The Interplay of Client Management and the Audit Committee on Auditor Performance Free

Interactions between company management, the external auditor, and the audit committee all help to shape financial reporting quality. In fact, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999, 7) describes these three main groups as forming a “three-legged stool” supporting responsible financial reporting, with the audit committee being “first among equals … and the ultimate monitor of the process.” In order to further enhance the audit committee's oversight role, the Public Company Accounting Oversight Board (PCAOB) recently issued Auditing Standard No. 16 (AS16), Communications with Audit Committees (PCAOB 2012). This new standard supports effective two-way communication between external auditors and audit committees that is meant to be flexible, timely, and ultimately more meaningful than the “boilerplate” requirements included in prior auditing standards.

The corporate governance literature also recognizes the importance of examining the interrelationships required among these corporate governance members for achieving high-quality financial reporting. However, to date little is known how the effectiveness of certain governance mechanisms, such as additional communication between audit committees and auditors, is influenced by characteristics of the other governance members. And despite reforms aimed at expanding the audit committee's role and authority in overseeing financial reporting, auditors continue to cite the significance of management's role in corporate governance, as well as its ability to exert significant influence during the audit (Cohen, Krishnamoorthy, and Wright 2010).

We recently conducted a study (Brown and Popova 2016) to examine the joint influence of client management and the audit committee on auditor performance. In light of the recent passage of AS16, we were particularly interested in whether auditors are effectively integrating audit committee guidance communicated to the audit team. We focused on the audit performance of senior-level auditors who traditionally have a minor role in evaluating corporate governance but are primarily responsible for executing the audit plan and managing the day-to-day audit tasks. And as noted by Cohen, Krishnamoorthy, and Wright (2002, 589), “If they (audit seniors) do not have a comprehensive understanding of governance factors, they may be insufficiently impounding information on governance.” In this paper, we discuss our theoretical development, experimental design, primary findings, and the main implications for audit firms, companies, and standard setters.

Audit committees are charged with setting clear expectations for auditor performance as part of monitoring the financial reporting process. Interviews with audit partners and managers and research involving current audit committee members indicates that these expectations frequently surround the need for reporting accuracy and accounting conservatism (DeZoort, Hermanson, and Houston 2008; Cohen et al. 2010). In these cases, the increased communication between auditors and the audit committee as recommended by AS16 is likely to create situations in which the auditor must contend with competing motivations to satisfy both management and the audit committee. Indeed, public accounting has been characterized as a system of “complex accountability” in which auditors may feel pressure from multiple sources (e.g., management and the audit committee) whose views and preferences may not always align (Gibbins and Newton 1994).

One factor that likely affects auditor performance when confronted with multiple levels of accountability is the auditor's familiarity with the client. Frequent interactions with management while conducting the audit can lead to heightened levels of familiarity and attachment to the audit client. While familiarity with management and the organization is necessary for auditors to properly plan and execute an audit, prior auditing research demonstrates that increased familiarity can also impair auditors' objectivity and lead to instances where auditors acquiesce to management-preferred positions (Bamber and Iyer 2007; see also Stefaniak and Cornell 2011).

In addition to client familiarity, a second factor likely impacting auditor performance under these conditions is management's incentives to influence the auditor. Much of the information gathered by auditors over the course of an audit is provided directly by management. Auditors may come to rely on management-provided information due to management's role in establishing an effective control environment and in preparing the financial statements. However, management is not an objective information source and, instead, may have incentives to manage earnings and influence the auditor into accepting a more aggressive reporting preference. For example, client personnel may have incentive compensation tied to specific company performance outcomes.

Prior auditing research indicates that the persuasiveness of management-provided information hinges on its perceived credibility. Specifically, information obtained from management is more persuasive when management's incentives for managing earnings are lower than when its incentives are higher (e.g., Robertson 2010). Likewise, auditor risk assessments, evidence evaluation, and likelihood of proposing audit adjustments are each impacted by perceptions of management credibility. We predicted that auditors would account for expected management bias when management's incentives were higher by discounting information consistent with its reporting preference. More importantly, we expected that by discounting management's reporting preference, auditors would be more likely to integrate the additional communication provided by the audit committee when evaluating evidence and forming their initial audit judgments.

On the other hand, when management is perceived as having lower incentives, we expected auditors to be more influenced by management's reporting preference than a competing preference communicated by the audit committee. This expectation is informed by audit theory and related research on client attachment and familiarity, as well as prior studies examining how auditors respond to competing preferences expressed by client management and an audit supervisor.¹ Interestingly, while following the audit committee's communicated expectations should be considered easier when management's incentives are lower because pressure to comply with management's preference is diminished, we predicted that the opposite would occur. That is, under such conditions, we predicted that auditors would actually tend to follow management's requests rather than the preferences expressed by the audit committee because of heightened familiarity and frequent interaction with management relative to the audit committee.

We conducted a controlled experiment to test our expectations on the joint influence of client management and the audit committee on auditor performance. Our participants were 58 external audit professionals with an average of four years of audit experience. The auditor participants were asked to review a case about a fictional audit client and make preliminary recommendations to the audit team on a single audit finding related to potential inventory obsolescence. The auditors received company background information, a summary of non-audited financial information for the current year, and information about the composition of the audit committee. Overall, the background information indicated that the client was successful and the auditors have had no issues of significance in prior audits.

After reviewing the background information, the auditors were presented with facts related to the potential inventory issue compiled by the audit team. The information included a balanced set of items indicative of higher and lower risk of obsolescence that both supported and refuted management's position that the inventory balance is fairly presented “as is.” The full amount of the potential inventory adjustment was beneath the audit team's calculated materiality threshold; however, the result of an adjustment could lead to a debt covenant violation by reducing one of the covenant ratios below an acceptable threshold.² We intentionally chose a subjective audit scenario with qualitative materiality considerations to allow for the audit committee's communication to be influential on auditor performance.

We manipulated two factors in the experiment: (1) Audit Committee Communication and (2) Management Incentives. In the Audit Committee Communication manipulation, approximately half of the auditor participants were provided with additional communication from the audit committee indicating its expectations for the audit, whereas the other half were not given additional audit committee communication. In particular, the participants provided with the additional communication were told that that the company's audit committee focuses on high-quality financial reporting such that the committee values accurate financial statements, even at the detriment to financial ratios or analyst forecasts. The communication further stated that the audit committee expects that any audit differences discovered in the course of the audit will be recorded by management and not waived by the audit team.

We manipulated Management Incentives as either high or low, based on personal and corporate incentives that management often has to influence auditors. In the high incentives condition, approximately half of the auditor participants were told that, in addition to the corporate incentive to avoid a debt covenant violation, management also has incentive compensation tied to receiving a clean audit report with no recorded audit adjustments. In the low incentives condition, the other half of the auditor participants were told that the company had secured a debt covenant waiver for the period under audit, substantially reducing management's corporate incentives to influence the auditor. Crossing these two factors yielded four versions of the case: (1) Audit Committee Communication—High Incentives, (2) Audit Committee Communication—Low Incentives, (3) No Audit Committee Communication—High Incentives, (4) No Audit Committee Communication—Low Incentives.

We captured auditors' responses for the likelihood that they would recommend an adjustment to management's inventory obsolescence estimate on an 11-point scale with endpoints labeled “very unlikely” and “very likely,” which was our primary dependent variable. We also requested that the participants compose a brief audit memo to document the evidence considered when forming their adjustment decision. Consistent with predictions, management's incentives moderated the effectiveness of additional audit committee communication (see Figure 1, Panel A for descriptive statistics and a depiction of the results). Specifically, auditors were more influenced by the audit committee's preference for more conservative reporting, and therefore more likely to recommend an inventory write-down, when management's incentives were higher (mean = 8.5) than when its incentives were lower (mean = 5.8). We also found an incremental benefit of audit committee communication when management has greater incentives to influence the auditor. In particular, auditors in the high management incentives condition were more likely to propose an audit adjustment in the presence of additional audit committee communication (mean = 8.5) than in its absence (mean = 6.8). However, when management's incentives were lower, we found no additional benefit of additional audit committee oversight, and auditors were least likely to propose an audit adjustment (i.e., the auditors were more complicit with management's request to accept the inventory balance “as is”).

The proposed audit adjustment results were further supported by an examination of the evidence items the auditors documented to arrive at their decision of whether to accept management's inventory obsolescence estimate. For this analysis, we computed a net evidence score by subtracting items documented supporting an inventory write-down from items documented that supported a decreased risk of inventory obsolescence. Thus, a positive score indicates that more items supporting management's reporting preference were documented than items supporting an inventory adjustment. As shown by the negative scores in the high Management Incentives condition depicted in Panel B of Figure 1, auditors were more likely to document evidence items opposing management's reporting preference when its incentives to influence the auditor were high compared to when management's incentives were low. Importantly, auditors were most likely to oppose management's position when its incentives were high and when accompanied by additional audit committee oversight (mean = −1.2). Cumulatively, our results indicate that management incentives and audit committee communication influenced not only the conclusions that auditors reached, but also the path auditors used (i.e., the evidence considered) to reach those conclusions.

The results of Brown and Popova (2016) provide important insights into how auditors integrate communicated expectations from the audit committee when performing an audit. In particular, the auditors in our study who were provided with additional communication followed the audit committee's guidance by requiring a more conservative inventory obsolescence estimate and also documented evidence that was more critical of management's expressed reporting preference, but only in conditions in which management was viewed as less credible. Given the recent passage of AS16, our results are both timely and indicate that communication between auditors and audit committees that is informal and flexible can have a positive influence on the financial reporting process. It is therefore incumbent on audit firm leaders to continuously work with audit committees to set forth their own communications protocol, as well as to ensure that their engagement teams understand the critical importance behind these communications. Because these positive effects diminished when management's incentives were lower, we also recommend that audit firms continue to impress upon their professionals the need to remain professionally skeptical by critically assessing information provided by management, especially evidence consistent with its reporting preferences. Understanding management incentives is integral to risk assessment and the design of the audit plan. Thus, audit firm leaders should consider holding preliminary meetings with the engagement team and the audit committee to solidify an understanding of these incentives and to allow the engagement team to properly tailor its audit plan in response to identified risks and incentives.

Our theory proposes that management's influence stems, at least in part, from auditors' frequent interactions and familiarity with management. Thus, companies and audit firms may wish to increase the frequency of interactions between auditors and audit committees in order to enhance the audit committee's influence. While such interactions are likely to increase as a result of AS16, the audit process may further benefit from increased exchanges that include senior-level auditors who are primarily responsible for executing the audit plan. Overall, the findings from Brown and Popova (2016) highlight how the interrelationships among management, the audit committee, and the auditor are necessary to achieve high-quality financial reporting. Audit firms, companies, and regulators can better address how to enhance the audit committee's oversight role and improve financial reporting quality by recognizing management's role and significant influence on corporate governance.