NASHVILLE, Tenn.óThink the accounting scandals of the past two years have straightened out the audit industry? Not so. A Vanderbilt University study reveals that, despite the attention called to the industry for its complicity in the corporate scandals, audit firms under pressure from major clients bending the rules are still prone to produce inaccurate audit opinionsóif they think they won’t be caught.
"Our study demonstrates that audit firms may lie to keep a profitable audit client if the expected benefits of keeping the client happy outweigh the expected costs of an audit failure if the firm gets caught," says Debra Jeter, associate professor of accounting at the Owen Graduate School of Management at Vanderbilt and co-author of the study.
The study suggests, however, that recent changes may improve the situation. As the public debate rages over whether the Sarbanes-Oxley Act of 2002 has reduced corporate fraud or improved the quality of corporate reporting, the increased public awareness and scrutiny will increase the likelihood of the audit firm getting caught, resulting indirectly in improved reporting. Similarly, other actions such as increased SEC enforcement and new rules set by the Public Company Accounting Oversight Board (PCOAB) have the potential to influence auditors’ decisions.
The study, one of the first to demonstrate what many had speculatedóthat auditors will act in their own best interestsówill be published in the November/December 2003 issue of the Journal of Accounting and Public Policy. "The Impact on the Market for Audit Services of Aggressive Competition by Auditors" is co-authored by Jeter; Paul Chaney, associate professor of accounting at the Owen School at Vanderbilt; and Pam Shaw of Tulane University.
The study sheds new light on how audit firms actually go about their business, given the pressures of the marketplace. "In an up market, the likelihood of an audit failure being discovered was low," Jeter explained. "Audit partners, such as in the Enron audit, may have viewed the benefits of producing a tainted audit as outweighing the costs of being discovered.
"If the likelihood that the firms will get caught if using questionable accounting increases," she explained, "their auditors, in evaluating the costs of an audit failure, will think twice and realize that their best interest lies in insisting on fair reporting."
The study shows that regulators can ensure more truthful audit opinions by increased scrutiny of financial statements and increased penalties. "Since audit firms assess the likelihood of audit failures, either covertly or overtly, policies that increase this probability are needed," Jeter said. "These might include increased scrutiny or enforcement by the SEC or mandatory rotation of auditors or partners in charge of an audit. The SEC or the PCAOB need to step up their efforts, and thereby increase the likelihood that violators will be caught."
For companies being audited, Jeter advised that companies must constantly monitor and improve the internal audit function. "Top management should require managers at various levels within the firm to certify the numbers they are responsible for. Companies should make sure that mostóif not allóaudit committee members are financially literate and that they meet more than once a year. This is vital."
The study suggests that audit firms should rotate partners in charge of large audits and that audits should remain independent of consulting work by the same firm. "Audit firms must recognize that a lack of independence not only damages the auditor’s reputation, but it also can reduce their clients’ market value," Jeter said. Recent news that Deloitte Touche Tohmatsu voted to keep both its consulting division and audit business may be bad news for both the audit firm and its clients. "For firms reluctant to pass up the often lucrative consulting work," she warns, "lost independence reduces the credibility of the financial statements."
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