Opinion Shopping Explained

Opinion shopping is when companies search for auditors willing to provide favorable views on their financial condition. Lenders and investors rely on independent evaluations to make decisions. Falsely declaring compliance with accounting standards can help a company stay in business. Although the Securities and Exchange Commission (SEC) prohibits opinion shopping, it's difficult to enforce due to companies being able to change auditors.

Basics

Opinion shopping involves seeking an external auditor who will provide a favorable assessment of a company's financial condition. This positive evaluation, known as an unqualified opinion, gives the impression that the company's financials are accurately presented and comply with generally accepted accounting principles (GAAP). As a result, the company can secure funding at better rates from lenders and maintain investor support.

How Does Opinion Shopping Work?

External Audits and the Accountant's Opinion

The SEC requires public companies to undergo external audits and disclose the results in their annual filings. These audits provide an accountant's opinion, a statement from an independent auditor assessing the quality of the financial reports.

Qualified vs. Unqualified Opinions

The accountant's opinion can be qualified or unqualified. A qualified opinion indicates concerns about the company's accounting principles or the information provided. Opinion shopping occurs when a company seeks an unqualified opinion that confirms its financial statements are presented fairly according to GAAP.

Implications of the Auditor's Opinion

The auditor's opinion has significant implications. Doubts about financial reports can deter investors and make it harder to secure loans. It may also result in a credit rating downgrade, making capital raising more challenging. Lenders and investors heavily rely on independent evaluations of a company's financial records, so a positive opinion from an auditor is crucial.

Companies Engaging in Opinion Shopping

Despite knowing it's frowned upon by regulators, some companies engage in opinion shopping. They search for auditors who overlook their financial reporting deficiencies.

A Brief History

Regulators are concerned about opinion shopping, which has been prohibited by the SEC, due to past financial scandals involving companies like Enron, Tyco, and WorldCom. Despite laws like The Sarbanes-Oxley Act of 2002 aimed at preventing fraudulent financial reporting, opinion shopping continues to be prevalent. A study by the American Accounting Association (AAA) revealed that over half of financially troubled U.S. businesses actively seek auditors who will provide favorable opinions. This strategy appears to pay off, as the research found that opinion shoppers receive fewer going concern opinions, which expressed doubts about a company's ability to continue, compared to non-opinion shoppers.

Red Flags and Gray Areas

When a company changes its audit firm quickly, it raises questions about opinion shopping. These companies may expect significant benefits in return for the costs associated with switching auditors. Auditors also face start-up costs when taking on a new client, so there may be pressure to provide positive assessments until these costs are recovered.

Some companies may dismiss auditors who disclose critical information about their accounting practices. This can influence auditors to be more lenient and flexible to attract more business. However, seeking a second opinion does not always indicate wrongdoing. Companies have the freedom to consult with other accountants to find a better fit for their business or to reduce audit fees.

It can be challenging to determine if changes are made solely to obtain more favorable opinions. A consistent pattern of switching auditors or a shift from a reputable big four accounting firm to a smaller one eager for new clients can be red flags warranting suspicion.

Conclusion

While opinion shopping may seem like a quick fix to secure funding, it carries significant risks for lenders and investors. Seeking unqualified opinions can lead to an inaccurate portrayal of financials, which can harm a company's reputation and long-term prospects. Regulators continue to monitor this practice closely, and companies should prioritize compliance with accounting standards and ethical financial reporting to maintain investor trust.