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How technology knowledge spillovers are transforming the audit profession

By Dr Bing Li

Dr Bing Li, is an Associate Professor in the Department of Accountancy. In a world of increasingly monopolistic accountancy firms she looks at the way in which technology knowledge spillovers are affecting the audit process, potentially to the benefit of both auditing companies and their clients. This article is based on the working paper, "Auditor expertise developed from client technological links," by He, Y., J.B. Kim, B. Li, and Z.B. Liu, 2020.

The 2018 Nobel laureate in Economics, Paul Romer, proposes that technology is the key input to a firm's production function and the key source of economic growth1. His models explain how innovative technologies in the early 1990s, such as computer codes for word processors or the internet, gave rise to increasing returns to scale in production and sustained exponential growth in the economy. Technology has moved on a long way since then, and these days technological platforms are increasingly shared across sectors. Firms interact with one another to inspire innovations, and technological advancement created by one firm can rapidly diffuse to other firms in related technological fields even when they are not in the same product market. Such knowledge "spillovers" have become increasingly important in the daily operation, growth and productivity of firms. In this innovation and technology-based economy, how can auditors best leverage their clients' technological position to make better auditing decisions and professional judgments?



The benefits of technology knowledge spillover

The new-found technological expertise is transforming the nature of audit work. By knowing how a client uses technology to execute and record business transactions, auditors are better able to design audit procedures which can more effectively and efficiently collect appropriate evidence. Traditional substantive audit tests may no longer be fit-for-purpose in the light of key technological developments such as the Internet of Things, artificial intelligence, and smart contracts used in the financial reporting and internal control process. Auditors should be aware of the benefits and risks resulting from the implementation of new technologies in financial reporting and how they may affect planned audit procedures.

Here's how technology spillover might work to the benefit of auditing companies. American Airlines Group Inc. (AA) and AT&T Inc. (AT&T), the world's largest telecommunications company, are both audited by the Ernst & Young Dallas office. Although these two firms do not belong to the same industry or share any supply-chain linkages, their main patents both cover the same technological field of "automated reservations system (Cooperative Patent Classifications (CPC): G06 and Q10)," which constitutes the online booking systems for their services/products. In a break from the traditional financial reporting process, most of the audit evidence for AA and AT&T is now available electronically, with many tests of controls and substantive tests performed using electronic data.

Clients may face many new business risks relating to their online reservation systems, for example, pervasive security risks such as virus attacks and infrastructure failures, or transaction integrity risks such as the need to distinguish between customer browsing, orders placed and cancelled. Auditors need to conduct tests of controls regarding whether the clients have implemented sufficient internal controls to address security and integrity risks, and to prevent unauthorised changes to the accounting system or records. It is plausible that Ernst & Young may develop their auditor expertise in the technology field of "automated reservations system" through their auditing of AA and AT&T, which, in turn, may facilitate their audit work for all other clients who have adopted the automated reservations system. Conversely, technology knowledge spillover from other clients in technology Class G06 and Q10 will benefit Ernst & Young's audits of AA and AT&T.



Innovation and client-specific production

Another way in which technological expertise can benefit auditors is related to innovation and client-specific production. Deloitte & Touche Chicago office provides audit services for both Deere & Co, an American manufacturer of agricultural, construction, and forestry machinery and Abbott Laboratories, an American medical devices and health care company. These two firms do not have any overlap in the supply-chain and product market. But both of their major patents cover the technological field of "measuring liquid level (CPC classes: G01F23)," which is crucial for their operations as it provides a way to reliably and accurately measure and monitor liquid inventories across the whole production process. From the auditor's point of view, the greater their experience in the technology field of "measuring liquid level," the better to evaluate the clients' inventory, which could influence the whole production process. If Deloitte & Touche gain expertise in liquid measuring knowledge from auditing Deere and Abbott, this will benefit their audit work on any other clients whose operations involve the same technology.



Auditor technological expertise is a benefit to clients

Technology knowledge transfer is occurring beyond traditional industry boundaries. Sharing an auditor with a product market competitor is a potential risk, which may result in negative business-stealing effects, a.k.a. product-market rivalry effects, to the leaked firm. But client firms are less likely to be concerned about potential leakage of proprietary information when they hire the same auditor as their close technology peers. Therefore, auditor technology specialisation developed from clients' technological proximity constitutes a critical type of auditor expertise, in distinction to auditor industry specialisation. One can therefore expect that auditors will be able to develop specialisation from clients with technology affinity to a greater extent than from those with product closeness, resulting in higher audit quality.



Technology affinity and audit fees

How does technology affinity affect audit fees? On the one hand, auditors who provide specialised services need to invest extra effort to gain and maintain their expert knowledge and to better polish their audit work. Such specialist auditors therefore require a normal rate of return on such additional investments, resulting in higher audit fees compared to non-specialist ones. In a similar vein, if auditors are able to develop a reputation for better audit quality arising from their technology specialisation, they can charge audit fee premiums for that expertise. Client firms are also willing to pay an audit fee premium for their auditors' technology specialisation. On the other hand, auditors will charge lower audit fees if client technology knowledge spillover provides auditors with economies of scale, reducing the effort required to understand, evaluate, and detect accounting problems.

In our paper2, we exploit the technological closeness among clients of the same auditor to examine whether auditors develop expertise from their client technological links beyond product-market specialisation. At the audit office level, we find that a firm's technological proximity to the other clients of its audit office improves audit quality and results in an audit fee discount. Interestingly, although we simultaneously examine both clients' technological proximity and industry-level product similarity in our main models, we do not find significant evidence of improved audit quality or decreased audit fees associated with product similarity. At the audit firm level, there is no strong evidence that either technological proximity or product similarity among clients of the same audit firm affects audit quality or audit fees. Taken together, our findings suggest that technology knowledge is client-specific and cannot be easily transferred beyond the individual audit office.



References:

Dr Bing Li
Associate Professor
Department of Accountancy