The Impact of Risk and the Potential for Loss on Managers' Demand for Audit Quality*

Abstract

This study uses experimental economic markets to investigate the impact of risk and the potential for loss on managers' demand for audit quality. We posit that these two important contextual factors influence managers' audit quality preferences. We study these factors because they are ubiquitous to companies, and we focus on their influence on managers because managers continue to play a significant role in the auditor hiring process and we know relatively little about their auditor preferences. We predict that risk, the potential for loss, and their interaction will each decrease manager demand for high audit quality due to a desire to achieve greater reporting flexibility. Experimental results are consistent with our predictions; specifically, increased risk, the potential for loss, and to a lesser extent their interaction, significantly reduce managers' likelihood of hiring the best available auditor in the market. Path analysis indicates that this reduction in audit quality demand leads to increases in misreporting. Finally, we observe investors overpaying for assets to a greater extent when managers hire lower-quality auditors. Our results show that the contextual factors of risk and the potential for loss, which are ubiquitous to companies, can reduce demand for audit quality, which can increase misreporting behavior and ultimately harm investors.

جهد مراقب الحسابات بعد تطبيق معايير المحاسبة المصرية المُعدَّلة لعام 2015: دليل من الشركات غير المالية المدرجة في البورصة المصرية (باللغة الانجليزية)

“…Therefore, this theory explains the goal of developing high-quality IFRS to help financial statement users make sound decisions considering the costs and benefits of implementing IFRS (Soyinka et al, 2017;IASB, 2018;Kamotho et al, 2022). Besides that, according to the signaling theory, the adoption of IFRS can be seen as an indication of improved transparency and quality of financial reports presented to all market participants which motivates managers to demand high-quality level of the audit process to reflect their desire in reducing the potential perceived increased risk (Hlel et al, 2020;Hurley et al, 2021).…”

Addressing Managerial Loss Aversion for the Corporate Value Creation Process: A Critical Analysis of the Literature and Preliminary Approaches

“…Another proven negative effect for corporate value creation is played by managerial loss aversion in the phase of choosing auditors. In practice, the loss aversion affects managers who, afraid of receiving severe and negative audit reports, lower audit quality demand (Hurley and Mayhew 2019;Hurley et al 2021).…”