A trio of new research studies support the Public Company Accounting Oversight Board’s proposal to require the identification of the lead auditor on public company financial reports.
The studies, two of which were published by the American Accounting Association in its journal The Accounting Review and another that will be presented at an accounting academic research conference this week, examine the issue of lead auditor identification, including whether it is valuable to investors to know the name of the engagement partner spearheading an auditing effort and whether being required to provide this information enhances the performance of engagement partners. The three studies focus on Sweden, China and the U.K., three of the countries that require identification of lead auditors in company financial statements.
The first study, entitled "Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions," is based on an analysis of audits performed over a seven-year period by the Swedish subsidiaries of the Big Four firms. The study found that aggressive or conservative reporting is associated with the particular engagement partners who head the audits over and above any influence of the Big Four firms that employ them. In addition, these individual differences in reporting style persist over time and across clients, and they contribute significantly to such economic factors as the credit ratings that client firms receive and how they are assessed by stock investors.
"A firm audited by an engagement partner who is consistently aggressive is more likely than other companies (other factors being equal) to be penalized through higher interest rates, lower credit ratings, and greater perceived likelihood of insolvency," explained one of the study's authors, W. Robert Knechel, a professor at the University of Florida who serves as editor of Auditing: A Journal of Practice and Theory, published by the American Accounting Association. "If the company is public, it is also likely to be penalized by a lower Tobin's Q, a measure that reflects investor approval of a firm and optimism about its prospects. In short, we find that the reporting differences of lead auditors have a significant effect on both the lending and equity markets."
The study was recently singled out for attention by PCAOB chairman James Doty, who cited its focus on "situations in which you have a continuous long record of identification of the engagement partner." Prof. Knechel was joined in the research by Ann Vanstraelen of Maastricht University in the Netherlands and Mikko Zerni of the University of Vaasa in Finland. The paper is slated for presentation at the Contemporary Accounting Research conference this week in Kingston, Canada.
The professors gauged the accounting styles of auditors, whether aggressive or conservative, in two principal ways—through their propensity to issue going-concern opinions and by their tendency to err on the high or low side in estimating the value of accruals. Patterns of aggressiveness and conservatism proved highly persistent over the years. Particularly striking was the propensity of some auditors to fail to issue going-concern opinions for firms that went bankrupt a year or less later, a tendency that the authors equated with aggressiveness. An auditor with a prior history of frequently erring in this way had a three to four times greater chance of doing it again in a subsequent year than a colleague without that history.
The second research study, "Do Individual Auditors Affect Audit Quality? Evidence from Archival Data,” is slated to appear in the November/December issue of the American Accounting Association’s journal The Accounting Review, This study is based on an analysis of 15,000 corporate annual reports issued over a 12-year period in China, where auditors are required to identify themselves in such reports. The researchers analyzed financial reports signed by approximately 800 auditors and concluded that, despite the constraints imposed on them by their accounting firms, "the effects that individual auditors have on audit quality are both economically and statistically significant, and are pronounced in both large and small audit firms."
The study explained, "The role of signing auditors in China is similar to that of engagement partners in other markets, in that signing auditors lead the audit team and are responsible for decision-making on significant matters...The names of signing auditors are disclosed, and their profile data are also publicly available."
"There is no reason to expect any different results in the U.S. and other Western settings,” said co-author Ferdinand A. Gul of Monash University's Sunway campus in Malaysia. “One has to wonder whether scandals like Enron and Tyco and WorldCom would have occurred if individual auditors had had to sign those companies' financial reports." He carried out the study with Donghui Wu of the Chinese University of Hong Kong and Zhifeng Yang of City University of Hong Kong.
What accounts for the differences in accounting styles from one auditor to the next? According to the study, "Signing auditors who are also partners or who have been exposed to Western accounting systems during that university education or who have worked in an international Big-4 audit firm are more conservative, while auditors who have obtained a master's degree or above or have a political affiliation are more aggressive." However, the authors conceded that "although we show that some observable demographic characteristics explain differences in audit quality across individual auditors to some extent, much of this variation remains unexplained."
Whatever the factors that drive them, wide divergences between individual practitioners emerged in the researchers' analysis of such critical aspects of auditing as the amount of accruals (non-cash items), high levels of which are often a clue to earnings manipulation; the frequency of modified opinions as opposed to unqualified endorsements; the amount of below-the-line, or non-core, items; and the frequency of reporting tiny profits, barely above break-even, another gauge of earnings manipulation
The third study, "Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom,"appeared in the September/October issue of The Accounting Review, and probes the effect on audit quality and cost of a U.K. regulation, effective April 2009, requiring engagement partners to sign corporate financial reports. The authors, Joseph V. Carcello of the University of Tennessee (and a member of the PCAOB’s Investment Advisory Group) and Chan Li of the University of Pittsburgh, concluded that the requirement “benefited investors and other financial users,” even though it resulted in “significantly higher audit fees.”
Describing the benefits that ensued from the requirement, the professors noted that it prompted several statistically significant changes in audit performance—specifically, decreases in abnormal accruals and the reporting of small earnings gains, both of which are commonly associated with earnings manipulation; an increased investor responsiveness to earnings reports, likely reflecting enhanced report credibility; and an increase in the incidence of qualified audit opinions, suggesting heightened auditor diligence.
The findings come from an analysis of the financial reports of between 726 and 1,168 companies listed on the London Stock Exchange from 2008 to 2010 (the different numbers reflect variability in available data from one company to another), specifically from comparing reports issued the first year of the signature requirement to those issued the previous year. From earlier to later, abnormal accruals dropped by 26 percent; the percentage of firms reporting hairbreadth earnings gains fell from 19 to 9.2 percent; investor response to reports went from negative to positive; and the percentage of audits issued with qualified opinions doubled from 3.3 to 6.5 percent.
Analysis with appropriate controls for client firms’ size, profitability, leverage and other company characteristics indicated that these developments were specifically attributable to the signature requirement and not to other factors or just plain chance. To further test the statistical significance of the improvements they uncovered, the professors compared them to auditing data from the U.S. and continental Europe on the possibility that the U.K results were influenced by global events that occurred concurrently with the implementation of the signature requirement. Their analysis found this was not the case.
At the same time, the study found that, after controlling for other factors that affect audit costs, companies in the U.K. paid 13.2 percent higher audit fees following implementation of the requirement than they would have paid based on the pattern of the previous year.
Is the increased cost worth the improvements in auditing that the study finds? The authors remained neutral on this question but simply observed that “whether these benefits exceed the costs is a decision best left to regulators and other policy-makers.” But Prof. Carcello, while emphasizing that he is speaking only for himself, noted that at the October 16 meeting of the Investment Advisory Group there was virtually unanimous agreement on the need for the PCAOB to expeditiously adopt an engagement partner identification requirement.
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