Study: Naming Audit Partners Boosts Audit Quality, Fees

Add the engagement partner's name to an audit report and you'll likely get a better audit, but it will come at a price.

How do we know? Because that's exactly what happened when the United Kingdom required the lead partner on audit engagements to take pen in hand and sign the report.

A new academic study finds that the U.K. signature requirement—imposed in 2006 and similar to one U.S. audit regulators are currently considering—has led to better audit quality, but also higher audit fees. The study, “Costs and Benefits of Requiring an Engagement Partner Signature: Recent Experience in the United Kingdom,” doesn't draw a perfect cause-and-effect line from the signature requirement to increased audit fees, but the evidence is pretty convincing, says Joe Carcello, a professor at the University of Tennessee who conducted the study with Chan Li, business professor at the University of Pittsburgh. The study is under review before it is due to be published in an academic journal.

Carcello, an advocate for tougher auditing standards, is a member of the Standing Advisory Group of the Public Company Accounting Oversight Board. The PCAOB is expected to act in the third quarter on a proposal to require audit firms to name the engagement partner in the audit report, along with outside auditors who played an important role in getting the audit done. The U.S. Treasury's Advisory Committee on the Auditing Profession recommended in 2009 that the PCAOB take a hard look at a signature requirement, contending that a signature would increase transparency and accountability for the audit.

The PCAOB posed the question in a 2009 concept release of whether auditors should be required to sign the audit report. Investors and users of financial statements supported the idea, believing it would give auditors an increased sense of duty to perform the audit with greater care. Audit firms generally did not favor a signature requirement, arguing they already know the full weight of their responsibility, especially in the post-Sarbanes-Oxley era with the PCAOB inspecting their work and the Securities and Exchange Commission hovering as well.

The PCAOB compromised, proposing that audit firms should disclose the name of the engagement partner along with the names of any outside firms or other specialists who contributed to the audit but not require the engagement partner's signature. The board said disclosure seemed to strike the right balance, enhancing accountability for the engagement partner while preserving the sense that the audit firm ultimately is responsible for the audit.

While the PCAOB may stop short of requiring the audit partner's signature, Carcello says Britain's Eighth Company Law Directive, enacted in 2006, is a reasonable proxy for what would happen in the United States. “It's not identical to the United States, but there's a lot of commonality,” he says. “And even though the PCAOB has moved away from a signature toward identification, it's still relevant. Whether a person signs his or her name or is identified, the transparency is still there.”

“To the extent disclosure of the engagement partner leads to better audit quality and an increase in cost, reasonable investors will be willing to pay for that.”

—Matthew Waldron,

Director of the Financial Reporting Policy Group,

CFA Institute

The study measured three accepted indicators of audit quality and discovered all three showed notable changes after British regulators put the signature requirement in place. The indicators—abnormal accruals, patterns around meeting earnings thresholds, and market response to earnings—are accepted in academic research as indicative of whether earnings are being managed, so changes in those indicators that suggest less earnings management are linked to better audit quality.

It could be that auditors are gathering more evidence or behaving more conservatively, says Carcello, but the study didn't make a firm determination about why quality improved after the signing requirement. It does address other possible causes for improvements in audit quality, including other measures included in the Eighth Company Law Directive, but it rules those out, he says. The study also notes audit fees rose in tandem with the implementation of the signature requirement, and it rules out other plausible causes for a rise in audit costs.

Arnie Hanish, chief accounting officer at Eli Lilly & Co., and a member of the SAG, says he will be studying the research in detail to better understand the cost issue. “I'm surprised that audit fees would go up just because of the signing requirement,” he says.

MAJOR POINTS

The following excerpt is from the ICAEW's letter to the PCAOB regarding improving the transparency of audits:

We support PCAOB's desire to improve transparency in auditor reporting. We also understand the discomfort of investors concerned about a lack of clarity regarding who is responsible for large multi-national audits, who has performed them, and the extent to which reliance has been placed on the work of auditors in distant jurisdictions whose business practices and cultures may not be well-understood in the United States.

Unfortunately, we believe that the PCAOB, with the best of intentions, risks creating a charter for more uncertainty, not less. Implementing these proposals could be seriously counterproductive. Providing a great deal of information about who has been involved with the audit in an attempt at improving transparency may well increase confusion about who is responsible for the audit, because there is an element of a trade-off between transparency and accountability. Excessive transparency in the form of information overload is not good for accountability. If everyone appears to be responsible, no-one is. There is a risk that investors will not be able to see the wood for the trees which would defeat the object of the proposals.

We believe that what investors really need to know is who is responsible for the audit. They have a right to know who has been involved in the audit but this information does not belong in the auditors' report. If a long list of people involved in the audit appears in the auditors' report, doubt will be cast, at best, on whether the engagement partner identified in the report, or indeed the firm, is actually responsible for the audit.

We do not believe that transparency is an end in itself, and we do not believe that of itself it will enhance investor protection. Having information is not the same as understanding it or putting it to good use and there is a risk that accountability will be lost in a sea of spurious transparency. A more appropriate home for this information would be with the audit committee, which should be in a good position to evaluate it and communicate salient points to the board and investors. It is likely that extensive public disclosures about firms involved in multinational audits will be tracked. Attempts will be made to equate poor audit quality with the extensive use of other firms, without proper consideration of the (usually very sound) reasons for using local auditors. It is possible that as a result, firms may inappropriately seek to restrict the performance of audits to members of network firms in the interests of appearance, regardless of the effect on audit quality, increasing audit costs, and quite possibly the cost of capital if the wrong messages are sent to the market.

While the proposals do not address the merits or otherwise of divided responsibility, we strongly believe that this continued practice is the root of many of the problems that the PCAOB is trying to remedy.

Source: ICAEW.

One question, Carcello says, is whether audit costs rose because the accounting firm did more work to produce better audits or simply because it charged a premium for adding a signature to the audit report, perhaps out of concern for increased litigation risk. To determine that, researchers would need access to data on how much time auditors spent on each engagement, and that's not available, he says. “It's possible that fees went up because firms were charging more money for the hours, not putting in more hours, but we think it's more plausible they were doing more work,” Carcello says.

Other possible causes for an increase in audit cost are hard to imagine, says Gaylen Hansen, a partner with Colorado regional firm Ehrhardt Keefe Steiner & Hottman and another member of the SAG. “If there were some notion of audit quality increasing without a related increase in cost, you'd have to question whether that made any sense,” he says. “I wouldn't think audit quality would go up unless someone was taking more time on the audit.”

Katharine Bagshaw, technical manager with the Institute of Chartered Accountants in England and Whales, says she hears anecdotally from audit firms that the signature requirement has not lead to any meaningful differences in the audit.

Matthew Waldron, director of the financial reporting policy group for the CFA Institute, says investors won't flinch if auditor identification leads to increased audit costs. “Investors must be able to rely on the audits of companies they invest in,” he says. “To the extent disclosure of the engagement partner leads to better audit quality and an increase in cost, reasonable investors will be willing to pay for that.”

Jeff Mahoney, general counsel for the Council of Institutional Investors, concurred. “The favorable investor and other market participant input received on this issue … suggests that investors, who ultimately pay the auditor's bill, are willing to potentially incur an added cost in exchange for increasing transparency and accountability of the audit,” he says.