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

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 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. Unfortunately, auditors are subject to conflicts of interest by, for example, providing non-audit services or the mere fact of being hired and paid by the audited company. Therefore, even if auditors act independently, investors have reason to think otherwise. This lack of trust can undermine a firm’s access to financing and the development of capital markets. Policymakers and scholars around the world have attempted to solve the auditor independence puzzle through a variety of mechanisms, including prohibitions and rotations. More recent proposals have also included breaking up audit firms and the empowerment of shareholders. This paper argues that none of these solutions is entirely convincing. For this reason, we propose a new model to solve the auditor independence puzzle. Our proposal is based on four pillars. 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, some studies have shown that audit committees seem to fail to perform their monitoring functions. A major reason appears to be 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.