Auditor industry specialization and real earnings management

This study examines whether audit partners’ industry specialization could reduce real activity earnings management (RM). We argue that partners with industry specialization can reduce RM because they can better assess their clients’ business risk, and will more protect their reputation than other auditors. However, the extent to which auditors can constrain RM depends on whether the type of RM can affect accruals and internal controls. Focusing on two types of RM, we find that individual audit partners’ industry expertise is negatively associated with overproduction, but do not find evidence that audit partners’ industry specialization reduces firms’ abnormal reduction of discretionary expenditures. Cross-sectional analysis shows that the effect of audit partners’ industry expertise on overproduction is stronger when the firm has better corporate governance and has at least one director with auditor-related experience on the board. These suggest that strong governance and director expertise act as a complement mechanism that facilitates auditors’ communication with corporate managers. Overall, the findings suggest that auditors with industry expertise care about their reputation in detecting accruals and thus put more efforts in constraining overproduction, but not in cutting discretionary expenses.