The Effect of Enforcement on Auditor Conservatism

Abstract

This paper provides a theoretical perspective on the effect of enforcement on auditor behavior and overall financial reporting quality. Therefore, we consider auditor conservatism as a strategy towards uncertainty, which might arise in highly discretionary accounting areas during the audit procedure.
Given a manipulating manager in equilibrium, we show that stricter enforcement increases both examination and conservative audit effort. While examination effort enhances the correctness of the audited accounting signals, auditor conservatism introduces a downward bias into the published reports as the auditor requires downward adjustments of the items that she could not verify during the first audit stage. Although a tightening of enforcement strictness prevents overstated reports, financial reporting quality is not necessarily increased. Stricter enforcement enhances the conformity of published reports with applicable accounting standards in environments of high manipulation risk. In environments of low manipulation risk, the relationship between examination and conservative effort determines whether increased enforcement strictness improves the overall financial reporting quality.

Keywords: auditor conservatism, audit quality, discretion, enforcement, financial reporting quality

JEL Classification: G38, M41, M42, M48