Empirical Tests of Audit Budget Dynamics

Abstract

Previous research in nonaudit contexts suggests that managers design budgets based on prior performance relative to budget targets, and that this “ratcheting” response can be asymmetrical (i.e., greater increase in target following good performance than the decrease in target following correspondingly bad performance). This implies a dynamic view of budgeting, in which the budget is an endogenous feature of the business environment, a perspective that is rare in the auditing literature. We hypothesize and find asymmetric budget ratcheting by audit firm supervisors in a sample of audit engagements. Further, we find that engagement teams' reported hours also vary asymmetrically with prior budget variance. Our results suggest temporal interdependence between audit firm supervisors and engagement teams as both parties act strategically to adapt budgeting and reporting behavior based on prior budget variances, with associated implications for audit quality.