The researchers examine whether social ties between engagement auditors and audit committee members shape audit outcomes. Although these social ties can facilitate information transfer and help auditors alleviate management pressure to waive correction of detected misstatements, close interpersonal relations can undermine auditors' monitoring of the financial reporting process.
The evidence implies that social ties between engagement auditors and audit committee members impair audit quality. In additional results consistent with expectations, the researchers generally find that this relation is concentrated where social ties are more salient, or firm governance is relatively poor and agency conflicts are more severe. Implying reciprocity stemming from social networks, they also report some suggestive evidence that audit fees are higher in the presence of social ties between an engagement auditor and the audit committee.
The analysis lends support to the narrative that the negative implications—namely, worse audit quality and higher audit fees—of these social ties may outweigh the benefits. This research is important for external auditors and audit committee members.
Xianjie He, Jeffrey A. Pittman, Oliver M. Rui, and Donghui Wu (2017). Do Social Ties between External Auditors and Audit Committee Members Affect Audit Quality? The Accounting Review, September 2017, Vol. 92, No. 5, pp. 61-87 http://www.aaajournals.org/doi/abs/10.2308/accr-51696?code=aaan-site
Expert opinion Peter Diekman
This study investigates the impact of social ties between the engagement auditor and members of the audit committee on audit quality. The research is conducted in the Chinese environment. Although, the Chinese conditions are comparable to those in the US and Europe, there are significant differences between the Chinese and the US and European business environment. This is an important delimitation of the research from a European perspective.
The research produces evidence that social ties between engagement auditors and members of the audit committee impair the quality of the audit. In addition, the audit fee appears to be higher when there are close social ties. The benefits of social ties between the engagement auditor and the audit committee members, such as easy exchange of information and alleviating management pressure on the auditor, do not outweigh the negative effects of these social ties, i.e. impaired audit quality and increased audit fees.
The results of this research support audit committee independence and corroborate indications that too close social ties between the auditor and audit committee may impair the audit quality. This means that the (historical) ties between former auditors and financial experts in audit committees with audit firms should be closely monitored. Having former auditors in an audit committee may lead to better mutual understanding of complex financial and reporting issues between the auditor and the audit committee. On the other hand, though, it may lead the favouritism bias, i.e. the unwarranted trust in information obtained from the audit committee and the injection of unintentional bias in the auditor’s judgment.
Example in the Dutch audit practice
Close ties between the audit committee and the engagement auditor leading to impaired audit quality may be exemplified in the case of the Weyl audit. In this case the former external auditor accepted a position in the client’s audit committee while succeeding audit partner took over responsibility of the audit engagement. This succeeding audit partner reported long time to the former audit partner. Social ties were very close and long standing. The disciplinary court case clearly demonstrated material impairment of the audit quality.
The relationship between the audit committee and the auditor is a sensitive one. At any point in time, the auditor must consider whether or not the fundamental principle of objectivity is at stake. At any time during the audit, the auditor must be mentally free to make a judgment even if this judgment may be detrimental to the client or may even lead to a modified auditor’s opinion. Whilst, it is good to have a close working relationship with the audit committee, the emphasis must be on professionalism in this relationship. It is therefore that the auditor should be reluctant to engage too much in social meetings with the client and its audit committee.
Prof. Dr. Peter Diekman RA, Managing director and owner, Forensic Consultancy Bussum BV, email@example.com