Looking into the “Black Box” of Audit Production: Auditors’ Response to Corporate Corruption Culture

Abstract

External auditors, through their intensive contact with clients, are exposed to extensive information concerning their clients, including the culture of corruption that exists within the firm. Using a novel measure of corporate corruption culture developed by Liu (2016) as the proxy for firms’ actual corruption culture, we analyze how auditors respond to the ex-ante fraud risk associated with clients’ corporate corruption culture and whether audit effort reduces the ex-post incidence of fraud arising from corruption culture. We find that audit fees and audit effort, as proxied by audit report lag, are greater for clients with a higher corruption culture. The results are robust when we constrain our sample to clients that have no restatement and no accounting fraud (as measured by the ex-post discovery) in our sample period and are robust to the inclusion of state×year- and audit-firm- fixed effects. Further, we show that audit effort reduces the incidence of fraud arising from corruption culture. Our findings provide insights into the effect of client corruption culture on audit production and offer evidence on the value of auditing.