Auditor Conservatism, Audit Quality, and Real Consequences for Clients

Abstract

Auditors tend to be more conservative in their audits when they face greater litigation risk. However, it is unclear whether this conservatism is always desirable or whether it can be excessive. To evaluate the usefulness of greater auditor conservatism, we examine whether auditor conservatism improves audit quality and imposes real operating consequences for clients. We examine auditor behavior in a sample of commercial bank clients, when one of their other bank-clients fails (as deemed by the FDIC). We find auditors that experience a bank failure within their portfolio become more conservative for surviving clients. However, we find that the larger loan loss provisions at surviving clients were no more timely, less accurate, and reversed in subsequent periods. This finding suggests that auditors’ initial portfolio-wide response to a specific client failure may be overly conservative. We also document that surviving client banks face real consequences in terms of constraints on their lending because of the auditor’s excessive conservatism. Overall, we conclude that, in some situations, auditors could over-react, leading to excessive conservatism, which in turn has adverse consequences for clients.

Keywords: Auditor conservatism, auditor portfolios, reporting quality, loan loss provisions

JEL Classification: G21; M41; M42