Client Corruption Culture and External Auditor Monitoring

Abstract

The existing empirical literature has shown that audit fees are higher for firms with greater perceived audit risk. However, there is no empirical evidence as to whether auditors are successful in reducing the incidence of fraud in situations when ex-ante fraud risk is high. Conceptually, any evaluation of auditors’ ability to prevent or detect fraud must recognize the importance of clients’ ex-ante fraud risk as a benchmark. The corporate governance literature shows that a firm’s fraud risk is deeply rooted in its corporate culture. Using client corruption culture as a measure of ex-ante fraud risk, we examine whether auditors are effective in reducing the incidence of accounting fraud associated with a corrupt client culture. We find that audit effort reduces the incidence of fraud attached to a corrupt client culture and audit effort (proxied by audit report lag) is greater for clients with a higher corruption culture. By contrast, the relationship between corruption culture and the incidence of accounting errors is insignificant (or much weaker). Rather, internal control weaknesses increase the risk of accounting errors, and additional audit effort in the presence of internal control weaknesses reduces the incidence of errors. Our findings provide insights into the monitoring role of auditors in fraud detection and prevention, and add to the auditing literature on the important role client corruption culture plays in audit production.

Keywords: Corporate Corruption Culture, Ex-Ante Fraud Risk, Audit Effort, Accounting Fraud, Restatement, Accounting Errors

JEL Classification: G30, M43, Z10