The Interplay between Financial Reporting Biases and Audit Quality

Abstract

We show that a firm's optimal financial reporting bias and an auditor's choice of audit effort are inextricably intertwined. Aggressive or conservative accounting practices influence the auditor's optimal choice of audit effort, and the auditor's incentive and ability to detect misstatements in turn influence the firm's optimal accounting bias. Due to this interplay, a shift to more aggressive accounting can reduce, rather than increase, the incidence of overstatements and hence overinvestment and investor litigation. While ex ante litigation risk is typically considered to be a major driver of conservative accounting practices in corporations, we derive conditions under which a heightened threat of litigation can encourage more aggressive accounting.