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Study: Audits lax for small banks and companies

Gopal Krishnan, the Joseph R. Perella and Amy M. Perella Chair of accounting, co-authored the study on auditor independence.

Jaws dropped 10 years ago when it was revealed that Enron paid Arthur Andersen $1 million a week to review its books, all while employing fraudulent accounting practices that masked Enron’s risks and actual performance. The company eventually went bankrupt.

Since then, federal regulations have helped keep big businesses, big banks and their auditors in check. However, a recent  study co-authored by a Lehigh accounting professor shows that not all the loopholes may have closed.  According to Gopal Krishnan, the Joseph R. Perella and Amy M. Perella Chair of accounting, small banks and companies that still control hundreds of millions of dollars are exempt from federal mandates and are more likely to have aggressive accounting.

“If you’re an auditor and paid a lot of money, it could potentially pose a threat to auditor’s independence,” says Krishnan, whose research was published in the current issue of The Accounting Review, published by the American Accounting Association.

Krishnan and fellow researchers analyzed 300 publicly owned banks over seven years, from 2000 through 2006. They found small banks were able to report smaller losses on money reserved for bad loans in order to show more income, which pleases investors.  

In addition, the study found that accounting firms paid high fees by banks were more accepting of banks’ “innovative” accounting practices, referred to as earnings management.

“There is limited research on the various relationships between banks and their auditors,” Krishnan says. “This is the first study to review auditor compensation and earnings management in the banking industry.”

No audits of internal controls

The Federal Deposit Insurance Corp (FDIC) requires exempt banks with $1 billion or less in assets from having their internal accounting controls audited. In 2005, the exemption was increased from $500 million.

The same trends hold true for small companies that are exempt from audits of their internal controls under the Dodd-Frank Wall Street Reform and Consumer Protection Act passed last year, Krishnan says. He cited preliminary results of a study looking at small companies with a market of less than $75 million and its auditors.

“When your internal controls are not audited, managers could employ more aggressive accounting and auditors could be unaware or more tolerant of this practice,” Krishnan says.

Story by Sally Gilotti

Posted on Friday, January 28, 2011

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