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07 March 2019

ECGI: Why do auditors fail? What might work? What won't?

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The paper written by John Coffee analyses the reasons of accounting scandals that have sprung up everywhere over the last two years. This article’s premise is that diversified institutional investors still care about auditing, but lack relevant information about the auditor’s relative performance.

Accounting scandals have sprung up everywhere over the last two years: the U.S., Europe, South Africa -- and, most of all, the U.K. The political reaction has also been the most intense in the U.K., where two governmental reports were released at the end of 2018. The first by Sir John Kingman has called for a new and tougher audit regulator who would have greater financial independence from the industry and stronger statutory powers. The second by the Competition and Markets Authority seeks to create greater competition within the audit industry (where the Big Four now audit 97% of the FTSE 350 -- a clear indication of oligopoly).

Meanwhile, the Labour Party is promising vaguely to “break up” the Big Four if elected.
Many recent reform proposals have sought one or more of the following:

(1) to curtail or eliminate the provision of consulting services by auditors to their audit clients; (2) enhanced competition (such by mandating that a non-Big Four auditor participate in a joint audit with a Big Four auditor); and

(3) greater involvement by the government in the selection of the auditor. Unfortunately, these proposals miss the forest for the trees. Even if consulting income may create conflicts and even if competition is lacking, the core problem that causes auditing failures is more basic: corporate managements regularly search for the most compliant auditor. This tendency has grown more pronounced as corporate executives are increasingly compensated through incentive equity compensation. In such an environment, management needs to maximize the stock price at all costs and often perceives the auditor as an obstacle to this end. Accordingly, the lesser obstacle is sought.

Although mandatory rotation of auditors was intended to protect auditor independence, it may in reality give management more frequent opportunities to retain the most accommodating auditor. Similarly, proposals to increase competition will not work if the competition is only for the favour of management.

Full paper


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