Companies that shop around among auditing firms for clean opinions on their financial statements can compromise the objectivity of outside auditors, according to new research.
The study, by Jong-Hag Choi of Seoul National University, Heesun Chung of Sejong University, Catherine Heyjung Sonu of Korea Open National University, and Yoonseok Zang of Singapore Management University, examined a set of 3,500 distressed U.S. companies over a nine-year period and found opinion shopping provided a tangible benefit to corporate management, but at the expense of auditor independence and investor interests. The study appears in the May issue of Auditing: A Journal of Practice and Theory, published by the American Accounting Association.
Opinion shopping skews the system away from transparency, according to the researchers, especially when it leads to switching auditors. “This study highlights the need to develop mechanisms that curb clients’ opportunistic auditor switches, such as regulatory intervention in the choice of a successor auditor or other mechanisms that discipline excessive client pressure,” said the paper. “Our findings also provide important implications for investors and audit committees by suggesting that both audit-opinion credibility and financial-reporting quality can be hampered by auditor-switching through opinion shopping.”
An estimated 57 percent of the companies examined in the study shopped for audit opinions. Of those, only 16 percent received going concern opinions, compared to 28 percent among non-opinion shoppers. Since going concern opinions usually result in adverse consequences for companies, such as negative market reaction, credit rating downgrade, and difficulty in raising new capital, companies are eager to avoid them. To a large extent opinion shopping enabled them to avoid going concern opinions. Of the 142 companies that filed for bankruptcy, 45 percent of the opinion shoppers had received clean audit opinions, compared to only 19 percent of the non-shoppers. However, that meant there were significantly fewer red flags for investors to warn them about companies that were in danger of going bankrupt.
The incidence of financial misstatements was significantly higher among companies that did opinion shopping than those that didn’t. The difference could be attributed to opinion shoppers who switched auditors rather than those that retained their audit firms. Opinion-shopping can lead companies to retain their current auditor if they decide that switching won’t lead to a better outcome. Opinion shoppers that didn’t switch auditors proved to be no more likely to restate their finances than non-shoppers.
"Successor auditors are incentivized to keep their new clients until they recover start-up costs and are thus more susceptible to client pressure,” said the study. “In addition, if auditors are concerned about reputation damages borne by early termination of audit contract, the successor auditors subsequent to switching opinion-shopping could be more vulnerable to the threats of dismissal. In contrast, incumbent auditors under non-switching opinion-shopping can be more resistant to client pressure, as they have recovered the start-up costs partly or fully from previous audit service." Further, clients that switch can be particularly aggressive in exerting influence, since “changing auditors is costly to clients because they should bear auditor searching costs and a share of the incoming auditor’s start-up costs … Clients’ willingness to incur such costs … may signal that their opinion-shopping incentives are relatively strong. This may result in more adverse effects on audit quality.”
Many of the audit firms who find themselves servicing the opinion shoppers who switch come from outside the Big Four. The study found the firms “tend to be non-Big 4 auditors…whose reputational capital is weak, [whose] pocket for litigation damages is not deep and…[who] are more likely to accept switching opinion-shoppers despite the higher litigation risk associated with accepting these clients.”
Those firms can be far from ideal, according to the study, which found “audit firms and offices that more frequently accept opinion-shopping clients tend to exhibit poorer audit quality not only for switching opinion-shoppers but for other clients.”
The researchers also looked into whether the Sarbanes-Oxley Act of 2002, which created the Public Company Accounting Oversight Board to do oversight of the audit profession, has reduced opinion shopping. Collecting data from before and after the establishment of the PCAOB in 2003, the researchers found that opinion shopping declined dramatically in the period from 2004 to 2006 but later returned to its pre-PCAOB level.
