Since January of last year, a Public Company Accounting Oversight Board regulation has required U.S. companies to disclose the engagement partner of their auditing firm. Has it benefited investors, as its proponents claimed it would? Or has it been of negligible value, as many accounting professionals predicted?

While it’s too early to tell, new research approaches the question in a novel way and suggests the answer could prove quite different than either side of the debate expected.

For a study reported in the spring issue of Behavioral Research in Accounting, a peer-reviewed journal of the American Accounting Association, researchers tested the effect of audit partner disclosure on 157 seasoned investors. The research found that, contrary to accounting-industry predictions, the information has a considerable impact on investment decisions.

But that impact may turn out to be more problematic than the regulation’s proponents foresaw.

Although the study does not purport to judge the wisdom of the new rule, its findings inevitably raise doubts about it. Co-author Tamara Lambert of Lehigh University says audit partner disclosure “may have a greater impact on investor decisions than would be warranted or than what regulators would have anticipated or intended”.

Prior research on audit partner disclosure has tended to focus on countries where partner disclosure has been required long enough to yield substantial outcome data. While the mandates’ effects have generally been positive, the current study notes that “the reporting, regulatory, and legal environment within these countries is quite different from that of the United States”.

Taking a different tack, the researchers focused on the intended beneficiaries of audit partner disclosure —individual investors— through an experiment that gauged their response to knowing the identities of engagement partners in addition to those of auditing firms.

The engagement partners named in the experiment were fictitious, and investors participating in the experiment received a bare minimum of information about them. Yet audit partner disclosure occasioned a striking shift of about 17 % in participants’ investment decisions, inviting suspicion that irrational factors were at play.

As the authors explained, social psychology research “finds that individuals’ judgments related to people are more extreme, more hastily and confidently formed, and more easily recalled than those made of groups.”

Is this true of judgments involving audit firms and engagement partners?

To explore this, the researchers focused on a common investment phenomenon called contagion, where a negative occurrence at a company lowers investors’ assessment not only of that firm but of other firms that share significant features with it.

Earlier research has found that when a company has to restate its finances —a sign of inferior accounting— contagion effects extend to other companies that use the same audit firm. The new research probed whether audit partner disclosure further increases this contagion effect.

And does it ever.

Participants were presented with information about five fictitious, publicly traded technology companies. The investors were told that all were located in the same region and had received an unqualified audit opinion from one of two Big 4 accounting firms operating in the same city. Also provided were five key performance metrics of the tech companies: ratio of assets to liabilities, days sales of inventories, return on assets, profit margin, and market share.

Key to the experiment were three factors:

• One of the tech companies, called US Technologies, surpassed all the others in every one of the five performance metrics.
• Another one, Wired States, recently restated its results from the prior year, with the restated metrics much lower than what was previously reported. While two other companies happened to use the same auditing firm as Wired States, only one of the two, US Technologies, also had the same engagement partner as the restating firm.
• All participants received the same information, with one exception: somewhat more than half were given the names of engagement partners in addition to those of the audit firms.

Among subjects who knew the identity of companies’ audit firms but not of the engagement partners, about 77 % chose to invest in US Technologies, whose performance metrics the study’s authors described as “markedly better than [those of] the other four firms”.

But among those who also knew the identity of engagement partners, only about 63 % chose US Technologies. The drop of 14 percentage points suggests a contagion effect more than 17 % greater than that caused by audit-firm identification alone.

Why should the gap be so big? Wrote the authors, “Social psychology research finds that when forming impressions, perceivers make more extreme trait judgments, make judgments more quickly and with greater confidence, and… are likely to react more strongly when the reactions are associated with an individual than when they are associated with a group”.

Does an effect that strong benefit investors? Or does the new regulation have too much potential to distort investment decision-making?

The authors demurred on that point, observing that had participants been presented with a full set of financial information, the study results could have been different.

Still, they suggested that the evidence uncovered in their experiment should give pause. At the least, they said, regulators should be prepared to monitor the effects of this rule with particular care.

“It is easy to imagine how [audit partners] would see their personal reputations tied to those of their clients — how, for example, it would reduce their incentive to push management to restate finances in the face of its reluctance to do so”, says Lambert.

Her co-authors were Benjamin Luippold of Babson College and Chad Stefaniak of the University of South Carolina.

Source: CFO