How Requiring More From Auditors Could Backfire

November 29, 2017

Professor Xu Jiang studies consequences of auditing standards

Professor Xu Jiang found greater reporting freedom can reduce bank runs

 

In 2018, the U.S. Securities & Exchange Commission will begin requiring auditors to provide more information about companies’ finances in their annual reports. Xu Jiang is a professor at Duke University's Fuqua School of Business who studies the economic consequences of accounting and auditing standards. Working with Fuqua colleague Qi Chen and Yun Zhang of George Washington University, Jiang created a theoretical model to test the potential impact of the new rule, and found it could have unintended effects on the quality of audits and the amount of effort auditors put in, as well as the efficiency of the investments resulting from their opinions.

Jiang discusses his findings in this Fuqua Q&A.

What’s the motivation behind the new rule, and how will it change auditor reports?

Currently, in principle an auditor’s report is basically a pass/fail. It just indicates whether a firm’s finances are consistent with general accounting principles; whether their accountants are doing their job. But in reality, typically you don’t see failures, because if auditors see the potential for failure, they will talk to the firm and allow them to make corrections that enable them to pass. And beyond the pass/fail aspect, there is very little information in auditors’ reports besides boilerplate language.

The new accounting rule requires auditors to provide more information, including how confident the auditor is about the firm’s financial reporting. This will result in firms receiving a more nuanced score, such as a high pass or a low pass. The Public Company Accounting Oversight Board, which recommends rules to the S.E.C., thinks that providing more information will help investors better understand whether a firm’s financial reports are truly reliable. But we find that it is not necessarily good for either firms or the economy.

How could more information not be a good thing?

Investors use auditor reports in two ways: for informational purposes, and in an insurance role. Investors are looking for information about firms they want to invest in; but they can also seek compensation from auditors if a firm fails after the auditor gave it a passing grade. Requiring auditors to be more explicit about their confidence in a firm could hurt their willingness to give some firms a high grade, out of a desire to limit their exposure to that kind of liability.

With which kind of firms would you expect to see this effect?

It would be most prevalent among industries where the business models are particularly complex; for example in banking or insurance, both of which are often involved with derivatives and other intricate financial instruments. When the business model is that complicated, even if the auditors do their job, the accounting earnings cannot reflect the actual economic earnings very precisely. That uncertainty increases the chances investors will seek repayment from the auditor later on if the economic earnings fall short, so an auditor would be less willing to give a high pass and offer investors more incentive to invest in the first place.

However, when a firm is in a business that is fairly straightforward from an accounting perspective – retail, for example – then we find audit quality will improve with an increase in information, because auditors can be more confident in their findings. Plus, of course, it produces more information that investors can use.

What can the S.E.C. learn from this research?

Changing the rules can always lead to unintended consequences. Our work shows the S.E.C. should give some thought to how this particular rule change should be applied, and that a one-size-fits-all approach doesn’t always work.

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