Auditors’ reputations linked to client portfolio, study finds

Author: Melissa Jackson

It’s an ongoing challenge for the average consumer to accurately assess the quality and value of professional service providers, whether it’s a mechanic or a medical professional, a real estate agent or a plumber, an auditor or a financial planner.

For most, the divining rod is reputation. The importance consumers place on reputation influences how service providers do business in order to manage their image.

For firms that perform external audits, strategic reputation management likely involves charging riskier clients a premium and ensuring their clients do not make reporting decisions that could reflect badly on the audit firm.

Zach Kowaleski 2018 Web
Zachary Kowaleski

It could also mean that auditors are selective when it comes to who is in their client portfolio and actively screen out companies whose past or potential future behavior might harm an auditor’s reputation. That strategy is what the University of Notre Dame’s Zachary Kowaleski and a group of researchers set out to explore in their paper “Auditors are Known by the Companies They Keep,” published in the Journal of Accounting and Economics. The paper is co-authored by Jonathan Cook of the Public Company Accounting Oversight Board, Michael Minnis of the University of Chicago, Andrew Sutherland of MIT and Karla Zehms of the University of Wisconsin.

“The central hypothesis of our paper is that an auditor’s reputation is in part formed by its client portfolio — auditors are known by the companies they keep,” they wrote. “Producers with a reputation for providing high quality services to high quality clients can, in turn, charge a premium.” They also propose that auditors with reputation-sensitive clients are least likely to accept or keep others with high misconduct risk.

Kowaleski, an assistant professor of accountancy at Notre Dame’s Mendoza College of Business, likens it to the Aesop’s Fable about a man who, when in the market to buy a donkey, took time to observe how his potential purchase behaved with the rest of the animals in his herd. The donkey immediately made a companion of the most idle donkey in the stable, so the fable goes, and the man returned the animal to the seller, noting that it would act the same as the one he chose for its companion.

“The moral of the story: You are known by the company you keep,” Kowaleski said. “In this study, we demonstrate that this also appears to be true of auditors. We show that an auditor's clients have similar misbehavior profiles that are unrelated to audit work. Furthermore, we observe evidence that auditors protect their reputations by avoiding clients who could harm their reputation.”

An auditor’s reputation, he noted, can take a hit when its client is caught behaving illegally or unethically. “In 2016, KPMG received scrutiny in response to the Wells Fargo account opening scandal even though Wells Fargo financial statements were not materially misstated,” Kowaleski said of the company’s acknowledged awareness of the fake customer accounts created by bank employees.

To study how reputation concerns factor into auditor-client relationships, the researchers aggregated more than 1.2 million adviser records from the U.S. broker-dealer market between 2001 and 2017. They also created measures for auditor misconduct disclosures and auditor reputation sensitivity and examined auditor’s client acceptance and continuation decisions.

Newly formed relationships between auditors and clients offered the researchers one window into the question of whether the existing clients in an auditor’s portfolio and newly acquired clients share a similar track record of misconduct behavior. The researchers theorized that if new client misconduct has no litigation risk, or the risk is such that auditors can mitigate it simply by charging a premium, no relationship would be found. But even controlling for a number of factors, they found “an economically and statistically significant” relationship. They also found that “audit-client pairs that are mismatched with respect to misconduct separate sooner than other pairs.” In fact, auditors with high reputations and clients with high misconduct had the shortest of all relationships.

Some auditors cater to clients who are particularly concerned with their auditor’s reputation, such as a bank or IPO, and this concern is reflected in who those audit firms opt to add or remove from their client portfolio. “Thus far, our evidence indicates that both audit firms and individual audit offices avoid high misconduct broker-dealers when they have reputation-sensitive clients in non-broker-dealer markets,” Kowaleski said.

The study revealed higher misconduct rates among broker-dealer clients whose auditors did not also serve bank clients. This suggests that “misconduct matching stems from reputation concerns rather than specialization,” the researchers wrote. They also found that even if they eliminated misconduct such as fraud or forgery as well as clients whose audit risk is inherently higher, the results were the same, indicating that reputation concern and not simply litigation risk was a factor.

Their analysis of the reputation management aspect of audit-client relationships also revealed something unexpected. “We were surprised to find that an auditor’s reputation for accepting high-misconduct clients predicts their new clients’ future misconduct,” Kowaleski said. While he and his co-authors stress that it should not be interpreted causally, they found that clients matching with lower reputation auditors have a higher rate of new misconduct incidents in the next year. “While this finding does not discern between sorting and treatment mechanisms,” they wrote, “it could provide a useful reference point for the 56 percent of Americans who rely on financial advisers as their conduit to engage the financial markets.”

Kowaleski, who studies the effect of the institutional setting on behavior, says their analysis also helps academics “parse apart two theories that often move together — reputation and litigation risk — emphasizing that reputation is important on its own.” He adds that it could be helpful to regulators concerned with financial misbehavior in the broker-dealer industry, as it illuminates an "unintended consequence of audit mandates: non-discerning auditors emerge to serve clients with low endogenous demand for auditing."

Originally posted on Mendoza News.