Risk & Compliance

Disclosing Engagement Partner Improves Audit Quality

It's especially so when audit committee members serve in the same role for other companies with the same audit-firm engagement partner, research fi...
David McCannDecember 22, 2016
Disclosing Engagement Partner Improves Audit Quality

A PCAOB regulation slated to take effect on Jan. 31, which requires accounting firms to identify the principal engagement partner in corporate audits, should be a solid plus for investors and regulators, a new study suggests.

Currently, companies disclose the audit firms overseeing their financial statements but not the partner in charge. However, research has found aggressive or conservative reporting styles to be more associated with the engagement partner’s influence than with the accounting firm per se.

Research reported in the current issue of Auditing: A Journal of Practice and Theory, published by the American Accounting Association, assesses the effect of engagement partners on audit quality. It makes clear how the new rule could help investors recognize situations ripe for auditor conflict of interest.

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Such situations are particularly likely to occur, the study finds, in “interlock networks” that arise when a member of a client’s audit committee fulfills the same function in one or more other companies that are also clients of the engagement partner. “Audit partner dependence on fees from [such interlock networks] erodes audit quality,” the study’s authors wrote.

For example, co-author Gary Monroe of UNSW Australia points out, in cases where an engagement partner earns more than 10% of his or her annual fees from a distressed company’s interlock network, the chance the firm will receive a going-concern opinion is less than half what it would be absent that degree of dependence.

“With that much reliance on interlock network fees,” Monroe says, “the probability of a going-concern opinion — that is, an opinion explicitly raising doubts about the firm’s future viability — is about 3.3%. Without it, the probability is about 7.3%. It’s a big difference.”

The study reveals the benefits of engagement-partner disclosure, which has been required in Australia since the 1970s. “Coupled with disclosure of audit committee members and audit fees, it uniquely enables investors and regulators to identify interlocking networks likely to impair audit quality,” Monroe says.

While the research found significant audit-quality deficits associated with interlock networks between audit committee and engagement partner (AC-AP links), it did not for other kinds of interlocks — for example, where clients share a common audit committee member and audit firm but not a common engagement partner.

The study’s conclusions derive from an analysis of financial reporting by hundreds of Australia-based public companies over a nine-year period.

The analysis comprised five varieties of interlocks among audit clients and two key measures of reporting quality: issuance of going-concern opinions for financially distressed companies; and amount of discretionary accruals. Discretionary accruals are non-cash accounting items that typically entail some element of guesswork (such as predictions of future write-offs for bad debts or estimates of inventory) and that are commonly associated with earnings manipulation.

Interlocks among audit clients were as follows:

  • Common audit-committee member and common audit-firm engagement partner
  • Common audit-committee member and common audit firm (but not engagement partner)
  • Common director not on audit committee and common audit-firm engagement partner
  • Common director not on audit committee and common audit firm (but not engagement partner)
  • Common audit-committee member but no common audit firm or engagement partner

The first of those interlocks was uniquely associated with a high level of discretionary accruals. “In cases where engagement partners earned 10% or more of their fees from interlock-network clients, a firm’s discretionary accruals amounted on average to 9.3% of its assets,” says Monroe. “Without that dependence, the mean level was 7.7%, almost one fifth lower.”

In addition to Monroe, the study’s authors are his UNSW Australia colleague Sarowar Hossain; Mark Wilson of Australian National University; and Christine Jubb of Swinburne University of Technology.

The new study, entitled “The Effect of Networked Clients’ Economic Importance on Audit Quality,” is in the November/January issue of Auditing: A Journal of Practice and Theory, published quarterly by the American Accounting Association.