A Theory of ‘Why and How’ Audit Firms Choose to Specialize

Posted by ARC Commitee - Jul 12, 2021

In a recent study, published in the European Accounting Review (EAR), Ronen Gal-Or and Esther Gal-Or examine analytically the strategic path auditors take towards becoming industry specialists in terms of their investments in the acquisition of industry specific knowledge and their pricing behavior.

A large body of empirical research examines whether and under what conditions industry specialist auditors provide a quality differentiated product (e.g. Balsam, Krishnan and Yang 2003; Reichelt and Wang 2010; Minutti-Meza 2013; Francis and Gunn 2015).  However, fewer studies explore the fundamental reasons why audit firms choose to specialize and the strategic path towards achieving specialization.  In their review of the literature, Gramling and Stone (2001) stated that “there is little direct inquiry into how and why auditing firms choose to focus on developing high levels of industry expertise within certain industries. Accordingly, there is little evidence suggesting how audit firms acquire market shares, and, choose and develop their client and industry portfolios.”  Nearly two decades later, not much has changed in this respect, as Defond and Zhang (2014) suggest that the literature has yet to examine directly “why audit firms choose to specialize.”  In response to this gap in the literature, our paper models the incentives of auditors to invest in industry-specific expertise when such expertise leads to quality differentiation from non-specialists.  We explore both the reasons why auditors pursue industry specialization and the process of investing in industry-specific knowledge necessary to attain specialization. In developing the model, we examine an auditor’s decision regarding allocation of resources across industries and his strategic pricing decision aimed at furthering expertise by attracting new industry clients.

In contrast to prior studies, which are static in nature, we develop a dynamic model to investigate analytically the incentives for and the strategic path towards becoming an industry specialist. Our analytical model utilizes an oligopolistic setting to examine the auditors’ incentives to invest in acquiring industry-specific expertise and to characterize the investment and pricing strategies of auditors on their path to achieving specialization.  We identify characteristics of the competitive environment that provide incentives to improve audit quality as accounting firms strive to achieve industry specialization. These characteristics include the extent of uniqueness of the accounting knowledge relevant to the industry and the extent to which it is difficult for auditors to differentiate themselves from competitors by using mechanisms other than industry specialization.  Increased barriers to differentiate from other auditors may arise, for instance, because of regulatory restrictions on other non-audit services the auditor can provide, or if rules on mandatory audit firm rotation are enacted.  Such regulatory interventions limit opportunities for audit firms to develop client loyalty because it prevents auditors from establishing stronger, long term ties with clients.

Our analytical model is a three-stage game with two auditors competing in two separate industries.  In the first stage, the auditors decide how to allocate resources between the two industries in order to improve their competitive positions when bidding for clients in each industry. This allocation decision determines the initial quality of service that the auditors can offer to clients in a given industry.   In the second stage, each auditor strategically quotes prices to attract industry clients, gain expertise, and further enhance the quality provided to all clients in the industry.  In the third stage, auditors modify their pricing strategies based on their success in gaining industry expertise in the first two stages of the game.

Despite our assumption that both industries are a priori equally profitable in terms of potential client loyalty and audit cost, we demonstrate that there exists an equilibrium, wherein each auditor targets a different industry for specialization. We find that greater specialization is more likely if accounting expertise is not easily transferable between the two industries, and/or when auditors do not have alternative mechanisms to achieve differentiation in the eyes of their clients.  The specialization equilibrium is characterized by quality differentiation between the auditors, with the specialist offering higher quality service than the non-specialist auditor. Hence, the answer to the question of “why” specialization leads to quality differentiation, relates to the uniqueness of the accounting knowledge in the industry and the difficulty of establishing differentiation by other means. The common belief in prior research has been that specialization arises because it improves the negotiating position of auditors by offering clients differentiated service that competing auditors cannot replicate (see Mayhew and Wilkins 2003).  However, the question of which characteristics of industries provide the greatest motivation to auditors to achieve specialization has not been previously addressed. Our model addresses this question directly and demonstrates the tradeoffs facing the auditor in his specialization decision.

To answer the question of “how” quality differentiation arises between specialist and non-specialist auditors, we argue that both initial industry knowledge acquisition and the experience gained by attracting a bigger group of clients in stage 2 of the game play a role in achieving specialization. Serving more clients in this early stage can foster learning and cultivate enhanced industry expertise.  In order to cultivate such learning, therefore, our model predicts that the auditor lowers his fees in stage 2 in order to attract a larger group of new clients. It is both the initial investment in personnel recruitment and training (in stage 1) and the pricing strategy followed by the auditor (in stage 2) that facilitate offering higher quality to all audit clients in the industry.

To summarize, our model demonstrates that quality differentiation alleviates competition on fees between auditors and raises their profits. By establishing a quality edge over the competitor in the first stage and pricing aggressively in the second stage, the auditor is rewarded with a bigger market share in the second stage, thus accumulating more experience and furthering his quality advantage over the competitor. The specialist auditor reaps the benefit from his initial investment in the acquisition of industry expertise in the third stage, when he continues to benefit from a bigger market share in spite of charging higher fees from clients. The incentives to acquire such industry specialization is especially strong when clients exhibit relatively low levels of loyalty to a given auditor because of low client specific incompatibility costs.

Discover more about our study at: https://doi.org/10.1080/09638180.2021.1890631

To cite this article: Esther Gal-Or & Ronen Gal-Or (2021): A Theory of ‘Why and How’ Audit Firms Choose to Specialize, European Accounting Review, Forthcoming.


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