Could shared cultural origins make a difference to audit quality? Audits take an objective look at accounting policies and financial reporting, don’t they? That may be so but, according to new research, similar characteristics – or ‘cultural proximity’, as the authors put it – between audit engagement partners and CFOs could produce better audits.
Academics in Australia and New Zealand undertook the study, Audit Quality: An Analysis of Audit Partner Cultural Proximity to Client Executives, asking whether cultural affinities help produce better audit outcomes. For this, they used family names as a proxy for cultural similarities. The names of audit partners and executives in US companies were found using data from the Public Company Accounting Oversight Board (PCAOB). Ancestry.com, a popular genealogy website, was then used to see if the names had the same origins.
'Cultural proximity between auditors and CFOs has substantial impacts on audit quality'
Flags of quality
Once matched pairs were found, the researchers then checked them against flags for accounting quality, such as accruals management, accounting restatements, accounting conservatism and going concern statements. The research included 2,082 auditor-CFO pairs and 2,034 auditor-CEO combinations.
While the auditor-CEO relationship yielded little of note, researchers found lower levels of earnings management, less chance of restatement, more accounting conservatism and more going concern statements at companies where the CFO and audit partners had names from a similar background.
‘We provide some of the first evidence that cultural proximity between auditors and CFOs has substantial impacts on multiple aspects of audit quality,’ the authors write.
The research follows mounting evidence that the personal attributes of executives and audit partners have an impact on outcomes. The authors point to a piece of recent research showing how the quality of audit partners can affect underpricing in initial public offerings. Another paper suggests individual auditor partner quality, determined by education and experience, might affect audit outcomes.
Elsewhere, an investigation revealed how narcissism in CEOs is associated with ‘over-investment’ and lower profits. (Intriguingly, this study used the size of a CEO’s signature as a proxy for narcissism.)
Proximity breeds connection
But research has so far ignored the cultural links between auditors and client executives. The authors, Anh Viet Pham, Mia Hang Pham and Cameron Truong (of Newcastle, Massey and Monash business schools) believe cultural proximities are important because they could ‘breed connections’ and ‘facilitate cooperation’. They, in turn, could ‘enhance both the quantity and quality’ of data shared between CFO and auditor, which would help overcome the ‘asymmetric information’ flows that plague audit relationships.
In other words, close cultural links should draw auditors closer to CFOs, which should, in turn, help engagement partners access better data about their clients.
There are strong reasons for examining auditor-CFO relationships, say the authors. Firstly, most studies of auditor independence focus on client companies hiring former audit partners, or auditors and executives attending the same university. This latest research adds a new dimension to the understanding of this key relationship.
‘We document that interpersonal factors between auditors and CFOs materially affect audit outcomes,’ write the authors.
Close cultural links should help engagement partners access better data about their clients
The research also helps build a better understanding of the role of CFOs at a time when academic interest tends to concentrate on chief executives. The authors note that the research 'adds to a stream of research that emphasises the necessity to consider corporate contexts in which CFOs may exhibit particularly strong influence on corporate decision-making'.
Lastly, the findings support arguments made by the PCAOB that ‘audit partner disclosure might be informative in understanding audit quality’.
The authors acknowledge the possibility of close cultural relationships going wrong. ‘For example, cultural proximity might make the professional relationship cosy, thereby impairing the independence of auditors,’ they write. Cultural proximity might also induce ‘group think’ and handicap work in places that involve innovation and problem-solving.
However, while the authors concede that these special relationships could go awry, they also conclude that their findings tend to show cultural proximities produce positive audit outcomes.
The study could be better. The academics acknowledge that the PCAOB has only required identification of auditors since 2017; a larger data set going further back in time could produce alternative results.
Also, the study looks only at public companies. The situation at unlisted firms may be different.
The research also helps build a better understanding of the role of CFOs at a time when academic interest tends to concentrate on chief executives
It’s worth bearing in mind, too, that almost all the auditors in the study came from Big Four firms. It’s possible that the results may vary for auditors from outside the Big Four.
The authors also acknowledge that unidentified cultural links may be at play. Though their statistics rule out age and gender as key factors in audit relationships, future research could ‘shed light on the specific channels through which cultural proximity affects information flows between auditors and CFOs’.
Nevertheless, the authors stand by their findings. ‘We find that auditor-CFO cultural proximity is associated with a lower level of accruals earnings management, a lower level of income-increasing management, a lower likelihood of restatements and a higher level of conditional conservatism,’ they write.
The big question may be what to do with the findings. Certainly, they may bolster regulatory moves to require more disclosure about individual auditors. The authors say that their research may also have implications for the way audit firms assign partners to specific clients.
That said, using cultural affinities as a yardstick for appointments might take audit firms into sensitive territory.
More likely, this research will provide a springboard into further investigation of professional relationships, how they work and how to avoid obvious pitfalls.
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