Verification Services and Financial Reporting Quality: Assessing the Potential of Review Procedures

Are financial statement reviews, which are limited to primarily analytical procedures and inquiries, a cost-effective verification service for some firms? The answer is important for owner/managers considering reviews as well as investors, lenders, regulators, and those interested in effective verification mechanism design. Using data from U.S. private companies choosing to have financial statements compiled, reviewed, or audited, we calculate four model-based financial reporting quality proxies and, to reflect broader economics, the cost of debt and verification fee estimates. Consistent with application of prescribed verification procedures, we find both reviews and audits yield significantly better reporting quality scores and lower cost of debt than zero-verification compilations. However, model-based reporting quality scores of reviews and audits are indistinguishable statistically, on average. Regarding broader economics, we find that relative to compilations, reviews yield more than half the added interest rate benefit associated with an audit, at considerably less than half the added cost. Overall, our results suggest reviews may provide a cost-effective verification alternative to audits, and the potential of analytical procedures warrants more attention by audit researchers and regulators.