Audit Adjustments and Public Sector Audit Quality

In the context of austerity‐inspired reforms to public audit in England we investigate the extent to which audit firms mitigate management bias in public sector financial reports. A substantial body of literature finds that both public and not‐for‐profit managers manage ‘earnings’ to report small surpluses close to zero by managing deficits upwards and surpluses downwards. Under agency theory, auditors acting in the interests of their principal(s) would tend to reverse this bias. We exploit privileged access to pre‐audit financial statements in the setting of the English National Health Service (NHS) to investigate the impact of audit adjustments on the pre‐audit financial statements of English NHS Foundation Trusts over the period 2010–2011 to 2014–2015. We find evidence that auditors act to reverse management bias in the case of Trusts with a pre‐audit deficit, but find no evidence that this is the case for Trusts with a pre‐audit surplus. In the case of Trusts in surplus, these findings are consistent with auditors’ interests being aligned with management, rather than principals.