Auditors defer more to former colleagues, study suggests

Auditors will show a little deference to management judgments when the CFO of the client company is an alumni of the audit firm, according to emerging academic research.

A study involving a 140 audit managers finds that 76 percent would defer to the CFO’s call on whether goodwill should be impaired when they knew the CFO hailed from the same audit firm. A little less than half would agree with the impairment call when told the CFO was with another Big 4 firm, and only 39 percent would agree when they had no information on the CFO’s background.

The study tasked audit managers, those with seven to 10 years of experience to reach to a set of facts involving an impairment of goodwill, which is an intangible asset that appears on corporate balance sheets when a company purchase another company for more than the fair value of its individual assets and liabilities. Investors often examine goodwill, and whether it holds up in subsequent periods, as an indicator of whether they got their money’s worth out of a corporate acquisition.

Companies are required to examine goodwill each reporting period to see if it is holding up, or if it has become impaired and must be marked down. The study participants were told to assume the role of a continuing audit manager for an engagement involving a medium-sized biotechnology company. They received a set of facts that the researchers describe as “sufficiently negative to suggest that goodwill impairment might be a definite possibility but not so overwhelmingly negative that subjects would automatically conclude impairment.”

The “alumni effect,” as it is called by the researchers, suggests the current one-year cooling off period required under auditor independence rules for public companies is not long enough, particularly if there are social bonds among former colleagues.

After scandals like Enron and others, Sarbanes-Oxley prohibits audit firms to perform public company audits for companies where the top financial or accounting executive worked for the audit firm in the prior year. Canada has a similar one-year ban, while the bar in the European Union and the United Kingdom is two years.

"It may be that five or 10 years would be enough,” said one of the authors, Michael Favere-Marchesi of Simon Fraser University. “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.”

Published by the American Accounting Association, the paper will appear in the association’s journal, Accounting Horizons.

Auditor independence continues to be a concern both at the Public Company Accounting Oversight Board and at the Securities and Exchange Commission. Recent indictments arising among former Big 4 and PCAOB staff also raise questions about cooling off periods between audit firms and regulatory bodies.