Understanding earnings quality - MIT Sloan School of Management

5.4.3 Studies of other auditor characteristics
Auditor effort: Direct studies of the effects of auditor effort are generally not possible because effort
is unobservable, but experimental settings and surveys provide some evidence on auditor effort.
Phillips (1999) suggests that auditors increase their effort when the risk of misstatements is high;
accordingly, the presence of auditing can deter financial reporting irregularities (e.g., Schneider and
Wilner, 1990). Hirst (1994) finds that auditing judgments reflect earnings management incentives
from management buyout and bonus plans, which suggests that an auditor’s ability to detect errors
varies with his effort to understand incentives. Nelson, Elliot, and Tarpley (2002) survey 253
auditors from one of the Big-five audit firms who identify 515 experiences of attempted earnings
management. The surveyed auditors suggest that they do adjust for attempted earnings management,
especially when attempted earnings management increases current-year earnings. Using a unique
archival dataset, Caramanis and Lennox (2008) document a significant negative relation between
audit hours worked, as a proxy for auditor effort, and discretionary accruals for a sample of audits
from Greece. 60
Industry expertise: Krishnan (2003) finds that the magnitude of discretionary accruals is lower for
clients of auditors with industry expertise.
Litigation risk: In an experiment, Barron, Pratt, and Stice (2001) find that auditors are more likely to
adjust errors that overstate earnings than errors that understate earnings, and they are more likely to
correct errors when litigation against the auditor of a competitor to the client firm for a similar
misstatement resulted in a loss to the auditor. They conclude that auditors are more likely to correct
60 However, an “in-basket” task experiment that asked managers to make discretionary accrual decisions and that varied
the manager’s perceptions of internal and external auditor aggressiveness based on fabricated correspondence included in
the experimental materials found no support for the hypothesis that internal and external auditors act as a deterrent to
aggressive financial reporting (Uecker, Brief, and Kinney, 1981).
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