Auditor industry specialization and corporate risk-taking

Abstract

Purpose – The purpose of this study is to examine the effects of higher-quality auditors on corporate risk-taking. Design/methodology/approach – Agency theory suggests that managers have incentives to avoid risk in the interests of perquisite consumption and self-preservation, while investors prefer that managers invest in all projects with a positive net present value, i.e. projects that generally increase corporate risk. Empirical literature finds that managerial risk-aversion is mitigated (and firm value enhanced) when investor protection is higher. The authors examine whether higher-quality auditing is one such mechanism to encourage shareholder-focused corporate risk-taking. They model measures of corporate risk as a function of whether a firm is audited by an industry specialist or not, controlling specifically for accounting quality. They then examine the incremental effect of higher-quality audits on other forms of external monitoring (analyst coverage and institutional holdings) for corporate risk. Findings – Using a sample from 2003 to 2007, the authors document a positive relationship between local-level audit industry specialization and both the standard deviation of annual stock returns and research and development expenditures (their measures of corporate risk-taking). They then find the effect is mitigated when firms have alternative external monitoring, in the form of either higher analyst coverage or greater institutional holdings. Research limitations/implications – Given the nature of the question the authors ask, particularly in the context of the auditor–client relationship, a potential limitation is the difficulty in assigning causation. Nonetheless, this study underscores the importance of auditors as an effective mechanism for monitoring corporate managers. Originality/value – This study provides novel evidence that auditors affect managerial decision making beyond a simple effect on financial statements, and should be of interest to boards of directors, regulators and investors.