Several auditor resignations, such as those at Shurgard Storage Centers, Glimcher Realty Trust and National Health Investors, have recently occurred in the REIT sector. Since auditors opine that a REIT's financial statements must comply with generally accepted accounting principles, a resignation may affect investor confidence in a REIT.

What do such events mean for creditors, and how does one evaluate the credit impact of an auditor resignation? Are changes in risk management practices at audit firms a contributing factor?

It is critical for Moody's Investors Service to understand the reason for an auditor resignation. In many cases it signals a deteriorating credit profile. However, in certain circumstances — due to auditor independence, for example — the resignation may not be of concern.

Looking under the hood

There are three ways in which Moody's may respond to an auditor resignation: (1) affirm the rating, which is appropriate in those cases in which the resignation is for normal business purposes; (2) put the rating on review for downgrade, which implies that there may be a problem, but the extent and gravity of the problem is in question; (3) or downgrade the rating.

Understanding the impact of the resignation on a REIT's prior audited financial statements is the first step in determining the overall effect on its credit profile. Prior periods may be restated because the new auditor disagrees with the REIT and the former auditor's application of generally accepted accounting principles, or because the resigning auditor retracts its audit opinions.

The retraction of prior audit opinions can be a serious development, and may portend significant problems, as well as the restatement of financial statements that may contain new information of importance to the analysis of the REIT. Of all the possible scenarios, an auditor resignation coupled with a retraction of previous audit opinions is the most serious.

Other reasons for an auditor resignation include disagreements between the REIT and the auditor, or the auditor determining that the risks, such as potential litigation, associated with the engagement exceed the rewards or fees.

Analysis is both art and science

When assessing a REIT's disagreements with its auditors, Moody's first seeks to understand the underlying accounting guidance, and then overlay how applying the differing interpretations would affect the REIT's financial statements and credit profile.

Also, an auditor resignation due to a disagreement with management may provide insight about management. Is the “tone at the top” focused on achieving results above all else? Is management overly aggressive in its application of accounting principles? In these situations, Moody's generally will put the REIT's rating on review for downgrade, providing time to formulate an opinion on the resignation's impact on the REIT's financial statements and credit profile.

Other factors to consider include the speed with which the REIT can replace the auditor, the type of replacement auditor chosen and the timing of the resignation. The quicker the replacement auditor is identified, the less likely there is a credit event associated with the resignation.

Lastly, a new auditor who does not have the benefit of previously auditing the company may not complete a full audit for another year, if the resignation occurs early in the year but after the REIT files its Form 10-K. This may shade one's ability to rely on interim data. In addition, the uncertainty surrounding potential financial issues or new disagreements with the new auditor frequently do not arise until the year-end audit is nearing completion.

In cases in which the reason for the auditor resignation is not clear, it is important for Moody's to broadly understand the risks perceived by the auditor. We believe the auditor's decisions in these particular cases were driven by a fundamental shift in the risk management practices of the audit firms involved, and may contain important information.

To the extent that the resignation is for normal business purposes due to a REIT merger, the REIT outgrowing the auditor or the auditor exiting the industry, it may not be a cause for concern. An auditor resignation may also indicate that the board is strongly concerned with the quality of the audit and/or with enhancing auditor independence.

Instances of auditor resignation may often be the result of a more aggressive risk analysis undertaken by the auditor. Therefore, investors should remain focused on the available information and consider all of the contributing factors in assessing the impact of the resignation on a REIT's creditworthiness.

Brian Harris is a vice president and senior analyst in Moody's Real Estate Finance Group and covers a portfolio of housing REITs.