07 February 2019

ECGI: Do managers successfully shop for compliant auditors? Evidence from accounting estimates

The paper written by Mark DeFond, Jieying Zhang and Yuping Zhao extends the opinion shopping literature by examining whether managers successfully shop for auditors who will allow questionable accounting practices.

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.

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.

Full paper

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