CURRENT AUDIT MODEL

Is the current audit model broken beyond repair for the 21st century and beyond?



Is the current audit model broken beyond repair for the 21st century and beyond?

Introduction

The simple view of the audit model is that public accountants (aka auditors) serve the public (and investor) interest when they render an opinion as to whether financial statements have been prepared in accordance with the rules. This is their raison d'être (reason for being). At least, this was the intent of the original legislation (Securites Act of 1933 & The Securities and Exchange Act of 1934). Since then, the SEC has many times stated that (1) it is the auditor opinion of the financial statements that makes them credible, and (2) without credible financial statements there can be no effective capital markets in the U.S. In other words, auditors work for the public, but get paid by companies (Ismail and Sobhy, 2009; 132-150).

It would be surprising if this model works, anymore. First of all, there is nothing “public” about auditors. They are in business for themselves to make a profit. Audit firms seek to maximize revenues and minimize expenses. Secondly, auditors are more likely to describe their relationship to companies as a partnership instead of being “independent of.” Thirdly, auditors serve their paying companies, not the public.

Going way back to the original principal-agent theory and motivation for auditing (described by Jensen & Mecking, summarized by Thornton, expanded by Simunic and Stein, interpreted and dressed up by Watts and Zimmerman) you would be pondering the theory. The basic theory is that in the absence of government regulation companies (and their management) are motivated to secure independent audits of their financial statements, and investors are not. If ownership is dispersed, then no single investor can own a large enough share of ownership to make worthwhile the funding of an audit (Alltizer, McAllister and Jarnagin, 2008; 44-47). These independent auditors are motivated to provide opinions free from bias or influence from management because they compete for clients on the basis of reputation and audit quality. The market for auditors is characterized by perfect competition (lots of auditors competing only on basis of reputation and quality). The theory also describes that audit opinions serve the public interest.

In the same way that we've discovered EMH doesn't really exist in the real world, I think it safe to say that the above auditing scenario doesn't exist in the real world.

The asymmetry of information flow between the company and auditors is problematic and expensive for auditors to overcome. The market for audit services is not characterized by perfect competition. Governments have stepped in to limit competition by providing barriers to entry. Unchecked consolidation has had many side effects (Sutton and Hampton, 2003; 57-73). In theory, the cost to audit firms of poor quality is loss of clients and lawsuits. Theory doesn't mention that audit firms face legal costs unrelated to audit quality (biz failure provokes lawsuits, so auditors have interest in seeing long-term survival of ...