Corporate accounting standards are an important basis for the measurement of firm and managerial performance and for the stewardship of corporate assets in a market economy. Understanding the process that culminates with the creation of accounting standards can provide insights into both their procedural legitimacy and how they will eventually be used. In a recent study, we examine the role of auditors in the accounting standard-setting process at the Financial Accounting Standards Board (FASB).
Auditors play a crucial role in the functioning of capital markets by serving as independent agents who attest that companies, in preparing their financial reports, conform to generally accepted accounting principles (GAAP). However, auditors’ role is hardly restricted to scrutinizing firms’ financial statements. Rather, auditors participate in the standard-setting process via comment-letter lobbying and thus influence financial reporting standards at their very genesis. But empirical evidence on the role of auditors in this political process is limited. In our study, we examine how auditors’ incentives influence their lobbying across nearly every financial reporting standard issued by the FASB from 1973 through 2006.
We focus on the group of auditors most likely to consistently lobby across standards and over time: the “Big N” firms. Since at least the inception of the FASB in 1973, the audit market in the U.S. has functioned as an oligopoly, with a few large firms – the Big Eight in the 1980s, the Big Four today – providing audit services for the vast majority of public companies. The Big N auditors have consistently represented an influential and economically significant fraction of auditing activity in the United States, and a study of their lobbying behavior can generate interesting insights.
Because we seek to compare auditor lobbying over a long time series spanning a number of different accounting issues, we focus on auditor lobbying over the “reliability” of proposed accounting standards. Reliability is a “fundamental qualitative characteristic” of accounting, as identified by the FASB in its own original conceptual framework. Reliability limits managers’ discretion in accounting choice to reporting methods that are verifiable, facilitating audits and potentially reducing litigation and regulatory costs by restricting client firms’ flexibility in accounting choices and hence their ability to misreport.
We identify three broad, non-mutually exclusive economic factors that can shape auditors’ lobbying incentives on reliability over time.
We first investigate whether the Big N auditors’ lobbying varies in response to changing litigation and regulatory exposure. We find that the proportion of lawsuits against auditors and the level of SEC enforcement on accounting and auditing issues are predictably associated with the nature of auditor lobbying. In periods with higher incidence of lawsuits and more intense levels of SEC enforcement, the Big N auditors are more likely to express concerns about decreased reliability. These results are consistent with auditors mitigating their litigation risk when lobbying on accounting standards.
We next investigate whether Big N auditors lobby for greater flexibility in standards in the interest of their clients. Auditors’ clients often prefer standards that allow flexibility to choose the most appropriate reporting method for a given transaction. Using firm-level characteristics that capture clients’ preferences for flexibility, we find no evidence that such preferences influence auditor lobbying.
Finally, we investigate the extent to which Big N auditor lobbying can be explained by changing trends in the priorities of standard setters. In particular, since the 1990s, the proportion of accounting standards using fair-value methodologies has increased. This increase represents an agenda shift toward fair-value accounting at the FASB. To the extent that this fair-value agenda does not detract from the Big N auditors’ own incentives, the auditors may support the agenda. Doing so helps them extract rents from the FASB on other issues. We examine how Big N auditor lobbying over decreased reliability has varied with the proposed use of fair-value methodologies in accounting. We find that the Big N auditors are less prone to express concerns about decreased reliability in these cases.
In supplemental tests, we examine the possibility that the changing nature of the Big N auditor oligopoly itself – e.g., eight versus four Big N firms – has influenced auditor lobbying. Fewer Big N audit firms imply a different competitive dynamic vis-à-vis clients and regulators. We find evidence that the changing nature of the Big N auditor oligopoly – in particular, the tightening of the oligopoly through a decrease in the number of Big N players – is associated with the auditors’ lobbying behavior. As the oligopoly tightens, surviving auditors exhibit a heightened tendency to express concern about decreased reliability. This finding is consistent with the notion that the fewer surviving Big N auditors are more visible targets for both regulatory action and litigation and thus prefer enhanced reliability in accounting standards. The finding is inconsistent with claims that the Big N auditors perceive themselves as “too big to fail,” which would predict the Big N auditors are at best agnostic with respect to decreased reliability in proposed standards.
Broadly, the evidence in our study provides a window into the nature of auditor lobbying in U.S. accounting standard setting, particularly how such lobbying has varied across numerous factors that are likely to have affected the auditing industry over the past forty years. Collectively, our evidence suggests that, contrary to conceptions that auditors play a stewardship role in creating and sustaining accounting rules, auditors’ own incentives play a prominent role in their lobbying activities on U.S. GAAP.
The preceding post comes to us from Abigail Allen, Lecturer of Business Administration at Harvard Business School, Karthik Ramanna, Associate Professor of Business Administration at Harvard Business School, and Sugata Roychowdhury, Associate Professor of Accounting at the Carroll School of Management at Boston College. It is based on their recent article entitled Auditor Lobbying on Accounting Standards, which is available here.