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

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

Martin Gelter, Aurelio Gurrea-Martinez

Series number :

Serial Number: 
479/2019

Date posted :

November 10 2019

Last revised :

November 10 2019
SSRN Share

Keywords

  • Auditing • 
  • Accounting • 
  • Big 4 • 
  • Enron • 
  • Sarbanes-Oxley • 
  • EU Audit Directive • 
  • EU Audit Regulation • 
  • gatekeepers • 
  • quasi-rents • 
  • auditor rotation • 
  • non-audit services • 
  • majority-of-the-minority approval • 
  • auditor compensation • 
  • transparency reports • 
  • audit firm governance

Auditors play a major role in corporate governance and capital markets. Ex ante, auditors facilitate firms’ access to finance by fostering trust among public investors. Ex post, auditors can prevent misbehavior and prevent financial fraud by corporate insiders.

In order to fulfill these goals, however, in addition to having the adequate knowledge and expertise, auditors must perform their functions in an independent manner. However, auditors often find themselves in situation where their actual independence or their independence in appearance is compromised (sometimes without a conscious decision or the auditor necessarily realizing the problem). For example, non-audit services may contribute to such conflicts. Moreover, the mere fact that the audited corporation typically selects the auditor raises questions about whether the system is set up for truly independent audits. Policymakers and scholars around the world have attempted to solve the auditor independence puzzle through a variety of mechanisms, including prohibitions of certain services, auditor rotation, and more recently breaking up of audit firms and the empowerment of shareholders. This paper argues that none of these solutions is entirely convincing. Drawing from the corporate governance, law and economics, and accounting literatures, this paper proposes a new model to strengthen auditor independence. We argue that future reform should emphasize three primary pillars for the benefit of public investors, but also for the promotion of firms' access to finance and the development of capital markets. First, in controlled firms, auditors should be elected with a majority-of-the-minority vote. Second, the role, composition of the audit committee are crucial to strengthen auditor independence. Third, policymakers must pay close 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 and credibility of auditors.

Published in

Published in: 
Publication Title: 
Vanderbilt Journal of Transnational Law, Forthcoming

Authors