In 2008, The New York Times reported that Big Four accounting firm KPMG was under investigation for misrepresenting audit information with mortgage client New Century Financial. Behind the scenes, KMPG’s in-house specialists had documented information that ran counter to the overly rosy financial picture the KMPG auditors painted to the world about New Century. The audit partner ignored the specialists’ warning and allowed New Century to file its financial statements without fixing the problems identified by the specialists. New Century later restated its misleading financial statements, leaving the accounting firm potentially liable for millions of dollars.
This KPMG example is on the extreme end of the scale, but it is not the only example of such a fiasco. My own experience as a former auditor sparked my interest in the relationship between audit teams and valuation specialists, and whether auditors are using their specialists most effectively.
At one point, I had a client who made more than 200 acquisitions over a three-year period. Companies are required to record what they pay as a premium when they buy another company. If my client pays more for a company than what the company is worth (otherwise known as its real value—assets minus liabilities) that difference is the premium, an amount that must be recorded and will be audited every year going forward to determine if the premium is still worth its recorded price.
After auditing more than 200 estimates from this client, I realized the degree to which the number on a company’s balance sheet is plucked out of thin air—not just with this company, but probably in the cases of many other companies as well. Audit firms bring in specialists to help with areas outside of traditional accounting and auditing expertise, and we used valuation specialists at my firm as well. With their help, my process throughout those three years got easier. Nevertheless, even with a master’s in finance, I felt like the working relationship was a bit disjointed as I struggled to pick up bits and pieces of specialist knowledge wherever I could.
I carried this interest in maximizing auditors’ use of their specialists’ knowledge through to my dissertation, where I examined how auditors respond to a “relational cue”—the additional details or commentary from specialists that indicate where a client might be making aggressive assumptions, or estimating in their favor. The cue is similar to a hint from the specialist about how things might fit together in the bigger audit picture.
Across two experiments, participants evaluated a biased estimate (for example, a client overestimated in his favor) that either included or did not include a relational cue from a specialist. The two experiments also included two risk indicators: client source credibility and engagement risk, or the risk to an accounting firm generally as the result of an audit.
Higher risk, greater auditor motivation
The findings from both studies suggest that the presence of risk seems to trigger a greater motivation on the part of the auditor to utilize the specialist’s work. The auditor seemed only to fully utilize the specialist’s commentary when there was an issue of client source credibility or some other red flag.
The idea behind using specialists to begin with is that they’re going to find things that you may not notice, regardless of the risk level. The fact that the cue was helpful to the auditor when he or she paid attention to it implies that we can help auditors get better at evaluating these very complex estimates that include so many assumptions and moving pieces.
Avenues for future research
Understanding how audit teams interact with specialists creates several avenues for future research exploration. First, if risk gives auditors greater motivation to dig deeper into specialists’ work, what are ways that we can motivate them to take specialist findings into account initially and not solely in high-risk situations? Second, can these findings on relational cues and auditor motivation be applied to other team settings within an audit? Reviewing the work of others on a given team, even if it’s not on the same equal footing as auditor and specialist, may be beneficial to the overall output and add value to the team environment.
The nature of the accounting field itself is changing, moving away from this idea of accounting as a historical record and more toward the realm of valuations and estimates. How will auditors approach this new future when the old ways of working are not valid anymore? Understanding the role of specialists and the value they can add to an audit team is an important start, and one that should not be underestimated.
Read the paper “When Do Auditors Use Specialists’ Work to Improve Problem Representations of and Judgments About Complex Estimates?” published by The Accounting Review.
Emily Griffith is an assistant professor in the Department of Accounting and Information Systems at the Wisconsin School of Business.