The impact of financial reporting flexibility on auditor risk judgement: Evidence from the implementation of FIN 46R

Abstract

This paper investigates how auditors respond, in terms of their pricing and audit work, to a reduction of clients’ financial reporting discretion upon the implementation of FIN 46R, which requires firms to consolidate the variable interest entities (VIE) under their control. Using a difference-in-differences research design, we find that auditors charge relatively fewer audit fees and have shorter audit report lags for firms that are significantly affected by FIN 46R, compared to a group of control firms. This result concurs with the view that auditors react favorably to the reduction of clients’ financial reporting discretion. Our finding is concentrated among clients with higher accrual earnings management constraints, auditors with less client-specific knowledge, and auditors who have no recent experience of audit failures (e.g., severe client restatements). Our results are robust to alternative identifications of treatment and control samples, and our conclusion remains valid after controlling for the contemporaneous adoption of Sarbanes-Oxley (SOX) Act. We also show that the relatively reduced audit fees and audit effort do not lead to the deterioration of audit quality.