The Effect of Enforcement on Auditor Conservatism

• In Event: Regulation and Auditing

Abstract

This paper provides a new perspective on the effect of enforcement on auditor behavior and overall financial reporting quality by considering auditor conservatism as a strategy towards uncertainty which might arise during the audit procedure. As an enforcement error finding reveals not only misconduct by the manager but also audit failures, the auditor in our theoretical model has incentive to carefully examine a managerial report in order to reveal and correct a potential manipulation (informative effort). Whenever facing insufficient audit evidence, however, the auditor can require downward adjustments of the items in doubt which shelters her from impending enforcement penalties (auditor conservatism). Given a manipulating manager, we show that stricter enforcement increases both, informative as well as conservative effort. While informative effort enhances the correctness of the audited accounting signals, auditor conservatism introduces a downward bias into the published reports. Although a tightening of enforcement strictness prevents overstated reports, financial reporting quality is therefore not necessarily increased. Stricter enforcement enhances conformity of published reports with applicable accounting standards in environments of high manipulation risk. In environments of intermediate and low manipulation risk, however, it depends on the relation of informative and conservative effort whether increased enforcement strictness improves the overall conformity of financial reporting with accounting standards.

Authors

• Mareike Peters-Olbrich, University of Cologne

• Selina Orthaus, University of Cologne