The Impact of Financial Reporting Flexibility on Auditor Risk Judgment – Evidence from a Natural Experiment

Abstract

This paper investigates how auditors respond, in terms of their pricing and audit work, to a reduction of clients’ financial reporting discretion upon the implementation of FIN 46R “Consolidation of Variable Interest Entities” in year 2003. The accounting standard mandatorily requires firms to consolidate the performance of variable interest entities (VIEs) under their control. These entities can no longer be off-balance sheet and managers’ flexibility in using these entities for manipulating earnings is substantially constrained. Using a difference-in-difference research design, we find that auditors charge relatively fewer audit fees and have shorter audit reporting lags for firms which are significantly affected by FIN 46R after its adoption, compared to a group of controlled firms. This result concurs with the view that auditors react favorably to the reduction of clients’ financial reporting discretion, by reducing their audit pricing and audit work. Our finding is concentrated among those clients with higher accrual earnings management constraints and auditors with less client specific knowledge and also auditors who have no clients conducting severe accounting restatements. Our results are robust to different matched control samples and our conclusion remains valid by using an alternative treatment sample which is not affected by the contemporaneous adoption of SOX Act.

Keywords: financial reporting flexibility, variable interest entities, audit pricing, FIN 46R