Master Thesis Proposal
Table of Contents
1.2 Relevance and Motivation
1.3 Research question
2.2 Audit market in the Netherlands
2.3 Audit Services
2.4 Agency Theory
2.5 Audit Quality
2.6 Auditor Industry specialization
2.7 Prior Research
2.8 Hypothesis Development
3.2 Research Approach
3.3 Independent variable: Auditor industry specialization
3.4 Dependent variable: Audit quality
3.5 Control variables
3.6 Regression model
APPENDIX A – Overview of the measurement method by empirical study
APPENDIX B – Overview of the theoretical literature
APPENDIX C – Conceptual framework variables
Chapter 1 – Introduction
The financial crisis that hit the global economy in 2008 had a major impact on audit firms.
In response to the financial scandals, the United States of America (hereafter: US) announced the Sarbanes-Oxley act in 2002. Shortly after this US scandal, the Netherlands also experienced their own breakdown. Unfortunately, auditors were the key players of these unpleasant affairs. Consequently, companies were losing confidence in auditors and financial reports were losing their purpose. The Dutch government has established a rule to monitor the accounting firms.The Audit Firms Supervision Act (“Wet toezichtaccountantsorganisatie”) (hereafter: WTA). The new rule should reduce the risk of significant misstatements in the financial statements and also enhance the audit quality.
Maintaining a high level of quality and avoiding a crisis from happening again should be top priority for all audit firms. In order to perform an audit, a certain amount of professional knowledge from auditors is required. It is not only the knowledge about how to design and implement the audit procedures, but also specific knowledge regarding the industry in which the client firm is operating. This industry’s specific knowledge is particularly valuable for understanding a client’s business and its business environment. Consequently, this specific knowledge can be qualified as the specialization of an audit firm.
In the last few decades, U.S and Dutch Governments have introduced mandatory auditor rotation to improve the independency of the auditors (Green Paper, 2010; PCAOB, 2011). Mandatory rotation limits the maximum number of years an audit firm can audit a client. On the other hand, when a mandatory audit firm rotation is applied, there is a risk that the auditor loses specific knowledge concerning the client’s firm in question (Jackson et al., 2008).
1.2 Relevance and Motivation
There is an ongoing discussion about the industry specialization and it became more interesting in the accounting literature (Cahan et al., 2011). Current studies show that there is a high interest to investigate the relationship between specialization and audit quality (Jiang et al., 2012). According to different prior research studies, specialization means when auditors have acquired enough knowledge in the specific industry based on practical experience and training (Low, 2004; Neal and Riley, 2004:170). Specialized auditors will be more likely to detect errors in a ﬁnancial statement compared to the auditors who are not specialized (Moroney and Carey, 2011). Auditor industry specialization benefits both the firm and its clients in several ways (Owhoso et al., 2002; Solomon et al., 1999; Taylor, 2000). Specialization will increase the audits’ effectiveness and efficiency, will enhance the qualitative audit and result in greater economies of scale (Krishnan, 2003; Solomon et al., 1999; Willenborg, 2002). However, literature on this topic contains research with contradicting results. Francis (2011) attributed the mixed results to the different methods of measuring auditor industry specialization.
Also in accordance with prior documents, both a positive and a negative relationship can occur between auditor industry specialization and audit quality. Krishnan’s study (2003) investigated if audits performed by industry specialists will have lower discretionary accruals in comparison to audits done by non-specialist auditors. Balsam et al., (2003) too, found it to have lower discretionary accruals. Lower discretionary accruals are an indication of higher audit quality. This means that the auditor who is more experienced performs better than a non-specialist auditor (Bonner and Lewis, 1990).
1.3 Research question
In this study, the association between the auditor industry specialization and audit quality was examined. The acquired knowledge could benefit policy makers as well as auditors to improve the quality of auditing. Based on the purpose and relevance of this study the following research question had been formulated:
What is the effect of auditor industry specialization on audit quality for Dutch publicly listed companies?
Auditor industry specialization
Figure 1: Conceptual model of the research question.
The following research questions will be divided by these sub questions:
1. What does the term audit services imply?
2. What does the term audit quality imply?
3. What does the term auditor industry specialization imply?
4. How is auditor industry specialization related to audit quality?
This study is not only of societal relevance, but also scientifically relevant as it contributes to the existing literature in several ways. Francis (2011) claimed in his study that “more research is needed to understand the source of industry expertise and its relation to global, country-level and office specific operations of large accounting firms”.
First, this study examined the industry specialization-audit quality relationship for the period well after the financial crisis of 2010-2015. The financial scandals cast a dark shadow on the audit industry in the Netherlands. Those scandals had a negative impact on the confidence in the audit markets. To restore confidence, the Dutch government had to develop a new rule. The “Code Tabaksblat” was introduced; this tool was meant to recover the above-mentioned lack of confidence. Due to the “Code Tabaksblat”, also known as the Dutch Corporate Governance code, the importance and the quality review for every audit performance increased. Most empirical investigations that directly investigated the above-mentioned relationship used pre-financial crisis periods without taking the risk of litigation during the years of the crisis into account (Balsam et al., 2003; Krishnan, 2003). Second, this study focused on the period after they had introduced the mandatory rotation. In theory, if an audit firm switch takes place, both the client and the firm may experience negative effects due to switching costs. According to Jackson et al. (2008) a mandatory rotation limits the auditor’s ability to gain specific client and industry-based knowledge. Thus, the audit quality of two years before and two years after the switch might be dissimilar.
Third, an extensive amount of literature has been conducted on the (expected) effects of industry specialization, particularly in the U.S. audit services market; however, rarely Europe focused upon. This study analyzed the audit services market in the Netherlands. No empirical studies to date have analyzed the possible effects of audit specialization in the Netherlands. Although there are some similarities between the U.S. and the Dutch audit services market, there are still significant differences between the two countries that can affect determining factors. Furthermore, a significant increase in audit firms in the Netherlands in the past decade has made the Dutch market suitable to empirically test the possible effects of auditor industry specialization. Increasing competition adds pressure to firm survival and encourages differentiation among firms in order to increase market share (Krishnan, 2003; Minutti-Meza, 2013)
Findings of this study could indicate whether empirical evidence on this topic is country-related rather than global.
The auditor industry specialization is measured through the market share approach. As an indicator for the auditor industry specialization, this research followed the definition of Palmrose (1986). Palmrose (1986) defined auditor industry specialization as the audit firm with the largest market share in a specific industry, possesses the most knowledge and is considered the industry specialist. In this study, audit quality is defined as the ability of auditors to detect and report any errors in a financial statement. To measure the audit quality, the discretionary accrual (hereafter; DA) is used as a proxy for audit quality as this is consistent with prior research (Francis et al., 1999; Reichelt and Wang, 2010). The method used to determine the DA is the Modified Jones model (1991). According to Reichelt and Wang (2010), the Modified Jones statistical model is the strongest in the detection of total accruals (Bartov et al., 2000; DeFond and Jiambalvo, 1994). If a high number of discretionary accruals has been detected, it will be used as an indicator for low audit quality. To test the hypothesis, a regression analysis is conducted. Besides the two main variables, a set of control variables based on prior studies is used (Cahan et al., 2011; Reichelt and Wang, 2010; Myers et al, .2003). These variables are Size, Leverage, CFO, Loss, Market value, ROA and Big4.
1.6 Structure of this thesis
This thesis is organized as follows:
This chapter provides a review of the theoretical background. The theoretical background includes the role of the auditor and financial statements, audit market in the Netherlands, audit quality and auditor industry specialization. Finally, the literature review on this topic will be presented and then hypothesis will be developed.
Chapter three describes the research design and the data sample is explained. The research design includes the regression model, and the way to measure the selected variables. A brief description is provided of how the sample is obtained.
In chapter four evidence is collected. Furthermore, the results obtained from the sampling are presented.
Chapter five contains the main conclusion of this empirical study as well as suggestions and limitations.
Chapter 2 – Theoretical background
In order to have a better understanding of the research question, this chapter explains the main concept of this research: first, a short description of competitive audit market in the Netherlands. A brief description of agency theory will be presented. Finally, the definitions of audit quality and industry specialization will be explained. This chapter provides an overview of the relevant literature regarding the relationship between industry specialization and audit quality. In this chapter six academic articles published between 1988 up to 2013 are included and presented in great detail. Those articles are compared by research objective and methodology. Finally, the hypothesis development will be discussed. (See appendix C for the summary).
2.2 Audit services
The auditor has the responsibility to ensure with reasonable assurance that a company’s financial statements are true and fair view. Audit service provided by auditors ‘is a professional service that improves the quality of information for decision makers’ (Arens, Elder, and Beasley, 2013: 8).To report the information in accordance with established criteria, auditors need to collect evidence. The evidence obtained can be quantifiable information (e.g. financial statement numbers) or qualified information (e.g. the efficiency of a firm’s operation. The result of the audit is included in the report as well as the auditor’s opinion. A high level of audit quality is when the auditor complies with auditing standards and gives the correct opinion about the client’s financial statements at an appropriate level of audit risk. Audit services can be seen as an economic exchange between a supplier, an auditor and direct users. There is growing demand for audit services as well as a growing expectation of audit services. Since such expectations are not new to the accounting profession, the parties need to be prevented from maximizing their own interest, and sufficient resources need to be employed. This is known as the agency problem. Independency is one of the important components of the accounting profession. Consequently, the auditor needs to remain independent of his clients even when a bond exists between them.
2.3 The audit market in Netherlands
Currently, in the Dutch competitive audit market, auditors are experiencing a lot of competition. In the world of accountancy, the most common expressions are the “Big 4”, “Big 6” and even “Big 8”. Due to the transition of some accounting firms, the “Big 8” reduced to the “Big 6” and then to the “Big 4” (Craswell et al., 1995). Due to the competitive audit market, it has become more difficult for the audit firms to recruit new clients. Accounting firms must differentiate themselves to be a specialist in some industry, using different strategies (Neal and Riley, 2004:170). All the Big4 firms consider themselves industry specialist. They have the resources and incentives to invest in their firms to develop training and education in a specific industry. Currently, the Big4 firms dominate the audit market. To maintain high audit quality, regulators introduced a set of new rules, for example the independence rules. The independence rules include the mandatory rotation and limit the audit firms to provide other services to their clients. Mandatory rotation ensures that the auditor is independent in relation to his clients.
2.4 Agency Theory
The agency theory is based on the principal-agent relationship. Agents can be defined as those who are obligated to perform and give a certain service for the benefit of principals.
This is based on an agreement (contract). Furthermore, according to this theory, there is a distinction between leadership and ownership; agents are the ones with leadership and principals are the ones with ownership. Also shareholders can be seen as principals, while the management of a company can be seen as agents.
Under some circumstances agents and principals cannot come to a specific business agreement. For example, to rate agents it is important that the company’s profits are as highly recognized as possible. However, for the principals it matters to conceal some of the profits due to tax purposes. On the other hand, a low profit usually affects the value of the shares and dividends payable.
Due to the information asymmetry between agents and principals, it is difficult to determine if the managers act in their own interests. There are several sources through which shareholders can obtain information about their company. The most important information source remains the financial statement. The purpose of publishing financial statements is to present to the stakeholders the company’s financial information as clearly and precisely as possible. Therefore, it is important that the financial statements are reliable. To increase the reliability, the financial statements must be audited by independent and competent third parties (Arens et al., 2013; DeAngelo, 1981)
2.5 Audit quality
Since the catastrophic experiences, audit quality has gained more attention. Not only are the shareholders attached to the quality of the financial reports but also other stakeholders like the government. There are many ways to define the audit quality but the most common study is DeAngelo’s (1981). Audit quality consists of two aspects: the competency and objectivity component. DeAngelo (1981) defined audit quality as (1) discovering material misstatements in financial statement and also (2) acting properly once defects are discovered. The first component covers the competence of auditors and the level of exertion while the second component covers the objectivity, professionalism and independence of the auditor. The importance of an audit quality is defined by the users’ perception. The audit market participants can be categorized in three groups (1) External users (2) the client and (3) the audit team.
Since audit quality is unobservable, different proxies have been used by researchers to measure audit quality.Although so many different proxies have been utilized, Lennox (1999) believed that most researchers generally agree that the size or brand name of audit firms is an appropriate indicator of audit quality. Deangelo (1981) also stated that the size of the audit firm is positively related to audit quality. The most common proxy for measuring audit quality, is the discretionary accrual, this is consistent with prior research (Balsam et al. 2003; Johnson et al. 2002; Lim and Tan 2008; Myers et al. 2003; Reichelt and Wang, 2010).In this study, audit quality is defined as the ability of auditors to detect and report any errors in a financial statement.
2.6 Industry Specialization
As in all industries the competition is very strong. To gain sustainable competitive advantages, an audit firm must differentiate itself from its competitors. One way to achieve these advantages is to obtain specializations in a particular industry. This strategy is used to recruit new clients and retain existing clients. Due to the specialization, auditors will gain more knowledge, will gain more insight into specific client’s characteristics and will perform better (Krishnan, 2003).
When they are specialized in a specific industry, the auditors will detect errors in the financial statements easily (Lowensohn, 2007).
In accordance with prior literature two methods used for measuring industry specialization are identified, namely the market share and portfolio share approach (Lowensohn, 2007). However, as stated in section one, the market share approach was used in this study. The market share approach is as follows: the firms with the largest market share develop the largest knowledge within that specific industry and have the expected benefits (Danos and Eichenseher, 1982). With the portfolio approach audit ﬁrms are viewed as if specialized in the industries in which those ﬁrms generate the most revenues related to their entire audit practices. Compared to those two approaches, prior researchers applied audit firm industry market share measures as proxies for audit firm industry specialization. There also many definitions of industry specialization. As mentioned above, this research followed the definition of Palmrose (1986). Palmrose (1986) defined auditor industry specialization audit firm with the largest market share as one that possesses most knowledge and is considered the industry specialist. These audit firms have the largest market shares within the industry which they are able to investment in industry-specific audit technologies. With such investments it is also assumed that they achieve increased economies of scale and improved audit quality. In this research firms are grouped into the internationally accepted SIC code to explicit industries.
The relation between auditor industry specialization and audit quality has been examined several times in the accounting literature.
Krishan’s study is the first study that will be discussed. For instance, the main research objective of Krishnan’s study (2003) was also investigated and that is whether audits performed by industry specialists will have lower discretionary accruals than those performed by non-specialist auditors. Additionally, Krishnan used as a sample a large clientele of “Big 6” firms. As proxy for industry specialization both market and portfolio share approaches were used for measuring industry specialization. The method they used to measure audit quality is the cross-sectional variation of Jones (1991).The findings showed lower discretionary accruals when performed by specialists.
Similarly, Balsam et al., (2003) also studied the association between auditor industry specialization and earnings quality. Their sample included clients of the “Big 6” in the US from 1991 to 1999.The absolute discretionary accruals and ‘earnings response coefficient’ (Hereafter: ERC) were used as proxies for earnings quality. The results they found were the same as in Krishan’s study, namely that auditor specialization decreases discretionary accruals and increases earnings in the ERC model. This implies that the industry specialists are able to improve the quality of the earnings.
Reichelt and Wang (2010) studied the same research question as mentioned above. The sample they used was based on national and city specialists and non-specialists. As proxy for audit quality the abnormal accruals model was used, and through tolerance of aggressive earnings management by measuring the propensity for meeting or beating analysts’ earnings forecasts by one penny per share. A proxy for specialization is auditor expertise. They found that when auditors have a large group of clients in the same industry, the expertise increases based on training and practical experience. The overall result showed that the existence of industry expertise is positively associated with audit quality.
Furthermore, Low (2004) examined the effects of industry specialization on auditors risk assessment and on the decision of audit planning. To test the regression model, they used the experiment method. In the experiment auditors from different industry specialization completed an audit case in the bank industry. He manipulated the information of the case to accomplish differential audit risk levels. The result showed an increase in audit quality of auditors’ risk assessments that influenced the quality of allocation of audit planning.
Other studies also examined the trends in industry specialization as well as factors that affected specialization during the years 1976 to 1993 (Hogan and Jeter, 1999). With supporting evidence it was proven during the investigation that in regulated industries auditors have higher concentration levels.
In Solomon et al. (1999) study, the experiment method was used to examine if specialized auditors have relatively more knowledge of financial statement non-error factors for their industries of specialization. They defined industry specialists as “auditors who are so designated by their firms and whose training and practice experience largely in a particular industry”. In the experiment, both partners and senior managers had specific knowledge in the finance and health industries. When they audited another industry, the quality would be lower.
The next study is by Dunn and Mayhew (2004).They examined the effect of industry specialization on the quality of the firm disclosures and financial reporting quality. The findings were that industry specialization increases the quality disclosures of a firm and decreases the fraudulent financial reporting. AIMR scores were used to measure quality in the financial reporting. As a result, they found a strong positive relationship between auditor specialist and the rankings of disclosed quality in unregulated industries. This result is limited to regulated industries because they did not find any evidence to support the hypothesis stated for regulated industries. According to Carcello and Nagy (2004), they found a negative relation between industry specialization and financial fraud. This negative relationship is weaker with bigger companies, since they have more power.
Some researchers were also interested in the moderating effect of long auditor-client relationship between industry specialization and audit quality. According to Lim and Tan (2010), the relationship between auditor tenure and audit quality was examined. A positive relationship was found between long tenure and industry specialization, because the longer the relationship between the audit firm and its clients, the more knowledge and experience will be gained to improve performance. Lowenshon (2007) stated that the audit quality will be higher when using longitudinal variable. Gul et al. (2009) examined the relationship between auditor tenure and earnings quality and found that the relationship is weaker when firms are audited by industry specialists.
In summary, as mentioned above, several previous studies have already researched the relation between auditor industry specialization and audit quality. Every study is unique which results in varying outcomes. The results in prior studies showed that auditors who are industry specialists perform higher quality audits. However, no empirical studies to date have analyzed the possible effects of audit specialization in the Netherlands.
In the introduction, several sub questions were formulated to provide a better understanding of the empirical study. In this chapter, the first three sub questions were answered. A brief summary of the answers is provided below:
1. What does the term audit services imply?
The auditor has the responsibility to ensure with reasonable assurance that a company’s financial statements are true and fair. Audit service provided by auditors ‘is a professional service that improves the quality of information for decision makers’ (Arens, Elder, and Beasley, 2013: 8).
2. What does the term audit quality imply?
Audit quality consists of two aspects: the competency and objectivity component. DeAngelo (1981) defined audit quality as (1) discovering material misstatements in financial statement and also (2) acting properly once defects are discovered. The first component covers the competence of auditors and the level of exertion while the second component covers the objectivity, professionalism and independence of the auditor.
3. What does the term auditor industry specialization imply?
There also many definitions of industry specialization. As mentioned above, this research followed the definition of Palmrose (1986). Palmrose (1986) defined auditor industry specialization audit firm with the largest market share as one that possesses most knowledge and is considered the industry specialist. These audit firms have the largest market shares within the industry which they are able to investment in industry-specific audit technologies. With such investments it is also assumed that they achieve increased economies of scale and improved audit quality
2.8 Hypothesis development
In order to survive the competition, audit firms need to differentiate themselves (Krishnan, 2003; Minutti-Meza, 2013). By investing in specific industry, they will gain advantage over their competitors. The aim of this is to investigate to what extent an auditor specialized in a particular industry gains specific knowledge and experience in that industry compared to non-specialized auditors. In order to maintain the audit quality, a set of new rules was introduced. Based on the discussion above, findings of prior literature support the fact that audit quality of a firm will be higher when the auditors are specialists because they have the resources, in-depth industry knowledge and the incentives to detect misstatements easily in the financial statements compared to non-specialist auditors (Krishnan, 2003). Based on this prior research, the following hypothesis was stated:
H1: Audit firms specialists is positively correlated with audit quality than non-specialist auditors.
Independent variable Dependent variable
Auditor industry specialization
Figure 2: Hypothesis 1
In this chapter the statements were made based on the literature review. In the next chapter the research method will be explained.
In order to test the hypothesis, a proper methodology was chosen after the literature review of chapter 3. Therefore, this chapter starts with an overview of all the research approaches available. Next, an explanation will be given about the possible methodology used to illustrate the relation between the auditor industry specialization and audit quality. This chapter contains the chosen methodology and the reason why this methodology had been chosen. In this chapter also the research design, the data collection method, the data analysis method and the target population will be discussed.
3.2 Research Approach
In the lessons of research skills the researcher learned that different methods can be used for a research. The most common research methods are qualitative, quantitative, desk or field research methods. The major difference between quantitative and qualitative is the likelihood to apply the results to real scenarios. Quantitative research is used to quantify the problem by way of generating numerical data or data that can be transformed into useable statistics. It is used to quantify attitudes, opinions, behaviors, and other defined variables – and generalize results from a larger sample population. Qualitative research methods focus on discovering and understanding the experiences, perspectives, and thoughts of participants. That implies that qualitative research explores meaning, purpose, or reality (Hiatt, 1986). According to Pope et al., (2000), qualitative research is a type of scientific study that seeks to understand a research problem or topic from the perspectives of the local population it involves. Qualitative research is especially effective in obtaining specific cultural information about the values, opinions, behaviors, and social contexts of particular populations. Accountant firms are confronted with competition nowadays. This study reflects the experience of the audit firms when dealing with enhanced audit quality beside the competition in the market. Since this study verified certain assumptions and gained new information on specialization and its effect on audit quality, the quantitative approach had been selected.
In this research, the auditor industry specialization was the independent variable. As mentioned above, Palmrose’s (1986) definition was followed and market share approach was used to measure. The market share approach employed was used by Balsam et al. (2003); Gull et al. (2009) Krishnan (2003); and by Minutti-Meza (2013) as well. Industries are defined based on their two-digit SIC code. The market share approach is as follows:
NIj,t = total net income of the current year operation of company j in year t
CFOj,t = total cash flow from operation of company j in year t
The second step is to estimate the coefficients b0, b1, b2and b3 based on the next equation:
NDAj,t= β1(1/Ajt-1) + β2(∆REVj,t-∆RECj,t)/Ajt-1 + β3 (PPEjt/Ajt-1) + Ԑj,t 
NDAit = non-discretionary accruals in year t for firm i;
REVj,t = change in the revenues of company j from year t-1 to year t
RECj,t = change in the receivables of company j from year t-1 to year t
PPEj,t = fixed assets of company j at the end of year t
Ajt-1= total assets of company j from yeart-1;
Ԑj,t = errors of company j in year t
β = coefficient
Finally, the discretionary accruals were computed using the following equation:
DAit = TAit – NDAit
DAjt = discretionary accruals in year t for company j;
NDAjt = non-discretionary accruals in year t for company j;
TAjt = total accruals in year t for company j;
Once the measure for discretionary accruals is estimated, the hypotheses can be tested. The model used to test the hypotheses will be presented in section 3.6.
3.5 Control Variables
To examine the correlation between audit quality and industry specialization, a regression model was used. Consequently, a set of control variables was included in the regression model. This study used the following variables Size, Leverage, CFO, LOSS, ROA, Market value and Big4 as control variables. This section will focus on these control variables.
Client size (Size)
Client size is included in the model because it is the most explanatory variable. Prior literature stated that the bigger the company is, the less chance they perform earnings quality. (Choi et al., 2010).Therefore, the expected sign is negative for Size.
The next control is leverage. Leverage is expected to be positive. Higher level of leverage is related to debt covenants and is associated with more discretionary accruals (Jackson et al., 2008).
The study of Francis and Yu (2009) said that when companies have more debts, they use accruals in increasing profits. That is the reason why debt levels will have a positive correlation with their discretionary accruals.
Return on Assets (ROA)
The return on assets (ROA) represents the profitability of a company related to its total assets. This represents how well the management is employing the company’s total assets in realizing profit.
In prior studies they found a negative relationship between return on assets ratio and discretionary accruals (Dechow et al., 1995).
Other control variables
The variables operating cash flow (CFO) and LOSS were included to control financial performance. The expected sign of the control variable LOSS is negative, because it is not possible anymore to avoid the recognition of a loss by managing earnings. Firms with a Big4 auditor are less likely to manage their earnings. In that way, a negative sign is expected in the regression model for the control variable Big4.The market value (MV) is positively associated with discretionary accruals (Myers et al., (2003)
The data was analyzed by using multivariate analysis. To examine the relationship between industry specialization and audit quality, the discretionary accrual was used. Despite the two main variables, a set of control variables based on prior studies was used (Reichelt and Wang, 2010; Cahan et al., 2011). To conclude, the regression model is as follows:
DAjt = β0 + β1SPECLSTj,t + β2SIZEj,t + β3LEVj,t+β4ROAj,t+ β5CFOj,t + β6LOSSj,t+β7MVj,t + β8Big4j,t+ Ԑ 
β = coefficient
SPECLST = indicator variable, 1 = auditors are industry specialists, and 0 otherwise
SIZE = the log of the total assets of firm j in year t
LEV = total liabilities of firm j in year t, scaled by total assets year t
ROA = net income of firm j in year t, scaled by total assets year t
CFO = operating cash flow of firm j in year t, scaled by total assets in year t
LOSS = indicator variable, 1 = net income < 0, and 0 otherwise
MV= market value of equity divided by book value of equity of firm j in year t
Big4 = indicator variable, 1 = as the firm is audited by a Big4 firm, and 0 otherwise
Ԑ = residual error
DAjt is the dependent variable and is measured by the discretionary accrual model of J. Jones (1991), as mentioned above. The independent variable is industry specialization and is measured as a dummy variable, 1 if the firm is audited by an industry specialist and 0 otherwise. Audit quality is expected to be higher (lower discretionary accrual) when a firm is audited by an industry specialist. Several control variables are included in the regression model. (See appendix C)
The sample of Dutch listed companies was obtained from ORBIS data of Bureau van Dijk between the periods 2010 up to 2015.It was a particularly interesting period, because it followed just after the financial crisis. ORBIS database was used for the annual financial information e.g. balance sheet and income statement numbers. ORBIS is a database that provides comprehensive information about companies worldwide.
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Appendix A: Overview of the measurement
|Article||Market Share||Portfolio share||Weigthed market share||Self-proclaimed|
|Hogan and Jeter (1999)||X||X|
|Balsam et al. (2003)||X|
|Dunn and Mayhew (2004)||X|
|Carcello and Nagy (2004||X|
|Gul et al. (2009)||X|
Table 5- Summary of Measurement used by empirical papers
Appendix B: Overview of the theoretical literature
|Author (s)||Proxy||Effect of auditor industry specialization on audit quality|
|Krishnan (2003)||Absolute discretionary accruals||The findings showed lower discretionary accruals when performed by specialists. This is consistent with clients of audit firm specialist having higher audit quality|
|Balsam et al ( 2003)||Absolute discretionary accruals and earnings response coefficients||That auditor specialization decreases discretionary accruals and increases earnings in the ERC model.|
|Reichelt and Wang (2010)||Abnormal accruals model||The overall result showed that the existence of industry expertise is positively associated with audit quality.|
|Dunn and Mayhew (2004)||AIMR scores were used to measure quality in the financial reporting.||As a result, they found a strong positive relationship between auditor specialist and the rankings of disclosed quality in unregulated industries.|
Table 6- Summary of the empirical papers used in this study
Appendix C: Conceptual framework variables
Independent variable Dependent variable Control variables
Auditor industry specialization
Market share approach
Figure 3– Conceptual framework variables
|Variables||Description||Expected relationship (+/-)|
|DA||Absolute value of discretionary accruals|
|Size||The log of the total assets of sample firm i in year t;||Negative|
|Leverage||Total liabilities of sample firm i in year t scaled by total assets year t;||Positive|
|ROA||Return on assets is the net income divided by total assets.||Negative|
|CFO||operating cash flow scaled by total assets at the beginning of the fiscal year||Negative|
|LOSS||1 if net income < 0, and 0 otherwise||Negative|
|MV||market value of equity divided by book value of equity||Positive|
|Big4||1 if the firm is audited by a Big 4 auditor, and 0 otherwise||Negative|
Table 7: Summary of the Variables in the Regression Model
large companies like Enron, Worldcom and Parmelat collapsed and went bankrupt
large companies as Ahold and KPNQwest
 The Green Paper is a tentative government report of policy proposals for debate and discussion.
 The Public Company Oversight Board (PCAOB) is a non-profit organization in the USA, which inspects audits of public listed companies.
 See Appendix A for the summary of measurement in empirical papers
 Big 4 refers to the four largest audit firms in the world: Deloitte, Ernst&Young, KPMG and PwC.
 Big-6 consisted of: Arthur Anderson, Coopers & Lybrand, Deloitte&Touche, Ernst&Young, KPMG Peat Marwick, and Price Waterhouse.
 Big 8 consisted of: Arthur Andersen, Arthur Young & Co., Coopers & Lybrand, Ernst &Whinney, Deloitte Haskins & Sells, Peat Marwick Mitchell, Price Waterhouse, and Touche Ross.
(e.g audit size, audit hours, audit fees, reputation, litigation rate and discretionary accruals).
 (e.g., Balsam et al. 2003, Reichelt and Wang 2010, Lowensohn et
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