Auditors Can Still Be Your Friend... With Benefits

by FEI Daily Staff

Despite conflict-of-interest worries surrounding the auditor/client relationship, having a deep bench of former public accounting “alumni” within your finance staff can actually increase audit quality.

“There are always reservations, including conflict of interest and favoritism when there are close ties and that audit quality could compromised,” says Andrew Bird, assistant professor of accounting at Carnegie Mellon University. “But it’s only at the higher level you can manipulate things. The opposite is true for audit quality when it comes to the rank and file alumni. It becomes a benefit”

Bird and his colleagues released a study this month titled “That's What Friends Are For: Audit Quality and Accounting Employee Affiliations with Audit Firms” that surveyed biographical data on over 63,000 accounting employees working at S&P 1500 companies who were previously employed at public accounting firms. The study conclude that companies with a larger proportion of auditor alumni working as accounting employees are “significantly less likely” to have financial material misstatements as well as having lower absolute abnormal accruals.

The study’s results show a one-standard-deviation increase in the “alumni rate” is associated with 5.5 percent decrease in the likelihood of financial misstatements, and a 0.4 percent decrease in absolute abnormal accruals relative to total assets and that ”the effects of alumni employees on audit quality are also economically significant.”

“[The] study has important implications for modern practice, in the sense that it indicates a positive effect of audit firm alumni on audit quality,” according to the report. “Companies may want to hire accounting employees, particularly at the professionals level, from their current auditors.”

Bird adds that the risk/reward curve for audit quality changes as you move up the executive ladder. “The higher level executives stand to gain more by manipulating financial statements and there is only an incidental improvement in audit quality,” he explained.