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Proxy advisors are a weak link in ratification of corporate auditors, new research finds

Why are the advisors’ recommendations so rarely against approval?

Even in a field as accustomed to litigation as corporate auditing, PricewaterhouseCoopers may be setting a record these days, beset, as it has been, with concurrent multibillion-dollar lawsuits for its role in three major company bankruptcies. Massive suits against PwC and other big auditors for bad advice in the recent financial crisis have renewed an old question – how to protect investors from deficient auditing not just through lawsuits after the fact but by preventing it in the first place.

An obvious answer would seem to be to give investors a say in the choice of corporate auditors. Yet, although most public companies do so – by including auditor-ratification balloting in the proxy materials sent annually to shareholders – rejection of auditors is a great rarity.  Indeed, so consistently sparse is shareholder opposition to retaining auditors that the question has been raised whether ratification votes matter at all.

Such doubts notwithstanding, research in the March issue of the quarterly journal Accounting Horizons, published by the American Accounting Association, presents evidence that auditor ratification does matter to corporate directors and investors. One study reports that in 12,079 instances in which less than five percent of votes were against auditor ratification, about 3.2% of firms changed auditors; conversely, in 585 cases where opposition was five percent or more, almost 5.8% made a switch. A second paper, based on a sample of 6,700 ratifications, finds that, despite the fact that an average of only 1.67% shares opposed or abstained from auditor approval, the greater the level of non-approval, the more adverse was the stock market reaction to the vote.

Yet, a third paper in the new Accounting Horizons essays a more fundamental question: Even though auditor-ratification votes may have some impact, how much do they contribute to improved accounting and thereby advance the interests of companies and their shareholders?

Judged by this standard, the paper suggests, ratification leaves much to be desired. And central to the problem are deficits in the advice that shareholders receive from proxy advisors, who, the paper finds, fail in important ways to meet the criteria that they themselves publish.

The study, by Lauren M. Cunningham of the University of Tennessee Knoxville, finds "variation in the extent to which proxy advisors follow their own guidelines." Most notably, while proxy advisors identify "aggressive accounting policies" as one of a handful of suspect practices, they recommend auditor rejection in only about 4% or 12% (depending on the measure used) of the cases where strong evidence of aggressive practices exists.

In the words of the study, "Additional scrutiny around the factors proxying for poor audit quality may result in a substantial increase to the rate of Against recommendations.”

Proxy advisory services, which provide guidance on corporate-governance issues submitted by thousands of companies to their shareholders, are overwhelmingly dominated by two organizations, Institutional Shareholder Services, Inc. (ISS) and Glass, Lewis & Co., LLC. The two services have come to wield enormous influence during the past decade as a result of SEC policies that make it highly advantageous for funds and financial advisers to follow advisors' recommendations in voting proxies.

Proxy advisors have been criticized for their checklist mentality – for making recommendations that are one-size-fits-all rather than geared to the specifics of a company. But, when it comes to key issues related to auditor ratification, they don't even seem to be following their own checklists.

A prime example, as indicated above, is aggressive accounting, which both leading proxy advisors specify as reasons to reject auditors – Glass Lewis in those exact words and ISS by clear implication.

One common measure of aggressive accounting – the kind that can easily get a company in trouble (if it isn’t in trouble already) – is the amount of a firm’s discretionary accruals, non-cash accounting items that typically entail some element of guesswork and that are widely associated with earnings manipulation. In research that comprised some 9,000 ratification elections over a three-and-a-half-year period, Prof. Cunningham identified 512 firms that were in the top tenth of their industry in reporting the most discretionary accruals in a given year. In only 22 instances, just 4%, did ISS or Glass Lewis recommend opposing retention of the auditor.

Also questionable, the study suggests, was the proxy advisors' response to formal restatements, whereby companies acknowledge misstating their finances in previous reports. A total of 112 companies in Prof. Cunningham's sample had issued financial restatements for years in which the current auditor was answerable, but in only 13 of those 112 cases, about 12%, did either proxy advisor recommend against retaining those auditors.

Prof. Cunningham concedes that part of the reason for this low percentage may be that her sample did not include firms that had changed auditors in the past year. Among companies that made a change, 5.4% had issued formal restatements, compared to only 1.2% of firms in the sample. ""It may be," she says, "that auditors responsible for some of the most egregious misstatements were dismissed before the ratification vote. Still, the fact that proxy advisors recommended rejection of only 12% of auditors who were present during the restated period warrants concern."

What accounts for the deficiencies of proxy advice? Prof. Cunningham believes them largely attributable to the lack of detail audit committees provide about their interaction with auditors, a lack that leads proxy advisors’ shareholder clients to be less attentive to audit quality than they might otherwise be.

“Proxy advisors’ guidelines are based on feedback from shareholders,” she writes. “If shareholders do not place a lot of emphasis on audit-quality proxies listed in the proxy-advisor guidelines, proxy advisors will be less likely to issue an Against recommendation for poor audit quality absent obvious signals of audit failure. Availability bias suggests that users of information [tend to rely on] information that is easily retrievable… Proxy advisors may be less willing to issue Against recommendations based on suspected poor audit quality because it lacks clear and centralized disclosure.”

In sum, the professor adds, “If ratification votes are to be meaningful, there needs to be an informed shareholder electorate. To that end, corporate audit committees should be more forthcoming and explicit about their auditor interactions than they have traditionally been.”

She notes that both the SEC and the Public Company Accounting Oversight Board have issued concept releases in the past several years expressing interest in more informative reports than audit committees have traditionally provided to investors. “Unfortunately,” she says, “the subject seems for the moment to have been relegated to the back burner. This is why it is so important for shareholders to let audit committees know when they need additional information to make their voting decisions.”

The study, entitled "Auditor Ratification: Can’t Get No (Dis)Satisfaction," is in the March issue of Accounting Horizons, published quarterly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include The Accounting Review, Auditing: A Journal of Practice and Theory, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of Financial Reporting, The Journal of the American Taxation Association, and Journal of Forensic Accounting Research.

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