A new academic study scrutinizes how bias may play a role when an auditor used to work in the same accounting firm as the CFO of the company being audited.
The study looked at the “familiarity threat” to auditor independence when a CFO or other top executive of a company being audited used to be employed by the firm performing the audit. Before the wave of accounting scandals of the early 2000s, approximately one-third of the biggest U.S. corporations had top executives who were alumni of their companies' outside auditing firms. That included Enron, Global Crossing and Waste Management, which all fell prey to the accounting scandals.
The Sarbanes-Oxley Act of 2002 including a provision making it unlawful for accounting firms to conduct audits if a top financial or accounting executive of the client was employed by the auditor during the prior year. Canada, the European Union, and the United Kingdom later imposed similar prohibitions on auditors, Canada for one year and the E.U. and U.K. for two.
A new academic study examined the so-called “alumni effect” among North American auditors, testing the willingness of Big Four managers to adopt a client’s position on a theoretical accounting issue. The study found that 76 percent do so if the client’s CFO is a former colleague at their Big Four firm, while only 44 percent do so if the CFO isn’t. The alumni effect occurs even if it has been two years since the CFO left the audit firm, double the minimum span required in the U.S. and Canada and the same as the minimum mandated in the U.K. and E.U. The study was conducted by Michael Favere-Marchesi and Craig E. N. Emby of Simon Fraser University's Beedie School of Business in British Columbia, Canada. It appears in the March issue of the journal Accounting Horizons, published by the American Accounting Association.
“Obviously, a one-year or two-year cooling-off period is not enough to avoid the alumni effect, particularly if it requires overcoming social bonds that colleagues often develop,” said Favere-Marchesi in a statement. “It may be that five or 10 years would be enough. Alternatively, it may be that audits of companies where a CFO or other higher-up is a former engagement partner should be banned entirely, as some research on auditor independence has suggested.”
The researchers conducted an experiment through the Internet of 140 managers of Big Four accounting firms in Canada and the U.S. The managers, who averaged about seven years of auditing experience, all received the same background information about a corporate client and its industry along with a draft of the current year’s financial statement. They were randomly assigned to one of three experimental conditions. One group was told that until two years ago the client company’s CFO was a partner in their accounting firm, a colleague with whom they worked on engagements involving this very client and others. A second group was told that the CFO formerly attained partnership at another Big Four firm. A third group received no information about the CFO’s prior employment history. They were asked to assume the role of a continuing audit manager on the account. The key issue in the experiment was the valuation of goodwill, which can change from one year to the next, depending on the circumstances, and is widely regarded as a fairly subjective matter. In the experiment, the CFO maintained that the value of goodwill should be unchanged from the level of the previous year, but the evidence was mixed. Participants received information that, in the words of the study, 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 the first group of participants, who were told the CFO was a former colleague and engagement partner, 35 out of 46, or 76 percent, agreed with the CFO that goodwill was not impaired and should be set at its previous level. In the second group, who were told the CFO was formerly with another Big Four accounting firm, 23 out of 48, or 48 percent, agreed to no impairment. In the third group, who received neither of those indications, only 39 percent agreed.
Being told the CFO had formerly been a Big Four partner appeared to incline participants to agreement on goodwill impairment but not nearly as much as the alumni effect did. The people who were least likely of all to be swayed were participants whose CFO had neither alumnus status nor a Big Four background.
