Julia Irvine 30 Apr 2018 03:25pm

Audit partner disclosure has significant effect on investors

An academic experiment in the US has cast doubt on the benefits of disclosing the name of the audit engagement partner in companies’ audit reports

The research has found that investors behave very differently when the partner is identified, suggesting that “irrational factors are at play” in making their investment decisions.

The study, published in the American Accounting Association’s Behavioural Research in Accounting journal, set out to test the effect of audit partner disclosure. This became mandatory for all US public company audits issued on or after 31 January last year.

Three academics – Tamara Lambert of Lehigh University, Benjamin Luippold of Babson College and Chad Stefaniak of the University of South Carolina – were curious to know whether the disclosure would benefit investors (as its supporters claimed) or whether it would have little impact (as many in the profession predicted).

They devised an experiment to gauge investors’ responses and invited 157 of them to participate. None were accountants and each had at least five and a half years’ experience in preparing and analysing financial information and in trading individual shares of stocks and bonds.

The researchers focused on “contagion”, a common investment phenomenon where a negative event at one company not only undermines investors’ views of that company but also of those companies that share significant features with it.

Previous research had found that when one company had to restate its finances (deemed to be inferior accounting), the standing of other companies with the same audit firm tend was lowered.

The participating investors were provided with information about five fictitious, publicly traded tech companies – American Computers, Computer World, Electronics USA, US Technologies and Wired States – and asked to consider whether or not to make long-term investments in them.

Each investor was given the same basic information: as well as being in the same industry, the five companies were based in the same area and had received an unqualified audit opinion from one of two Big Four auditing firms operating in the same city.

They also received five key performance metrics: ratio of assets to liabilities, day’s sales of inventories, return on assets, profit margin and market share.

Additionally, they were told that: US Technologies came out far better than the others in all five performance metrics; and Wired States had recently restated its result from the prior year resulting in far lower metrics than previously reported.

Two other companies use the same auditing firm as Wired States but only one of the two, US Technologies, shared the same auditor.

Around half the investors were also given the names of engagement partners as well as the audit firms.

Interestingly, of the group who only knew the audit firm’s name, 77% chose to invest in US Technologies, compared to 63% of the group who also knew the auditor’s name. In other words, there was a significant shift of around 17% in the participant’s investment decisions.

“All participants were provided with the information that US Technologies was linked to the contaminated company by the same audit firm, while audit partner disclosure participants saw both the audit firm and partner name,” the research says.

“That is, our results suggest that audit partner identity disclosure results in partner-based contagion above and beyond any effect due to shared industry and shared firm.”

The academics think that this unexpected finding could well be attributed to the social psychology research finding that “individuals’ judgments related to people are more extreme, more hastily and confidently formed, and more easily recalled than those made of groups”.

They admit that the results might have been different had they given the investors a full set of financial statements. Nevertheless, the experiment does indicate that regulators should monitor the effects of the disclosure requirement carefully, given that it clearly has the potential to distort investment decision-taking.

Lambert says that she and her fellow researchers were surprised that the regulators hadn’t seemed to have taken into account the potential long-term effects of the requirement on audit independence.

“With the whole new layer of pressure on audit partners that our research reveals, it is easy to imagine how they would see their personal reputations tied to those of their clients – how, for example, it would reduce their incentive to push management to restate finances in the face of its reluctance to do so.”

In the UK, audit partner disclosure has been a requirement since 2006 when the Companies Act was introduced. The general conclusion is that it has made no difference to the audit process nor impacted on liability. 

However, as the US academics point out, the reporting, regulatory and legal environment in the US is very different.