The effects of industry specialization on auditors' inherent risk assessments and second-order uncertainty

This paper contributes to the auditing expertise literature by examining the effects of industry specialization on auditors' inherent risk (IR) assessments, and on auditors' uncertainty in specifying such assessments. Two groups of auditors (banking specialists and nonbanking specialists) provided planning-stage IR assessments and related second-order uncertainty (SOU) assessments. Analysis of the assessments supports several conclusions. First, consistent with the notion that industry experience facilitates the development of an industry-distinct knowledge base pertinent to IR assessment, nonspecialists experienced significantly more uncertainty about their IR assessments, relative to specialists. This result was observed for IR assessments pertinent not only to the loans account, but also to the premises and equipment (P&E) account, although the effect was not as pronounced for the P&E account which has a more similar analog in most other types of clients.;Second, and also consistent with the previous notion, nonspecialists' IR assessments were generally significantly higher for a financial statement account unique to the industry than industry specialists' IR assessments, indicating a conservative bias when industry knowledge is lacking. This result has important implications regarding audit testing; an example illustrates that the nonbanking group's IR assessments would result in hypothetical samples sizes (using the participating firm's sample size algorithm) that are on average 12 percent larger than the banking group's, holding all else constant (;Third, consistent with the notion that common experience standardizes knowledge bases pertinent to IR assessments, specialists exhibited significantly more (similar) consensus in their IR assessments for an account unique (not unique) to banking clients than (compared to) nonspecialists. Relatedly, the variance in uncertainty about IR assessments was significantly smaller for industry specialists, supporting the assertion that common experience standardizes knowledge bases pertinent to IR assessments and reduces individual differences in perceptions about the adequacy of knowledge bases which support IR assessments.;The findings presented have not been documented previously, and contribute to the literature on expertise in auditing. Several other avenues of research are suggested and advocated including the investigation of additional questions about the effects of industry specialization on audit judgment.