The Interaction between Informal and Formal Institutions: Corruption Culture and External Auditor Monitoring

Abstract

The literature shows that a firm’s fraud risk is rooted in its culture. I investigate whether auditors play a role in mitigating the impact of corrupt corporate cultures on accounting fraud. I find that, on average, firms with high corruption cultures are less likely to have high-quality auditors and that this negative association is more pronounced when firms can better generate funds internally. Nevertheless, the association between corruption culture and auditor choice has an inverted-U relationship. This is consistent with firms with high corruption cultures demanding higher-quality auditors to mitigate agency conflicts and that auditors rejecting clients when fraud risk is too high. Given auditor choice, audit effort is higher for firms with higher corruption cultures and mitigates the positive relation between corruption culture and financial reporting fraud. This paper operationalizes the nature of audit production and acknowledges the value of auditors in detecting and correcting fraud in pre-audit financial statements.

Keywords: Corporate Corruption Culture, Informal Institution, Formal Institution, Audit Effort, Accounting Fraud, Audit Fees

JEL Classification: G30, M40, Z10