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Hiring Executives with Audit Experience and Paying Them Well is Stupid, Says Research

Holding out money

Since the dawn of time, or at least since the dawn of the green eyeshade, corporations have looked to fill the C-suite with financially literate hires. And who, I ask, is more financially literate than a former accounting professional? Well, other than whoever is in charge of laundering drug money for the Sinaloa cartel, probably no one. I’m speaking in sweeping generalizations here of course, but we all know one of the major reasons Big 4 accounting firms are able to treat new hires like losing racehorses is because experience at a public accounting firm is a valuable commodity. You could be the dumbest, greasiest, most mediocre accountant ever to account but so long as you have that Big 4 resume item, someone, somewhere will want you.

Well according to new research, those someones may be idiots. As it turns out, hiring corporate execs with audit experience and cutting them nice fat paychecks can increase the risk of financial misstatements. This goes against accepted wisdom that these individuals — specifically, their experience and knowledge — can have a positive effect on overall reduction of risk. In fact, it may be that very knowledge at work toward increased risk of misstatement.

“[E]xecutives could use their higher-order ability to hide misstatements or to avoid current-period adjustments when the external auditor finds misstatements,” wrote the paper’s authors.

The paper, hauntingly titled Do Auditors Recognize the Potential Dark Side of Executives’ Accounting Competence?, was authored by professors Anne Albrecht of Texas Christian University, Elaine Mauldin of University of Missouri, and Nathan Newton of Florida State University. It was published in The Accounting Review’s November 2018 edition.

“Accounting competence is good because they’re able to generate more reliable financial statements,” said Albrecht. “But it’s bad because the knowledge of accounting procedures allows them to make the misstatements in the first place, and their knowledge of the auditing process allows them to hide it.”

As if that weren’t bad enough, they also identified the “buddy” aspect of individuals with a shared background as an increased risk factor. In other words, company auditors may be less skeptical when dealing with an executive who was a former auditor themselves. If anything, auditors should use their heads and realize that just because someone is in the club doesn’t make them any more trustworthy than some MBA who couldn’t tell a tick from a tie, but so these things go.

“That shared background generates trust so that auditors aren’t necessarily as skeptical of management as perhaps they should be,” said Albrecht.

The important part of the research isn’t just background, but compensation. For the study, the authors looked at corporate officers at 3,252 public companies over a 10-year period. The first thing to determine was “accounting competence,” which they defined as “an executive with experience as an audit manager or partner at a public accounting firm.” Next, and this is the important bit, they analyzed executive team pay, established average compensation, and adjusted for competence. Any compensation that was above the predicted amount was considered “excess.”

From there, they found that the overall restatement rate across all companies in the 10-year-period examined was about 10%. This rate was slightly lower for companies with executives with an audit background at 9.5%, which fits into expectations that former auditors in executive roles decrease misstatement risk. However, when audit competence and high excess compensation were combined, the study found restatements jumped to 11%; alternatively, the restatement rate for companies with competency but low excess compensation was 8%.

SO what does this tell us? Well, maybe it tells us that reducing executive pay for individuals with an auditing background can reduce the risk of misstatement. Obviously it isn’t that simple.

“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,” said the study’s authors. “Instead … accounting competence interacts with other fraud-risk elements to increase the risk of material misstatement.”

“[O]ur results suggest a dark side of accounting competence emerges in the presence of certain incentives, but auditors view accounting competence favorably despite the heightened risk,” they wrote.

Read more: The Dark Side of Accounting Expertise []