Can auditors be independent? – Experimental evidence on the effects of client type

Recent regulatory initiatives stress that an independent oversight board, rather than the management board, should be the client of the auditor. In an experiment, we test whether the type of client affects auditors’ independence. Unique features of the German institutional setting enable us to realistically vary the type of auditors’ client as our treatment variable: we portray the client either as the management preferring aggressive accounting or the oversight board preferring conservative accounting. We measure auditors’ perceived client retention incentives and accountability pressure in a post-experiment questionnaire to capture potential threats to independence. We find that the type of auditors’ client affects auditors’ behaviour contingent on the degree of the perceived threats to independence. Our findings imply that both client retention incentives and accountability pressure represent distinctive threats to auditors’ independence and that the effectiveness of an oversight board in enhancing auditors’ independence depends on the underlying threat

Auditors’ Response to Different Reporting Environments: Experimental Evidence from the Quantity and Quality of Auditors’ Evidence Demands in China

There has been a significant worldwide movement to adopt International Financial Reporting Standards (IFRS), which are more principles-based compared to many of the more rules-based national accounting standards that they replaced. The majority of previous studies focus on how this financial reporting environment change influences earnings quality, while there has been limited research on how auditors respond to IFRS. We perform an experiment using Chinese professional auditors to test the joint effects of the type of accounting standards and the strength of the financial regulatory regime on both the quantity and quality of auditors' evidence demands. We find that auditors are likely to have more evidence demands and, particularly, more diagnostic evidence demands under principles-based accounting standards. This influence is more pronounced under the stronger financial regulatory regime. The effect of the institutional environment on IFRS standards is an important international reporting topic particularly for emerging markets like China where there is strong economic growth with an increased focus on reporting standards and regulation. China is an ideal environment to examine this topic because it is the largest country in the world to adopt IFRS, and many Chinese auditors have experienced both rules- and principles-based accounting standards

Do key audit matters impact financial reporting behavior?

This study experimentally examines whether the implementation of key audit matters (KAMs) in auditors' reports affects managers' reporting behavior. In line with prior research in psychology, we argue that greater transparency through KAMs leads to higher accountability pressure as managers may expect their judgments to be scrutinized more strongly in the presence of KAMs and, hence, to an improvement of financial reporting quality. Further, we examine whether informational precision (firm-specific versus nonfirm-specific information) in a KAM section moderates the effect of KAM presence on reporting behavior. Our findings show that managers' tendency to make an aggressive financial reporting decision is reduced in the presence of KAMs (compared to the absence of KAMs). This effect remains even when the description of the KAM is of low informational precision. Thus, our results suggest that KAMs serve as a beneficial mechanism for enhancing financial reporting quality by attenuating aggressive financial reporting behavior, regardless of the precision employed by auditors

The Role of Risk Management and Governance in Determining Audit Demand

Most prior research into audit fees has been based on a theoretical model which treats audit fees as the by-product of a production function ignoring potential demand forces that may drive the level of the audit fee. Inspired by prior 'anomalous' results, we take a different perspective by focusing on demand factors that may affect the level of the audit fee. Using data collected from a sample of listed companies in Belgium, we consider both disclosures about risk and risk management and actual decisions about corporate governance to examine whether audit fees are higher when these demand forces exist. In general, we expect that external auditing will increase in situations where there are multiple stakeholders with individual risk profiles who can shift some of the cost of monitoring to other stakeholders. Consistent with our theory and expectations, our results indicate that audit fees are higher when a company has an audit committee, discloses a relatively high level of financial risk management, and has a larger proportion of independent Board Members. Audit fees are lower when a company discloses a relatively high level of compliance risk management. The latter result indicates that controls are only complementary as long as they are voluntary, as mandated controls act as substitutes for non-mandated controls. Copyright 2006 The Authors Journal compilation (c) 2006 Blackwell Publishing Ltd.