Auditing Section Research Summaries Space

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    Voluntary Audits versus Mandatory Audits
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.02 Client Risk Assessment 
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    Title:
    Voluntary Audits versus Mandatory Audits
    Practical Implications:

    This analysis provides empirical support for the argument that the mandatory requirement suppresses information that is conveyed when companies are allowed to choose whether to be audited. Moreover, additional tests indicate that the opt-out companies were only passively complying with the audit requirement—evident in their attempts to reduce costs through auditor choice and fees—under the mandatory regime. In other words, it is difficult to force companies to privately contract for stringent audits if they would choose not to be audited voluntarily. However, the research on private companies cannot contribute valid insights on the relative merits of voluntary and mandatory audits for public companies.

    For more information on this study, please contact Clive Lennox.

    Citation:

    Lennox, C. S. and J. A. Pittman. 2011. Voluntary Audits versus Mandatory Audits. The Accounting Review 86 (5): 1655-1678. 

    Keywords:
    voluntary audits; mandatory audits; credit ratings
    Purpose of the Study:

    Exploiting a natural experiment in which voluntary audits replace mandatory audits for U.K. private companies, we analyze whether imposing audits suppresses valuable information about the types of companies that would voluntarily choose to be audited. Companies should be compelled to have their financial statements audited to ensure that outsiders have access to reliable accounting information. In the other direction, requiring audits suppresses the signal that is conveyed when companies exercise their discretion in choosing whether to be audited. This study provides empirical evidence on the merits of these competing arguments by analyzing economic outcomes for private companies stemming from a regime switch from mandatory to voluntary audits. The purpose of our analysis is to isolate whether this regime change permitted firms to signal new information about their types.

    Design/Method/ Approach:

    The authors compile the sample from the Financial Analysis Made Easy (FAME) database. By design, each company in the sample was required to have an audit in 2003, but not in 2004. There are two observations per company, with the first pertaining to the final year of the mandatory audit regime (2003) and the second to the initial year of the voluntary regime (2004).

    To gauge whether voluntary audits reveal new information about borrowers’ types, the authors examine the changes in credit ratings after the transition from mandatory to voluntary audits in a natural experiment. They control for the assurance benefits of auditing to isolate the role signaling plays by focusing on companies that are audited under both regimes. These companies experience no change in audit assurance, although they can now reveal for the first time their desire to be audited. The study also tests whether the companies that would choose to avoid an audit under the voluntary regime were privately contracting for a relatively low level of audit assurance during the mandatory regime.

    Findings:
    • The authors find that credit ratings rise for companies that continue being audited during the first year of the voluntary regime, and they interpret this evidence as implying that these companies enjoy ratings upgrades because their decision to remain audited conveys an incrementally positive signal about their credit risk. The level of audit assurance appears stable for these companies during the transition from mandatory to voluntary audits, as their audit fees and auditor choices do not change following the regime switch.
    • The authors also examine the impact of the regime switch on credit ratings for the companies that choose to opt out of the audit, and find that credit ratings drop when companies abandon the audit, which conveys a negative signal about their type and reduces financial reporting credibility; i.e., both signaling and the drop in assurance are responsible for their ratings falling.
    Category:
    Client Acceptance and Continuance
    Sub-category:
    Client Risk Assessment