When a company hires an external auditor to provide an independent assessment of its financial reporting, the auditor’s work is intended to give the public confidence about the credibility of the company’s operations – but the current system could be incentivizing auditors to face significant pressure from dishonest companies.
There’s an inherent ethical conflict between an auditor’s duty to provide an objective assessment and the fact that they were hired by – and will be paid by – the same company whose finances they’re auditing, says the accounting department’s Eric Lohwasser.
New research from Lohwasser and his coauthor, published recently in Journal of Business Ethics, found that companies whose reported earnings fell just short of analysts’ expectations are more likely to fire their auditors.
The presumption is that these companies are more likely to believe that their auditors are constraining earnings management strategies, leading them to make an opportunistic auditor switch.
“It appears as though, from our research, clients are getting rid of auditors that may be constraining them and selecting auditors that are more flexible,” Lohwasser said. “It puts a lot of pressure on auditors who need to maintain independence to appropriately do their job, but face pressure to retain their clients. That adds tension to the overall process of how we do things.”
“Earnings Management, Auditor Changes and Ethics: Evidence
from Companies Missing Earnings Expectations”
Eric Lohwasser, Yaou Zhou1
Journal of Business Ethics
1 Montclair State University
The research shows that auditors are essentially being penalized for doing a key part of their job: constraining questionable financial reporting practices.
Auditors under pressure
Lohwasser looked at companies that barely missed analysts’ expectations of earnings because in most cases when a company is close to meeting expectations, its leadership can use earnings management techniques to push it to meet those expectations.
“We look at those companies, and we say that it’s more likely that they had an auditor that constrained their earnings relative to other companies,” Lohwasser said. “Then we try to say, ‘Does that have an actual implication on who their auditor is that they select in the in the periods after that?’”
Using more than 19,000 observations across 15 years, the researchers found that just missing earnings expectations does mean a company is more likely to switch out their auditor. They further support their argument – that these auditors are being let go because they were constraining the company – by examining whether the auditor that comes in next is more flexible.
The research also found that a company is more likely to fire their auditor in response to missing earnings expectations if it has weak corporate governance, if it has experienced negative market reactions to earnings announcements or if it has higher levels of accruals flexibility.
Typically, a company’s executives will recommend an auditor to its audit committee, which then approves the auditor, ostensibly acting as a watchdog throughout the process.
“When there’s lower corporate governance, this is more likely to happen, because they’re less likely to force the company to keep with that auditor that constrained their earnings management,” he said.
Highlighting flaws in the system
Throughout his academic career, Lohwasser has been interested in examining conflicts of interest or incentives that are misaligned with what we’re trying to achieve in society.
“Most of my research is focused on misaligned incentives and conflicts of interest between different groups, and how misaligned incentives can negatively affect the systems that we have set up in order to provide stability in financial reporting and accurate information to the public and capital markets,” Lohwasser said.
With this paper, Lohwasser hopes to draw attention to this apparent ethical conflict, urging regulators to examine the system with the goal of minimizing any ethical tensions. Also, by paying closer attention to the pressures that auditors face, regulators could identify companies that are engaging in nefarious practices.
Firing an auditor after just missing earnings expectations could be considered a risk factor when the U.S. Securities and Exchange Commission, the Public Company Accounting Oversight Board or other regulators are concerned about a company’s financial statements or audit quality, Lohwasser said.
“Regulators largely focus on auditor actions and auditor compliance when it comes to auditor independence and focus less on clients’ actions towards their auditors as a pressure,” he said. “We show an important way in which clients are putting pressure on auditors. It’s worth a closer look by regulators – and separately, it’s worth regulators considering clients that take these types of actions, because they’re likely to have more questionable reporting.”
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