Investors can now look up the audit partner’s name when a company announces a financial restatement or other negative accounting-related event and that may increase their willingness to blame that partner for the problem and shift investments away from other companies where the same partner signs the opinion, according to new research.
The research, “Audit Partner Disclosure: An Experimental Exploration of Accounting Information Contagion” published in the Spring 2018 issue of the peer-reviewed journal of the American Accounting Association, Behavioral Research in Accounting, by Tamara A. Lambert, an assistant professor of accounting at Lehigh University, Benjamin L. Luippold, an associate professor of accounting and law at Babson College, and Chad M. Stefaniak, an associate professor of accounting at the University of South Carolina, is based on an experiment to examine investor reaction to audit partner disclosure. It looks at whether investors develop negative feelings about all investments audited by the same firm and signed by the same partner after a negative accounting event at one investment.
Two hundred twenty-five individuals with investment experience participated in the study. They were instructed to review and provide their opinions of five hypothetical companies for long-term investment purposes, one of which had recently restated its prior-year audited financial statements. One at one firm signed two opinions, and two other partners at a different firm signed three audit opinions, including one partner responsible for the company that had recently had problems and one other opinion.
All study participants were provided with the information that the problem company was linked to the other company via the same audit firm, while some study participants saw both the audit firm and partner name.
Although they caveat the results since the research was based on a model, not actual company events, the researchers write they found that the test investors were 17% less likely to invest in a company that shared an audit partner with a company that experienced a restatement or similar negative accounting disclosure. This effect goes beyond a negative view that developed about the problem company’s audit firm.
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The audit partner public identification rule went into effect for audits issued on or after January 31, 2017.
The researchers say that investors and investor groups were supportive of the new rule from the start—the Public Company Accounting Oversight Board first proposed the rule in 2009—and welcomed the opportunity to investigate the experience and ‘‘track record’’ of individual audit partners.
Public accounting firms, on the other hand, were very concerned that third-parties such as media and activist investors would be able to search for the name of partners assigned to public companies after a negative accounting disclosure or other issue that cause a negative market reaction and make “ill-informed inferences about audit quality” according to comment letters and testimony posted by the PCAOB on its site.
“Investors are going to pay attention to who the partner is now and partners are going to be more concerned about how negative events at one client affect their reputation with other current or potential clients,” Stefaniak told MarketWatch in an interview.
Based on the PCAOB’s data collected from the Form AP process, MarketWatch analyzed how often an audit partner in one of the Big 4 global audit firms—Deloitte LLP, Ernst & Young LLP, KPMG LLP, and PwC LLP—is assigned responsibility for more than one public company audit opinion.
The PCAOB’s Form AP database, where investors can search for partner assignments now, has collected 13,279 records so far for fiscal years 2016 and 2017 as well as forms that were filed after the January 1, 2017 effective date until today, April 27. The Big 4 firms assign more than one public company audit to between 70%-74% of the partners who are responsible for signing opinions. So the vast majority of large firm audit partners of public companies are vulnerable to the risk that if one of their clients discloses an accounting issue, the rest of their clients can associate that partner with the incident.
Lambert told MarketWatch in the interview that there is another potential unintended consequence that could significantly affect audit quality and the integrity of financial information. Audit partners could pull punches, avoiding hard decisions that would result in association with problematic clients, she explained.
“This is one more level of pressure on audit partners to find a way to avoid blame for negative news events at clients, especially after one occurs and their name is now publicly associated with it,” Lambert told MarketWatch. “Negative accounting events can be misunderstood,” she said, so partners may be tempted to take risk averse actions to future negative public disclosures.
This research, begun more than seven years ago and first submitted for publication in June of 2016, was completed before the Form AP process became effective in January 2017.
The “contagion effect” refers to a phenomenon where a negative event such as a restatement that occurs at one reporting entity affects investors’ assessments of financial information provided by a related, as described in research published in 2008.
This study looked at whether investors are more likely to expect a future accounting restatement at a company linked to a restating firm by the same audit partner than at a company linked by the same audit firm and industry only. The researchers concluded that investors do believe a company audited by the same partner as a company that just reported a restatement is more likely to experience a future restatement, than when only the audit firm or industry is shared.
Additional reporting by Katie Marriner.