Diversification By The Audit Office And Its Impact On Audit Quality

Prior research documents a positive association between audit office size and audit quality (Francis and Yu 2009; Choi et al. 2010; Francis et al. 2012). Since firms diversify with the intention of revenue expansion (Palepu 1985), large audit offices are likely to be more diversified. Moreover, strategic management theory suggests that diversification may have positive / negative effect on the quality of output, depending on the nature of diversification. Thus, the interrelationship of diversification, audit office size, and audit quality is an interesting yet unexplored research issue. This paper examines the impact of four different diversification strategies: industry diversification, client diversification, geographic diversification, and service diversification on two proxies of audit quality, mainly, discretionary accruals and propensity to meet-or-beat earnings expectations by a cent. Results suggest that, holding audit office and auditee attributes constant, industry diversification, client diversification, and geographic diversification have detrimental effects on audit quality, possibly because such diverse audit engagements strain the resources of the audit office. On the other hand, service diversification, results in improvement of audit quality, possibly due to knowledge spill-over effect from providing multiple services to the same client, such as, tax compliance and planning, auditing employee benefit plans, acquisition related consultancy services, internal control reviews, and attest services. The pecking order of various strategies available for revenue expansion is also studied. The results suggest that the more effective a diversification strategy, the greater the detrimental effect on audit quality. Audit offices with more reputation in the local audit market manage diversification better, probably due to higher visibility costs and greater potential for loss of quasi-rents. Finally, consistent with theory, increase (decrease) in diversification levels over time has negative (positive) impact on audit quality. These results are robust to various controls from extant research. The findings of this paper are important since they identify additional factors that explain audit quality at the audit office level.