Addressing the Auditor Independence Puzzle: Regulatory Models and Proposal for Reform

Auditors play a major role in corporate governance and capital markets. Ex ante, auditors facilitate firms’ access to finance by creating trust from public investors. Ex post, auditors can prevent misbehavior and financial fraud by corporate insiders. In order to fulfill these goals, however, in addition to having the relevant knowledge and expertise, auditors should perform their functions in an independent manner. Unfortunately, for a variety of reasons, including the possibility of providing non-audit services or the fact of being hired and paid by the audited company, auditors face a clear conflict of interest. Therefore, even if they eventually act independently, investors have incentives to think otherwise. And if so, this lack of trust must be translated into an overall increase in a firm’s cost of capital.

Regulators have attempted to solve the auditors’ independence puzzle through a variety of mechanisms, including prohibitions and rotations. Likewise, politicians and scholars have recently suggested new proposals to deal with this problem, including breaking up audit firms and empowering public investors.

In a recent paper, to be published in the Vanderbilt Journal of Transnational Law, we argue that all of the regulatory responses previously suggested in the literature present some flaws. In our view, they do not effectively reduce an auditor’s conflict of interests or they do so at a very high cost for the audit profession that may undermine the quality of the auditor’s work. For this reason, our paper suggests new strategies to solve the auditors’ independence puzzle.

The paper is structured as follows. Section 1 provides an overview of the importance of auditors, and how most countries around the world require public companies to audit their financial statements. Section 2 describes the economics of auditor independence, drawing on two models developed in the law and economics literature and the accounting literature, concluding with theoretical explanations for why audits sometimes fail. Section 3 evaluates traditional responses to audit failures. Section 4 discusses some proposals to solve the auditors’ independence puzzle recently suggested in the literature. Section 5 proposes new strategies to enhance the independence of auditors. Section 6 summarizes and concludes.

We argue that three primary problems undermine the independence and credibility of auditors. First, in companies with controlling shareholders, the controller has a strong influence in the nomination and supervision of auditors. On the one hand, they control the shareholder meeting. On the other, the controller has the ability to appoint the majority of the board, and therefore the audit committee. This influence of the controlling shareholders undermines the ability (or at least credibility) of auditors to effectively monitor corporate insiders.

Second, our paper challenges the traditional gatekeeper and quasi-rent models used to explain why auditors may have incentives to conduct audits thoroughly and independently. Namely, we argue that both models do not sufficiently take into account the internal agency problems existing within an audit firm. While reputational benefits can be enjoyed by both audit partners and audit firms, most of the costs generated by an accounting scandal are borne exclusively by the audit firm, with audit partners often being able to transition to an equivalent position elsewhere. For this and a number of other reasons, they do not have strong incentives to monitor their peers. Moreover, since misbehavior by audit firms does not seem to entail strong market sanctions (as shown by the fact audit firms are still hired even if they are sanctioned for breaking the law), except in severe financial scandals such as Enron, audit firms do not have strong incentives ex ante to implement internal policies to prevent misbehavior.

Finally, our paper discusses how the provision of non-audit services may undermine the independence and credibility of auditors. Firstly, the provision of non-audit services may increase the economic dependency of auditors on their clients. Secondly, the possibility of providing future professional services may make auditors lose part of their independence, or at least public investors can reasonably think so. Thirdly, a variety of non-audit services, including certain types of tax and consultancy work, can create problems of self-review for the audit firm, for some professional services of this kind may require auditors to review their own work. Therefore, a more severe conflict of interest may arise.

On the basis of these problems, our paper suggests several recommendations to enhance the independence of auditors. First, we argue that, in the context of controlled firms, auditors should be elected with a majority-of-the-minority vote. Second, the regulation of non-audit services should be amended in order to impose longer temporal limitations as well as stricter restrictions on the types of services potentially provided to the audit client. Third, policymakers must pay closer attention to the internal governance and compensation systems of audit firms. We argue that increased transparency by audit firms is essential to enhancing the independence of auditors. Finally, recent empirical studies have shown that audit committees seem to fail to perform their monitoring functions. In our opinion, this is due to the influence of corporate insiders in the audit committee. For this reason, a change in the role and composition of the audit committee also seems necessary to enhance the independence and credibility of auditors.

Martin Gelter is a Professor of Law at School of Law, Fordam University, New York.

Aurelio Gurrea-Martínez is an Assistant Professor at Singapore Management University, Singapore.