A new study questions the usefulness of proxy advisory services in helping corporate boards of directors and investors decide whether to keep or change auditing firms.

The study, by Lauren M. Cunningham of the University of Tennessee Knoxville, found that audit firms are rarely rejected when auditor ratification ballots are included in the proxy materials sent annually to shareholders. However, the study, which appears in the March issue of the quarterly journal Accounting Horizons, published by the American Accounting Association, found some evidence from two earlier studies that auditor ratification does matter to company directors and investors. The new study examined how much auditor ratification votes contribute to improved accounting and advance the interests of companies and shareholders. The paper suggested auditor ratification leaves much to be desired.

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The two dominant proxy advisory service providers, Institutional Shareholder Services, Inc. and Glass, Lewis & Co., LLC, have tremendous influence, thanks to SEC policies that encourage funds and financial advisors to follow their recommendations in voting proxies. However, proxy advisors have been criticized for having too much of a “checklist” mentality. They make recommendations that tend to be one-size-fits-all, rather than being targeted toward specific companies. But, when it comes to key issues related to auditor ratification, they don't even seem to be following their own checklists.

While proxy advisors identify “aggressive accounting policies” as one of a handful of suspect practices, they recommend auditor rejection in only about 4 percent or 12 percent (depending on the measure used) of the cases where strong evidence exists of aggressive practices.

One common measure of aggressive accounting is the amount of a company’s discretionary accruals, non-cash accounting items that typically involve some guesswork and are widely associated with earnings manipulation. In researching 9,000 ratification elections over a three-and-a-half-year period, Cunningham identified 512 companies that were in the top tenth of their industry in reporting the most discretionary accruals in a given year. But in only 22 cases, or just 4 percent, did ISS or Glass Lewis recommend opposing retention of the auditor.

Glass Lewis did not immediately respond to a request for comment from Accounting Today. ISS declined to comment.

The study also questioned the proxy advisors’ response to formal restatements, in which companies acknowledge misstating their finances in prior reports. A total of 112 companies in Cunningham’s sample had issued financial restatements for years in which the current auditor was answerable, but in only 13 of those 112 cases, or about 12 percent, did either proxy advisor recommend against retaining those audit firms.

Cunningham acknowledged that part of the reason for such a low percentage could be that her sample did not include companies that had changed auditors within the past year. Among the companies that changed their auditing firms, 5.4 percent had issued formal restatements, compared to only 1.2 percent of firms in the sample.

“It may be that auditors responsible for some of the most egregious misstatements were dismissed before the ratification vote,” she wrote. “Still, the fact that proxy advisors recommended rejection of only 12 percent of auditors who were present during the restated period warrants concern.”

Cunningham believes the problematic proxy advice may be largely due to the lack of detail that audit committees provide about their interactions with auditors. That leads proxy advisors’ shareholder clients to be less attentive to audit quality than they otherwise might be.

“Proxy advisors’ guidelines are based on feedback from shareholders,” she wrote. “If shareholders do not place a lot of emphasis on audit-quality proxies listed in the proxy-advisor guidelines, proxy advisors will be less likely to issue an Against recommendation for poor audit quality absent obvious signals of audit failure.”

Cunningham believes it is important for shareholders to receive better information about how audit committees are working with auditing firms. “If ratification votes are to be meaningful, there needs to be an informed shareholder electorate,” she wrote. “To that end, corporate audit committees should be more forthcoming and explicit about their auditor interactions than they have traditionally been.”

Michael Cohn

Michael Cohn, editor-in-chief of AccountingToday.com, has been covering business and technology for a variety of publications since 1985.