Ji, Et Al (2019)

ACCOUNTING HORIZONS American Accounting Association
Vol. 33, No. 1 DOI: 10.2308/acch-52350

March 2019
pp. 125–152
Does the Market Value Auditors’ Industry Specializations?

Evidence from the Contagion Effects of Restatements
Amy E. Ji
Saint Joseph’s University
Krishna R. Kumar
The George Washington University
Hang Pei
California State University, San Bernardino
Yanfeng Xue
The George Washington University
SYNOPSIS: This study investigates whether auditors’ industry specializations are valued by the capital market. By
using a quasi-experimental research design, we control for the confounding effects of auditor choices, which are
often found in prior studies. Specifically, we examine whether an auditor’s non-restating audit clients suffer collateral
damage from restatements of the same auditor’s other clients. If an auditor’s industry specialization is valued by the
market, the contagion effect should be greater for clients of industry specialist auditors. We find that the non-restating
clients of city-level industry specialists whose other clients issue restatements experience 0.8 percent abnormal
returns around restatement announcements. For national industry specialists, we find negative market reaction to
the auditors’ non-restating clients only when the restatements convey severe negative signals. Overall, the evidence
is consistent with the notion that auditors’ reputations as national- and city-level specialists are priced at a premium in
the capital markets.
Keywords: auditor specialization; market valuation; restatements; contagion effect.
I. INTRODUCTION
I
n this study, we re-examine whether auditors’ industry specializations are priced in the capital market. Prior empirical
evidence on the value creation of auditor industry specialization is often confounded by the endogeneity problem caused
by the self-selection between auditors and their clients. Auditors and clients choose each other based on client and auditor
characteristics that may not be observable to researchers, making it difficult to draw a causal relation between market reaction
and auditor choices. To control for the confounding factors, we use a quasi-experimental research design and study the
contagion effect of restatements when non-restating firms are audited by the industry specialist auditor that also audits the
restating firms.
Auditor industry specialization is a crucial factor contributing to audit quality and has been studied extensively by prior
literature. Prior studies find that industry specialization improves auditors’ abilities to assess audit risk and detect misstatements
(Owhoso, Messier, and Lynch 2002; Low 2004). Prior literature also documents that industry specialists’ clients have higher
We thank workshop participants at The George Washington University, the 2015 AAA Mid-Atlantic Region Meeting, and the 2017 Pan-Pacific Business
Research Conference for helpful comments and suggestions. We also appreciate the comments and suggestions from Professor Jagan Krishnan (editor) and
two anonymous reviewers.
Our co-author, also mentor and dear friend, Professor Krishna Kumar, passed away in 2014. We dedicate this paper to the memory of Krishna.
Editor’s note: Accepted by Jagan Krishnan, under the Senior Editorship of Teri Lombardi Yohn.
Submitted: March 2017
Accepted: October 2018
Published Online: January 2019
125
126 Ji, Kumar, Pei, and Xue
reporting quality as demonstrated by lower discretionary accruals and lower likelihood to meet or beat analysts’ consensus
forecasts by a small margin (Balsam, Krishnan, and Yang 2003; Krishnan 2003; Lim and Tan 2008; Reichelt and Wang 2010).
Given these benefits, audit clients of industry specialists should be priced at a premium by rational investors. Previous
auditing literature found support for this prediction. For example, Balsam et al. (2003) find that investors are more responsive to
earnings news of firms audited by industry specialists. Knechel, Naiker, and Pacheco (2007) find that stock markets respond
positively (negatively) when companies switch to an industry specialist (non-specialist) auditor. However, recent literature
argues that the study of industry specialization is often confounded by audit clients’ characteristics (Minutti-Meza 2013). At the
core of the issue is the endogeneity problem inherent to the voluntary matches between auditors and clients. Hence, we re-
examine the relation between auditor’s industry specialization and the pricing of audit clients with a unique quasi-experimental
research design. We focus on the contagion/spillover effect of financial report restatements (Gleason, Jenkins, and Johnson
2008; Francis and Michas 2013; Irani, Tate, and Xu 2015). Specifically, we identify the restating companies’ auditors during
the restated periods. We then construct a sample of the auditors’ non-restating clients at the time of restatement announcement
and test whether these clients suffer collateral damage from the restatements.1 Our prediction is that a severe audit failure such
as a restatement will damage an auditor’s reputation as an industry specialist, which, in turn, will negatively affect the auditor’s
other clients. If auditors suffering from their clients’ restatements are no longer perceived as industry specialists, our design is
in spirit the same as testing the effects of forced switching from specialists to non-specialists.2 As the ‘‘switches’’ are forced
upon the non-restating clients, we control for the endogeneity problem in auditor choices.
We find that the average three-day cumulative abnormal returns around restatements of the non-restating clients of city-
level specialists are 0.8 percent. However, we do not find a similar negative market reaction to non-restating clients of
national industry specialists. There are at least two alternative explanations for the results: (1) the clients of national specialists
do not enjoy the price premium as city-level specialists do or (2) an average restatement does not cause detectable damage to a
national specialist’s reputation. To evaluate these alternatives, we perform cross-sectional analyses conditional on the severity
of the restatements. We find that the market reaction to the non-restating clients of national specialists is significantly negative
when (1) the restatements are due to fraud, (2) the restating firms experience large stock price declines, or (3) the restating firms
are relatively large. We also show that the market reaction to city-level specialists’ clients is more negative when the
restatements involve fraud. These results are consistent with the notion that an auditor’s reputation as an industry specialist at
both the national- and city-levels is priced at a premium. In addition, the specialist reputation at the national-level seems to be
more resistant to negative news events than that at the city-level. One potential concern with our findings is that they’re driven
by the similarities among the clients of a specialist auditor. We conduct a battery of robustness tests and the results hold.
However, we acknowledge that it’s impossible to completely control for all the similarities and our results could still be
affected by the similarities among specialist auditors’ clients.
Our study makes several important contributions to the auditing literature. First, we confirm and consolidate the previous
documented positive relation between auditor industry specialization and clients’ stock market valuations. Our unique quasi-
experimental research design controls for the endogeneity problem in auditor choices. Our evidence also contributes to the
ongoing debate on whether investors value higher audit quality (e.g., Donovan, Frankel, Lee, Martin, and Seo 2014). Second,
we provide evidence validating the widely used measure of industry specialization based on within-industry market share.
Although recent studies question the validity of the measure (Lawrence et al. 2011; Minutti-Meza 2013), we find that investors’
initial assessments of auditor specialization are positively correlated with an auditor’s within-industry market share. However,
our results also demonstrate that investors do not fixate on the market share-based measure and subsequently adjust their
perception by incorporating additional signals, such as financial restatements. Third, we find interesting differences between
investors’ reactions to national specialists’ reputation damage and those to city-level specialists’ reputation damage. Our results
are consistent with investors adjusting their valuation of city-level specialization for all non-clerical restatements whereas the
valuation adjustments to national specialists occur only for severe or high-profile restatements.
Last, this study contributes to our understanding of restatements’ contagion effects. Consistent with prior literature
(Gleason et al. 2008), we show that restatements, as a type of severe accounting failure, have far-reaching impacts on firms that
are not directly involved. Our focus is different from that of Gleason et al. (2008). While they find non-restating firms face
share price declines when peer firms in the same industry issue restatements, we show that, in samples of same-industry firms,
non-restating firms hiring an industry specialist auditor whose other clients issue restatements suffer additional losses.
1
As our focus is on restatement’s effect on an auditor’s industry reputation, we require the non-restating clients to be in the same industry as the restating
ones.
2
Companies may restate their financial reports for technical reasons such as to comply with new accounting/audit regulations. We exclude restatements
due to clerical errors and that do not involve fraud or accounting issues from our sample.
Accounting Horizons
Volume 33, Number 1, 2019
Does the Market Value Auditors’ Industry Specializations? Evidence from the Contagion Effects of Restatements 127
The rest of the paper is organized as follows. Section II presents literature review and hypothesis development. Section III
describes the research design. Section IV describes the sample and present descriptive statistics. Section V presents empirical
results and Section VI concludes.
II. PRIOR LITERATURE AND HYPOTHESES
Audit Quality, Industry Specialization, and Capital Market Pricing

Auditors provide crucial validation of the credibility of manager-prepared financial statements. High-quality audits
improve the quality of financial reports and help reduce agency costs between shareholders and managers (Jensen and
Meckling 1976; Watts and Zimmerman 1983). It is therefore important to understand the determinants of audit quality. Early
auditing literature often uses auditors’ size or brand name (Big N versus non-Big N) as a proxy of audit quality (DeAngelo
1981; Beatty 1989; Simunic 1980; Palmrose 1988; Dye 1993; Teoh and Wong 1993; Becker, DeFond, Jiambalvo, and
Subramanyam 1998; Lennox 1999). Later studies investigate the relation between audit quality and auditor industry
specialization and the evidence generally supports the positive association between the two. For example, Craswell, Francis,
and Taylor (1995) find that specialist auditors earn a fee premium over non-specialists, consistent with the notion that clients
pay more to acquire higher quality services from the specialists. Owhoso et al. (2002) find that specialists have greater ability to
detect errors in their specialized industries. Balsam et al. (2003) and Krishnan (2003) document lower discretionary accruals, an
indication of high earnings quality, for clients of specialist auditors.
More recent studies also examine auditor industry specialization at both city-level (or local offices) and national-level (or
firm-wide). The city-level perspective assumes that (1) industry expertise develops and resides in the human capital of local
office personnel and (2) at least some of this expertise is non-transferable across regions. The national specialization, on the
other hand, captures the transferrable part of the industry knowledge and expertise (e.g., through training programs, movement
of personnel across local offices and auditor firms, etc.) (Ferguson, Francis, and Stokes 2003). Ferguson et al. (2003) and
Francis et al. (2005) document that the audit fee premium for specialist auditors is primarily caused by specialization at the city-
level. Reichelt and Wang (2010) find that joint national- and city-level specialists’ clients have lower discretionary accruals and
are more likely to receive going-concern opinions.
If auditor industry specialization improves audit clients’ financial reporting quality, it is expected that, in an efficient capital
market, investors will price specialist auditors’ clients at a premium. Balsam et al. (2003) find that earnings response
coefficients (ERCs), a measure of investors’ reaction to earnings news, are higher for the clients of specialist auditors than for
those of non-specialists. However, a recent study suggests that client characteristics may confound the relation between auditor
market share and clients’ earnings quality (Minutti-Meza 2013). In particular, client characteristics may be the underlying
determinants of audit clients’ earnings quality and their choice of auditors.
Another stream of literature examines the market reaction to auditor switches. For example, Knechel et al. (2007) find that
switching to (from) specialist auditors from (to) non-specialists is associated with a significant positive (negative) market
reaction, consistent with the notion that industry specialization is priced at a premium in stock markets. The research design
effectively uses the switching firms as their own control and reduces the impact of observable characteristics. However, the
decision to switch auditors may also reveal previously unobserved characteristics of the switching firm, involved auditors, and/
or the relationships between parties (e.g., risk assessment of the client). The unobserved characteristics were not (perfectly)
priced and the stock prices would be adjusted with such revelations. As a result, the market reaction to auditor switches cannot
be unambiguously attributed to changes in industry specialization. To control for the confounding effects, we identify a setting
where the auditor ‘‘switches’’ are exogenous and therefore should not be associated with unobserved characteristics of the
‘‘switching’’ firms.
The Contagion Effect of Restatements and Hypothesis Development

Financial restatements are often viewed as a severe type of financial reporting failure and may result in serious capital
market consequences for the restating firms (Palmrose, Richardson, and Scholz 2004; Hennes, Leone, and Miller 2008).
Moreover, financial restatements raise litigation risk for the restating firms (Palmrose and Scholz 2004) and increase the chance
of top executive turnovers (Hennes et al. 2008).
Recent studies show that restatements have a contagion/spillover effect on non-restating firms. Gleason et al. (2008) find
that firms operating in the industry of restating firms suffer a mean abnormal return of 0.5 percent around restatement
announcements. Francis and Michas (2013) find that non-restating firms hiring the auditors of restating firms have high
discretionary accruals during the restated period and such effect persists for up to five subsequent years. Swanquist and Whited
(2015) document that local audit offices’ market share declines following their clients’ restatement announcements, and Irani et
Accounting Horizons
al. (2015) found that non-restating clients suffer negative market returns and are more likely to dismiss their auditors after
restatements, both consistent with auditors’ reputations being tainted by restatements.
Although closely related, our paper is significantly different from prior literature on restatement’s contagion effects. We
use the contagion effect as a quasi-experimental setting to examine a different research question: does the capital market value
auditors’ industry specializations? If the capital market values auditors’ industry specializations, the industry specialists’ clients
should be valued at a premium by investors in the capital market prior to the restatements. A restatement in an auditor’s
specialized industry, however, is inconsistent with the high-quality services expected from auditors with industry expertise.
Therefore, we predict that the clients of specialist auditors will experience additional negative market reaction around the
announcements of such restatements, reflecting impairment to the auditor’s reputation as a specialist. Note that this impairment
of reputation affects not only restating clients but also non-restating ones. Our analysis focuses on market reactions to the non-
restating clients, i.e., the contagion effects of the restatements.
The non-restating clients provide a cleaner setting for the following reasons. First, for the restating client, it is difficult to
isolate the impact from the specialist auditor’s reputational damage. The impact from the restatement itself is the first order
effect triggering the market reaction and we usually do not have enough data to sufficiently control for the underlying causes of
the restatements. Furthermore, the underlying causes may be correlated with auditor specialization. For example, among firms
with restatements, the clients of specialist auditors may have less economically damaging restatements. Second, even if we can
isolate the impact from an auditor’s reputation damage on restating firms, the effect may not be straightforward. On one hand,
the market will react negatively to the reputation damage. On the other hand, among restating firms, the market may hope that
the specialized auditors can handle the situation better (no additional restatements, smaller regulatory consequences etc.).
Market participants may also hope to recover the loss from auditors, and specialist auditors are usually larger and can provide
more insurance for such losses. Finally, for non-restating clients, since there are no other obvious events related to audit quality,
we can more safely infer that any market reaction is due to the contagion effect and therefore from the auditor’s reputational
impact.
In our setting, a non-restating client is a company that (1) is served by the same auditor as the restating client and (2)
operates in the same industry as the restating client. Because the auditor’s industry specialist reputation is industry-specific, we
focus on the non-restating firms in the same industry as the restating ones. We do not have a priori reason why a client in a
different industry should be affected. For instance, we do not expect the damage to an auditor’s computer-industry-specific
reputation would affect its clients in the food industry. We will discuss the details of identifying the auditor and the restating
and non-restating clients in Sections III and IV.
Our primary interest is in testing the markets’ pricing of auditor industry specialization. Focusing on the contagion effects
of restatements helps control for the previously discussed endogeneity problem in auditor choices. Intuitively, our analysis is
similar to testing the effect of forced auditor switches (from industry specialists to non-specialists), where the ‘‘switches’’ in our
setting are involuntary rather than by choice for the non-restating clients. Below, we state our first hypothesis about the
contagion effects of the impairment to an auditor’s industry specialization reputation.
H1: The market reacts more negatively to the non-restating clients of industry specialist auditors compared with non-
restating clients of non-specialist auditors around the restatement announcement dates.
We examine auditor industry expertise at both the national- and city-levels. To test the impairment of city-level industry
specialist reputation, we focus on the non-restating clients having the same local audit offices as the restating firms.3 We refer to
these non-restating clients as the same-city clients. We do not have a priori reason to expect that the damage of an auditor’s
city-level reputation will affect its non-local clients.
The contagion effects of restatements are likely to vary depending on the nature of the restatements involved. We use three
different measures to gauge the severity of the restatements’ impact on auditors’ reputations as industry specialists. And as in
H1, we examine the industry expertise at both the national- and city-levels.
First, we distinguish the restatements that involve fraud/irregularities from those related to unintentional misapplications of
GAAP. Prior studies find that the market reactions to restating firms are more negative for restatements that involve fraud than
those that do not (Palmrose et al. 2004; Hennes et al. 2008). Auditors are charged with ensuring the integrity of financial
statements. Fraud indicates an auditor’s failure in performing this important task and we therefore predict that fraudulent
restatements will be more damaging to auditors’ reputations as industry specialists and lead to larger stock price declines for the
non-restating clients. An alternative view is that fraud is idiosyncratic and hard to uncover, and auditors may not be punished
3
We define local offices at the Metropolitan Statistical Area (MSA) level, i.e., an audit firm’s offices within the same MSA city code are grouped together
as one office.
Accounting Horizons
more for failing to detect management’s wrongdoing compared to errors in routine accounting treatment. It is an empirical
question whether a fraud causes greater reputational damage to specialist auditors.
H2: Market reactions to the non-restating clients of the industry specialists are more negative when the restatements
involve fraud than when they do not.
Second, following Gleason et al. (2008), we use the intensity of the market reactions to the restating clients as a proxy for
the severity of restatements. A larger market reaction to the restating clients should lead to a stronger contagion reaction to the
non-restating clients as the restatements are perceived to be more severe by investors.
H3: Market reactions to the non-restating clients of the industry specialists are more negative when the market reactions to
the restating clients are more negative.
Third, Gleason et al. (2008) document that the restatements of large firms cause greater contagion effects. The restatements
of large firms are more visible events and could lead to greater damage to an auditor’s industry specialization reputation.
Therefore, we hypothesize that non-restating clients will face larger stock price declines when larger firms in the industry
restate.
H4: Market reactions to the non-restating clients of the industry specialists are more negative when the sizes of restating
clients are larger.
III. RESEARCH DESIGN
Measuring Industry Specializations

Following prior literature (Ferguson et al. 2003; Francis et al. 2005; Reichelt and Wang 2010), we use auditors’ within-
industry market shares to proxy for investors’ initial assessments of auditor industry specialization. An auditor’s within-
industry market share is calculated by dividing the auditors’ total audit fees earned from a given industry by the sum of all
auditors’ fees earned from the same industry:
P
jk Audit Feei;jk
Market Sharei;k ¼ P P
i jk Audit Feei;jk
where subscript i denotes an auditor and jk denotes a client of the auditor from industry k. We define industry using two-digit
SIC codes in the main tests and use alternative industry classification methods in sensitivity analyses.
Additionally, following prior literature (Ferguson et al. 2003; Francis et al. 2005; Reichelt and Wang 2010), we define a
national- (city-level) industry specialist as the auditor with the highest within-industry market share nationwide (within a city
area). We define a city as a Metropolitan Statistical Area (MSA) designated by the U.S. Census Bureau. Smaller local offices of
an auditor with the same MSA code are grouped together and treated as one office.
Our event study design needs to capture market reactions to the change in an auditor’s reputation as an industry specialist
around a restatement announcement. It is therefore important to measure the auditor’s industry specialization reputation
immediately prior to the restatement announcement date. To achieve this goal, we calculate the auditor market share on a
rolling-prior-12-month-basis instead of over each fiscal year. That is, for each restatement, we calculate an auditor’s within-
industry market share by (1) summing its within-industry audit fees over the 12-month period prior to the restatement
announcement date and (2) dividing the sum by total within-industry audit fees earned by all auditors over the same period.
Identification of Auditors and Non-Restating Clients

Figure 1 plots the timeline of events and our design in identifying the auditor responsible for the restatement and our
sample of non-restating clients. The restating clients refer to the companies that restate their financial reports. The restating
clients are not the focus of our study and we merely use them to identify the restatement events and the auditors responsible for
the restatement. The misstatement period refers to the fiscal periods for which previously released financial statements of the
restating client are found to be inaccurate. We identify the misstatement period with the restatement beginning date and
restatement ending date from the Audit Analytics database. The misstatement period auditor is the engagement auditor for the
restating client during the misstatement period. The non-restating clients are the firms that (1) are audited by the misstatement
period auditor on the restatement announcement date and (2) have the same two-digit SIC industry classification as the restating
client.
Accounting Horizons
FIGURE 1
Timeline
The restatement announcement date is the day on which such misstatement is announced to the public. Firms commonly
make restatement announcements through press releases or with the releases of current period quarterly/annual reports. Because
we focus on the non-restating clients, the cases where the restating clients release earnings news on the same day or around the
restatement announcement have less impact on our study. However, we do delete the cases where the non-restating clients’
earnings announcement overlaps with the restatement announcement to eliminate the possible confounding effect of earnings
releases. Details about the sample collection process are discussed in Section IV. The contagion market reaction refers to the
cumulative abnormal returns of non-restating clients during the three-day period centered on the restatement announcement
date.
Note that there is a lag between the end of the misstatement period and the restatement announcement date. Therefore, the
misstatement period auditor may or may not be the current auditor for the restating client on the restatement announcement
date. In fact, we do not require the restating client to keep the misstatement auditor because the focus of our analysis is on the
non-restating clients. Similarly, we do not require the non-restating clients to have the misstatement auditor during the
misstatement period because our focus is on the market reaction around the restatement announcement date and the damage to
the auditor’s reputation happens only around the restatement announcement date. In short, we test whether the auditor’s past
opportunistic behavior will affect its current clients, disregarding whether the past client (the direct victim) still hires the auditor
or how long the current clients (the indirect victims) have been engaged.
Market Reactions to the Restating and Non-Restating Clients

More severe restatements are likely to cause greater damage to auditors’ industry specialist reputations and, thus, are more
likely to negatively affect the non-restating clients. Following Gleason et al. (2008), we use the three-day cumulative abnormal
returns to the restating clients to control for the severity of restatements. The underlying assumption is that, with the maintained
hypothesis of market efficiency, investors’ reactions to the restating client could serve as a catch-all measure for the net effect of
the restatement. Prior studies also show that restatements involving fraud and affecting core accounts are associated with more
negative returns (Palmrose et al. 2004; Hennes et al. 2008). We control for these effects in the regression analysis. The full list
of control variables is discussed later in the ‘‘control variables’’ subsection.
The cumulative abnormal return to the restating client, CARRES, is calculated by summing the size-portfolio adjusted
returns of the restating client, SARRES, over the three-day period centered on the restatement announcement date:
SARRES;t ¼ RRES;t Rsize port;t
X
þ1
CARRES ¼ SARRES;t
t¼1
where date 0 is the restatement announcement date.
Accounting Horizons
To measure the contagion effect of restatements, we calculate non-restating clients’ size-adjusted cumulative abnormal
return (CARNONRES) over the three-day period around the restatement announcement date. The definition of CARNONRES is
similar to that of CARRES:
SARNONRES;t ¼ RNONRES;t Rsize port;t
X
þ1
CARNONRES ¼ SARNONRES;t
t¼1
H1 predicts that the market reaction is negatively associated with the auditor’s industry expertise at both the national- and
city-levels. To test this hypothesis at the national-level, we use the following regression model:
CARNONRES ¼ b0 þ b1 NATL þ cControls þ e ð1Þ
where NATL is an indicator that equals 1 if the misstatement period auditor is a national specialist over the 12-month period
immediately prior to the restatement announcement date, and 0 otherwise. Our prediction is b1 , 0.
To test H1 with regard to the auditor’s city-level industry expertise, we use the following specification:
CARNONRES ¼ b0 þ b1 CITY þ b2 SAMECITY þ b3 CITY 3 SAMECITY þ cControls þ e ð2Þ
where CITY is an indicator that equals 1 if the misstatement period auditor is a city-specific specialist over the 12-month period
immediately prior to the restatement announcement date, and 0 otherwise; and SAMECITY is an indicator that equals 1 if the
restating and non-restating firms are audited by the same city-level auditor office, and 0 otherwise.
We do not have a prediction for b1 because we do not have a priori reason to believe that the change in an auditor’s
specialization reputation in one city will affect the auditor’s clients in a different city. Instead, we focus on the interaction term:
we predict b3 , 0. Interacting with SAMECITY ensures that we focus on the non-restating clients in the same city as the
restating ones.
To assess the restatement’s incremental effects on the auditor’s national- and city-level specialization reputation, we test
the following specification. We predict both b1 and b3 to be negative.
CARNONRES ¼ b0 þ b1 NATL þ b2 CITY þ b3 CITY 3 SAMECITY þ b4 SAMECITY þ cControls þ e ð3Þ
To investigate H2, H3, and H4, we interact three proxies for restatement severity with the national- and city-level industry
specialist indicators in separate regressions. We also run a regression including all three proxies and their interaction with both
the national- and city-level specialist indicators:
CARNONRES ¼ b0 þ b1 NATL þ b2 NATL 3 SEVERE þ b3 CITY þ b4 CITY 3 SAMECITY
þ b5 CITY 3 SAMECITY 3 SEVERE þ b6 SAMECITY þ b7 SEVERE þ b8 SAMECITY 3 SEVERE
þ cControls þ e ð4Þ
SEVERE is FRAUD, LGRESCAR, or LGRESSIZE for H2, H3, or H4, respectively. We predict a negative b2 because we
hypothesize more severe restatements will lead to greater damage to auditors’ national-level industry reputation. Similarly, we
predict a negative b5 because we expect the damage to an auditor’s city-level industry specialist reputation to be greater if the
restatement is more severe. In all regression models, the continuous variables are winsorized at 1 and 99 percent levels and
standard errors are clustered at firm-levels.
Control Variables
We control for the characteristics of restatements and restating firms that may potentially affect the contagion market
reaction to non-restating firms following prior studies (Palmrose et al. 2004; Francis et al. 2005; Hennes et al. 2008; Gleason et
al. 2008). We control for the severity of restatements with CARRES. It is reasonable to assume that more severe restatements
would more negatively affect shareholder wealth. We include the size of the restating firm (RESSIZE) because restatements in
larger firms are more visible and thus could result in greater reputation damage to the auditor. We also include the relative size
of the restating and non-restating firms to control for their similarity (SIMILARITY). We include a dummy variable, FRAUD, to
capture the incremental effects of fraudulent misstatements. We use three dummies, SECINVOL, AUDINVOL, and
BOARDINVOL, to control for SEC, auditor, and board involvement in the restatement, respectively. We use a dummy variable,
REVENUE, to capture the effects of revenue-recognition related restatements.
For each auditor, there might be multiple client restatements closely clustered, and the reputational damage is likely
stronger after multiple restatements. To control for repeated restatements, we add an indicator variable that is equal to 1 if this is
the first restatement in 12 months, and 0 otherwise (FIRST_FIRM for a national audit firm and FIRST_OFF for an audit office).
Accounting Horizons
We also control for common risk factors used in return event studies and non-restating firms’ characteristics (SIZE, EP, and
BOOKMKT). We include the ratio of long-term debt to total assets (LEVERAGE) to control for the potential impact of debt
levels. We estimate and include BETA using non-restating firms’ daily returns over the (256, 2) day period, where day 0 is
the restatement announcement date. At least 100 daily returns are required for the estimation for each non-restating firm.
Finally, to control for restatement’s contagion effects associated with an auditor’s general expertise, we include the auditor
office size (OFFICESIZE), which is the sum of audit fees from all engagements of a city-level auditor office in a given fiscal
year period (Francis and Michas 2013).
Additional Analyses
We conduct a battery of additional analyses and robustness checks to corroborate the findings in our main tests.
Mutually Exclusively Defined Industry Specialization Measures

In the main tests, we do not consider the interaction between national- and city-level specialization—an auditor could be
neither, either, or both a national- and city-level specialist. Following prior studies, we modify Model (3) slightly to include
mutually exclusively defined industry specialization measures considered in prior literature. NATLONLY (CITYONLY)
indicates auditor specialization at only the national- (city-); whereas JOINT indicates specialization at both the national- and
city-level:
CARNONRES ¼ b0 þ b1 JOINT þ b2 NATLONLY þ b3 CITYONLY þ b4 JOINT 3 SAMECITY þ b5 CITY 3 SAMECITY
þ b6 SAMECITY þ cControls þ e
ð5Þ
H1 predicts negative b1 and b2 for the national-level auditor industry expertise and negative b4 and b5 for city-level
expertise. For the cross-sectional analysis, we also estimate a model similar to Model (4) with the set of exclusively defined
auditor industry specialization indicators (JOINT, NATLONLY, and CITYONLY).
Similarities between Restating and Non-Restating Firms

A key challenge of our results is that the restating and non-restating firms, when being clients of the same specialist
auditor, have a lot of similarities. To verify that our results are not driven by investors’ reactions to the uncontrolled similarities
between the restating firms and non-restating firms when they share the same specialist auditor, we conduct the following
robustness checks:
(1) Propensity score matching sample. Specifically, we use the propensity score matching method to pair each specialist-
audited (SA) non-restating firm with one non-specialist-audited (NSA) non-restating firm that operates in the same
industry. A propensity score is calculated from the Logit model of the likelihood of being audited by a specialist
auditor or office (i.e., the treatment) based on client characteristics such as total assets, accruals, sales growth, book-to-
market ratio, return on assets, leverage, audit fees, and number of business and geographic segments. Each SA non-
restating firm is then matched with one NSA (with replacement) on the closeness of the propensity score. We then
examine whether the non-restating firms audited by the specialist auditor suffer more negative market returns when
their auditor’s other client announced a restatement, compared to the matched non-restating firms audited by non-
specialist auditors.
(2) Alternative windows of negative returns. We examine whether there is still a contagion effect via specialist auditors for
firms that experience extreme negative returns not due to restatements. Because our database may not completely
capture all the restatements, we identify firms experiencing negative returns around an earnings announcement date
when there is no restatement in the surrounding period from our database. This specification helps to isolate the
negative returns that are clearly not due to restatements but rather because of negative news about fundamentals
conveyed by earnings announcements. We then examine whether firms sharing the same specialist auditor with these
negative-earnings-news firms also experience significant negative returns. If the contagion effect does not exist in this
setting, we can argue that the contagion effect we document in the main test is more likely to be driven by restatements
rather than investors’ reactions to the similarities between restating and non-restating firms.
(3) Additional negative consequences after restatements. When an auditor’s reputation as an industry specialist is
tarnished, there are likely other negative consequences in addition to the negative market reaction, e.g., auditor
dismissal as documented by Irani et al. (2015). We examine the loss of clients, reduction in audit fee revenue, and
PCAOB enforcement on audit firms after the restatement of a client to provide additional evidence.
Accounting Horizons
TABLE 1
Sample Selection Process
Panel A: Restatement Sample

All restatements on Audit Analytics from 2000 to 2012 12,522
Delete if no misstatement period auditor information (297)
Delete if multiple auditors are recorded for the misstatement period (2,954)
Delete if missing SIC code (6)
Delete if missing auditor national industry market share data (1,364)
Delete if missing return data for the restating firm on CRSP (3,899)
Delete if the announcement period cumulative abnormal return (CAR) is greater than 0.01 (2,097)
Delete if restatement only involves clerical errors as marked in Audit Analytics database (93)
Initial restatement sample 1,812
Delete if no corresponding non-restating firms that meet sample selection process outlined in (1,108)
Panel B
Full restatement sample 704
Delete if missing auditor city-level industry market share data (12)
City-level restatement sample 692
Panel B: Non-Restating Firms Sample

Identify all firms that: a) are audited by the misstatement auditor on the restatement announcement date on Audit Analytics, 48,824
and b) have the same two-digit SIC industry classification as the restating client
Delete if missing return data on CRSP or control variables on Compustat (7,991)
Delete if non-restating firm has an earnings announcement within the three-day period around restatement announcement (4,401)
Delete if financial service or utility industry (6,490)
Full non-restating firms sample 29,942
Delete if missing auditor city-level industry market share data (2,616)
City-level non-restating firms sample 27,326
(4) Additional control variables capturing the similarities between the restating and non-restating firms. In our main
regression model, we include the relative size of the restating and non-restating firms to control for their similarity
(SIMILARITY). It is reasonable to assume that the similarities exist on other dimensions. As a robustness check, we
repeat our main tests after including relative measures capturing the similarities between restating and non-restating
firms in the following five dimensions: size, accruals, leverage ratio, number of business and geographic segments, and
audit fees. We do not include these measures in our original model because requiring them reduces our sample size by
about 30 percent.
Alternative Specifications and Other Sensitivity Analyses

We also conduct sensitivity analyses using alternative specifications for abnormal returns, industry classifications, and
auditor industry expertise. We discuss these tests and their results in detail when we discuss the empirical results.
IV. SAMPLE AND DESCRIPTIVE STATISTICS
Restatements Sample Selection Process

Table 1, Panel A summarizes the restatement sample selection process. We obtain a total of 12,522 restatements from
Audit Analytics announced between January 1, 2000 and December 31, 2012. We delete 297 observations where the
misstatement period auditor cannot be identified. To help pinpoint the auditor responsible for the restatement, we further delete
2,954 observations where there are multiple auditors recorded for the misstatement period. Next, we merge the restatement data
and audit fee data from Audit Analytics with stock return data from CRSP. We require the three-day restatement announcement
CAR of the restating clients to be available in order to control for the severity of the restatements. In addition, we delete
restatements where the CAR of the restating client is either positive or lying between 0 and 1.0 percent because our research
Accounting Horizons
focus is on the restatements that have material negative impact to auditor reputation. The cutoff of 1.0 percent is consistent
with prior literature (Gleason et al. 2008). For the same reason, we delete restatements if they involve only clerical errors as
marked by the Audit Analytics database.4 To assess an auditor’s level of industry specialization, we require audit fee data of
each misstatement auditor during the rolling-prior-12-month period, reducing the sample to a total of 1,812 restatements.5
In the next subsection, we describe the process to identify non-restating clients associated with the 1,812 restatements.
Because not all restatements have non-restating clients that meet our sample selection criteria, the number of unique
restatements in the final sample is further reduced to 704.
Non-Restating Clients Sample Selection Process

Table 1, Panel B summarizes the identification and sample selection process of the non-restating clients. To identify non-
restating firms for each restatement, we search the Audit Analytics database for all firms that (1) have the misstatement period’s
auditor on the restatement date and (2) are in the same two-digit SIC industry classification as the restating client. We find
48,824 matches. We then delete 7,991 observations where control variables from Compustat and/or CRSP are missing. We
further drop 4,401 observations where the non-restating firm made the earnings announcement during the three-day window
around the restatement announcement date to avoid the confounding effect of earnings news. Last, following prior literature in
auditor industry specialization, we drop the financial service (6000–6999 SIC code range) and utility industries (4000–4999
SIC code range). We obtain a final non-restating client sample of 29,942 observations. For a city-level analysis, we require the
availability of city-level auditor specialization data, which results in a smaller city-level sample of 27,326 observations.6 The
full sample of non-restating clients is associated with a total of 704 unique restatements while the city-level sample has 692
unique restatements announced between the year 2000 and 2012.
Descriptive Statistics
Table 2, Panel A summarizes the descriptive statistics for the restatement firms. The average three-day cumulative
abnormal return of restating clients on the restatement announcement date (CARRES) is 7 percent. Four percent of the
restatements involve fraud as reported by Audit Analytics. The percentage of SEC, auditor, and board involvement in the
restatement process is 9, 63, and 50 percent, respectively. Twenty-seven percent of the restatements involve revenue
recognition problems.
Table 2, Panel B reports the summary statistics for the non-restating sample. The mean three-day cumulative abnormal
return of non-restating clients (CARNONRES) is 0, suggesting that the market on average does not punish the non-restating clients
for the restatements. The average size of non-restating clients is similar to that of restating clients, as the mean natural logarithm
of total assets is 5.84 and 5.86 for the non-restating and restating clients, respectively. Thirty-two percent of non-restating
clients have a national-level industry specialist auditor prior to the restatements and 43 percent have a city-level industry
specialist. The percentages of joint, national-only, and city-only specialists in our sample are 16, 17, and 27, respectively. Eight
percent of non-restating firms are with the same auditor office on the restatement announcement dates as the restating firms
during the restatement period (SAMECITY).
Table 2, Panel C compares the non-restating clients of industry specialist auditors and non-industry specialist auditors. The
two groups are different on several dimensions. Clients of industry specialists, both at the national-level and city-level, are
larger with less growth opportunity as measured by higher EP or lower book-to-market ratios. Clients of city-level specialist
auditors have smaller market beta. This is not surprising given that industry specialist auditors are usually larger audit firms that
deal with larger clients. In our setting, because we use the same auditor’s clients as controls and control for all major auditor
and firm characteristics, the difference between the two groups of firms should not pose a significant concern.
The un-tabulated univariate analysis suggests no significant correlation between market reaction to non-restating firms
(CARNONRES) and the auditor’s industry specializations (NATL, CITY, NATLONLY, CITYONLY, and JOINT). Although the two
measures of industry specializations, NATL and CITY, are significantly correlated, the correlation is smaller than 0.1, indicating
that the national- and city-level expertise do not have significant overlap.
4
The Audit Analytics database marks each restatement with three non-exclusive indicators: (1) fraud, (2) accounting errors, or (3) clerical errors. We drop
all restatement observations that are marked as clerical errors but not as fraud or accounting errors from our sample.
5
To assess the national-level industry specialization, we need the audit fee and client two-digit SIC industry classification from Audit Analytics. We use
all available within-industry audit fee observations on Audit Analytics in the rolling-prior-12-month to calculate the total industry audit fees.
6
To assess the city-level industry specialization, we need audit fee, client two-digit SIC industry classification, and the engagement auditor office as
printed on the auditor’s opinion. In addition, we need to be able to map the auditor office location to an MSA. These requirements and processes result in
fewer observations in our city-level sample as compared with the full sample.
Accounting Horizons
TABLE 2
Summary Statistics
Panel A: Restatement Sample Summary Statistics

25th 75th
n Mean Std. Dev. Percentile Median Percentile
CARRES 704 0.07 0.08 0.10 0.05 0.02
RESSIZE 704 5.86 1.81 4.54 5.79 7.01
FRAUD 704 0.04 0.20 0.00 0.00 0.00
SECINVOL 704 0.09 0.29 0.00 0.00 0.00
AUDINVOL 704 0.63 0.48 0.00 1.00 1.00
BOARDINVOL 704 0.50 0.50 0.00 0.00 1.00
REVENUE 704 0.27 0.44 0.00 0.00 1.00
Panel B: Non-Restating Sample Summary Statistics

25th 75th
n Mean Std. Dev. Percentile Median Percentile
Main Variables
CARNONRES 29,942 0.00 0.05 0.02 0.00 0.02
NATL 29,942 0.32 0.47 0.00 0.00 1.00
CITY 27,326 0.43 0.49 0.00 0.00 1.00
NATLONLY 27,326 0.17 0.37 0.00 0.00 0.00
CITYONLY 27,326 0.27 0.44 0.00 0.00 1.00
JOINT 27,326 0.16 0.37 0.00 0.00 0.00
SAMECITY 27,326 0.08 0.27 0.00 0.00 0.00
Other Variables
OFFICESIZE 29,942 84.95 111.91 17.68 48.42 105.11
CARRES 29,942 0.08 0.08 0.10 0.05 0.02
SIZE 29,942 5.84 1.80 4.53 5.70 7.04
EP 29,942 0.47 6.33 0.60 0.12 0.61
BOOKMKT 29,942 0.51 0.47 0.23 0.39 0.64
LEVERAGE 29,942 0.12 0.18 0.00 0.02 0.20
BETA 29,942 1.22 0.68 0.74 1.17 1.63
RESSIZE 29,942 5.82 1.85 4.53 5.70 6.91
FRAUD 29,942 0.05 0.22 0.00 0.00 0.00
SECINVOL 29,942 0.11 0.31 0.00 0.00 0.00
AUDINVOL 29,942 0.61 0.49 0.00 1.00 1.00
BOARDINVOL 29,942 0.48 0.50 0.00 0.00 1.00
REVENUE 29,942 0.32 0.47 0.00 0.00 1.00
BIG4 29,942 0.96 0.19 1.00 1.00 1.00
SIMILARITY 29,942 1.12 0.54 0.75 1.01 1.34
FIRST_FIRM 29,942 0.01 0.12 0.00 0.00 0.00
FIRST_OFF 29,942 0.04 0.19 0.00 0.00 0.00
(continued on next page)
V. EMPIRICAL RESULTS
Main Results
In Table 3, we present results for H1, where the three-day cumulative abnormal returns of the non-restating firms on the
restatement announcement dates are the dependent variable. Column (1) reports the results at the national-level. We find that
CARNONRES is negative (0.1 percent) for non-restating clients with a national specialist auditor immediately prior to the
restatement but the coefficient is not statistically significant. Column (2) reports results of non-restating clients of city-level
specialist auditors. The coefficient for CITY 3 SAMECITY is 0.8 percent and significant at the 1 percent level (t ¼3.54). In
Accounting Horizons
TABLE 2 (continued)
Panel C: Mean and Median Differences Tests of Non-Restating Client Characteristics
Mean- Mean Diff Median- Median- Diff
Non-Specialist Specialist (t-stat) Non-Specialist Specialist (v2)
Specialization Level: NATL
SIZE 5.793 5.946 0.153*** 5.666 5.742 0.076***
(6.841) (7.643)
EP 0.553 0.299 0.254*** 0.112 0.146 0.034***
(3.234) (24.918)
BOOKMKT 0.507 0.503 0.004 0.390 0.387 0.003
(0.770) (0.355)
LEVERAGE 0.123 0.124 0.001 0.020 0.031 0.011***
(0.273) (10.423)
BETA 1.214 1.218 0.004 1.168 1.157 0.011
(0.504) (1.481)
Specialization Level: CITY 3 SAMECITY

SIZE 5.838 6.161 0.323*** 5.687 6.018 0.331***
(5.546) (273.520)
EP 0.480 0.309 0.170 0.123 0.120 0.003
(0.825) (0.038)
BOOKMKT 0.498 0.431 0.067*** 0.387 0.353 0.034***
(4.580) (10.455)
LEVERAGE 0.121 0.126 0.005 0.017 0.018 0.001
(0.084) (0.000)
BETA 1.232 1.186 0.046** 1.180 1.132 0.049**
(2.120) (5.428)
All variables are defined in Appendix A.
Column (3), we include in the regression both national- and city-level specialization variables. The coefficient on NATL is again
negative but not significant. For city-level specialists, CITY 3 SAMECITY has a negative and significant coefficient of 0.8
percent at the 1 percent level (t ¼ 3.56). This is consistent with the notion that non-restating clients of city-level specialists
suffer additional damage due to the auditors’ reputational damage.
The coefficients on SAMECITY in both Columns (2) and (3) are significantly positive at the 1 percent level. This suggests
that if the non-restating firms are with the same audit office as the restating firms, but the audit office is not a local industry
specialist, the non-restating clients are punished less around restatement announcements compared to those clients audited by
the city specialist or by a different audit office. We conjecture these interesting results are due to the competition effect among
firms that operate in the same city area and have the same industry classification. Specifically, bad news for one firm can be
good news for the firm’s close competitors that operate in the same city and same industry.
To verify the conjecture and make sure that this effect does not compromise our main findings, we first produce a 2 3 2
matrix of CARNONRES for our sample of non-restating firms in Table 3, Panel B. The positive coefficient on SAMECITY is
demonstrated by the positive mean in the upper right cell of the matrix (not statistically significant from 0 though). That is, non-
restating firms located in the same city as the restating firm but not affected by the reputational damage of the city specialist
auditor are not punished as much compared to other non-restating firms. Non-restating firms not located in the same city as the
restating firm do not enjoy as much positive impact from the failure of a competitor, and, for them, the negative contagion
effect of the restatement is more dominant.
Because this competition effect is not related to auditor specialization, we also verify the effect in a larger sample without
the requirement that the non-restating firm has the same auditor as the restating firm. The regression model takes the following
form:
CARNONRES ¼ b0 þ b1 SAMEINDUSTRY þ b2 SAMECITY þ b3 SAMEINDUSTRY 3 SAMECITY þ cControls þ e ð6Þ
Note that, in this large sample, because we no longer track auditors, SAMECITY is defined as an indicator variable that is
equal to 1 if the non-restating firm is in the same geographic area as the restating firm, 0 otherwise. The regression is similar to
the analysis in Gleason et al. (2008). The un-tabulated regression results first confirm Gleason et al.’s (2008) results that the
Accounting Horizons
TABLE 3
The Market Reaction to Non-Restating Firms around Restatement Announcement
Panel A: Tests Results Estimating Models (1)–(3)

Pred. (1) (2) (3)
Sign CARNONRES CARNONRES CARNONRES
Test Variables
NATL 0.001 0.001
(1.13) (0.91)
CITY ? 0.000 0.000
(0.41) (0.30)
CITY 3 SAMECITY 0.008*** 0.008***
(3.54) (3.56)
SAMECITY ? 0.005*** 0.005***
(2.93) (2.99)
Control Variables
OFFICESIZE 0.000 0.000 0.000
(0.72) (1.33) (1.58)
CARRES 0.000 0.002 0.001
(0.09) (0.38) (0.34)
RESSIZE 0.002*** 0.002*** 0.002***
(6.07) (4.64) (4.54)
FRAUD 0.001 0.001 0.001
(0.40) (0.77) (0.75)
SECINVOL 0.002** 0.002** 0.002**
(2.06) (2.24) (2.29)
AUDINVOL 0.005*** 0.004*** 0.004***
(6.49) (4.42) (4.17)
BOARDINVOL 0.003*** 0.003*** 0.003***
(4.38) (3.81) (3.60)
REVENUE 0.000 0.000 0.000
(0.33) (0.23) (0.15)
BIG4 0.007*** 0.004** 0.003
(4.20) (2.42) (1.54)
SIZE 0.001*** 0.001*** 0.001***
(3.56) (2.96) (2.96)
EP 0.000* 0.000 0.000
(1.73) (1.11) (1.18)
BOOKMKT 0.001 0.001* 0.001*
(1.33) (1.88) (1.90)
LEVERAGE 0.000 0.001 0.000
(0.17) (0.28) (0.27)
BETA 0.002*** 0.002*** 0.002***
(3.96) (4.07) (4.00)
SIMILARITY (SIZE) 0.005*** 0.003** 0.003**
(3.57) (2.39) (2.39)
FIRST_FIRM 0.008*** 0.022***
(2.94) (4.52)
FIRST_OFF 0.001 0.004*
(0.37) (1.71)
Constant 0.001 0.005 0.009
(0.02) (0.11) (0.19)
Year Effects Yes Yes Yes
Industry Effects Yes Yes Yes
Accounting Horizons
TABLE 3 (continued)
Pred. (1) (2) (3)
Observations 29,942 27,326 27,326
Adjusted R2 0.0063 0.0076 0.0083
Overall F-stat 3.83*** 4.24*** 4.43***
Degree of Freedom—M 67 65 67
Degree of Freedom—R 29,874 27,260 27,258
Combined effect test of CITY 3 SAMECITY þ SAMECITY
F-stat 14.34*** 14.27***
p-value 0.000 0.000
Panel B: Average Non-Restating Firm Size-Adjusted Stock Returns on Restatement Announcement Date Sorted by
CITY and SAMECITY
CITY ¼ 1 CITY ¼ 0
SAMECITY ¼ 1 0.0057 0.0023
(t ¼ 4.007) (t ¼ 1.509)
n ¼ 1,147 n ¼ 1,251
SAMECITY ¼ 0 0.0013 0.0017
(t ¼ 2.967) (t ¼ 4.070)
n ¼ 12,419 n ¼ 16,973
*, **, *** Indicate statistical significance at 10 percent, 5 percent, and 1 percent level, respectively.
One-tailed tests are used when a directional hypothesis is specified; two-tailed tests are used otherwise. Panel A reports the tests results estimating Models
(1)–(3). Panel B reports t-statistics of mean CARNONRES and the number of observations for each group. p-value is based on two-tailed test.
non-restating firms of the same industry classification as the restating firm suffer a contagion stock effect. That is, the
coefficient on SAMEINDUSTRY is significantly negative (0.002, t ¼ 14.99). More importantly for our study, the results
suggest that when the non-restating firm is closely competing with the restating firm, (i.e., when both firms operate in the same
city and same industry), there is a positive market reaction to the non-restating firm (SAMEINDUSTRY 3 SAMECITY) when its
close competitor releases bad news (restatement). The coefficient on SAMEINDUSTRY 3 SAMECITY is significantly positive
(0.002, t ¼ 3.06). We also repeat the test excluding all firms sharing the same auditors as the restating firms and results are
unchanged. In addition, in robustness tests presented later, we use a propensity score matched sample and the coefficient on
SAMECITY is no longer significant, suggesting a better matching helps alleviate this effect.
To make sure that the positive effect of SAMECITY does not offset the negative contagion effect for city specialist auditors,
we report in the tables the test statistics testing the sum of coefficients on SAMECITY and CITY 3 SAMECITY. The tests show
that the sum of coefficients is negative and significant at the 1 percent level for both Columns (2) and (3).
To summarize, we do not find strong support for H1 regarding the auditor’s reputation as a national industry specialist.
However, the estimation results are consistent with the notion that the market reacts negatively to the damage of the auditor’s
reputation as a city-level industry specialist due to the restatement.
Cross-Sectional Analysis Controlling for Severity of Restatements

Although we find only partial support for H1, it does not suggest that the market does not price an auditor’s reputation as a
national-level industry specialist. One potential explanation is that national specialists’ reputations, once acquired, are more
resistant to negative shocks. We next examine whether the damage to the reputation of national- and city-level specialists varies
with the severity of restatements.
Following existing literature, we use three measures to approximate the severity of the restatements and test whether the
market reaction varies with the measures. Specifically, H2, H3, and H4 test whether market reaction is more negative when (1)
the restatements involve fraud (H2), (2) the restating firms face larger stock price declines (H3), and (3) the restating clients are
larger (H4). We include the interactions of three severity proxies with both national- and city-level specialization indicators
(Equation 4). In Table 4, we present these results.
Accounting Horizons
TABLE 4
Cross-Sectional Analyses of Auditor Industry Specialization’s Impact on Market Reaction
Pred. (1) (2) (3)
Test Variables
NATL 0.000 0.001 0.001
(0.22) (1.40) (0.59)
NATL 3 FRAUD 0.013***
(4.55)
NATL 3 LGRESCAR 0.004***
(3.35)
NATL 3 LGRESSIZE 0.002**
(1.79)
CITY ? 0.001 0.000 0.001
(0.92) (0.47) (1.16)
CITY 3 FRAUD ? 0.008***
(2.79)
CITY 3 LGRESCAR ? 0.001
(0.96)
CITY 3 LGRESSIZE ? 0.002
(1.35)
CITY 3 SAMECITY 0.007*** 0.006** 0.010***
(3.04) (2.08) (3.05)
CITY 3 SAMECITY 3 FRAUD 0.028**
(2.28)
CITY 3 SAMECITY 3 LGRESCAR 0.005
(1.05)
CITY 3 SAMECITY 3 LGRESSIZE 0.004
(0.88)
SAMECITY ? 0.004*** 0.004* 0.008***
(2.72) (1.87) (3.39)
Control Variables
FRAUD 0.003 0.001 0.001
(1.57) (0.65) (0.66)
LGRESCAR 0.003***
(2.86)
LGRESSIZE 0.001
(0.57)
SAMECITY 3 FRAUD 0.009
(1.06)
SAMECITY 3 LGRESCAR 0.001
(0.22)
SAMECITY 3 LGRESSIZE 0.006*
(1.78)
OFFICESIZE 0.000 0.000 0.000
(1.61) (1.53) (1.61)
CARRES 0.000 0.003 0.001
(0.06) (0.56) (0.31)
RESSIZE 0.002*** 0.002*** 0.001***
(4.66) (4.67) (2.96)
SECINVOL 0.003*** 0.003** 0.002**
(2.95) (2.48) (2.38)
AUDINVOL 0.004*** 0.003*** 0.004***
(4.52) (4.11) (4.14)
BOARDINVOL 0.003*** 0.003*** 0.003***
(3.59) (3.35) (3.39)
Accounting Horizons
TABLE 4 (continued)
Pred. (1) (2) (3)
REVENUE 0.000 0.000 0.000
(0.61) (0.11) (0.10)
BIG4 0.003 0.003* 0.003
(1.51) (1.69) (1.49)
SIZE 0.001*** 0.001*** 0.001***
(2.88) (3.08) (2.76)
EP 0.000 0.000 0.000
(1.21) (1.16) (1.19)
BOOKMKT 0.001* 0.001* 0.001*
(1.89) (1.91) (1.88)
LEVERAGE 0.000 0.000 0.001
(0.23) (0.22) (0.29)
BETA 0.002*** 0.002*** 0.002***
(3.93) (4.00) (4.04)
SIMILARITY (SIZE) 0.003** 0.004** 0.003**
(2.35) (2.55) (2.11)
FIRST_FIRM 0.022*** 0.022*** 0.023***
(4.40) (4.54) (4.54)
FIRST_OFF 0.004* 0.004* 0.004*
(1.71) (1.66) (1.72)
Constant 0.008 0.011 0.011
(0.16) (0.22) (0.23)
Observations 27,326 27,326 27,326
Adjusted R2 0.0093 0.0088 0.0085
Overall F-stat 4.61*** 4.35*** 4.25***
One-tailed tests are used when a directional hypothesis is specified; two-tailed tests are used otherwise.
Column (1) shows the OLS estimation results for the regression that includes the FRAUD interactions (H2). Both variables
of interest, NATL 3 FRAUD and CITY 3 SAMECITY 3 FRAUD, display negative (1.3 and 2.8 percent) and significant
coefficients at the 1 percent level (t ¼ 4.55 and 2.28). The results are consistent with our prediction that national- and city-
level auditor specialist effects are more pronounced when there are frauds involved in the restatements.
Column (2) shows the OLS estimation results for the regression that includes the LGRESCAR interactions (H3). The
variable of interest, NATL 3 LGRESCAR, has a significantly negative coefficient (0.4 percent, t ¼3.35), indicating that the
auditor’s reputation as a national industry specialist is damaged when a restating firm experiences large share price declines.
The coefficient of CITY 3 SAMECITY 3 LGRESCAR is not significant, implying that the effect of city-level specialization is not
affected by the magnitude of share price declines of the restating client.
Column (3) exhibits the estimation results for the regression with LGRESSIZE interactions (H4). The coefficient on NATL
3 LGRESSIZE is negative (0.3 percent) and significant (t ¼2.07), suggesting that investors re-evaluate the auditor’s national
industry specialization when large and more visible clients restate. The coefficient on CITY 3 SAMECITY 3 LGRESSIZE is not
significant. Thus, we do not find support for the hypothesis that the effect of restatement on city-level specialization reputation
varies with the size of restating clients.
Overall, we find that financial restatements caused by accounting fraud result in greater damage to an auditor’s reputation
as an industry specialist both at the national- and city-level, compared with restatements caused by unintentional
misapplications of GAAP. In addition, we find that the reputation as a national specialist suffers more severe damage when the
restatement triggers more negative returns and the restating client is more visible.
Accounting Horizons
TABLE 5
Exclusive Industry Specialization Variables
Panel A: Market Reaction Tests

(1)
CARNONRES
Pred.
Sign Coeff. t-stat.
NATLONLY 0.000 (0.07)
JOINT 0.001* (1.35)
CITYONLY 3 SAMECITY 0.010*** (3.77)
JOINT 3 SAMECITY 0.006** (2.06)
Constant ?
Control Variables Yes
Industry Fixed Effects Yes
Year Fixed Effects Yes
Observations 27,326
Adjusted R2 0.0075
Panel B: Cross-Sectional Analysis of Market Reactions

(1) (2) (3)
FRAUD LGRESSIZE LGRESCAR
Dependent Variable: Pred.
CARNONRES Sign Coeff. t-Stat. Coeff. t-Stat. Coeff. t-Stat.
NATLONLY 3 SEVERE 0.010*** (2.40) 0.002 (0.84) 0.006*** (2.94)
JOINT 3 SEVERE 0.008** (1.81) 0.007*** (3.91) 0.000 (0.11)
CITYONLY 3 SAMECITY 3 SEVERE 0.056*** (4.60) 0.006 (1.02) 0.004 (0.72)
JOINT 3 SAMECITY 3 SEVERE 0.010 (0.72) 0.001 (0.17) 0.004 (0.65)
Constant ? 0.010** (2.50) 0.013*** (3.37) 0.013*** (3.31)
Control Variables Yes Yes Yes
Industry Fixed Effects Yes Yes Yes
Year Fixed Effects Yes Yes Yes
Observations 27,326 27,326 27,326
Adjusted R2 0.0088 0.0079 0.0079
*, **, *** Indicate significance at the 10 percent, 5 percent, and 1 percent level, respectively.
This table reports industry specialization’s impact on market reaction to non-restating firms when industry specialization levels are exclusively defined.
Panel A presents results of Equation (4), and Panel B presents results under three specifications where the severity of restatement is proxied by FRAUD,
LGRESCAR, and LGRESSIZE, respectively. To conserve space, only the main variables (interactions) of interest are reported. All regressions include the
full set of control variables, year, and industry fixed effects. One-tailed tests are used whenever a directional hypothesis is specified. Standard errors are
clustered at the firm-level.
Additional Analyses and Robustness Tests

Mutually Exclusively Defined National, City-Level, and Joint Industry Specializations
Following prior studies, we also test the impact of industry specialization on the market reaction to non-restating firms
using the mutually exclusively defined national-level, city-level, and joint industry specializations. The results are reported in
Table 5. The findings are consistent with the main results. At the national-level, we do not find that the market reacts negatively
to non-restating clients of the national-only industry specialist; however, we find some evidence that the market reacts
negatively to non-restating clients of the city and national joint specialist. In a cross-sectional analysis, we find that the market
reacts negatively to national-only and joint specialist’s non-restating clients when the restatements are more severe. At the city-
level, we find that the market reacts negatively to both city-only and joint specialist’s non-restating clients and the reaction is
more negative when fraud is involved.
Accounting Horizons
Robustness Checks for the Similarities between Restating and Non-Restating Firms
(1) Propensity score matching sample. We create the matched samples using the propensity score matching method to pair
each specialist-audited (SA) non-restating firm with one non-specialist-audited (NSA) non-restating firm that operates
in the same industry. Specifically, we use a logit estimation model to calculate a propensity score for each SA non-
restating firm in our sample. The Logit model estimates the likelihood of being audited by a specialist auditor or office
(i.e., the treatment) based on client characteristics. Each SA non-restating firm is then matched with one NSA (with
replacement) on the closeness of the propensity score. This process results in 15,270 observations in the national-level
matched sample and 19,450 observations in the city-level matched sample. The city-level matched sample has more
observations because there are about 2,000 more specialist-audited clients at the auditor city office level than at the
national auditor firm level. The difference is then doubled once matching is applied. The sample construction process
is detailed in Table 6 Panel A. We also present a comparison of the treatment firms with the matched control firms in
Table 6 Panel B. For the national-level matched sample, the two groups are similar in all dimensions except for
ACCRUALS. The control sample on average has more negative total accruals than the treatment group. For the city-
level sample, the two groups are also similar in most dimensions. The only variable showing significant difference is
ASSETS.
We estimate Models (1) through (4) using the matched samples. Table 6, Panel C reports the results estimating Models (1)
through (3), and the main findings still hold as in our original sample. Panel D reports the results estimating Model (4). For the
cross-sectional results of the national specialists, although the signs are still negative, they are no longer statistically significant.
For the city-level specialist, CITY 3 SAMECITY 3 LGRESCAR is negative and statistically significant, suggesting that the
severity of the restatement has additional impact on the reputational damage on the city-level industry specialization.
(2) Alternative windows of negative returns. In this test, we first identify earnings announcement (EA) firms from 2001–
2012 quarterly earnings announcements in Compustat that have at least one negative 10 percent size-portfolio-adjusted
CAR in the three-day window around the earnings announcement. We then collect the non-earnings announcement
(NEA) sample. The NEA firms have the same auditor and industry classification (SIC two-digit) as the EA firms on
earnings announcement dates. We delete firms that have already announced earnings for that fiscal quarter from our
NEA sample. We further require that there are no client restatements for the EA firms’ auditors within a 615-day
period around the earnings announcements and that there are no client restatements for the audit office within a 690-
day period around earnings announcements. We examine whether the NEA firms also suffer negative returns due to
contagion effect. The control variables are similar to those in our main tests except that we do not have restatement-
related controls.
As expected, none of the main coefficients are statistically significant, indicating that negative returns due to negative
fundamental news rather than restatements do not become contagious through specialist auditors (results are untabulated). We
also repeat the test using 5 percent as the cut off for returns and the results are the same: none of the main coefficients are
statistically significant.
(3) Additional negative consequences after restatements. When an auditor’s reputation as an industry specialist is
tarnished, there are likely other negative consequences in addition to the negative market reaction. We examine the
loss of clients, reduction in audit fee revenue, and PCAOB enforcement on audit firms after the restatement of a client
to provide additional evidence.
In Table 7, Panel A, we provide summary statistics comparing the number of clients during the year before and after
restatements. The t-test results confirm that both specialist and non-specialist auditors lose clients in the same industry as the
restating clients (but not clients outside of the industry). We find that national specialists on average lose 4.5 more within-
industry clients than non-specialists (t ¼ 4.78). However, the city-level specialists lose fewer (0.37) within-industry clients
than non-specialists (t ¼ 1.71). This could be due to the limited alternative auditors at the city-level, because, by definition,
city-level specialists dominate the local market. The results for city-level specialists are not necessarily contradictory to our
main findings. Our main results suggest that the stock market reacts negatively to the local non-restating firms following the
announcement of restatements. One explanation for this negative market return could be that the local clients could not readily
hire a different high-quality local audit firm that provides better assurance on future reporting quality.
We also replicate the regression analysis by Irani et al. (2015) with our measures of auditor specialization added. We start
with our non-restating client sample and add all but one variable from Irani et al. (2015). The variable we replace is Auditor_
Mkt, which is an auditor specialization measure. We replace it with NATL, CITY, and CITY 3 SAMECITY. In city-level tests, we
also add the size of the audit office as a control. The dependent variable is AUD_DIS (auditor is replaced in the year following
restatement) or OFF_DIS (audit office is dismissed in the year following restatement). The results are reported in Table 7, Panel
Accounting Horizons
TABLE 6
Robustness Checks Using Propensity Score Matched Sample
The Market Reaction to Non-Restating Firms around Restatement Announcement
Panel A: Sample Selection Process

Specialist- Non-Specialist-
Audited Audited
Number of non-restating firms in full sample 29,942
Less: Non-specialist auditor clients (20,443)
Clients of specialist auditors 9,499
Match specialist clients with non-specialist clients (1,864)
7,635 7,635
Final Matched Sample—National-Level 15,270
Number of non-restating firms in city-level sample 27,326
Less: Non-specialist audit office clients (15,610)
Clients of specialist audit offices 11,716
Match specialist clients with non-specialist clients (1,991)
9,725 9,725
Final Matched Sample—City-Level 19,450
Panel B: Covariate Balance Check

Treated Mean Control Mean Difference t-stat
National-Level Matched Sample
ASSETS 2,574.23 2,656.71 82.47 0.77
ACCRUALS 35.83 40.65 4.82 2.26*
SALESGROW 0.20 0.19 0.01 0.83
BM 0.48 0.49 0.01 1.71
ROA 0.06 0.07 0.01 1.93
LEVERAGE 0.13 0.12 0.00 0.44
AUDFEE 1,481,063 1,480,134 929.00 0.02
City-Level Matched Sample
ASSETS 2,791.22 2,597.72 193.50 2.08*
ACCRUALS 40.14 39.21 0.93 0.48
SALESGROW 0.21 0.22 0.00 0.45
BM 0.45 0.44 0.00 0.82
ROA 0.07 0.07 0.00 0.29
LEVERAGE 0.13 0.13 0.00 0.94
AUDFEE 1,676,410 1,632,026 44,384 1.17
Panel C: The Market Reaction to Non-Restating Firms around Restatement Announcement

Pred. (1) (2) (3)
Test Variables
NATL 0.001 0.001*
(0.85) (1.63)
CITY ? 0.001 0.001
(1.59) (1.37)
CITY 3 SAMECITY 0.005*** 0.005***
(2.36) (2.40)
Accounting Horizons
TABLE 6 (continued)
Pred. (1) (2) (3)
SAMECITY ? 0.002 0.002
(1.05) (1.17)
Control Variables
OFFICESIZE 0.000 0.000 0.000
(1.44) (1.18) (1.48)
CARRES 0.007 0.002 0.002
(1.45) (0.40) (0.51)
RESSIZE 0.001*** 0.001*** 0.001***
(4.58) (4.72) (4.17)
FRAUD 0.005** 0.000 0.000
(2.49) (0.19) (0.07)
SECINVOL 0.001 0.001 0.001
(0.88) (1.26) (1.38)
AUDINVOL 0.003*** 0.001 0.001
(3.15) (1.06) (1.11)
BOARDINVOL 0.002* 0.002*** 0.002***
(1.93) (2.81) (2.58)
REVENUE 0.001 0.001 0.001
(0.93) (1.30) (1.17)
BIG4 0.013*** 0.007*** 0.005***
(5.29) (3.56) (2.68)
SIZE 0.001** 0.001*** 0.001***
(2.20) (2.90) (2.94)
EP 0.000 0.000 0.000
(0.03) (0.17) (0.13)
BOOKMKT 0.001 0.000 0.000
(0.71) (0.20) (0.18)
LEVERAGE 0.005** 0.005** 0.005**
(2.32) (2.51) (2.46)
BETA 0.002** 0.003*** 0.003***
(2.41) (5.24) (5.27)
FIRST_FIRM 0.002 0.043***
(0.25) (5.16)
FIRST_OFF 0.002 0.005**
(0.84) (2.08)
Constant 0.007 0.004 0.003
(1.55) (1.09) (0.75)
Observations 15,270 19,450 19,450
Adjusted R2 0.0086 0.0114 0.0128
Overall F-stat 4.09*** 5.87*** 6.24***
Combined effect test of CITY 3 SAMECITY þ SAMECITY
F-stat 8.60** 8.47**
p-value 0.003 0.004
Column (1) results are obtained in the matched sample created based on national auditor industry specialization. Column (2) and (3) results are obtained in
the matched sample created based on city-level auditor industry specialization. We also report the overall F-stat for model fitness and the test statistics of
the combined coefficient of CITY 3 SAMECITY þ SAMECITY.
Accounting Horizons
TABLE 6 (continued)
Panel D: Cross-Sectional Differences in Auditor Industry Specialization’s Impact on Market Reaction

Pred. (1) (2) (3)
Test Variables
NATL 0.001* 0.001 0.000
(1.61) (0.64) (0.20)
NATL 3 FRAUD 0.002
(0.44)
NATL 3 LGRESCAR 0.002
(1.08)
NATL 3 LGRESSIZE 0.002
(1.18)
CITY ? 0.001 0.002** 0.001
(1.05) (1.96) (0.53)
CITY 3 FRAUD ? 0.006*
(1.69)
CITY 3 LGRESCAR ? 0.006***
(4.38)
CITY 3 LGRESSIZE ? 0.001
(0.59)
CITY 3 SAMECITY 0.005** 0.003 0.006**
(2.29) (1.00) (1.83)
CITY 3 SAMECITY 3 FRAUD 0.000
(0.03)
CITY 3 SAMECITY 3 LGRESCAR 0.006*
(1.32)
CITY 3 SAMECITY 3 LGRESSIZE 0.002
(0.33)
SAMECITY ? 0.002 0.001 0.003
(1.30) (0.59) (1.08)
Control Variables
FRAUD 0.006 0.000 0.000
(1.49) (0.03) (0.17)
LGRESCAR 0.006***
(5.26)
LGRESSIZE 0.002
(1.43)
SAMECITY 3 FRAUD 0.013
(0.97)
SAMECITY 3 LGRESCAR 0.000
(0.06)
SAMECITY 3 LGRESSIZE 0.001
(0.40)
OFFICESIZE 0.000 0.000 0.000
(1.61) (1.57) (1.51)
CARRES 0.002 0.012** 0.003
(0.47) (2.17) (0.61)
RESSIZE 0.001*** 0.001*** 0.001***
(4.18) (3.78) (3.13)
SECINVOL 0.001 0.002* 0.002
(1.36) (1.68) (1.54)
AUDINVOL 0.001 0.001 0.001
(1.19) (0.82) (1.12)
BOARDINVOL 0.002*** 0.002** 0.002**
(2.65) (1.97) (2.43)
Accounting Horizons
TABLE 6 (continued)
Pred. (1) (2) (3)
REVENUE 0.001 0.001 0.001
(1.22) (1.10) (1.27)
BIG4 0.005*** 0.006*** 0.005**
(2.66) (2.89) (2.49)
SIZE 0.001*** 0.001*** 0.001***
(2.95) (2.87) (2.94)
EP 0.000 0.000 0.000
(0.12) (0.05) (0.17)
BOOKMKT 0.000 0.000 0.000
(0.20) (0.21) (0.18)
LEVERAGE 0.005** 0.005** 0.005**
(2.50) (2.44) (2.47)
BETA 0.003*** 0.003*** 0.003***
(5.24) (5.20) (5.30)
FIRST_FIRM 0.043*** 0.041*** 0.043***
(5.15) (4.93) (5.16)
FIRST_OFF 0.005** 0.005** 0.005**
(2.07) (2.12) (2.13)
Constant 0.002 0.006 0.002
(0.61) (1.53) (0.55)
Observations 19,450 19,450 19,450
Adjusted R2 0.0129 0.0145 0.0126
Overall F-Stat 5.89*** 6.40*** 5.70***
All results are obtained in the matched sample created based on city-level auditor industry specialization. One-tailed tests are used when a directional
hypothesis is specified; two-tailed tests are used otherwise.
B. Consistent with Irani et al.’s (2015) main results, we find that auditor dismissal is positively correlated with the number of
restatements an auditor has in the prior year. Our focus is the national- and office-level auditor expertise. As expected, we find
that at the national-level, specialist auditors are more likely to be dismissed than non-specialists. However, at the city-level, the
coefficients are not statistically significant, which is consistent with the findings in the summary statistics.
We also examine the change in audit fee revenue following a client restatement. Table 7, Panel C reports the findings. The
dependent variable is the change in audit fee revenue from one year prior to restatements to one year after restatements. As
expected, audit fee revenue declines for both the national specialists and office-level specialists following client restatements.
Finally, we study the PCAOB enforcement following restatement. We hand-collect two measures of PCAOB enforcement:
audit deficiency identified in PCAOB reports for annually inspected auditors and PCAOB settled disciplinary orders against
auditors. Unfortunately, for the first measure, all annually inspected auditors in our sample have deficiencies identified by the
PCAOB, providing no variation for a test. For the second measure, we collect all PCAOB settled disciplinary orders from the
PCAOB’s website and read through the order to identify the settlement auditor and audit office. A regression analysis using the
PCAOB settlement yields no significant results for specialist vs. non-specialist auditors, suggesting that client restatement does
not trigger PCAOB settlement actions.
(4) Additional control variables capturing the similarities between the restating and non-restating firms. We repeat our
main tests (Models (1) to (4)) after including relative measures capturing the similarities between restating and non-
restating firms in the following five dimensions: size, accruals, leverage ratio, number of business and geographic
segments, and audit fees. The empirical results are similar to our main findings.
Accounting Horizons
TABLE 7
Loss of Audit Clients and Audit Fee Revenue After Restatement
Panel A: Change of Clients During the One Year Before and One Year After Restatements
Obs. Mean Std. Err. Std. Dev.
National Specialist Auditor Sample
(1) Number of within-industry clients for the auditor firm prior to and after restatements:
PRIOR 704 61.00 1.64 43.39
POST 704 63.51 1.71 45.45
Difference 2.51*** 0.42 11.19
(5.95)
(2) Comparison of loss of within-industry clients between national specialist and
non-specialists:
NON-SPEC 511 1.29 0.47 10.57
SPECIALIST 193 5.74 0.87 12.13
Difference 4.45*** 0.93
(4.78)
(3) Number of out-of-industry clients for the auditor firm prior to and after restatements:
PRIOR 704 1,387.90 17.44 462.62
POST 704 1,381.80 18.27 484.64
Difference 6.10 6.73 178.44
(0.91)
(4) Comparison loss of out-of-industry clients between national specialist and
non-specialists:
NON-SPEC 511 4.25 7.09 160.31
SPECIALIST 193 10.98 15.82 219.72
Difference 6.73 15.08
(0.45)
City-Level Sample
(1) Number of within-industry clients for the audit office prior to and after restatements:
PRIOR 533 6.50 0.32 7.28
POST 533 6.80 0.34 7.75
Difference 0.30*** 0.11 2.45
(2.85)
(2) Comparison of loss of within-industry clients between city-level specialist and
non-specialists:
NON-SPEC 316 0.45 0.13 2.27
SPECIALIST 217 0.08 0.18 2.68
Difference 0.37* 0.22
(1.71)
(3) Number of out-of-industry clients for the audit office prior to and after restatements:
PRIOR 532 71.81 3.50 80.66
POST 532 72.05 3.47 79.94
Difference 0.24 0.83 19.18
(0.29)
(4) Comparison of loss of out-of-industry clients between city-level specialist and non-specialists:
NON-SPEC 316 0.08 1.08 19.27
SPECIALIST 216 0.48 1.30 19.09
Difference 0.40 1.69
(0.24)
Accounting Horizons
TABLE 7 (continued)
Panel B: Auditor Dismissal the Year After Restatements
Pred. (1) (2) (3)
Sign AUD_DIStþ1 OFF_DIStþ1 OFF_DIStþ1
NATL þ 0.698*** 0.460***
(6.37) (4.75)
CITY 3 SAMECITY þ 0.091 0.116
(1.01) (1.27)
CITY ? 1.009*** 0.914***
(3.27) (2.95)
SAMECITY ? 0.486** 0.441*
(2.06) (1.86)
Control Variables
OFFICESIZEt 0.001*** 0.001**
(3.03) (2.24)
RES_AUDITORt 15.437*** 15.103*** 12.633***
(5.98) (7.02) (5.64)
BIG4t 1.459*** 0.784** 0.840***
(4.40) (2.52) (2.70)
TENUREt 0.081** 0.107*** 0.103***
(2.36) (3.71) (3.57)
%AUDFEEt 0.454 0.770** 0.833***
(1.26) (2.48) (2.69)
LnASSETSt 0.503*** 0.519*** 0.532***
(9.11) (11.11) (11.29)
%DASSETSt 0.002 0.004*** 0.004***
(1.24) (3.49) (3.33)
LEVERAGEt 0.077 0.650*** 0.638***
(0.28) (2.92) (2.87)
%DLEVERAGEt 0.000 0.000 0.000
(1.45) (1.61) (1.54)
ROAt 0.865** 0.466 0.405
(2.05) (1.20) (1.05)
LOSSt 0.678*** 0.576*** 0.570***
(4.70) (4.57) (4.51)
MARKETVOLt 0.740 8.793* 8.854*
(0.13) (1.91) (1.92)
WEAKICt 1.187*** 1.034*** 1.052***
(9.12) (8.80) (8.91)
MGMTCHGt 0.018 0.194* 0.200*
(0.13) (1.74) (1.79)
Constant 0.016 0.525 0.394
(0.03) (1.18) (0.88)
Observations 14,045 12,890 12,890
Pseudo R2 0.1562 0.1335 0.1377
This analysis replicates the Irani et al. (2015) study with added measures of auditor industry specialization.
Alternative Specifications for Industry Specializations, Abnormal Returns, and Industry Classifications
We also replicate our main analyses using alternative specifications for auditor industry specializations, abnormal returns,
and industry classifications. Specifically, for industry specializations, we use three alternative definitions: (1) a national- (city-
level) specialist is the auditor that leads in audit fee market share nation-wide (city-wide) in an industry and if the market share
is at least 10 percent higher than that of the auditor holding the second place (Mayhew and Wilkins 2003; Reichelt and Wang
2010); (2) a national- (city-level) specialist is the auditor that has at least 30 percent (50 percent) audit fee market share nation-
Accounting Horizons
TABLE 7 (continued)
Panel C: Change in Audit Fee Revenue After Restatement
Pred. (1) (2) (3)
Sign DAUDFEES DAUDFEES DAUDFEES
NATL 0.014*** 0.009*
(2.47) (1.50)
CITY ? 0.012** 0.012**
(2.27) (2.13)
CITY 3 SAMECITY 0.028* 0.027*
(1.39) (1.37)
SAMECITY ? 0.008 0.008
(0.59) (0.61)
Control Variables
BIG4 0.053*** 0.056*** 0.058***
(3.17) (3.15) (3.25)
DSIZE 0.037*** 0.043*** 0.043***
(4.72) (5.27) (5.26)
DLEVERAGE 0.016 0.027 0.027
(0.63) (1.02) (1.01)
DRECEIVABLE 0.052 0.141** 0.142**
(0.90) (2.29) (2.31)
DINVENTORY 0.156* 0.156 0.154
(1.67) (1.57) (1.55)
DLIQUIDITY 0.003*** 0.004*** 0.004***
(3.23) (3.34) (3.35)
DROA 0.016*** 0.016*** 0.016***
(3.34) (3.24) (3.24)
CIFIRM 3.991 4.372 4.382
(1.19) (1.30) (1.30)
CIOFF 0.251 0.480 0.474
(0.90) (1.20) (1.18)
GCOPINION 0.051*** 0.052*** 0.052***
(3.52) (3.45) (3.47)
Constant 0.260 0.208 0.214
(0.75) (0.60) (0.62)
Observations 19,804 18,131 18,131
Adjusted R2 0.2502 0.2547 0.2548
Overall F-test of Model Fitness
F-stat 112.98*** 106.02*** 104.30***
Variable definitions not shown below are available in Appendix A.
Variable Definitions:
AUD_DIStþ1 ¼ an indicator that equals 1 if the auditor is dismissed by the non-restating firm in the year following restatement;
OFF_DIStþ1 ¼ an indicator that equals 1 if the audit office is dismissed by the non-restating firm in the year following restatement;
RES_AUDITORt (control variable) ¼ equals the number of restatements the auditor is involved in divided by the number of clients of the auditor;
WEAKICt (control variable) ¼ an indicator variable of internal control weakness;
MGMTCHGt (control variable) ¼ an indicator variable for top management change;
BIG4 ¼ an indicator that equals 1 if the auditor is a Big 4 firm;
BM ¼ book-to-market ratio of equity for the non-restating client;
CIFIRM ¼ client importance to the auditor firm defined as the proportion of client assets to the total assets of all clients of the auditor;
CIOFF ¼ client importance to the audit office defined as the proportion of client assets to the total assets of all clients of the audit office;
GCOPINION ¼ an indicator that equals 1 if the non-restating client receives a going concern opinion;
INVENTORY ¼ inventory of non-restating client in a fiscal year;
LIQUIDITY ¼ liquidity of non-restating client defined as total current assets divided by total current liabilities;
Accounting Horizons
TABLE 7 (continued)
LnASSETS ¼ natural log of assets of non-restating client at the end of the fiscal quarter preceding the restatement announcement date;
LOSS ¼ an indicator that equals 1 if the non-restating client has a loss in a fiscal year;
MARKETVOL ¼ standard deviation of daily stock returns of the non-restating client in a calendar year prior to restatement;
RECEIVABLE ¼ total receivables of non-restating client in a fiscal year; and
TENURE = auditor tenure with the non-restating client.
wide (city-wide) in an industry (Reichelt and Wang 2010); and (3) we first take the natural logarithm of the audit fees and set
the auditor having the highest sum of ln(audit fees) nation-wide (city-wide) in the industry as the national- (city-level) industry
specialist.
For market returns, instead of size-adjusted returns, we use CRSP value-weighted as well as equal-weighted market
adjusted cumulative abnormal returns. And, for industry classifications, we use the Fama-French 48 industry classification to
replace the two-digit SIC codes. For each of the alternative specifications, we replicate the main tests as well as the cross-
sectional analyses (Models (1) to (4)). All the (un-tabulated) results are qualitatively similar to our main findings.
VI. CONCLUSION
In this paper, we examine whether an auditor’s reputation as an industry specialist adds value to its clients in the capital
market. Specifically, we examine whether the non-restating firms suffer collateral damage in the capital market when their
auditor’s industry-specific reputation is damaged in the case of restatements of its other clients. Our argument is that any
damage to an auditor’s reputation is likely to cause negative impact on its clients if the auditor’s reputation as an industry
specialist is valuable and previously priced in the capital market. We find that the capital market reacts negatively when an
auditor’s reputation as a city-level industry specialist is damaged by restatements and such an effect is more pronounced when
there are frauds involved in the restatements. For national-level industry specialist auditors, we do not find significant results in
the main tests. In further analyses, we find negative market reaction for national-level specialists when (1) the restatements
involve fraud (2) the restating firms face larger stock price declines, and (3) the restating clients are larger. We conduct a battery
of robustness checks and our main results remain.
Using a quasi-experimental research design, this study decreases the confounding factors in the existing literature and
improves our understanding of the capital market implications of auditor industry specialization. The study also provides
validation of the widely used market share-based measures of auditor industry expertise. Our results suggest that investors’
initial assessments of industry specialization are correlated with the auditor’s within-industry market share. However, investors
are not fixated on the initial assessment as they use financial restatements as supplemental signals to adjust the valuation of
auditor industry expertise. In addition, our results highlight the differences in investors’ reactions to auditor clients of national-
versus city-level industry specialists. Last, we contribute to the restatement literature by showing that a restatement is a type of
audit failure. It negatively impacts not only the restating company but also its auditor and the auditor’s other clients.
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Accounting Horizons
APPENDIX A
Variable Definitions
Variable Definition
Restatement-Level Variables
CARRES Restating firm (1, þ1) three-day size-adjusted cumulative abnormal return around the restatement
announcement date.
RESSIZE Natural log of restating firm’s total assets for the quarter ending immediately before the restatement.
FRAUD An indicator that equals 1 if the restatement involves fraud as reported in the Audit Analytics database,
and 0 otherwise.
SECINVOL An indicator that equals 1 if the restatement involves SEC investigation as reported in the Audit
Analytics database, and 0 otherwise.
AUDINVOL An indicator that equals 1 if the auditor has knowledge or is involved in the restatement as reported in
the Audit Analytics database, and 0 otherwise.
BOARDINVOL An indicator that equals 1 if the Board of Directors/Audit Committee is involved or notified in the
restatement as reported in the Audit Analytics database, and 0 otherwise.
REVENUE An indicator that equals 1 if the restatement involves problems of revenue recognition as reported in the
Audit Analytics database, and 0 otherwise.
LGRESCAR An indicator that equals 1 if the restating firm’s three-day CAR is more negative than the sample
median, and 0 otherwise.
LGRESSIZE An indicator that equals 1 if the restating firm’s natural log of total assets for the quarter ending
immediately before the restatement is larger than the sample median, and 0 otherwise.
FIRST_FIRM (FIRST_OFF) An indicator that equals 1 if it is the first restatement for the auditor firm (audit office) in prior 12-
month period, and 0 otherwise.
Non-Restating Firm-Level Variables
CARNONRES Non-restating firm’s (1, þ1) three-day size-adjusted cumulative abnormal return around the
restatement announcement date.
SAMECITY An indicator that equals 1 if, on the restatement announcement date, the non-restating firm’s auditor
office is the auditor office of the restating firm during the misstatement period, and 0 otherwise.
NATL An indicator that equals 1 if the non-restating firm’s auditor is a national-level industry specialist, i.e.,
has the highest industry market share nation-wide in the 12-month period prior to the restatement
announcement date, and 0 otherwise.
CITY An indicator that equals 1 if the non-restating firm’s auditor is a city-level industry specialist, i.e., has
the highest industry market share in the city in the 12-month period prior to the restatement
announcement date, and 0 otherwise.
NATLONLY An indicator that equals 1 if the non-restating firm’s auditor is a national-level but not a city-level
industry specialist, and 0 otherwise.
CITYONLY An indicator that equals 1 if the non-restating firm’s auditor is a city-level but not a national-level
industry specialist, and 0 otherwise.
JOINT An indicator that equals 1 if the non-restating firm’s auditor is both a city- and national-level industry
specialist, and 0 otherwise.
SIZE Natural log of non-restating firm’s total assets for the quarter ending immediately before the restatement.
EP Non-restating firm’s earnings to price ratio (IBQ/PRCCQ CSHOQ) for the quarter ending immediately
before the restatement.
BOOKMKT Non-restating firm’s book to market value of equity ((ATQ LTQ)/(PRCCQ CSHOQ)) for the
quarter ending immediately before the restatement.
LEVERAGE Non-restating firm’s leverage ratio (DLTTQ/ATQ) for the quarter ending immediately before the
restatement.
BETA Non-restating firm’s beta estimated with daily stock return over the (255, 2) period, requiring at
least 100 observations available for each stock.
OFFICESIZE The total audit fees (in millions) earned by an audit office during the prior fiscal year.
SIMILARITY A measure of similarity between the non-restating firm and the restating firm calculated as SIZE of non-
restating firm divided by SIZE of restating firm.
SALESGROW Sales growth over the same quarter of last year.
AUDFEE Audit fee paid by the non-restating client.
ROA Return on assets of non-restating client defined as income before extraordinary items divided by total
assets.
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ACCOUNTING HORIZONS American Accounting Association

Vol. 33, No. 1 DOI: 10.2308/acch-52350

Does the Market Value Auditors’ Industry Specializations?

II. PRIOR LITERATURE AND HYPOTHESES

Audit Quality, Industry Specialization, and Capital Market Pricing

The Contagion Effect of Restatements and Hypothesis Development

III. RESEARCH DESIGN

Measuring Industry Specializations

Identification of Auditors and Non-Restating Clients

Market Reactions to the Restating and Non-Restating Clients

where date 0 is the restatement announcement date.

Mutually Exclusively Defined Industry Specialization Measures

Similarities between Restating and Non-Restating Firms

Panel A: Restatement Sample

Panel B: Non-Restating Firms Sample

Alternative Specifications and Other Sensitivity Analyses

IV. SAMPLE AND DESCRIPTIVE STATISTICS

Restatements Sample Selection Process

Non-Restating Clients Sample Selection Process

Panel A: Restatement Sample Summary Statistics

Panel B: Non-Restating Sample Summary Statistics

Specialization Level: CITY 3 SAMECITY

Panel A: Tests Results Estimating Models (1)–(3)

Cross-Sectional Analysis Controlling for Severity of Restatements

Panel A: Market Reaction Tests

Panel B: Cross-Sectional Analysis of Market Reactions

Additional Analyses and Robustness Tests

Panel A: Sample Selection Process

Panel B: Covariate Balance Check

Panel C: The Market Reaction to Non-Restating Firms around Restatement Announcement

Panel D: Cross-Sectional Differences in Auditor Industry Specialization’s Impact on Market Reaction

(continued on next page)

Variable definitions not shown below are available in Appendix A.

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