The effects of industry specialization on auditors' inherent risk assessments and second-order uncertainty.

Abstract

A significant literature has developed which examines the relationship between auditors' expertise and their work experience. Much of the expertise paradigm literature centers on (1) whether a link between experience and task performance exists, and (2) describing the nature of the cognitive changes associated with the link. A significant, but largely unresearched component of this link is the impact of auditors' industry specialization on audit judgment. Industry specialization is currently receiving considerable attention from practitioners and academics alike. This paper examines the effects of industry specialization on auditors' inherent risk (IR) assessments, and on auditors' uncertainty in specifying such assessments. For several constructed audit cases, two groups of auditors (banking specialists and nonbanking specialists, both with approximately the same amount of CPA firm auditing tenure) from a "big-six" accounting firm were requested to provide planning-stage IR assessments and related second-order uncertainty (SOU) assessments. The results support several conclusions. First, consistent with the notion that industry experience facilitates the development of an industry-distinct knowledge base pertinent to IR assessment and that auditors who lack such experience lack such knowledge, nonspecialists experienced significantly more uncertainty about their IR assessments, relative to specialists. This result was observed for IR assessments pertinent not only to the loans account, but also to the premises and equipment (P&E) account, although the effect was not as pronounced for the P&E account which has a more similar analog in most other types of clients. Second, and also consistent with the notion that specialized experience leads to the development of specific knowledge pertinent to the risk assessment task, nonspecialists' IR assessments were generally significantly higher for a financial statement account unique to the industry--than industry specialists' IR assessments, indicating a conservative bias when industry knowledge is lacking. This result has potentially important implications regarding audit testing; given that IR assessments determine, at least in part, the extent of audit testing, it implies-holding all else constant--that the nonbanking group would be significantly more inefficient relative to the banking group in terms of audit effort expended in audit sampling. An example illustrates that the nonbanking group's risk assessments resulted in hypothetical samples sizes for the completeness assertion for the loans account (using the participating firm's sample size algorithm) that were on average J.2 percent larger than the banking group's, holding all else constant (t = 9.02, P < .01). Clearly this result has implications for audit policy; it indicates that specialization may provide some economy in the audit. This result helps to explain the trend toward industry specialization in general. Third, consistent with the notion that common experience standardizes knowledge bases pertinent to IR assessments, specialists exhibited significantly more consensus in their IR assessments for an account unique to banking clients. Nonspecialists and specialists exhibited similar levels of IR assessment consensus for an account common to most audits. Relatedly, the variance in uncertainty about IR assessments was significantly smaller for industry specialists. This result supports the assertion that common experience standardizes knowledge bases pertinent to IR assessments and reduces individual differences in perceptions about the adequacy of knowledge bases which support IR assessments. Given the results of the study, further investigation is warranted regarding questions about the effects of specialization on audit judgment. The findings presented have not been documented previously, and add to the literature on expertise in auditing. Several other avenues of research are advocated including additional questions about the effects of industry specialization on audit judgment. Addressing these issues may lead to further refinements in models of auditor expertise and serve to advance the literature and practice policy regarding industry specialization.