While dismissing an auditor might seem like a cost-saving move, a new study shows it can lead to poorer investment decisions within companies.
Poor investment decisions can have a long-term negative impact on the companies’ financial health. Auditors are thus like financial health check-up professionals. They investigate the companies’ accounts and ensure that everything is in order, which in turn helps management to make well-informed decisions and to use the companies’ resources to generate high returns on investments.
In a recent study, we shed light on how the expertise of auditors affects the investment efficiency of Norwegian firms. We investigated 151 667 firms in Norway, including both non-financial listed firms and private firms. We assess whether the companies’ investments reflect their growth opportunities, which are captured by sales growth.
Auditing brings clear benefits
A regulatory change in 2011 allowed small companies to opt out of auditing. The study shows that companies that decided to forego external auditing as a result tended to overinvest.
Comparatively, the smaller companies that chose to keep their auditors, showed higher investment efficiency. These results are consistent with our expectations, as the expertise and knowledge of external auditors can help the companies’ management to make smarter decisions.
Eliminating audit fees provided smaller companies with more free cash that could be used for investment, but it also meant losing access to the auditors’ knowledge and resources which led to poorer investment decisions.
Similarly, larger companies that had to undergo mandatory auditing also made more efficient investment choices. The implication is clear: having a sharp, knowledgeable auditor on board seems to be more of an asset than a liability, helping firms make better investment decisions.
Not just any auditor will do
Our findings also suggest that auditors who are industry specialists or are part of large, recognized audit firms (in Norway, often referred to as the Big 5, that is, BDO, Deloitte, EY, KPMG, and PwC) tend to help companies make better investment decisions.
These audit firms generally possess more knowledge and offer higher audit quality than smaller audit firms. Typically, the Big 5 invest more in auditing practices, have a longer history, and maintain a better reputation for providing internationally standardized audit services. In our study, we show that the industry knowledge and high audit quality of the Big 5 provides useful information for their clients. Small client companies often lack opportunities to access this information other than through their external auditors.
This is important information for Norwegian companies and their auditors, as well as for policymakers and government regulators like Finanstilsynet.