Would an Audit Judgment Rule Improve Audit Committee Oversight and Audit Quality?

Abstract

The current regulatory environment encourages auditors to engage in “defensive auditing.” That is, auditors must show that they complied with widely accepted standard procedures in order to reduce their exposure to PCAOB inspectors and courts. This could discourage innovation in auditing, since new and innovative procedures are not standard practice. A new stream of research examines a proposed change to legal rules that would protect auditors from being second-guessed, even when they make non-standard judgments, provided that they are made rigorously and in good faith. This proposed “Audit Judgment Rule” (“AJR”) could potentially improve audit quality by encouraging innovation. We review two studies that examine the effects of such an AJR on the judgments of audit committee members and auditors. Results of these studies suggest that an AJR may have unintended consequences, reducing audit innovation and audit quality. We discuss implications for implementing an AJR, including directions for future research.