The crisis and the auditor’s ‘structural dependence’ theory

October 7, 2008

Prem Sikka, who is a well-known critic of the current accounting system, is providing yet another list of companies who are now failing financial, but receiving a ‘clean bill of health’ from the auditors regarding their latest annual reports. We cannot argue with the facts, of course, but when it comes to explaining the reasons, or perhaps the mechanisms behind the auditing failures, we may have to dig deeper. Sikka is saying that

auditors are expected to be independent of the companies that they audit [yet] Auditors continue to act as advisers to the companies that they audit. They are hired and remunerated by the very organisations that they are supposed to be auditing. The auditor’s dependence for fees on corporate barons makes it impossible for them to be independent.

The dynamic implied in this described structural set of affairs is that there is self-censorship on the account of the auditor. Auditors realize that things are wrong with the companies they audit, yet – fearing for their auditing and consulting fees – they let things slip, hoping that there won’t be a complete collapse. I guess that the main concern I have here is empirical. The picture described sounds plausible, especially if remember the cases of Enron and WorldCom, but to establish the theory we would need to examine cases of auditors who did try to ‘test their clients’. That is, what would happen to an auditing firm that would not give a ‘clean bill of health’ to a large client? Would they lose lucrative consulting contracts with that client? Maybe even have their auditing contract withdrawn? If it can be shown empirically that such organisational set of norms on the part of the auditors’ clients exists and brings about effective results (i.e. auditors yield to their clients’ wills) then the theory of the auditor’s structural dependence on the client can be strengthened.   

Furthermore, in boiling down the role of the auditor to an agent that simply has to make the decision of either being independent (and then, possibly, pay the prices), or play along with the client, we portray a picture of reality that is too simplistic. For example, it can be assumed that there are different mechanisms in which a client and an auditor interact and surely not all of them bring about the same result of independence or, as Sikka suggests, the lack thereof.

One Response to “The crisis and the auditor’s ‘structural dependence’ theory”

  1. danielbeunza Says:

    The post is right on target, and I would go further. The problem is broader than auditor dependence on the companies. Several other financial intermediaries that produce the knowledge building blocks on Wall Street — securities analysts, credit rating agencies — suffer the same problem. Knowledge on Wall Street is not being paid for properly. Is this an instance of Arrow’s Paradox (you cannot sell information), or is there a deeper problem?

    As for empirical tests… we have one very recent in the realm of credit rating. After the scandal of sudden downgradings this past spring, Moodys became a lot more stringent. The result, unfortunately, is that it lost business.


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