The Impact of Audits on Financial Statement Error in the Presence of Incentive and Opportunity

• In Event: Audit Quality II

Abstract

This study seeks to enhance our understanding of the effectiveness of audits vis-à-vis reviews in mitigating error, particularly in the presence of incentives to misreport and opportunities for error to occur. Prior research examines the effectiveness of audits in mitigating error in the financial statements of private firms choosing to have an audit. We employ a unique within-firm research design that mitigates the potential risk of correlated omitted variables and extends the finding that audits are effective in mitigating error to include public firms for whom an annual audit is mandatory. We employ a fresh approach to estimating financial statement error, which allows for a greatly expanded sample and new insights into the statistical and economic significance of audits in mitigating error. We also introduce novel proxies for incentives to misreport and opportunity for error to occur, which are designed based on auditor guidance provided in AU §316.85 (PCAOB 2002). We find that the audit is associated with reduced financial statement error. This benefit is magnified in the presence of opportunity for error to occur due to complexity or weak internal controls but is mitigated in the presence of incentives to misreport. The extent of mitigation, although statistically significant, is not economically significant. Consequently, our results suggest that audits substantially reduce the extent of error in public firms’ financial statements; even in circumstances in which managers might actively seek to conceal errors from auditors.

Authors

• Melissa Fay Lewis-Western, Brigham Young University

• Erik S. Boyle, University of Utah

• Christine Ann Botosan, University of Utah