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. Thereby, 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, we show that stricter enforcement increases both, examination as well as 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 she was not able to verify during the first audit stage. Although a tightening of enforcement strictness prevents overstated reports, financial reporting quality is therefore not necessarily increased. Stricter enforcement enhances conformity of published reports with applicable accounting standards in environments of high manipulation risk. In environments of low manipulation risk, however, it depends on the relation of examination and conservative effort whether increased enforcement strictness improves the overall financial reporting quality.