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Corporate Audits and How to Fix Them

  • Joshua Ronen
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    Auditors are supposed to be watchdogs, but in the last decade or so, they sometimes looked like lapdogs -- more interested in serving the companies they audited than in assuring a flow of accurate information to investors. The auditing profession is based on what looks like a structural infirmity: auditors are paid by the companies they audit. An old German proverb holds: "Whose bread I eat, his song I sing." While this saying was originally meant as a prayer of thanksgiving, the old proverb takes on a darker meaning for those who study the auditing profession. This paper begins with an overview of the practice of audits, the auditing profession, and the problems that auditors continue to face in terms not only of providing audits of high quality, but also in providing audits that investors feel comfortable trusting to be of high quality. It then turns to a number of reforms that have been proposed, including ways of building reputation, liability reform, capitalizing or insuring auditing firms, and greater competition in the auditing profession. However, none of these suggested reforms, individually or collectively, severs the agency relation between the client management and the auditors. As a result, the conflict of interest, although it can be mitigated by some of these reforms, continues to threaten auditors' independence, both real and perceived. In conclusion, I'll discuss my own proposal for financial statements insurance, which would redefine the relationship between auditors and firms in such a way that auditors would no longer be beholden to management.

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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/jep.24.2.189
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    Article provided by American Economic Association in its journal Journal of Economic Perspectives.

    Volume (Year): 24 (2010)
    Issue (Month): 2 (Spring)
    Pages: 189-210

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    Handle: RePEc:aea:jecper:v:24:y:2010:i:2:p:189-210
    Note: DOI: 10.1257/jep.24.2.189
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    1. DeAngelo, Linda Elizabeth, 1981. "Auditor size and audit quality," Journal of Accounting and Economics, Elsevier, vol. 3(3), pages 183-199, December.
    2. Arrunada, Benito & Paz-Ares, Candido, 1997. "Mandatory rotation of company auditors: A critical examination," International Review of Law and Economics, Elsevier, vol. 17(1), pages 31-61, March.
    3. Coffee, John C., 2004. "Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms," Berkeley Olin Program in Law & Economics, Working Paper Series qt13d8s2qs, Berkeley Olin Program in Law & Economics.
    4. Mark L. DeFond, 2002. "Do Non-Audit Service Fees Impair Auditor Independence? Evidence from Going Concern Audit Opinions," Journal of Accounting Research, Wiley Blackwell, vol. 40(4), pages 1247-1274, 09.
    5. Goldberg, Victor P, 1988. "Accountable Accountants: Is Third-Party Liability Necessary?," The Journal of Legal Studies, University of Chicago Press, vol. 17(2), pages 295-312, June.
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