AUDIT FEES, INDUSTRY SPECIALIZATION, AND COMPLIANCE WITH GAAS REPORTING STANDARDS

Academic and professional studies have established that audits of gove rnmental units frequently do not comply with Generally Accepted Auditi ng Standards (GAAS). Two possible explanations for this noncompliance, asserted by professionals and regulators, are (1) that the procuremen t practices of governmental entities focus on low audit fee rather tha n compliance with GAAS and (2) that some audit firms lack knowledge of the unique aspects of governmental auditing, i.e., they lack industry -specific knowledge. Testing these explanations requires data on compl iance to GAAS, audit fee, and proxies for industry-specific knowledge. Such data are typically not available to researchers. A unique data b ase containing all of these measures is used to test whether violation s of GAAS reporting standards decrease with increases in audit fee and industry-specific knowledge. Specifically, for a sample of 935 Califo rnia school district audits, an index of violations of GAAS reporting standards is regressed on audit fee and on industry specialization (a proxy for industry-specific knowledge), after controlling for other au dit firm characteristics and for client characteristics. Empirical res ults show that violations of GAAS reporting standards decrease as audi t fee increases. Further, industry specialization is associated with f ewer violations of GAAS reporting standards. Finally, violations of GA AS reporting standards are fewer for large audit firms, for audit firm s with CPAs that are members of the state CPA society, for audit firms previously flagged for submitting a substandard audit(s), and for cli ents that changed audit firms. Violations of GAAS reporting standards are more frequent for audits of large clients. Neither membership in t he AICPA's Division of Firms nor the quality of the client's internal controls are related to violations. These results have implications fo r clients who want to procure high quality audits. Auditor selection c riteria emphasizing technical competence over low audit fee should res ult in selection of an auditor that will produce relatively high audit quality. Further, specialization in the client's industry by the loca l off ice of the audit firm is a useful signal regarding the technical competence of the auditor. Finally, this paper provides evidence that specialization in an industry by the local office of the audit firm i ncreases compliance to GAAS. If industry specialization creates brand name, then the variation in compliance across the auditor's clients in an industry should decrease with its industry specialization.