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Some experts suggest that mandatory joint audits might help to improve the reliability of accounting numbers. But what are the additional costs involved and is the case for joint audits supported by the evidence?
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External auditors have certified corporate accounts for several decades, encouraging financial discipline from CEOs and CFOs who have an incentive to manage earnings. Those auditors provide independent oversight of an organization’s financial reporting and the processes involved. They go through financial records and systems, offer opinions on whether financial statements are free from material misstatements, and produce a report based on their findings. Depending on the regulatory environment, they may have a statutory duty to report certain findings to the authorities. There may also be a legal duty owed to third parties affected by the financial reporting of the audited organization. In addition, firms providing auditing services may provide other services, such as management consultancy, for example.
While there have always been occasional corporate misdemeanors, overall, the auditors have fulfilled their role well over the last century. Since the beginning of the millennium, however, financial scandals have shaken investor confidence in the US and in Europe. Moreover, the 2008 financial crisis has led investors to doubt audit quality and, hence, the reliability of the accounting numbers disclosed by public companies.
As the dust settled following the 2008 financial crisis, governments, practitioners and academics, hurried to identify the causes and develop measures that might help avoid similar problems in the future. Auditing was one area of financial services that came under scrutiny. As commentators noted, in several cases auditing firms provided a clean bill of health to firms that subsequently ran into severe difficulties. One suggested solution was mandatory joint audits, in order to provide more rigorous oversight. However, as Paul André and Alain Schatt, professors of accounting at HEC Lausanne, and their colleagues show, two auditors are not necessarily better than one.
André, Schatt and their co-authors decided to investigate the impact of joint audits – on audit costs primarily, but also in terms of audit quality. To do this the authors looked at 2007–2011 data for 210 French firms where joint audits are compulsory, and also for 142 Italian companies, and 279 firms in the UK.
The authors predicted that joint audits would prove more costly, partly due to additional costs involved in coordinating the actions of the two auditors. Plus there are the costs associated with compensating for the risk that an auditor might be held accountable for irregularities that emerge later on. Although in a joint audit one auditor usually adopts the lead role, theoretically bearing the greater risk, in practice both firms may act cautiously, charging fees as if they were bearing equal risk.
All things being equal, in countries where the auditing regulatory regime is tighter and the risks of legal liability greater, the fees charged by auditors will be higher to compensate. Thus audit fees in France would be similar to those in Italy, which has a similar legal regime, but lower than in the UK, which has a more exacting legal regime.
The results were telling. French companies pay on average 34.9% and 61.3% higher fees than UK and Italian companies, respectively. Where French firms used two auditors that were not from the “big four” (the four largest international professional service companies), fees were a little over 50% greater than for Italian or British companies with non-big four auditors. If one auditor was a big four firm, then French firms paid about a quarter more than UK firms with a big four auditor, and about 55% more than Italian companies audited by a big four firm. Where a French firm appointed two big 4 auditors, the difference is even greater.
It is possible, of course, that joint audits provide a better quality service and merit an associated increase in costs of some magnitude. The authors also investigated this possibility. As it is difficult to assess quality in this situation, they used earnings management, and in particular abnormal accruals, as a proxy. The logic being that managers can try to manage reported earnings to achieve their own goals, whether for maximizing bonuses, protecting their position, or bumping up share prices.
Theoretically, auditing’s monitoring process should reduce the incentive to manage earnings. With better audit quality, there should be less earnings management as signalled by discretionary liabilities arising from management decisions. However, an examination of the earnings management data suggests that additional costs cannot be attributed to improved quality. This does not mean that there are no additional benefits, but further research is needed to establish what, if any, they might be.
What the research does show, however, is that joint audits cost significantly more than single firm audits. Audit fees are higher in France than in both the UK and Italy, an unexpected finding based on the relative strength of the legal regimes. With many other factors controlled for, it seems highly likely higher costs are due to the joint audit requirement.
Given the findings, it might be time for supporters of joint audits to reconsider the cost-benefit equation of this expensive arrangement. Maybe the case for joint audits doesn’t add up, after all.
Related paper: Are Joint Audits Associated with Higher Audit Fees? European Accounting Review, Vol. 25, No. 2, 245–274. Paul André, Géraldine Broye, Christopher Pong & Alain Schatt (2016)