August 13, 2019
Published: International Accounting Bulletin
Auditors get a bad reputation when they do their job properly according to new research. In a report being presented at the American Accounting Association’s annual meeting entitled Don’t Make Me Look Bad: How the Audit Market Penalizes Auditors for Doing Their Job, researchers found that flagging material weaknesses in companies’ internal controls over financial reporting is bad for auditors’ business! A material weakness (ICMW) is judged by auditors to exist if a firm’s control of its finances is sufficiently flawed to create a reasonable possibility that a material financial misstatement will occur.
In the words of co-authors Stephen P. Rowe and Elizabeth N. Cowle of the University of Arkansas: “The issuance of an ICMW should neither impair the issuing auditor’s reputation, nor deter clients from selecting auditors with a history of issuing ICMWs.” Yet, “…auditors who issue an ICMW are perceived as less attractive in the audit market,” which therefore ‘disincentivizes auditors from disclosing internal-control information that could make their clients look bad’.
Based on 13 years’ data from 885 local offices of 358 audit firms in the US, Rowe and Cowle find that offices which reported ICMWs for one or more clients in the course of a year saw their average fee total in the following year grow by about 8% less than would have been the case had they issued none. Moreover, that decline was in addition to lost fees from clients who were found to have ICMWs and responded by switching auditors, something companies tagged with ICMWs often do.
In short, ‘the issuance of an ICMW affects auditor selection and retention decisions even among clients that do not receive an ICMW’, the study states. To which Prof. Rowe adds: “What our research measures is reputation. When an auditor issues an ICMW opinion, word gets around.”
He added: “In the informal conversations we have had with practitioners, we’ve often found they already had a notion of what we document. In other words, what we’ve been the first to do in this study is provide confirmation on a large scale for what is already part of the day-to-day calculus of many in the audit profession.”
In total, the researchers analyzed about 5,000 office-years’ worth of data spanning 2004 (the first year when IC opinions became available following passage of Sarbanes-Oxley) through 2016. On average, about 25% of the bureaus issued at least one ICMW opinion per year. Since only offices with more than three clients were included in the sample, one ICMW opinion could affect as many as 25% or as little as 2-3% of a bureau’s clients.
Even in fairly large offices, results suggest a considerable negative effect from a single ICMW opinion. For example, in one year the San Francisco office of one Big-4 firm issued no ICMW in the 12 public audits it conducted, while the bureau of another Big-4 in the same city reported one ICMW in 26 public audits. During the following year, the former issued 14 audit opinions, an increase of about 17%, while the latter’s fall-off in business was such that it issued 21 audit opinions, a drop of almost 20%.
In addition to finding significant negative impacts on client numbers and fees in the year following as little as a single ICMW report, the researchers discovered both impacts to worsen even more 1) when an office issued two or more such reports; 2) when ICMWs were issued for large companies (higher market capitalization, and likely more visibility, than the median of an office’s clients); and 3) when ICMW reports involved multiple issues (the more issues, the more negative the effect).
Rowe and Cowle also found 4) that companies in the sample who switched offices predominantly migrated to auditors with lower incidences of ICMWs; 5) that the ratio of clients with high F-scores (that is, with heightened likelihood of manipulating or misstating earnings) tended to drop when an office issued an ICMW; and 6) that the negative after-effect on office business of ICMW opinions persists beyond the subsequent year to a second year before apparently petering out.
In sum, 17 years after the passage of Sarbanes-Oxley the study raises fresh doubts about the still-controversial bill as well as about the new PCAOB mandate on CAMs that the authors see as having evolved from it. These doubts, they believe, ought to be of serious concern. Comments Prof. Rowe: “Sarbanes-Oxley represented the principal legislative response to a severe crisis not only for the accounting profession but for the free-market system. While some studies have found SOX to be of value, the issue, as this study suggests, is far from settled. To anyone who believes in the free-market system, this needs to be concerning.