Does Auditor Quality Matter for Diversification?

Montgomery (1994) reports that two-thirds of the Fortune 500 U.S. public companies were remarkably diversified and involved in more than one industry. These firms accounted for nearly 50% of U.S. employment and owned about 60% of the total assets of publicly traded firms (Martin and Sayrak, 2003). Also, the Financial Accounting Standards Board (FASB) in June 1997 issued SFAS No. 131, which was enacted to improve information disclosure about the diversity of a diversified firm’s operations. Thus, diversified firms constitute a significant portion of the U.S. economy and important sector for accountants.
First, this study examines the relation between the auditor quality (auditor size and auditor industry specialization) and the excess value attributed to diversification. Consistent with the hypothesis that monitoring and governance of audit are important to the capital markets, we find that (1) diversified firms are more likely to employ a Big N auditor or an industry-specialist auditor to signal the credibility of financial statement information for enhanced disclosures, (2) the relation between auditor quality and the excess value is most pronounced in diversified firms, and (3) the information role of audits is statistically significant to the stock market. Overall, our results suggest that, through their roles of producing valuable information to the investors, auditor quality matter to capital market participants.
Second, we investigate how auditor quality relates to the investment efficiency in the diversified firms suffering from sever agency problems. We hypothesize that auditor quality can enhance investment efficiency in the diversification by reducing information asymmetry in two ways: First, an auditor can provide greater credibility information to shareholders, thereby helping them monitor managers’ actions, improving investment efficiencies. Second, auditors can improve the efficient allocation of capital across business segment, thereby removing information asymmetries between division managers and headquarters in internal capital markets. Our results are consistent with these hypotheses, suggesting that auditor quality can provide a monitoring mechanism on enhancing investment efficiency across segment and efficient allocation in internal capital. They are robust to correct for self-selection of auditor choice, different measures of auditor quality, alternative investment measures, and numerous control variables.