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As audit competition increases, so does corporate opinion-shopping with regard to a key aspect of financial reporting, new research finds
Auditor competition. That phrase can be music to the ears of financial regulators, who in the EU have cited it as a principal reason for a rule, effective next month, to require firms to rotate auditors and whose U.S. counterparts continue to ponder a similar mandate.
The assumption has been that, by upsetting long-term cozy relationships between accountants and their client companies and inducing competition for the clients' auditing business, the rule will enhance corporate financial reporting. But now some new research finds that in at least one important way competition undermines that goal and appears to compromise auditor independence.
A study in the American Accounting Association journal The Accounting Review finds that competition for audit clients fosters opinion-shopping with respect to internal controls, the systems that firms establish to assure that financial statements are reliable and accord with generally accepted accounting principles. Under the Sarbanes-Oxley bill, passed by Congress in 2002 in response to major corporate-accounting scandals, companies and their auditors are required not only to make the traditional annual certification of overall accounting quality but also to vouch specifically for the effectiveness of internal controls.
The new research, which, the authors say, is "the first to document the existence of opinion-shopping in any form in the post-SOX era," concludes that shopping for favorable auditor opinions on internal controls" is most pervasive when [auditor] competition is relatively high...suggesting that increased competition in audit markets may actually impact audit quality negatively." In the wake of SOX, the study finds, internal controls, which once were a non-factor in opinion-shopping, have become a major factor.
Comments Michael S. Wilkins of Trinity University, a co-author of the new paper, "While it may seem natural for companies to shop for favorable audit opinions and switch auditors to get them, a number of studies have concluded switching is futile, citing evidence that, on average, opinions are no more favorable post-switch than they were pre-switch. This evidence notwithstanding, what our findings suggest is that clients would receive adverse internal-control opinions even more frequently without opinion-shopping. Note that opinion-shopping doesn't necessarily mean changing auditors; it can also drive a decision not to switch.
"In short," Prof. Wilkins adds, "our findings suggest that opinion-shopping pays; that concern over internal controls has become a major factor in motivating it; that companies engage in it to a significant degree; and that competition among auditors increases its prevalence." Collaborating with him on the research were a Trinity colleague Julie S. Persellin, Nathan J. Newton of the University of Missouri, and Dechun Wang of Texas A&M University.
In a further discovery likely to be of interest to investors as well as regulators, the researchers add to the evidence that auditor dismissals late in a company's fiscal year are a sign of company trouble. In the words of the study, "auditor dismissals that occur relatively late in the reporting period are much more likely to be associated with opinion-shopping than auditor dismissals [in the first and second quarters], particularly when audit markets are competitive." This is especially likely to be the case, they find, when companies switch from one of the Big Four auditors to a mid-tier or smaller firm. Thus, "54% of the late switchers in our sample change to mid-tier or smaller auditors, compared to only 33% of early switchers. To the extent that late dismissals are more likely to be associated with opinion-shopping activities, a relationship between opinion-shopping and auditor quality appears to exist in [those] dismissal situations."
The paper's findings are based on seven years' worth of financial, market, and audit information (2005 through 2011) drawn from large corporate databases, an aggregation of data covering 11,846 firm-years. The professors conducted an analysis in two stages. First they examined auditors' reports of material weakness (MW) in internal controls (the most adverse internal-control opinion that can be reached) in firms' current and prior year. Controlling for more than 20 factors that might contribute to an MW verdict (for example, whether the company has to restate earnings or suffers a net loss or is at risk for bankruptcy or has relatively low institutional ownership), they found that, in general, chances of an MW opinion diminished if a company dismissed its auditor and, unsurprisingly, this was especially true if that auditor had issued an MW opinion the previous year.
Based on the correlations uncovered in this first stage of analysis, the professors investigated whether decisions to retain or dismiss auditors might reflect shopping for a favorable opinion on internal controls. They found that decisions did so to a significant degree, with a less than 5% chance the relationship was mere coincidence.
The researchers then probed how this opinion-shopping might be related to the amount of competition among auditing firms and found its prevalence to increase with the amount of competition in a market. This leads Prof. Wilkins to observe that "the findings are consistent with a previous paper by our group which shows an increasing likelihood of financial restatements in markets with high competition. The implication of both papers is that, when audit firms are subject to greater competition, audit quality suffers."
He also takes note of a 2015 Accounting Review study by other investigators that indicated a pattern of avoidance among a large sample of companies in reporting internal-control weaknesses. "Our study suggests a likely mechanism for at least some of that avoidance – namely, opinion-shopping," he says.
In conclusion, Prof. Wilkins observes that evaluating internal controls poses considerable challenges to auditor independence. "Before SOX, clients engaged in opinion-shopping either to get auditors to buy off on aggressive accounting or to avoid going-concern opinions that cast doubt on a firm’s basic financial viability, opinions that were rarely issued. With SOX’s introduction of internal-control reporting, there is an additional, major reason to shop for opinions, and the practice is probably more widespread than ever before. And, given the large element of judgment, the grey area, in opinions about internal controls, it is not surprising that some regulators have expressed concern that deficiencies which should be labeled material weaknesses are instead classified as significant deficiencies, which require no external reporting.
"In any event," he adds, "our study strongly suggests that competition serves to increase opinion-shopping with respect to an essential element in financial reporting. Most of the discussion of opinion-shopping since SOX has occurred in connection with the issue of mandatory auditor rotation, so our findings should certainly give pause to those who view increased competition as necessarily a favorable outcome of such a requirement."
The new study, entitled “Internal Control Opinion Shopping and Audit Market Competition,” is in the March/April issue of The Accounting Review, published every two months 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 Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.