The Economic Effect of Differing Levels of Auditor Assurance on Bankers' Lending Decisions

This study examines the economic impact of three different levels of auditor assurance on loan decisions of bank loan officers. Sixty-seven experienced loan officers were administered a research instrument containing a hypothetical loan application with accompanying financial statements and accounting schedules. Three levels of auditor assurance were manipulated in the experiment by having the financial statements compiled, reviewed, or audited as those terms are defined in the Statement on Standards for Accounting and Review Services No. 1, issued by the American Institute of Certified Public Accountants in 1979 (SSARS No. 1). The loan officers were asked to make two decisions: would they recommend making a loan and what interest rate would be charged on such a loan? Since 1979, SSARS No. 1 permits CPAs in the United States to perform compilations or reviews for private companies, in addition to audits. Auditor assurance with respect to financial statements is monotonically increasing as one moves from compilations to reviews to audits, because of a corresponding increase in professional responsibility and related evidence collection procedures. Strictly speaking, compilations provide no assurance because the CPA disclaims an opinion and only assembles client data in the proper format for financial statements as required by GAAP. However, a compilation provides some albeit limited assurance because the auditor is required to (1) have a general understanding of the client's industry prior to undertaking the compilation, (2) follow up on any problems discovered during the compilation, and (3) withdraw from the engagement should the client fail to address problem areas. Reviews offer more assurance than compilations, though considerably less than audits, because of the restricted scope of the engagement.(1) SSARS No. 1 (para. 4) states: The objective of a review differs significantly from the objective of a compilation. The inquiry and analytical procedures performed in a review should provide the accountant with a reasonable basis for limited assurance that there are no material modifications that should be made to the financial statements. No expression of assurance is contemplated in a compilation. The objective of a review also differs significantly from the objective of an examination of financial statements in accordance with generally accepted auditing standards. The objective of an audit is to provide a reasonable basis for expressing an opinion regarding the financial statements taken as a whole. A review does not provide a basis for the expression of such an opinion because a review does not contemplate a study and evaluation of internal accounting control, tests of accounting records and of responses to inquiries by obtaining corroborating evidential matter through inspection, observation or confirmation, and certain other procedures ordinarily performed during an audit. In spite of this unique institutional development, we know of only two studies of its economic effect. One is Abdel-khalik's (1989) survey of the owners of 56 small firms concerning the perceived benefits of audits versus reviews. The other is the study by Johnson, Pany, and White (1983) of 98 bank loan officers who perceived that audited financial statements were more likely to be materially free of misstatements (compared to no attestation, compilations, or reviews). However, the type of auditor attestation was found to have no economic effect on either the loan acceptance or interest rate decision. A possible reason for this is the suggestion by Waterston (1979) that loan officers may not have initially understood the differences among audits, reviews, and compilations. Our study overcomes this potential problem by using a later period after reviews and compilations have been in use for a number of years. Our subjects also indicated familiarity with the three forms of assurance. The conceptual link between auditor assurance and bank officer lending decisions is that auditor assurance reduces information risk in the financial statements and related accounting schedules accompanying the loan application (i. …