As regulators review audit independence requirements to figure out whether the rules should be changed in order to promote auditor objectivity and skepticism, a recent academic study points to a negative incentive system that may impair independence and bring down audit quality.
The study found that audit firms “are significantly more likely to remove” a partner from a continuing engagement when the partner issued an adverse internal control opinion in the previous year. Such problem is tied to the client-pay audit model, which critics say produces inherent conflicts of interest.
In particular, researchers found that partners that issued adverse internal control opinions experienced unfavorable changes in their client portfolios with lower fees and less prestigious assignments.
To do the study, researchers looked at the auditor’s attestation of management’s internal control over financial reporting (ICFR) under Section 404(b) of the Sarbanes-Oxley Act of 2002, which applies to publicly-traded companies. Section 404(b) requires the external auditor to issue an adverse opinion when there is a material weakness in the client’s ICFR.
“We also find that partner consequences are greatest when adverse ICOs [internal control opinions] are likely to be more subjective and when they are issued to more important clients,” the study stated. “Our results are consistent with audit partners experiencing negative consequences when they issue opinions that strain auditor-client relations, even though these opinions provide valuable information to capital market participants and are not likely to reflect lower audit quality.”
The study was carried out by Ashleigh Bakke of the University of Kansas, Elizabeth Cowle of Colorado State University, Stephen Rowe of the University of Arkansas and Michael Wilkins of the University of Kansas. The research paper was published in March 2023.
Previous studies have found that poor audit quality could lead to negative consequences for the audit engagement partners. For example, client restatements often lead to partner changes that could impact the partner’s career, including fewer audit hours, fewer public-company clients, lower partners ratings and an increased likelihood of internal inspections.
“Our setting has the potential to offer important new insights, however, because adverse ICOs strain auditor-client relations without necessarily reflecting low audit quality (and potentially reflecting high audit quality),” the study notes.
Previous research findings suggest that clients may switch audit firms to avoid getting adverse internal control opinions. And researchers believe that firms may reassign the partners to keep clients from leaving.
“Stated differently, catering to the preferences of clients may be in the audit firm’s best economic interest, even though doing so may come at the expense of adverse ICO partners,” the study noted. “Our findings are particularly relevant in light of recent research suggesting that problems with 404(b) audits continue to be a primary concern for the PCAOB.”
Over the years, the PCAOB’s inspection staff has continued to find problems with ICFR audits.
Details of Study
For the study, the researchers looked at a sample consisting of audit partners and their public company clients with audit opinions filed from January 2017 through December 2020. The sample captures partner changes and partner portfolio changes through December 2021.
The sample for client-level turnover tests consisted of 8,111 client-year observations, and the sample for partner-level portfolio tests consisted of 6,514 partner-year observations.
The study found about 6.7 percent instances of engagement partners who issued an adverse ICFR opinion to any of their clients.
Among the full 404(b) sample of clients, those with partners who issue adverse ICFR opinions were about 4.4 percent more likely to experience a change in partners within the next year relative to clients with engagement partners who did not issue adverse opinions. The study found that partners that issue adverse opinions experienced 9 percent lower growth in average fees across their portfolios, which corresponds with 14.7 percent lower growth in total fees across all clients. This is $480,690 based on the sample average portfolio size of $3.27 million in public client fees.
The researchers also looked at a narrow sample of 404(b) clients only, and it showed even stronger consequences for the partners that gave adverse ICFR opinions. These partners experienced 18 percent lower growth in average fees and 19.6 percent lower growth in total audit fees. For the average partner in this sample, these changes represent a $640,920 decrease in 404(b) client fees.
Further, partners who gave adverse ICFR opinions experienced a 7.9 percent increase in average fees, a 5.7 percent increase in total fees and a 10 percent increase in the number of non-404(b) clients. These results represent an increase of $186,390 in non-404(b) client fees for the average partner, but the results also show that the increases do not offset decreases in 404(b) client fees.
This article originally appeared in the April 24, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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