Review Procedures and Financial Reporting Quality: Inferences from U.S. Private Firms

Are “full audits” cost-effective in improving financial reporting quality compared to “reviews,” which are based primarily on analytical procedures and inquiries? The answer is important because independent verification cost-effectiveness is being challenged globally and recent advances in confirmatory data analytics may change the economics of reviews and audits. We obtain financial statement data for U.S. private firms having financial statements compiled, reviewed, or audited. We examine four accounting-based financial reporting quality proxies and, to reflect broader economics, we examine cost of debt. We find financial reporting quality for both reviews and audits is significantly better than for compilations, but is statistically indistinguishable between reviews and audits, on average. Cost of debt significantly decreases with each additional level of CPA firm verification service, although reviews capture most of the cost of debt benefit increment between audits and compilations. We estimate incremental CPA service fees and find that, when compared to compilations, reviews are associated with less than half the fee increment for an audit. Overall, our tests are consistent with enhanced reporting quality from both reviews and audits, and diminishing marginal returns to “full” audit procedures beyond a review for both financial reporting quality and cost of debt.