We are taught not to bite the hand that feeds us. But what happens when someone feels coerced to engage in fraud at the behest of a large client?
For example, take the accounting industry. An “independent” auditor’s job is to safeguard the public interest certifying that a company has accurately portrayed its finances. Yet the audit firm is paid by the company it audits. This can lead to a loss of independence.
When an auditor is paid by a large company to provide an opinion on the fairness of their financial statements, they can be pressured into issuing misleading reports.
Look at the Enron scandal. In 2001, Enron, one of the largest companies in the U.S., disintegrated almost overnight because it fooled investors and regulators alike with its fake holdings and off-the-books accounting. The scandal revealed that Enron’s auditor Arthur Andersen, one of the Big Five public accounting firms at the time, had failed to flag the fraudulent accounting.
Enron paid Arthur Andersen over $50 million in audit and non-audit fees. Driven by the attraction of having such a large and visible client, the partner in charge of the audit possibly succumbed to Enron’s wishes.
The Sarbanes-Oxley Act of 2002 (SOX Act), which stemmed from this financial disaster, introduced enhanced regulations to preserve auditors’ independence.
Even though there are mechanisms in place now to foster auditor independence, what happens when auditors and audit firms are hired by influential clients?
Jayanthi Krishnan and Jagan (Krish) Krishnan, professors of accounting at the Fox School, examined whether client influence at the audit-office level affects auditor resignations from risky clients in their article, “Client influence and auditor independence revisited: Evidence from auditor resignations,” co-authored by Tom Adams, PhD ’16 and published in the Journal of Accounting and Public Policy.
“Our research is not limited to big companies like Amazon and Facebook. For a small audit office in Oklahoma, for example, a small company that dominates its portfolio of clients by paying higher fees than other clients would be considered influential,” says Jayanthi. “We are also looking at clients that are ‘risky’ in the sense that their financials indicate some potential problems.”
How do auditors treat these risky clients—which could account for significant slices of auditors’ revenue streams—in the post-SOX era?
“When auditors are faced with what we call independence risk, they usually have two options: either give in to what the clients want to not lose their business or resign from the engagement, which is an extreme step,” explains Jayanthi.
“If an auditor has controls in place to mitigate this independence risk associated with influential clients, there should be no association between resignations and client influence,” adds Krish.
The researchers found that, on average, auditors are more likely to resign from influential clients, holding true for both large and small clients that are considered influential.
What’s more, they found that the resignations are more concentrated in certain situations, such as smaller audit offices or accounting firms or audit offices lacking specific expertise. So although firms are supposed to have peer reviews and other independence-risk mitigating controls in place, smaller offices may not be able to effectively implement them.
Krish and Jayanthi caution that their research should not be interpreted as meaning that smaller auditors do not respect or follow independence rules.
Krish clarifies, “These auditors take the extreme step of resigning from engagements possibly in response to independence risk. Thus, auditor independence is not impaired. But, because auditor resignations from clients are not really in the interest of the client or the auditing profession, our study suggests that accounting firms should strengthen their internal policies for dealing with independence risk.”
Their study is timely because the U.S. Securities and Exchange Commission (SEC) is currently exploring changes to auditor independence rules that would relax regulations in certain cases.
“While we cannot address the possible impact of upcoming changes, our research shows that influential clients can be large or small,” says Jayanthi. “Accounting firms and regulators should be aware of this.”
Preventing financial scandals and collusions is of the utmost importance to auditors. Many big accounting firms have rules that prevent direct independence conflicts for their personnel. For example, they require new hires to complete independence requirements before they join the organization. Accounting professional standards can also prevent specific employees, and their spouses and dependents, from holding publicly traded shares of a company that is audited by the accounting firm or an audit office.
“These requirements are the first steps to the auditor maintaining its independence. But this study highlights independent behavior by auditors while they are conducting audits,” says Krish.
“The bottom line is that the auditor must maintain its controls against independence risk and retain the client while conducting the audit with integrity. It’s a balancing act for the auditor. And it is this balancing act that causes auditors to resign rather than impairing their independence related to an influential client.”
This article originally ran in On the Verge, the Fox School’s flagship research publication. To check out the full issue of On The Verge: Business With Purpose, click here.