Accounting & Tax

New Study Faults Work Of Auditors Who Consult

Auditing firms are more likely to stretch the bounds of accepted accounting practices when they are receiving substantial consulting fees from the ...
CFO.com StaffAugust 1, 2001

According to the Wall Street Journal Online, an academic study to be released Wednesday found that auditing firms are more likely to compromise and stretch the bounds of accepted accounting practices when they are receiving substantial consulting fees from the firms they audit.

The study — by professors at Massachusetts Institute of Technology, Michigan State University and Stanford University — is one of the first to pore through financial filings to answer empirically one of the key questions facing the accounting industry: How objective can an accounting firm be in an audit when it is also making millions of dollars providing the same client with other services?

Even as securities regulators in the past year have sought to toughen auditor-independence standards, accounting firms have been adamant that there isn’t evidence to support claims that consulting work interferes with their ability to conduct an honest review of a client’s books.

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“Our study suggests that paying an accounting firm more for nonaudit services impairs auditor independence and reduces the quality of earnings,” Karen Nelson, a co-author and accounting professor at Stanford, told WSJ.com. The report is based on a review of 4,200 company filings with regulators since February, when the Securities and Exchange Commission began requiring disclosure of fees to auditing firms.

Al Anderson, a senior vice president at the American Institute of Certified Public Accountants, a trade group, told WSJ.com that though the group as of Tuesday hadn’t had time to assess the study in detail, in general it is “unfair” to conclude that auditors are “less independent” if they work for the same firm as the company’s consultants.

The study defined auditors as potentially compromised if clients pay them less for their annual audit than they do for consulting and other services. Some 47 percent of the firms surveyed fell into this category, according to WSJ.com.

When accounting firms depend on consulting fees, their clients are more likely to carry substantially higher discretionary reserves, which are balance-sheet accounts that can offset earnings shortfalls, the study said. One way to build discretionary reserves, the researchers said, is to take a bigger charge against earnings than necessary when doing a merger, then dip into this “cookie jar” to increase future earnings.

The SEC has expressed skepticism of these discretionary reserves because of their ability to be tapped to help companies meet or beat earnings estimates. Auditors who are afraid of jeopardizing consulting relationships may have an incentive not to question what the SEC considers “earnings management,” the study says.