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By Madhukar Singh
By the time the HIH Royal Commission delivered its final report in 2003, other major corporate collapses internationally had been discovered to have audit failures. The early 2000s was a time when the auditing profession lost major credibility. Audit firms and their partners were scrambling to control the damage caused by the audit failures of Arthur Andersen – which was also the auditor for HIH when it collapsed. The U.S. regulators took action to restore investor confidence in capital markets and resolve perceived auditor independence issues by passing the Sarbanes-Oxley Act in 2002 – that among other things: (1) prohibited eight forms of non-audit services (NAS) from being provided by the auditor to their clients, and (2) set the foundation for the three-year cooling-off rule affecting the eligibility of retired audit firm partner appointments to company boards and audit committees. At that time, Australia adopted a less stringent approach, as the CLERP 9 Act of 2004 did not introduce a blanket ban on the joint provision of NAS nor eligibility rules for retired audit firm partners.
However, many large audit firms had a requirement for partners to exit the respective firms after they turn 55, which has since been outlawed (Tadros, 2021). As a partial incentive for accepting a retirement at 55, audit firms’ former equity partners are given a lifetime payment by the firm, which is up to a certain percentage of the audit firm’s annual net profits. This tightly held information came to light when a former PwC Australia partner, Mr Bill Edge, provided written disclosures at the time of his appointment as the acting chairman of the Financial Reporting Council – rekindling commentary and debate about auditor independence within the industry, society, and academia.
The study “Do Alma Mater Ties Between the Auditor and Audit Committee Affect Audit Quality?”, recently published in Contemporary Accounting Research and authored by Divesh Sharma, Madhukar Singh, and Arvind Patel, examines whether the presence of former audit firm partners (of the current company auditors) on boards and its audit committees (AFAPs) are associated with that company’s NAS purchases from its current auditor and whether that behaviour is associated with high financial reporting quality.
New Zealand, like Australia, does not limit the provision of NAS by a company’s auditor and does not restrict audit firm alumni from serving on company boards or audit committees. New Zealand also has relatively low litigation risk and a saturated audit market, where audit firms compete for about 180 listed NZX firms and the Big 4 firms audit about 90 percent of the total audit market (Hay et al. 2006). As established in prior research, auditors tend to take greater risks in low litigation risk settings and saturated markets in the pursuit of revenue and clients.
The authors report that, when AFAPs serve on company audit committees, they are more likely to approve the purchase of more NAS because AFAPs’ lifelong payouts are often linked to the earnings of their prior employer, thus creating incentives to prefer their alma mater for NAS. Based on this reason, it is obvious that a former audit firm partner would approve the purchase of more NAS from their alma mater firm. The question then is: would purchases of NAS be beneficial or harmful to financial reporting quality?
Given corporate experiences in the early 2000s, regulators and investors around the world are and would be concerned that NAS creates a conflict of interest that can threaten financial reporting quality. However, the joint provision of NAS and audit services and having former audit firm partners serve on the board and audit committees are not necessarily bad. The benefits of NAS and audit firm alumni on boards have been highlighted by both the HIH Royal Commission Report and prior academic research.
The HIH report refers to the CLERP 9 discussion paper (later the CLERP 9 Act of 2004), which argues that a prohibition of NAS purchases would; (1) increase audit costs that cannot be spread across business lines, (2) restrict the competitiveness of the NAS/consulting industry, (3) still be provided by embedding it into audit activities, and (4) force audit firms to set up separate legal entities devoted to providing NAS but there will be no real “separation in substance”. Prior studies have also found positive spillover benefits in the form of shorter audit lags and lower audit fees when auditors provided both audit and NAS to the same client.
To test the effects of audit firm alumni on financial reporting quality, the authors of the study specifically analyse whether the presence of AFAPs on audit committees, that approves purchases of high NAS is associated with discretionary accruals – an academic proxy of earnings management, and modified audit opinions – an academic proxy of audit quality. Interestingly, the results suggest that the presence of an AFAP that coincides with greater NAS purchases from the alma mater audit firm may undermine audit quality (higher earnings management and a lower likelihood of issuing modified audit opinions). The authors also analyse audit fees and audit lag to check if the presence of AFAPs is associated with knowledge spillover benefits – but find no significant evidence to suggest that NAS purchases by AFAPs are beneficial. Therefore, the results of the study suggest that the presence of an AFAP on the audit committee, that approves purchases of more NAS is in fact harmful to financial reporting quality.
On the contrary, when the authors consider unaffiliated former audit partners – former audit firm partners that have no prior alma mater ties with the current auditor of the company – they find that unaffiliated former audit firm partners on audit committees are not related to NAS purchases, implying that unaffiliated former audit firm partners prevent harmful effects on financial reporting quality that may be associated with NAS purchases.
This study has potential implications for regulators, audit firms, and corporate boards. The findings suggest that Australian and New Zealand regulators may wish to consider revisiting their governance guidelines. For example, regulators may want to consider some limits on the joint provision of NAS to audit clients like Europe and/or require audit committees to declare potential conflicts of interest. On the other hand, audit firms may want to consider realigning client allocations across partners or offices that have ties with the client’s audit committee after evaluating whether financial incentives to current and former partners have unintended audit quality consequences. Company boards may want to consider potential social ties between the auditor and directors when they nominate directors to the audit committee.
Read more articles at Audit Discoveries
Further Reading
Sharma, D. S., Singh, M. K., & Patel, A. (2022). Do Alma Mater Ties between the Auditor and Audit Committee Affect Audit Quality?. Contemporary Accounting Research, 39(1), 371-403. https://doi.org/10.1111/1911-3846.12730
Citation
Singh, Madhukar (2022), Auditor Independence. Is It Still Under Threat?, Audit Discoveries, Australian National Centre for Audit and Assurance Research, The Australian National University, Canberra, 17 October 2022, Available at: https://rsa.anu.edu.au/news/2022/auditor-independence-it-still-under-threat
About the Author
Madhukar Singh is an auditing lecturer in the Research School of Accounting at the Australian National University. His research interests are in the areas of auditor reporting, auditor independence, financial reporting quality, and the role of corporate governance in financial reporting processes.
Contact Details
Website: https://cbe.anu.edu.au/about/staff-directory/dr-madhukar-singh
Disclaimer
This article includes reportage and opinion. The reportage and opinions are for general information only. The opinions expressed in articles are those of the individual authors and do not represent the opinions of the editors, ANCAAR, ANU or the institutions to which the authors are attached.