Auditors Don’t Always Use Their Powers for Good

Posted by Jeff Pelliccio on Jan 4, 2019 9:00:00 AM

In ICS insights, Job Trends, Candidate, Accounting and Finance

According to a new and recently released academic study, the combination of high levels of executive compensation, along with accounting expertise, can significantly increase the risk of a misreporting regarding financial reporting. For example, when a chief executive, which includes the finance officer, of a company or corporation has experience as a manager or partner at an audit firm, and if they receive an incentive to misreport, then the chances of a misstatement in a financial statement are increased significantly. This was concluded based on research done over a decade by three accounting professors with over 3,000 different public companies. The report’s authors came to the conclusion that if an executive had prior experience in an audit firm, they could opt to use that experience to try and avoid adjustments or hide misstatements when an auditor discovered a misstatement, thus resulting in misreporting. 

This is a finding that is slightly contradictory to the situations that began the Sarbanes-Oxley Act, which required that there be individuals in place with more accounting expertise in audit committees and in the C-suite. The authors of the new study, which is set to be published in the American Accounting Association academic journal, has acknowledged that research and practice have worked to establish that it is necessary for there to be a significant knowledge of financial reporting and accounting to ensure reliable financial reports.

While keeping the above assumption in mind, the three people who worked on the study performed it to figure out if there may be a “darker side” to this type of expertise. The team looked specifically at whether or not an incentive such as executive compensation levels could spur these actions.

What the study discovered was that when auditing backgrounds were not present in a top management official, and the companies where the pay to the executives was over the median or at 75 percent, they were four percent more likely to experience misreporting compared to a company where the pay was somewhat low, or at 25 percent. But when executives had an audit background, then the payments that were paying higher were up to 30 percent more likely to wind up having misstatements when compared to the lower-paying companies.

The research that was done actually points out that the actual auditing process alone among top executives in a company were not assorted with any altering in the likelihood of a misstatement. According to the report, the increase was seen in association with higher amounts of executive compensation.

It is required by auditing standards for the auditors to think about executive competence when they are assessing the actual risk of a misstatement occurring. However, the language actually focuses the auditors on the risk of a misstatement that is associated with a lack of competence, according to the authors of the report.

There is no one telling an auditor to actually believe that the executive team at any client company is attempting to outsmart them in some way. However, the authors have provided evidence of the possible downside to the management characteristic that is considered to be beneficial in auditing standards, according to the report.

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