In the absence of a strong audit committee, management can get an upper hand over auditors when it releases unaudited earnings results to the market, according to emerging academic research.
A new study out of Indiana University finds auditors, especially less experienced auditors, answering to only moderately effective audit committees feel some pressure to conform to management’s judgments when earnings releases are shared with investors before audits are complete. The study is based on a controlled experiment involving more than 100 “highly experienced” audit partners and senior managers to explore their audit judgments when management publishes preliminary earnings information before auditors are finished with their work.
Before the Sarbanes-Oxley Act, roughly three-fourths of earnings announcements occurred on or after the date of the audit report, the study finds. That has virtually flipped over the past decade, with about 70 percent of public companies releasing unaudited earnings an average of 16 days before the date of the audit report.
Earlier research has already established that auditors tend to let aggressive management judgments slide when engagement risk is regarded to be low, when auditors perceive a threat of losing a client, or when auditors demonstrate an affinity for clients, the study says. The Securities and Exchange Commission is exploring the entire earnings reporting process with an eye on whether it could be made more effective and less burdensome. The Public Company Accounting Oversight Board (PCAOB) recently issued new standards on auditing estimates, which directs auditors to, among other things, get more skeptical.
“Auditors succumb to client pressures and thereby leave aggressive end-of-year financial reporting unchecked when earnings have already been released,” the study concludes. Less experienced auditors overseen by moderately effective audit committees are less likely to challenge aggressive management judgments and more likely to steer their search for audit evidence and their audit judgments in favor of management’s conclusions, the study says.
“We identify and provide evidence on two factors that should mitigate auditors’ adoption of client-preferred directional goals when faced with client pressures: stronger audit committees and higher auditor professional identification,” the study says.
The PCAOB has been hounding auditors through inspection findings for the past several years to get more skeptical in their exercise of professional judgment, but the study also gives audit committees some marching orders. Audit committees need to be more independent of management, more up-to-speed on regulatory requirements, and more actively involved in accounting issues “to better advocate and support auditors who face client pressures,” the study says.