Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Auditor Conservatism and Investment Efficiency
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 11.0 Audit Quality and Quality Control, 11.08 Proxies for Audit Quality 
    855 Views
    Title:
    Auditor Conservatism and Investment Efficiency
    Practical Implications:

    This study provides an additional perspective on the economic implications of Section 201 of SOX, arguing that a one-size-fits-all requirement that restricts auditors from providing their clients with many nonaudit services is generally suboptimal.

    Citation:

    Lu, T. and H. Sapra. 2009. Auditor Conservatism and Investment Efficiency. The Accounting Review 84 (6): 1933-1958.

    Keywords:
    Auditor conservatism, audit quality, investment efficiency, nonaudit services
    Purpose of the Study:

    Auditing reduces information risk in companies’ financial statements, thus improving investors’ investment decisions. However, empirical research suggests that auditors have become increasingly conservative following the demise of Arthur Anderson and the enactment of the Sarbanes-Oxley Act (SOX). This study develops a theoretical framework to investigate how auditor conservatism and audit quality arise (i.e. determinants) and how they affect the information content of financial statements (i.e. consequences) to determine whether: 

    • Client characteristics exist that either induce or deter auditor conservatism (i.e. determinants).
    • Audit quality is impaired or improved by auditor conservatism.
    • Investment efficiency is affected. That is, whether auditor conservatism triggers over/under investment decisions.
    • The results provide any insight on the potential effects of Section 201 of SOX, which aims at constraining client pressure on auditors by prohibiting auditors from providing many nonaudit services to their clients.
    Design/Method/ Approach:

    The authors develop a theoretical model to investigate the tension between the auditor’s expected fees from the client and the expected legal liability of overstatements in the client’s financial statements to determine the auditor’s supply of auditing. Next they model the market’s interpretation of the audited financial statements in order to value that company and make investment decisions. They then explore how the capital market’s pricing rule generates demand for auditing. Finally, the authors characterize how the company makes its audit fee decision in light of its demand for auditing. Taken with the auditor’s supply of auditing, the authors determine equilibrium auditor conservatism and audit quality.

    Findings:
    • Clients with high business risk induce auditor conservatism, while clients with low business risk induce auditor aggressiveness.
    • If auditor conservatism is in force (high business risk), then a greater client pressure on auditors improves audit quality; but if auditor aggressiveness is in force (low business risk), then a greater client pressure on auditors impairs audit quality. This finding is contrary to the widely-held belief that client pressure on an auditor is always harmful.
    • The nature of investment efficiency depends upon the auditor’s attestation. Auditor conservatism triggers overinvestment, while auditor aggressiveness triggers underinvestment.
    • Mandatory restriction of client pressure in general and nonaudit services in particular increases auditor conservatism, decreases a conservative auditor’s audit quality and increases an aggressive auditor’s audit quality, increases overinvestment and decreases underinvestment, and increases the audit fee.
    Category:
    Audit Quality & Quality Control
    Sub-category:
    Proxies for Audit Quality
    Home:
    home button