Shopping for a Pretty Picture or An Accurate One?

It's assumed that public companies shopping around for a favourable audit opinion have something to hide. Instead, they may be acting as proper corporate stewards
Shopping for a Pretty Picture or An Accurate One?

The essentials

  • A study researched the motives for audit opinion shopping by public companies.
  • The researchers found that same-firm office switches resulted in improved going-concern opinions.
  • They found the motive for these switches had more to do with surfacing better financial information than with hiding bad information. Clients were more likely to engage with larger offices with specific areas of expertise to receive the most informed decision.

For financial managers of public corporations, the choice of auditor is not a decision to be taken lightly. There’s a lot at stake: an auditor’s take on the financial health and viability of an organization — known as a “going concern” opinion — can be an important signal to potential and existing investors.

That’s why companies have been known to engage in opinion shopping, seeking an auditor who sees the world through rose-coloured glasses. But it’s not as easy as it sounds. Switching audit firms can itself be a red flag and doesn’t necessarily lead to better outcomes. Most studies have found that audit firm switching does not result in higher quality audit opinions.

For investors and observers, the assumption is almost always that a company that switches auditors has something to hide. But what if it truly believes that its own interpretation offers a more accurate picture of financial health than the opinion of an outsider?

This was the question explored by Yu Hou of Smith School of Business and colleagues Jere R. Francis of the Trulaske College of Business and Feng Chen of the Rotman School of Management.

Motives for Opinion Shopping

The research team set out to test the motives for opinion shopping not between different auditing firms but within an auditing firm itself. 

"In the case of an auditor switch,” says Hou, "you have to tell everybody [by disclosing the switch to a regulatory body such as the Securities and Exchange Commission]. This can be very costly and your stock price is able to drop significantly. But doing this at the office-level within the same firm, you can do it under the radar.”

Previous research has shown that practices can vary widely within different offices of the same accounting firm. Even though standardized audit plans are developed at the national or firm level, in practice auditors must rely on their professional judgment. Even with the same training, they have varying experiences that help develop their professional characteristics such as industry expertise and technical experience.

For their study, the researchers analyzed data from same-firm audit office switches between 2000 and 2015. Their initial focus was to see if the corporations would switch auditing offices opportunistically, and, as a result, receive a favourable going concern opinion from a compromised auditor.

“We were interested in researching further into the going concern due to its nature of being precise and accurate,” says Hou. “It can be easily measured by determining whether the organization goes bankrupt within the next year or not. Compared to other measures, such as earnings quality, going concern is the most important in determining a corporation’s financial security, and why we believed it to be the worthiest of analysis.”

Intra-Firm Switches Pay Off

The researchers found that the same-firm office switches indeed result in improved going-concern opinions. While this may have been proof of a compromised auditor’s opinion, Hou suspected that the motive for these intra-firm switches had more to do with surfacing better financial information than with hiding bad information. Far from being compromised, the new auditor may be more capable at differentiating between a conservative view and actual going concerns. The researchers coined this motive “informational opinion shopping.”

Unlike classic opinion shopping, informational opinion shopping is not motivated by opportunism. Rather it is the result of management’s concern that its current auditor does not have a complete grasp of the company or industry. Under this belief, earnings quality of a company would be higher and shareholders would be provided a more accurate depiction of the client’s financial situation.

With more research, Hou’s findings concluded that clients were more likely to engage with larger offices with specific areas of expertise to receive the most informed decision. Hou recounts the example of an Albertan financial institution deciding to appoint a Toronto auditor to audit its practice. The firm’s financial manager believed that a larger practice located in the heart of Canada’s financial district would provide greater expertise about their practice.  

“At the end of the day, we’re human. Even with the same training, we behave differently”

This discovery speaks well for senior management of publicly-traded companies. With informational opinion shopping, financial managers act as proper corporate stewards by ensuring high earnings quality. The finding surprised Hou. “While it was within our expectation, we did not know that this type of opinion shopping would dominate the other, and we were just as surprised as anyone else.

“That being said, the motivations for the switch are good,” he added. “At the end of the day, we’re human. Even with the same training, we behave differently. We have different experiences and knowledge. That itself is common.”

The study’s findings do give regulators a reason to look into requiring corporations to disclose any sort of auditor switches, even within the same firm. With this study, it is easy to see why. Disclosing this will inform shareholders that the auditor’s opinion includes the most information possible and avoids excessive conservativism.

“It is in people's interest to disclose,” says Hou. “I think this study actually tells people regulators should do more.” 

Tim Riffault

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