Audits and Bank Failure: Do Financial Statement Audits Reduce Losses to Capital Providers?

Abstract

We assess whether financial statement audits reduce the risk of losses to capital providers. Prior research documents a negative association between financial statement audits and perceived credit risk or interest costs, but surprisingly few studies assess whether lower perceived risk or interest costs are associated with fewer adverse risk-related operational outcomes, such as defaults. Using a sample of small, privately held commercial and savings banks subject to failure during the crisis years, and operationalizing default as failures resulting in losses to the FDIC insurance fund, we find firms having mandatory or voluntary financial statement audits are 33% to 50% less likely to experience defaults, compared to samples of unaudited firms, including samples matched on propensity to obtain an audit. These results are consistent with audited firms posing less default risk to creditors. That both mandatory and voluntary audits are negatively associated with failure after matching on other firm characteristics suggests the benefits of audits are not limited to voluntary audit regimes. Finding the presence of an audit is associated with a reduction in failure outcomes is important for regulators and other stakeholders as they weigh costs and benefits of mandatory audits.