Do Auditors Overemphasize Contextual Benchmarks? Archival Evidence on Contrast Effects in Auditors’ Assessment of Client Risk

Abstract

As part of planning and performing financial statement audits, auditors must assess their clients’ risk. Assessed risk permeates the audit process, driving decisions regarding client retention, audit pricing, the extent of audit testing, and the nature of auditors’ written opinions. Although auditors aim to assess each client’s risk independently, prior research suggests that individuals draw on their idiosyncratic experiences and environments for benchmarks against which to contrast the case at hand. These “contrast effects” may skew auditors’ perceptions of risk, particularly if they rely on unrepresentative benchmark firms. I provide archival evidence consistent with this prediction. Using a large sample of public firms, I find that after controlling for clients’ actual risk, auditors more strictly constrain the use of discretionary accruals, are more likely to issue going concern opinions, and charge higher audit fees when clients appear riskier in the context of other clients audited by the same practice office. The reverse is true for clients that appear less risky in the context of other clients audited by the same practice office.

Keywords: Behavioral decision making; audit client risk; contrast effects