What Do Auditors Communicate to the Audit Committee About Management’s Accounting Choices?

Abstract

Audit committees are responsible for overseeing the financial reporting process, but they may not acquire the knowledge they need to be effective if, as prior research documents, they are seldom involved in auditor-client manager negotiations over accounting issues. Audit committees that prefer low involvement in the negotiation process rely on auditor-provided information, rather than on first-hand knowledge, to evaluate these negotiation outcomes. In this study, we investigate how the audit committee’s oversight approach can establish accountability and set the tone for more open communications with auditors. Specifically, we examine whether the audit committee’s reputation for asking questions (proactive vs. reactive) compensates for a lack of first-hand knowledge (arising from low involvement) by motivating auditors to communicate their insights on issues that were resolved with management. In our experiment, experienced auditors resolved an inventory valuation issue, and then drafted a written communication about it to the audit committee. We find that auditors communicate valuable insights (e.g., concerns about management’s significant assumptions), which could compensate for low audit committee involvement, but only when audit committees keep auditors accountable through a reputation for proactive questioning. While auditors can contribute more value to the audit committee’s oversight efforts by filling in its knowledge gaps, our results suggest that auditors instead focus their communications on avoiding audit committee scrutiny.