A former partner of a Big Four accountancy firm sits on the audit committee of a company that the member’s previous firm is hired to audit. Should investors suspect the quality of the company’s financial reporting?
Research has been mixed on the threat posed to auditor independence when a top manager of a client, such as the CEO or CFO, is an “alumnus” of its accounting firm.
Even as suspicion persists that such relationships might be too cozy, a new study by Professors of Accountancy Dr. Thomas C. Omer and Dr. Marjorie K. Shelley of the University of Nebraska–Lincoln College of Business and their co-authors should go some way to alleviate concerns about another client-auditor tie. Specifically, the presence of accountancy alumni on the audit committees of companies being audited by those members’ former employers.
Although the Sarbanes-Oxley Act of 2002 charges audit committees with responsibility for the quality of corporate financial reporting, little research has been done on how this is affected by members’ prior ties to their companies’ accounting firms. Omer and Shelley’s study seeks to rectify this lack of research by investigating the effect of such past ties in a large sample of former partners of Big Four accountancies, the firms that conduct the lion’s share of audits for the world’s major corporations.
The former partners acquit themselves admirably, conclude Omer, Shelley and their fellow researchers Dr. Brant E. Christensen of the University of Oklahoma and Dr. Paul A. Wong of the University of California, Davis.
“We found that familiarity with the audit firm improves both the quality and efficiency of the audit,” said Omer. “Additionally, the data lessens concern about excessively cozy auditor-client relationships. While the affiliated audit committees – those which include a former partner of the company’s accounting firm – are less likely to dismiss their audit firm, we found the committees do not show undue preference that would compromise the integrity of the audit.”
The researchers examined data from 4,906 companies audited by one of the Big Four firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – during the nine years starting in 2004, the second year following passage of Sarbanes-Oxley. In an average year, about 6 percent of the sample had an audit committee member who was a former partner of whichever Big Four firm was performing that year’s company audit. Twelve percent of the sample had a member who was a former partner of another Big Four firm, and the remainder had no former Big Four partners on their audit committees. The researchers analyzed the relationship of these conditions to several variables including financial restatements, the incidence of dismissals of the audit firm, size of audit fees and reporting lag, as evidenced by the number of days between fiscal years’ ends and issuances of annual reports.
“Finding negative relations between affiliated partners and misstatements, internal control weakness reporting, audit fees, and reporting lag suggests investors are being provided reliable financial statements in a timely manner, which facilitates decision making and the cost of those benefits is not excessive,” said Shelley.
Companies with affiliated audit committees are, on average, 21 percent less likely than those without them to misstate their financial results and 26 percent less likely to be late in reporting material weaknesses in their systems of financial reporting.
As the paper explains, “Prior studies that focused on affiliated management warn of lower audit quality linked to affiliated partners, ostensibly because the audit firms are more hesitant to challenge aggressive accounting decisions by a former partner of their firm…Concerns about a loss of auditor objectivity should be lower when the affiliated partner serves on the audit committee because the committee’s financial reporting quality objectives align with the audit firm…Affiliated partners can use their knowledge of, and identification with, the audit firm to improve the audit process and the communication between the two parties. Thus [they] are likely to improve audit quality.”
Omer said, “Affiliated audit committee members improve audit quality by working with the audit firm to perform the appropriate audit procedures, not merely more tests. This improves quality while reducing hours, and thus, audit fees.”
Omer, Shelley and their co-authors see the research as providing evidence of the virtue in “having an audit committee member with personal, in-depth knowledge of the audit firm and longer audit-firm tenure.” The findings can not only prove valuable to other scholars but also to regulators and practitioners.
“There are continuing concerns of regulators related to former accounting firm personnel working for clients. This study suggests the cooling off period required and divestiture from the accounting firm before taking positions on the audit committee whose responsibility is the financial reporting process, is working,” said Omer.
While the study shows former partners improve audit quality, cost and reporting lag, both professors caution that rapidly changing audit technologies may affect their ability to continue to provide these benefits, especially those related to understanding specific audit firms’ technologies.
“Affiliated Former Partners on the Audit Committee: Influence on the Auditor-Client Relationship and Audit Quality,” appears in the August/October issue of Auditing: A Journal of Practice and Theory, published quarterly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research and practice.