A comparison of auditors' self-reported industry expertise and alternative measures of industry...

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A comparison of auditors' self-reported industry expertiseand alternative measures ofindustry specialisationJayanthi Krishnan aa Temple UniversityPublished online: 29 May 2012.

To cite this article: Jayanthi Krishnan (2001) A comparison of auditors'self-reported industry expertise and alternative measures of industryspecialisation, Asia-Pacific Journal of Accounting & Economics, 8:2, 127-142, DOI:10.1080/16081625.2001.10510593

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Research Note A comparison of auditors' self-reported

industry expertise and alternative measures of industry specialisation

Jayanthi Krishnan*t Temple Universitv

Received October 2000; Accepted March 2001

Abstract

Auditing research requiring measures of auditor industry expertise have relied largely on auditors' market shares as proxies for industry expertise. This study systematically documents differences in these proxies for each of the Big Six (now Big Five) and a subset of non-Big Six auditors. Next, it examines an alternative measure based on the industry's share in the auditor's portfolio. Finally, it compares the market shares-based measures and the alternative measure with audit firms' postings of their industry specialisation in their home pages on the World Wide Web. The numbers indicate that the auditors' self-reported specialisations are not correlated with market shares for most auditors. The findings suggest that future studies should consider alternative measures of specialisation in studies of audit market outcomes.© City University of Hong Kong.

JEL classification: LJO, L84 and M41

Keywords: industry specialisation; industry expertise; portfolio shares; market shares

1. Introduction

It is generally accepted that industry specialisation by auditors is a characteristic of the audit market (Gramling and Stone, 2001). Opposite views have been expressed about the effects of the concentration that results from industry specialisation. On the one hand,

"Correspondence to Dr Jayanthi Krishnan, Assistant Professor, Department of Accounting, The Fox School of Business and Management, 13th and Montgomery Streets, Philadelphia, PA 19122, USA. Tel: (215) 204 3085; Fax: (215) 204 5587; E-mail: [email protected].

' I appreciate the helpful comments of Ferdi Gul (co-editor). an anonymous reviewer, Roger Martin (discussant) and workshop participants at the 1999 American Accounting Association Mid-Year Auditing Section Conference.

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128 Jayanthi Krishnan I Asia-Pacific Journal of Accounting & Economics 8 (2001) 127-142

concerns about the possible adverse effects of concentration on competition are raised periodically by policymakers (Carmichael, 1997), particularly when auditor mergers take place (Minyard and Tabor, 1991 ). On the other hand, such concerns are countered by arguments based on product differentiation (Simunic and Stein, 1987) theory that industry concentration by auditors contributes to higher audit quality (Craswell et al., 1995).

Many empirical studies have examined the effects of industry specialisation on audit market outcomes such as audit fees, auditor litigation, and auditors' compliance with generally accepted auditing standards. Because auditor industry expertise is generally unobservable, these studies have relied on proxies based on auditors' market shares in the industry to measure such expertise. The results of these studies are mixed and provide only partial support for the product differentiation hypothesis.

This paper presents a descriptive analysis of the proxies used in prior work to measure auditors' industry expertise. It makes three contributions to the literature on auditor industry specialisation. First, it documents the differences in the proxies (based on auditor market shares) for each of the Big Six and a subset of non-Big Six auditors.' Market shares are measured using different bases, such as the square root of client assets, client sales, or the number of clients. The results indicate that these different measures yield different rankings of specialists and non-specialists, and that, in general, the non-Big Six auditors are not classified as specialists. Second, this study examines an alternative measure based on the industry's share in the auditor's portfolio (Yardley et al., 1992). The numbers indicate that this measure yields some specialisations for non-Big Six firms, and different rankings from the market share measures. Third, this study compares industry market shares and industry portfolio shares with an independent outside (albeit imperfect) indication of auditors' industry expertise, the audit firms' postings of their industry specialisation in their home pages on the World Wide Web. It is found that the auditors' self-reported specialisation is not correlated with national market shares for most auditors. However, the selfreported specialisations are more closely associated with the industry's share in the auditor's portfolio. The findings suggest that future studies should consider alternative measures of specialisation in studies of audit market outcomes.

2. Auditor industry expertise and measures of industry specialisation

An auditor's industry specialisation reflects its expertise in industry-specific accounting issues. Table 1 lists previous work in which the effect of industry specialisation on various audit market outcomes has been tested." It suggests the following. First, because an auditor's specialist status at the engagement level is not observed, most studies have relied on measures based on auditors' national market share in the industry. Three bases

'The data in this study precedes the merger of Price Waterhouse and Coopers and Lybrand. The big audit firms are therefore referred to as the Big Six.

2 The focus in this Table is on tests of the product differentiation theory. Other studies, not included in Table I, that examine industry specialisation using market share measures include, Eichenseher and Danos ( 1981 ). Danos and Eichenseher ( 1982). and Hogan and Jeter ( 1999).

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Jayanthi Krishnan I Asia-Pacific Journal of Accounting & Economics 8 (2001) 127-142 129

have been employed to measure market shares: the square root of assets, sales and number of clients. The two most frequently used measures are auditors' industry market shares in continuous form, and a 0 I 1 discrete variable indicating market leadership (the largest suppliers in each industry). Two studies (Deis and Giroux (1992), O'Keefe et al. (1994))

Table 1 Summary of Studies Relating to Industry Specialisation and Audit Market Outcomes

Study

Impact of Industry Specialisation on:h

Audit fees Palmrose ( 1986) Pearson and Trompeter ( 1994) Craswell, Francis, and Taylor ( 1995)

Fee cutting on first year audits Ettredge and Greenberg ( 1990)

Auditor litigation Lys and Watts ( 1994)

Compliance with standards Deis and Giroux ( 1992) O'Keefe, King, and Gaver (1994)

Perceptions of audit quality Carcello, Hermanson, McGrath (1992) Shockley and Holt (1983)

Measure of Specialisation

Market leader Market leader' 10% Market share'

Change in industry share' Client perception of auditor expertise'

Industry market share" Market leader'

Local market sharei Local market share'

Questionnaire' Number of clients'" I Total revenues from clients"

Finding'

*

*

* *

* indicates a significant finding in the predicted direction: - indicates no statistical significance or a perverse finding. Product differentiation hypothesis predicts the following effects of industry specialisation on: audit fees: positive; fee cutting: negative; auditor litigation: negative; compliance with standards: positive; perceptions of audit quality: positive. Defined as the largest supplier in an industry, and the second and third largest suppliers when there are "readily observable differences" between the second and third or between the third and the remaining suppliers. Market share is defined using sales. Dummy variable, coded I for a market leader (based on market share using square root of assets). 0 otherwise. Market share measured in terms of numbers of clients or audit fees. Market share measured by share of auditor in client sales. Management cites new auditor's expertise as reason for auditor change. Percentage of the client's two-digit SIC industry audited. Dummy variable indicating whether the audit firm has the largest share in that industry. Number of audits in industry (Texas school districts) performed by local office of auditor. Number of audits in industry (California school districts) performed by local office of auditor. Questions about industry knowledge of engagement partner I manager I senior manager. Number of banks in the Fortune 50 banks audited by each Big Eight auditor. Total revenues of auditor's Fortune 50 bank clients.

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that are limited to single-industry samples have employed measures of state-level industry shares. While these latter measures are likely to be more precise than aggregate measures of specialisation, they are not generally available in most research situations. Second, studies that are based on national market share measures do not provide unambiguous support for a product differentiation explanation of auditor industry specialisation.

2.1 Rationale for the use of market shares as the measure of industry specialisation

The rationale for using market share as the proxy for industry expertise is the assumption that an auditor's industry market share is positively associated with industry expertise. However, there are both theoretical and empirical reasons why market shares may be inadequate measures of industry expertise. On a theoretical level, the assumption that industry expertise will be reflected in market shares is consistent with supply-based survivorship theories but may not hold under product differentiation. The supply-based theories argue that industry expertise leads to production efficiencies through economies of scale, resulting in lower cost audits. Consequently, in equilibrium, an audit firm's operation in an industry will expand to the point where the production economies are exhausted. Thus, the existence of economies of scale implies that industry expertise is positively associated with the auditor's industry market share. The assumptions underlying this argument are that the audit market is price competitive, and that audit quality is homogeneous.

However, product differentiation theory argues that audits are not homogeneous, and that auditors offer quality differentiated audits. Product differentiation (of which industry expertise is a component) enables an individual firm to differentiate its product in the view of the buyer, and so make a niche for itself in the market. Each audit firm faces a downward sloping demand curve because of its ability to attract a clientele. Consequently, the equilibrium quantity-price configuration for the firm is not at the minimum point of the average cost curve.

Figures la through lc use basic microeconomic theory to depict auditors' equilibrium in one industry in the absence (Figure la) and presence (Figures lb and lc) of product differentiation. In Figure la, the audit product is assumed to be homogeneous; industry expertise does not enhance quality. Under competitive conditions, the individual firm's demand curve (D) for audit services is a horizontal straight line at the price established by the market. The average cost curve shown (AC) depicts the cost of producing the audit service at various output levels. It can be shown that, in equilibrium, the firm operates at the minimum point (q"') of its average cost curve (Tirole, 1988), at which all economies of scale have been exhausted. Thus, in industries where there are substantial economies of scale, the auditor will have a large market share.

In Figures I b and 1 c, auditors are assumed to engage in product differentiation, and other things equal, industry expertise enhances audit quality. Each firm faces a downward sloping demand curve for its services. The firm's equilibrium is once again determined by the interaction of demand and cost conditions, and depends on their exact positions. Figure I b depicts one possibility for an industry with an expert auditor and a non-expert auditor. The auditors are assumed to have identical cost curves (AC), but the industry nonexpert has a flatter (more elastic) demand curve (marked Dn) than the expert (De). This illustration suggests a rather perverse conclusion: that the expert operates at a level lower

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o"

$ Figure la

AC

D

Quantity q

$ Figure lb

AC

/ o"

Quantity

$ Figure lc ACe

AC"

q" qe Quantity

AC =Average Cost; D =Demand curve; q =Quantity of audit output Superscript definitions: * =market equilibrium; e =expert; n =non-expert

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than the non-expert because the latter has a flatter demand curve. Thus, with identical cost structures in an industry, the market shares of expert auditors may actually be less than that of non-experts.

It is, however, likely that the expert and non-expert auditors have different cost structures. Since the possibilities are numerous, Figure lc depicts one example, where the expert's cost curve is higher than the non-expert's. The expert operates at a higher level (has a higher market share) than the non-expert. However, different combinations of demand and cost conditions will generate different results.3 Unfortunately, the theory of product differentiation does not offer any general predictions. Therefore, one cannot predict a positive association between industry expertise and market share if one hypothesises that the expertise is a component of product differentiation.4

On an empirical level as well, national market shares measures used in prior work may not always reflect the realities of the audit market. Auditors may, for example, develop expertise in industries in localised markets, and such expertise may not be reflected in the national shares. This is in keeping with the product differentiation argument that a producer can develop a niche thus differentiating its products from competitors.5 Second, some auditors may choose to further develop niches within industry groups based on other client characteristics. Small auditors may not be able to compete with bigger auditors for larger clients, and might decide to concentrate within an industry on smaller companies. Note that national market share numbers would rarely suggest that the non-Big Six auditors are specialists in any industry. Yet anecdotal evidence suggests that they are viewed as local experts for some industries. For example, in November of 1995, Porter Mcleod National Retail Inc. changed its auditor from Lehman, Butterwick & Co. to Ehrhardt Keefe Steiner & Hottman, citing the latter's expertise in the "construction industry."6 Also, examination of the Web pages of smaller auditors suggests that they target smaller client companies. For example, Grant Thornton states, "Our firm has developed a special niche in serving midsize, owner-managed, growth-minded manufacturers and distributors."

2.2 An alternative measure of industry specialisation

If national measures of industry shares are inadequate, are there alternative accessible measures that the researcher might use? An alternative investigated here is the industry's

3 For example. a reviewer points outs that experts may be able to reduce their fixed costs by operating in a single industry and not incurring the costs of understanding the peculiarities of a range of industries.

4 Note that if expertise is not a component of product ditierentiation, then (other things equal) demand curves for experts and non-experts would not differ, and auditors' shares would be driven purely by cost differences.

5 Some evidence that non-Big Six firms develop niche-specific expertise based on industry expertise is provided by Cullinan (1998).

6 Source: 10-K filing for the year ended 31 December 1995. Other examples are: Matzel & Mumford Mortgage Funding, Inc., changed auditors from Mintz Rosenfeld & Company to BDO Seidman, citing BOO's "greater experience and expertise" (8-K filing dated 17 May 1996); Michigan Financial Corp changed auditors from Ernst and Young to Crowe, Chizek and Co., citing the latter's "impressive individuals and industry expertise" (Public Accounting Report, 15 July 1996).

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share in the auditors' portfolio, rather than an auditor's share in the industry. Kwon (1996) uses auditors' portfolio shares as one measure of industry specialisation. Yardley et al. (1992) suggest it as an alternative to the market share measures. This measure focuses on the auditor's choice of industry portfolio, which depends on the auditor's investment in the industry. Thus, use of this proxy would assume, not unreasonably, that the auditor devotes more resources to industries in which it has expertise than in industries in which it does not have expertise. Thus, this measure may provide an estimate of the auditors' industry expertise regardless of the client segments or local areas within the industry that it chooses to target.

3. Empirical Analysis

3.1 Data

The data is from the June 1997 and December 1997 discs of the Compact D I SEC database. All observations with financial year-ends in 1996 or 1997 and with valid data were retained. In line with most previous work, the unit of analysis is the two-digit SIC industry. To ensure some variability within industries and within auditor clienteles, only industries with at least 10 observations, and auditors with at least five clients were included. This resulted in a sample of 62 two-digit industries, and 97 auditors. The Big Six auditors constitute 84 per cent of the sample, seven large non-Big Six auditors account for 8.8 per cent and 84 other non-Big Six auditors account for 6.8 per cent. All the Big Six firms operate in most industries. Not surprisingly, the non-Big Six operate in fewer industries, the number varying from six for Crowe Chizek to 52 for BDO Seidman.

3.2 Industry market shares measures

Following prior studies, three measures are constructed: (1) the auditor's industry market share; (2) market leadership (1 if the auditor is one of the largest three suppliers in the industry, 0 otherwise); and (3) industry specialist (1 if the auditor has a 10 per cent or greater market share, 0 otherwise). Each measure is constructed using three bases: square root of assets, sales and number of clients. 7 Table 2 indicates that the average industry market shares are much higher for the Big Six compared to the non-Big Six. The three bases yield differences that are more marked for the non-Big Six than the Big Six auditors. The discrete measures in Panels B and C suggest that, while the Big Six are specialists in most industries, the non-Big Six (with one exception in Panel B and two exceptions in Panel C) are not specialists in any industry. This is inconsistent with anecdotal evidence that the non-Big Six are viewed as specialists in some industries. Table 2 also shows large differences in the number of specialisations for each auditor yielded by the different bases and the discrete

7 While sales and assets are used most frequently, some studies (e.g. Danos and Eichenseher, 1982) use the square root of assets as a proxy for audit fees.

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Table 2 Market Share Measures of Industry Specialisation

Panel A: Average Industry Market Share(%), by Auditor

Auditor MKTSHA(%) MKTSHS(%)

Arthur Andersen 17.73 17.95 Coopers & Lybrand 11.96 10.80 Ernst & Young 20.74 19.71 Deloitte & Touche 16.36 17.28 KPMG Peat Marwick 17.58 19.13 Price Waterhouse 14.25 17.11 BDO Seidman 1.17 0.35 Crowe Chizek 0.78 0.12 Grant Thornton 1.37 0.57 McGladrey & Pullen 0.52 0.17 Moore Stephens 0.32 0.06 Richard A. Eisner & Co. 0.31 0.04 Hein +Associates 0.19 0.02 Other non-Big Six 0.25 0.05

MKTSHA MKTSHS MKTSHN

=Auditor share in industry, based on square root of assets. =Auditor share in industry, based on sales. =Auditor share in industry, based on number of clients.

MKTSHN(%)

17.66 11.40 17.93 14.73 15.06 10.91 3.56 2.06 3.26 1.45 1.33 1.52 1.55 0.98

Panel B: Number of Industry Specialisations, Measured by Market Leadership, by Auditor

Auditor MKTLEADA MKTLEADS MKTLEADN

Arthur Andersen 31 34 46 Coopers & Lybrand 16 19 16 Ernst & Young 49 42 47 Deloitte & Touche 31 32 28 KPMG Peat Marwick 33 31 35 Price Waterhouse 26 27 13 BDO Seidman 0 0 0 Crowe Chizek 0 0 0 Grant Thornton 0 I I McGladrey & Pullen 0 0 0 Moore Stephens 0 0 0 Richard A. Eisner & Co. 0 0 0 Hein + Associates 0 0 0 Other non-Big Six 0 0 0

MKTLEADA = I, if auditor is one of largest three suppliers in industry (based on MKTSHA), 0 otherwise. MKTLEADS = I, if auditor is one of largest three suppliers in industry (based on MKTSHS), 0 otherwise. MKTLEADN = 1, if auditor is one of largest three suppliers in industry (based on MKTSHN), 0 otherwise.

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Table 2 (cont.)

Panel C: Number of Industry Specialisations, Based on a I 0 Per Cent Cut-off for Market Share, by Auditor

Auditor SPIOA SPIOS SPION

Arthur Andersen 49 37 51 Coopers & Lybrand 32 21 32 Ernst & Young 56 42 58 Deloitte & Touche 47 39 49 KPMG Peat Marwick 48 36 50 Price Waterhouse 35 29 31 BOO Seidman 0 0 I Crowe Chizek 0 0 0 Grant Thornton 0 0 2 McGladrey & Pullen 0 0 0 Moore Stephens 0 0 0 Richard A. Eisner & Co. 0 0 0 Hein +Associates 0 0 0 Other non-Big Six 0 0 0

SPIOA = I, if MKTSHA 2: I 0%, 0 otherwise. SPIOS = I, if MKTSHS 2: I 0%, 0 otherwise. SPION = I, if MKTSHN 2: I 0%, 0 otherwise.

measures. Using the 10 per cent cut-offs, the Big Six are characterised as specialists in most industries; using market leadership, the Big Six have fewer specialisations.8 These differences may explain why prior studies using a variety of measures yielded different results. Also note that most prior work included both Big Six and non-Big Six clients in their samples. Because the market share-based measures rarely classify the non-Big Six as specialists, empirical results will also differ according to the sample composition.

3.3 Industry portfolio shares

The alternative measure is the industry portfolio share, the share of each industry in the auditor's client portfolio. These shares were constructed for the three bases: square root of assets (PORTA), sales (PORTS) and number of clients (PORTN). The higher the portfolio

'Correlations between market share measures based on square root of assets and sales, and square root of assets and number of clients, are in the range 0.56-0.93 and are significantly different from zero. Correlations between market share based on sales and number of clients, however, tend to be lower (less than 0.5 in most cases), and 4 of the 13 numbers are not different from zero at conventional ( 10% or less) significance levels. Results of studies can therefore differ according to the base chosen to measure market shares. Correlations between auditor specialist classifications using the discrete measures show less agreement. In particular, specialist classifications based on sales and numbers of clients are likely to be significantly different, using both the I 0% cut-off measures and the market leadership measures.

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share for an industry, the more likely the auditor is an industry specialist. A discrete specialist-nonspecialist classification analogous to the discrete market share measure is also constructed. Because there are 62 industries in the sample, an auditor that does not specialise in any industry could be expected to have a portfolio that is distributed evenly over the industries, with each industry accounting for 1 I 62 or 1.6 per cent of the auditor's portfolio. Therefore, an auditor is defined as an industry specialist if the industry accounts for 1.6 per cent or more of its portfolio, for each of the three bases (PORTDA, PORTDS, PORTDN).

Table 3, Panel A shows median portfolio shares along with the range of portfolio shares for each auditor. Median shares are presented because average portfolio share for an auditor is the reciprocal of the number of industries in which the firm operates.9 The median portfolio shares for the Big Six are in general lower than those for the non-Big Six. The ranges of portfolio shares indicate that the non-Big Six divide their resources more unevenly over their portfolios. For example, the highest shares for four of the non-Big Six are higher than those for the Big Six firms. Similarly, the minimum portfolio shares are also in general higher for the non-Big Six than the Big Six. Note that the portfolio composition of auditors need not depend on the number of industries in which they operate. For example, an auditor operating in 45 industries can choose to divide its portfolio in a number of ways. Two examples of portfolios are: 1 I 45 or 2.22 per cent in each industry (portfolio 1 ); or a 99 per cent share in one industry and 0.023 per cent each in the other 44 industries (portfolio 2). While portfolio 1 might involve industry specialisations, portfolio 2 almost certainly must indicate specialisation in one industry. The fact that the non-Big Six have relatively uneven portfolios suggests that they concentrate resources on some industries. By contrast, the fact that the Big Six have more balanced portfolios need not indicate absence of specialisation because their resources are large enough for them to be able to make substantial investments in each industry.

Table 3, Panel B shows the number of specialisations using a 1.6 per cent portfolio share as a cut-off. The number of industries in which the Big Six firms are specialists is lower compared to those in Table 2. The non-Big Six firms are now classified as specialists in some industries, whereas they were viewed as non-specialists in almost all industries using market shares.

Thus, Tables 2 and 3 indicate that while portfolio share measures reveal some non-Big Six specialisations as well as Big Six specialisations, market share measures yield only Big Six specialisations. In addition, measures of association indicate that the portfolio share measure yields different specialist-nonspecialist classifications for the Big Six auditors from those yielded by the market share measures. Spearman correlations of market shares and portfolio shares (not presented) indicate that of the 39 correlations examined (13 auditors x 3 bases), 22 were less than 0.5 in magnitude, nine were between 0.5 and 0.6, and eight were greater than 0.6.

9 Since the sum of the industry portfolio shares is one for each auditor, the mean portfolio share is I I n where n is the number of industries in which the auditor operates.

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Table 3 Portfolio Shares

Panel A: Median and Range of Industry Por(folio Shares{%), by Auditor

Range (Minimum-Maximum) for Portfolio Shares

Auditor PORTA PORTS PORTN PORTA PORTS PORTN

Arthur Andersen 0.82 0.45 0.90 0.06- 14.94 0.01-19.51 0.05-9.87 Coopers & Lybrand 0.70 0.23 0.76 0.01-9.09 0.00-28.18 0.08- 13.29 Ernst & Young 0.80 0.45 0.74 0.05- 14.65 0.01- 16.82 0.15- 11.43 Oeloitte & Touche 0.69 0.29 1.11 0.03- 10.04 0.002- 17.49 0.07-8.17 KPMG Peat Marwick 0.60 0.32 0.69 0.01-23.79 0.002- 36.24 0.05- 16.59 Price Waterhouse 0.80 0.37 0.97 0.01-8.18 0.0001-23.18 0.09- 10.92 BOO Seidman 1.42 0.78 0.91 0.05- 10.02 0.000-19.93 0.30- 10.30 Crowe Chizek 0.57 2.64 2.35 0.29-97.47 0.05-85.65 1.18-90.59 Grant Thornton 0.84 0.75 0.99 0.10-29.49 0.01-29.13 0.33- 15.79 McGladrey & Pullen 1.41 1.94 1.75 0.14-59.69 0.04-18.94 0.88-35.97 Moore Stephens 1.92 1.89 3.57 0.07- 15.08 0.00-14.02 1.79-17.86 Richard A. Eisner & Co. 1.94 2.23 2.90 0.43-14.49 0.00-21.73 1.45-14.49 Hein + Associates 4.07 4.35 3.64 1.09-26.67 0.01- 18.49 1.82-27.27

PORTA =Share of industry in auditor's portfolio, based on square root of assets. PORTS =Share of industry in auditor's portfolio, based on sales. PORTN =Share of industry in auditor's portfolio. based on number of clients.

Panel B: Number of Specialisations Based on 1.6 Per Cent or Greater Portfolio Shares

Auditor PORTDA PORTDS PORTDN

Arthur Andersen 17 15 17 Coopers & Lybrand 18 II 17 Ernst & Young 18 15 17 Oeloitte & Touche 20 13 21 KPMG Peat Marwick 15 10 17 Price Waterhouse 20 13 19 BOO Seidman 25 18 19 Crowe Chizek 4 4 Grant Thornton 13 12 15 McGiadrey & Pullen 10 15 20 Moore Stephens 14 12 23 Richard A. Eisner & Co. 16 14 15 Hein +Associates 16 14 19

PORTO A = I, if PORTA~ 1.6%, 0 otherwise. PORTOS = I. if PORTS ~ 1.6%, 0 otherwise. PORTON = I, if PORTN ~ 1.6%, 0 otherwise.

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3.4 Auditors' self-reported industry specialisation

This section presents the results of comparing the different measures with an independent (albeit imperfect) source of information on auditors' specialisation.10 The home pages of the 13 major auditors on the World Wide Web were examined in January of 1998. In describing the services they offer, 9 out of the 13 firms (all Big Six, Grant Thornton, McGladrey & Pullen, and Richard A. Eisner & Co.) include sections containing lists of industries in which they claim expertise. The basic premise is that these lists indicate industries in which the auditors actually possess expertise rather than industries in which they claim to possess expertise because they would like to attract clients. There are several limitations with the information given. In general, the categories are highly aggregative, such as "manufacturing" or "high technology". In some cases, an item listed under "industries" is in fact a service area such as "government contracting" or "entrepreneurial services". In order to analyse these specialisations, the listed industries were assigned SIC codes. Because of the aggregate nature of most listed industries, two digit codes were assigned. Where the auditor claimed expertise using an industry name that does not correspond to one on the SIC's list of names (e.g. "Life Sciences", which, using some elaboration in the Ernst & Young Website, was interpreted as biotechnical and drug companies), some judgment was called for in the assignment of SIC codes.

The SIC coding revealed that all auditors except Price Waterhouse and Richard A. Eisner & Co. claim expertise in more than 50 per cent of the industries in which they operate. 11 The next step is to compare the auditors' self-claimed industry expertise with the market share-based and portfolio share-based measures of specialisation. Table 4 presents comparisons of these measures between industries in which the auditors claim expertise and industries in which they do not claim expertise. If the auditors' Web postings can be interpreted as their industry expertise, one would expect a "good" proxy of industry expertise to have higher values for the self-reported specialist industries than the nonspecialist industries. Table 4, Panel A indicates that in most cases, there is no difference in the market shares for self-reported specialist and non-specialist industries. One Big Six firm, Arthur Andersen, shows higher share for specialist industries compared to non-specialist industries. In all, 6 of the 27 pairwise comparisons of market shares show significant differences at the l 0 per cent level or less in the expected direction. To the extent that the self-reported expertise information is credible, market shares do not seem to capture auditor industry expertise.

Wilcoxon tests for portfolio shares (Table 4, Panel A) are different when compared to those for market shares. Four of the Big Six firms show significant differences in the

"'In a study of trends in auditor industry concentration. Hogan and Jeter ( 1999) use information from the Web pages for the Big Six auditors.

11 The number of self-reported specialisations is as follows: Arthur Andersen 44, Coopers & Lybrand 53, Ernst & Young 35. Deloitte & Touche 40, KPMG Peat Marwick 47, Price Waterhouse 17, Grant Thornton 29, McGiadrey & Pullen 22. Richard A. Eisner & Co. 4 .

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Table4 Comparison of Self-Reported Specialisations and Market Share and Alternative Measures

Panel A: Comparison of Market and Portfolio Sharesfor Specialist and Nonspecialist Industries, by Auditor

Auditor Median Market Shares (%) Median Portfolio Shares (%)

MKTSHA MKTSHS MKTSHN PORTA PORTS PORTN

Arthur Nonspecialist Industries 12.44 7.27 15.46 0.57 0.23 0.53 Andersen Specialist Industries 17.63 15.32 18.13 0.92 0.47 0.93

Wilcoxon Z p-value (0.03) (0.01) (0.01) (0.12) (0.11) (0.10)

Coopers Nonspecialist Industries 9.61 8.09 8.82 0.32 0.15 0.38 & Lybrand Specialist Industries 10.33 6.46 11.11 0.74 0.27 0.83


Ernst Nonspecialist Industries 19.57 18.99 18.48 0.48 0.27 0.59 & Young Specialist Industries 19.10 17.17 18.63 1.05 0.81 0.99


Deloitte Nonspecialist Industries 13.61 11.47 12.92 0.61 0.14 0.62 & Touche Specialist Industries 14.72 12.78 15.47 1.04 0.53 1.27


KPMGPeat Nonspecialist Industries 16.53 16.05 12.66 0.61 0.28 0.85 Marwick Specialist Industries 14.26 10.63 14.23 0.54 0.38 0.64


Price Nonspecialist Industries 11.24 10.50 10.13 0.51 0.20 0.70 Waterhouse Specialist Industries 12.58 7.99 10.68 3.13 1.22 2.46


Grant Nonspecialist Industries 0.69 0.17 1.99 0.79 0.64 0.99 Thornton Specialist Industries 1.02 0.21 2.61 0.90 0.98 0.99


McGladrey Nonspecialist Industries 0.29 0.022 0.58 1.23 4.77 1.75 & Pullen Specialist Industries 0.26 0.017 1.29 1.42 1.82 1.75


Richard A. Nonspecialist Industries 0.13 0.003 0.74 1.85 1.15 2.90 Eisner& Co. Specialist Industries 0.31 0.015 1.42 10.08 11.70 7.97


MKTSHA =Auditor share in industry, based on square root of assets. MKTSHS =Auditor share in industry, based on sales. MKTSHN =Auditor share in industry, based on number of clients. PORTA =Share of industry in auditor's portfolio, based on square root of assets. PORTS =Share of industry in auditor's portfolio, based on sales. PORTN =Share of industry in auditor's portfolio, based on number of clients.

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Table 4 (cont.)

Panel B: P-Values for Wilcoxon Test of Differences in Market Leadership and 10 Per Cent or Greater Market Shares Measures Between Specialist and Nonspecialist Industries

P-Values for Differences Between P-Values for Differences Between Specialist and Nonspecialist Specialist and Nonspecialist

Samples for Samples for

Auditor MKTLEADA MKTLEADS MKTLEADN SPlOA SPlOS SPlON

Arthur Andersen 0.10 0.27 0.06 0.06 0.01 0.10 Coopers & Lybrand 0.40 0.43 0.40 0.33 0.49 0.03 Ernst & Young 0.24 0.31 0.28 0.46 0.27 0.20 Deloitte & Touche 0.24 0.36 0.36 0.14 0.29 0.32 KPMG Peat Marwick o.oz 0.13 0.11 0.50 0.05 0.34 Price Waterhouse 0.34 0.28 0.10 0.37 0.36 0.16 Grant Thornton 0.50 0.24 0.10 0.50 0.50 0.35 McG!adrey & Pullen 0.50 0.50 0.50 0.50 0.50 0.50 Richard A. Eisner & Co. 0.50 0.50 0.50 0.50 0.50 0.50

MKTLEADA = I, if auditor is one of largest three suppliers in industry (based on MKTSHA), 0 otherwise. MKTLEADS = I, if auditor is one of largest three suppliers in industry (based on MKTSHS), 0 otherwise. MKTLEADN = I, if auditor is one of largest three suppliers in industry (based on MKTSHN), 0 otherwise. SPIOA =I, ifMKTSHA ~ 10%,0 otherwise. SPIOS =I, ifMKTSHS ~ 10%,0 otherwise. SPION =I, ifMKTSHN ~ 10%,0 otherwise.

Panel C: P-Values for Wilcoxon Test of Differences in Portfolio Share Measures Between Specialist and Nonspecialist Industries

P-Values for Differences Between Specialist and Nonspecialist Samples for

Auditor PORTDA PORTDS PORTDN

Arthur Andersen 0.37 0.50 0.37 Coopers & Lybrand 0.10 0.07 0.36 Ernst & Young 0.07 0.21 0.03 Deloitte & Touche 0.00 0.01 0.04 KPMG Peat Marwick 0.35 0.15 0.23 Price Waterhouse 0.00 0.02 0.00 Grant Thornton 0.04 0.19 0.42 McG!adrey & Pullen 0.46 0.43 0.39 Richard A. Eisner & Co. 0.37 0.04 0.31

PORTO A = I, if PORTA~ 1.6%, 0 otherwise. PORTDS = I, if PORTS ~ 1.6%, 0 otherwise. PORTDN = I, if PORTN ~ 1.6%, 0 otherwise.

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predicted direction. Arthur Andersen has significantly higher portfolio shares for specialist industries for one of the three bases (number of clients) only. KPMG shows no significant difference. For the non-Big Six, only one firm, Richard A. Eisner & Co., shows significant differences. Of the 27 pairwise comparisons of portfolio shares, 16 are statistically significant in the expected direction. Given the aggregate nature of the Web information, and the subjective nature of the classification process, it is not surprising that the results are not consistent across the auditors. However, the numbers suggest that auditors' portfolio shares are more closely related to auditors' self-reported industry expertise than auditors' market shares. Panels B and C of Table 4 present tests for differences for the discrete measures. The numbers in Panel B are consistent with the continuous market share measures in Panel A, in that few (6 out of 54) differences are statistically significant in the expected direction. In Panel C, the 1.6 per cent or more portfolio shares show greater shares for specialist than for non-specialist industries in 12 out of 27 cases.

4. Conclusions

Product differentiation-based explanations of auditor industry expertise argue that such expertise contributes to the credibility of the audit, and therefore enhances audit quality. Yet tests of this theory have yielded mixed results. Most of these tests have relied on auditors' industry market share as the proxy for auditor industry expertise. However, market share measures may not be adequate proxies for industry specialisation. Basic microeconomics of product differentiation reveals that, because the auditor faces a downward sloping demand curve, an expert's share of the market need not be higher than the share of the non-expert. This is borne out by anecdotal evidence that non-Big Six firms are able to form small niches and are viewed as experts in some industries.

Since the auditor's industry expertise is not observed, a direct test of the relation between industry expertise and market share measures is not possible. Instead, market shares and an alternative measure, industry portfolio shares, are compared with the audit firms' self-claimed industry expertise as reported on their Web pages. While the results differ across the audit firms, auditor market share measures are not generally correlated with auditors' self-reported expertise. By contrast, auditor portfolio shares are generally more closely related to self-reported auditor expertise than the market shares. To the extent that the Web information can be interpreted as reflecting auditor industry expertise, the results suggest that portfolio shares may be better proxies for industry expertise than market shares. The reason for this is not clear. One explanation is that portfolio shares measure auditors' investment in industries, and perhaps capture their product differentiation efforts to make small niches that may not be reflected in market shares.

Some caveats should be noted. First, the audit firms' self-reported industry expertise tend to be fairly general, and because they do not translate perfectly into SIC codes, should be interpreted with some caution. Second, one explanation for the results reported could be simply that audit firms report expertise in industries which dominate their portfolios. Despite these caveats, the findings of this study point to the need to explore different proxies for industry expertise. Future studies should use alternative measures to examine audit market outcomes, such as audit fees and audit quality, and perhaps compare the results with those based on market shares.

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