Audit quality matters to mutual fund investors, study finds

LAWRENCE — It is common knowledge that investments flow into mutual funds that report strong past performance, but this positive association appears to be stronger when a fund's audit quality is taken into account, according to a study that includes two University of Kansas School of Business professors.

"The study adds to the broader accounting literature suggesting that external audit matters," said Adi Masli, associate professor of accounting.

Masli and Lei Li, KU assistant professor of finance, co-authored the recent study with Bradley Goldie, assistant professor of finance at Miami University, published in the journal Contemporary Accounting Research.

The researchers hand-collected author information for a sample of U.S.-based, open-end bond mutual funds from 2005 to 2009. Little evidence had existed about whether auditor quality influenced investors' confidence in the reliability of a mutual fund's financial reports.

However, the auditing of bond mutual funds requires significant auditor expertise, especially because fund managers estimate daily the fair market value of holdings that are often opaque and illiquid, the researchers said. Audits of bond funds are also more challenging and complex than audits of equity funds, likely because bond funds hold securities with values that are more difficult to assess.

Fund managers can also use their discretion to manipulate the fund's performance results, likely making the audit quality more important in judging the quality of a fund.

"In the case of the study, the flow of investor monies into funds reporting better performance is stronger when the fund engages an auditor that displays higher quality measures," Masli said. "We also show that certain auditor traits are associated with the auditor issuance of an emphasis-of-matter paragraph, which goes beyond the typical audit opinion."

In an emphasis-of-matter paragraph, an auditor indicates a significant uncertainty considered important enough to mention in the report.

The researchers found the positive association between a bond mutual fund's reported performance and investment flows was stronger for funds with auditors who are viewed as industry specialists and have long tenures in the field. Funds that pay higher audit fees also saw a stronger connection between their performance and ability to secure more investments.

It is likely these three factors lead to additional disclosures that investors evaluate in choosing mutual funds, the researchers said.

"The study should be of interest to mutual fund managers and auditing firms. For fund managers, the study demonstrates that traits of the external audit can impact investments into funds," Masli said. "For auditing firms, the study adds to the broad accounting literature indicating that capital market participants do care about the auditor's work and the quality of external audits."

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