How Economic Conditions Affect Auditors’ Judgment

Auditor judgment and technical competence are central to audits, and a lack of those qualities has led to many audit deficiencies, according to the Public Company Accounting Oversight Board (PCAOB), the UK’s Financial Reporting Council (FRC), and other regulators around the world. In our recent article, “Long-Term Impact of Economic Conditions on Auditors’ Judgment,” available here, we use two newly-available archival datasets on auditors’ personal information and their audit adjustments, and provide evidence on whether and how the economic conditions at the time of an auditor’s entry into the labor market affect her judgment and decision-making years later.

Our hypothesis is grounded in a large literature in behavioral economics on imprinting, which is defined as “a process whereby, during a brief period of susceptibility, a focal entity develops characteristics that reflect prominent features of the environment, and these characteristics continue to persist despite significant environmental changes in subsequent periods.” Prior research strongly suggests that the early-career stage is a sensitive period of imprinting for individuals. For example, Schoar and Zuo (2017, available here) find that CEOs who entered the labor market during recessions adopt a more conservative management style.

We hypothesize that a higher degree of professional skepticism is imprinted on auditors who enter the labor market during economic downturns. An auditor can be passively imprinted since the environment determines the type of exposure that she receives. Alternatively, an auditor might actively build a certain type of human capital in an environment that highlights its value. It is well-known that economic downturns are characterized by greater uncertainty, which makes it harder for outsiders to assess a company’s financial performance. In addition, economic downturns adversely affect corporate earnings, and executives often face pressure to embellish their financial performance in those periods. To the extent that the auditors’ role is “to obtain reasonable assurance about whether the financial statements are free of material misstatement,” auditors should be more skeptical in the presence of heightened uncertainty during economic downturns. Consistent with this argument, prior research finds that auditors pay more attention to fraud detection during economic downturns. We hypothesize that auditors who join the profession in economic downturns (we label them as “downturn auditors”) would view skepticism as a critical attribute of the audit professionals and actively develop a skeptical mindset, and that those auditors would carry the imprint of their initial environment throughout their careers.

We test our hypothesis using a sample of 8,163 audits conducted from 2006 to 2011. We find that audit adjustments occur more frequently for engagement partners who started their careers in economic downturns. In addition, we find evidence that auditors who entered the labor market during a period with heightened exposure to audit failure investigations develop a higher degree of professional skepticism than their peers. Furthermore, we find that starting during more severe economic downturns has a greater effect on an auditor’s adjustment decisions. Together, these results suggest that an auditor’s attitude developed at job market entry affects her audit work even years later, when she becomes an engagement partner.

We perform a battery of additional tests and analyses to ascertain the robustness of our findings. First, for the sub-sample of company-years with no audit adjustments, downturn auditors are more likely to issue a modified audit opinion. This result is consistent with the idea that a downturn auditor’s professional skepticism will be reflected in her proclivity to issue a modified audit opinion in the absence of an audit adjustment. Second, companies audited by downturn auditors are less likely to misstate their financial reports or face enforcement actions from the regulator. This finding is consistent with other auditors (versus downturn auditors) being insufficiently skeptical.

Third, a higher degree of professional skepticism is not equivalent to a higher degree of pessimism: Our results hold for downward and upward adjustments, as well as for large and small adjustments. Fourth, an auditor’s career path depends on economic conditions at her labor market entry and can partly explain her adjustment decisions. Fifth, downturn auditors bill slightly more audit hours but do not charge higher audit fees, and controlling for audit effort does not affect our results. Sixth, working in big audit firms does not appear to mute the difference between downturn auditors and other auditors. This result suggests that auditors’ cognitive features are unlikely to be counter-balanced by strong governance, which is consistent with the recent findings in the literature that engagement partners’ own style leaves an imprint despite the standardization of audit procedures in big audit firms.

Our hypothesis is that imprinting contributes to auditors’ professional skepticism and the documented audit outcomes. Auditor selection is a potential alternative explanation for our findings. Audit firms might choose to hire more skeptical or talented job applicants as junior staff during economic downturns. However, a person’s degree of skepticism or talent is unobservable to outsiders, and employers must rely on a person’s observable characteristics to determine whether to hire her. A common criterion used by audit firms for hiring decisions is success at university, which is viewed as requiring curiosity and an inquiring mind. We compare the observable characteristics of downturn auditors and other auditors at labor market entry, i.e., whether the auditor has a college or higher degree, the reputation of the auditor’s undergraduate university, whether the auditor’s college major is accounting, whether the auditor is a Chinese Communist Party member, and the auditor’s gender. Because we do not observe systematic differences between downturn auditors and other auditors on these observable characteristics, we conclude that selection is unlikely to explain the documented phenomena.

Our findings suggest a link (but not necessarily a causal relation) between an auditor’s early career experience and audit outcomes. Audit partners are not randomly assigned to clients, and clients can actively engage in partner-level opinion shopping. Risky clients might press audit firms to assign less skeptical auditors (e.g., auditors who started their career during economic good times) as their engagement partners. If this were true, we would expect to observe that companies audited by these auditors are less likely to make an audit adjustment or receive a modified opinion but are more likely to commit accounting fraud. While this self-selection story presents a complication in interpreting our results, it still supports our hypothesis that an engagement partner’s initial mindset for an audit carries the imprint of the economic environment at her job market entry, which risky clients take into account when engaging in opinion shopping.

Our findings potentially have broad implications for the auditing profession. Whether economic downturns affect an auditor’s level of professional skepticism through imprinting or selection, these cohort effects seem to change the composition of available auditors in the future. Our results suggest that after an extended economic expansion in a region, there could be a limited supply of skeptical auditors in that region. Our study represents an initial step towards better understanding the formation and selection of auditors in the labor market.

This post comes to us from Professor Xianjie He at Shanghai University of Finance and Economics, Professor S.P. Kothari at MIT Sloan School of Management, Professor Tusheng Xiao at Central University of Finance and Economics, and Professor Luo Zuo at Cornell University. It is based on their recent article, “Long-Term Impact of Economic Conditions on Auditors’ Judgment,” available here.