Julia Irvine 9 Nov 2018 08:57am

Auditing experience in the boardroom a “two-edged” sword

A combination of former auditors in the boardroom and excessive executive pay makes it 30% more likely that the company will make misstatements, research has revealed

At the same time, having accounting competence in the C-suite – long regarded as essential to ensuring that financial reports are correctly prepared – also makes it less likely that the auditors will pick up on misstatements, since they tend to trust the directors more.

The research – Do Auditors Recognise the Potential Dark Side of Executives’ Accounting Competence? by academics Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri and Nathan Newton of Florida State University, published in the American Accounting Association’s journal, the Accounting Review – looked at data from 3,252 public companies over a 10-year period. They focused in particular on CFOs, chief executives and other top executives.

It found that where the executives had a background as partners or managers in audit firms, this could “substantially increase the present likelihood of financial misstatements”.

Coming from an audit background gives executive directors the advantage of an extensive knowledge of audit procedures and negotiation tactics. “As a result, executives could use their higher-order ability to hide misstatements or to avoid current-period adjustments when the external auditor finds misstatements,” they warned.

The academics stressed that accounting competence on its own does not lead to misstatements. Rather its interaction with other fraud risk elements increases the risk of material misstatement.

The risk element they chose to study was executive compensation, on the grounds that “auditing standards specifically include them in risk assessment”. Also, earlier research had pointed to compensation-based incentives inducing misstatements.

What they found was that accounting expertise among senior corporate managers significantly increased the extent to which executive pay excesses induce financial misreporting.

When top management had no auditing experience, companies which paid their executives well above the median (at the 75th percentile) were only around 4% more likely to misstate than those that paid relatively low (at the 25th percentile).

However, when audit firm experience was present, the high-pay companies were around 30% more likely than their low-pay peers to misstate. This, the academics say, is the “downside to a management characteristic [accounting expertise] considered beneficial in auditing standards”. 

Interestingly, it’s a downside that auditors appear to be unaware of. According to the research, auditors will charge companies higher fees where they pay their executives excessively but where there are board members from an auditing background, the fees will be lower.

“This result is consistent with auditors’ over-trusting executives with accounting competence and discounting the fee premium associated with excess compensation,” the academics say. In other words, “executives’ accounting competence increase[es] the risk of material misstatement when combined with compensation-based incentives to misreport”.

“However, we do not observe that audit fees reflect this increased risk, suggesting that auditors focus on the upside of accounting competence.”

The academics concluded that auditors do need to be aware that executives with auditing experience represent a “two-edged sword” that can either enhance or undermine financial reporting.

“Based on current auditing standards, auditors must consider executives’ competence when assessing the risk of material misstatement,” they said.

“Yet, the standards focus on risks associated with a lack of competence and omit potential risk associated with higher competence…We provide evidence about the potential downside to a management characteristic considered beneficial in auditing standards.”

This finding, they suggest, should be taken into account by regulators, standard-setters, board directors and especially by external auditors, not least because, of the 3,252 companies surveyed, in any one year around 12% had one or more top executives with prior audit experience as partners or managers.

Around 10% of company financial reports contained misstatements that had to be restated subsequently.