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April 25, 2018

Does requiring firms to reveal audit engagement partners benefit investors? A novel experiment raises doubts

Since January of last year, after more than a decade of discussion and debate, a new regulation from the U.S. Public Company Oversight Accounting Board has required the annual report of each public corporation not only to identify the firm responsible for the company financial audit, as previously mandated, but to disclose the audit-firm partner leading this engagement.

Has audit partner disclosure (APD) benefited investors, as its proponents claimed it would do, or has it been of negligible value, as many in the accounting industry predicted? While it is still too early to tell, some new research approaches the question in a novel way and suggests the answer could prove quite different than either side of the debate expected.

A study in the spring issue of Behavioral Research in Accounting, a peer-reviewed journal of the American Accounting Association, tests the effect of audit partner disclosure (APD) on 157 seasoned investors and finds that, contrary to accounting industry predictions, the information has a considerable impact on investment decisions.

But that impact may turn out to be more problematic than the regulation’s proponents foresaw, for, although the study does not purport to judge the wisdom of the new rule, its findings inevitably raise doubts about it. In the words of co-author Tamara A. Lambert of Lehigh University, audit partner disclosure "may have a greater impact on investor decisions than would be warranted or than what regulators would have anticipated or intended."

Concurring with this observation are Prof. Lambert’s two co-authors, Benjamin L. Luippold of Babson College and Chad M. Stefaniak of the University of South Carolina.

Prior research on APD has tended to focus on countries where partner disclosure has been required long enough to yield substantial outcome data. While the mandates’ effects have generally been found to be positive, the authors of the current study note that “the reporting, regulatory, and legal environment within these countries is quite different from that of the United States.” Taking a different tack, they focus on the intended beneficiaries of APD – namely, individual investors – through an experiment that gauges their response to knowing the identities of engagement partners in addition to those of auditing firms.

As suggested above, the response is considerable. Although the engagement partners named in the experiment are fictitious, and investors participating in the experiment receive a bare minimum of information about them, APD occasions a striking shift of about 17% in participants’ investment decisions, inviting suspicion that irrational factors are at play. As the authors explain, social psychology research “finds that individuals’ judgments related to people are more extreme, more hastily and confidently formed, and more easily recalled than those made of groups.”

Is this true of judgments involving audit firms and engagement partners?

To explore this, the researchers focus on a common investment phenomenon called contagion, where a negative occurrence at a company lowers investors’ assessment not only of that firm but of other firms that share significant features with it.  Earlier research has found that when a company has to restate its finances – a sign of inferior accounting – contagion effects extend to other companies that use the same audit firm. What the new research probes is whether APD further increases this contagion effect.

The 157 participants in the experiment, which was conducted via computer, were about evenly divided between male and female; were college graduates averaging about 49 years of age; had at least five and a half years of work experience preparing and analyzing financial information; and were experienced in trading individual shares of stocks or bonds and not simply investing in mutual funds. CPAs were excluded out of concern that familiarity with the APD issue would affect their experiment responses.

Participants were presented with information about five fictitious, publicly traded tech companies, which they were asked to consider for long-term investments – American Computers, Computer World, Electronics USA, US Technologies, and Wired States. The basic information about the companies, provided to all investors, was that, besides being in the same industry, all were located in the same region and had received an unqualified audit opinion from one of two Big-4 accounting firms operating in the same city, with the audit firms being identified as ABC or DEF. In addition, five key performance metrics of the tech companies were provided – ratio of assets to liabilities, days’ sales of inventories, return on assets, profit margin and market share.

Key to the experiment are three factors:

■   One of the tech companies, US Technologies, surpasses all the others in every one of the five performance metrics.

■   One company, Wired States, recently restated its results from the prior year, with the restated metrics much lower than what was previously reported. While two other companies happen to use the same auditing firm as Wired States, only one of the two, US Technologies, also has the same engagement partner as the restating firm.

■   All participants receive the same information, with one exception: somewhat more than half are given the names of engagement partners in addition to those of the audit firms.

Among subjects who knew the identity of companies’ audit firms but not of the engagement partners, about 77% chose to invest in US Technologies, whose performance metrics the study’s authors describe as “markedly better than [those of] the other four firms.” Among those who also knew the identity of engagement partners, only about 63% chose US Technologies. The drop of 14 percentage points suggests a contagion effect more than 17% greater than that caused by audit-firm identification alone.

As the authors note, “All participants were provided with the information that US Technologies was linked to the contaminated firm by the same audit firm, while APD participants saw both the audit firm and partner name. That is, our results suggest that audit partner identity disclosure results in partner-based contagion above and beyond any effect due to shared industry and shared firm.”

Why should the gap be so big? Social psychology research, the authors believe, suggests a likely answer. In the words of the study, “Social psychology research finds that when forming impressions, perceivers make more extreme trait judgments, make judgements more quickly and with greater confidence and…are likely to react more strongly when the reactions are associated with an individual than when they are associated with a group.”

Is an effect this strong of benefit to investors? Or does the new regulation have too much potential to distort investment decision-making? The authors demur, observing that “for the sake of brevity, participants were only provided with limited information rather than a full set of financial information…Other information within a complete set of financial statements could moderate our results.”

Still, they think the evidence uncovered in their experiment should give pause. At the least, regulators, they believe, should be prepared to monitor the effects of this rule with particular care.

Prof. Lambert adds: “As we worked on this research, we were surprised that there seemed to be no consideration by regulators of potential long-term effects to audit independence. With the whole new layer of pressure on audit partners that our research reveals, it is easy to imagine how they would see their personal reputations tied to those of their clients – how, for example, it would reduce their incentive to push management to restate finances in the face of its reluctance to do so.”

The paper, entitled “Audit Partner Disclosure: An Experimental Exploration of Accounting Information Contagion," is in the spring issue of Behavioral Research in Accounting, a peer-reviewed journal published twice yearly 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, Accounting Horizons, Issues in Accounting Education, Journal of Management Accounting Research, Journal of Information Systems, The Journal of the American Taxation AssociationJournal of Financial Reporting, and Journal of Forensic Accounting Research.

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