Effects of country-level legal, extra-legal and political institutions on auditing: A cross-country analysis of the auditor specialization premium

Abstract

In this cross-country study of the specialist auditor premium, which spans the US and 12 other countries, we provide evidence that country-level institutional strength increases average audit fees, but reduces the incremental demand for specialist auditors. This finding supports the hypothesis that strong institutions and the demand for specialist knowledge act as substitutes in providing the requisite assurance of financial statements.

Introduction

The auditing literature provides evidence that specialist auditor knowledge is an important determinant of audit quality (Balsam et al., 2003, Craswell et al., 1995, Beasley and Petroni, 2001) and that investors pay a premium for the additional assurance about an auditee’s earnings that specialist auditors provide (Carson, 2009, Carson and Fargher, 2007, Casterella et al., 2004). A different strand of the literature suggests that auditees’ earnings quality is improved not only by firm-level auditing, but also by country-level legal, extra-legal and political institutions (Haw et al., 2004, Bushman et al., 2004, LaPorta et al., 2000a, LaPorta et al., 2000b, Rajan and Zingales, 2003). These findings suggest that the strength of country-wide institutions may influence the premium that investors are willing to pay for specialist auditors. In this paper, using data from the US and from 12 non-US countries that exhibit different levels of institutional strength, we examine the effects of institutions on both average audit fees and the specialist fee premium.¹

Strong country-level institutions increase the legal and reputation costs of audit failure for all auditors in a particular jurisdiction. Both specialist and non-specialist auditors therefore have a stronger incentive to acquire and deploy industry-specific knowledge (off-engagement effort) and increase on-engagement audit effort to produce higher-quality audits. Greater audit effort is manifested in higher audit fees. In addition, by increasing the litigation and reputation risks of misreporting for managers, strong institutions can improve the quality of clients’ pre-audit reports. Taken together, then, the incentives for even non-specialist auditors to acquire industry knowledge and improved pre-audit information from clients may “crowd out” the incremental value of the assurance provided by specialist auditors. Alternatively, increased disclosure and transparency on the part of managers may enhance the value of specialist auditor knowledge and increase the premium that investors are willing to pay for it. Whether the crowding-out (substitutive) or enhancement (complementary) effect prevails is a matter for empirical resolution.²

Our findings support the existence of a specialist premium. We find that the average audit fee is higher and the specialist fee premium is lower in countries with stronger institutions, which supports the crowding-out effect, i.e., a substitutive relationship between institutional strength and demand for specialist auditor knowledge. This substitutive relationship remains in analysis that includes the US sample, although, consistent with the literature, the specialist premium disappears when only US and/or UK data are used.

We contribute to the literature by demonstrating that country-level institutions significantly affect auditing at the firm level. To the best of our knowledge, this is the first study to document a substitutive, rather than complementary, relationship between country-level institutional strength and incremental firm-level demand for specialist auditor knowledge. For auditors, these results indicate that audit specialization is incrementally more (less) valuable when the institutional environment is weak (strong). For analysts, they suggest that the credibility of financial statements depends on both the auditor and the underlying institutional structure in a given jurisdiction.

The remainder of the paper is organized as follows. Related work is discussed briefly in the next section. The third section provides our research framework, measures of legal, extra-legal and political institutions, and arguments with regard to the potential effects of such institutions on auditing. Our models, analysis and results are presented in the fourth section, and we discuss our findings and draw conclusions in the fifth and final section.