Research Spotlight

Bank regulation or bank auditing?

Professor Aloke Ghosh, Fulbright Distinguished Chair, Professor of Accountancy at the Zicklin School of Business, Baruch College, City University of New York, presented his research titled “Do Bank Regulation and Supervision Displace Bank Auditing?” in the Accounting Seminar Series at the Indian School of Business on 11 August 2017. Professor Ghosh’s work explores whether banking regulation and supervisory activities have any effect on the external audits of banks in the United States (US).

Professor Ghosh noted that, because of banks’ complexity, opaqueness, and agency conflicts, bank regulators and supervisors pay close attention to banks’ accounting practices and their internal controls. For instance, banks are subject to a complex set of laws and regulations that restrict their allowed activities, specify minimum capital and liquidity levels, and govern other matters. Similarly, bank supervision involves periodic on-site examination and ongoing off-site monitoring of banks’ financial condition and risks; the adequacy of banks’ accounting, internal control, and risk management systems; and banks’ compliance with applicable laws and regulations. A key commonality is that banking regulation and supervision shares similarities with bank auditing.
 
One consequence of banking supervision and monitoring is that banks have lower inherent risk, control risk, and audit risk. Because these three risk factors determine the amount of work the auditor decides to expend before certifying any financial statement, auditors are expected to work less in bank audits because auditors encounter lower risk in bank audits relative to other audits of non-regulated companies.

Are there any economic implications of lower audit effort in banks? The answer is yes. Professor Ghosh finds that the reduced effort leads to certain types of earnings management that are likely have minor effects on banks’ solvency ratios but are more likely to have capital market consequences, which may lead to reduced market discipline over banks.
 
The abstract of the paper is as below:
 
Do Bank Regulation and Supervision Displace Bank Auditing?
We hypothesize that bank regulatory and supervisory activities substitute for bank auditing activities, providing auditors with incentives to expend less effort on audits of banks than on audits of similar firms not subject to regulation and supervision. We show that banks exhibit fewer internal control and accounting problems, as measured by the frequencies of disclosed material internal control weaknesses and financial statement restatements, than do similar firms. We show that auditors expend less effort, as indicated by lower audit fees and shorter audit report lags, in audits of banks than in audits of similar firms, more so when bank regulation and supervision are more intense. Lastly, we show that banks are more likely than similar firms to exhibit two types of earnings management that are of minor concern to bank regulators and supervisors but have capital market consequences and so should concern auditors: more frequent small positive earnings changes and longer strings of earnings increases.
 
Professor Aloke Ghosh can be reached at his website http://alokeghosh.com/ and on Twitter at @alokeghosh_prof