Most people don’t like delivering bad news. For most of us, it’s little more than the matter of muscling through an uncomfortable conversation. For accounting firms, it can mean the difference between finding new clients or stagnating, according to new research by CSU College of Business faculty.
In “Don’t Make Me Look Bad: How the Audit Market Penalizes Auditors for Doing their Job,” Elizabeth Cowle and her coauthor find that audit firms that issue many critical findings achieve lower business growth than those that issue fewer critical opinions. By examining the issuance of adverse internal control opinions (ICOs), or critical opinions audit firms issue following the discovery of unacceptable internal control practices, and tracking those against audit firms’ client and fee growth, Cowle discovered adverse ICOs were linked to a 2.8 percent lower growth rate in audit firms’ client lists. Those critical firms also collected an average of 4.2 percent fewer audit fees than their less stringent counterparts.
The research, which was published in The Accounting Review, sheds new light on the dynamics between companies and the third-party auditors entrusted to serve as watchdogs for investors.
“It’s this paradox in that we find that audit firms that do a thorough job in examining clients’ financial statements could be making themselves less attractive in the marketplace,” Cowle explained.
Her research goes deeper to suggest that the lowered earnings that result from issuing adverse ICOs may be driven by an audit firm’s reputation for critical opinions. First, the impact of an adverse ICO is even more pronounced when issued for a high-profile client. Because large companies are more visible in the marketplace, auditors’ adverse opinions are more likely to be covered in the news and talked about in boardrooms, magnifying the impact of the bad news, she said.
Second, when auditors with a reputation for stringency issue fewer adverse internal control opinions of their clients, they’re able to rebound and recoup some of their lost growth. Taken collectively, Cowle’s findings indicate that firms may gravitate toward auditors with a reputation for leniency.
“The more diligent you’re being as an auditor, the less attractive you may be to prospective clients,” Cowle said. “Many clients generally prefer the easier audit.”
Audit Committees May Undermine Safeguards
Companies’ penchant for seeking out lax auditors may undermine safeguards established in the wake of several corporate finance and accounting scandals in the early 2000s. The 2002 Sarbanes-Oxley Act requires public companies to hire independent audit firms and expanded the scope of required financial disclosures to the Securities and Exchange Commission. The act was intended to shine a light into corporate finances and give investors more tools to understand a company’s financial health though independent examinations of their books.
As part of these regulations, companies are required to appoint an audit committee to select its audit firm, which is drawn from members of its board and by law, must contain a financial expert. An existing body of accounting research indicates that the more financial experts included in the audit committee, the more insulated it is from the company’s pressure to suppress bad news.
“One of the primary purposes of having an audit committee is to mitigate potential independence issues,” Cowle explained. “When you have more effective, more independent audit committees, they should be considering factors such as the company’s potential bias when selecting auditors, but not all audit committees are created the same.”
Changing audit firms is a costly decision for a company, and only about 5 percent of firms each year change auditors. Often the identification of an internal control weakness or the issuance of a restatement, the practice of reissuing old financial statements to correct errors, drive companies’ decisions to find a new audit firm.
The practice of letting companies indirectly select their audit firm through audit committees has been seen as a potential conflict of interest or lack of independence for years. Cowle’s research may add fuel to calls to rethink policies to ensure greater auditor independence to protect shareholders.
“Companies with more effective audit committees should be aware of the company’s potential bias for a more lenient audit firm and factor this into their auditor selection decisions,” she said.