Auditor Opinion-Shopping Aids Companies At Expense Of Investors: Study

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Opinion-shopping for auditors pays off for troubled firms but to the likely detriment of investors, research finds

Does corporate opinion-shopping compromise the professional objectivity of external auditors – in other words, compromise auditor independence? It would hardly be surprising for corporate executives, particularly of companies caught in a financial squeeze, to seek external auditors likely to be amenable to their influence, whether such opinion-shopping means sticking with the auditor the firm already has or switching to another one. Yet, there has been relatively little research – and the evidence has been mixed – on whether opinion-shopping is generally successful for client companies and whether it diminishes auditor independence and audit quality.

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Now, in what may be the widest-ranging research to date of these questions, a study of a large number of distressed U.S. firms finds opinion-shopping to be of tangible benefit to corporate managements though at the expense of auditor independence and investor interests.

The paper, in the current issue of the American Accounting Association quarterly Auditing: A Journal of Practice and Theory, reports that most firms in the study sample engaged in auditor opinion-shopping and that it paid off nicely in reduced likelihood of receiving going-concern opinions, even as it increased financial misstatements. The Sarbanes-Oxley law, promulgated by the U.S. Congress in 2002, in response to major corporate financial scandals, has had little effect on this state of affairs, according to the new research, a joint effort of Jong-Hag Choi of Seoul National University, Heesun Chung of Sejong University, Catherine Heyjung Sonu of Korea Open National University, and Yoonseok Zang of Singapore Management University.

Opinion-shopping does, indeed, tilt the current system away from transparency, the new research suggests, particularly when shopping results in switching auditors. As the professors write, “this study highlights the need to develop mechanisms that curb clients’ opportunistic auditor switches, such as regulatory intervention in the choice of a successor auditor or other mechanisms that discipline excessive client pressure. Our findings also provide important implications for investors and audit committees by suggesting that both audit-opinion credibility and financial-reporting quality can be hampered by auditor-switching through opinion shopping.”

An estimated 57% of the firms in the study sample shopped opinions, among which only 16% received going concern opinions (GCOs), compared to the 28% among non-opinion-shoppers. GCOs express substantial doubt about a firm’s ability to continue as a going concern in the near future, and since they typically bring adverse consequences, such as negative market reaction, credit rating downgrade, and difficulty in raising new capital, companies are eager to avoid this judgment. And to a considerable extent opinion-shopping enabled them to do so: of 142 firms that filed for bankruptcy, 45% of the opinion-shoppers had received clean opinions, compared to only 19% of the non-shoppers. In other words, there were significantly fewer red flags for investors with respect to the former group of companies.

Evidence of auditing lapses as a result of opinion-shopping also turns up in other, equally important ways – for example, in the incidence of financial misstatements, which was significantly higher among firms that engaged in opinion-shopping than among those that did not. The disparity was attributable to opinion-shoppers that switched auditors rather than those that retained incumbents (opinion-shopping, as indicated above, can lead firms to retain their current auditor if they calculate that switching will bring no better outcome). Opinion-shoppers that didn’t switch auditors proved no more likely to restate finances than non-shoppers.

Why this difference between the two groups of opinion-shoppers? In the words of the study, "successor auditors are incentivized to keep their new clients until they recover start-up costs and are thus more susceptible to client pressure. In addition, if auditors are concerned about reputation damages borne by early termination of audit contract, the successor auditors subsequent to switching opinion-shopping could be more vulnerable to the threats of dismissal. In contrast, incumbent auditors under non-switching opinion-shopping can be more resistant to client pressure, as they have recovered the start-up costs partly or fully from previous audit service." Further, clients that switch can be particularly aggressive in exerting influence, since “changing auditors is costly to clients because they should bear auditor searching costs and a share of the incoming auditor’s start-up costs…Clients’ willingness to incur such costs…may signal that their opinion-shopping incentives are relatively strong. This may result in more adverse effects on audit quality.”

To whom do opinion-shoppers switch? Dividing at the median audit firms that have more or fewer switching opinion shoppers as clients, the professors find that those in the former group “tend to be non-Big 4 auditors…whose reputational capital is weak, [whose] pocket for litigation damages is not deep and…[who] are more likely to accept switching opinion-shoppers despite the higher litigation risk associated with accepting these clients.” In sum, “audit firms and offices that more frequently accept opinion-shopping clients tend to exhibit poorer audit quality not only for switching opinion-shoppers but for other clients.”

The professors also investigate whether the Sarbanes-Oxley law, which created the Public Company Accounting Oversight Board to provide national oversight of corporate auditing, has reduced opinion-shopping. Collecting data from before and after the establishment of the PCAOB in 2003, the professors find that opinion-shopping sharply declined in the period 2004-2006 but subsequently returned to its pre-PCAOB level.

The study’s findings emerge from analysis of data from some 3,560 distressed public companies over a nine-year period. Firms were defined as distressed if they reported either negative net income or negative operating cash flow in a given year. Whether or not companies engaged in opinion-shopping was determined through analysis of a complex array of factors that included firms’ financial profiles (for example, the amounts of their assets, debt, return on assets, and operating cash flow); whether firms’ prior-year audit resulted in a clean opinion or a GCO; and sizes of auditors’ practices and whether they were Big 4 practices.

From large-scale analysis of 11,628 company-years’ worth of data, favored patterns emerge of when it pays for firms to retain auditors rather than switch and vice versa – when, for example, a company improves its chance of avoiding a GCO this year by switching from the auditor that gave it one last year. Choices of whether to stay or switch that are in keeping with favored avoidance patterns were deemed by the researchers to constitute evidence of opinion-shopping. And with this evidence in hand, additional analysis yielded findings on the negative effect of opinion-shopping on audit quality, such as through increased incidence of misstatements.

What lessons does the new research offer to regulators and investors? Comments Prof. Choi, “Using the statistical model provided in our study, regulators and sophisticated investors can identify companies that switch auditors after opinion-shopping, something that should be of value given the increased likelihood of misstatements among such firms. As for less sophisticated investors, they can benefit by simply exercising an extra measure of caution in assessing any company that changes auditors after receiving a going concern opinion.”

The study, “Opinion-Shopping to Avoid a Going Concern Audit Opinion and Subsequent Audit Quality,” is in the May issue of the  Auditing: A Journal of Practice and Theory, which is 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 Information Systems, Journal of Financial Reporting, Journal of Management Accounting Research, Journal of Forensic Accounting Research, and Journal of the American Taxation Association.

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