Is Government Regulation of Auditors Redundant?


With Market Discipline at Work, 

Is Government Regulation of Auditors Redundant?

by Gary S. Robson and Gary H. Roseman

Gary S. Robson is an Associate Professor of Accounting at Williamson College of Business Administration, Youngstown State University and Gary H. Roseman is an Assistant Professor of Economics at the Campbell School of Business, Berry College

The perceived problems in financial reporting after the accounting scandals and the long bear market have politicians scuffling for position with rewards of expanded bureaucracy. Pressures for regulation to ensure that the Big 5, recently referred to as the “Final Four,” accounting firms perform well in the future concern accountants and economists. These concerns center on two observations: that it is impossible to ensure that such events will not recur and that markets discipline those involved. In fact, on the first point, economists would argue that problems of moral hazard may multiply with regulation.

Accounting firms, shareholders and their boards of directors, as well as financial analysts, all face market discipline that immediately started working toward a decreased probability of future accounting scandals. This nimbleness and immediate adaptability is the advantage of market discipline over government regulation. Public accounting firms, investment firms, and even the government cannot provide guarantees against business failures; such guarantees are impossible in any society and especially in one that adheres to the Schumpeterian notion of “creative destruction” of entrepreneurship. This process precludes the designation of some firms as “too big to fail.” Market forces will decrease the likelihood of massive failures like Enron and WorldCom, but they may come again.

After a $7 million fine by the SEC in June 2001 for auditing/consulting misconduct with Waste Management, followed by a $110 million settlement of a class action suit by Sunbeam shareholders, and then, a few months later, Enron, opponents of laissez-faire may say that there is proof that markets do not discipline and if they do, it is certainly not a speedy process. Information does not flow freely and there are long and variable lags, just like in macroeconomic fiscal policy. Lags in recognition and implementation exist and slowed the response to Andersen’s conduct. But once the lags passed, the move in the accounting profession was inexorably in the direction of minimization of repeats.

The charges brought against Arthur Andersen are not the totality of the punishment. The firm no longer audits publicly traded corporations after 89 years in the business because companies have replaced Andersen as their auditor so as to maintain credibility of their financial statements. Andersen is a skeletal remnant of the four billion dollar entity it was a year ago. Andersen has fewer than 1,000 employees remaining from a staff of over 28,000 employees prior to the Enron fiasco. Some Andersen partners wanted both consulting and auditing fees, but now all Andersen partners have borne the costs. Partners from all the other firms have taken notice.

An accounting firm’s reputation is one of its most valuable assets. This reputation is a signal for which Fortune 500 companies pay a premium. For public accountants who overlooked the value of goodwill on their balance sheets, Arthur Andersen has provided a significant reminder. The market tosses out firms that do not provide a product at the levels of price and quality consistent with their industry practices and expectations. Andersen has been tossed. Any firm not mindful of recent lessons concerning auditor independence could be next.

To prevent conflicts of interest, a seemingly reasonable step would be to prevent auditors from selling consulting services, at least to companies which they audit. This would, however, deny a firm’s management the freedom to contract with a party of choice, which management may see as the best particular provider of a source of added value. Shareholders lose with a reduction in the amount of value added per dollar of expenditures.

Even if many investors might not see financial statements, market preferences surface via stock analysts. Analysts can note the purchase of auditing and consulting services from the same firm and take this information into consideration when formulating recommendations. With the memory of recent events not likely to fade quickly, analysts will measure the costs to their reputations of overlooking such combinations of services. Fund managers will also beware these combinations. Certainly, public accounting firms will be shy about mixing services if their future faces the same path as Andersen. These market participants have dealt for years with pressures from brokers and investment bankers’ in-house analysts to inflate a company’s prospects, yet American financial markets have worked well and promoted a degree of mobility of capital that has produced a positive secular trend in standards of living.

Analysts still made the wrong call on Enron, as well as on others. There is no need to outlaw these mistakes because the market makes these mistakes costly. Some market-watchers did not overlook the problems. Some short sellers made large profits. Forbes reported that, before the end of April 2001, three of eight investment newsletters that tracked Enron advised its readers to sell the issue. The share price was still more than $55 in late April 2001. This information was available long before the appearance in October 2001 of Enron’s restrictions on sales of its shares in its employees’ 401(k) plans.

Please note that those shares may not have been such a concern had these employees followed standard and customary financial planning advice on portfolio diversification. Again, financial mistakes of this sort are not illegal and no reason exists to outlaw them.

The incentives for vigilance are in place and work most of the time. Markets only tend toward efficiency, meaning they do not produce a fail-safe system, but neither does government regulation. Remember this is the same government that has problems monitoring its expenditures (e.g. paid in excess of $200 each for hammers), the same government that has problems tracking money (e.g. hundreds of millions of dollars unaccounted for in educational funds during Richard Riley’s tenure), and the same government that struggles to control income tax fraud. And the tendency toward efficiency in markets means that the makers of such mistakes bear the costs and therefore they and their fellow market players take all of the foreseeable steps to minimize the frequency of mistakes.

The investing public’s evaluation of auditing/consulting deals and the quality of firms’ financial information will manifest themselves in share price movements. Audits with questionable independence, unclear financial statements and shifts in balance sheet entries will depress share prices, while forthcoming rivals will reap the rewards of higher prices, ceteris paribus, in debt and equities markets.


(Business Quest)

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