Audit quality and audit market competition are high on industry and regulatory radar screens, and have been for years. The European Union’s mandate that requires auditor rotation takes effect in June, and the United States has considered similar rules.
That all makes a new study published recently by the American Accounting Association particularly apropos.
But the study adds a twist to the belief that increased competition for clients’ auditing business will improve corporate financial reporting. Rather, competition may actually compromise auditor independence. That’s because it increases the likelihood of opinion shopping based on internal controls, according to the study, Internal Control Opinion Shopping and Audit Market Competition, which was published in the March/April issue of The Accounting Review.
“Our empirical results suggest that clients are successful in shopping for clean internal control opinions,” the authors note. “In addition, we find evidence that internal control opinion shopping occurs primarily in competitive audit markets. Finally, our results indicate that among auditor dismissal clients, opinion shopping is more likely to occur when dismissals are made relatively late during a reporting period and when audit market competition is high.”
That, the authors say, has “implications for the current policy debate regarding audit quality and audit market competition.”
The Sarbanes-Oxley (SOX) Act of 2002 requires companies and their auditors to vouch for their internal controls. The study’s authors contend that their research is the first to document opinion shopping in any form since SOX was enacted. And because shopping for favorable auditor opinions on internal controls is greatest when competition is high, internal controls – once a nonissue – has become a very big issue, according to the study.
“In short, our findings suggest that opinion shopping pays, that concern over internal controls has become a major factor in motivating it, that companies engage in it to a significant degree, and that competition among auditors increases its prevalence,” study co-author Michael Wilkins, a business professor at Trinity University, said in a prepared statement.
Wilkins’ colleagues in the study included Julie Persellin, associate professor in accounting at Trinity University; Nathan Newton, assistant professor of accountancy at the University of Missouri; and Dechun Wang, associate professor in accounting at Texas A&M University.
Here’s a closer look at the study’s other points and findings:
- Auditor dismissals late in the reporting period are much more likely to be associated with opinion shopping, particularly when audit markets are competitive – especially when companies switch from a Big Four auditor to a smaller firm.
- While there’s been improvement in internal controls since SOX, certain regulatory findings and other reports indicate that “to the extent that questionable audit rigor and/or potentially misclassified internal control deficiencies at least partially reflect acquiescence to client preferences, the existence of internal control opinion shopping would be consistent” with the findings.
- Internal control opinion shopping appears to exist and audit opinion shopping doesn’t, which suggests that audit clients consider internal control reports as more important. “As such, regulators may wish to increase their monitoring of internal control issues,” the study states.
- A “critical problem with many opinion-shopping studies is their implicit assumption that while a decision to change auditors might be associated with opinion shopping, a decision not to change auditors could not be associated with opinion shopping,” the authors note.
- Audit clients appear to be successful in seeking clean internal control opinions. “More specifically, our results suggest that clients would have received adverse internal control opinions more frequently if they had made different auditor retention or dismissal decisions,” the study states.
- “Significant opinion-shopping activity appears to exist among firms that have clean internal control opinions in advance of financial statement restatements,” the study states.
About Terry Sheridan
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.