Apr 4, 2016

Wear Your Audi­tor on Your Sleeve

If a top-notch per­son con­ducts your audit, it pays to let investors know.

Yevgenia Nayberg

Based on the research of

Daniel Aobdia

Chan-Jane Lin

Reining Petacchi

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.

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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.

Featured Faculty

Daniel Aobdia

Associate Professor of Accounting Information & Management

About the Writer

Gwen Moran is a writer and author specializing in business and finance.

About the Research

Aobdia, Daniel, Chan-Jane Lin, and Reining Petacchi. 2015. “Capital Market Consequences of Audit Partner Quality.” Accounting Review. 90(6): 2143–2176.

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