Corporate Audits and How to Fix Them

A uditors 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 fl ow of accurate information to investors. The auditing profession is based on what looks like a structural infi rmity: 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. If rational investors cannot trust fi nancial statements from companies, they will be less willing to invest, which in turn will depress stock prices and increase the cost of capital for all fi rms (as a starting point in this literature, see Hughes, Liu, and Liu, 2007; Lambert, Leuz, and Verrecchia, 2007, and references cited therein). 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 fi rms, 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 confl ict 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 “fi nancial statements insurance,” Corporate Audits and How to Fix Them