New clients, audit quality, and audit partner industry expertise: Evidence from Taiwan
| Date | 01 November 2017 |
| Author | Dana A. Forgione,Li‐Lin Liu,Xinmei Xie,Yu‐Shan Chang |
| Published date | 01 November 2017 |
| DOI | http://doi.org/10.1111/ijau.12095 |
ORIGINAL ARTICLE
New clients, audit quality, and audit partner industry expertise:
Evidence from Taiwan
Li‐Lin Liu
1
|Xinmei Xie
2
|Yu‐Shan Chang
3
|Dana A. Forgione
4
1
College of Business Administration & Public
Policy, California State University, Dominguez
Hills, CA, USA
2
College of Business Administration, California
State University, Stanislaus, Turlock, CA, USA
3
College of Commerce, Tamkang University,
New Taipei City, Taiwan
4
College of Business, University of Texas at
San Antonio, San Antonio, TX, USA
Correspondence
Dana A. Forgione, Professor of Accounting,
College of Business, University of Texas at San
Antonio, One UTSA Circle, San Antonio, TX
78249, USA.
Email: dana.forgione@utsa.edu
New client acceptance decisions are critical for auditors. Audit quality can be negatively affected
by limited knowledge of the new client's operations and finances. This may be mitigated for
auditors with industry specialization. We examine whether new clientele negatively affect audit
quality at the individual level and how the association with audit quality varies across auditors
with different levels of industry specialization. Our study fills a gap in the literature by directly
addressing the effects of new clients on audit quality for specialist and non‐specialist auditors,
as well as portfolio‐concentration experts, and sheds light on the nature of risks associated with
new client acceptance decisions. We find both industry specialists and portfolio‐concentration
experts can maintain their audit quality when accepting new clients, while there is a decline in
quality for auditors who are neither industry specialists nor portfolio‐concentration experts.
KEYWORDS
Audit quality, auditor industry expertise, auditor tenure, newclient acceptance decision
1|INTRODUCTION
Audit quality is critical and fundamental for capital markets to function
effectively. Over the past decade there have been growing concerns
about both audit quality and earnings quality. Prior literature (Chen,
Lin, & Lin, 2008; Ghosh & Moon, 2005; Johnson, Khurana, & Reynolds,
2002) indicates that audit quality is positively related with auditors'
tenure. However, there is no direct evidence on how audit quality is
affected by new client acceptance decisions at the individual partner
level. One possibility is that auditors can manage to maintain their
audit quality upon accepting new clients and further improve their
audit quality though their tenure. Therefore auditors with long tenure
have better quality than auditors with shorter tenure. Another possibil-
ity is that audit quality is temporarily reduced because of the limited
knowledge about the new clients. But auditors improve audit quality
later as the auditors get to know their new clients better. In this study,
we investigate the effect of the new client acceptance decision on
audit quality at the individual audit partner level.
Before commencing a new client relationship, a professional
auditor will investigate the potential client and determine whether
acceptance would create an unacceptable risk. However, the audit
quality of audit partners may be negatively affected by the acceptance
of new clients if they are not sufficiently familiar with the operational
and financial properties of the new clients. As learning theory in
psychology (Lapre, Mukkerjee, & VanWassenhove, 2000) suggests, it
takes time for auditors to develop sufficient client‐specific knowledge
to perform an effective audit. If an auditor has good control over the
risks associated with new clients, the effect of a new client acceptance
decision on audit quality may be minimal. If an auditor underestimates
the potential risk of the new client because of limited knowledge about
the operational and financial properties of the new client, the audit
quality can be negatively affected at a significant level. Prior literature
reports that audit firms and audit partners with longer tenure are asso-
ciated with higher audit quality or earnings quality (Chen et al., 2008;
Ghosh & Moon, 2005; Johnson et al., 2002). This suggests the possibil-
ity that audit quality declined upon the new client acceptance decision
and rebounded later as the auditor accumulated sufficient knowledge
about the client. Despite the importance of client acceptance decisions
in the profession, the effect of new clientele on audit quality is rela-
tively underexplored in the literature.
On the other hand, industry specialization has been documented
to be associated with higher audit quality and earnings quality (Balsam,
Krishnan, & Yang, 2003; Krishnan, 2003). Industry specialists provide
higher quality audits through their experience serving other clients in
the same industry as well as through learning and sharing best
practices across the industry (Dunn & Mayhew, 2004). The higher qual-
ity of audits by industry specialists is also attributed to the fact that they
invest heavily in technology, physical facilities, personnel, and organiza-
tional control systems that enable them to detect irregularities and
misrepresentations more easily (Simunic & Stein, 1987). Daugherty,
Received: 25 November 2015 Revised: 8 March 2017 Accepted: 18 March 2017
DOI: 10.1111/ijau.12095
288 © 2017 John Wiley & Sons Ltd Int J Audit. 2017;21:288–303.wileyonlinelibrary.com/journal/ijau
Dickins, Hatfield, and Higgs (2012) documented in their survey that
partners in the United States prefer to learn a new industry in order
to avoid relocation as a result of more stringent partner rotation
requirements. The reported preference suggests the importance of
industry‐related experience to auditors when they work on new clients.
When a new client is accepted, an auditor may not have sufficient cli-
ent‐specific knowledge. However, auditors with industry expertise
can better understand the client's business because of the spillover
effects of industry specialization. Therefore, we can expect that audi-
tors with industry expertise are more likely to detect misrepresenta-
tions and irregularities in new clients than auditors without such
industry expertise and are thus less likely to experience the temporary
decline in their audit quality.
In this study, we investigate whether the new client effect exists
and varies across groups of auditors with different industry specializa-
tion. Our study fills a gap in the literature by directly addressing the
effects of new clients on audit quality for specialist and non‐specialist
auditors, as well as portfolio‐concentration experts, and sheds light on
the nature of risks associated with new client acceptance decisions.
We define specialist audit partners using two alternative measures.
We first refer to a specialist audit partner as an industry specialist if
the auditor has high audit industry market share—which is the propor-
tion of audit fees earned by that auditor in an industry out of total
audit fees earned by all auditors serving the same industry. Second,
we refer to a specialist audit partner as a portfolio‐concentration
expert if the auditor has a high auditor portfolio share—which is the
proportion of an auditor's audit fees earned from one industry out
of all industries served by that auditor. We use both the number
of clients and client revenues to estimate the proportion of audit
fees received from a particular industry. We then partition the
original sample into four subsamples by the two definitions of
specialist auditors: (1) auditors who are both industry specialists
and portfolio‐concentration experts, (2) auditors who are portfolio‐
concentration experts but not industry specialists, (3) auditors who
are industry specialists but not portfolio‐concentration experts, and
(4) auditors who are neither industry specialists nor portfolio‐
concentration experts. We then examine and compare the effect of
new clients on audit quality in these four subsamples.
Our results show that the new client effect on audit quality is
significant only in subsample 4—auditors who are neither industry spe-
cialists nor portfolio‐concentration experts. The results do not support
a negative new client effect on audit quality for the other three sub-
samples of auditors, who are either industry specialists or portfolio‐
concentration experts, or both. It suggests that both industry special-
ists and portfolio‐concentration experts can maintain their audit
quality with new clientele. Moreover, we find that, after new clients
are accepted, there is a positive association between audit quality
and audit tenure for auditors who are not industry specialists, which
indicates that the non‐industry specialist auditors including portfolio‐
concentration experts can further improve their audit quality as they
accumulate more knowledge about their clients and industries.
This study contributes to the literature in two ways. First, we
investigate the effect of new clients on audit quality at the audit part-
ner level across tiers of auditors with different industry expertise. Our
results suggest that not only industry specialists, but also portfolio‐
concentration experts, can maintain their audit quality with new clien-
tele by applying their knowledge of the industry in the audit of the new
client. Our results shed light on the risks associated with client accep-
tance decisions for auditors of different specialist expertise, which has
potential implications for regulators, practitioners, and researchers.
Second, our study extends the work of Gul, Fung, and Jaggi (2009),
who found that the association between shorter auditor tenure and
lower earnings quality was weaker for firms audited by industry
specialists, compared to non‐specialists. However, Audousset‐Coulier,
Jeny, and Jiang (2016) report that the use of different industry special-
ization proxies results in inconsistent classifications of auditors as
specialists. Specifically, a non‐specialist can still be called an expert if
the majority of their clients are from the same industry. Therefore,
our study partitions the auditors into four tiers by whether or not an
auditor is an industry specialist, and whether or not an auditor is a
portfolio‐concentration expert. Our results indicate that there is no
significant association between audit quality and audit tenure for
industry specialists, which is consistent with Gul et al. (2009).
However, we find a significant and positive association between audit
quality and audit tenure for portfolio‐concentration experts, which
indicates that, unlike industry specialists, portfolio‐concentration
experts can further develop their knowledge about the industry and
improve their audit quality.
The remainder of this paper is organized into five additional
sections. In Section 2, we review the related literature. Section 3
develops the hypotheses, describes our research design and sample
selection. Section 4 summarizes the empirical results. Section 5
discusses our sensitivity tests. Finally, Section 6 presents our limitations
and conclusions.
2|LITERATURE REVIEW
Our study is related to two literature streams. First, our study is related
to the literature on the association between audit tenure and audit
quality. Second, our study is related to the literature on the association
between auditor industry specialization and audit quality.
2.1 |Audit tenure
Prior literature has suggested that audit firms and audit partners with
longer tenure are associated with higher audit quality or earnings
quality (Chen et al., 2008; Ghosh & Moon, 2005; Johnson et al.,
2002). Johnson et al. (2002), for example, examined the relationship
between audit firm tenure and audit quality and found that short tenure
(two to three years) is associated with larger absolute discretionary
accruals, but long tenure (nine or more years) is not. This suggested that
long audit firm tenures are not associated with a decline in earnings
quality. Chen et al. (2008) looked into the audit partner level. They
reported that the absolute and positive values of discretionary accruals
decrease significantly with audit partner tenure. Gul et al. (2009) went a
step further and examined the effect of industry expertise on the
association between audit tenure and audit quality at the firm level.
They found that the association between shorter audit firm tenure
and lower earnings quality is weaker for firms audited by industry
LIU ET AL.289
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