financial statements.

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Working Paper
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Citation: Brown, S. V. 2017. Specialization Through Client Commonality and Its Effect on Audit Production Costs. Working Paper.

DOI: To Be Determined