The Interrelation between Audit Quality and Managerial Reporting Choices and Its Effects on Financial Reporting Quality

43 Pages Posted: 22 Jul 2016 Last revised: 19 Dec 2018

See all articles by Evelyn Patterson

Evelyn Patterson

Indiana University-Kelley School of Business

Reed Smith

Kelley School of Business

Samuel L. Tiras

Indiana University - Kelley School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: November 2018

Abstract

Two distinct lines of research have been dedicated to empirically testing how financial reporting quality (measured as the earnings response coefficient or ERC) is associated with management's choice of reporting bias and with audit quality. However, researchers have yet to consider how ERCs are affected by either the auditor's reaction to changes in the manager’s reporting bias or the manager’s reaction to changes in audit quality. Our study provides theoretical guidance on these interrelations, and how changes in the manager’s or the auditor’s incentives affect both reporting bias and audit quality. Specifically, when the manager’s cost (benefit) of reporting bias increases (decreases), we find that expected bias decreases, inducing the auditor to react by reducing audit quality. Because we also find that the association between expected audit quality and ERCs is always positive, changes in managerial incentives for biased reporting lead to a positive association between ERCs and expected reporting bias. When the cost of auditing decreases or the cost of auditor liability increases, we find that expected audit quality increases, inducing the manager to react by decreasing reporting bias. In this case, changes in the costs of audit quality lead to a negative association between ERCs and expected reporting bias. Finally, we demonstrate the impact of our theoretical findings by focusing on the empirical observations documented in the extant literature on managerial ownership and accounting expertise on the audit committee. In light of our framework, we provide new interpretations of these empirical observations and new predictions for future research.

Keywords: Strategic Auditing, Financial Reporting Quality

JEL Classification: C72, M21, M42

Suggested Citation

Patterson, Evelyn and Smith, J. Reed and Tiras, Samuel L., The Interrelation between Audit Quality and Managerial Reporting Choices and Its Effects on Financial Reporting Quality (November 2018). Kelley School of Business Research Paper No. 16-60, Available at SSRN: https://ssrn.com/abstract=2812853 or http://dx.doi.org/10.2139/ssrn.2812853

Evelyn Patterson (Contact Author)

Indiana University-Kelley School of Business ( email )

801 West Michigan
Indianapolis, IN 46202
United States
317-278-7843 (Phone)

HOME PAGE: http://kelley.iupui.edu/faculty/FacultyProfile.cfm?netid=evpatter

J. Reed Smith

Kelley School of Business ( email )

801 W Michigan Street
BS 4002
Indianapolis, IN 46202
United States
317-274-0867 (Phone)
317-274-3312 (Fax)

Samuel L. Tiras

Indiana University - Kelley School of Business ( email )

801 W. Michigan Street
Indianapolis, IN 46202
United States
(317) 274-3420 (Phone)

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