Apparently doubting the quality of the audit, investors punish companies when they first learn that others from outside the principal audit firm had a hand in assuring the company’s financial statements.
An academic study recently published by the American Accounting Association says investors would benefit from disclosures like those proposed by the Public Company Accounting Oversight Board that would require auditors to identify who outside of the principal audit firm participated in the audit. “Many people don’t realize that most audits of multinational companies involve more than one auditing firm,” said Carol Callaway Dee, associate professor of accounting at the University of Colorado, one of three authors of the study, in a prepared statement. “We found that investors reacted in a negative way when they learned of audits being done by these other firms. And the stock prices fell.”
The PCAOB has been trying for several years to require audit firms to disclose in the audit report the names of firms or individuals who are not employed with the principal audit firm who somehow contributed to the audit work. Dee first addressed the PCAOB with her and her team’s research in 2012. The idea has languished, however, because it has been packaged with a much more controversial proposal to require audit firms to also provide the name of the engagement partner in audit reports, an idea that has met great resistance over concerns about increased liability for auditors. The PCAOB has said it plans to put forth a new proposal to require the name of the engagement partner to be provided in some separate filing with the PCAOB, leaving the fate of identifying others involved in the audit unclear.
Academics began calling attention to the practice of Big 4 firms outsourcing or offshoring portions of audit work as far back as 2008, saying the firms were pilot testing such efforts. At that time, the firms and the PCAOB had little to say about the practice. The recent study sought to determine whether audit quality suffers when the principal audit firm outsources portions of the audit work, and whether investors take note of outsourced audit work. The study concluded based on a measure of discretionary accruals that audit quality is diminished where a firm outsources portions of the audit work, and that investors react negatively when they first learn of outsourcing.
The study says some offshore auditors may have the required expertise to do the audit work, but may not understand the American audit and regulatory environment. They might not have the same level of supervision by the principal auditor, and they may not be inspected by the PCAOB, depending on whether they are located in a jurisdiction where the PCAOB is so far barred from performing inspections.
The study concluded the proposed PCAOB rule mandating more transparency would help investors in evaluating the overall quality of the audit. “Our findings suggest that the PCAOB’s proposal requiring disclosure of other audit participants would, if implemented, provide information useful to investors in assessing audit quality for SEC issuers,” the study says.