As published in MicroCap Review Magazine
Judged By the Company You Keep
Corey Fischer, CPA
Your mother was right. If she told you once, she told you a hundred times: “You will be judged by the company you keep.” The company she was talking about, of course, were the weird friends with whom you were hanging out. Little did she know that one day you’d be hanging out with a different kind of company—a publicly traded company, and you’d be doing it from the C-suite. Still, mother was right. It’s all about reputation.
A new study has found that a company’s reputation has become a major factor in engaging and retaining an audit firm. Company misconduct that results in a public scandal and negative media coverage often involves brand damage, investor concern, litigation, even consumer boycotts. Researchers at University of Colorado Denver, Bentley University, and Northeastern University found that when a company suffers negative media coverage the damage often spills over and lands on the shoulders of financial auditors as well.
As reported in CU Denver Today, the researchers used a new dataset called RepRisk and examined auditor response to negative media coverage related to Environmental, Social and Governance (ESG) scandals. Negative media was defined as coverage that exposes misconduct or is critical of a company’s ESG practices. Examples included such things as overuse and wasting of resources (environment issue); impacts on communities, social discrimination, and child labor (social issues); corruption and bribery, and anti-competitive practices (governance issues).
Researchers found that when a company moved from 25th to 75th percentile of negative media coverage, it resulted in a 19.5% increase in likelihood of auditor resignations and 4.68% increase in audit fees.
Public companies have always been selective in choosing an audit firm. And, rightly so. When an audit firm fails or suffers reputational damage, the company is damaged as well. It may involve restatement of financials and loss of investor confidence. Companies, however, have tools to easily check the performance and reputation of an audit firm thanks to the Public Company Accounting Oversight Board (PCAOB).
The PCAOB was created as a private-sector, nonprofit corporation by the Public Company Accounting Reform and Investor Protection Act, commonly known as Sarbanes Oxley for short, or just SOX for even shorter.
Don’t let the “private-sector, nonprofit” description fool you into thinking the PCAOB is some warm and fuzzy group with a Facebook page. Well actually they do have a Facebook page, but they also have very sharp teeth.
If this sounds a lot like the SEC, it should. The PCAOB is governed by a five member board that is appointed by the SEC. Its annual budget is approved by the SEC. It is headquartered in Washington D.C. just like the SEC. And, it has about 800 employees.
The PCAOB has four major functions overseeing audit firms: 1) registration, 2) inspection, 3) standard-setting and 4) enforcement. It is the inspection function that offers an important tool for companies to check the performance and reputation of audit firms.
The inspection process involves a team of PCAOB auditors spending several days thoroughly examining the working papers of selected audits done by an audit firm. Think of it as auditors getting audited.
Upon completion, a report is generated that will cite any insufficiencies found. More serious violations may institute an enforcement action, loss of license, and worse. Because the PCAOB posts all inspection reports online, it is an important tool that companies can use to periodically review the inspection records of their current audit firm, and one they should use as part of their due diligence prior to an audit engagement.
The research study points out how client misbehavior can adversely affect their audit firms. Unfortunately there is no easy tool for audit firms to assess whether a client company will become embroiled in a negative media episode, especially when it comes to the brave new world of ESGs.
The reputations of companies and their audit firms have become ever so entwined. Media coverage can provide needed and deserved exposure to misdeeds. Too often, unfortunately, that coverage provides more heat than light, and serves as no more than an accelerant.
Corey Fischer, CPA, is Firm Managing Partner of Weinberg & Company, a multi-office, PCAOB and CPAB-Registered firm specializing in the audit, assurance and tax needs of micro and small cap companies. He has more than 25 years of experience, having worked with the Big 4 accounting firms, and as an SEC reporting officer for a number of NASDAQ-listed companies. Based in Los Angeles, he is an expert in financial reporting, SEC compliance, raising debt and equity, mergers and acquisitions and structuring accounting operations. E-mail: email@example.com or 310-601-2200. Visit www.weinbergla.com