The Relationship between an Independent Audit and Financial Reporting Quality: Evidence from Small Private Commercial Banks

Abstract

The study starts by examining whether the decision to have an independent audit is systematic and endogenous. Private commercial banks with under $500 million in total assets are regulatory exempt from an independent audit requirement.However, approximately 56% of these small private commercial banks voluntarily decided to have an independent audit. Utilizing a set of machine learning algorithms, Ifind that the decision to have an independent audit is systematically determinable and is endogenously determined given a set of bank characteristics. I also find that bank size, profitability, growth, complexity of operations, and type of ownership may influence the decision to have an independent audit at small private commercial banks.In the main part of the study, I analyze whether an independent audit improves financial reporting quality. Financial reporting quality is quantitatively measured by material accuracy, conservative recognition of probable losses, and the magnitude of discretionary accruals. Based on these quantitative measures, I find that having an independent audit does not improve financial reporting quality. More specifically, the iii results in this study indicate that independently audited small private commercial banks had a higher likelihood of having a restatement, were less conservative in recognizing probable loan losses, and had higher magnitudes of discretionary accruals. Collectively, the results in this study provide rigorous and substantial evidence that the quality of financial reporting may not increase by having an independent audit and may not support the benefits of procuring an independent audit absent regulatory requirements.Moreover, the study implicates the quality of audits being performed at small private commercial banks and perhaps suggests that the audit methodology used by external auditors has to be reconsidered.iv ACKNOWLEDGEMENTS

The “Big Four” and “Sai”– A Case Study on the Management of Financial Audit Independence

“…Researchers demonstrated that there are connections between the type of audit report and the auditors' awareness or even unconscious interests or factors (Chan & Kogan, 2012;Constantinides, 2002;Geiger & Raghunandan, 2002;Moore et al, 2003;Rosman, 2011;Tara, 2011 Based on these researchers' findings and on our analysed case results, we suggest that the independence of financial auditing could be improved by finding solutions that eliminate, as much as possible, the material connections between the auditors and those being audited.…”