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SYNOPSIS:
The increasing occurrence of accounting restatements has drawn considerable attention from regulators, audit firms, and corporate boards concerning audit and financial statement quality. Research suggests that auditor industry specialization is associated with improved error detection and greater financial statement quality. We examine the impact of auditor industry specialization on a sample of restatement and nonrestatement firms and find that auditor industry specialization is negatively associated with the likelihood of accounting restatement. In addition, focusing on the subset of restatement firms, we find that auditor industry specialization reduces the likelihood of issuing restatements affecting core operating accounts, suggesting that industry specialization adds value in auditing a particularly critical area of the firms' continuing operations. Finally, we find changing from a nonspecialist to a specialist auditor increases the likelihood of restatement, and changing from a specialist to a nonspecialist reduces the likelihood of restatement. Our findings are consistent with industry specialization enhancing auditors' role in improving the quality of the financial reporting process, particularly related to the core operations of their clients.
Keywords: audit quality; auditor industry specialization; financial restatements.
Data Availability: All data are available from public sources.
INTRODUCTION
Accounting restatements are central to the public policy debate concerning the quality of externally reported financial statements. Trust in the capital markets depends on the level of confidence investors place in financial statements when making investment decisions. The incidence of accounting restatements has substantially increased in recent years, rising to a record 1,876 restatements in 2006 (Reilly 2007). This increase has drawn substantial public scrutiny of auditors' roles in ensuring the quality of financial statements, compromising investor confidence in the financial reporting process. The Securities and Exchange Commission (SEC) considers accounting restatements "the most visible indicator of improper accounting" (Schroeder 2001) and Congressional interest spurred the General Accounting Office's (2002) report on the proliferation, potential causes, and implications of accounting restatements.
The underlying causes for the increase in accounting restatements have been debated in boardrooms, the business press, and academic research. Studies suggest that capital market pressures motivate managers to adopt more aggressive accounting policies that lead to restatements (e.g., Richardson et al. 2002). External auditors play a critical role in the financial reporting process by providing an objective review of financial statements, which can...