Auditors who issue adverse opinions regarding a client’s internal controls can find their careers derailed, according to a recent study.
The study, released in March, found that firms are far more likely to remove a partner from a continuing engagement when the partner has issued an adverse internal control partner for any of clients in the previous year.
The researchers found that individual partners who issue negative opinions about a client’s internal controls experience unfavorable changes in their client portfolios in the form of lower fees and less prestigious client assignments. The negative consequences for partners were most dire when their adverse opinions were issued about the firm’s more important clients.
Issuing adverse internal control opinions can potentially hurt the careers of auditors who issue them. “The portfolio changes we document (i.e., decrease) suggest potentially significant monetary implications for audit partners who issue adverse ICOs,” said Elizabeth Cowle, an accounting professor at Colorado State University who co-authored the study. “Given other research which finds that partner compensation is linked to the size of a partner’s client portfolio, our evidence suggests that issuing adverse ICOs could potentially have career consequences for auditors who issue them.”
The study noted that auditors historically have been seen as the “gatekeepers” of the capital markets but often confront tradeoffs between fulfilling their fiduciary duties to the public and maintaining positive relationships with their clients, citing previous research. Those tradeoffs have become more apparent as the audit profession has placed greater emphasis on maximizing profits and embraced a “client as king” culture.
“Given the tension associated with issuing an adverse ICO, examining how audit firms manage the partners who sign adverse ICOs provides important evidence about how the firms balance their contrasting incentives,” said the study, which was co-authored by Cowle, along with Asheligh Bakke and Michael Wilkins of the University of Kansas and Stephen Rowe of the University of Arkansas.
The researchers examined client-level partner turnover to determine whether engagement partners who issue adverse internal control opinions to any of their clients are more likely to be reassigned after the opinions are issued. They found that partners were in fact more likely to be reassigned, especially with clients for whom they were doing Sarbanes-Oxley 404(b) internal control audits.
The results were consistent with audit partners experiencing negative consequences when they issued opinions that can put a strain on auditor-client relations, even though these opinions can provide valuable information to capital market participants and aren’t likely to reflect lower audit quality.
Not surprisingly, the negative consequences of issuing adverse internal control opinions could be deterring auditors from issuing such opinions. “Specifically our findings suggest that issuing adverse ICOs could be detrimental to audit partner career outcomes, which could certainly affect their likelihood to issue such opinions,” said Cowle.
The study suggests that auditors and audit firms are loath to issue negative internal control opinions to avoid losing business to competing firms or colleagues.
“Our findings support the concern that managing client relationships may hinder auditors’ ability to adequately fulfill their gatekeeper role in the area of internal controls over financial reporting (given that avoiding adverse ICOs seems to be in the best economic interests of both companies and audit firms, at least from a client revenue standpoint),” said Cowle.
Auditor independence has become more of a concern to regulators like the Public Company Accounting Oversight Board and the Securities and Exchange Commission. On Tuesday, the PCAOB debuted its first newly expanded audit firm inspection reports, which now include a section devoted to auditor independence (see story). The reports will now say not only when the PCAOB inspectors have uncovered auditor independence issues, but also when the firms admit the issues to the inspectors.
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