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Do former regulators improve the quality of audits?

Marianne Klinker — Mon, 08 Jan 2024 13:44:01 +0000

Do former regulators improve the quality of audits? Marianne Klinker Mon, 01/08/2024 - 08:44

A �鶹��Ƶ professor unpacks the complex, nuanced impact of the “revolving door” between industry and regulators in the accounting world.

In their auditing capacity, accounting firms, such as the “Big Four”—Deloitte, EY, KPMG and PWC—function as watchdogs for publicly traded companies. They’re tasked with ensuring financial disclosures are accurate and above board. But who watches the watchdogs?

The Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board (PCAOB), whose mandate is to monitor and inspect firms conducting audits of public companies and report its findings to the public. Yet, in a pattern familiar from other government-industry configurations, the border between regulator and regulated is often less a brick wall than a revolving door. Large accounting firms, including the Big Four, have been hiring more and more PCAOB employees, especially since 2010, when the board expanded its remit to include internal control audits.

Steve Maex

“Firms began moving in the direction of hiring significant numbers of PCAOB employees after a string of weak inspection reports in the early 2010s, ostensibly to get a sense of what they could do to better comply with auditing standards,” says Steve Maex, an assistant professor of accounting in the Donald G. Costello College of Business at �鶹��Ƶ.

Maex’s recently published paper in Review of Accounting Studies, co-authored with Jagan Krishnan and Jayanthi Krishnan from Temple University, evaluates the effects of such hiring. The researchers tracked the audit quality of large accounting firms over the period in which this hiring emerged and explored the relationship between the hiring and a variety of audit outcomes.

“There’s no single proxy that can be used to capture the many dimensions of audit quality,” Maex points out. So, the team used various indicators, including clients’ financial restatements, discretionary accruals (disparities between reported income and cash flow), the accuracy of internal control opinions issued by the auditor, and audit fees.

The researchers found that clients of firms that hired ex-PCAOB employees issued fewer restatements in general, which suggests fewer egregious errors on the part of the auditor. Further, for clients that would be more pre-disposed to misstating their financials, this quality-enhancing effect was also identified in terms of lower discretionary accruals, higher accuracy of internal control audit opinions, and higher fees that clients were willing to pay. In other words, the former PCAOB personnel seemed to help their firms focus on the highest risk issues and clients in their portfolios.

The researchers found that clients of firms that hired ex-PCAOB employees issued fewer restatements in general, which suggests fewer egregious errors on the part of the auditor.

Maex and his coauthors surmise that these professionals, during their experience with PCAOB, acquired “regulatory audit quality expertise” that would not be as easily accessible to those without such experience. “The practitioners we interviewed said that [at the PCAOB] you get exposed to a variety of different audit practices and processes and develop an understanding of what works and does not work well. This contrasts with many audit firm partners who start and finish their career in the same accounting firm and therefore may only be exposed to their own firm’s methodology and a handful of clients that they support,” he explains.

This broad-based, generalizable skillset involves a greater aptitude for gauging and addressing risk. “To the extent that they can help the firm identify high-risk clients, that right off the bat can help them allocate resources intelligently. These individuals are going to be really good at finding strategies, solutions, and methodologies to handle the firm’s high-risk clients more effectively.”

For Maex, these findings form part of an active stream of accounting research studying the role of regulatory oversight on auditing firms. Furthermore, the work is relevant in light of recent events in which ex-PCAOB auditors at KPMG tipped off the firm about the board’s inspection plans. The ensuing scandal sparked debate about possible misconduct enabled by the revolving door.

Maex’s research highlights that the movement of former regulators to accounting firms offers potential upsides for audit quality notwithstanding these ethical considerations. Rather than seeking to inhibit transfers on ethical grounds, regulators could explore different types of talent exchanges with firmer guardrails against misconduct. The SEC’s Professional Accounting Fellows program, which admits experienced accounting professionals for a limited period of time and under fixed parameters, could serve as a model.

“The goal of the regulators, we like to think, is the same as the audit firms: to ensure audit quality is as strong as it could be,” Maex says. “If there were no conversations about how to achieve that between the two, that could be problematic. The challenge is balancing that against the negative outcomes, which receive significant publicity when they occur.”

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�鶹��Ƶ researcher helps the SEC walk the talk

Marianne Klinker — Tue, 31 Jan 2023 14:37:09 +0000

�鶹��Ƶ researcher helps the SEC walk the talk Marianne Klinker Tue, 01/31/2023 - 09:37

Research by �鶹��Ƶ Accounting Professor Bret Johnson, a former SEC staff accountant and academic fellow, shows how seemingly mundane intra-agency policies can have unintended effects that benefit Wall Street over Main Street.

The U.S. Securities and Exchange Commission (SEC) has long seen itself as a friend to the retail investor, doing everything it can to ensure that financial markets offer both large and small players roughly equal opportunity to succeed. Most recently, that mandate provided the rationale for a slate of sweeping rule changes that would, among other things, shine a light on the opaque business arrangements between wholesale brokers and trading apps such as Robinhood. It adds up to what some industry insiders are calling the largest-scale SEC intervention in nearly 20 years.

Bret Johnson

To its credit, the SEC is just as committed to promoting fairness and transparency in-house as it is to ambitious industry reforms. The agency even invites accounting academics to research its inner workings via the SEC Academic Fellowship Program. �鶹��Ƶ School of Business accounting professor and former SEC staff accountant Bret Johnson was selected for the year-long program starting in August 2020.

Johnson says, "My role was to be a liaison between the SEC and the academic community…Often, my research uncovers some problem or something they can improve on, some inefficiencies. And I found they are very open to embracing this type of research."

For example, Johnson's recent research paper in Review of Accounting Studies co-authored by Michael Iselin of the University of Minnesota, Jacob Ott of the London School of Economics, and Jacob Raleigh of Monash University, finds that while the SEC's monitoring arm – the Division of Corporation Finance (DCF), where he worked for six years – seems to focus less on firms with a high percentage of retail ownership, the Division of Enforcement (DOE) appears to take a harder line with these firms. In other words, irregularities are less likely to be spotted early and addressed through non-punitive means when the firm in question has a larger proportion of retail investors.

"My role was to be a liaison between the SEC and the academic community…Often, my research uncovers some problem or something they can improve on, some inefficiencies. And I found they are very open to embracing this type of research." - Bret Johnson

The SEC's enforcement-heavy approach may disadvantage retail investors because once the enforcement action becomes common knowledge, the "Main Street" investors who hold disproportionate stock in the target company will lose out when the share price falls. In this way, the SEC does not seem to be acting in accordance with its stated mission to protect mom and pop investors.

Johnson can only guess at what's going on here. He speculates that firms that attract retail investors may share other characteristics that cause the SEC to flag them for enforcement rather than monitoring. For instance, the paper finds that retail ownership was positively associated with firm visibility and performance volatility, and negatively associated with external monitoring and structural complexity. The discrepancy may also have to do with how resources are distributed between the DOE and DCF.

In other cases, the agency's good-faith attempts to increase market transparency on behalf of less savvy investors can backfire. Based on analytics from the publicly available filings database on the SEC website, Johnson's 2020 paper in The Accounting Review, co-authored by Michael S. Drake and Jacob R. Thornock of Brigham Young University, and Darren T. Roulstone of The Ohio State University, concluded that institutional users (e.g. investment banks, hedge funds, asset managers, and financial institutions) were profiting handsomely from their search activities on the online resource, while retail investors saw little to no benefit. Abnormal search volume from Wall Street was associated with future returns for the focal firms of up to 10.5 percent. No such pattern was seen on Main Street.

In addition, how the SEC balances the need for transparency against its relationships with companies can have unintentional knock-on effects. Johnson’s 2022 paper in Management Science, co-authored by Marshall A. Geiger and Abdullah Kumas of the University of Richmond, and Keith L. Jones of the University of Kansas, found that for companies that had just received an SEC comment letter, there was a sizeable uptick in sell-offs among mutual funds and other major players during the short period (initially 45 days, then shortened to 20 days) before the letter went public. The best explanation was that high-ranking executives were sharing non-public information with investors close to the company concerned.

The 20-day privacy window is meant to prevent companies’ confidential information from being accidentally released through an over-hasty process. But it may also create information asymmetry that benefits industry insiders at the expense of retail investors – the very favoritism that the agency intends to combat.

There are no simple answers to the questions posed by Johnson’s research. Even seemingly mundane intra-agency decisions, such as resource allocations and the length of the confidentiality window for comment letters, can have complicated ripple effects. Sometimes, it takes an informed outsider to trace these ripple effects and draw evidence-based conclusions. "I am happy to see that the SEC continues to solicit – and take seriously – academic research into its policies and practices," Johnson says. After all, sweeping industry reforms may make headlines, but fine-tuning how the agency itself functions is a quieter but no less material way of promoting fairness and transparency in financial markets.

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The de-globalization of financial reporting

Jennifer Anzaldi — Wed, 28 Sep 2022 13:34:04 +0000

The de-globalization of financial reporting Jennifer Anzaldi Wed, 09/28/2022 - 09:34

Jenelle Conaway

Remember when the world was flat? During globalization’s peak era–from the collapse of the Soviet Union to around the time of the 2008 financial crisis, let’s say–there was general agreement that the world was on a path toward economic and political convergence. We were told that in the future there would be fewer serious structural barriers impeding the free flow of money, goods, and people across borders. From the standpoint of financial investments, hopes of global convergence rested largely upon the expectation that global companies were moving toward unified standards for financial reporting.

Then as now, there were two standards-setting bodies with enough international prominence to guide this convergence. One was the Financial Accounting Standards Board in the United States, responsible for codifying the Generally Accepting Accounting Principles (U.S. GAAP), which homegrown firms listed on U.S. stock exchanges are required to use. The other was the International Accounting Standards Board (IASB), whose rules for financial reporting are known as International Financial Reporting Standards (IFRS).

The stated intention of both boards was to steadily increase comparability, until U.S. GAAP and IFRS became sufficiently identical to make the merger official with little disruption to companies. Additionally, it was hoped that the existence of a single set of standards would exert pressure on holdout economies that maintained local reporting regimes. The resulting uniformity would provide the transparency needed to knit together a truly global marketplace.

As Jenelle Conaway, assistant professor of accounting at �鶹��Ƶ School of Business, explains, “Being able to compare companies more easily makes for more efficient investment choices. And that scales from the individual level up to banks choosing who they lend to, and companies choosing who they want to merge with and acquire.”

But in the years since 2008, as globalization’s allure has dimmed, comparability trends have grown more complicated, Conaway’s recent research finds. Her paper in Contemporary Accounting Research tracks financial reporting data for more than 20,000 firms–categorized into subsamples according to the accounting standards used by each firm–across the 36 largest economies. Her observations span two time horizons: 1990-2001 and 2002-2018. Juxtaposing these two periods enabled Conaway to isolate the impact of concerted regulatory action in 2002, a banner year for the global-convergence campaign.

Conaway measured comparability by analyzing how similar economic events were reflected in the various companies’ financial statements. As Conaway points out, comparability should never be taken for granted, even when the companies concerned ostensibly have much in common.

“A lot of people think accounting is black and white, but there is a lot of discretion involved,” she says. “By and large, comparability is going to be greater among companies applying the same accounting rules. But it will likely never be perfectly comparable because of the judgement involved in financial reporting decisions.” By extension, it’s also possible for companies located in different countries–and therefore following separate accounting standards–to be more comparable than expected in some areas.

These ambiguities surrounding comparability show up in Conaway’s findings. Her results reveal that the 2002 regulatory push worked as intended, accelerating convergence of accounting practices over the following 16 years. However, the improvements in comparability were not universal. Comparability plateaued among companies using U.S. GAAP and IFRS, mainly owning to these regulators having stalled in their progress toward the single-standard goal. Simultaneously, countries with their own financial reporting standards–including major economies such as India and China–started to drift in an international direction, without officially signing onto either IFRS or U.S. GAAP.

For Conaway, the reasons boil down to costs and benefits. For the large multinationals that are long-term adherents to IFRS and U.S. GAAP, the ideal of perfect comparability may compromise the company’s ability to present its financials in the most relevant and reliable light. Past their current standard of compliance that satisfies both regulators and investors, these major players seem to have no pressing incentive to further improve comparability.

Local-standard companies outside the U.S. and Europe, however, are still edging toward their cost/benefit sweet spot. Despite the U.S.’s outsized influence, representing as it does over 40 percent of global equity market capitalization, Conaway’s findings show that IFRS serves as a more congenial (if unofficial) role model for them. “Those firms are still technically following their countries’ accounting rules, but they are interpreting them or applying them in a way that makes the resulting financial statements more comparable to those of IFRS firms only,” says Conaway.

IFRS’ international origins help explain its advantage over U.S. GAAP. Conaway says that “the IASB standard-setting process has always taken into consideration the needs of a diverse set of constituents, whereas the FASB is mostly concerned with investors in the U.S.” For countries seeking the advantageous mix of high quality standards and strong network effects, IFRS is a more appealing platform. Similarly, companies using local standards are internationalizing their reporting in line with IFRS to reap these benefits, while stopping short of official adoption.

This study points to IFRS as the de facto global standard–a trajectory Conaway finds noteworthy. “The development of U.S. GAAP dates back to the 1930’s, long before IFRS picked up momentum in the early 2000’s.” Because of the costs involved in switching accounting standards, “Any change is a really slow process, which is why it is remarkable how widespread IFRS has become over the past two decades.”

Conaway suggests that while internationalization is increasing among firms that haven’t yet signed onto either standard, the ebbing of enthusiasm for global comparability among regulators should concern U.S. investors. “Many retail investors are not aware of the intricacies of U.S. GAAP compared to IFRS. If the global market is shifting towards IFRS, and U.S. GAAP and IFRS are not becoming more comparable with each other, then information processing costs will be greater for investors unfamiliar with IFRS.”

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Can the Structure of State Audit Agencies Deter Corruption?

Jennifer Anzaldi — Thu, 02 Jun 2022 14:32:21 +0000

Can the Structure of State Audit Agencies Deter Corruption? Jennifer Anzaldi Thu, 06/02/2022 - 10:32

Syrena Shirley

Government corruption has universally corrosive effects on U.S. society. Yet there is little uniformity to the structure of state-level corruption oversight agencies. Syrena Shirley, an assistant professor of accounting at �鶹��Ƶ, recently published a research paper in Current Issues in Auditing suggesting that in the fight against corruption, these structural inconsistencies are impactful. Though rarely studied, they yield important insights that could help agencies throughout the country improve their effectiveness.

U.S. states have two main functions for identifying and combating corruption: financial statement audits for various state and local government units, and fraud investigation entities which usually include whistle-blower programs. States can choose either to manage both in-house, or to outsource one or both to external vendors. Specifically, states that keep fraud examination in-house can either situate both functions within the audit agency, or assign fraud investigation elsewhere (in most cases, the state attorney general’s office).

To gauge the real-world implications of these choices, Shirley and her co-authors Renee Flasher of The Pennsylvania State University—Harrisburg and James P. Higgins of LWG CPA & Advisors culled data from state agency websites as well as a sprawling reference guide called the Book of the States. Because records regarding less egregious corruption charges that stay at the state or local level are spotty at best, the researchers relied upon federal corruption conviction statistics from the U.S. Department of Justice (DOJ) as a rough index.

The analysis revealed a clear pattern: States whose audit departments handled both financial vetting and fraud investigations had fewer state and local government officials convicted of corruption, while those that outsourced and/or split the two had a higher number of convictions. This pattern held after the researchers controlled for the ratio of police officers to population, reflecting each state’s general toughness on crime.

Shirley offers two possible explanations for her findings. First, she says “there is more efficiency with the two groups being in closer contact and closer communication” when fraud investigators work within state audit agencies rather than the attorney general’s office or a third-party contractor. This may increase the likelihood of corrupt officials being caught before their misconduct rises to the level of a DOJ indictment.

Second, the united front of fraud investigation and financial audits possibly projects an intimidating image to would-be fraudsters that may prevent them from stepping out of line in the first place. “You’re sending this message of strict oversight, and paying close attention to what’s going on, through the combined structure,” Shirley says. “That’s where we’re saying some of the deterrence benefit is coming from.”

However, she hesitates to say for sure whether her findings are primarily driven by deterrence, increased efficiency in detection or a combination of the two. “With this research design and with the data that we have, we are very limited in making a causation statement and so this is more of an association.”

Shirley suggests that her research into audit agencies may help state and local governments evolve anti-corruption best practices and learn from one another. “Many states and local governments operate independently. Further, they may operate the way they’ve been designed since however long, without necessarily thinking about efficiencies from other places, or good habits from elsewhere that could be adopted.”

Shirley says she would like to delve deeper into the lesser-known inducements and hindrances to government malfeasance such as corruption. A former auditor for KPMG and accountant at JPMorgan, her PhD dissertation addressed corporate misconduct. Currently, her academic research—the present paper is her debut publication—resides at the intersection of accounting and the law. “Most of the studies I’m looking at have to do with misconduct, whether it’s public corruption involving government officials or in the corporate world,” she says.

The first hurdle for corruption researchers to overcome, Shirley suggests, is often incomplete or fractured data. Take the present study as an example. The lack of a central database of state audit practices required Shirley and her collaborators to scour state government websites and hand-collect information. “Part of where we come in with our research is looking at the data that doesn’t exist in a nice form. This is how issues can permeate where nobody’s really looking at it, because nobody can quantify it.”

Shirley’s research concentration feeds into her classroom work, which includes teaching fraud examination to �鶹��Ƶ graduate students. “Overall, the takeaway—and this is what I tell my students in class—is that fraud is real, corruption is real, and it’s something that we have to be more vigilant about tackling.”

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