Title: Breaking the Market's Dependence on Independence: An Alternative to the "Independent" Outside Auditor
Abstract: INTRODUCTION A cornerstone of financial reporting by public companies is the requirement that their annual financial statements be audited by independent outside auditors. As a result of the rising tide of financial misstatements by public companies, however, there have been serious concerns as to whether outside auditors adequately carried out their responsibilities and, in particular, whether their independence was compromised. The resulting Sarbanes-Oxley Act attempts to provide regulatory reform to the accounting industry.1 The reform includes the creation of an accounting oversight board and restrictions on an outside auditor of a public company from providing the same company with certain consulting services. Professional and regulatory requirements of independence, however, are not effective when outside auditors are seduced by large fees. Although the Sarbanes-Oxley Act seeks to restrict consulting fees, a cause for the breakdown of independence, and further regulate the accounting industry, the Act leaves untouched several fundamental facts regarding an outside auditor. First, an outside auditor can never truly be independent since they are paid and selected by the same corporations that are being audited. Second, and related to the first fact, an outside auditor is only financially motivated to do what is minimally required, based on Generally Accepted Auditing Standards (GAAS)2, in auditing the financial statements of a company. As a result, an outside auditor has little financial incentive to take innovative or comprehensive steps, such as forensic procedures, to ensure that a company's books are accurate. This Article reviews recent SEC enforcement actions and other civil litigation against outside auditors regarding corporate financial misstatements. The review shows that despite a vigorous enforcement effort, it is difficult to deter audit firms from violating, in repeated and systemic fashion, the federal securities laws and professional standards, including rules requiring independence by auditors. The review of these cases shows that lucrative fees almost always played a role in the violations. This Article also reviews various behavioral research studies showing that company-hired auditors' strong and subconscious bias in favor of their employers greatly dilutes the effectiveness of deterrence. This Article explores whether there can be an alternative to the current system of relying on independent outside auditors retained by corporations themselves to audit corporate financial statements. One alternative is to take advantage of the fact that there are outside parties, such as institutional investors, that have a strong financial interest in determining the accurate financial condition of public companies. Specifically, this Article proposes a system in which institutional investors and other outside parties would retain accounting or other financial professionals (investor-hired auditors) to audit or otherwise review the financial data of the public companies. The financial interest of these investor-hired auditors will be aligned with the financial interests of the investors. They will be financially motivated not to do the minimum, but to do their utmost, including finding innovative steps, to determine the most accurate picture of a public company's financial condition. As a result, the quality of financial data will also improve. Such a system, however, is not possible today because the public, and any investor-hired auditor, unlike auditors retained by public companies, do not have access to public companies' raw financial data to perform any meaningful analysis. In addition, compared to auditors hired by the companies, the public does not have the same level of access to management to question or have discussions regarding the companies' financial condition. Thus, a system in which it will be feasible for outside parties to retain financial professionals meaningfully to review and analyze public companies must enable such professionals to have: * access to public companies' raw financial data; and * access to management to discuss specific accounting questions or issues. …
Publication Year: 2004
Publication Date: 2004-01-01
Language: en
Type: article
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Cited By Count: 1
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