AMERICAN ACCOUNTING ASSOCIATION
CONTACT: Ben Haimowitz (212-233-6170)
Call it the SEC's seasons-greeting cards to GE and Alcoa. In letters two days before Christmas, the commission gave both companies leave to exclude from their 2012 annual meetings a shareholder proposal that would provide for rotation of their auditors. Some weeks earlier the commission did the same for Hewlett Packard, Walt Disney, and John Deere and early in the new year for AT&T, General Dynamics and others, all on the grounds that such proposals run counter to a decades-old rule excluding from proxy materials proposals that will affect firms' "ordinary business."
These episodes constitute the latest chapter of a longstanding controversy surrounding what is generally a thoroughly routine aspect of corporate governance -- stockholder ratification of firms' choice of external auditors. Companies have been inviting investors to weigh in on this since the 1930s, and the great majority continue to do so today; yet, oddly enough, shareholders' right to have a say on auditor selection has remained uncertain -- notwithstanding the recommendation of a blue-ribbon Treasury commission in 2008 that annual shareholder ratification be mandatory.
Now a new study in a prestigious scholarly journal may give new impetus to the cause of ratification. Research in the current issue of The Accounting Review, published by the American Accounting Association, finds that companies that put auditor selection to a shareholder vote are considerably less likely than those that do not to have to make financial restatements. Only 5.1% of the former group have to restate their results compared to 8.1% of the latter. And the difference is even more pronounced -- 3.5% versus 6.1% -- for restatements that are serious enough to lower the price of the company's stock, as measured by the five-day cumulative abnormal return surrounding the restatement announcement date.
In other words, firms that forego shareholder ratification are almost 75% to more likely than others to have to issue restatements serious enough to have a negative effect on their stock price.
What accounts for this improvement in audit quality? "Shareholder involvement in auditor selection strengthens the power of the auditor in any negotiations with management and increases the 'pressure to perform' on the auditor," the study concludes. "If there is a shareholder vote, then questions will be raised if an auditor who routinely gets 98 percent ratification drops down to 95 or 90 percent support from shareholders." To prevent such an eventuality or the possibility, however remote, of a negative vote, "it is likely that auditors would spend extra effort and be more cautious in negotiations with the client."
"Most companies have been assuming for a long time that shareholder ratification is a good thing, and in this case the companies have now been proved right," comments Kannan Raghunandan, an accounting professor at Florida International University, who carried out the study with an FIU colleague Dasartha V. Rama and Mai Dao of the University of Toledo. "The oddity is that over the course of all these decades no one ever thought of actually testing whether getting the stockholders involved makes a difference. Well, clearly it does, and, perhaps our findings will help motivate less wavering by regulators on this issue."
The study also finds that the higher quality of audits in companies that give shareholders a say in auditor choice comes at a price, with those firms paying about nine percent more on average than other companies. Since the median cost of an external audit among firms included in the study was about $1.5 million, on average this amounts to a difference of about $135,000. Companies that submit auditor selection for shareholder ratification tend to be larger than those that do not; are more likely to be audited by a Big 4 firm; and are less likely to change auditors.
The professors' findings emerged from an analysis of 1,382 companies included in a major corporate database for 2006, a year early enough to allow ample time for subsequent restatements of financial results. Some 1,036 companies, or about three fourths of the total, had shareholder ratification of auditor choice. In all, 81 of the companies issued financial restatements, 57 of which were serious enough to negatively affect their stock price.
The study, entitled "Shareholder Voting on Auditor Selection, Audit Fees, and Audit Quality," is in the January/February issue of The Accounting Review, published six times a year 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 Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and The Journal of the American Taxation Association.