Do Managers Successfully Shop for Compliant Auditors? Evidence from Accounting Estimates

Do Managers Successfully Shop for Compliant Auditors? Evidence from Accounting Estimates

Mark DeFond, Jieying Zhang, Yuping Zhao

February 06 2019

Financial reports are important tools used by investors to evaluate company performance and future prospects. Auditors safeguard the integrity of the financial reports by providing reasonable assurance that financial statements are fairly presented in accordance with GAAP. In the U.S. auditors are required to issue a modified audit opinion when there is substantial doubt about the company’s ability to continue as a going concern. Prior research documents significantly negative market reactions and negative consequences for executives for companies that receive modified audit opinions. As a result, managers have incentives to “shop” for auditors who are willing to issue “clean” (i.e., unmodified) audit opinions.

Historically, regulators have been concerned about opinion shopping since the 1960’s. The SEC defines opinion shopping as “the search for an auditor willing to support a proposed accounting treatment designed to help a firm achieve its reporting objectives even though that treatment might frustrate reliable reporting”. Thus, regulators’ concerns about opinion shopping are not limited to literally shopping for a clean audit opinion. The broader concern is that managers are able to find an auditor who will allow an accounting treatment that achieves an opportunistic reporting objective. However, prior research on opinion shopping has focused almost exclusively on managers’ attempts to switch auditors in order to avoid receiving a modified audit opinion, and fails to find evidence of successful opinion shopping. We extend the opinion shopping literature by examining whether managers successfully shop for auditors who will allow questionable accounting practices.

Accounting estimates are used pervasively in preparing financial reports. For example, estimates are required to arrive at the lives and salvage values of long-term assets, for the computation of reserves, and in the recognition of revenues. Because accounting estimates are inherently subjective, they allow management a great deal of discretion, which provides an opportunity for managers to propose estimates that meet their reporting objectives. Since auditors are aware of this discretion, they are likely to challenge manager-proposed accounting estimates, which creates an incentive for managers to shop for an auditor who will allow their opportunistic accounting treatment. The subjective nature of accounting estimates also means even well-intentioned managers and auditors can legitimately disagree over the proper accounting, providing managers with a justification to shop for a more compliant auditor after the incumbent auditor objects to the change.

Using manually collected data from SEC filings, we find an increase in both the magnitude and frequency with which managers use accounting estimates to increase reported income. We further find that companies who use estimates to increase income following an auditor switch are more likely to subsequently restate earnings downward, receive fewer going-concern opinions (by reporting higher earnings), experience lower abnormal stock returns in the years following the switch, and tend to switch auditors during the fourth quarter or following a disagreement with the predecessor auditor. These findings provide evidence that managers successfully shop for more compliant auditors. We also find that managers’ switch decisions maximize the ex-ante likelihood of reporting income-increasing changes in estimates, and that companies are more likely to switch to auditors whose clients have a greater likelihood of reporting income-increasing changes in estimates. Taken together, we provide evidence that auditor-switch companies successfully shop for compliant auditors that will allow the use of opportunistic accounting that meets management’s reporting objectives.

Authors

Real name: 
Research Member
University of Southern California
Real name:
Jieying Zhang
Real name:
Yuping Zhao