Partner industry specialisation and audit pricing in the UK
Accounting firms are generally organised as partnerships, and this provides them with a structure that allows optimal delegation of the decision rights to the partner level where relevant specific knowledge is located.
Partners play the central role in planning and administering the external audit service provided to the client and are accountable for the final audit report that they sign. Partner autonomy suggests that audit outcomes vary with partners’ characteristics, including their expertise, and that the accounting firms nationally, or even the individual engagement offices of the accounting firms, play a less important role in administering audit engagements.
Extant literature in auditing implicitly assumes that industry expertise is homogeneous across individual partners within the same audit firm (national-level perspective) or within the same city for a given firm (office-level perspective).
The assumptions are that knowledge can be shared through practices such as internal benchmarking of best practices, use of standardised industry-tailored audit programs and extending the reach of professionals from their primary local-office clientele to other clients through travel and internal consultative practices.
However, more recent research has started focusing on industry expertise at the audit-partner level. This is based on the argument that an audit partner’s industry expertise developed from individual personal beliefs, experiences, and values are not easily transferred between city offices or partners within the same audit firm. Besides that, not all types of industry knowledge can be documented and transferred, and an individual audit partner’s professional judgement is unique and is controlled by the innate ability of the individual partner.
In addition, there are factors that deter auditors from sharing what they know with others. For example, the pursuit of personal benefits and power by individual auditors, constraints and workload pressure that reduce knowledge sharing efforts, or inadequacy in audit firms’ information technology may deter auditors from sharing their knowledge with others.
In 2008, the UK regulator, the Financial Reporting Council (FRC), proposed an audit quality framework showing that audit partner skills, knowledge and expertise are important drivers of audit quality. Consistently, the disclosure of the name of the senior statutory auditor (or engagement partner) signing off the auditor’s report for and on behalf of the audit firm was made mandatory in the UK beginning from 6 April 2008 (Section 503 of Companies Act 2006).
In the context of our study, these developments indicate that partner specialisation is a crucial component in understanding auditor specialisation premiums and transferability of industry expertise within an audit firm. Furthermore, the extent to which partner industry expertise contributes to higher audit quality remains an unanswered empirical question in the UK.
Therefore, our study empirically examines whether industry expertise at the partner level is independently associated with audit pricing within the UK market.
As explained earlier, this study is motivated by the issue of differentiating auditor quality and the opportunity provided by the mandatory requirement for the disclosure of the engagement partner’s name in the auditor’s report in the UK. This requirement provides an opportunity to investigate whether audit industry expertise is driven by firm, office or partner level expertise, or some combination of them.
Unlike the situation in the US and Australia, our findings suggest that the fee premium attached to auditor industry expertise is a joint product of firm and partner level of industry expertise. The fee premium is highest when the client is also audited by the leading industry partner.
These findings provide evidence that partner industry leadership is an important but not a necessary condition for a fee premium in the UK audit market. The findings provide support for the argument that industry expertise is uniquely attributable to the individual audit partner’s human capital in terms of their knowledge and experience from leading audit engagements in a particular industry.
Expertise also captured at the firm national level remains an important aspect in generating fee premiums. The evidence also confirms recent results that in the UK there is a shift of industry specialisation from the city level to the national level. Our findings are generally robust to alternative measures of industry leadership.
The results of this study are of interest in understanding the economic importance of investing in partner industry specialisation. The results are also relevant in assessing the impact of the mandatory disclosure of a partner’s identity in the U.K audit market, and in reassessing the impact of the mandatory rotation of audit partners and audit firms.
Whether auditor specialisation fee premiums are related to a particular person (partner) or team, or to the audit firm as a whole, is a relevant question to audit committees, analysts, standard setters and regulators, as it reflects on whether audit quality is uniform for a firm or office, or varies by partner. Such information could be important in choosing an auditor or deciding whether to rely on a set of accounts. Thus, investigating this issue sheds some light on this under-researched topic.
This Blog post is extracted from a journal article entitled “Partner industry specialisation and audit pricing in the United Kingdom” published in the Journal of International Accounting, Auditing and Taxation. The paper is co-authored by Dr Khairul Ayuni Mohd Kharuddin (Loughborough University), Dr Ilias G. Basioudis (Aston University) and Professor David Hay (University of Auckland, New Zealand).
This Blog post was written by Dr Khairul Ayuni Mohd Kharuddin, Lecturer in Accounting and member of the Accounting and Finance discipline group at the SBE. Ayuni can be reached via K.Mohd-Kharuddin@lboro.ac.uk