Dive Brief:
- Audit partners who write adverse internal control opinions are more likely than their less critical peers to be pulled from an engagement and shifted to less prestigious, lower-fee client assignments, according to a study.
- The setback for auditor partners is especially severe when their ICOs are somewhat subjective and when they focus on more important clients, according to the study published last month by academics at the University of Arkansas, Colorado State University and the University of Kansas.
- Audit partners suffer “negative consequences when they issue opinions that strain auditor-client relations, even though these opinions provide valuable information to capital market participants and are not likely to reflect lower audit quality,” the authors said.
Dive Insight:
Release of the study coincided with a proposal last month by the Public Company Accounting Oversight Board to update “foundational” audit standards, including unifying rules on skepticism and independence, with special attention to the engagement partner’s responsibilities.
The board requested public comment on its proposal by May 30.
The academic study notes that audit firms face a conflict between sustaining income from client fees and meeting an obligation under Section 404(b) of the Sarbanes-Oxley Act of 2002 to issue an adverse ICO when finding weaknesses in a client’s internal controls.
“While auditors historically have been viewed as ‘gatekeepers’ of capital markets, they face tradeoffs between fulfilling their fiduciary duties to the public and maintaining positive relationships with their clients,” the researchers said.
“Such tradeoffs have become more apparent in recent years as the audit profession has placed increasing emphasis on maximizing profits and embraced the ‘client as king’ culture,” they said. Only 4.6% of 404(b) auditor attestations disclosed an adverse ICO in 2020 compared with 16.2% in 2005, they noted.
The researchers reviewed audit opinions filed by audit partners regarding their publicly traded clients from January 2017 through December 2020, and changes in partner client portfolios through December 2021.
Clients whose audit partners wrote an adverse ICO were about 4.4% more likely to have a change in partners within the following year compared with clients that did not receive an adverse ICO, the researchers said.
“Following the issuance of adverse ICOs, partners are less likely to be assigned to additional 404(b) clients and are more likely to be assigned to additional non-404(b) clients,” resulting in net loss in client revenue within the partners’ portfolios, the researchers said.
“The portfolio changes we document suggest potentially significant monetary implications for audit partners who issue adverse ICOs,” they said, noting that compensation correlates to the size of a partner’s client portfolio.
Partners who wrote adverse ICOs saw 9% less growth in fees on average across their portfolios, the researchers said.
“Audit firms appear to be motivated more strongly by the economic incentives that drive positive client relations than by reputational and regulatory incentives that would encourage more conservative — and potentially higher quality — internal control evaluation,” they said.
“Our evidence suggests that audit firm responses to adverse ICO patterns may discourage auditors with a more critical mindset from staying in the profession,” the researchers said.
