Julia Irvine 16 Feb 2018 09:01am

Big Four auditor independence suffers from alumni effect

Social bonding and the cachet of being a member of the Big Four elite creates familiarity between auditor and audited and potentially undermines professional scepticism, according to new research

Academics Michael Favere-Marchesi and Craig Emby of Simon Fraser University found that Big Four auditors who deal with CFOs of audit clients with whom they once worked as their audit engagement partner are likely to be more trusting and employ less professional scepticism when forming judgments on the financial statements.

They are also likely to be more confident in the judgment they make if the CFO has been a partner either in their firm or any of the other three Big Four firms.

Equally, where the auditors disagree with the audit client’s position, they are likely to be more tentative about their decision where the CFO is a former partner of their firm or of another Big Four firm.

However, if the auditors are presented with a CFO whose experience and affiliation are not disclosed, they are far more likely to exercise a proper level of professional scepticism and challenge the audit client’s position.

The two academics say that their findings suggest the existence of an alumni effect – which is deeply worrying given that professional scepticism is a key characteristic of an independent auditor.

“The fact that the current auditors are more likely to concur with the client’s position when the client is a former audit partner of their firm can be interpreted as indicating reduced professional scepticism, but the results of the test of the second hypothesis suggest that source credibility also influences the auditor’s confidence in a CFO’s position.

“The fact that the participants were more confident in their decision to concur with the client’s position when the CFO was a former engagement partner than when the CFO was an audit partner from another Big Four firm and even more when the CFO did not have affiliation with the auditors or with any Big Four firm suggests that the current auditors were influenced by the source credibility of the CFO.”

The research was carried out among 140 audit managers from Big Four firms throughout Canada and the US, who were hand-picked by their senior partners. Their experience ranged from four to 15 years.

They were presented with a case study which involved the audit of a company in the biotech industry where concern had been expressed that the purchased goodwill might be impaired.

The participants were randomly assigned one of three scenarios: the CFO was an engagement partner until two years ago and they worked with him on this and other audits; the CFO is a former audit partner of another Big Four firm; or there was no indication of the CFO’s background.

The CFO had decided, the managers were told, that the value of goodwill should stay at the same level as the previous year. However, they were provided with the previous year's financial statements and other evidence which told a less clear story.

The information 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 other words, the researchers said, the case offered “a sufficiently rich context to provide some tension and the need for judgment in evaluation goodwill impairment”.

In the first case, where the CFO had been someone they had worked with, 76% of the managers thought the goodwill was not impaired; in the second, where the CFO was a former Big Four partner, 48% thought it was not impaired; and in the third case, the figure was 39%.

The two academics believe that the findings should give the profession’s regulators pause for thought.

Currently, there are regulations in place that govern how quickly auditors can move across from audit firm to audit client. In the UK the cooling-off period is two years for public interest entities and one year for others and in North America it is one year for listed companies.

Favere-Marchesi told economia online that if the profession really wanted to solve threats to independence for once and for all, regulators should go “all way out”.

“These artificial cooling-off periods of one year or two years are obviously not serving their purpose. I personally would prefer an outright ban that would shut the practice of revolving doors once and for all, although I think that a much longer cooling-off period (say 10 years) would certainly greatly diminish this familiarity threat.”

He thought that cooling-off periods should apply to all staff in a public accounting firm that worked on the client’s account, not just audit personnel (at all levels, from associate to partner), but also non-audit staff (tax, IT consultants and so on).

“We have already prohibited certain activities from being performed by auditors (eg financial information systems design and implementation, appraisal or valuation services, actuarial services, internal audit outsourcing services) so I think an outright ban on audit firm to audit clients where one of their own has taken a top financial or accounting executive position is not so far-fetched.”

The Alumni Effect and Professional Skepticism: An Experimental Investigation has been published by the American Accounting Association.