Industry Norms, Regulator Concerns and Audit Judgment

Abstract
This paper investigates the effect of industry norms on auditor’s support for the client-preferred
accounting. We conducted a 2*2 between-subjects experiment based on the inconsistent revenue
recognition practices in Chinese real estate industry. We manipulated the two independent variables
industry norms (present vs. absent) and regulator concerns (present vs. absent). Our results suggestthat auditors are more likely to support client’s choices if client-preferred accounting is aligned with
one of the industry norms. Further analysis found that the impact of industry norms was only
pronounced when the matter was of concern to regulators. Meanwhile, we find that legal risk does
play a mediation role in the effect of industry norms on audit judgment. These results remind
regulators that the different industry norms may allow for opportunistic behaviors in the principleoriented environment.
Keywords: audit judgment; industry norms; regulator comment letters; motivated reasoning1

Industry Norms, Regulator Concerns and Audit Judgment
Introduction
The principle-oriented International Financial Reporting Standards (IFRS) have been widely
accepted all over the world. These standards are considered as imprecise and require practitioners to
use more professional judgments. It increases the second-guess of regulators (Agoglia, et al, 2011),
and lead to higher legal risk for auditors (Hail, 2010). Kadous and Mercer (2012) find thatcompliance with industry reporting norms provide auditors with safe harbor protection fromnegligence verdicts when accounting standards are imprecise. But would the auditor exploit the safe
harbor effect of industry norms to make choices that are more inclined to clients' wishes?
The purpose of this study is to examine whether the industry norms would reduce the auditors’
legal risk perception and thus more likely to encourage the auditors to support the clients’ accounting
methods. In this study, industry norms refer to the prevailing accounting practices in an industry.
Further understanding the impact of industry norms on auditors’ decisions is crucial because it could
provide insight about the additional benchmarks used by auditors under imprecise accounting
standards.
Chinese Accounting Standards (CAS) have substantially converged with IFRS. In China, thereal estate companies recognize revenue either at the completion of handover procedure or at thecompletion and official inspection of the project. Both practices are considered as industry norms
though the latter may be several months earlier than the former. Furthermore, the most litigation risk
faced by the auditors in China are from the sanctions imposed by regulators (Chan and Wu, 2010). If
the regulator express concerns on a specific issue, the legal risk on the issue will increase. Therefore
2this paper will further examine how regulator concerns affect auditors' consideration of industry
norms.
We use motivated reasoning theory and current research on negligence verdict to makepredictions about the influence of industry norms. On one hand, individuals’ decision processes are
influenced by their goals and that “individuals committed to directional goals, or goals to reach apreferred conclusion, are more likely to reach their desired conclusion” (Kadous, Kennedy and
Peecher, 2003). And in the field of auditing, prior study find that auditors have directional goals of
supporting client preferred methods and tend to exploit ambiguity inherent in accounting standards tojustify those methods (Hatfield et al., 2011; Ng and Tan, 2003; Lord and DeZoort, 2001; Salterio andKoonce, 1997). On the other hand, in most cases, whether the auditor exercised reasonable care andcompetence is assessed relative to the levels that other professionals in the field would apply in thesame situation (Causey and Causey 1991). That is, an auditor should be judged negligent if she/he
fail to choose the accounting policy that other reasonably careful auditors would. In other words, theauditor can be defended if the accounting treatment preferred by the client conforms to an industry
norm. Thus, when client-preferred accounting is aligned with one of the industry norms, auditors will
perceive less risk and are more inclined to support client’s choices. As this effect is based on the risk
perception, it may change depending on whether the auditors perceive their legal risk increased, say,when the regulator express concerns on the specific issue.
We test our hypotheses with an experiment. We invited 76 auditors to participate in theexperiment and asked them to assume to be the audit manager who was in charge of auditing a realestate enterprise. One pre-sale of commercial residential apartment’s project of a public company has
been completed construction and inspection but has not been delivered to the customer yet. The
3

client believes that revenue can be recognized in the current year. And the participants are required tomake their decision of supporting the client or not. We carry out our study using a 2×2 betweensubjects experiment and manipulate the two independent variables industry norms (present vs.
absent) and regulator concerns (present vs. absent). The participants are randomly divided into fourgroups to evaluate their propensity to agree to recognize revenue in the current year and theirperception of litigation risk.
We find that auditors are more likely to support client’s choices if client-preferred accounting isaligned with one of the industry norms. Further analysis suggest that the impact of industry norms is
only pronounced when the matter is of concern to regulators. We assume that auditors base theirdecisions on their perception of legal risk. This paper finds that legal risk perception does play a
mediation role in the effect of industry norms on audit judgment. The main experiment is based on
the background of CAS No.14 issued by the Ministry of Finance of China in 2006. Since the newrevenue standard has been in effect, it is not known whether the above result still exist under the newstandard. Through supplementary analysis, we find that the precision of new income standards (CASNo.14, 2017) has been considered as improved and the effect of industry norms on audit judgment
has been weakened.
The main contributions of our study are as follows. Firstly, Kadous and Mercer (2012) provides
evidence that jurors will take into account of the industry norms in judging auditors’ negligenceliability. Following their research, Grenier et al (2015) argues that auditors would herd to industry
norms to mitigate the elevated litigation exposure associated with imprecise standards. However they
assumed rather than empirically investigated how auditors use the industry norms. This paper
extends this line of research by investigating whether auditors would herd to the industry norm that4

benefits them most. Secondly, this paper provides more evidence of the motivated reasoning in audit
judgment under imprecise standards. Previous studies find that auditors will take advantage of theambiguity of accounting standards (Hackenbrack and Nelson 1996; Salterio and Koonce, 1997; Ng
and Tan 2003) and the inherent complexity of auditing standards (Hatfield et al., 2011) to prove therationality of client-preferred accounting. The result of this research suggest that auditors will also
take advantage of the industry norms and use it to justify the client-preferred accounting. Thirdly,
this research also contributes to the literature on regulator comment letter, key audit matter and newrevenue accounting standards. Our results show that auditors’ decision will be impacted if theregulator express concern on the issues addressed as a key audit matter. This result supplement our
understanding of how the key audit matters impact the auditor’s legal risk (Gimbar Hansen &Ozlanski, 2016;Brasel, Doxey, Grenier, & Reffett, 2016). Though the new revenue standard is stillprinciple-based, our study shows that the new principles seem to be clearer. Finally, these results
remind the regulators that different industry norms not only jeopardize the comparability, but also
allow for opportunistic behaviors in the principle-oriented environment.
The remainder of this study is structured as follows. In section 2, we develop the hypotheses.
Section 3 describes the experimental design as well as the participants. Section 4 reports the results
as well as tests of mechanisms and additional analyses, and section 5 concludes.

BACKGROUND AND THEORETICAL DEVELOPMENT
Background
The principle oriented IFRS has been widely used in the world. China signed a joint statementwith the International Accounting Standards Board (IASB) on November 8, 2005, formallyconfirming that China's accounting standards system has substantially converged with IFRS. In April
5

2010, the Ministry of Finance of China released the Roadmap for the Continuous Convergence of
CAS and IFRS which clarified the goal of the convergence (MOF, 2010). In academic research,principle-oriented standards are as also considered as imprecise standards as there are less guidance(for example, Agoglia et al, 2011). Thus China also adopts an imprecise standard system. One of theexamples is the revenue recognition. Since 2006, the revenue standard was based on the “risk andreward transferring model”. In 2018, a new revenue standard was published which was based on the“control model”, converging with IFRS 16.
For many years, most Chinese enterprises in the real estate industry take the completion of thehandover procedure as the transfer point of risk and reward. But some large public real estatecompanies recognize revenue immediately after the completion and official inspection of the project,
if they have already received payment or had collection rights, such as Vanke. In most cases, theconstruction completion could be several months earlier than the handover procedure completion.
Although Chinese Security Regulatory Committee has expressed concerns about the incomparabilityof the two different accounting practices (CSRC, 2013, 2014), nothing has changed so far. And it is
not clear whether the two different industry norms would cause other problems rather thanincomparability. We searched for the annual report of 2018 and find that the two different practices
continue to exist even when the new revenue standard is already in effect.
Industry Norms and Audit Judgement
Prior studies have examined the effects of accounting standard precision on preparer (Psaros
and Trotman 2004; Agoglia et al. 2011) and auditor behavior (Trompeter 1994; Hackenbrack andNelson 1996; Gibbins et al. 2001; Nelson et al. 2002; Kadous et al. 2003; Ng and Tan 2003; Segovia
et al. 2009) as well as legal risks (Hail et al. 2010; Kadous and Mercer, 2012).In particular, Kadous6

and Mercer (2012) use an experiment to find that compliance with industry reporting norms appears
to provide auditors with safe harbor protection from negligence verdicts when accounting standards
are imprecise. In their setting, the participants are mock jurors. However, whether the auditors willtake advantage of the safe harbor of industry norms still need further test.
There is agency problem between auditors and clients. The company’s stakeholders entrust theauditor to audit the company's financial position, the results of its operations and cash flows during agiven period so as to guard against the opportunism behavior of the management. Meanwhile, theauditors are directly paid by the company. Therefore, they face the conflict of public interest andpersonal interest. Especially when client management exerts pressure, audit partners may be inclined
to accept management's decision (PCAOB, 2011). In our opinion, auditors are more likely to supportclient-preferred accounting when there are different norms in the industry and one of them is in linewith the client's preferences.
Firstly, motivated reasoning theory holds that individuals who are committed to directional
goals engage in biased reasoning to reach those goals (Kunda1990, 1999). Directional goals refer toconclusions superior to others. Individuals with directional goals search for, interpret and process
information in a biased way in order to reach their desired conclusions. Prior study find that auditors
have directional goals of supporting client method choices, and they may take advantage of theambiguity of accounting standards (Hackenbrack and Nelson 1996; Salterio and Koonce, 1997; Ng
and Tan 2003) and the inherent complexity of audit standards (Hatfield et al., 2011) to deduce therationality of clients’ decisions. As long as the decision is justified, auditors are likely to accept themethod preferred by the client (kadous, 2003). For example, auditors support client preferred
methods when in-house precedents are ambiguous (Salterio and Koonce, 1997). However, Kadous
7

(2003) find auditors will increase the intensity of effort devoted to justifying the client-preferred
method. This additional justification effort will increase acceptability of that method. Thus, evenquality assessments cannot increase auditors' objectivity.
In the setting of this paper, according to the motivated reasoning theory, the ambiguity ofimprecise standards provides discretion for auditors to support client method choices. In thispremise, industry norms improve acceptance of client's preferences and auditors will take advantage
of industry norms to justify client’s choice.
Secondly, even in the US, it is generally difficult to prove fraud against auditors because proofof intent to deceive or reckless behavior is required. Consequently, most litigation against auditors
alleges negligence rather than fraud (Causey and Causey,1991; Grubbs and Ethridge, 2007). It issimilar in China. In defining negligence, the practice of other professionals in the same situation areoften taken into account (Causey and Causey, 1991). That is, an auditor should be judged negligent if
she/he fail to make the correct accounting treatment that other reasonably careful auditors would. In
other words, the auditor can be defended if the accounting treatment preferred by the client conforms
to an industry norm. Thus, when client-preferred accounting is aligned with one of industry norms,
the auditor will perceive less risk and are more inclined to support client’s choices, even though it
might be more aggressive.
Thus, we formally state the following hypothesis:
H1: when client-preferred accounting is aligned with one of the industry norms, the auditors
are more inclined to support client’s aggressive choice.
Regulator Concerns
In China, auditors are facing less litigation risk than the U.S., but the risk of regulatory sanction8

is not negligible (Firth et al, 2012). As indicated by Chan and Wu (2010):” Although Chinese
auditors’ level of exposure to litigation risk is less than that of their US counterparts, there areregulatory bodies in place to oversee audit firms”. Besides sanctions of Chinese Securities
Regulatory Commission (CSRC), the inquiry letter issued by the stock exchanges is also a powerful
regulatory tool. Since 2013, the regulators of Chinese stock market reformed the information
disclosure regulation. The pre-disclosure approval has been changed to post disclosure review.
Specifically, after the public companies disclose their financial reports, the stock exchanges may
issue inquiry letters on important matters in the financial reports (Chen Yunsen, 2018). According to
WIND database, Shanghai and Shenzhen stock exchanges have issued an increasing number ofinquiry letters about financial reports year by year, with a total of 970 inquiry letters in 2018. Amongwhich, the accounting issues account for 43%.
Generally speaking, the focus of the inquiry letter about financial reports is closely related to thekey matters of the audit work, such as weak internal control, risk of going concern, litigation issues,
etc. If the financial report audited by the auditor is inquired by exchanges, the audit risk will increasesignificantly (Chen et al., 2018). In particular, according to the requirements of Auditing Standardsof Chinese Certified Public Accountants No. 1504 -- Communication of Key Audit Matters in Audit
Reports, auditors need to disclose the audit procedures of the key audit matters in detail in the audit
reports from January 1, 2018. We checked inquiry letters about the financial report in 2018 and findthat the exchange would also directly inquire the listed companies and their auditors about the key
audit matters (such as CSG, 000012). The exchange's concerns to this issue superimpose the highrisk of key audit matters, which reduces the risk tolerance of auditors. Auditors will invest more timeand energy in the audit work. And they will become more conservative, especially on the key audit
9matters. Therefore, we expect that the exchange concerns may moderate the main effect of industry
norms on auditors’ decision. Specifically, when regulators are particularly focused on a key audit
matter, auditors may be more conservative and thus the industry norms will have less impact on
auditor’s support for client’s aggressive decisions.
Conversely, there is another explanation. Many research suggests a weak regulatoryenvironment in China (Chan and Wu, 2011; Firth et al, 2012). In the absence of legal constraints,
auditors face less legal risk. Therefore, they are prone to compromise with clients because of income
dependence. Under this premise, the safe harbor effect of industry norms does not play a role. In
other words, the auditor is likely to support the client's decision, whether or not the industry norms
exist. However, when it is known that a key audit matter is concerned by the exchange, the auditor
faces higher reputation risk, litigation risk and administrative penalty risk (Chen et al., 2018). In thiscase, industry norms, one of which is aligned with client’s preference, justify the client's decisions.
Then auditors are more inclined to support the client. In contrast, without industry norms as a safe
harbor, auditors are less inclined to compromise with clients given the higher potential risks.
Therefore, when regulators are particularly focused on a key audit matter, industry norms will havemore impact on auditor’s support for client decisions.
Therefore, we formally state the following two competing hypotheses:
H2a: When regulators specifically focus on a key audit matter, industry norms will have more
impact on auditor’s support for client’s aggressive choice on that matter.
H2b: When regulators specifically focus on a key audit matter, industry norms will have less
impact on auditor’s support for client’s aggressive choice on that matter.

RESEARCH DESIGN
10Participant
Through personal connection, we invited 76 auditors from local accounting firms to participate
in our experiment. We sent out and collected electronic questionnaires by online questionnaire
platform called Wenjuanxing. The participants were randomly divided into four groups and took an
average of 25 minutes to fill out the questionnaire. In order to ensure that participants completed thequestionnaire carefully and effectively, before the questionnaire distribution process, we obtained the
support from partners and senior managers of the accounting firms, who invited auditors withprofessional experience to answer directly. Meanwhile, we communicated with some participants
directly beforehand and afterwards to further improve participants' participation, which also
facilitated more appropriate analysis of experimental results.
Table 1 shows the participant profile. Participants have a mean age of 31. Most of them arefemale (71%), which is higher than the current proportion of female CPAs in China (50.33%, 2017)as shown on website of the Chinese Institute of Certified Public Accountants. Their average working
experience is 6.86 years, which imply that they have reached the management level and have richaudit experience according to the normal promotion system of the accounting firm. In addition, mostof the participants are familiar with accounting standards and key audit matters (KAMs). And lessthan 50% of them are familiar with the real estate industry, which helps us to study the effect ofindustry norms. If the participants are familiar enough with the real estate industry, it will reducemanipulating effect of industry norms.
Table 1
Descriptive Statistics

11

industry-

Industry- norms/no-no-industry-no-industry-norms/regulator-

regulator-concerns

norms/regulator-

norms/no-regulator-

concerns

concerns

concerns

Total

33.35

29.95

31.05

31.94

31.47

(6.73)(5.07)(6.58)(6.06)（6.11）

0.12

0.29

0.50

0.22

0.29

(0.33)(0.46)(0.51)(0.43)(0.46)

WORKING

7.88

7.05

6

6.61

6.86

LIFE

(4.88)(4.96)(3.34)(7.15)(5.15)

Familiar with

72.06

68.33

66

61.67

66.97

Standards(13.12)(17.84)(20.10)(25.95)(19.75)

Familiar with

56.18

43.10

43

37.5

44.67

Industry(22.88)(22.94)(25.57)(25.10)(24.58)

Familiar with

67.94

55.71

51.5

42.22

54.14

KAMs

(15.52)(25.56)(23.46)(30.01)(25.47)AGE

GENDERWe find that most individual characteristics are not associated with participants’ binary decision
either in favor of or against the client’s choice. Participants’ age (p=0.849), experience (p=0.535),
familiarity with KAM (p=0.355) are unrelated to their binary decision. However, gender issignificantly related to participants’ judgement. We find that female auditors are more inclined tosupport the client preferred treatment than are male auditors, which may be because the number offemale participants is much higher than that of males. In addition, the more familiar participants are12with the industry, the more likely they are to agree with client’s choice. People who are morefamiliar with the real estate industry have a better understanding of the various norms existing in theindustry. According to our hypothesis, they are more likely to take advantage of industry norms to
support client’s preference.
Material and Design
We carry out our study using a 2×2 between-subjects experiment and manipulate the two
independent variables industry norms (present vs. absent) and regulator concerns (present vs.
absent). For industry norms, we provided two popular revenue-recognition policies andrepresentative companies in the real estate industry to participants in industry-norms conditions, andparticipants in no-industry-norms conditions were not provided (see Appendix I). For regulator
concerns, we provided the material of inquiry letters to participants in regulatory-concern conditions,and participants in no-regulatory-concern conditions were not provided (see Appendix Ⅱ).
Specifically, the material includes inquiry letters issued on key audit matters of revenue recognitionin 2017.
The participants were instructed to assume that they are the engagement manager and in chargeof the current audit of a commercial real estate development company for the financial year ending at
December 31, 2018. They are planning to audit the current-year revenue recognition of pre-sale ofcommercial residential houses and one of them has been completed construction and inspection but
the key has not been delivered to customer yet. The management believes that revenue should berecognized in the current year. However, some auditors in the audit team believe this is too
aggressive. Because standards do not indicate clearly which time-point shall be considered as thetransfer of risk and rewards, thus requires the auditor to make professional judgment. We informed13

participants that this client was important to them in order to motivate their directional goals to
support the client’s choice.
The experimental instrument begins with instructions for participants and Chinese AccountingStandards (CAS) No.14 issued in 2006. Participants then received the information on pre-salearrangements, company background information and commercial residential houses information.
Besides, the material includes the client and other auditors’ judgement and their respective
explanations. Four groups all obtained the above information and received corresponding
manipulation material respectively.
Dependent Variable
The primary purpose of this study is to investigate the effects of industry norms on audit
judgement. Therefore, our main dependent variable is participants’ ratings of the likelihood that they
support the client-preferred accounting (0 = Not at all likely, 100 = Extremely likely). We also
gathered their binary decisions (0 = Not support, 1 = Support), as well as several other measuresrelated to auditors’ decision-making process. We ask the legal risk that auditors perceive if they
support client (0-100). Finally, participants responded to some manipulation check question anddemographic questions.

RESULT
Manipulation CheckTo evaluate the effectiveness of our manipulations of industry norms, we asked participants if
the case materials mentioned revenue recognition policies of Vanke and China Merchants Shekou.
Of the 76 participants responding to this question, 60(79%) responded correctly. The 16 participants
who answered incorrectly were all in the no-industry-norms condition, some of whom we
14interviewed after the questionnaire. They said “because they thought that Vanke and China
Merchants Shekou mentioned in the question are representatives of the industry, and they
subconsciously chose yes". In addition, we asked each participant to indicate whether the casematerials involved inquiry letters issued on key audit matters of revenue recognition in 2017 toverify that they attended to our manipulation of regulator concerns. Of the 76 participants responding
to this question, 49 (64%) responded correctly. The 27 participants who answered incorrectly were
all in no-regulatory-condition.
Although our manipulations seem ineffective, the participants who responded incorrectly are all
those who didn’t receive the relevant material and unconsciously chose yes, which has little
influence on the test of the hypothesis. Therefore, we report results for all participants in the tests
below.
Hypothesis Test
Participants chose either in favor of the client or not, based on their understanding of accounting
standards and background information. Participants who were not able to make certain choice areclassified as ‘‘Null’’. Table 2, Panel A and Figure 1, Panel A show the number and percentage ofauditors that support client-preferred accounting (i.e., recognize revenue in current year).
To test our hypotheses, we firstly use auditors’ binary decision as our dependent variable. Table
2, Panel B reports the simple main effect of industry norms and regulator concerns. H1 predicts that
auditors are more inclined to support client’s choices when client-preferred accounting is alignedwith one of industry norms. To test H1, we assign 1 to the industry-norms condition and 0 to noindustry-norms condition. As we expected, participants in the industry-norms condition (50%) are
more likely to support the client than another condition (29.41%) and the difference is statistically15significant (χ²=3.088, p < 0.1). When it comes to H2, Table2, and Panel C reports the moderation
effect of regulator concerns. We find that when a matter has caught the attention of regulators,
auditors are more likely to take advantage of industry norms to justify and support the clientpreferred accounting (mean industry-norms/regulator concerns=62.5% vs. mean no-industry-norms/regulator
concerns=26.32%, χ²=4.644, p < 0.05), while the effect is not significant when there is lack of regulatorsconcerns (mean industry-norms/no-regulator concerns=40% vs. mean no-industry-norms/no-regulator concerns=33.33%,
χ²=0.163，p＞0.1).
Further, we provide evidence from our tests of auditors’ ratings of the likelihood that they
support the client-preferred accounting. Unlike auditors’ binary decisions, the continuous dependent
variable allows for more sensitive statistical tests (Kadous 2000). In table 3, Panel A, we report themean and standard deviation by experiment condition. Results are also displayed graphically in
Figure 1, Panel B. To test our hypotheses, we estimate an ANOVA model of auditors’ ratings of thelikelihood that they support clients. The results confirm the hypothesis once again. The auditor withindustry norms is more inclined to support client choice (F = 2.87, p < 0.1) and this effect issignificant only in regulator-concerns condition(F=3.01，p<0.1), otherwise not(F=0.36，p>0.1).
Therefore, we believe that the results from our analysis provide important insights into the needfor the regulators to consider industry norms in combination with the inquiry letters.
Table 2
Descriptive Data
Panel A: Binary Decision

Regulator Concerns
16Industry

regulator-

no- regulator-

Total

Norms

concerns

concerns

industry-

62.5%

40%

50%

norms

N=16

N=20

N=36

no-industry-

26.32%

33.33%

29.41%

norms

N=19

N=15

N=34

Total

42.86%

37.14%

N=35

N=35

Panel B：Simple Main Effect- Chi-square Test
Factordf

χ²

p(two-tailed)Industry Norms

1

3.088

0.079

Regulator Concerns

1

0.238

0.626

Panel C：Planned Contrasts
Hypothesis

resultχ²

p(two-tailed)

H2a：Industry-norms/regulator concerns

support

4.644

0.031

nonsupport

0.163

0.686

VS. no-industry-norms/regulator concerns
H2b：Industry-norms/no-regulator
concerns VS. no-industry-norms/noregulator concerns

Table 317

Descriptive Data
Panel A: continuous dependent variable-mean (standard deviation)

Regulator Concerns
Industry Norms

regulator-concernsno- regulator-

Total

concerns
industry-norms

56.18

51.43

53.55

（31.40）（33.21）（32．07）

N=17

N=21

N=38

no-industry-

37.25

45.28

41.05

norms

（34.43）（30.12）（32.28）

N=20

N=18

N=38

45.95

48.59

（33.99）（31.56）

N=37

N=39

Total

Panel B：Simple Main Effect-One Way ANOVA
Factordf

MSFp(two-tailed)Industry Norms

12968.75

2.87

0.0946

Regulator Concerns

1

132.710.12

0.7261Fp(two-tailed)

Panel C：Planned Contrasts
Hypothesis

result18

H2a：Industry-norms/regulator concerns

support3.01

0.0917

nonsupport

0.36

0.5511

VS. no-industry-norms/regulator concerns
H2b：Industry-norms/no-regulator
concerns VS. no-industry-norms/noregulator concerns

Figure 1
Propensity to support the client-preferred accounting

Panel A: Binary Decision
70.00%

62.50%

60.00%
50.00%
40.00%

40%

33.33%

30.00%
26.32%

20.00%

regulator-concern
no-regulator-concern

10.00%
0.00%
industry-norms

no-industry-norms

Panel B: continuous dependent variable19

56.18

60

51.43

50

45.28

40
37.25
30

regulator-concern
no-regulator-concern

20
100
industry-norms

no-industry-norms

Mediation of legal risk perception
While our results provide evidence in support of our hypotheses, they do not demonstrate
auditors’ decision process. According to motivated reasoning and current research on negligenceverdict, we theorize that industry norms appropriately provide reasons for supporting and justifying
the accounting treatment that clients prefer, which reduces the perceived legal risks. To validate thistheory, we exam the mediation effect of legal risks. To measure perceived legal risk, we asked
participants to rate on a 100-point scale, with larger values representing higher legal risk that auditors
perceive.
Figure 2 shows the results of the mediation analysis. First, we document a significant main
effect of industry norms on auditors’ propensity to support the client-preferred accounting(p=0.095), such that auditors familiar with industry norms are more likely to support the clientpreferred accounting. Second, we establish a significant relationship between industry norms andperceived legal risks (p=0.001). And coefficient is negative, which is consistent with argument
underlying H1. Finally, we included perceived legal risks in the general liner model on propensity tosupport the client-preferred accounting, and the significance of industry norms is fully mediated (p <20

0.001). Consistent with the theory underlying H1, these results suggest that the presence of industry
norms does provide a safe harbor (Kadous and Mercer, 2012), which reduces the auditors’ perceived
legal risk and thus makes auditors tend to satisfy the client's choice.
Figure 2
Consideration of Perceived Legal Risk as Mediating the Relationship between
Industry Norms and Audit Judgement

Step 3：-0.86***

Step 2：-17.11***(-5.70)(-3.61)

Step 1：12.5*（1.69）
Step 3： -5.84 (-0.80)***,**,* Indicate p＜0.01,p＜0.01,p＜0.1, respectively; P-values represent two-tailed tests.

Supplement Analysis
In May 2014, IASB released a new revenue standards (IFRS 15). Then the Chinese Ministry of
Finance issued the revised CAS No.14 (new version of revenue standards) in July 2017. The
criterion of revenue recognition changed from "transfer of risk and reward" to "transfer of control".
Considering the norms in the real estate industry is under the old version of revenue standards, so
our main experiment is based on the background of CAS No.14 issued in 2006. But at the final phase21

of the main experiment, we provided the new version of revenue standards and asked the participants
whether the new version was more precise than the old version. And we also ask them to rate thelikelihood that they support the client-preferred accounting under the new version of revenue
standards. As a result, 85.5 percentages of the subjects believed that the new version was relatively
more precise, and under the new version, the main effect of industry norms disappeared (F=0.43,
p=0.51). This result may suggest that the “control model” is better than the “risk and reward model”.
But the result shall be interpreted cautiously as it is a within subject design and may becontaminated.

CONCLUSION
With the widely adoption of and convergence with IFRS, the principle-oriented IFRS bringchallenges to auditors in making professional judgment all over the world. Because the flexibility
underlying the imprecise standards, auditor’s legal risk may be higher. But Kadous and Mercer(2012) find that compliance with industry reporting norms appears to provide auditors with safe
harbor protection from negligence verdicts when accounting standards are imprecise. And on thatpremise, our focus is whether the auditors will take advantage of the safe harbor of industry norms to
defend themselves to support client-preferred accounting. China’s real estate industry provides
appropriate setting to answer this question because there are two prevailing revenue recognition
timing point. Thus we designed an experiment with a case of a real estate company and test whether
auditors will be more likely to agree with their client when they know the client’s choice isconsistent with one of the industry norms.
We find that when client-preferred accounting is aligned with one of industry norms, the auditors
are more inclined to support client’s choices. And when the matter has caught the attention of22

regulators, auditors are more likely to take advantage of industry norms to justify and support theclient-preferred accounting, while the effect is not significant when there is lack of regulatorsconcerns. This is because there is agency problem between auditors and clients. The auditor has the
motivation to accept client-preferred accounting for compensation, and they also face the supervisionof exercising reasonable care and competence from some parties, such as inquiry letters issued byexchanges. Industry norms appropriately provide reasons for supporting and justifying theaccounting treatment that clients prefer, which reduces the perceived legal risks. This paper finds thatlegal risk does play a mediation role in the effect of industry norms on audit judgment. The main
experiment is based on the background of CAS No.14 issued by the ministry of finance of China in
2006. Through supplementary analysis, it is found that the accuracy of new income standards (CASNo.14, 2017) has been improved and the effect of industry norms on audit judgment has been
weakened.
Our study has limitations, the impacts of which can be addressed in future research. First, due tothe limited sample size, this paper sets the client’s preference as "recognize revenue in current year".
If the client wish to postpone the recognition of the revenue in next year, it is unclear whether theauditor's judgment will still be significantly affected by industry norms. Second, new version ofrevenue standards has been implemented from January 1, 2018. Although the questionnaire
eventually asked the auditor’s judgment under the new version of revenue standards, and we havepreliminary results that the precision of new income standards (CAS No.14, 2017) has been
improved and the effect of industry norms on audit judgment has been weakened. However, thewithin subject design may contaminate the results. Finally, with regard to regulator concerns, thispaper manipulates the post-event supervision of exchanges that are subject to non-administrative
23

penalties. In addition, auditors are also facing the regulation of CSRC and MOF, so relevant
researches can be done in the future.

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APPENDIX Ⅰ：Industry Norms

Two popular revenue-recognition policies and representative companies in the realestate industry
Revenue-

Representative Companies

Accounting Policy

Completion of

Vanke (000002)

Take Vanke as an example:

the Project

AVIC SUNDA (000043)

Inspection

Oceanwide (000046)

Recognition
Point

Real estate sales recognize revenue after the(Construction

completion of construction and acceptance，Completion

signing a sales contract, obtaining the payment

Stage)

certificate of the property delivered by the buyer
according to the sales contract (usually
receiving a deposit equivalent to 20% or moreof the contract amount or/and confirmed the restof the payment arrangements)
Take CMSK as an example:

Completion ofChina Merchants Shekou

the Handover(001979)

Procedure

Beijing Capital Development

Real estate sales recognize revenue after the(Delivery Stage)(600376)

completion of construction, acceptance andPoly (600048)

transfer procedures.
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APPENDIX Ⅱ：Regulator Concerns
In recent years, Shanghai and Shenzhen Stock Exchange have comprehensively sorted out andupgraded their business rule systems. According to regulatory requirements of “being legal, strict andcomprehensive”, they have strengthened their supervision. The intensive issuance of inquiry letters is
one of the manifestations, which shows the power of the frontline supervision of the exchange.
Especially, the inquiry letter about financial reports is a powerful non-administrative regulation toregulate the financial reports of listed companies.
In the real estate industry, the exchange attaches great importance to the regulatory
verification of revenue recognition. More than 80 percent of inquiry letters about financial reports
in this industry are related to revenue. Meanwhile, revenue recognition is also a key matter in theannual report audit. According to statistics, about 70 percent of audit reports in 2017 disclosed
revenue as a key audit matter. Especially, the exchange issued an inquiry letter about KAM to aleading company, which asked the company to disclosure additional information about the transfer
of risk and reward, as well as asked auditors to elaborate on audit procedures.
In this experiment, the audit team plans to disclosure revenue recognition as a key audit
matter.

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