Auditors’ consideration of material income-increasing versus material income-decreasing items: are conservatism and risk affected by company level information?

Abstract

Auditors tend to focus more on income-increasing items compared to income-decreasing items because they are trained to be more conservative and also because the risk of litigation is significantly higher for failing to detect material income-increasing items compared to material income-decreasing items. Auditors’ consideration of transaction level items is also affected by their evaluation of company level information. In this study we examine how the interaction between company level information and sign of the material items affect auditors’ evaluation of income-increasing and income-decreasing items. The results indicate that in the absence of company level information, auditors intuitively associate a higher risk and audit effort to income-increasing items. When the company level information indicates that management is under pressure to inflate earnings, auditor conservatism and risk associated with income-increasing items gets amplified leading to an increase in the difference in assessed risk and audit effort between income-increasing and decreasing items. However, when the company level information indicates that management is not under pressure to inflate earnings, there are no significant differences in assessed risk and audit effort between income-increasing and income-decreasing items. These results indicate that auditor conservatism is affected by company level information.