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

We 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. 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. We argue that both the initial investments in improving quality and the experience gained by attracting a bigger group of clients play a role in achieving specialization. Serving more clients fosters learning and cultivates enhanced industry expertise. In order to cultivate such learning, our model predicts that the auditor lowers his fees in early stages of his journey to achieving specialization in order to attract a larger group of new clients. In contrast to prior studies, our analysis examines factors influencing the supply of rather than the demand for industry specialization.