Extant research provides compelling evidence that individual auditors have distinct auditing styles, which significantly impact audit outcomes (Gul et al., 2013; Lennox and Wu, 2018; Cameran et al., 2020). However, there is limited understanding of how auditing styles are shaped and evolve over time. In a recent study, forthcoming in the European Accounting Review, we addressed this gap by investigating how prior engagements with bankrupt clients (i.e., bankruptcy experiences) influence auditors’ professional skepticism, conservatism, and client management decisions, using data from a large sample of Swedish firms.
We proposed that experiencing a client’s bankruptcy may lead auditors to reassess engagement risk upward, prompting them to adopt strategies (such as exerting more effort and providing higher quality audits) to reduce this risk to a tolerable level. Moreover, a client’s bankruptcy may reveal deficiencies in audit quality, exposing the auditor to regulatory scrutiny and increasing their litigation and reputation risks. Based on this line of reasoning, we predicted that auditors with bankruptcy experience will exhibit higher professional skepticism and deliver greater audit quality. We also expected these experiences to affect client management decisions, particularly by making them avoid financially distressed clients.
We tested our predictions on a sample of Swedish public and private firms, which allowed us to observe auditors’ experiences and their impact across auditors’ entire portfolios. Our evidence revealed a positive and significant relation between auditors’ bankruptcy experiences and audit quality. In other words, their clients manage their earnings less. We also found that auditors with such experiences charge higher audit fees and are more likely to issue a going-concern opinion to financially distressed clients. However, these going concern opinions are not always more accurate. While auditors with bankruptcy experience are better at identifying distressed firms that subsequently go bankrupt, they tend to be overly cautious issuing more going concern opinions also to clients that do not ultimately go bankrupt.
Bankruptcy experiences also affect client management decisions – auditors with bankruptcy experiences are less likely to accept financially distressed clients and more likely to resign from such clients. These effects were observed both at Big 4 and non-Big 4 audit firms, indicating that even standardized procedures and stronger quality controls of Big 4 firms are unlikely to countervail the influence of individual auditors’ styles and preferences.
We also investigated the mechanisms through which the observed effects take place. The documented increase in audit quality delivered by auditors with bankruptcy experience may reflect a rational adjustment to previously suboptimal audit practices that exposed them to greater regulatory scrutiny and litigation risk. Alternatively, even if prior audit quality was adequate, bankruptcies can be lengthy and stressful events that harm an auditor’s reputation and may prompt them to reassess their audit risk assessments. Our analysis did not find evidence that prior audit quality was generally inadequate. However, we observed that the effects of bankruptcy experiences on audit outcomes and client management decisions were more pronounced when the auditors had been sanctioned.
Finally, we examined how the saliency and recency of bankruptcy experiences affects auditors’ decision-making and found that bankruptcies of larger, more visible clients as well as bankruptcy events that occurred within the previous three years are more impactful for auditors’ behavior.
In summary, our study highlights how prior professional experiences shape auditors’ decision-making and audit outcomes. Unlike prior studies investigating the effects of rare, once-in-a-lifetime events, we focused on bankruptcy experiences, which are in general more frequent, more recent, and more directly relevant to auditors’ decision-making. Our findings also suggest that audit styles are not time-invariant but evolve throughout an auditor’s career.
References:
Cameran, M., Campa, D., & Francis, J. R. (2022). The relative importance of auditor characteristics versus client factors in explaining audit quality. Journal of Accounting, Auditing & Finance, 37(4), 751-776.
Gul, F. A., Wu, D., & Yang, Z. (2013). Do individual auditors affect audit quality? Evidence from archival data. The Accounting Review, 88(6), 1993-2023.
Lennox, C. S., & Wu, X. (2018). A review of the archival literature on audit partners. Accounting Horizons, 32(2), 1-35.
This post is by Mariya Ivanova at the Stockholm School of Economics and NHH Norwegian School of Economics, Milda Tylaite at the Stockholm School of Economics, and Liwei Zhu at CUNEF. It is based on their recent article, “The Impact of Client Bankruptcies on Auditors’ Judgment and Future Audit Engagements”, which is forthcoming at the European Accounting Review.
