Why Do Auditors Fail? What Might Work? What Won't?

Accounting scandals have sprung up everywhere over the last two years: the U.S., Europe, South Africa -- and, most of all, the U.K. The political reaction has also been the most intense in the U.K., where two governmental reports were released at the end of 2018. The first by Sir John Kingman has called for a new and tougher audit regulator who would have greater financial independence from the industry and stronger statutory powers. The second by the Competition and Markets Authority seeks to create greater competition within the audit industry (where the Big Four now audit 97% of the FTSE 350 -- a clear indication of oligopoly).

Meanwhile, the Labour Party is promising vaguely to “break up” the Big Four if elected.
Many recent reform proposals have sought one or more of the following: (1) to curtail or eliminate the provision of consulting services by auditors to their audit clients; (2) enhanced competition (such by mandating that a non-Big Four auditor participate in a joint audit with a Big Four auditor); and (3) greater involvement by the government in the selection of the auditor. Unfortunately, these proposals miss the forest for the trees. Even if consulting income may create conflicts and even if competition is lacking, the core problem that causes auditing failures is more basic: corporate managements regularly search for the most compliant auditor. This tendency has grown more pronounced as corporate executives are increasingly compensated through incentive equity compensation. In such an environment, management needs to maximize the stock price at all costs and often perceives the auditor as an obstacle to this end. Accordingly, the lesser obstacle is sought.

Once we recognize this unpleasant truth, some recent “reforms” look counterproductive. For example, although mandatory rotation of auditors was intended to protect auditor independence, it may in reality give management more frequent opportunities to retain the most accommodating auditor. Similarly, proposals to increase competition will not work if the competition is only for the favor of management.

What then might work? This article’s premise is that diversified institutional investors still care about auditing, but lack relevant information about the auditor’s relative performance. How can that informational deficit be cured? The most important development in corporate governance over the last fifteen years has been the rise of shareholder activism. It has created a new infrastructure of institutions -- in particular, proxy advisors and activist funds -- which could be put into service to facilitate shareholders choice.

Today, although auditors serve investors, they are selected by managements (whose interests are far from well aligned with those of investors). Instead of merely ratifying management’s choice of auditor, the shareholders could themselves select the auditor (as U.K. law expressly recognizes).

Thus, a sensible strategy for auditor reform should have two elements: (1) the audit regulator should annually grade the auditor’s performance on a client by client basis (in the case of public companies) and publish its grades, and (2) a defined percentage of the shareholders (say 10%) should be entitled to nominate a different auditor and place its nominee before the shareholders for a vote at the annual meeting. Neither step is radical. In fact, grades are today given by the audit regulator in the U.K., but the process is far from transparent.

Who would respond to this new opportunity? Although it is often assumed that large diversified institutional investors prefer to remain passive, this misstates their preferences.

Because of the large number of companies in their portfolios, these institutions are reluctant to become involved in firm-specific disputes, but they do participate and exercise voice with respect to more “generic” issues of corporate governance that recur across their portfolios. For example, they support shareholder proposals on board diversity, climate change, and basic corporate governance issues, in part because they can follow a common policy. Selecting the auditor represents such a “generic” issue because, across their portfolios, institutional investors could follow a common policy of voting against a poorly graded auditor.

Another class of investors could prove to be the catalyst here. Activist investors (such as hedge funds) are today searching for governance issues where they can present themselves as the shareholders’ champion (and then seek board representation). They are more than happy to play the role of instigator and bear costs. Proxy advisors (such as Institutional Shareholder Services) are similarly ready today to advise shareholders to vote against management’s position, and they deem audit quality to be a leading issue. Thus, if we arm institutional investors with accurate information from the audit regulator and their proxy advisors offer recommendations, proposals to change the auditor will get a receptive hearing from institutional investors.

The goal here is to reduce the agency costs in the investor/auditor relationship. That goal will be resisted. Sadly, if all that happens from recent accounting scandals is that further restrictions are placed on the receipt of consulting income from audit clients, then these reforms will have done little more than re-arrange the deck chairs on the Titanic.