This study examines whether auditor industry specialist duration (i.e., the cumulative number of years an audit firm can be deemed an industry specialist) affects earnings management. Using a sample of 17,546 observations during the period of 2006 to 2014, we find that audits performed by firms with longer industry specialist durations are associated with lower levels of earnings management, as proxied by the absolute value of discretionary accruals. This finding enhances the industry specialization literature by showing that, in the long run, specialist auditors constrain the accrual management activities of their clients. However, we also find that audits performed by firms with longer industry specialist durations are associated with greater levels of real earnings management. In turn, this is consistent with real earnings management surfacing as an unintended consequence of specialist auditors being able to better constrain the accrual management activities of their clients (Chi, Lisic, & Pevzner, 2011).

Introduction

This study investigates the role of time relative to industry specialization and auditor performance. Specifically, we examine whether auditor industry specialist duration (i.e., the cumulative number of years an audit firm can be deemed an industry specialist) affects earnings management. Obtaining a better understanding of the impact of specialist duration on auditor performance is important due to the tacit and transient nature of industry expertise. While prior studies recognize that expertise takes time to develop (Bonner & Lewis, 1990; Bonner & Walker, 1994; Goodwin & Wu, 2014), the effects of the auditor “seasoning” process has been largely ignored by preceding studies based on industry market share dominance (Gaver & Utke, 2019). Furthermore, several elements of the expertise puzzle, such as the dynamic environment of the audit profession and the challenges/opportunities associated with prolonged auditor tenures, further accentuate the importance of time as a determinant of the association between industry specialization and auditor performance. In this study, we distinguish between industry specialist duration (i.e., specialist tenure) and the current status of audit firms as industry specialists. We posit that there are two possible outcomes regarding the impact of specialist duration on earnings management. The first prospect is a negative association between duration and earnings management. This would suggest that an audit firm’s history as an industry specialist provides its staff with additional insights about its clients’ operations and industry, leading to more effective audits. That is, auditors with larger or dominant market shares benefit from greater exposure to clients from the same industry over time. This prediction is based on the notion that industry expertise follows market share dominance.