When we think of financial audits we often think of them as standalone reports. But new research predicts that the reliability of the financial reports an auditor issues depends on whether the auditor has multiple clients as well as upon the financial stability of the auditing firm itself.
Perhaps even more significantly, the stock price of a given firm varies based on the quality of audits of other firms in the client portfolio of its auditor.
The research was prompted by the fallout from the accounting scandals at Enron, Sunbeam, Worldcom, Tyco, Waste Management, and other firms.
"When the news about Enron hit, other clients of Andersen's [Enron's accounting firm] experienced negative stock market returns," says Anne Beyer, assistant professor of accounting at Stanford GSB. In research conducted jointly with Sri Sridhar of Northwestern University, the scholars raised questions about how the quality of a particular audit is related to the auditor's entire client portfolio — and how investors' perception of audit quality can impact the stock prices of all client firms.
Their research model predicts that the market capitalization of the firm being reviewed depends not only on its publicly available audit report, but also on the audit reports of all the clients of the same auditor. Because investors can be uncertain about auditors' integrity, they continually update their impressions. "It turns out that the market's perception of the auditor's integrity is influenced by all the audit reports he or she has issued," says Beyer.
Specifically, the model predicts that the stock price of a firm — and thus its market capitalization — increases if its auditor has issued high-quality audits for other clients, says Beyer. Alternatively, if investors learn that an auditor has issued a low-quality report, the stock price of other companies being audited by him or her declines. This is exactly what happened in the case of Arthur Andersen's other auditing clients after the Enron debacle.
According to the researchers' model, the failure of an audit report to correctly predict a firm's impending economic difficulties can be due to one or both of two auditing defects: either the auditor has failed to gather sufficient evidence to form a professional assessment of a client's future economic prospects or the report does not accurately reflect the difficulties that were discovered during the audit process. There are a number of reasons an auditor might do the latter, most notably if he or she is likely to get additional lucrative work from that client for issuing a misrepresentative positive report.
"If the auditor issues a friendly report, the client is more likely to stay with him or her, or give them consulting projects with higher profit margins," says Beyer.
An auditor's incentive to issue reliable audit reports can also depend on other factors including the litigation environment, the other audit engagements he or she is working on, as well as the auditor's "capital at risk" in case a poor audit is discovered. For example, when an auditor has limited financial resources, he or she is more careful to issue reliable audit reports than is the case if the audit firm is financially stable. "If I am an auditor, and I have limited capital, I want to be careful about incurring major losses due to legal liabilities resulting from a poor audit," Beyer says. Thus, possessing limited financial resources can actually cause auditors to act more ethically, or at least cautiously.
In addition to studying the "portfolio effect" of audits, Beyer and Sridhar used the model to determine how increased governance regulations — such as the Sarbanes-Oxley Act and mandates of the Public Company Accounting Oversight Board — are affecting the quality of audits. Surprisingly, the model predicts that stricter governance measures can actually decrease the quality of reports being issued by auditors.
"As governance measures become stricter, the opportunities for unscrupulous auditors to misrepresent the financial status of a client are reduced — and the penalties for getting caught are much greater," says Beyer. This is, of course, the intention of such regulations. But as the incentives for presenting overly rosy pictures of clients decline, so do those for being diligent about the first part of the auditing process — the gathering of information. "Thus, increasing governance might actually have a bad effect," says Beyer.
This raises an interesting issue, says Beyer: As increasingly more regulations are passed, legislators must take into account whether more rigorous compliance requirements will alter people's behavior and thus have unintended consequences.
Are there any takeaways for managers seeking to choose an auditor? In hindsight, "You could try and learn about the integrity and quality of an auditor by looking at what reports he or she has issued in the past," says Beyer, admitting, however, usually a failed audit is only revealed when there's a disaster," and by then it's too late."