An Examination of Auditors’ Responsiveness to Risk Cues: Evidence from Fair Value Estimates

Abstract

PCAOB inspections and field studies consistently highlight difficulties faced by auditors when testing fair value estimates, but the root causes of these deficiencies are less understood. One strategy to reduce bias and improve audit quality is to enhance auditors’ effectiveness in incorporating cues into their risk assessment process. In this study, we seek to understand whether and when auditors incorporate cues indicating increased risk into their evaluation of fair value estimates. Consistent with concerns about auditors’ performance in this area, we find that more than one-third of fair value estimates in our security-level dataset differ from the true fair value by a non-trivial amount that should warrant further auditor consideration. If auditors effectively incorporate cues, we predict a negative association between observable risk cues and fair value errors. Our findings indicate auditors’ ability to integrate cues depends on the nature of the cue and expertise of the auditor. We fail to find evidence that either experts or non-experts incorporate indirect cues identified in the planning stage of the audit, which require drawing connections across accounts or time. In contrast, experts appear to outperform non-experts only in incorporating direct cues identified during substantive testing. These analyses enhance our understanding of variation in auditors’ performance and highlights potential areas for improvement.

Keywords: fair value, investment security, expert auditors, Big 4, cues, property-casualty insurance companies

JEL Classification: M41, M42, G22, G23