Apr 4, 2016
Wear Your Auditor on Your Sleeve
If a top-notch person conducts your audit, it pays to let investors know.
Engaging a big-name auditing firm holds cachet for public companies, as well as for those preparing to launch an initial public offering (IPO). Many experts like to see that the audit has been done by one of the “Big Four” auditing firms, Deloitte, Ernst & Young, KPMG, or PricewaterhouseCoopers, as an indication of audit quality. After all, financial-industry representatives rely on audited financial statements to make decisions about everything from loan limits and terms to IPO valuation. So quality matters.
But not all partners in these high-flying firms are created equal. It turns out that capital markets also care which specific partner is leading the audit, according to new research from the Kellogg School.
The only problem: people are not currently privy to this information in the United States.
Traditionally, the audit-reporting process in the U.S. “has been extremely plain vanilla,” says Daniel Aobdia, an assistant professor of accounting information and management. Audit reports are typically boilerplate documents that adhere to existing Public Company Accounting Oversight Board (PCAOB) reporting standards. In the U.S., the reports disclose the audit firm, but not the partners within the firm who completed the audit.
“Given that the identity of the partners is disclosed, audit partners develop a track record over time, which is observable to investors.”
But, of course, some people are just better at their jobs. Wouldn’t a thumbs-up from an excellent auditor be more valuable than one from someone whose work was less than stellar?
Does the Right Audit Partner Matter?
To explore the issue, Aobdia and his coauthors, Chan-Jane Lin of National Taiwan University and Reining Petacchi of MIT, looked to Taiwan, where individual partners are required to sign audit reports.
“Given that the identity of the partners is disclosed, audit partners develop a track record over time, which is observable to investors,” the researchers write.
The role of an audit is to obtain reasonable assurance that a company’s financial statements, including its earnings numbers, are accurate. If the use of high-quality audit partners was important to investors, the research team expected to see companies with good auditors perform better in areas like investor response to earnings announcements, debt terms, and IPO pricing. If the skill and history of the partner did not matter, performance would be similar regardless of the auditor’s track record.
“If a company is not doing well, and all its financial statements are inflated because earnings are cooked, a bad partner may not notice it,” Aobdia says. “Whereas if you have a good partner, they are likely to notice that the earnings are cooked. Therefore, they are going to ask the company to modify the numbers, especially prior to an IPO.”
For their study, the researchers first had to define a “high-quality” audit partner. Aobdia says it was important to separate the quality of the partner from the quality of the auditing firm, as well as from the client being audited. After all, a great auditor should not be judged poorly if the company she audited had very poor quality financial reporting to begin with. Likewise, a bad auditor should not be buoyed simply because she audits a great company.
So the researchers looked at the performance of auditors’ clients from 1995 to 2005 in Taiwan and developed a complex model to pinpoint the contribution of the auditing partners to the financial-reporting quality of the company.
Instead of relying simply on the strength of an auditor’s firm, the researchers defined “high-quality” auditors as those who have a positive influence on the financial-reporting quality of their clients, beyond what can be normally expected from these clients or their audit firms. When audited by these high-quality partners, clients tended to have more accurate financial reports and were less likely to need to restate their financial statements. “Low-quality” auditors, on the other hand, were more likely to have clients that, while working with these auditors, had less accurate financial reports. These partners were also more likely to be subject to sanctions or other disciplinary action by regulators.
The Markets Respond to a Quality Audit
Next, the team looked at market results in the subsequent five years, from 2006 to 2010. The findings were clear: in Taiwan, auditor quality had an impact in four key areas.
IPO value was better. Pre-IPO firms experienced less underpricing when working with good auditors. Since a firm’s value is not always clear to investors at IPO, the quality of the auditor can be a signal that the company’s financials are strong and have been thoroughly vetted by a skilled professional. Aobdia says this was one of the most important findings of the study.
Equity markets responded more to earnings announcements. The better the auditor, the more investors respond to unexpected portions of earnings announcements. Essentially, investors pay more attention to the earnings of clients audited by better partners, because they can trust the numbers more.
Auditor upgrades mattered. Markets respond positively for companies when a poor or mediocre auditing partner they have been using is replaced with a better partner. The researchers found this move generated a positive return of 0.7 to 1.2 percent to investors—again because investors have more confidence in the value of the clients.
Debt terms improved. The impact of a strong auditor extended beyond equity markets. Companies that engaged high-quality auditing partners got better debt terms. This may indicate that banks like to see high-quality auditors as a signal that the company’s financial statements are sound.
Spurring Action in the U.S.
The research is already having an impact on efforts to make audits more transparent.
The research team started circulating its working paper in 2013. Soon after, the PCAOB, which regulates audits in the U.S., began citing the research in its campaign to require audit-partner disclosure, something it had been considering since 2009.
In December 2015, the PCAOB voted unanimously to require audit firms to disclose the names of their partners in charge of each audit. The move is still subject to Securities and Exchange Commission approval.
Of course, it is unclear whether U.S. investors will react as definitively as Taiwanese investors to audit-partner quality, Aobdia says. Taiwan’s financial sector has some marked differences, including being much smaller with different rules and less litigation. However, it is also possible that data-driven U.S. financial professionals and institutions will use audit-partner information even more than in Taiwan as part of their investment and lending decisions, he says.
Either way, the new rule adds another dimension of transparency.
“We got some results that showed that capital markets care about this information,” he says.
Editor’s note: Daniel Aobdia is currently a Senior Economic Research Fellow at the Public Company Accounting Oversight Board (PCAOB). This research was conducted before that affiliation, and the views expressed here are his own and do not necessarily represent those of the Board, individual Board members, or staff of the PCAOB.
Aobdia, Daniel, Chan-Jane Lin, and Reining Petacchi. 2015. “Capital Market Consequences of Audit Partner Quality.” Accounting Review. 90(6): 2143–2176.