The Effect of Client Industry Agglomerations on Auditor Industry Specialization

• Published date: 01 December 2023
• Author: W. ROBERT KNECHEL,DEVIN WILLIAMS
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/1475-679X.12503

DOI: 10.1111/1475-679X.12503

Journal of Accounting Research

Vol. 61 No. 5 December 2023

Printed in U.S.A.

The Effect of Client Industry

Agglomerations on Auditor Industry

Specialization

W. ROBERT KNECHEL∗,†AND DEVIN WILLIAMS‡

Received 23 March 2020; accepted 20 July 2023

ABSTRACT

Prior research on auditor industry specialization documents fee premiums

for local audit offices that are industry specialists. This research assumes that

the effects of specialization are uniform across markets. We examine industry

specialization based on the economic theory of industry agglomeration (ge-

ographic areas with high industry concentration). Agglomeration economies

can facilitate access to knowledge for auditors serving a specific industry in

those locations. We find that industry specialists in agglomerations earn a fee

premium in excess of specialists in other markets. We find that nonspecial-

ist offices in agglomerations also earn fee premiums in that industry when

compared to nonspecialists in other markets even when controlling for these

groups’ absolute share of the national market. We also address whether or

not this expertise can be shared among offices in an agglomeration special-

ist’s firm. Wefind that audit offices that have easy connections to a within-firm

office in an agglomerated market can earn a fee premium relative to more dis-

tant offices, suggesting a benefit from knowledge transfer. This fee premium

∗University of Florida; †University of Auckland; ‡Price College of Business, University of

Oklahoma

Accepted by Douglas Skinner. We thank Sarah Bonner, Matt Cobabe, Patty Dechow, Julie

Griesser, Justin Lieby, Randy Priem, Sarah Stein, Cindy Zhang, and workshop participants at

KU Leuven, Georgetown University, Massachusetts Institute of Technology, Michigan State

University, Rice University, Penn State University, University of Auckland, University of Ade-

laide, University of Connecticut, University of Kentucky,University of Massachusetts - Amherst,

University of Southern California, Virginia Tech, University of Technology Sydney, and Wash-

ington University in St. Louis for helpful comments.

1771

© 2023 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

1772 w. r. knechel and d. williams

accrues to offices that would not be considered a specialist using traditional

market share measures in a given industry. These findings indicate that the

benefit of industry specialization depends on more than local market share.

JEL codes: D40, M41, M42, R32

Keywords: audit; audit fees; industry specialization

1. Introduction

Auditor industry expertise has been the focus of a great deal of research,

most of which makes an implicit assumption that industry specialization,

whether measured at the national or local office level, has a consistent

effect on audits across firms or offices. That is, specialists in one locale

are treated as having comparable expertise as specialists in other locales.

However, results in the experimental literature suggest that the impact of

industry specialization may be more nuanced (Bedard [1991], Hammer-

sley [2006], Moroney [2007], Moroney and Simnett [2009]). We know

from previous research that audit offices that develop industry specializa-

tion command higher fees (Craswell, Francis, and Taylor [1995], Francis

[2004], Cahan, Jeter, and Naiker [2011]) and generally perform higher

quality work (DeFond, Francis, and Wong [2000], Kwon, Lim, and Tan

[2007], Seavey, Imhof, and Westfall [2017], Gaver and Utke [2019]). We

also know that the effect of industry specialization may be conditional on

the nature of the client or audit firm (Cahan et al. [2008], Minutti-Meza

[2013], Bills, Jeter, and Stein [2015]). Although previous research suggests

consistent effects of industry specialization, not all markets may provide

equal benefits to local auditors. The purpose of this paper is to examine

how concentration in a client-industry market may affect the nature of in-

dustry specialization among auditors.

The most common measures of industry specialization are based on rela-

tive market-shares within a locale. These measures may be affected by local

market factors other than auditor expertise (e.g., audit pricing strategies,

client industry concentration, and market competition). For example, a

specialist office that serves numerous clients in a location that has a large

pool of clients in an industry may be different than one that has a dominant

market share in a market with few clients in an industry. As a result, the

benefits of industry specialization are likely to vary across industry-location

combinations and may be much more complex than simple, local market

share measures reveal. In this paper, we assume that auditor industry spe-

cialization is influenced by the concentration of clients in a given market.

We argue that auditors in highly concentrated client markets benefit the

most from specialization. Economists refer to a high concentration of com-

panies in an industry in a local market as an industry agglomeration.Wealso

validate that the benefits enjoyed by auditors in industry agglomerations are

due to specialization and not other economic factors by examining if and

client industry agglomerations and auditorspecialization1773

how industry-specific knowledge transfers from industry agglomerations to

other offices.

The economic theory of agglomeration has addressed the costs and ben-

efits of industry concentration in a specific location.1Previous research has

studied the effect of industry agglomeration, economies of scale from spe-

cialization, and economic geography (Marshall [1920], Krugman [1991],

Porter [2000], Kolko [2001], Rosenthal and Strange [2004], Ganesan,

Malter, and Rindfleisch [2005], Lovely, Rosenthal, and Sharma [2005],

McCann [2007], Glaeser and Gottlieb [2009], Ellison, Glaeser, and Kerr

[2010]), but the accounting literature has not utilized these industry-

centric theories to analyze the behavior of individual audit markets. It is

well documented that members of the supply chain of a company clus-

ter with their major customers (Marshall [1920], Rosenthal and Strange

[2004], Ellison, Glaeser, and Kerr [2010]). In the case of suppliers of tangi-

ble inputs, the logic of colocation may be to reduce inventory, production,

and transportation costs, that is, to achieve efficiencies in a just-in-time sup-

ply chain. The same logic potentially applies to financial service providers,

including accountants and auditors. The decision of suppliers to colocate

with their clients in an industry agglomeration will lead to an increased

presence of professional service providers (Coval and Moskowitz [2001],

Ivkovi´

c and Weisbenner, [2005], Parwada [2008]).2Given that professional

service firms create value through their use of intangible knowledge assets

(Vera-Munoz, Ho, and Chow [2006]), the concentration of professional

expertise in a location can make that knowledge more valuable because of

labor market pooling, input sharing, and knowledge spillovers (Marshall

[1920]).

A concentration of knowledge that arises in an agglomerated market is

referred to as a knowledge reservoir (Argote and Ingram [2000], McGrath

and Argote [2001]). We argue that some of the benefits observed for com-

panies because of the expanded knowledge reservoir in an agglomerated

industry will also accrue to the service providers that support the concen-

trated industry (e.g., auditors benefit from a larger and more knowledge-

able industry-specific labor pool). For example, Houston is well known as

the oil-and-gas capital of the United States with 61% of all public company

sales in the oil-and-gas industry in 2018. As a result, an audit office in Hous-

1Merriam-Webster On-Line defines agglomeration as “a localized economy in which a large

number of companies, services, and industries exist in close proximity to one another and ben-

efit from the cost reductions and gains in efficiency that result from this proximity.” Economic

literature makes a distinction between urban agglomerations (i.e., the economics of cities) and

single-industry agglomerations, which we study (Glaeser and Gottlieb [2009], Ellison, Glaeser,

and Kerr [2010]).

2Note, auditing/accounting does not meet the definition of an agglomeration itself. Al-

though accounting firms can be very large, they have many lines of business and services

across multiple industries and locations, that is, an accounting firm will be relatively spread

out to service a myriad of clients and industries in different locations. Thus, we use the term

“agglomeration” to refer to concentration in the industry of a client only.