Studies Make a Case for Engagement Partner Identification
by Terri Eyden on
Do Auditors Affect Audit Quality?
The second report, Do Individual Auditors Affect Audit Quality? Evidence from Archival Data, which is scheduled to be published in the AAA's November/December 2013 issue of The Accounting Review, analyzes 15,000 corporate annual reports over a twelve-year period in China, where auditors are required to identify themselves in such reports.
The authors of the study, Ferdinand Gul, Donghui Wu, PhD, and Zhifeng Yang, analyzed corporate annual reports signed by nearly 800 auditors and concluded that, despite the constraints that accounting firms impose on them, "the effects that individual auditors have on audit quality are both economically and statistically significant, and are pronounced in both large and small audit firms."
The role of signing auditors in China is similar to that of engagement partners in other markets, the authors noted, in that signing auditors lead the audit team and are responsible for decision-making on significant matters.
"The names of signing auditors are disclosed, and their profile data are also publicly available," the authors wrote.
Much like the report authored by Knechel, Vanstraelen, and Zerni, aggressive and conservative accounting styles were found among auditors in China, according to Gul, Wu, and Yang.
"Signing auditors who are also partners or who have been exposed to Western accounting systems during [their] university education or who have worked in an international Big Four audit firm are more conservative, while auditors who have obtained a master's degree or above or have a political affiliation are more aggressive," the authors wrote. "Although we show that some observable demographic characteristics explain differences in audit quality across individual auditors to some extent, much of this variation remains unexplained."
Wide divergences between individual practitioners emerged in the authors' analysis of the following four critical aspects of auditing:
- Amount of accruals (noncash items), high levels of which are often a clue to earnings manipulation.
- Frequency of modified opinions as opposed to unqualified endorsements.
- Amount of below-the-line, or noncore, items.
- Frequency of reporting tiny profits, barely above break-even – another gauge of earnings manipulation.
Insights from the United Kingdom
The third study, Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom, by Joseph Carcello and Chan Li, was published in the September/October 2013 issue of The Accounting Review.
The authors examined the effect on audit quality and cost of a UK regulation, which went into effect in April 2009 and requires engagement partners to sign corporate financial reports. They concluded that the requirement benefited investors and other financial users, even though it resulted in "significantly higher audit fees."
The authors noted the requirement resulted in several statistically significant changes in audit performance, mostly decreases in abnormal accruals and the reporting of small earnings gains, both of which are commonly associated with the following:
- Earnings manipulation.
- Increased investor responsiveness to earnings reports, likely reflecting enhanced report credibility.
- Increase in the incidence of qualified audit opinions, suggesting heightened auditor diligence.
The study features an analysis of financial reports of between 726 and 1,168 companies listed on the London Stock Exchange from 2008 to 2010 (the different numbers reflect variability in available data from one company to another) – specifically from comparing reports issued the first year of the signature requirement versus those issued the previous year. Based on the data, the following key results emerged:
- Abnormal accruals dropped by 26 percent.
- The percentage of firms reporting hairbreadth earnings gains fell from 19 percent to 9.2 percent.
- Investor response to reports went from negative to positive.
- The percentage of audits issued with qualified opinions nearly doubled, from 3.3 percent to 6.5 percent.
Analysis with appropriate controls for client firms' size, profitability, leverage, and other company characteristics indicated that these results were specifically attributable to the signature requirement and not other factors or by chance.
The study also revealed that, after controlling for other factors that affect audit costs, UK companies paid 13.2 percent higher audit fees following implementation of the requirement than they would have paid during the previous year.
Although the authors remained neutral on whether audit engagement partner identification is needed in the United States, Carcello, who sits on the PCAOB Investment Advisory Group, noted that at an October 16 meeting of the advisory group, there was virtually unanimous agreement on the need for the PCAOB to adopt an engagement partner identification requirement.