Having executives with backgrounds as partners or managers at audit firms can significantly increase some companies’ likelihood of financial misstatements, according to a new academic study that warns external auditors to be on the lookout for it.
The study, “Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?” describes that competence as “a two-edged sword,” as that prior experience “provides 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."
Not all companies were at risk from having audit-experienced execs, according to the study, which was written by accounting professors Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri, and Nathan J. Newton of Florida State, and focused on the CFOs, CEOs and other top executives of more than 3,000 public companies.
“We do not expect that accounting competence alone leads to misstatements, because accounting competence may provide the ability to produce reliable financial reports, and we have no reason to expect more or less integrity from executives with accounting competence than from those without it,” the authors wrote. “Instead ... accounting competence interacts with other fraud risk elements to increase the risk of material misstatement."
Accounting competence was primarily a risk factor at companies that had high levels of executive pay (based on deviation from expected levels of compensation), which were “considerably more likely” to misstate their financials.
“A dark side of accounting competence emerg[es] in the presence of compensation-based incentives,” the study authors wrote.
Companies with high levels of executive compensation but with no corporate managers with auditing backgrounds were about 4 percent more likely to misstate their financials than companies with relatively low compensation, while those with both high pay and auditing backgrounds among the leadership were about 30 percent more likely to restate.
However, auditors don’t seem to take this into account, the authors wrote, “over-trusting executives with accounting competence and discounting the fee premium associated with excess compensation.”
“Executives’ accounting competence increase[es] the risk of material misstatement when combined with compensation-based incentives to misreport,” the study noted. “However, we do not observe that audit fees reflect this increased risk, suggesting that auditors focus on the upside of accounting competence.”
While lack of accounting experience among corporate management has long been considered a risk factor in audits, the opposite hasn’t held true.
The authors concluded, “Based on current auditing standards, auditors must consider executives’ competence when assessing the risk of material misstatement. Yet, the standards focus on risks associated with a lack of competence and omit potential risk associated with higher competence.”
The study appears in the November issue of the American Accounting Association’s journal, “The Accounting Review.”
