Blog: Does appointment of a former partner of the client’s audit firm to the client’s audit committee impair audit quality?

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Studies of former partners of audit firms that have assumed management positions at audit clients have raised concerns, at least pre-SOX, about potentially lower audit quality, perhaps reflecting hesitation by the audit firm to “challenge aggressive accounting decisions” made by former partners of their firms. But what happens when a former partner joins the audit client’s audit committee? Does the former partner feel pressured not to question the audit firm’s decisions or lose objectivity about the quality of the work of the audit firm? Does the audit firm feel pressured to accept the company’s more aggressive accounting decisions when a former partner sits on the audit committee? In this study, published in Auditing: a Journal of Practice & Theory, a group of academics looked at that question.  Their conclusion was that affiliated former partners on audit committees actually led to improved audit processes and outcomes. Why? Applying psychology’s “social identity theory,” the authors posit that the former partners continued to identify with their former firms, but instead of losing their objectivity, the former audit partners “use their knowledge of, and identification with, the audit firm to improve the audit process and the communication between the two parties,” leading to improvement in audit quality.

Partners in accounting firms are usually highly sought after as candidates for audit committees of public companies: not only do they bring a wealth of accounting, audit and financial reporting experience, but they can also assume the important role of “audit committee financial expert.” (Note that, to avoid potential conflicts of interest, severing of financial ties and cooling-off periods are required prior to appointment of former affiliated partners to the audit committee. For example, for NYSE- or Nasdaq-listed companies, a director is not independent if he or she was, within the last three years, a partner or employee of the audit firm and personally worked on the listed company’s audit within that time.)

Looking at a sample of publicly available information for Big 4 audit clients between 2004 and 2012 (which involved 22,840 company-year observations), the authors first confirmed and extended prior research showing that audit committee affiliations not only incrementally increase the likelihood of initially hiring the affiliated audit firm, but also mean that the audit firm is significantly less likely to be dismissed in the next year—once again consistent with identity theory.

Importantly, however, although audit firm retention was longer on average at companies with affiliated former partners on their audit committees, the authors found “no evidence that this affiliation results in inappropriate favoritism toward the audit firm that compromises audit quality.” Rather, in part because the audit committee’s goals closely align with the auditor’s, the authors found “evidence that affiliated partners serving on audit committees improve the effectiveness of the external audit function.” One reason is that affiliated former partners “can provide the audit committee with a more informed perspective on the audit firm’s processes, procedures, and terminology. This personal knowledge of the audit firm can help improve communication, further improving the quality of the audit.”

As proxies for poor audit quality, the authors looked at the restatements and failure to timely report material weaknesses.  More specifically, subsequent financial statement restatements were viewed as the “primary proxy for audit quality. However, because audit quality is a multifaceted construct that is difficult to measure using a single variable, we also use the late filing of a material weakness as a second proxy. Failing to report a material weakness when subsequent information indicates that a material weakness existed is an element of audit quality previously studied by academics…and is a PCAOB audit-quality indicator.”

The authors found “an association between affiliated audit committees and higher audit quality,” as well as “an association between affiliated audit committees and increased effectiveness of auditors’ efforts in reducing the likelihood of subsequent restatement.” In particular, the authors found that companies with former affiliated partners on their audit committees were 21% less likely to restate their financial statements and 26% less likely to be late in reporting material weaknesses.  In addition, the authors found no effect on the likelihood of issuing a going concern opinion and “some evidence of affiliated audit committees being less likely to announce a restatement….Thus, affiliated audit committee members appear to improve audit quality by preventing uncorrected material misstatements.” By comparison, the authors found “no effect on audit quality for unaffiliated partners on the audit committee.”

But apparently affiliated audit committee members don’t go overboard on identity theory. The authors also found “no evidence that affiliated audit committees seek to enrich their former audit firm through higher audit fees in the current year”; on the contrary, they found that companies with affiliated former partners on the audit committee, “on average, pay 3.0 percent lower audit fees than other companies,” and had “shorter audit report lags.”

Instead of concluding that lower audit fees necessarily mean less auditor effort, the authors suggest that “affiliated audit committee members improve audit quality by working with the audit firm to perform the appropriate audit procedures, not merely more tests. In this case, audit teams could become more efficient and effective, thus improving quality while reducing hours (i.e., audit fees). Further, affiliated audit committees can help the existing level of auditor effort be more effective in reducing the risk of material misstatement.” The authors also cite to another study showing lower non-audit fees where an affiliated partner sits on the audit committee.

Thus, as a result of “the joint efforts of two complimentary governance mechanisms”—the audit committee and the external auditor—the presence of an affiliated former partner on the committee appears “to improve audit efficiency, consistent with greater knowledge of both the client and the audit firm.”  Could it mean full employment for former audit partners?

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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