Two recent studies we co-authored found that auditors with valuable expertise in a specific class of complex transactions and accounts improve audit quality.
However, our findings show that industry expertise is not sufficient when auditing complex accounts. Instead, gaining task-specific expertise is highly valuable when auditing specific complex accounting issues that transcend industry boundaries.
Both studies examine the audit of fair value reporting and mergers and acquisitions. Errors in the accounts associated with these transactions are prevalent and can have significant ramifications for company shareholders, creditors, employees, management and other stakeholders. These accounts and transactions are considered challenging to audit because they are complex and involve subjectivity, technical difficulty and consideration of future outcomes. Inspections by the Public Company Accounting Oversight Board repeatedly identify deficiencies in the audits of both types of accounts. Although the Financial Accounting Standards Board has been working to reduce unnecessary complexity in financial reporting, FASB recognizes that “simplification is not easy” and, as a result, certain transactions remain challenging to report and audit.
Given that simplification of accounting rules is not always achievable, we propose that an alternative solution to simplifying accounting standards is to engage with auditors who possess expertise in auditing especially complex transactions. We hypothesize that auditors who frequently encounter a similar class of accounts can develop task-specific expertise as they can leverage specific first-hand experience to gain knowledge, develop custom audit methodologies, and conduct effective audit procedures that lead to improved audit quality.
Our study has implications for audit clients and auditors alike. Auditors should consider focusing on gaining task-specific expertise. Clients with significant fair value assets and liabilities and those with an acquisitive strategy should consider switching to auditors with expertise in these areas.
The first study, published in The Accounting Review (co-authored by Jaehan Ahn of Northeastern University, and us, Udi Hoitash of Northeastern University and Rani Hoitash of Bentley University), examines auditors’ fair value expertise. The study finds that clients of auditors with expertise in Level 3 fair value estimates produce higher audit quality related to these accounts. We measured quality in several ways. For example, we saw lower audit quality when the financial statements contain an error (a misstatement) that requires the reports to be corrected. We found that firms with fair value expert auditors have less fair-value-related misstatements and are less likely to receive comment letters that pertain to fair value reporting from the Securities and Exchange Commission. We also reported that the extent of auditor fair value expertise is associated with more value-relevant fair value disclosures to stock market participants.
Engaging with a fair-value expert auditor can be highly beneficial to public companies with significant fair-value Level 3 assets and liabilities. Auditors with fair value expertise can contribute significantly to the credibility and usefulness of FV disclosures.
The second study, forthcoming in Auditing: A Journal of Practice and Theory (co-authored by Ronen Gal-Or of Bentley University and us), is focused on mergers and acquisitions. Likewise, we found that auditor M&A expertise is associated with fewer M&A related misstatements. However, these benefits accrue only to firms that operate in industries with complex accounting. We found that in certain cases, M&A expert auditors are able to pass some cost savings to their clients during acquisition years and that clients that engage in M&As are more likely to switch to these auditors.
Mergers and acquisitions are complicated events that can give rise to costly misreporting. Our results suggest that firms with an acquisitive strategy that engage with M&A expert auditors experience can improve their M&A-related audit outcomes.
