The Relationship between an Independent Audit and Financial Reporting Conservatism: Evidence from Small Private Commercial Banks

Abstract

The objective of this paper is to examine the relationship between an independent audit and financial reporting conservatism in the small private commercial bank setting. We use the timely recognition of probable losses and the minimal use of discretionary accruals as proxies for conservatism. Intuition and prior literature leads us to hypothesize that banks that are audited should exhibit greater conservatism in financial reporting than those banks that are not audited. However, we find evidence that persistently audited banks are on average less conservative. In contrast, we find evidence that banks are on average more conservative in the period in which they switched from not being audited to audited. Collectively, the evidence suggests there is an initial positive relationship between an independent audit and financial reporting conservatism. However, there is a negative relationship between an independent audit and financial reporting conservatism when an independent audit is a persistent occurrence.

Keywords: Independent Audit, Financial Reporting, Conservatism, Discretionary Accruals, Commercial Banks