When an audit isn’t worth the cost

In the United States, every public firm must submit its annual financial statements to independent auditors, who then confirm that the company has conformed to Generally Accepted Accounting Principles (GAAP). Naturally, the publicly available data from this practice has fueled academic studies for decades. While these studies are certainly valuable, they’ve ignored the vast majority of firms in the U.S. since most are private and not beholden to the same regulations as public companies.

Brad Badertscher

Instead, private firms can choose from three different assurance levels for financial reporting: the audit, the review or the compilation. Audits are expensive, requiring a certified public accountant (CPA) to systemically inspect each financial document and empirically test financial details. During a review, a CPA limits the inspection to analytical procedures and inquiries of management while a compilation is when a CPA simply confirms that financial statements are presented in a GAAP format. Audits provide the highest level of assurance while compilations provide the least.

Pioneering research published in the Journal of Accounting and Economics examines the three assurance levels chosen by private firms and how these choices affect the quality of financial reporting relative to their costs and benefits.

“Because public firms all have to be audited, the story is that audits are obviously the highest quality assurance and would lead to the best outcome on financial statements,” said Brad Badertscher, the Deloitte Professor of Accountancy at the University of Notre Dame’s Mendoza College of Business. “But for private firms, it’s not always clear. We wanted to know if there is a difference in quality based on these levels of assurance.”

The paper, “Assurance level choice, CPA fees, and financial reporting benefits: Inferences from U.S. private firms,” is co-authored by Badertscher, Jaewoo Kim of the University of Oregon, William R. Kinney Jr. of the University of Texas at Austin, and Edward Owens of the University of Utah. For the first time, the researchers were able to pull data from two independent sources: Sageworks, a financial analysis and risk management software for private firms, and from a medium-sized CPA firm that works with private companies.

“This was significant in that what got it published was the uniqueness of the data and ability to speak to something that no one really knows a lot about,” said Badertscher, who is an expert on private firm accounting and financial report quality. “We were able to build a model to predict the cost of the data that we have on the private firms and then look at the relationship between the cost and quality measures. This is brand new to the literature.”

The authors calculated four proxies for financial reporting quality used in prior literature and found that financial reporting quality is generally better for successively higher assurance levels. Yet, while financial reporting quality was significantly better for audits compared to compilations, the difference between reviews and audits for private companies was modest.

“We went into this thinking there’s going to be an obvious winner and that audits are going to show higher quality, but it turns out the reviews are pretty darn close to the audits,” Badertscher said. “It could be that the software and data analytics we have access to for the review’s key analytical procedures are really good at identifying weaknesses and therefore lead to better financial statements. The audit is still really important for asking management about relationships and getting additional invoices, but at some point there’s a marginal cost that it’s just not going to be worth it.”

The team also studied the association between assurance level and cost of debt in terms of lender perspectives on risk and found that banking institutions place greater value on audits. So even if the quality of the financial statements is the same, the banker is more likely to lend at a lower rate if there’s an audit as opposed to a review.

“The audit may be worth it in terms of your benefit on the saving on interest because you can get a lower cost of debt,” said Badertscher.

Though the review fared better than the researchers anticipated before the study, Badertscher was pleasantly surprised to discover CPAs were less startled when the results were presented to them. “Auditors who work in private firms were not surprised at the power of the review,” he said. “It just doesn’t get talked about in academics because the only data you could use previously was through public firms, which are all audited.”

Badertscher doesn’t believe the audit is going away — far from it — but he does think the review is on the rise, even for public firms. “The SEC is encouraging more firms to go public, but a huge cost to going public is the audit,” he said. “If investors can rely on reviews, especially with improved analytics, then in certain situations for smaller firms, you may see more opportunities for reviews to be utilized.”