Splitting audit responsibility can protect accounting firms against lawsuits, though making them more likely to get fired

Based on the research of Jaime Schmidt

“United we stand, divided we fall” doesn’t always work for auditing. Sometimes, it makes sense for an accounting firm to divide the load, such as when a multinational client has subsidiaries in other countries, where local auditors can provide specialized expertise.

Sharing part of an audit might also happen if a company has an equity investment in another business that wants to keep its long-standing auditor.

Ironically, though, regulations on whether auditors can inform companies and shareholders that they’ve divided audit responsibility are … divided. U.S. standards allow auditors to disclose divided responsibility in the audit report, but international ones don’t.

When a U.S. auditor discloses divided responsibility, the auditor does not have to supervise the other auditor’s work. It simply states that its audit opinion is based on its work and the other auditor’s work.

But the International Auditing and Assurance Standards Board (IAASB) does not allow such disclosure. Instead, it requires the signing auditor to supervise the other contributing auditor. The IAASB contends that disclosing divided responsibility could reduce accountability — by making others hold the lead auditor less accountable if an audit goes wrong.

Which side’s right? In new research from Texas McCombs, Jaime Schmidt, a professor of accounting, clarifies the benefits and risks for auditing firms. She renders a split decision, finding that dividing responsibility makes firms less likely to get sued but more likely to get fired.

“We’re trying to shed light on whether or not rule makers should allow accounting firms to disclose divided audit work, to see whether it really does change people’s perceptions and make them less accountable,” says Schmidt.

A Litigation Shield

With Bethany Courson of the University of Mississippi, Keith Czerney of the University of Missouri-Columbia, and Anne Thompson of the University of Illinois Urbana-Champaign, Schmidt examined 6,437 restatements or revisions of a company’s previously issued financial statements, announced from 2000 to 2018.

Because restatements correct material errors, they’re more prone to draw lawsuits from investors, because inaccurate information often results in investor financial losses.

The researchers found, however, that both companies and auditors were significantly less likely to get sued when the lead auditor disclosed divided responsibility in the audit report.

Only 17% of companies that received audit opinions with division of responsibility language got sued by shareholders after a restatement, compared with 25% of those without division.
When litigation did happen, only 5% of auditors who disclosed division of responsibility were named as defendants, versus 14% of those who did not divide.

“Dividing work does seem to provide some litigation risk protection and makes lead auditors less accountable,” Schmidt says. “So, the evidence suggests that the international regulators were right.”

Downside of Disclosing Division

However, splitting audit work had a potential cost: losing accounts. During the year after an audit, clients dismissed 11% of auditors who divided responsibility, compared with 7% of those who did not divide it.

Auditors were more likely to get dismissed if the divided audit involved consolidated subsidiaries. That suggests to Schmidt that clients prefer standard and consistent language for both a company and its subsidiaries, so that they don’t stand out in comparison to competitors.

That result helps to explain why so few auditors choose to disclose divided responsibility, says Schmidt: only 1.46% of audits she studied.

“For auditors, the risk of being dismissed is a big one,” she says. “They don’t want to lose a client or source of revenue.”

But overall, she suggests, firms shouldn’t fear splitting responsibility when it otherwise makes accounting sense.

“The litigation protection probably is a bigger benefit than risk of dismissal,” says Schmidt. “The protection it provides could be worth it — though it probably depends somewhat on the size of the client.”

“The Consequences of Dividing Responsibility for an Audit Engagement” is published in Auditing: A Journal of Practice and Theory.

Story by Deborah Lynn Blumberg