Does shareholders’ ratification of auditors actually help improve accounting and, in turn, the interests of companies? After all, that ratification vote gives shareholders the chance to say what they think about the auditor. But, historically, only 2 percent vote against changing audit firms.
A recent study published by the American Accounting Association indicates that auditor ratification is deficient in several ways. Why that’s so lies in a confluence of how the ratification method works, how complacent shareholders may be about the information they need, how much information audit committees release about the auditor, and how proxy advisors present all that to shareholders.
Auditor Ratification: Can’t Get No (Dis)Satisfaction, by Lauren Cunningham, assistant professor of accounting and information management at the University of Tennessee and a former audit manager at Grant Thornton, finds that proxy advisors significantly vary in whether they follow their own guidelines.
Proxy advisors, the study states, “conduct independent research and provide summarized voting recommendations, for or against, that assist shareholders in synthesizing information and making effective voting decisions. Proxy advisors are engaged by, and paid by, subscribing shareholders.”
But proxy advisors often are criticized “for making recommendations that are one-size-fits-all rather than geared to the specifics of a company,” the study states. “But when it comes to key issues related to auditor ratification, they don’t even seem to be following their own checklists.”
But those checklists or guidelines are based on shareholder feedback, the study states. If shareholders don’t respond to signs of poor audit quality, or if shareholders don’t emphasize audit quality proxies in the advisor guidelines, proxy advisors “will be less likely to issue an against recommendation for poor audit quality absent obvious signals of audit failure.”
Yet, if investors and other interested parties delved deeper into the “proxying for poor audit quality,” the result likely could mean more against recommendations for auditor ratification, the study states.
Take aggressive accounting policies, such as the amount of a firm’s discretionary accruals – noncash accounting items that usually involve guesswork and are widely linked to earnings manipulation. In researching 9,000 ratifications in more than three years, Cunningham identified 512 firms in the top tenth of their industry in reporting the most discretionary accruals in a given year. But proxy advisors recommended against retaining the auditor only 22 times.
Part of the problem may well lie in insufficient detail coming out of audit committees about their interactions with auditors. And if the audit committee doesn’t say much, then proxy advisors’ clients – the shareholders – won’t pay as much attention to audit quality, the study states.
“Availability bias suggests that users of information consider information that is easily retrievable,” the study states. “Proxy advisors may be less willing to issue against recommendations based on suspected poor audit quality because it lacks clear and centralized disclosure.”
Even if shareholders recommend changing the auditor, the total percent of dissenting votes likely doesn’t hit the benchmark that the audit committee considers necessary to make changes, the study states. That’s especially when these votes are voluntary and request ratification of what the audit committee has already decided.
In fact, Cunningham notes that other studies have shown that managers use 20 percent as the threshold to indicate substantial shareholder disapproval. Votes below that mark may not warrant action.
Cunningham also notes that the Center for Audit Quality and the Public Company Accounting Oversight Board are studying the feasibility of defining and requiring disclosure of audit quality measures. But the focus is on audit committee disclosures. Those won’t be available to shareholders unless audit committees voluntarily provide them.
“My findings may be useful to these discussions because they suggest that even a reasonably sophisticated user, such as a proxy advisor, often lacks clear enough evidence about poor audit quality to warrant issuing an against recommendation,” Cunningham states.