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Industry Specialization by Auditors

Article  in  Auditing A Journal of Practice & Theory · May 1999

DOI: 10.2308/aud.1999.18.1.1

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 Industry Specialization by Auditors

Chris E. Hogan
Assistant Professor
Owen Graduate School of Management

Debra C. Jeter
Assistant Professor
Owen Graduate School of Management

May 1998

Please Direct All Correspondence To:

Chris E. Hogan
Owen Graduate School of Management
Vanderbilt University
401 21st Avenue South
Nashville, TN 37203
Office: (615) 343-4334
Fax: (615) 343-7177
email: hogance@ctrvax.vanderbilt.edu

The authors acknowledge the support of the Dean’s Fund for Faculty Research at Vanderbilt
University and the helpful comments of Germain Boer, Paul Chaney, Phil Drake, Randal Elder,
Craig Lewis, Tom McKee, the reviewers, and participants of the 1997 Auditing Midyear
Conference and the 1997 Southeast Region American Accounting Association Meeting.
 Industry Specialization by Auditors

SUMMARY
Dramatic changes in recent years in the audit market suggest the timeliness of an
investigation of trends in auditor concentration and an extension of prior research (e.g. Danos
and Eichenseher 1982). In recent press, large audit firms have claimed that specialization is a
goal of increasing importance. Peat Marwick, for example, has restructured along industry lines,
claiming to be recruiting professionals for national teams of multi-disciplinary experts organized
to “focus on the same industry to serve clients optimally.” On the other hand, litigation concerns
might prompt auditors to diversify their risks by diversifying their clientele.
In this study, we examine trends in industry specialization from 1976 to 1993 and the
industry factors which may affect specialization; whether market share increases are greater for
audit firms classified as specialists; and whether the nation’s largest audit firms have increased
their market share in the industries which they have identified as their focus industries. We find
evidence that concentration levels have increased over this period, consistent with the claims of
the large audit firms. We find that auditor concentration levels are higher in regulated industries,
in more concentrated industries, and in industries experiencing rapid growth, but lower in
industries with a high risk of litigation. Levels of concentration have increased over time in
nonregulated industries providing evidence that scale economies or superior efficiencies of
heavy-involvement auditors are not limited to regulated industries but extend to nonregulated
industries as well. We also find that for the audit firms classified as market leaders at the
beginning of the year, market share has increased over time, whereas market share has declined
for firms with smaller share at the beginning of the year. This suggests that there are returns to
investing in specialization.

Key Words: Industry specialization, auditor concentration

Data Availability: Data are available from sources identified in the paper.
 Industry Specialization by Auditors

Claims by large auditors suggest that industry specialization is a goal of increasing

importance for some, if not all, of the country’s largest auditors. This implies that these firms

perceive a benefit from specialization, whether increased market share, profits, audit quality, or

merely the maintenance of market share in a competitive environment.1 Specialization was also

specified as being critical for the survival of the CPA profession at a recent CPA Vision Project

National Future Forum held in January 1998. Specialization was one of five top issues facing the

profession as identified by member delegates from around the country attending over a hundred

Future Forums during the past fall (The CPA Letter, April 1998).

With the lifting of bans on advertising and direct solicitation, the audit market has

undergone significant change since most of the previous research studies investigating auditor

specialization. Other changes include a decline in the relative importance of audit services as a

proportion of total accounting firm revenue, an increase in the importance of international

services, and an increase in litigation concerns. In this environment, auditors may strive to

maintain or increase share by increasing quality and/or reducing costs via their specialization

efforts. Regulators in the U.S. and abroad have expressed concern about the impact of industry

concentrations on competition in the audit market.

The recent mergers of the firms previously referred to as the Big 8 have also drawn the

attention of regulators concerned about the impact on concentration rates and market structure

(McDonald et al. 1998). These mergers suggest not only the competitiveness of the market but

also a potential joining of expertise or specialization skills. For example, Price Waterhouse

1
claims that their plans to merge with Coopers & Lybrand arose in part from complementary

strengths in industry markets and cited, as an example, Coopers & Lybrand’s strength in

telecommunications as complementary to Price Waterhouse’s strength in entertainment and

media. The proposed union will enhance their ability, they claim, to serve as business advisors

with deep industry expertise in priority industries. In contrast, in calling off the planned merger

between KPMG and Ernst & Young, these firms mentioned differences in client industry mix as

indicative of a possible incompatibility of firm cultures. Other concerns were voiced, however,

including the possibility of too much over-lap in certain industries. For example, the firms may

have feared the loss of clients like Coke (Ernst & Young’s client) and Pepsi (KPMG’s)

concerned with confidentiality. Further, regulators feared the new merged firm might “dominate

the audit market for clients in certain industries,” and might create conflicts between auditing and

consulting units (McDonald et al. 1998).

In view of recent changes in the market for audit services, an investigation of recent

trends in specialization by auditors is particularly timely. Our purpose is not to consider the

competitiveness of the audit market, but rather to examine changes in auditor focus over time and

assess the extent to which auditors have been successful in increasing market share in their key

industries. Hence, we combine the merged audit firms before the date of the mergers which

decreased the number of large auditors from eight to six.2 To the extent that industry

specialization enables auditors to offer higher quality services (either audit or non-audit)3 or to

reduce audit production costs, efforts to specialize should yield economic benefits. However,

there are also costs to specialization including investments in technology, personnel and training.

In addition, increasing concerns by auditors related to potential litigation might prompt auditors

2
to diversify their risks by diversifying their clientele. This study examines recent trends in

industry specialization by auditors, measured both in levels of auditor concentration and market

share, controlling for demand- and supply-side factors which may affect observed levels of

specialization. We also investigate market share in industries identified by specific auditors as

their industries of focus and provide some insight into the distinctive personalities of individual

auditors.

A number of researchers have examined the issue of auditor specialization or

concentration in a variety of contexts. Danos and Eichenseher (1982) conclude that firms gaining

market share are more cost effective than firms losing market share, either due to operating

efficiency or scale economies. Eichenseher and Danos (1981) find no significant difference

between the concentration levels in 1964 and 1975. Danos and Eichenseher (1982), however,

present evidence that large (Big 8) auditors with high levels of industry involvement (greater than

or equal to 15% market share) gained greater share from 1972-1979 among regulated clients, but

their share was eroded among nonregulated client industries. They infer that scale economies

from high levels of concentration are limited to regulated industries. Further, they suggest that

the observed shifts to low-involvement auditors in nonregulated industries during their time

period implies either diseconomies of scale in nonregulated industries, or a preference for an

auditor who is not associated with the client’s competitors. Similarly, Kwon (1996) suggests that

specialization may not be observed in concentrated industries where firms have a greater

preference for auditors different from their competitors.

We extend these studies by examining concentration levels and market share from the

mid-1970's into the 1990's and provide a contrast to the conclusions drawn from the earlier

3
periods examined in prior studies. We find evidence of a significant increase in concentration

levels during the period we examine. Further, we find that, while concentration levels remain

higher for regulated industries, the increase in concentration over our time period has been

greater in nonregulated industries. Thus, in spite of some reluctance to have the same auditor as

one’s competitors, firms in nonregulated industries appear to be switching to specialist auditors

(market leaders) and away from low-involvement auditors. We infer that superior operating

efficiency or economies of scale to heavy-involvement auditors are not limited to regulated

industries but extend to nonregulated industries as well. An alternative interpretation is that

auditors specialize as a means of improving their quality, and firms in nonregulated industries are

switching to the auditor perceived as offering higher quality services. In addition, we find

evidence that concentration levels are higher in industries with greater client-firm concentration

and in industries exhibiting rapid growth, but lower in industries with a greater risk of litigation.

In an analysis of trends in auditor market share, we provide evidence that market leaders

continued to increase their market share, suggesting that there are returns to investing in

specialization. Our investigation of whether or not auditor market share in industries identified

by the Big 6 firms as being their key industries (based on their listings in the World-Wide Web4)

exceeds market share in industries not so designated provides mixed results. The relation

between auditor market share and industry-specific characteristics varies widely across Big 6

auditors.

BASIS AND METHOD FOR DESCRIPTIVE ANALYSIS

Claims by Big 6 auditing firms of increased or increasing levels of industry expertise

suggest that the firms perceive a net benefit to specialization, and a resulting trend toward

4
increased specialization might be observed. A number of industry-specific factors, discussed

below, may affect auditors’ incentives or abilities to concentrate in specific industries. Using

industry concentration ratios and market share as measures of specialization, we test whether

specialization increases over time. If auditors' efforts to increase industry expertise are evidenced

in increasing revenues in their industries of focus, concentration indexes and market shares for

industry specialists should increase over time. However, if auditors are in reality striving to

maintain share in a competitive market, if their efforts are unsuccessful, or if they are

diversifying because of litigation concerns, we may not find evidence of such a trend.

The difficulty of compliance with industry-specific regulation and reporting requirements

may lead to economies of scale for auditors dealing with clients’ regulatory complexities (the

Commission on Auditors’ Responsibilities [AICPA, 1978], Arnett and Danos 1979, and

Eichenseher and Danos 1981), resulting in greater auditor concentration within regulated

industries. Auditors are also likely to be interested in attracting large or growing clients. Thus,

they may focus their specialization efforts on industries characterized by relatively large clients

or by relatively rapid growth.

Other industry-specific considerations may lead to reduced concentration. If clients

consider their auditors to be a potential source of proprietary information transfer, then clients in

concentrated industries may resist having the same auditor as their competitors (Kwon 1996).5

Specialization may not be observed, or observed to a lesser extent, in industries with a high risk

of litigation. Industries identified by prior research as having a high risk of litigation include

chemicals and allied products, industrial machinery and equipment including computers,

5
electronic and other equipment, instruments and related products, depository institutions, holding

and other investment offices, and business services (Bohn and Choi 1996; O’Brien 1995).6

If several large auditors develop expertise in the same industry, then expertise will not

necessarily lead to greater auditor concentration. An examination of the industries of focus listed

by the Big 6 firms (see table 2) reveals a number of overlapping industries (communications and

financial services, for example). In industries where more than one auditor claims to specialize,

some auditors may be unable to translate their intentions or believed expertise into significantly

greater revenues.

Market Share and Concentration Measures

The following notation is used throughout the remainder of the paper.

i= 1,2,..., I = an index for audit firms

j= 1,2,..., J = an index for client firms
k= 1,2,..., K = an index for client industries
Ik = the number of audit firms in industry k
Jik = the number of clients served by audit firm i in industry k

The market share (MS) of industry k which is audited by auditor i can be calculated as

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follows:

where Aijk is the total assets of client firm j in industry k audited by auditor i. A three-firm

auditor concentration ratio by industry (ACR3k) can be calculated as the sum of the market shares

of the top three audit firms in each industry, while a two-firm auditor concentration ratio could be

the sum of the market shares of the top two audit firms in the industry (ACR2k). The ACR3k is

the percentage of industry k audited by the top three audit firms in that industry, with a value of 1

6
indicating that 100% of an industry is audited by three or fewer firms. The concentration ratios

measure overall concentration, regardless of which three firms dominate. If the overall level of

industry specialization is increasing, we would expect to see an increase in the value of ACR3k

for each industry over time.7 One concern in interpreting the ratios and indexes is the effect of the

mergers of the Big 8 into the Big 6 audit firms. As previously stated, we combine the merged

firms before the date of the mergers so that comparisons over time may be made.8

A measure of industry concentration, the ratio of a client firm to all client firms within an

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industry, is calculated as follows:

where A again is the total assets of client firm j. A four-firm industry concentration ratio

(CCR4k) is calculated by summing the four largest values of CCRjk for each industry. The value

of CCR4k increases as industry concentration increases, and equals one if an industry has four or

fewer firms. This measure simply captures the concentration of firms in an industry without

regard to auditor.

Data

The data used in this study are drawn from the Compustat tapes. The sample includes

firms on Compustat with auditor and assets data available for the 18-year period 1976 through

1993. We do not require firms to have data for all years, thus minimizing survivorship bias. We

use two-digit SIC codes to define industries. There are 58 two-digit SIC code categories

remaining after eliminating industries with fewer than ten firms. The descriptive statistics

presented in table 1 show that the mean market share value (MS) is approximately fifteen

7
percent;9 on average, sixty-four percent of an industry is audited by three or fewer auditors

(ACR3). The largest four client firms account for an average of twenty-eight percent of industry

assets (CCR4). Based on our classifications of regulated and high litigation-risk industries,

approximately twenty-six percent of the observations are in a regulated industry (REG), and

approximately ten percent of the observations are in a high litigation-risk industry (LITRISK).10

The mean of the industries’ average firm size is about 15.5 (MEANSIZE), measured as the

square root of total assets (where total assets are measured in millions). We categorized

approximately 15.5 percent of the observations in our sample as being in an industry exhibiting

relatively rapid growth (GROWTH).11

-- Insert table 1 here --

Table 2 lists the specific industries each of the Big 6 firms has identified as its “target

industries,” based on information provided on the World-Wide Web. We assign two-digit SIC

codes to the industries for testing purposes. There is a significant amount of overlap among the

Big 6 in categories claimed as areas of expertise. For example, all six firms claim financial

services and communications (or telecommunications) as key industries, and five of the six claim

health care or health services. Also, two of the firms, Coopers and Lybrand and Deloitte and

Touche, list several more industries than do the others. An additional limitation of the categories

provided on the Web is that firms may include client industries for which their expertise lies

predominantly in advisory or other non-audit services. As seen in table 1, approximately fifty-

seven percent of the observations are in the Big 6 firms' self-proclaimed industries of focus

(SPEC).

-- Insert table 2 here --

8
 ANALYSIS AND RESULTS

Principal Regression

To examine trends in auditor concentration, we estimate a regression with the three-firm

auditor concentration ratio as the dependent variable regressed against a time trend variable; we

include independent control variables for the regulated (unregulated) nature of the industry, the

concentration of firms in the industry, the relative litigation risk of the industry, the average size

of firms in the industry, high growth industries, and the number of auditors claiming the industry

as a specialty. We also include an interactive variable to capture the trend over time for regulated

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versus nonregulated industries. We present this regression in equation (3).

where:
ACR3kt = the three-firm auditor concentration ratio for industry k in year t
TIME = a linear time effect variable (time=1,2,...,18)
REGk = 1 if industry k is regulated, and 0 otherwise
REGk*TIME = the interaction of REGk and TIME defined above
CCR4kt = the four-firm industry concentration ratio in year t
LITRISKk = 1 if industry k is a high litigation-risk industry, 0 otherwise
MEANSIZEkt = the average size, measured by square root of total assets (measured in
millions), of all firms in industry k in year t
GROWTHkt = 1 if industry k is a rapid growth industry in year t, 0 otherwise
NSPECk = the number of Big 6 firms claiming industry k as a focus industry

Our data source Compustat did not code non-Big 6 auditors individually during most of

our test period. Hence, we were unable to include any of the non-Big 6 auditors which may have

9
appeared as one of the top three auditors in our industries (based on two-digit SIC codes);

however, we consider this possibility as remote and thus not a serious limitation.12

-- Insert table 3 here --

As seen in table 3, the coefficient on the variable TIME is positive and statistically

significant at the 0.01 level, suggesting an increase in auditor concentration over our time

period.13 This finding is consistent with auditors’ claims of increased specialization and with

arguments that benefits accrue to specialists. It is inconsistent with arguments that auditors’

claims of industry focus merely reflect efforts to maintain market share in a competitive

environment. To test for a nonlinear time trend, we estimated the model with the polynomial

terms TIME2 and TIME3; however, neither of these variables were significant.

Alternative explanations for the positive trend over time should be considered. For

example, as client size increases, larger audit firms may have greater competitive advantage over

smaller auditors. However, we control for client size and growth as determinants of auditor

concentration by including size and growth variables. Further, if the increase over time were

driven solely by changes in client size and not by specialization, we would expect the Big 6

advantage over non-Big 6 auditors to increase but not necessarily the top two or three auditors

over the other Big 6 auditors. Our results are robust to specification of our dependent variable as

a two-firm, three-firm, or four-firm concentration ratio, which strengthens our confidence in

interpreting the evidence as consistent with increasing specialization levels.

The coefficient on the variable REG, presented in table 3, is positive and significant at the

0.01 level. This suggests that the level of concentration is greater in regulated industries,

consistent with Danos and Eichenseher's (1982) findings. The coefficient on the interactive

10
variable REG*TIME is negative and significant at the 0.01 level. The trend over time in

concentration levels for regulated industries is captured by the sum of the variables TIME and

REG*TIME (0.003 and -0.004). Thus there has been essentially no change in concentration

levels during our time period among regulated industries and a positive change among

nonregulated industries.

The coefficient on the four-firm industry concentration variable, CCR4, is positive and

significant. This result at first appears inconsistent with (opposite in direction from) the

conclusions reached by Kwon (1996). Kwon argues that as industry concentration increases,

client firms' desire to have an auditor different from their competitors increases, resulting in

lower auditor dominance. Kwon’s dependent variables are designed to measure auditor

dominance in terms of the one-to-one mapping of auditors and auditees, and are measures of

auditor dispersion.14 He includes a four-firm auditor concentration ratio (ACR4) only as a control

variable. Kwon’s measures of auditor dominance are negatively correlated with the client

concentration ratio, consistent with his hypothesis, whereas the four-firm auditor concentration

ratio is positively correlated with client concentration. Kwon’s measures of auditor dominance

and auditor concentration are negatively correlated. When we measure dominance using the ratio

of the number of client firms to the number of audit firms in an industry, we obtain results

consistent with Kwon’s. However, when we measure dominance by alternative means (for

example, using the percentage of an industry audited by the top three auditors), we find a very

different relation. When we repeat the estimation of equation (3) with a two-firm auditor

concentration ratio as the dependent variable (which may better capture auditor dominance), our

results are robust with regard to the coefficient on the industry concentration measure; i.e. we

11
find a positive relation between auditor concentration and industry (client) concentration. The

relation between auditor dominance and industry concentration is sensitive to the specification of

the measure for dominance. As noted by Kwon (1996), client firms’ desire for auditors different

than their competitors’ may result in audit firms specializing in a broadly defined industry sense,

but diversifying in a narrowly defined industry sense.

The coefficient on the variable LITRISK is negative and significant at the 0.01 level,

suggesting that auditor concentration is lower in industries identified as high in litigation risk.

This is not surprising, as we would expect auditors to be risk averse and, ceteris paribus, the net

rewards of specializing in these industries would be lower than in less litigation-prone industries.

We also estimated regression equation (3) with an interaction term LITRISK*TIME; however,

this variable was not significant, and did not alter the results presented. We find our results to be

robust across alternative classification schemes for high-risk industries. For example, whether we

expand our classification to include all financial services, exclude chemicals and allied products,

or use a scheme based strictly on the auditing literature (Palmrose 1988; Stice 1991; St. Pierre

and Anderson 1984), our results are robust. The coefficient on LITRISK remains negative and

significant at the 0.01 level.

The coefficient on the variable NSPEC is positive and significant at the 0.01 level,

providing evidence that the number of firms claiming to be specialists in a particular industry is

positively related to auditor concentration levels. This is somewhat surprising, since it suggests

that specialization (concentration) efforts are not hindered when more firms claim expertise. One

possible explanation is that auditors may follow suit, or attempt to develop specialization skills

when they find themselves losing share to specialists.

12
 As previously mentioned, the average size of client firms in the industry may affect

auditor concentration. Prior research has shown that large client firms typically hire a Big 6

auditing firm. Thus, industries with larger firms on average might be expected to have fewer

clients with non-Big 6 audit firms, resulting in higher concentration levels. Auditors may focus

their specialization efforts on industries characterized by relatively large clients. The positive

coefficient on MEANSIZE is consistent with these arguments. Similarly, auditors may target

industries which have exhibited, or are expected to exhibit, rapid growth, consistent with the

positive coefficient observed on GROWTH.

Trends in Auditor Market Share

We also test whether firms already classified as industry experts were able to increase

market share during our test period. We use auditor market share as the dependent variable rather

than ACR3, which is calculated at the industry level. In addition, we rank the auditor's market

share within each industry at the beginning of the year, and classify auditor market share as being

in the top third, middle third, or bottom third for each industry and year. This allows us to

examine whether trends are different for market leaders. We estimate the following regression

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separately for the top, middle and bottom third beginning-of-year market share categories.

where:
MSikt =the market share of auditor i in industry k in year t
TIME = a linear time effect variable
CCR4kt = the four-firm industry concentration ratio in year t
REGkt = 1 if industry k is regulated, and 0 otherwise
LITRISKkt = 1 if industry k is a high litigation-risk industry, and 0 otherwise

13
The control variables CCR4, REG and LITRISK are included for reasons discussed previously.

We also estimate regression equation (4) with the addition of an interactive variable REG*TIME

and with additional control variables.

-- Insert table 4 here --

The results of estimating regression equation (4) are presented in table 4. These results

show that for audit leaders (defined as the top third of our sample, or top two auditors, in terms

of market share in a given industry at the beginning of the year), the trend over time has been

significantly positive. This suggests that market leaders continue to increase their share. Firms in

the middle third also exhibit a positive trend in market share over time, while firms in the bottom

one-third show a significant decline in market share over time.15 We also estimated the

regression equation with the addition of the control variables included in regression equation (3),

and the results are robust.16 We repeat the estimation with the addition of an interactive variable

for TIME*REG, and the coefficient on this variable is insignificant for all three partitions.

To test whether the coefficient on TIME is significantly different for the three partitions,

we use the indicator variable method of structuring the Chow test and find evidence of significant

differences across regimes in all variables. The trend over time in auditor market share is more

positive for those audit firms already ranked as leaders in a given industry in comparison to audit

firms with smaller market shares. The adjusted R-square values in table 4 range from .01 for the

middle third to .06 for the top third, suggesting that additional factors, not included in our

analysis, could be important in explaining market share.

The results presented in table 4 are largely consistent with evidence presented by Danos

and Eichenseher (1982); however, the former study found that the positive trend for market

14
leaders held only for regulated industries. In the present study the coefficient on REG is positive

for the top third, suggesting greater share in regulated than in non-regulated industries for market

leaders. However, when we add an interactive variable REG*TIME, the coefficient on the

interactive variable is not significantly different from zero for any of the partitions (not

presented). Thus, when we partition by market share category, we see no evidence that the trends

over time have been different for regulated and non-regulated industries during our sample

period. The coefficient on REG is not significant for the middle third, and is negative and

significant for the bottom third, indicating that firms ranked as fifth or sixth in a given industry

have greater share when the industry is not regulated.

The coefficient on the variable CCR4 is positive and significant for the top third of our

sample, suggesting that market share is greater in concentrated industries than in less

concentrated industries. However, for the bottom third of our sample, the coefficient on CCR4 is

negative and significant, indicating that firms with a relatively small piece of the audit market

have greater share in less concentrated industries. The relation between market share and CCR4

is not statistically significant for firms in the middle third.

The coefficient on the variable LITRISK is negative and significant for the top third of

our sample, indicating that market share among market leaders is generally lower in litigation-

prone industries than in less risky industries. For the auditors who are not leaders (the lower two-

thirds of our sample), the coefficient on LITRISK is positive and significant, suggesting greater

share in the industries identified as having a relatively high risk of litigation. These results

indicate greater auditor dispersion in litigation-prone industries.

15
 In summary, taking the results of this test in conjunction with the results presented in

table 3, we see evidence that specialization is increasing over our test period. In particular market

leaders have gained further share in the period from 1976 to 1993, as well as firms ranked third

or fourth, while firms ranked as fifth or sixth have lost market share. This trend is not limited to

regulated industries but appears to encompass both regulated and unregulated industries.

However, concentration levels, as indicated in able 3, have remained fairly constant for regulated

industries but have increased significantly for nonregulated industries. Finally, the results for our

other control variables suggest that market leaders have greater share in concentrated industries

and lower share in litigation-prone industries.

Tests of Market Share in Focus Industries of the Big 6

Palmrose (1986) identified audit firms considered to be experts within twelve different

industries. Table 5 presents a comparison of the firms which Palmrose identified as experts

(market leaders) in the 1979-1980 period to the experts in 1988 and 1993. Of the eighteen firms

identified by Palmrose during the 1979-1980 period, twelve would still be considered experts in

1988 and eleven in 1993. This suggests that firms maintain their expert status over extended time

periods with respect to most industries, but gradual changes occur. Some shifts may be related to

auditors’ lack of focus in more recent years on industries characterized by relatively slow growth,

e.g. railroads, or industries in which merger activity has resulted in the loss of a client firm or

firms.17

-- Insert table 5 here --

Next, we are interested in ascertaining whether or not the Big 6 firms’ market shares are

greater in the industries identified in table 2 as their industries of focus, and whether the trend in

16
the firms’ market shares within these industries is more positive than for other industries. We

control for industry concentration, regulation and litigation risk for reasons similar to those

discussed previously; e.g. auditors may be able to increase share in complex, concentrated, or

regulated industries if clients perceive the advantages of having specialists as relatively attractive

in these industries. We estimate the following regression separately for each Big 6 firm, and for

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the non-Big 6 firms as a group.18

where:
MSikt = the market share of auditor i in industry k in year t
TIME = a linear time effect variable
CCR4kt = the four-firm industry concentration ratio in year t
REGk = 1 if industry k is regulated, and 0 otherwise
LITRISKk = 1 if industry k is a high litigation-risk industry, and 0 otherwise
SPECik = 1 if industry k is identified as a focus industry of auditor i, and 0 otherwise
NSPECk = the number of Big 6 firms claiming industry k as a focus industry
SPECik*TIME = the interaction of SPECik and TIME

If the Big 6 firms’ efforts to focus on the industries they have identified are successful in terms of

market share, we expect a positive coefficient on the SPEC variable in regression equation (5). If

the number of firms claiming to be specialists in a particular industry is inversely related to an

individual auditor’s market share, then the coefficient on NSPEC would be negative.

-- Insert table 6 here --

Table 6 presents the results of estimating regression equation (5) for each of the Big 6

firms individually in an effort to provide insight into the ways different audit firms develop

distinctive personalities. The coefficient on the variable SPEC is positive for four of the six audit

firms, but only statistically significant (and positive) for three, and it is negative and significant

17
for two of the six. This provides limited support for a hypothesis that auditors have greater

market share in their self-proclaimed industries of focus. One possible explanation is that the

increase in concentration lags behind the listing; some auditors may list those industries where

they plan future growth. Identifying themselves as industry experts may be an attempt at product

differentiation. Mature industries are typically characterized by consolidation, low growth in

profitability, brand proliferation, and product differentiation. The market for audit services may

be argued to fall into the category of a mature industry. Recent developments, such as the merger

of the Big 8 into fewer firms, are consistent with this categorization.

Since there are no specified criteria that must be applied by an auditor in choosing the

industries to include on the Web listing, our test of the SPEC variable is admittedly difficult to

interpret. At a minimum, it suggests that caution be applied in interpreting an auditor’s listings as

evidence of great concentration or expertise. The listings on the World-Wide Web of key

industries for each Big 6 auditor have only been available in recent years. By extending these

definitions into previous years, we introduce a potential source of error. However, when we

repeat our tests, using the variables SPEC and NSPEC, on sub-periods prior to the 1990s in

comparison to the 1990s, we find that the results are similar (and statistically significant) for the

period prior to the 1990s, before the listings were actually compiled. We suggest that the listings

reflect specializations or industries of focus that had been evolving over the years and did not

commence at the time of the listing, but recognize that they may reflect future plans as well.

An alternative way to consider the effect of auditors’ self-proclaimed industries of focus

on the market for audit services is to regress the variable SPEC against client switches. We

perform a logistic regression (not presented), in which the dependent variable is 1 if a firm

18
switches auditors in a given year, 0 otherwise, and the independent variables include the

following: the variable SPEC, defined as 1 if the client’s industry is listed as a focus industry by

the new auditor, 0 otherwise; and the variable SPECLAG, defined as 1 if the client’s industry is

listed as a focus industry by the previous auditor, 0 otherwise. The coefficient on SPEC is

significant and positive, and the coefficient on SPECLAG is negative and significant. This

provides additional evidence that, overall, Big 6 auditors tend to be successful at attracting new

clients in their industries of focus.

An examination of the relations between market share and our independent variables

(presented in table 6) reveals considerable variation among the Big 6 auditors. For example,

Arthur Andersen, Coopers & Lybrand and Deloitte & Touche have significantly greater market

share in regulated industries than in nonregulated ones, but Ernst & Young, KPMG Peat

Marwick and Price Waterhouse have smaller share in regulated industries. Only Arthur Andersen

and KPMG Peat Marwick exhibit significant growth in overall market share over time, while

Deloitte & Touche shows a decline in market share overall but a fairly level share for its

industries of focus (represented by the sum of the coefficients on TIME [-.002] and TIME*SPEC

[.002]). Estimation of regression equation (5) reveals two of the Big 6 auditors as having greater

market share in litigation-prone industries: Price Waterhouse (with the greatest market share in

industrial and commercial machinery and computer equipment) and KPMG Peat Marwick (with

the greatest market share in electronic and other electrical equipment and components, except

computer equipment). The other four appear to have heavier concentration in industries that are

not litigation-prone. It is not surprising that the relations between market share and the control

variables vary across individual Big 6 auditors, as not all auditors can gain share in the same

19
types of industries. We also estimate regression equation (5) including the control variables

MEANSIZE and GROWTH (not presented), and the sign and significance of the coefficients on

these variables vary across Big 6 auditors; however, the results presented in table 6 are robust.

We also estimate regression equation (5) for all non-Big 6 auditors as a group. These

results are included in table 6. For non-Big 6 auditors, we find a significant decrease in market

share over time, consistent with our findings for the bottom third of Big 6 auditors in each

industry. This provides additional evidence that low-involvement auditors are losing share over

time to market leaders or medium-involvement firms. The coefficient on NSPEC is negative and

significant for the non-Big 6 auditors as a group, suggesting less share in industries where several

Big 6 auditors have expressed a focus.

SUMMARY AND CONCLUSIONS

Using concentration ratios and market share as measures of specialization, we examine

changes in these indexes over time. Unlike previous research which examined changes during the

1970's, we find evidence that the concentration levels have increased significantly over time

(from 1976 to 1993). The benefits of industry expertise or specialization are likely to increase

with the complexity of the industry. Prior research suggests greater concentration in regulated

industries and different patterns of growth for industry experts in regulated vs. nonregulated

industries. Our results are consistent with greater concentration in the regulated industries, but do

not suggest that the greater concentration has continued to increase over time. To the contrary,

we present evidence that the increase over time is greater among nonregulated industries during

our time period. We infer that economies of scale or superior operating efficiencies of high-

involvement auditors are not limited to regulated industries but extend to nonregulated industries

20
as well. An alternative interpretation is that specialists provide higher quality services (either

audit or non-audit), and clients switch for this reason to specialist auditors. We present evidence

that auditor concentration levels are positively related to the concentration of firms in the

industry and, somewhat surprisingly, positively related to the number of auditors claiming

expertise in a given industry. We also find evidence of lower concentration in industries

identified in prior research as having relatively high litigation risk and higher concentration in

industries identified as exhibiting rapid growth.

We compare trends in market share over time for auditors categorized as industry leaders

based on market share to trends for auditors with smaller shares. We find evidence that leaders

continued to increase their share during our test period, while auditors with smaller share

experienced declines in market share. Because the factors affecting levels of industry market

share are likely to vary by audit firm, we examine the relation between industry market share and

industry characteristics separately for each of the Big 6 auditors and find distinct differences. For

example, even the relationships between market share and industry regulation or concentration

appear to be different across Big 6 firms.

In summary, it appears that audit firms are making efforts to increase their levels of

specialization and are meeting with varying degrees of success. Concentration in nonregulated

industries has lagged concentration in regulated industries, but appears to be gaining ground.

Heavier auditor concentration in industries characterized by relatively low litigation risk, rapid

growth, and relatively large clients suggests that market leaders may be focusing their

specialization efforts to a greater degree on these industries. Evidence of an increasing level of

industry specialization by auditors is consistent with a view of the market for audit services as a

21
mature industry, and the trend toward specialization as an effort at product differentiation. As

concluded at a recent CPA Vision Project Forum, “It is in the arena of identifying market

opportunities that did not previously exist that CPAs will need to apply new specialized

skills...”(The CPA Letter, April 1998, 12).

22
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25
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 REFERENCES

American Institute of Certified Public Accountants (AICPA). 1978. The commission on auditors’
responsibilities, report, conclusions and recommendations (The Commission on
Auditors’ Responsibilities).

__________________. 1998. CPA vision project identifies top five issues for profession. The
CPA Letter 78 (April): 1,12.

Arnett, H.E., and P. Danos. 1979. CPA Firm Viability. University of Michigan.

Bohn, J., and S. Choi. 1996. Fraud in the new issues market: Empirical evidence on securities class actions

Chaney, P., D. Jeter, and P. Shaw. 1997. Client-auditor realignment and restrictions on auditor
solicitation. The Accounting Review 72 (July): 433-454.

Craswell, A., J. Francis, and S. Taylor. 1995. Auditor brand name reputation and industry
specializations. Journal of Accounting and Economics 20 (December): 297-322.

Danos, P., and J. W. Eichenseher. 1982. Audit industry dynamics: Factors affecting changes in client-indust

Eichenseher, J. W., and P. Danos. 1981. The analysis of industry-specific auditor concentration:
Towards an explanatory model. The Accounting Review 56 (July): 479-492.

Financial World (September 27, 1994). The deal for the future?: 45-46.

Kwon, S.Y. 1996. The impact of competition within the client’s industry on the auditor selection
decision. Auditing: A Journal of Practice & Theory 15 (Spring): 53-70.

McDonald, E., J.S. Lublin, and C. Goldsmith. 1998. Ernst & KPMG cancel merger, citing
regulatory, cultural issues. Wall Street Journal Europe (February 16): 3.

Minyard, D.H., and R.H. Tabor. 1991. The effect of Big 8 mergers on auditor concentration. Accounting Ho

O’Brien, V. 1997. A study of class action securities fraud cases 1988-1996. Law &
Economics Consulting Group, Inc. Emeryville, CA.

Palmrose, Z. 1986. Audit fees and auditor size: Further evidence. Journal of Accounting
Research 24 (Spring): 97-110.

___________. 1988. An analysis of auditor litigation and audit service quality. The Accounting
Review 63 (January): 55-73.

28
St. Pierre, K., and J.A. Anderson. 1984. An analysis of the factors associated with lawsuits
against public accountants. The Accounting Review 59 (April): 242-263.

Starry, C., and N.W. McGaughey. 1993. Growth industries: Past, present, and future. Journal of Business and

Stice, J.D. 1991. Using financial and market information to identify pre-engagement factors
associated with lawsuits against auditors. The Accounting Review 66 (July). 516-534.

Tonge, S., and C. Wootton. 1991. Auditor concentration and competition among the large public
accounting firms: Post-merger status and future implications. Journal of Accounting and
Public Policy 10 (Summer): 157-172.

Weiss, L., and M. Klass. 1986. Regulatory Reform: What Actually Happened. Little, Brown and
Company.

White, H. 1980. A heteroskedasticity-consistent covariance matrix estimator and a direct test for
heteroskedasticity. Econometrica (May): 817-838.

Wootton, C. W., S. Tonge, and C. Wolk. 1994. Pre and post Big 8 mergers: Comparison of auditor concen

29
 TABLE 1
Descriptive Statistics

Standard
Variables n* Mean Median Deviation Minimum Maximum
NOF 1044 91.420 56.000 109.705 10.000 529.000
ACR3kt 1044 0.643 0.632 0.103 0.363 0.952
Hkt 1044 0.208 0.193 0.054 0.145 0.499
MSikt 6059 0.151 0.134 0.093 0.000 0.688
CCR4kt 1044 0.279 0.226 0.161 0.055 0.796
REGk 1044 0.259 0.000 0.438 0.000 1.000
MEANSIZEkt 1044 15.511 11.195 12.788 1.300 87.795
GROWTHkt 1044 0.155 0.000 0.362 0.000 1.000
SPECik 6059 0.570 1.000 0.495 0.000 1.000
NSPECk 1044 3.517 3.000 2.208 0.000 6.000
LITRISKk 1044 0.103 0.000 0.305 0.000 1.000

*
1,044 observations= 58 two-digit SIC code industries times 18 years; 6,059 observations = 58 two-digit SIC code
industries times 18 years times 6 audit firms (less 205 observations with zero market share).
NOF = the average yearly number of client firms per industry over the 18-year period
ACR3kt = the three-firm auditor concentration ratio for industry k in year t
Hkt = the Herfindahl index for industry k in year t
MSikt = the market share of auditor i in industry k in year t
TIME = a linear time effect variable
CCR4kt = the four-firm industry concentration ratio in year t
REGk = 1 if industry k is regulated, and 0 otherwise
MEANSIZEkt = the average size, measured by the square root of total assets (measured in millions), of all the firms in
industry k in year t
GROWTHkt = 1 if industry k is a high growth industry in year t, 0 otherwise
SPECik = 1 if auditor i is a specialist in industry k, and 0 otherwise
NSPECk = the number of Big 6 firms claiming to be a specialist in industry k
LITRISKk = 1 if industry k is a high litigation-risk industry, and 0 otherwise

30
 TABLE 2
Focus Industries of Big 6 Firms

Firm/Key Industries SIC Codes Firm/Key Industries SIC Codes

Arthur Andersen Ernst & Young

Communications 48 Consumer Products 20-33
Financial Services 60,62-64,67 Financial Services 60,62,67
Government 91-97 Health Care 80
Health Services 80 Info, Communic & 48,73,78
Entertnmt
Products 20-39 Insurance 63,64
Utilities 49 Manufacturing 34-39
Real estate/Construction 15-17
Coopers & Lybrand
Energy, Util & Nat Res 10-14,49 KPMG Peat Marwick
Engineering & 15-17,87 Financial Services 60,62-64,67
Construction
Financial Services 60,62-64 Health Care & Life 80
Sciences
Government Contracting 91-97 Info, Commun & 48,73,78
Entertmnt
Health Care 80 Mfg, Retailing & Distrib 20-39,52-59
Information/Communicatio 48,73,78 Public Services 91-97
n
Manfturing, incl high tech 20-39
Real Estate 65,70 Price Waterhouse
Retail/Wholesale 50-59 Financial Services 60,62-64,67
Transportation 40- Products 20-39
42,44,45,47
Venture Capital 67 Energy 49
Entertmnt, Media & 48,70,78,79,8
Comm 4
Deloitte & Touche
Aerosp, Auto & Defense 37
Mfg
Construction 15-17
Financial Services 60,62-64,67
Food and Consumer Prods 20-33
Health Care 80
High Tech/Electronic Svcs 35,36,38

31
 Higher Education 82
Mfg Consulting Services 87
Public Sector 91-97
Public Utilities 49
Real Estate 65,70
Telecommunications 48
TRADE/Retail and Distrib 52-59

where:
Focus industries = the industries identified by the Big 6 firms on the World-Wide Web as focus industries

32
 TABLE 3
Test of Auditor Concentration

ACR3kt = β0 + β1TIME + β2REGk + β3REGk*TIME + β4CCR4kt

+ β5LITRISKk+ β6MEANSIZEkt + β7GROWTHkt + β8NSPECk + _

Variable Coefficient* Std Error* p-value (two-tailed)*

Intercept 0.475 0.011 0.001
TIME 0.003 0.001 0.001
REG 0.068 0.014 0.001
REG*TIME -0.004 0.001 0.004
CCR4 0.273 0.022 0.001
LITRISK -0.041 0.007 0.001
MEANSIZE 0.002 0.001 0.001
GROWTH 0.033 0.006 0.001
NSPEC 0.006 0.001 0.001
Adjusted R2 0.30

*
This table contains estimated regression coefficients with White’s (1980) heteroskedasticity-
adjusted standard errors and p-values.

n= 1,044 industry-years
ACR3kt = the three-firm auditor concentration ratio in year t
TIME = a linear time effect variable
REGk = 1 if industry k is regulated, and 0 otherwise
REGk*TIME = the interaction of REGk and TIME defined above
CCR4kt = the four-firm industry concentration ratio in year t
MEANSIZEkt = the average size, measured by square root of total assets (measured in
millions), of all firms in industry k in year t
GROWTHkt = 1 if industry k is a high growth industry in year t, 0 otherwise
LITRISKk = 1 if industry k is a high litigation-risk industry, and 0 otherwise
NSPECk = the number of Big 6 firms claiming specialization in industry k

33
 TABLE 4
Regression Coefficients from Tests for Trends in Auditor Market Share
(p-values)*

MSikt = γ0i + γ1iTIME + γ2iCCR4kt + γ3iREGk + γ4iLITRISKk + _

Market Share Category Int TIME CCR4 REG LITRISK Adj R2

at beginning of year
Top Third (n=1,928) .184 .002 .102 .019 -.018 0.06
(.001) (.001) (.001) (.001) (.001)
Middle Third (n=1,961) .118 .001 .016 .004 .010 0.01
(.001) (.001) (.155) (.116) (.001)
Bottom Third (n=1,785) .096 -.001 -.049 -.006 0.015 0.05
(.003) (.057) (.001) (.036) (.001)

*
This table contains estimated regression coefficients with White’s (1980) heteroskedasticity-
adjusted p-values in parentheses.

MSikt = the market share of auditor i in industry k in year t

TIME = a linear time effect variable
CCR4kt = the four-firm industry concentration ratio in year t
REGk = 1 if industry k is regulated, and 0 otherwise
LITRISKk = 1 if industry k is a high litigation-risk industry, and 0 otherwise

34
 TABLE 5
Audit Firms Considered Specialists in Selected Industries
(A Comparison to Palmrose (1986) study)

Palmrose 1979-1980
Industry Specialists* 1988 Specialists* 1993 Specialists*
Beverages-Liquor PW PMM, TR DT
Office Equipment PW, PMM EW EY
Railroad DHS, PW PW, CL, EW PMM, CL, EY
Trucking AA, TR, EW AA, TR, EW AA, DT, EY
Air AA AA, AY, EW AA, EY
Telephone Comm. CL CL CL
Electric Utilities AA, DHS AA, DHS AA, DT
Gas Utilities AA AA AA
Combo Utilities DHS, AA AA, DHS, PW AA, DT, PW
Retail Trade (food) PMM PMM, TR DT, CL
Savings and Loans PMM ** **
Lodging AA AA AA

* Consistent with Palmrose (1986), industry specialists are the largest supplier in the industry, plus the second and third
largest suppliers in industries in which there are observable differences between the second and third or third and
remaining firms.
**Insufficient observations are available to determine the industry specialist (our sample is limited to publicly-traded
client firms, whereas Palmrose’s sample includes both public and nonpublic firms)
AA = Arthur Andersen; AY = Arthur Young; CL = Coopers & Lybrand; DHS = Deloitte, Haskins & Sells; DT = Deloitte
& Touche (after the 1989 merger); EW = Ernst & Whinney; EY = Ernst & Young (after the 1989 merger); PMM = KPMG
Peat Marwick; PW = Price Waterhouse; TR = Touche Ross

35
 TABLE 6
Regression Coefficients from Tests of Industry Focus and Market Share
(p-values)*

MSikt = γ0i + γ1iTIME + γ2iCCR4kt + γ3iREGk + γ4iLITRISKk

+ γ5iSPECik + γ6iNSPECk + γ7iTIMESPECik + _

Big 6 LIT N TIM

Firm** n Int TIM CC REG RISK SPE SPEC ESP Adj R2
E R4 C EC
AA 1036 .115 .003 .009 .022 -.019 .023 .006 - 0.03
(.00 (.001 (.72 (.00 (.013 (.208 (.037) .002
1) ) 0) 1) ) ) (.05
6)
C&L 979 .086 -.001 .014 .046 -.037 -.038 .012 .001 0.12
(.00 (.803 (.56 (.00 (.001 (.010 (.001) (.50
1) ) 5) 1) ) ) 8)
D&T 1036 .219 -.002 - .015 -.009 .026 -.015 .002 0.06
(.00 (.024 .040 (.05 (.152 (.043 (.001) (.03
1) ) (.10 0) ) ) 9)
8)
E&Y 1036 .183 .001 - - -.036 .065 -.011 .002 0.09
(.00 (.207 .006 .014 (.001 (.001 (.001) (.06
1) ) (.78 (.01 ) ) 2)
7) 5)
KPM 1020 .124 .002 .125 - .083 -.030 -.010 .001 0.21
G (.00 (.007 (.00 .006 (.001 (.013 (.001) (.46
1) ) 1) (.22 ) ) 2)
5)
PW 952 .108 .000 .018 - 0.014 .047 -.002 - 0.03
(.00 (.651 (.50 .009 (.045 (.001 (.263) .001
1) ) 0) (.18 ) ) (.17
5) 1)
Non- 1037 .217 -.007 .053 - .014 - -.010 - 0.21
Big 6 (.00 (.001 (.03 .042 (.078 (.001)
1) ) 1) (.00 )
1)
*
This table contains estimated regression coefficients with White’s (1980) heteroskedasticity-
adjusted p-values in parentheses.
**
AA = Arthur Andersen, C&L = Coopers and Lybrand, D&T = Deloitte and Touche, E&Y =
Ernst and Young, KPMG = KPMG Peat Marwick, PW = Price Waterhouse
MSikt = the market share of auditor i in industry k in year t
TIME = a linear time effect variable
CCR4kt = the four-firm industry concentration ratio in year t
REGk = 1 if industry k is regulated, and 0 otherwise
LITRISKk = 1 if industry k is a high litigation-risk industry, and 0 otherwise
SPECik = 1 if auditor i is a specialist in industry k, and 0 otherwise
NSPECk = the number of Big 6 firms claiming specialization in industry k
TIMESPECik = the interaction of TIME and SPECik

ENDNOTES

1. Results of prior studies examining the link between industry specialization and factors

reasonably expected to be influenced by such specialization have been mixed. Palmrose (1986)

uses industry specialization as a control variable in examining determinants of audit fees. She

argues that audit fees of industry specialists may be higher if specialists provide higher quality

services; however, no association is found between audit fees and specialization. Similarly,

Chaney, Jeter, and Shaw (1997) include industry specialization as a control variable in examining

client-auditor realignment, arguing that clients may switch to an auditor regarded as a specialist

in their industry, and find no significant association. In contrast to the Palmrose (1986) study,

Craswell, Francis and Taylor (1995) present evidence that, for a sample of Australian companies,

industry specialist Big 8 auditors earn a premium over nonspecialist Big 8 auditors.

2. We refer to the Big 6 firms throughout the paper because our time period ends prior to the merger

between Price Waterhouse and Coopers & Lybrand.

3. It seems likely that specialization in audit services may facilitate or feed specialization in non-

audit services.
4. For example, Ernst & Young LLP claims, in its home page, to be the “leader in serving the

following industries...,” while KPMG Peat Marwick LLP lists “five lines of business” in its home

page. See table 2 for a listing by auditor. Since Web site listings were not available for the early years

of our analysis, we extend available listings from more recent years into previous years. This

limitation is discussed further in the results section.

5. Arguments to the contrary include the possibility that highly concentrated client industries may

be more complex, and the auditor expertise of industry specialists may be more valuable in such

cases. Further, as argued by Eichenseher and Danos (1981), higher auditor concentration levels are

expected in industries with higher levels of client concentration, ceteris paribus, as there is a one-to-

one mapping of buyers to sellers of audit services.

6. We repeat our analysis using alternative classifications of high-risk industries based on other

studies which examine auditor litigation in particular (Palmrose 1988; Stice 1991; St. Pierre and

Anderson 1984). Results are qualitatively identical to those presented.

7. An alternative measure of auditor concentration is a Herfindahl index. Similar to Eichenseher and

Danos (1981), we find a significant positive correlation between the Herfindahl index calculated by

industry, and the three-firm auditor concentration ratio (.62, p-value<.001). We present the tests and

results using the auditor concentration ratio as the dependent variable due to ease of interpretation.

8. Studies frequently used a four-firm auditor concentration ratio to measure auditor concentration

prior to the mergers of the Big 8 firms. Since we use six audit firms throughout our study, it seems

reasonable to focus on a three-firm concentration ratio. However, we repeat our tests using four-firm
ratios with similar results.

9. Since all non-Big 6 auditors are treated as a single category, the mean market share is higher than

would be the case if the market shares of non-Big 6 auditors were computed individually.

10. We classify firms in the following two-digit SIC codes as regulated using two sources, a listing

provided in Regulatory Reform: What Actually Happened, and Danos and Eichenseher (1982): 10

(Metal mining), 12 (Coal mining), 13 (Oil and gas extraction), 14 (Mining and quarrying of

nonmetallic minerals), 20 (Food and kindred products), 29 (Petroleum refining and related

industries), 40 (Railroad transportation), 41 (Transit, passenger transportation), 42 (Motor freight

transportation), 44 (Water transportation), 45 (Air transportation), 46 (Pipelines, except natural gas),

48 (Communications), 49 (Electric, gas and sanitary services), 60 (Depository institutions), 61

(Nondepository credit institutions), 62 (Security and commodity brokers, dealers), 63 (Insurance

carriers), 64 (Insurance agents, brokers, and service), and 67 (Holding and other investment offices).

Based on prior research (Bohn and Choi 1996; O’Brien 1995), we classify firms in the following

two-digit SIC codes as relatively high litigation-risk industries: 28 (Chemicals and allied products),

35 (Industrial and commercial machinery and computer equipment), 36 (Electronic and other

electrical equipment and components, except computer equipment), 38 (Measuring, analyzing, and

controlling instruments), 60 (Depository institutions), 67 (Holding and other investment offices), and

73 (Business services).

11. Based on a study by Starry and McGaughey (1993), who identify the top twelve industries over

five consecutive five-year periods in terms of sales growth, we classify the following industries (two-

digit SIC codes) as rapid growth industries during the periods listed: 1976-1981 29, 35, 46, 49, 59,
60, 62, 73, 80; 1980-1984 35, 36, 59, 60, 62, 73, 80; 1982-1986 36, 37, 53, 56, 59, 60, 62, 63, 80;

and 1987-1993 35, 45, 48, 49, 52, 57, 73, 78, 80.

12. The market share values were calculated including the non-Big 6 auditors as a group; however,

we eliminated this group if it appeared in the top three market share levels that constitute ACR3k.

Subsequent to 1988 (when Compustat began to code non-Big 8 auditors separately), there was only

one non-Big 6 auditor ranked in the top three market shares in any industry.

13. We also employ alternative tests to consider the possibility that trend has varied over time,

including a fixed effects model. Comparing each year in our test period to the year 1976, we find

evidence that every year after 1976 exhibits higher concentration levels, significantly so beginning

in 1988.

14. Kwon’s measures of auditor dominance are as follows:

Install Equation Editor and double-

click here to view equation.
where k=1,2,...,K is an index for client industries; Ik=the number of audit firms in industry k; Jik=the

number of clients served by audit firm i in industry k; Jk=Σi=1Ik Jik/Ik.

15. We alternately classify auditor market share by fifths to consider the sensitivity of the results to

our definition of expertise or specialization. We find that our results are robust; specifically, we find

evidence of an increase in market share by leaders (top fifth) and a decline in share in the bottom

fifth.

16. For example, when we add the variables MEANSIZE and GROWTH to regression equation

(4), they are both positive and significant for the top third of the market share sample, suggesting that
 market leaders have greater share in industries characterized by large firms and by relatively rapid

growth. The coefficient on GROWTH is significantly negative for the middle third sample, and not

significant for the bottom third. The coefficient on MEANSIZE is not significant in the middle or

bottom third. Adding these variables does not alter the sign or significance levels of the results

reported in table 4.

17. To consider the potential impact of merger activity within industries on our classifications and

tests, we searched the EconLit database for “declining industries” and “industries and mergers.”

Those industries mentioned most often as declining (in number of firms) due to mergers were

railroads, airlines, steel and garment manufacturers. We estimate regression equation (3) with an

additional variable set equal to one for these industries and an interactive term between this variable

and TIME. The first coefficient is significantly positive, the coefficient on the interactive term is

significantly negative, and all other results are robust. This suggests that the heavier client

concentration in these industries leads to higher auditor concentration, but that auditors may have

shifted their focus away from these industries over time.

18. For the non-Big 6 firm regression, we omit the variables SPEC and SPEC*TIME since we do

not have any information available on the target industries of these firms.

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