Unveiling Informal Business Networks

Researcher from Singapore Management University is uncovering the implications of informal business networks between top executives and their independent auditors.

Associate Professor Zang Yoonseok

SMU Office of Research – As people criss-cross the business world, they weave relationships across negotiation tables, through airport lounges and into boardrooms. Auditors of financial statements circulate widely in this world, yet when it comes to their clients they must remain above the fray. The closer they are to the clients they check, the more trust drains from the opinion they write.

To ensure auditors and their clients keep a safe distance between each other, regulators have issued phone book-sized regulations and standards. But to know everything about auditor-client networks is impossible, and even when we do see connections, it is difficult to ascertain if the relationship facilitates or endangers the audit.

In accountancy, eventually the numbers resolve all mysteries. Connecting the dots across business databases is how Singapore Management University (SMU) School of Accountancy Associate Professor Zang Yoonseok sheds new light on previously unexamined business ties.

Linking informal relationships and bad accounting

Like investors and regulators around the world, Professor Zang was curious about why, despite their universally acknowledged importance and tight regulations, auditors sometimes spectacularly fail to raise the red flag on bad accounting.

Previous research and the standards followed by auditors focused on formal relationships that create obvious conflicts of interest for auditors, and the most apparent of these includes financial relationships – or prospects of landing a plum job at the client after the audit.

But the research appeared to overlook informal business and social networks between auditors and their clients, which could be just as important, explains Professor Zang, who joined up with colleagues in Korea and Holland to study the impact of these relationships on audit quality.

“We observed that many companies in the United States liked to appoint board CEOs and CFOs from other companies in the industry, and we thought it would be possible to study how these networks affected the audit,” he notes.

The researchers used a database called Audit Analytics to identify firms that had switched auditors, and BoardEx, to identify CEO/CFOs who knew the auditors from their membership on other boards. This work harvested a sample of 597 firms that switched auditors to Big 4 auditors over the period of 2003–2012.

Their results, published in a paper titled “The Downside of Network Ties between CEO/CFOs and Auditors through External Directorships”, revealed that when CEOs or CFOs have business ties with a new auditor through their directorship of another company, their companies were more likely to appoint connected auditors.

Perhaps more significantly, companies that appointed connected auditors also experienced poorer quality audits, compared to companies that appointed non-connected auditors. This means that they experienced more misstatements, an increased propensity to meet or just beat earnings benchmarks, and an increased magnitude of accounting decisions made by management choices rather than business reasons—which is known in the industry as discretionary accruals.

Professor Zang suggests that two factors could be causing the drop in audit quality. One is familiarity, which could slowly eat away the auditor’s professional scepticism. The second is compromised independence, due to the CEO’s or CFO’s ‘bargaining power’ over an auditor who also audits a company where the CEO or CFO is a director. “Some CEOs and CFOs are very powerful—they exercise big influences in board decisions. That is why it is always better to keep a good distance between auditors and executives,” he stresses.

Conservative accounting—less accurate but better?

In another example of bringing real world insight into areas previously only examined through theory, Professor Zang’s empirical research has also uncovered the impact on audit quality of another controversial change in the accounting world—the move away from conservative accounting.

Under a conservative accounting approach, companies are slower to recognise profits and faster to acknowledge losses in the reported accounts. In recent years, standard setters have steered away from this seemingly prudent approach in favour of real-time accuracy—for example reporting the fair market value is favoured over reporting historical-based assessments.

In theory, auditors prefer conservative accounting so that companies will not hold on to bad news until the last possible moment.

Putting this theory to the test, Professor Zang and his colleagues used audit-related information from the Audit Analytics database for the period of 2000–2010, and merged it with other data to obtain financial and stock return variables.

Their findings, in the article recently published in The Accounting Review “Client Conservatism and Auditor-Client Contracting” with M. L. DeFond and C.Y. Lim, pointed to benefits not previously appreciated with conservative accounting. They found that auditors of more conservative clients charged lower fees, issued fewer going concern opinions, and resigned less frequently.

More opportunities to investigate factors affecting audit quality could come with further changes to financial reporting and auditing rules, says Professor Zang. These include proposals in the US to disclose the name of the individual audit partners in charge of the audit, rather than just the name of the audit firm.

“With more information about an individual’s background, social interactions, and educational background, we could do more interesting research about the impact of networks on audit quality,” he says.

The effect of informal business networks on audit quality might be particularly important to markets with limited pools of directors, like Singapore, says Professor Zang. “Companies like to find directors with experience in the industry, and this creates many connections across many companies. If we do not pay close attention, independence could be endangered.”

By David Turner