Emerging academic research suggests audit firms may be shielding low-performing partners from client scrutiny by remaining coy about regulatory inspection results.
Using information provided by audit regulators that’s not available to the general public, the new research out of Northwestern and Georgetown universities makes a case for identifying companies and engagement partners in audit firm inspection reports as a way to hold partners more accountable for their work. The study says the visibility of audit incidents is a critical factor in whether audit clients demand new leadership on their engagements.
The study is focused on determining what consequences engagement partners suffer when a particular audit engagement is determined to be faulty, including whether engagement partners “bear direct costs” resulting from audit incidents. Highly visible incidents of defective audit work are easy to identify when a company ends up in restatement, which is done through public filings. Less visible incidents of defective audit work are called out by regulatory inspections, but the reports published by the Public Company Accounting Oversight Board do not identify the companies whose engagements are found to be faulty.
The researchers said they found highly visible audit incidents, such as restatements, increases the likelihood of engagement partner replacement by 42 percent. Even among companies that do not restate, if their engagement is overseen by a partner involved in a restatement, they’re 32 percent more likely to replace the engagement partner.
Yet when a company’s inspection is called out by PCAOB inspectors for audit deficiencies, the research finds no increase in the likelihood that an engagement partner will be reappointed, either for the inspected company or for other clients of the same engagement partner.
Even further, the research found companies are less likely to replace engagement partners after a favorable inspection report, an “asymmetric result” suggesting audit partners “may use their informational advantage to selectively disclose favorable inspection news (or play down unfavorable news) to their clients.” That suggest audit firms may be using PCAOB inspection results as a marketing tool, the authors said.
“We find that the likelihood of nonrestating clients switching their engagement partners hinges critically on the quality of the audit firm’s internal control system on partner management,” the study says. “The result suggests that in the regulatory regime where information on partner identity associated with a particular audit is not publicly available, clients rely on audit firms to voluntarily disclose information about audit incidents associated with their partners, and this limits the market disciplining mechanism.”
Audit committees have long been advised to question audit firms about inspection results to find out if their own audits were selected for inspection and if any deficiencies were identified, but audit firms are under no obligation to volunteer such information. The PCAOB recently instituted a Form AP filing system whereby engagement partners will be identified on each audit engagement, information that until recently was nonpublic unless voluntarily provided by audit firms, but specific audit engagements that are called out for deficiencies in audit inspection reports remain unidentified in PCAOB inspection reports.