Adverse Effects of Accounting Enforcement on Financial Reporting Quality – The Role of Auditor Conservatism

Abstract

This paper provides a theoretical perspective on the effect of enforcement on auditor-client interaction and overall financial reporting quality. We grasp the financial report as the joint outcome of negotiations between the preparer and the auditor. In our model, the audit might result in situations of inconclusive evidence which the auditor can approach either by being conservative or aggressive. While auditor aggressiveness leads to more overstatements, 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. Facing a conservative auditor, the preparer as better-informed party has incentive to exercise validating effort in order to convince the auditor to change her opinion. We find that if enforcement is relatively weak, the auditor is aggressive and stricter enforcement increases audit quality and thereby overall financial reporting quality. In a relatively strict enforcement environment, in turn, the auditor is conservative and might economize on her audit effort as she free-rides on the subsequent validating effort of the preparer. Shedding light on adverse side effects of enforcement, we thus provide conditions under which the financial reporting quality deteriorates with stricter enforcement.

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

JEL Classification: G38, M41, M42, M48