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Auditing negligence: Get to the root of it
January, 13th 2009

The rise and fall of Satyam Computer Services is the stuff of management textbooks but has lessons for regulators as well. While the promotersof the company are clearly guilty of fraud, the role of the companys auditors, PriceWaterhouse, is also open to question.

Remember, investigations into the Enron fraud showed company auditorsArthur Andersonas guilty as Enrons CEO. Consequently, investigators in India too will be on the lookout for evidence of collusion between the companys auditors and promoters. It is too early to say whether they will find any.

Nonetheless there is no denying that the present system whereby auditors are, in practice, appointed by company managements does create a perverse incentive, a conflict of interest that heightens the risk of fraud.

To quote Joshua Ronen, Professor of Accounting at the Stern School of Business, New York, misaligned incentives of auditors possibly contributed to the failure of their gate-keeping function. In a paper published in the Stanford Journal of Law, Business and Finance* soon after the Enron debacle, he argues that although we may be enraged that certain individuals and companies violated our trust, prosecution and ultimate punishment may not fully deter wrongdoing.

Overhauling the regulatory structure and adding layers of supervision and monitoring by the government would be at best inefficient and socially wasteful. The solution, says Ronen, lies in a market mechanism that realigns the incentives of the players so that honesty is pursued in the self-interest of CEOs, CFOs, boards of directors
, and auditors and perverse incentives are eliminated.

In an ideal world where everyone is 100% ethical, conflicts of interest would not pose a problem. Auditors, even if they are appointed by company managements, know they are actually responsible to its shareholders and must act as their watchdog.

But we do not live in a Utopian world. We live in a world where there will always be elements prepared to bid goodbye to ethics if the inducement is high enough. So we need to install institutional mechanisms to guard against such situations. Unfortunately, this has just not been addressed, despite the rash of measures, including the Sarbanes-Oxley Act, enacted after the Enron debacle.

The net result is the incentives driving auditors behaviour are not conducive to obtaining unbiased reports. On the contrary, auditors operate under perverse incentives, where they are paid by companies they audit and hence are beholden to the CEOs and CFOs , who ultimately make the call regarding hiring of their services.

On paper, shareholders vote on management recommendations regarding which auditor is to be hired. But thanks to widely dispersed share ownership and proxy voting, in practice, it is management that calls all the shots. Fear of losing future business means audit companies are likely to hesitate to fall foul of management and be more willing to turn a blind eye to unethical/wrong management practices.

Ronen argues that no exogenous force legislation, regulation, enforcement or litigationcan resolve this conflict of interest. It can only be resolved by severing the agency relationship between the client and the auditor and instituting in its place an agency relationship between the auditor and a principal, whose economic interests are aligned with the interests of investors.

 
 
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