AQRM Red Flags: Auditors

The Audit Analytics Accounting Quality + Risk Matrix (AQRM) makes it easy to identify accounting, audit, and governance red flags for public companies. This blog series breaks down the risks associated with specific firm-level events included in the AQRM.

A public company’s external auditor is an important aspect of a company’s overall corporate governance. A company with good corporate governance will engage a qualified audit firm and provide appropriate levels of funding to ensure a quality audit can be conducted. Therefore, it is important to understand a company’s relationship with their audit firm and how the relationship changes over time.

The Audit Analytics Accounting Quality + Risk Matrix (AQRM) monitors aspects of a company-audit firm relationship. These include:

  • Significant votes against an auditor ratification;
  • An auditor’s assessment of a company’s ability to continue as a going concern;
  • A change in the audit firm engagement partner;
  • A change in the audit firm;
  • Significant changes in audit fees;
  • Unusually high audit fees compared to peers; and
  • Significant non-audit fees paid to the external audit firm.

Academic literature has shown many links between information about a company’s audit firm, audit and accounting quality, and market reactions. In Tanyi and Roland’s 2017 paper Market Reaction to Auditor Ratification Vote Tally, the professors found that “lower shareholder approval of the auditor is associated with a negative market reaction [and] withheld votes are associated with a higher likelihood of a future auditor dismissal.”

In Griffin and Lont’s 2010 paper Do Investors Care about Auditor Dismissals and Resignations? What Drives the Response?, the authors found that “investors react most negatively to resignation announcements.”

The theory behind some of these auditor concepts as risks are straight-forward. Companies with going concerns are more likely to become insolvent. And companies that pay external audit firms significant non-audit fees are more likely to impair auditor independence.

While others are more indirect. A change in audit engagement partner means the loss of client knowledge, which can impact the quality of an audit. And unusually high audit fees are an indicator of higher assessed audit risk.

Because these events have varying levels of correlation between event and market reaction, we assign a severity to each “red flag”. The most severe events – going concerns and auditor changes with issues – receive a critical flag. Moderately severe events – majority votes against during an auditor ratification, non-audit fees that exceed 50% of total fees, and auditor changes without issues – receive a significant flag. And all other events receive a notable flag.

Shyft Group, Inc [SHYF] has received five different auditor related “red flags” since 2017. In 2017, Shyft Group had two notable events. Audit fees increased by 26% year-over-year and non-audit fees represented 42% of total fees paid to the external auditor. In 2021, Shyft Group had two more notable events and one critical event. Over 5% of shareholders voted against ratifying the company’s external auditor. Subsequently, Shyft Group changed their auditor and the associated audit engagement partner.

Shyft Group also received flags related to financial reporting, controls, and insiders. The company recorded several impairments and deviated from Benford’s law; disclosed control issues related to revenue recognition and issued a late filing for the company’s annual report; and saw turnover of the company’s chief financial officer.

As Shyft Group shows, issues arising from a company’s relationship with their audit firm can be indicative of other issues. Paying attention to this relationship can facilitate valuable insight into a company’s corporate governance.

The Audit Analytics Accounting Quality + Risk Matrix (AQRM) can be used to monitor, compare, and evaluate certain aspects of company-auditor relationships along with many other “red flag” disclosures. For more information, please contact us.

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