Familiarity may breed contempt, but not in corporate accounting, according to new research.

In accounting, the term “familiarity threat” refers to the threat to auditor independence that arises when a CFO or other top executive of a company being audited was formerly employed by the accounting firm conducting the audit.

In the years leading up to the notorious corporate accounting scandals at the turn of the century, about one third of the largest U.S. corporations, including such disgraced firms as Enron, Global Crossings, and Waste Management, had top executives who were alumni of their companies’ external auditors.

It is hardly surprising that the principal legislation in response to such scandals, the Sarbanes-Oxley Act of 2002 (SOX), took aim at this alumni effect. Section 206 of the legislation decreed it unlawful for accounting firms to perform audits if a top financial or accounting executive of the client was employed by the auditor during the preceding year.

Unsurprisingly too, Canada, the European Union, and the United Kingdom have imposed similar prohibitions, Canada for one year and the others for two years.

But such restrictions are not an effective answer to familiarity threat, suggests a paper in the March issue of the journal Accounting Horizons, published by the American Accounting Association.

The new research, the first post-SOX experimental study of the alumni effect among North American auditors, tests the willingness of managers at the Big 4 auditing firms to adopt a client’s position on a conjectural accounting matter.

The study’s key finding: 76% are inclined to do so if the client’s CFO is a former colleague at their Big-4 audit firm, while only 44% would do so otherwise. And the alumni effect occurs even if it has been two years since the CFO left the audit firm.

“Obviously, a one-year or two-year cooling-off period is not enough to avoid the alumni effect, particularly if it requires overcoming social bonds that colleagues often develop,” says Michael Favere-Marchesi of Simon Fraser University’s Beedie School of Business, who carried out the study with Beedie colleague Craig E.N. Emby.

“It may be that five or ten years would be enough,” he continues. “Alternatively, it may be that audits of companies where a CFO or other higher-up is a former engagement partner should be banned entirely, as some research on auditor independence has suggested.”

The study’s findings are based on an experiment conducted via the Internet with 140 managers of Big 4 accounting firms in the United States and Canada. The managers, who averaged about seven years of auditing experience, all received the same background information about a corporate client and its industry as well as a draft of the current year’s financial statement.

In addition, participants were randomly assigned to one of three experimental conditions, as follows:

  • One group was told that until two years ago the client company’s CFO was a partner in their accounting firm, a colleague with whom they worked on engagements involving this very client and others.
  • A second group was told that the CFO formerly attained partnership at another Big 4 accounting firm.
  • A third group received no information about the CFO’s prior employment history.

Participants were asked to assume the role of a continuing audit manager on the account. The key issue in the experiment was the valuation of goodwill, an asset on corporate balance sheets that arises when a firm purchases a company for more than the fair value of its net assets. Goodwill represents the difference between that identifiable fair value and the purchase price.

The client being audited was a medium-sized company in the biotechnology field, where purchased goodwill is often an accounting issue. The valuation of goodwill can change from year to year, depending on a variety of circumstances, and accountants widely regard it as a fairly subjective, even speculative measure.

In the case at hand, the CFO maintained that the value of goodwill should be unchanged from the level of the previous year. Evidence to that effect, however, was mixed. Participants received information that, in the words of the study, was “sufficiently negative to suggest that goodwill impairment might be a definite possibility but not so overwhelmingly negative that subjects would automatically conclude impairment.”

In the first group of participants, which was told the CFO was a former colleague and engagement partner, 35 of 46, or 76%, agreed with the CFO that goodwill was not impaired and should be set at its prior level. In the second group, which was told the CFO was formerly with another Big-4 accounting firm, 23 of 48, or 48%, agreed to no impairment, and in the third group, which received neither of those indications, only 39% agreed.

The researchers urge regulators “to push for a more robust cooling-off period covering a wider range of management positions.” They note that the Public Company Accounting Oversight Board has raised the possibility of a longer period.

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One response to “Auditor Independence Rule Isn’t Tough Enough”

  1. There’s probably no “automatic” about it. The alumni effect is about sharing accounting philosophy, not lack of independence. Public accountants usually do the work, but are influenced (76% of the time) by knowing that the CFOs accounting philosophy matches their own, (48%) by knowing that a CPA skilled but possibly with a different philosophy came to this conclusion, or by (39% with a bit of snobbery) believing that without any knowledge of what kind of practitioner came to this conclusion, they would have to look extra hard to decide whether it’s the same conclusion they would have made. And, there is nothing inherently wrong with adopting the client’s position. Should a CPA argue or change the conclusion simply to appear independent?

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