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Sharing knowledge in an auditor network relates to higher quality and compensation

Datum:23 september 2020
Auteur:James Zhang
Sharing knowledge in an auditor network relates to higher quality and compensation
Sharing knowledge in an auditor network relates to higher quality and compensation

Recent Widecard scandal (wikipedia.org/wiki/Wirecard_scandal) has drawn attention to audit deficiency again, both from media (such as Financial Times and Wall Street Journal) and audit regulators. While it is important to maintain independence from clients, audit regulators consistently emphasize the role played by auditor’s knowledge and expertise to detect fraud. During audit practice, especially when time pressure is high, of high relevance to their performance (and compensation) is how auditors can exploit their knowledge and expertise.

During audit practice, auditors are regularly assigned to different engagement teams, consisting of assurance auditors (typically including assistants, associates, managers, directors and partners) and other experts (e.g., tax, IT professionals). In this way a two-mode (bipartite) network [1] develops, with different network structures representing different amounts of audit knowledge available for an auditor. Part of my PhD project examines the association between network structure and auditor compensation, an important incentive for auditors to deliver high quality audits.

Academic studies in the auditing show that audit knowledge is more likely to be tacit rather than explicit [2], knowledge that cannot be acquired directly, develops over time, and requires intense interactions during audit practice. One example is fair value accounting (e.g., the valuation of complex financial instruments), which involves substantial judgement, and is difficult to transmit to other auditors directly. Due to this characteristic, when auditors share and change engagement team memberships, auditors will be likely to make such tacit knowledge flow through different auditors across different engagements, via intense interactions. Thus, as knowledge flow through one specific auditor increases, auditors are able to perform better on the current complex audit tasks, and therefore can receive better performance evaluations and compensation. Moreover, knowledgeable auditors can signal important values for audit firms that will compensate them more to retain talents.

My PhD project tests whether there is a positive association between tacit audit knowledge flow and auditor compensation. Academic studies in social networks, utilizing the perspective of strong ties involving intense interactions, show that the knowledge flow is positively associated with projects’ financial success and organizational creative and innovative outcomes. Academic studies in economics also reveal a positive association between network connectivity and individual wages. As such, we hypothesized that this relationship is positive, and indeed, we have found a positive association in our auditing context study. This has strong implications for modern knowledge-intensive project teams. The key issue is how to mix the knowledge and expertise when designing project teams and make tacit knowledge diffuse easily.

Now, as long as there is a positive association between tacit audit knowledge and auditor compensation, an important incentive for high quality audit work (also an important incentive for employees in almost all organizations), the question is how to make the tacit knowledge flow and diffuse. In our context, we utilize the network structure from a bipartite network, where a better network structure represents more tacit knowledge flow. In essence, this is relevant to Human Resources (HR) practice. That is, when staffing, HR should mix different auditors with different types of knowledge and expertise. One example is relevant to audit partners with specific industrial expertise, such as finance. Audit partners can be designed with a network structure so that such type of audit industrial knowledge can be quickly diffused, resulting in potentially more quality, and compensation.

Deju (James) Zhang (james.zhang rug.nl) is a PhD candidate at Faculty of Economics and Business, the University of Groningen. He works with Prof. Dr. Floor Rink at Department of HRM & OB, and Prof. Dr. Reggy Hooghiemstra and Dr. Dennis Veltrop at Department of Accounting. His research is largely related to Multiple Team Membership and Audit Quality.

[1] Borgatti, S. P., and M. G. Everett. 1997. Network analysis of 2-mode data. Social Networks 19(3): 243-270.

[2] Bol, J. C., C. Estep, F. Moers, and M. E. Peecher. 2018. The role of tacit knowledge in auditor expertise and human capital development. Journal of Accounting Research 56(4): 1205-1252.