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Earnings quality, internal control weaknesses and industry-specialist audits

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  • Bikki Jaggi
  • Santanu Mitra
  • Mahmud Hossain

Abstract

Previous studies demonstrate that the quality of audit services provided by industry specialist auditors is higher than that of non-specialist auditors (e.g., Reichelt and Wang in J Account Res 48(3):647–686, 2010 ; Gul et al. in J Account Econ 47:265–287, 2009 ; Payne in Audit J Pract Theory 27(2):109–136, 2008 ; Balsam et al. in Audit J Pract Theory 22(2):71–97, 2003 ; Krishnan in Account Horizons (Supplement):1–16, 2003 ). Implementation of Section 404 of the Sarbanes–Oxley Act (SOX) presents special challenges to auditors to maintain the credibility of audit services when their clients have internal control weaknesses (ICW). This study examines whether audits of ICW firms by industry-specialists reflect a better earnings quality compared to audits by non-specialists in the post-SOX period. We use the matched pair sample constructed on the basis of propensity score matching process that controls for endogeneity and auditor’s self-selection bias and evaluate earnings quality measured in terms of performance-adjusted discretionary accruals and accruals quality. Our multivariate regression analyses produce evidence that earnings quality of the ICW firms audited by Big 4 industry specialists is higher than that of the ICW firms audited by Big 4 non-specialists. The superior specialist effect is, however, mainly confined to the firms having pervasive company-level control weaknesses. We find inconsequential difference between earnings quality of the firms with account-specific ICW regardless of whether they are audited by specialist and non-specialist auditors. Our additional analyses further show that any earnings quality difference between Big 4 and non-Big 4 clients is mainly attributed to specialist audit services provided by Big 4 auditors. We do not find any earnings quality difference between Big 4 non-specialists and non-Big 4 clients. Collectively, our study shows that in the enhanced regulatory post-SOX period, Big 4 auditors still provide higher quality audits if they have industry expertise, especially in a situation where companies have pervasive company-level control weaknesses. Copyright Springer Science+Business Media New York 2015

Suggested Citation

  • Bikki Jaggi & Santanu Mitra & Mahmud Hossain, 2015. "Earnings quality, internal control weaknesses and industry-specialist audits," Review of Quantitative Finance and Accounting, Springer, vol. 45(1), pages 1-32, July.
    • Handle: RePEc:kap:rqfnac:v:45:y:2015:i:1:p:1-32
    DOI: 10.1007/s11156-013-0431-3
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    Cited by:

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    3. Mounia Boulhaga & Abdelfettah Bouri & Hany Elbardan, 2022. "The effect of internal control quality on real and accrual-based earnings management: evidence from France," Journal of Management Control: Zeitschrift für Planung und Unternehmenssteuerung, Springer, vol. 33(4), pages 545-567, December.
    4. Ching-Lung Chen & Chung-Yu Chen, 2018. "Do Weak Internal Controls Affect Institutional Ownership Decisions?," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 21(03), pages 1-37, September.
    5. Chan Li & K. K. Raman & Lili Sun & Rong Yang, 2020. "The SOX 404 control audit and the effectiveness of additional audit effort in lowering the risk of financial misstatements," Review of Quantitative Finance and Accounting, Springer, vol. 54(3), pages 981-1009, April.
    6. Gerald J. Lobo & Yuan Xie & Joseph H. Zhang, 2018. "Innovation, financial reporting quality, and audit quality," Review of Quantitative Finance and Accounting, Springer, vol. 51(3), pages 719-749, October.
    7. Hanwen Chen & Wang Dong & Hongling Han & Nan Zhou, 2017. "A comprehensive and quantitative internal control index: construction, validation, and impact," Review of Quantitative Finance and Accounting, Springer, vol. 49(2), pages 337-377, August.
    8. Wunhong Su & Liuzhen Zhang & Chao Ge & Shuai Chen, 2022. "Association between Internal Control and Sustainability: A Literature Review Based on the SOX Act Framework," Sustainability, MDPI, vol. 14(15), pages 1-30, August.
    9. Helena Isidro & José G. Dias, 2017. "Earnings quality and the heterogeneous relation between earnings and stock returns," Review of Quantitative Finance and Accounting, Springer, vol. 49(4), pages 1143-1165, November.
    10. Chalmers, Keryn & Hay, David & Khlif, Hichem, 2019. "Internal control in accounting research: A review," Journal of Accounting Literature, Elsevier, vol. 42(C), pages 80-103.
    11. Yi-Hsing Liao & Hua Lee & Chao-Jung Chen, 2023. "The informational role of audit partner industry specialization," Review of Quantitative Finance and Accounting, Springer, vol. 60(1), pages 69-109, January.
    12. Sharad Asthana & Inder Khurana & K. K. Raman, 2019. "Fee competition among Big 4 auditors and audit quality," Review of Quantitative Finance and Accounting, Springer, vol. 52(2), pages 403-438, February.

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    More about this item

    Keywords

    Discretionary accruals; Accruals quality; Audit quality; Internal control weaknesses; SOX Section 404; Auditor’s industry specialization; Company-level and account-specific internal control weaknesses; Earnings quality; M40; M41; M42;
    All these keywords.

    JEL classification:

    • M40 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - General
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • M42 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Auditing

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