A study in the November issue of the American Accounting Association journal, the Accounting Review, looked at whether the presence, as well as the absence, of accounting expertise among top company managers can compromise financial reporting.

Focusing on the CFOs, CEOs, and other top executives of more than 3,000 public companies, accounting professors Anne Albrecht of Texas Christian University, Elaine Mauldin of the University of Missouri, and Nathan Newton of Florida State University concluded that executives' backgrounds as partners or managers in audit firms can substantially increase the present likelihood of financial misstatements.

According to the study, that prior experience, ‘provides extensive knowledge of audit procedures and negotiation tactics. As a result, executives could use their higher-order ability to hide misstatements or to avoid current-period adjustments when the external auditor finds misstatements.’

The academics describe accounting competence on the corporate top team as a ‘two-edged sword’ that can either enhance or subvert financial reporting.

The researchers said: ‘We do not expect that accounting competence alone leads to misstatements, because accounting competence may provide the ability to produce reliable financial reports, and we have no reason to expect more or less integrity from executives with accounting competence than from those without it. Instead...accounting competence interacts with other fraud risk elements to increase the risk of material misstatement.’

One risk element the study considered was executive compensation, since ‘auditing standards specifically include them in risk assessment and prior research suggests compensation-based incentives induce misstatements.’

The study results showed that when auditing backgrounds were absent from top management, companies where executive pay was well above the median (at the 75th percentile) were only about 4% more likely to misstate than firms where that pay was relatively low (at the 25th percentile).

But when audit-firm experience was present in executive suites, the high-pay firms were about 30% more likely than their low-pay counterparts to misstate.

The study’s authors argue that an apparent lack of awareness of this downside among external auditors is making the problem worse.

Although auditors typically charge companies higher fees in response to excesses in executive pay, the boost is much less when there is auditing background in the executive suite. According to the study, ‘this result is consistent with auditors’ over-trusting executives with accounting competence and discounting the fee premium associated with excess compensation.’

The study concluded that by itself, past auditing experience among top executives did not significantly increase the likelihood of financial misreporting. But the likelihood increased greatly when that expertise met up with excess executive compensation, so much so that high-pay firms became considerably more likely than their low-pay counterparts to misstate.

According to the authors, this combination of risk factors meant ‘a dark side of accounting competence emerg[es] in the presence of compensation-based incentives.’

The study drew on data from 3,252 public companies over a 10-year period. In any given year an average of about 12% of the firms had one or more top executives (as listed in proxy statements or annual reports) who had prior audit experience as a partner or manager at a public accounting firm. About 61% of the executives with this background were CFOs and about 9% were CEOs. About 10% of company financial reports contained misstatements that were corrected by subsequent restatements.

Do auditors recognize the potential dark side of executives’ accounting competence? is here

Report by Pat Sweet