The Association between Client‐specific Investment Opportunities and Audit Fees of Industry Specialists and Non‐Specialists

• Author: Debra C. Jeter,Steven F. Cahan,Jayne M. Godfrey,Jane Hamilton
• DOI: http://doi.org/10.1111/ijau.12029
• Date: 01 July 2015
• Published date: 01 July 2015

The Association between Client-specific Investment Opportunities and Audit

Fees of Industry Specialists and Non-Specialists

Steven F. Cahan,1Jayne M. Godfrey,2Jane Hamilton3and Debra C. Jeter4

1University of Auckland

2Australian National University

3La Trobe University

4Vanderbilt University

Audit clients’ investment opportunity sets (IOS) include firm-specific opportunities that are unique to the client,

as well as opportunities generalizable to the client’s industry and opportunities even more generically available to

all firms. Prior research does not examine the variation in audit fees related to firm-specific IOS nor how

firm-specific IOS affects the premiums charged by industry specialist auditors. We find that firm-specific IOS plays

a distinct role in the pricing of audit services, leading to higher fees as the auditor demands compensation for

increased audit risk. Further, we find that the ability of an industry specialist auditor to charge fee premiums is

reduced in the case of clients that are highly differentiated based on firm-specific IOS, as the knowledge gleaned

in auditing other clients within the industry is often not applicable to clients in more unique IOS environments.We

contribute to the literature by showing that industry specialist premiums are not constant for firms in the same

industry; rather, they reflect a trade-off between firm- and industry-specific knowledge.

Key words: Industry specialization, audit fees, specialist premiums, investment opportunities, auditor expertise,

industry-specific knowledge, client-specific knowledge, opportunity set, pricing of audit services, auditor market

share.

I. INTRODUCTION

In the strand of research examining whether industry

specialist auditors earn fee premiums, most studies find

evidence of fee premiums for specialists (e.g., Craswell,

Francis & Taylor, 1995; DeFond, Francis & Wong, 2000;

Francis, Reichelt & Wang, 2005; Carson, 2009; Reichelt &

Wang, 2010), though some do not (Pearson & Trompeter,

1994; Ferguson & Stokes, 2002; Francis & Yu, 2009). A

potential limitation of these studies is that they assume

fee premiums are constant across firms within a given

industry (e.g., Moroney & Simnett, 2009; Francis &

Seavey, 2012).

Several studies consider differences in specialist

premiums across industries, including studies that focus

on the specialist’s market position. For example, Mayhew

and Wilkins (2003) find premiums only for specialists

who have a significantly larger market share than their

competitors. Cahan, Jeter and Naiker (2011) find the

specialist premium to be inversely related to the

proportion of industry clients audited by the specialists.

An alternative approach is to focus on differences in

industry characteristics. Cahan, Godfrey, Hamilton and

Jeter (2008) (hereafter CGHJ) argue that specialists

are attracted to industries with greater investment

opportunities, and using industry-level data, they find

higher audit fees in these industries. Consistent with

CGHJ, Francis and Seavey (2012) suggest that industry

expertise is more important when industry complexity is

high, leading to larger fee premiums for auditors who

choose to specialize in complex industries.

O’Keefe, King and Gaver (1994) argue that audit

production is a function of the auditor’s general,

industry-wide, and client-specific knowledge. We apply

O’Keefe et al.’s (1994) audit knowledge classification to

argue that as client firms become more uniquely

differentiated from others within their industry, their

auditors need to invest in greater client-specific

knowledge, even in an industry in which the auditor

specializes. As such, for highly differentiated firms, the

auditor’s investment in industry-wide knowledge

becomes less directly applicable, and the auditormay not

be able to charge the full industry specialist premium that

would be applicable if firms were perfectly homogeneous

within a given industry. Together, the increased

client-specific knowledge requirement and reduced

utility of industry-wide knowledge imply higher

firm-specific audit fees but potentially lower industry

specialization premiums payable by firms that are unique

relative to other firms in the same industry. Ours is the

first study to examine variation in the specialist premium

among firms within an industry.Thus, the assumption in

prior literature of a specialist premium that applies

equallyto all firms in a given industry may be flawed, and

lead to some of the mixed or perplexing evidence in this

body of literature.

Our measure of client-specific knowledge is the

firm-specific element of investment opportunities.

Using industry-level data, CGHJ find that industry

specialization is more likely when the industry-wide

investment opportunity set (IOS) is greater and more

homogeneous, and that auditfees are positively related to

the level and homogeneity of industry-wide IOS. We use

firm-level data and compute firm-specific IOS based on a

factor analysis of four variables related to investment

intensity, growth in market value of assets, market-to-

book ratio, and R&D expenditures (Baber,Janakiraman &

Kang, 1996). Controlling for both industry IOS and the

homogeneity of industry IOS, we find that while audit

fees are positively related to firm-specific IOS, the

industry specialist premium declines as firm-specific IOS

increases.

Correspondence to: Debra Jeter, Owen GraduateSchool of Management,

Vanderbilt University, Nashville, TN, USA. Email: debra.jeter

@owen.vanderbilt.edu

International Journal of Auditing doi:10.1111/ijau.12029

Int. J. Audit. 19: 57–71 (2015)

© 2014 John Wiley & Sons Ltd ISSN 1090-6738