Study: SOX Regulations Not Enough to Overcome ‘Alumni Effect’ in Audits

New research shows that auditors are more accommodating to clients who once worked at a Big 4 firm, threatening auditor independence and professional skepticism.

The so-called “alumni effect,” was outlined in a paper published in the March issue Accounting Horizons, a journal of the American Accounting Association.

In the wake of high-profile accounting scandals at Enron, Global Crossings and other companies in the early 2000s, lawmakers passed the Sarbanes-Oxley Act (SOX), which banned accounting firms from performing audits if a top financial or accounting executive of the client was employed by the auditor during the preceding year. After all, top executives of Enron and Global Crossings were alumni of their companies’ external auditors.

However, the new research suggests that SOX is not effective in eliminating the threat to independence.

In a controlled experiment with three different conditions, audit managers assessed the potential impairment of goodwill. The study says: “The results indicate that auditors are more likely to make a judgment that agrees with the client’s position when the CFO is a former engagement partner from their firm, and are more confident in the CFO’s position when the CFO is a former Big 4 partner, whether from their own firm or another firm, than when the CFO is not identified as having any affiliation with any audit firm.”

The study says 76% adopt the client’s position if the client’s CFO is a former colleague at their Big 4 audit firm, while only 44% do so if the CFO is not. The alumni effect occurs even if it has been two years since the CFO left the audit firm, double the minimum required in the U.S.

“Obviously, a one-year or two-year cooling-off period is not enough to avoid the alumni effect, particularly if it requires overcoming social bonds that colleagues often develop,” says Michael Favere-Marchesi of Simon Fraser University’s Beedie School of Business, who was quoted in Favere-Marchesi conducted the study with Beedie colleague Craig Emby. “It may be that five or 10 years would be enough. Alternatively, it may be that audits of companies where a CFO or other higher-up is a former engagement partner should be banned entirely, as some research on auditor independence has suggested.”

These conclusions are based on an online experiment involving 140 managers of Big 4 firms in Canada and the U.S. The managers all received the same background information about a corporate client and its industry as well as a draft of the current year’s financial statement. Three experimental conditions were set regarding the CFO’s background, and the key issue was the valuation of goodwill, an asset on corporate balance sheets that arises when a firm purchases a company for more than the fair value of its net assets.

“Being told the CFO had formerly been a Big 4 partner inclined participants to agreement on goodwill impairment but not nearly as much as the alumni effect did,” reported. “And least likely of all to be swayed were participants whose CFO had neither alumnus status nor Big 4 imprimatur.”

The study authors urge regulators for “a more robust cooling-off period covering a wider range of management positions,” noting that the possibility of a longer period has been raised by the SEC’s PCAOB.