Danger when alumnus of a firm’s audit firm sits on audit committee?

Threat to quality if alumnus of a company’s audit firm sits on board audit committee? Quite the contrary, study finds

audit quality

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Benefits include higher audit quality, lower fees, timelier reporting

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A former partner of a Big-Four accountancy sits on the audit committee of a company that the member’s former 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. But, even as suspicion persists that such relationships might be too cozy, a new study should go some way to allay concerns about another client-auditor tie – 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, there has been little research on how this is affected by members’ prior ties to their companies’ accounting firms. Now a new study in Auditing: A Journal of Practice and Theory, a peer-reviewed publication of the American Accounting Association, seeks to rectify this lack by investigating the effect of such past ties in a large sample of former partners of Big-4 accountancies, the firms that conduct the lion’s share of audits for the world’s major corporations.

Findings on audit committee

The former partners acquit themselves admirably, conclude researchers Thomas C. Omer and Marjorie K. Shelley of University of Nebraska—Lincoln, Brant E. Christensen of the University of Oklahoma, and Paul A. Wong of University of California, Davis.

What the professors call “affiliated audit committees” (i.e., those which include a former partner of the company’s accounting firm) yield, in the study’s words, a “combination of higher quality, lower fees, more timely audits, and more effective auditor efforts…[which] help improve both the quality and efficiency of the audit.” As for concerns about excessively cozy auditor-client relationships, such committees, “while less likely [than non-affiliateds] to dismiss their former audit firm, do not show undue preference to their former audit firm that compromises the integrity of the audit.”

More specifically, companies with affiliated audit committees are, on average, 21% less likely than those without them to misstate their financial results and 26% 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.”

The researchers add: “Affiliated audit committee members…improve audit quality by working with the audit firm to perform the appropriate audit procedures, not merely more tests…thus improving quality while reducing hours (i.e., audit fees).”

The study’s findings are based on data concerning a total of 4,906 distinct companies that were audited by the Big 4 during the nine years starting in 2004, the second year following passage of Sarbanes-Oxley. In an average year about 6% of the sample had an audit-committee member who was a former partner of whichever Big-4 firm was performing that year’s company audit; 12% had a member who was a former partner of another Big-4 firm; and the remainder had no former Big-4 partner on their audit committees. The professors analyzed the relationship of these various conditions to several variables, including 1) the quality of companies’ annual financial statements, as measured by the incidence of misstatements (a mean of 16% per year) and belated reporting of material weaknesses in companies’ systems of financial reporting (13% a year), with both deficiencies revealed by subsequent restatements; 2) the incidence of dismissals of audit firms; 3) size of audit fees; and 4) reporting lag, as evidenced by the number of days between fiscal years’ ends and issuances of annual reports. As would be expected, all analysis controlled for many factors that can affect these four variables.

As suggested above, the researchers find significantly negative relationships between affiliated audit committees and all four variables, meaning 1) less likelihood of misstatements and of belated reporting of material weaknesses; 2) less likelihood of audit-firm dismissal; 3) lower audit fees; and 4) less lag in issuance of financial reports. Interestingly, too, they found no significant relationship between audit quality and the presence on the audit committee of a non-affiliated former Big-4 partner. This suggests, the professors write, “the unique effect of affiliation on the coordination between the audit committee and the audit firm.” In addition, the presence of non-affiliated Big-4 partners was associated with relatively high audit fees.

In conclusion, the 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, they add, should be of value not only to other scholars but to regulators and practitioners.

“Affiliated Former Partners on the Audit Committee: Influence on the Auditor-Client Relationship and Audit Quality,” is in the August/October issue of Accounting: A Journal of Practice and Theory, a peer-reviewed journal published quarterly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.



About the Author

Jacob Wolinsky
Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Prior to ValueWalk, Jacob was VP of Business Development at SumZero. Prior to SumZero, Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver