New Wharton research challenges the idea that lucrative consulting contracts routinely lead auditors to look the other way when preparing financial audits, a key allegation in the scandals at WorldCom, Tyco and Enron.
Following those accounting debacles, Congress and regulators focused on the apparent conflict between accountants who were doing audits while earning high-margin consulting fees at the troubled firms. In a burst of reform, including passage of the Sarbanes-Oxley legislation and new Securities and Exchange Commission regulations, most accounting firms were forced to separate their auditing and consulting businesses.
Now, in a paper titled Fees Paid to Audit Firms, Accrual Choices and Corporate Governance, Wharton accounting professors David Larcker and Scott Richardson present new research questioning whether auditors who also work as consultants provide poor audits. The research suggests that accounting firms that have greater financial dependence on the client actually improve the quality of earnings reports at firms with weak corporate governance.
“There is a populist notion floating around out there saying that if a firm does a lot of consulting it will pay more attention to the consulting income than the audit,” says Larcker. “There’s no denying big audit failures have occurred.” But the question to ask, he adds, is how “systemic” this behavior is.
The Wharton researchers found a positive association between non-audit fees and unusual accounting behavior in 8.5% of the cases studied. The research also shows that these firms were clustered among companies with small market capitalization, lower book-to-market ratio, lower institutional holdings, and higher insider holdings – traditional indications of weak corporate governance.
“Concurrent weakness in corporate governance appears to be an important determinant of the relation between auditor independence and earnings quality,” the paper states.
Richardson says it is important to consider the big picture, noting that some bad audits will be inevitable considering the fact that thousands of public and private companies are audited each year. In addition, he states, the problems at Waste Management, Enron, WorldCom, Tyco, Sunbeam and Adelphia occurred over a short period of time.
The most surprising part of the abuses, according to Larcker, was that in most cases they were not elaborate schemes to manipulate earnings, but simple clear-cut fraud. For example, he points to the Pennsylvania cable company, Adelphia, where accountants failed to ensure separate accounts for the business and personal use of executives.
Parmalat, the Italian milk company, is the current focus of accounting irregularities. European prosecutors allege executives of the firm may have diverted up to $10 billion over the past 15 years. Authorities say the fraud began to unravel when they uncovered a forged Bank of America document indicating the firm had $4.98 billion in an account that didn’t exist.
At Enron, however, the obfuscation was part of a new model that included the use of limited liability partnerships, according to Larcker. “Enron was much more complicated. There was bad accounting” involved and bad behavior, but the wrongdoing “was much more complicated and hidden.”
Key Asset: Reputation
Earlier research into audit problems centered largely on the ratio of non-audit fees to total fees earned by auditors, leading reformers to focus on the theory that accounting firms will compromise audits to remain in a client’s good graces to earn high-margin consulting fees, Larcker says.
The Wharton study looked at that allegation too, but added a series of other measures of auditor independence and corporate governance. The research drew on new reporting requirements in 2000 that made companies disclose what they paid for audit services and used data from 2000 and 2001 representing more than 5,000 firm years audited by the major accounting companies, Arthur Andersen, Ernst & Young, Deloitte, KPMG, PricewaterhouseCoopers, BDO Seidman and Grant Thornton.
Larcker acknowledges it is difficult to quantify the quality of accounting, but one angle their study took was to look for large accruals, or the difference between earnings and cash flow. This measure was then correlated with the amount of fees paid by the client as a percent of the accounting firms’ overall revenue. The analysis showed that accounting firms that are heavily dependent on a client for a large percent of their revenue were more careful with that firms’ accounting.
“Overall, our results are most consistent with auditor behavior being constrained by the reputation effects associated with allowing clients to engage in unusual accrual choices,” the paper says. Adds Richardson: “When you have a big client you don’t want the client to go south on you because it would have a devastating effect on your reputation.”
While regulators have attempted to legislate good behavior, Larcker points out that an accounting firm’s reputation is critical. “Audit firms only have two attributes, technical knowledge and reputation. If one or the other goes away it’s devastating for the value of those organizations. If you have thousands of audits being done there are going to be some bad ones, but it’s hard to imagine in the U.S. economy that all those audits are tainted because careers and wealth are tied in.”
The study also indicates that auditors may have acted with greater caution for firms with small institutional holdings and high-growth prospects. “For these firms the auditor appears to be playing a key role in the governance process to limit abnormal accrual choices,” the paper states. In other words, the auditor is “stepping up to the plate where it is needed most.”
The new SEC rules limit auditors from providing many consulting services, including the design of financial systems, appraisal and valuation services, actuarial and legal advice and other services related to audits. The SEC did not prohibit auditors from doing tax planning.
As a result, all the major accounting firms, except for Deloitte, have spun off their consulting services. The restructuring was traumatic for the industry and has the potential to reduce the compensation of audit partners due to the loss of consulting income, says Larcker. In addition, he points out that many accounting firms argue their clients benefit from using consultants who also act as auditors because these consultant/auditors have better insights into the company.
Many parts of the Sarbanes-Oxley legislation are beneficial, particularly the formation of the Public Company Accounting Oversight Board, Larcker adds. But provisions limiting auditing firms from working as consultants may have gone too far, he suggests. “You had a situation where there was public pressure to do something, but Sarbanes-Oxley is very blunt.”
He argues the law punishes the majority of accounting firms who never were guilty of shabby auditing practices. “From a legislative standpoint you don’t want to set a law up to stop something if only a small number of people are doing it,” he says. “It’s not exactly clear that the audit firms doing a lot of consulting were doing bad audits. When you look at the data in an agnostic way, it doesn’t pop right out that we have a big problem.”