LAWRENCE — It seems like common sense that an audit committee might want to include individuals who have accounting experience. That’s not always the case.
“It’s not necessarily that auditors are acting nefariously when they over-audit. It’s just that people respond to incentives, and auditors have an incentive to protect their reputations and avoid inspection findings,” said Mike Wilkins, the Larry D. Horner and KPMG Professor of Accounting at the University of Kansas.
His article "Audit Committee Accounting Expertise and the Mitigation of Strategic Auditor Behavior" proposes such expertise helps reduce information irregularities between the auditor and the client, thereby limiting auditors’ ability to over-audit and under-audit. The study is published in The Accounting Review.
“All of these organizations have audit committees. If you truly are interested in trying to ensure that the quality of the audit work is what you want it to be, it’s really important you have the right type of individuals on the committee,” said Wilkins, who co-wrote the article with James Hansen, Ling Lei Lisic and Timothy Seidel.
Wilkins’ team conducted tests using three different settings: two associated with over-auditing and one associated with under-auditing. The study reveals that when audit committees have accounting expertise, clients: 1) pay lower fees when changes in standards decrease required audit effort; 2) pay a smaller fee premium when material weaknesses are remediated; and 3) have a reduced likelihood of restatement when audit market competition is high.
“There’s a tendency for auditors, particularly in large firms who are inspected every year, to over-audit,” he said.
“This is to make sure they’re doing things as well as they’re able to at all times, when you could have instances where maybe some of the extra work they’re doing is not entirely necessary. One of the jobs of the audit committee is to monitor the auditors. Technically, it’s an active role, but it’s not like the committee is physically there actually watching what the auditor is doing.”
The research relies on the concept of credence goods, which are defined as those with qualities that are difficult or impossible to evaluate even after a purchase has occurred.
For comparison, Wilkins uses the analogy of someone who needs to get their car repaired.
“You take your car in, and the person who is repairing your car is the expert. They also are the party who is selling you the service. You’re not the expert. You can’t observe what they’re doing. Even if you could, you might not have any idea whether the work is good or not. So you have to trust them to explain what you need and to charge you honestly for it,” he said.
Similarly, an audit committee is not watching someone audit everything. But if the committee contains a person with accounting expertise, then collectively this group should comprehend more about what is actually needed.
“Plus, the auditor obviously knows who’s on the committee,” Wilkins said. “So if the auditor knows that some of the committee members are accounting experts, then he might be less likely to over-audit or not audit enough.”
Why wouldn’t companies consider including accounting experts on their audit committees?
“I don’t think it’s likely they actively would avoid it. It’s just that they might not understand the benefit of having someone on there who has accounting expertise verses other types of financial expertise,” said Wilkins, an expert in auditing research who came to KU in 2017.
Among the interesting revelations in his study is the results in certain situations apply more for smaller firms than for the Big Four accounting firms (Deloitte, Ernst & Young, KPMG and PwC).
“Auditors work hard to uphold their reputation. That is a very strong incentive from their perspective,” he said.
“But smaller audit firms are generally less monitored by factors related to litigation and reputation. So it’s even more important in those situations that the audit committee is working toward doing what it needs to be doing.”
Wilkins hopes this paper yields both academic and practical implications.
He said, “What our results show here is that — particularly for companies that are not audited by the large audit firms — it really adds a lot of value to have somebody on the audit committee with significant accounting experience.”
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