Addressing the Auditor Independence Puzzle: Regulatory Models and Proposal for Reform

Auditors play a major role in corporate governance and capital markets by creating trust on public investors and reducing the risk of financial misconduct by corporate insiders. In order to achieve these functions, however, auditors should have the adequate knowledge and expertise, and they should conduct their work in an independent manner. Unfortunately, for a variety of reasons, including the possibility of providing non-audit services or the mere fact that they are hired and paid by the audited company, auditors face a conflict of interest that can undermine their independence, or public investors can reasonably think so. Therefore, this lack of trust may ultimately harm firms´ access to finance and the development of capital markets.

Regulators have attempted to solve the auditor’s independence puzzle through a variety of mechanisms, including prohibitions and rotations. Likewise, politicians and scholars have recently suggested new proposals to deal with this problem, including breaking up audit firms and empowering public investors.

In our paper, we argue that all of the regulatory responses previously suggested in the literature present some flaws. In our view, they do not effectively reduce the auditor’s conflict of interests or they do so at a very high cost for the audit profession that may undermine the quality of the auditor’s work. For this reason, our paper suggests new strategies to solve the auditors’ independence puzzle.

First, we argue that, in the context of controlled firms, auditors should be elected with a majority-of-the-minority vote. Second, while auditors in many jurisdictions are subject to certain temporal prohibitions to be hired by previous clients, we believe that the length of these temporal prohibitions should be extended. Moreover, regulators should also restrict the type of services potentially provided to the audit client. Third, policymakers must pay closer attention to the internal governance and compensation systems of audit firms. We argue that increased transparency of audit firms is essential to enhance the independence of auditors. Finally, recent empirical studies have shown that audit committees seem to fail to perform their monitoring functions. In our opinion, this is due to the influence of corporate insiders on the audit committee. For this reason, we propose to increase the power and presence of public investors in the audit committee.