Audit fees, industry specialization, and compliance with GAAS reporting standards

Academic and professional studies have established that audits of governmental units frequently do not comply with Generally Accepted Auditing Standards (GAAS). Two possible explanations for this noncompliance, asserted by professionals and regulators, are (1) that the procurement practices of governmental entities focus on low audit fee rather than compliance with GAAS and (2) that some audit firms lack knowledge of the unique aspects of governmental auditing, i.e., they lack industry-specific knowledge.

Testing these explanations requires data on compliance to GAAS, audit fee, and proxies for industry-specific knowledge. Such data are typically not available to researchers. A unique data base containing all of these measures is used to test whether violations of GAAS reporting standards decrease with increases in audit fee and industry-specific knowledge. Specifically, for a sample of 935 California school district audits, an index of violations of GAAS reporting standards is regressed on audit fee and on industry specialization (a proxy for industry-specific knowledge), after controlling for other audit firm characteristics and for client characteristics.

Empirical results show that violations of GAAS reporting standards decrease as audit fee increases. Further, industry specialization is associated with fewer violations of GAAS reporting standards. Finally, violations of GAAS reporting standards are fewer for large audit firms, for audit firms with CPAs that are members of the state CPA society, for audit firms previously flagged for submitting a substandard audit(s), and for clients that changed audit firms. Violations of GAAS reporting standards are more frequent for audits of large clients. Neither membership in the AICPA's Division of Firms nor the quality of the client's internal controls are related to violations.

These results have implications for clients who want to procure high quality audits. Auditor selection criteria emphasizing technical competence over low audit fee should result in selection of an auditor that will produce relatively high audit quality. Further, specialization in the client's industry by the local office of the audit firm is a useful signal regarding the technical competence of the auditor.

Finally, this paper provides evidence that specialization in an industry by the local office of the audit firm increases compliance to GAAS. If industry specialization creates brand name, then the variation in compliance across the auditor's clients in an industry should decrease with its industry specialization.