A Modest Proposal for Auditor Independence

Here’s how to give public companies a powerful incentive to keep their financial reporting practices squeaky clean
By: 
Alan Morantz
An auditor checks the company's annual financial statements.

The essentials

  • Though auditor independence is a cornerstone of financial reporting for public companies, in reality auditors are hired, compensated and fired at the whim of the firms they are auditing.
  • A longtime researcher proposes that, for companies with clear problems reporting financials, the securities regulator should appoint a new external auditor for three to five years.
  • This new auditor would report any problems directly to the regulator. And while the auditor would set its professional fees, the company being audited would pay the bill. 

The auditing profession is built upon the sturdy scaffolding of codes of conduct, professional designations and regulation. When matters get wobbly, as they did with the serial accounting scandals of the early 2000s, regulatory screws are tightened and expectations ratcheted up. Shareholders and prospective investors don’t want to be left questioning the veracity of audited financial statements.

For a typical reporting engagement, this scaffolding has served the market well. But beneath the rhetoric of “auditor independence” lies a discomfiting truth: auditors are hired, compensated and fired at the whim of their clients—the firms they’re auditing. This is not a good look.

“The problem is fundamental,” says Steve Salterio, Stephen J.R. Smith Chair of Accounting and Auditing at Smith School of Business. “The client is normally the management or board of the firm that may have reason to take advantage of the inherent imprecision in accounting for their benefit and subtly pressure the auditor to achieve this.”

Short of blowing up the business model for who pays the auditor’s invoice, there are plenty of ideas for dealing with companies bent on gaming the system. Among them: setting a limit on the number of years individual audit partners or their firms can work with a client, or mandating dual audit firms for larger companies. Such measures offer incremental protection but fail to address the fundamental conflict of interest in the auditor-client relationship.

Fear of oversight

Salterio believes he has figured out how to cut this Gordian knot. His proposal draws from a key insight he gained as a young practising auditor and leading academic researcher: that boards and management of public companies will do just about anything to avoid more government oversight. His solution exploits this fear.

For the vast majority of audits, Salterio says, the system works just fine. Hundreds of studies show “on average” benefits from the current auditor-client model. His proposal addresses only those cases where there are clear problems with financial reporting: when an audited firm veers from financial reporting standards; when litigation suggests there are shortcomings; or when market regulators discover material weaknesses in an audit.

Under Salterio’s plan, when these red flags appear, the securities regulator would be empowered to appoint a new external auditor for the wayward company for three to five years. This hand-picked auditor would have a mandate to report any issues related to the quality of financial information directly to the securities regulator. Here’s the kicker: the chosen auditor would set its professional fee (subject to approval by the regulator) but the company being audited would pay the bill.

If Salterio is right, companies will be motivated to ensure their books are squeaky clean to avoid the doomsday scenario of greater regulatory oversight and no control over the cost of their audit.

The Korean experience

Salterio came up with the idea more than 10 years ago. In 2011, he pitched his proposal to the Public Company Accounting Oversight Board (PCAOB), the U.S. audit regulator (that also covers Canadian public companies listed on a U.S. stock exchange), when the PCAOB was considering how to enhance auditor independence. The Canadian audit regulator, the Canadian Public Accountability Board (CPAB), also caught wind of the proposal. The regulators’ response was, in essence, “Nice theory, but we don’t see how it would work in practice.”

Salterio now has the evidence to support his plan. In South Korea, public companies with suspect accounting practices are subject to oversight by the stock exchange regulator in a similar way to what Salterio proposes. The Korean Financial Services Commission (FSC) can impose its choice of an auditor on a company that reports the financial reporting problems Salterio highlighted, in addition to negative operating income or operating cash flows for three consecutive years.

Research on the Korean audit setting shows that, since the reforms were enacted in the early 1990s, Korean public companies have adopted stronger accounting measures—using somewhat more conservative accounting policy choices and increasing disclosures—to avoid triggering FSC oversight.

As the Korean experience shows, Salterio’s proposal elegantly aligns the interests of companies and their external auditors to insist on accurate reporting in order to, in his words, “keep the long arm of the government out of its business.” It’s all about motivated reasoning.

“The proposed reform acts as a deterrent to low-quality reporting,” says Salterio. “Based on their aversion to government oversight, boards and management have strong incentives to insist on the initial production of high-quality financial information and to work with the external audit firm to ensure that quality is built into the disclosures.”

The average auditor would certainly welcome having the client’s interests align with their own. By disposition and training, auditors want to do a thorough job but they must spend considerable time blocking out background noise. It might come from their bosses reminding them to be mindful of their firm’s business interests or imploring them to “see the world” as their client sees it. Or it might come from client board members or executives pleading for some slack to fix things before an unfavourable financial report is published.

So Salterio’s fix for the auditor-client relationship seems like a win-win for both sides as well as for shareholders and investors. PCAOB and CPAB poobahs, here’s your evidence. Are you listening?

Smith School of Business

Goodes Hall, Queen's University
Kingston, Ontario
Canada K7L 3N6

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