It’s hardly surprising for corporate executives, particularly those with companies caught in a financial squeeze, to seek an auditor likely to be amenable to their influence.
Yet there has been relatively little research — and the evidence has been mixed — on whether “opinion-shopping” is generally successful and whether it diminishes auditor independence and audit quality.
Now, in what may be the widest-ranging research to date of these questions, a study of distressed U.S. firms finds opinion-shopping to be of tangible benefit to corporate managements. However, that benefit comes at the expense of auditor independence and investor interests.
The paper, in the May issue of the American Accounting Association quarterly Auditing: A Journal of Practice and Theory, reports that most companies in the study sample engaged in auditor opinion-shopping. And the practice paid off nicely in a reduced likelihood of receiving going-concern opinions, even as it increased financial misstatements.
The Sarbanes-Oxley Act, promulgated by Congress in 2002 in response to major corporate financial scandals, has had little effect on this state of affairs. So found the research, by Jong-Hag Choi of Seoul National University, Heesun Chung of Sejong University, Catherine Heyjung Sonu of Korea Open National University, and Yoonseok Zang of Singapore Management University.
Opinion-shopping does indeed tilt away from transparency, the research suggests, particularly when it results in switching auditors.
“This study highlights the need to develop mechanisms that curb clients’ opportunistic auditor switches, such as regulatory intervention in the choice of a successor auditor or other mechanisms that discipline excessive client pressure,” the authors wrote.
The findings, they added, “also provide important implications for investors and audit committees by suggesting that both audit-opinion credibility and financial-reporting quality can be hampered by auditor-switching through opinion shopping.”
“Audit firms and offices that more frequently accept opinion-shopping clients tend to exhibit poorer audit quality not only for switching opinion-shoppers but for other clients.”
An estimated 57% of the studied companies shopped opinions, among which only 16% received going concern opinions (GCOs), compared with 28% among non-opinion-shoppers.
GCOs express substantial doubt about a company’s ability to continue as a going concern in the near future. Because they typically bring adverse consequences, such as negative market reaction, credit rating downgrade, and difficulty in raising new capital, companies are eager to avoid this judgment.
And to a considerable extent opinion-shopping enabled the studied companies to do so. Among the 142 that filed for bankruptcy, 45% of the opinion-shoppers had received clean opinions, compared with only 19% of the non-shoppers. In other words, there were significantly fewer red flags for investors with respect to the former group of companies.
Evidence of auditing lapses as a result of opinion-shopping also turns up in other ways. For example, the incidence of financial misstatements was significantly higher among firms that engaged in opinion-shopping and switched auditors.
“Successor auditors are incentivized to keep their new clients until they recover start-up costs and are thus more susceptible to client pressure,” the professors wrote. In contrast, incumbent auditors have recovered some or all of their client start-up costs.
To whom do opinion-shoppers switch? Dividing at the median audit firms that have more or fewer switching opinion-shoppers as clients, the professors find that the former tend to be non-Big 4 auditors “whose reputational capital is weak” and are more likely to accept opinion-shoppers despite the associated higher litigation risk.
“Audit firms and offices that more frequently accept opinion-shopping clients tend to exhibit poorer audit quality not only for switching opinion-shoppers but for other clients,” according to the research report.
The professors also investigated whether Sarbanes-Oxley, which created the Public Company Accounting Oversight Board, has reduced opinion-shopping. Collecting data from before and after the PCAOB’s 2003 establishment, the professors found that opinion-shopping sharply declined in the period 2004-2006 but subsequently returned to its pre-PCAOB level.
The study analyzed data from some 3,560 distressed public companies over a nine-year period. Companies were defined as distressed if they reported either negative net income or negative operating cash flow in a given year.
Whether companies engaged in opinion-shopping was determined through analysis of a complex array of factors that included companies’ financial profiles (for example, their assets, debt, return on assets, and operating cash flow); whether their prior-year audit resulted in a clean opinion or a GCO; and the sizes of auditors’ practices.
From large-scale analysis of 11,628 company-years’ worth of data, patterns emerged for when it paid for to retain their auditors rather than switch, and vice versa. For example, a company improves its chance of avoiding a GCO this year by switching from the auditor that gave it one last year.
“Using the statistical model provided in our study, regulators and sophisticated investors can identify companies that switch auditors after opinion-shopping — something that should be of value given the increased likelihood of misstatements among such firms.”