Are auditors unable to detect classification shifting or merely not willing to report it? evidence from India

Abstract

Prior research suggests that Big-4 auditors fail to curb classification shifting in the countries with weak legal institutions. However, it is not known whether the auditors are unable to detect the use of this earnings management tool or if they are able to detect such misclassifications but are not motivated to report them. We conduct two experiments to examine this issue. Our results indicate that, auditors are sensitive to various types of classification shifting while assessing fraud risk and audit effort. However, their willingness to report such discretionary earnings management is affected by the overall legal liability regimes and institutional controls of the region in which their clients operate. More specifically, our results indicate that the presence of weak legal institutions in a country reduces the litigation risk faced by auditors which make them less likely to report misclassifications. On the other hand, auditors are significantly more likely to report misclassifications by qualifying their audit report if, a company is cross listed in a country with strong institutional controls and legal regime.