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Auditor Conservatism and Investment Efficiency

Tong Lu

University of Houston

Haresh Sapra

University of Chicago - Booth School of Business

Accounting Review, Forthcoming
Chicago GSB Research Paper No. 08-03

We develop a theoretical framework to investigate (i) both the determinants and the consequences of auditor conservatism in a capital market setting and (ii) the implications of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive the following results. First, by varying the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism while companies with low business risk induce auditor aggressiveness. Second, if auditor conservatism is in force, a greater client pressure on auditors (in the form of granting or withholding potential client business opportunities) improves audit quality and if auditor aggressiveness is in force, a greater client pressure on auditors impairs audit quality. Third, the nature of a firm's investment inefficiency (overinvestment or underinvestment) depends on its auditor's attestation (conservatism or aggressiveness). Fourth, our model sheds light on the potential effects of Section 201 of the Sarbanes-Oxley Act, which prohibits public companies from granting their auditors many types of nonaudit services. Overall, the above results are useful both for public policy making and for empirical research.

Number of Pages in PDF File: 35

Keywords: auditor conservatism, audit quality, investment efficiency, nonaudit services

JEL Classification: M49, G38, G31

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Date posted: July 17, 2008 ; Last revised: February 13, 2009

Suggested Citation

Lu, Tong and Sapra, Haresh, Auditor Conservatism and Investment Efficiency. Accounting Review, Forthcoming; Chicago GSB Research Paper No. 08-03. Available at SSRN: http://ssrn.com/abstract=1161272

Contact Information

Tong Lu
University of Houston ( email )
Houston, TX 77204
United States
Haresh Sapra (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
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