Wednesday, 18 March 2009

Auditors: one of the guilty parties?

David Jacobson: As the crisis progresses (or should that be ‘regresses’?), analyses of its aetiology will no doubt develop in their complexity and, one hopes, will contribute to knowledge and, ultimately, to solutions. There is certainly a growing willingness to attribute blame. Here are some examples plucked from reports in a variety of newspapers and other media.

1. It’s the government’s fault. Policy continued to encourage investment in property development long after it was clear that demand – especially in commercial property – was collapsing.

2. It’s the banks’ fault. They gave loans inappropriately despite the warnings that they should cut back.

3. It’s the regulator’s fault because his office didn’t regulate enough – the light touch approach to regulation in Ireland was inappropriate because it enabled financial service companies to do what turned out to be against their own interests.

4. It’s the auditors’ fault because they approved the accounts of the banks when they should not have done so.

5. It’s the major property developers’ fault because they borrowed money and continued to build long after they should have cut back, given the impending collapse in the property market.

6. It’s the fault of financial markets which are inherently inefficient, under-estimating risk in the upswing, and over-estimating risk in the downswing of the cycle.

7. It’s the fault of the “golden circle”, including top bankers, property developers and perhaps politicians and officials, who were all too greedy, and continued to gamble with what turned out to be public money.

Support for each of these propositions can be found – as well as for a number of others. They could, together, all be correct. And each of them could be developed in interesting ways that link to economic theory, or critiques thereof.

Let us take number 4, for example. The current rules and regulations in relation to auditing can be argued to be seriously defective. One of the theories of economics that has gained a huge amount of support from those who believe in markets is agency theory. In short, this theory argues that people act in their own interest, usually pecuniary. It focuses on contracts and suggests that contracts should be formulated in such a way as to meet the interests of the contracting parties. For example, managers of companies should be contracted to act in the interests of the shareholder – they should act, in other words, to maximize profits rather than their own salaries or perks.

Now consider auditors. Their interest is in obtaining their audit fees. To obtain increasing numbers of clients who will pay them audit fees, they need to act in such a way as to keep their clients happy. Keeping clients happy may not be in the public interest, however. But the client, not the public, pays for the audit. As Jim Stewart (2006) has suggested, if auditing is done correctly, proving that the accounts of a company accurately reflect all the salient details of the business, then the output of the audit can be considered to be a public good. In contrast, perhaps bad auditing is a private good?

This analysis leads to the conclusion that 4 above could be true, and that, moreover, nothing about it should surprise us. A better way of organising and providing the public good of audit output would be to create a greater distance between the companies and the auditors. If it is a public good, the public should pay for it. Perhaps companies could be taxed enough so that the additional taxes could pay for the auditing service.

Ref: Stewart, J. (2006) “Auditing as a Public Good and the Regulation of Auditing”, Journal of Corporate Law Studies, Vol. 6, No. 2, pp.329-359.

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