Nov 7th 2013
By Jason Bramwell
Three research studies – two of which were published recently in an American Accounting Association (AAA) journal and the other presented during an academic accounting conference last month – make a case for requiring audit engagement partner identification in the audit report, an issue the Public Company Accounting Oversight Board (PCAOB) is expected to discuss by the end of the year.
The three studies examine whether knowing the name of the engagement partner leading an auditing effort is valuable to investors and whether being required to provide this information enhances the performance of engagement partners. The studies specifically focus on Sweden, China, and the United Kingdom, each of which requires identification of lead auditors in company financial statements.
The PCAOB may reexamine a proposal before the end of this year that could require disclosure of the engagement partner's name in the audit report. The PCAOB may also require disclosure in the audit report of other accounting firms and other persons not employed by the auditor who took part in the audit.
According to the PCAOB standard-setting agenda dated June 30, 2013, the project, "Audit Transparency: Identification of the Engagement Partner and Other Public Accounting Firms or Persons That Are Not Employed by the Auditor but Participate in the Audit," is scheduled for adoption or re-proposal sometime between now and December.
Does Engagement Partner Identity Matter?
The first study, Does the Identity of Engagement Partners Matter? An Analysis of Audit Partner Reporting Decisions, which was presented during the Canadian Academic Accounting Association's 28th Annual Contemporary Accounting Research Conference on October 25, is based on an analysis of audits performed over a seven-year period by the Swedish subsidiaries of the Big Four accounting firms.
The authors of the study – W. Robert Knechel, Ann Vanstraelen, and Mikko Zerni – made the following three conclusions:
- That aggressive or conservative reporting is associated with the particular engagement partners who head the audits over and above any influence of the Big Four firms that employ them.
- That these individual differences in reporting style persist over time and across clients.
- That they contribute significantly to such economic factors as the credit ratings that client firms receive and how they are assessed by stock investors.
"A firm audited by an engagement partner who is consistently aggressive is more likely than other companies – other factors being equal – to be penalized through higher interest rates, lower credit ratings, and greater perceived likelihood of insolvency," Knechel, a professor in the Fisher School of Accounting at the University of Florida Warrington College of Business Administration and editor of Auditing: A Journal of Practice and Theory, published by the AAA, said in a written statement. "If the company is public, it is also likely to be penalized by a lower Tobin's Q – a measure that reflects investor approval of a firm and optimism about its prospects. In short, we find that the reporting differences of lead auditors have a significant effect on both the lending and equity markets."
The authors reviewed the accounting styles of auditors – both aggressive and conservative – in two specific ways:
- Through their propensity to issue going concern opinions (the warnings about firms' future viability that auditors insert in financial reports of distressed companies).
- By their tendency to err on the high or low side in estimating the value of accruals (noncash items, such as accounts receivable or inventory).
The authors found that some auditors failed to issue going concern opinions for firms that went bankrupt a year or less later, a tendency that the authors equated with aggressiveness. An auditor with a prior history of frequently erring in this way were three to four times more likely of doing it again in a subsequent year than an auditor without that history.
"Collectively, the findings of this paper emphasize the importance of analyzing audit quality at the level of the individual auditor and contribute to the limited, but growing, evidence that the characteristics of individual auditors effect audit outcomes," the authors concluded in the study. "Because the auditor's reputation is a potentially critical aspect of audit quality, the reported findings should be of interest to practitioners, regulators, academics, and users of financial statements. Specifically, our results imply that the identity of the engagement partner matters to the market."
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.