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Alternative perspectives to deal with


auditors agency problem

Article in Critical Perspectives on Accounting May 2007


DOI: 10.1016/j.cpa.2006.01.011

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Ilanit Gavious
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Critical Perspectives on Accounting 18 (2007) 451467

Alternative perspectives to deal with


auditors agency problem
Ilanit Gavious
School of Management, Department of Business Administration, P.O. Box 653,
Ben-Gurion University, Beer-Sheva 84105, Israel

Received 30 July 2005; accepted 22 January 2006

Abstract

Auditors agency problem stems from the mechanism according to which auditors (the agents)
are being appointed to companies and paid for their services by the managements they audit (the
principals). This mechanism creates an inherent conflict of interests for auditors. The Sarbanes-Oxley
Act of 2002 was enacted as part of the efforts to strengthen auditors independence and mitigate
the effect managements have on their auditors. However, the Act has been, and still is criticized for
deficiencies embedded in its provisions. This paper presents an alternative regulatory framework for
auditors based on analysis of the Sarbanes-Oxley Act provisions related to auditors and of other
perspectives to deal with auditors agency problem from previous studies. The proposed framework
aims to decrease the ability and incentives of both managements and auditors to collaborate in financial
statement fraud. Under the premise that auditors need to function in a framework that discourages
immoral behavior, the main provisions of the Sarbanes-Oxley Act related to auditors independence
are addressed, requiring audit-firm rotation instead of audit-partner rotation, and expending the time-
window between provision of audit and non-audit services. In addition, it is proposed that retiring
audit firms accompany entering audit firms until completion of the first annual financial statement
audit and that audit fees will be scrutinized by the SEC.
2006 Elsevier Ltd. All rights reserved.

Keywords: Agency problem; Auditors conflict of interests; Auditor independence; Sarbanes-Oxley Act of 2002;
Financial statement fraud; Accounting fraud; Misrepresentation in financial statements; Enron

Tel.: +972 8 6477538; fax: +972 8 6477691.


E-mail address: madaril@bgu.ac.il.

1045-2354/$ see front matter 2006 Elsevier Ltd. All rights reserved.
doi:10.1016/j.cpa.2006.01.011
452 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

1. Introduction

High-profile bankruptcies in recent years involving large U.S. firms (e.g., Enron, World-
com and Global Crossing) and the criminal indictment of Arthur Andersen catalyzed public
criticism against external auditors. They were held responsible for not detecting the poten-
tial for bankruptcy and thus for not warning investors. The ability to detect an imminent
bankruptcy based on accounting information has been extensively examined during the past
four decades (e.g., Altman, 1968; Beaver, 1966; Flagg et al., 1991; Kane et al., 1996; Koh
and Killough, 1990; Ohlson, 1980). Accounting information available prior to bankruptcy
has been shown to be associated with the likelihood of bankruptcy. Stated differently, firms
financial statements in the years prior to bankruptcy are useful in predicting the bankruptcy.
Altman (1968) and Zemijewski (1984), for example, indicate that symptoms of financial
distress may become evident as early as four years prior to bankruptcy; however, the most
noticeable change occurs between the third and the second years before bankruptcy filing.
The public expects financial professionals, including auditors and financial analysts, to be
able to predict and warn of imminent bankruptcy. The roles of auditors and financial ana-
lysts are discerned in a report submitted to the U.S. Senate in 2002, The Worsening Crisis
of Confidence on Wall Street, by Weiss Ratings Inc. (see Section 2). The report states that
for shareholders seeking protection, Wall Street research analysts are merely the second
line of defense. The first line of defense is manned by public auditors . . ..
Hence, if bankruptcy occurs unexpectedly, auditors may be suspected by the public for
collaborating with the failing management in misleading the market during the years prior to
bankruptcy. Specifically, the suspicion is that auditors deliberately avoid their responsibility
to issue a going-concern opinion when substantial doubt exists about the firms ability
to continue as a going-concern. Moreover, direct involvement of auditors in fraudulent
activities has been revealed in cases such as that of the Arthur Andersen accounting firm
after the downfall of some of its clients (especially that of Enron corporation). Such direct
involvement may include encouraging management to illegitimately manage earnings using
aggressive accounting techniques.
Auditors involvement in accounting frauds is a product of a mechanism in which their
role as independent intermediaries between companies and market participants (including
investors, creditors and employees) is impaired. Sikka and Willmott (1995) argue that in
the process of defining, defending and extending its jurisdiction, the accountancy profession
attaches considerable importance to its image of independence. However, a mechanism
in which auditors (the agents) are being appointed and paid for their services directly
by their auditees (the principals) creates an inherent conflict of interests for the former
(henceforth referred to as auditors agency problem). In the current setting, auditors are
many times driven to comply with the wishes of their auditees, in order to minimize the
risk of loosing fees from an audit engagement. As the audit engagement lengthens, the
strings (economic and personal) between auditors and their auditees thicken. These strings
impair auditors role as independent gatekeepers. AICPAs Statement on Auditing Standards
(SAS) No. 1 provides that an auditor with a financial interest in a company might be
unbiased in expressing his opinion . . . the public would be reluctant to believe that he was
unbiased. Massive accounting frauds during the past several years, and the revelation of
auditors involvement in these frauds, prove the public right for suspecting that financial
I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 453

interests bias auditors judgment. Realizing that auditors independence and competence
must be strengthened, AICPA issued SAS No. 99 in 2002. SAS No. 99 requires auditors
to consider the possibility that a material misstatement due to fraud could be present, be
skeptical and act upon this skepticism; however, it does not deal with auditors agency
problem.
The Securities and Exchange Commission (SEC) also realized it had to strengthen its
requirements regarding auditors independence. On July 30, 2002, the Sarbanes-Oxley
Act was passed into law, aiming to enhance auditors independence, improve corporate
governance, and thus improve financial statements quality. However, it has been, and still is
being, criticized by both practitioners and academicians for being too ambiguous and for not
sufficiently addressing the core problem of auditors conflict of interests (e.g., Cotton, 2002;
Cullinan, 2004; Kopel, 2003a; McMillan, 2004). This paper discusses the provisions of the
Sarbanes-Oxley Act relating to auditors independence and their potential weaknesses.
Extensive literature exists on the issue of auditor independence (see, e.g., Cotton, 2002;
Dontoh et al., 2004; Kinney et al., 2004; Kopel, 2003a; Kopel, 2003b; McMillan, 2004;
Rezaee, 2005; Ronen, 2002).1 This paper addresses the concern that existing rules and
regulations do not sufficiently cope with auditors agency problem (Cotton, 2002; Cullinan,
2004; Kopel, 2003a; McMillan, 2004; Nixon, 2004b; and Rezaee, 2005 among others). This
concern has led to a search for better ways to deal with this problem. However, whereas
many studies exist that criticize the current state of affairs, only a few present an alternative.
The main study to present an alternative solution to auditors agency problem is that of
Ronen (2002). His suggested solution is based on a new institutional mechanism, in which
companies do not appoint and pay auditors; instead they are able to purchase financial
statement insurance. The insurance company would be the one to appoint and pay auditors,
in order to adequately determine the terms of the insurance policy. The terms of the policy
will have to be publicized within the insured financial statements so that the public would
be able to distinguish between high-quality financial statements (higher limits of coverage
and smaller premiums) and low-quality financial statements (smaller limits of coverage and
higher premiums).2
This paper suggests another perspective to deal with auditors agency problem. It aims
to deal directly with the main loopholes and weaknesses embedded in the provisions of the
Sarbanes-Oxley Act relating to auditors independence. First, in the proposed regulatory
framework, the audit-firm, rather than audit-partners within the firm, must rotate off the
audit engagement after a few consecutive years (e.g., a seven-year time limit). It is realized
that a long-term relationship between an auditor and an auditee is problematic; however,
replacing one audit-partner with another does not disengage the audit-rms interests in a
long-term audit-client. Thus, an audit engagement between an accounting rm and a certain
company should be limited in time.

1 Additional literature on auditor independence includes Baker (2005), Lindberg and Beck (2004), Siegel and

McGrath (2003), Wyman (2004), among many others. The extensive literature on auditor independence, especially
during the years following the financial scandals in the U.S., reflects evolving worldwide interest in this important
issue.
2 Dontoh et al. (2004) provide a formal economic model for the financial statement insurance concept, pioneered

by Ronen (2002).
454 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

Second, in the proposed regulatory framework, the time period separating between the
provision of audit and non-audit services is extended relative to the current rules (which
prohibit provision of the two types of services contemporaneously). Given that economic
interests and loyalties are built over time, and may not be terminated instantly by the time
a non-audit or audit engagement is terminated, contemporaneously may be too short a
time-window to disengage economic interests that may spill over from one type of service
to another.
The restrictions on audit and non-audit engagements between accounting firms and their
clients as per the proposed regulatory framework reduce auditors incentives to cooperate
with audit-clients in fraudulent activities. The premise is that auditors need to operate in a
framework that discourages immoral behavior. Still, auditors may face an encouragement
to comply with their clients wishes through higher audit fees. In addition, mandatory audit-
firm rotation may increase the chance of an audit failure. To deal with these possibilities,
additional regulations aimed to reduce the risks of the proposed framework are presented.
It is suggested that the SEC would scrutinize audit fees and that retiring audit firms would
accompany entering audit firms until completion of the first annual financial statement
audit. This paper discusses the implementation of such regulations.
The remainder of this paper is organized as follows: in Section 2, the role of external
auditors in recent accounting frauds is discussed. Section 3 presents the provisions of the
Sarbanes-Oxley Act related to auditors independence, together with a discussion of their
weaknesses. Section 4 discusses auditors agency problem and solutions suggested in pre-
vious studies. Section 5 presents an alternative perspective to deal with auditors agency
problem, based on a change in the regulatory framework for auditors. Section 6 contains
summary and concluding remarks.

2. Auditors role in recent accounting frauds

Recent accounting frauds involving large U.S. firms like Enron and Worldcom have
caused enormous losses to market participants, estimated at more than US$ 500 billion
(Cotton, 2002; Rezaee, 2002). Accountants involvement in the frauds was highlighted,
shaking markets trust in the accounting profession, mainly within the big five international
accounting firms. The professions reputation of integrity and reliability was damaged thus
causing financial losses to accounting firms. The ultimate price has been paid by Arthur
Andersen for encouraging clients such as Enron, Worldcom, Quest and Global Crossing
to use accounting techniques to deceive and mislead the market. Arthur Andersen ceased
to exist. Other accounting firms also paid their price either by facing audit-failure-related
class action suits and/or losing value due to the loss of markets trust. For example, Price-
WaterhouseCoopers international consulting arm lost 80% of its value within a little more
than one year (from 2000 to 2002; see McMillan, 2004).3
Motivated by the recent financial scandals, a report entitled The Worsening Crisis
of Confidence on Wall Street was submitted to the U.S. Senate on July, 5, 2002. The

3 McMillan (2004) elaborates that PWCs consulting arm was sold to IBM in the summer of 2002 for US$ 3.5

billion, dramatically less than the US$ 18 billion offered by Hewlett Packard in 2000.
I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 455

report, based on a study conducted by Weiss Ratings Inc., aimed to determine whether
auditors detect and warn of accounting irregularities and imminent bankruptcies.4 The
report criticizes auditors for not recognizing going-concern situations thus failing to predict
bankruptcies that occurred within one year after the date of the most recent financial state-
ment. The researchers conclude that The data demonstrate a broad and massive failure by
auditors to adequately detect and warn of accounting irregularities and bankruptcies as the
first line of defense against precisely such problems.

3. The Sarbanes-Oxley Actprovisions related to auditors independence and


their potential weaknesses

SAS No.1 provides that


It is of outmost importance to the profession that the general public maintains con-
fidence in the independence of independent auditors. Public confidence would be
impaired by evidence that independence was actually lacking, and it might also be
impaired by the existence of circumstances which reasonable people might believe
likely to influence independence. To be independent, the auditor must be intellectually
honest; to be recognized as independent, he must be free from any obligation to or
interest in the client, its management, or its owners . . .
The revelations of massive accounting scandals have proved existing rules requiring
auditors independence to be insufficient. In response, the Sarbanes-Oxley Act was passed
into law on July 30, 2002. The Sarbanes-Oxley Act is aimed at enhancing auditors indepen-
dence, improving corporate governance and thus, improving financial statements quality.
This article focuses on the main provisions directly related to auditors independence. In
January 2003 the SEC approved new rules, Strengthening the Commissions Require-
ments Regarding Auditors Independence, mandated by title II of the Sarbanes-Oxley Act
(henceforth new SEC rules). The new SEC rules severely restrict auditors from providing
non-audit services to a client, contemporaneously with the audit of that client.5 Auditors

4 Information on the Weiss report was extracted from Akers et al. (2003). The database used in the Weiss study
included 45 companies that declared bankruptcy between January 1, 2001 and June 30, 2002, after having received
an unqualified audit report (i.e., without their auditors issuing a going-concern opinion). For each firm, seven
financial ratios, alleged to be useful predictors of bankruptcy, were computed based on the financial statements
for the last fiscal period preceding its bankruptcy. The financial ratios used in the Weiss report include cash flows
from operations to total debt; net working capital to total assets; debt to equity; return on equity; current ratio; net
income to sales; and cash flow to current liabilities. Akers et al. discuss the weaknesses of the Weiss report and
show that, applied to a broader group of companies, Weiss criteria would have incorrectly predicted bankruptcy
for nearly half of the non-bankrupt companies studied.
5 The prohibited non-audit services include: (1) bookkeeping or other related services; (2) financial information

systems design and implementation; (3) appraisal (valuation) services, fairness opinions; (4) actuarial services; (5)
internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment
adviser, or investment banking services; (8) legal services and expert services unrelated to audit; (9) any other
service that the Public Company Accounting Oversight Board determines by regulation is impermissible. Any
non-audit services that are not described above, including tax services, are not prohibited, provided that the activity
is approved in advance by the audit committee of the company.
456 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

providing non-audit services to their audit-clients face conflict of interests, especially when
non-audit fees out-weigh audit fees. Nixon (2004a) reports that non-audit to audit earnings
has dropped from 3:1 in 2001 (pre Sarbanes-Oxley Act) to 1.9:1 in 2002 to 1.3:1 in 2004.
Whereas non-audit earnings decreased in the years post-Sarbanes-Oxley Act, audit earn-
ings increased. It should be noted that accounting practitioners have claimed that providing
non-audit services does not damage audit quality (see, for example, citations in Nixon,
2004a). At the same time, academic research does not provide unequivocal conclusions
regarding this issue (e.g., Kinney et al., 2004; Lai, 2003; McMillan, 2004). Lai (2003)
shows that restricting non-audit services enhances auditors independence.6 On the con-
trary, McMillan (2004) doubts the efficacy of this restriction, claiming it does not answer the
moral inadequacy question which underlies the main problem of the accounting profession.
McMillan asserts that If the problem is that an auditor is susceptible to excessive pressure
from management such that the audit veracity will be compromised then how does limiting
non-audit service ipso facto provide moral backbone to resist that pressure? In addition
to questioning the effectiveness of prohibiting non-audit services, critics have claimed that
the definition of the prohibited services according to the new SEC rules is broad and thus
ambiguous. It is not clear enough what is the scope of the prohibition against providing
non-audit services (see Kopel, 2003a, for discussion and examples of misinterpretation that
may occur due to this ambiguity).
The new SEC rules also prohibit an audit partner from being compensated for non-
audit services provided to its audit-clients. However, he can be compensated for non-audit
services provided to non-audit-clients. The accounting firm is required to disclose its fees
by four categories: audit fees; audit-related fees7 ; tax fees; all other fees. Moreover, the rules
enable companies to allocate fees from certain non-audit services, such as tax and consulting
services, in the audit fees category to the extant that such services are necessary to comply
with GAAS (see also, Kopel, 2003b). Kopel (2003b) asserts that this wrinkle in the fee
disclosure rules will create headaches for attorneys and accountants in determining the
proper allocation of non-audit services to the audit fees category. This creates a loophole
that may allow non-audit fees to spill over to the audit and/or audit-related fees category.
In all, the main weakness of the fee disclosure rules is the difficulty to assess whether the
accounting firm appropriately classified its fees into the four categories.
In addition to limiting non-audit services to audit-clients, the new SEC rules also require
enhancement of auditors rotation and expansion and clarification of reports by auditors to
audit committees of boards of directors. Regarding auditors rotation, the requirement is
that lead and concurring partners rotate off the audit engagement after five consecutive years
whereas other audit partners8 rotate after seven consecutive years. Additionally, lead and
concurring partners (other audit partners) are required for a five-year (two-year) time-out

6 Lai (2003) uses the issue of modified audit opinion and the provision of discretionary accruals as measures of

auditors independence.
7 Audit-related fees may include, e.g., fees paid for due diligence services, internal control reviews, account-

ing consultation and audit services in the course of transactions such as mergers and acquisitions, consultation
concerning financial accounting and reporting standards, etc.
8 Audit partners are defined as a partner or persons in an equivalent position, other than a partner who consults

with others on the audit engagement team during the audit, review or attestation engagement regarding technical
or industry-specific issues, transactions, or events, who is a member of the audit engagement team who has
I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 457

provision before returning to the engagement.9 As for auditors reports to audit committees,
the requirement is that the accounting firm must report to the issuers audit committee
prior to the filing of the audit report with the SEC all critical accounting policies and
practices to be used; all alternative treatments of financial information within GAAP that
have been discussed with management officials of the issuer, ramifications of the use of such
alternative disclosures and treatments, and the treatment preferred by the accounting firm;
other material written communications between the accounting firm and the management.
The communication between the accounting firm and the audit committee does not have
to be in writing; however both parties are expected to document these communications.
Naturally, this expectation of the SEC would be difficult to impose as its implementation
would be hard to monitor.
The new SEC rules require a cooling-off period, according to which an accounting firm
cannot perform audit services for an issuer if a person serving in a position10 for that issuer
was employed by the accounting firm and participated in the audit of that issuer during the
one-year period preceding the date of the initiation of the audit. Purportedly, a one-year
period may seem insufficient for cooling-off before being employed by the client, without
the accounting firm losing independence. However, empirical evidence does not support
this concern. Geiger et al. (2005) compare between companies that hired senior financial
reporting executives (e.g., CFO, VP-Finance, Controller) directly from their accounting firm
with companies that hired these individuals from other sources or retained their incumbent
financial reporting executives. They find that earnings management (in the form of increased
accounting accruals) is no greater in companies hiring senior financial reporting executives
directly from the external audit firm. No significant differences are found in the changes of
reported accounting accruals in the years surrounding the hiring of their former auditors,
compared to the groups of control firms that did not hire their former auditors. In addition,
the changes in accruals in the years surrounding the hiring of former auditors are relatively
stable. Geiger et al. conclude that these hiring situations (so-called revolving door) do
not impair auditor independence.
The efficiency and eventual impact of the Sarbanes-Oxley Act of 2002 is yet to be
seen. As elaborated above, each of the provisions related to auditors independence has
its embedded weaknesses. Beyond specific deficiencies, the Act is mainly criticized as too
ambiguous (e.g., Kopel, 2003a)11 and insufficiently addressing the core problem of auditors
conflict of interests (e.g., Cotton, 2002; McMillan, 2004). Cullinan (2004) asserts that the

responsibility for decision making on significant auditing, accounting and reporting matters that affect the financial
statements, or who maintains regular contact with management and the audit committee. Audit partners also
include lead partners on audits of subsidiaries whose assets or revenues constitute at least 20% of the consolidated
assets or revenues.
9 Small accounting firms are exempted from the partner rotation requirements. For that matter, an accounting

firm is small if it has fewer than five audit clients and less than ten partners.
10 The cooling-off provision applies to the positions of chief executive officer, controller, chief financial officer,

chief accounting officer, member of the board of directors, general counsel position, other financial positions (e.g.,
treasurer).
11 The role of the new Public Company Accounting Oversight Board (PCAOB) created by the Sarbanse-Oxley

Act of 2002 also seems to be ambiguous. Rezaee (2005), for example, points at the uncertainty regarding the
extent to which the new oversight board will issue audit standards. See also Cullinan (2004).
458 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

Sarbanes-Oxley Act is unlikely to be completely effective in dealing with future frauds


since it attacks specific symptoms of the audit breakdown that occurred in the Enron case.
According to Rezaee (2005), additional regulations are still required for, inter alia, creating
a new regulatory framework for auditors and establishing higher standards for corporate
governance. This study proposes additional regulations and changes to existing provisions
required to further reduce auditors conflict of interests and restore public confidence in
audited financial statements.

4. Auditors agency problem and solutions from previous studies

Auditors agency problem stems from a mechanism in which auditors (the agents) are
being appointed and paid for their services directly by their auditees (the principals). Dontoh
et al. (2004) and Lai (2003), among others, claim that it is management that hires or fires
an auditor and pays for audit and non-audit services. Here lies the main problemthe
auditor is obviously dependent upon the management he audits. The main consideration
of auditors working in the current setting is to minimize the risk of loosing audit fees, and
prior to the Sarbanes-Oxley Act, also loosing even higher amounts of non-audit fees. The
Sarbanes-Oxley Act provides only a partial solution to the problem, given that the (partial)
elimination of non-audit fees from audit-clients does not eliminate auditors dependence
upon management for their audit fees. This dependency may drive auditors to comply with
managements wishes and even collaborate in fraudulent activities.
Auditors are aware of the risk in collaborating with fraudulent management. SAS No.
99 specifically instructs auditors to exercise professional skepticism when considering the
possibility that fraudulent misstatements could be present. It gives guidelines to the con-
sideration of fraud as part of planning the audit and when gathering and evaluating audit
evidence. It also provides guidance regarding auditors communications about fraud to
management, the audit committee, and others. Auditors who choose to allow low-quality
financial statements to be released to the market understand they may have to face legal
liability from shareholders class action suits. However, reality has proven that they might
be more concerned with the risk of loosing a client, especially if it is a long-term client.
This loyalty to long-term clients paid-off in many cases where auditors were sued by
shareholders, when the latter were eventually compensated out of the corporations own
resources. Further, both management and auditors know that some cases do not find their
way into a court of law because of the high costs of suing auditors. Dontoh et al. (2004) fur-
ther discuss the inefficiency of an increased liability exposure of auditors. First, they claim
that such an increase in the liability exposure of auditors cannot deter malpractice because
it fails to address the misallocation of risk and resources. They explain that, Imposing
higher litigation penalties on the auditor ex post does not enhance the ability of society
to distinguish, ex ante, between firms with intrinsically high returns and the Enrons and
Worldcoms of the world which have intrinsically low or negative returns but misrepresent
themselves as high-return firms. Second, according to Dontoh et al. increased exposure
to liability and high-legislated penalties may drive auditors out of the business of auditing
altogether. Third, as intentional misrepresentation is difficult to discover or prove, adding
layers of supervision and monitoring by the government would be inefficient and socially
I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 459

wasteful as prosecution and punishment may not adequately deter wrongdoing. Fourth,
Dontoh et al. assert that little can be done in the short run to cultivate ethical personalities.
They conclude that an alternative solution to auditors agency problem is needed, one that
is not based on legislation, regulation, enforcement, or litigation.
Ronen (2002) suggests an alternative institutional mechanism to eliminate auditors
conflict of interests, called Financial Statement Insurance (FSI, see also Dontoh et al.,
2004 who provide an economic model for FSI, and Ronen and Cherny, 2002). In the FSI
mechanism companies would not appoint and pay auditors; instead, they would be able to
purchase financial statement insurance that provides coverage to investors against losses
suffered as a result of misrepresentation in financial statements. The terms of the insur-
ance policy would have to be publicizedboth the amount of insurance coverage and the
associated premiums.12 In the FSI model, those firms announcing higher (smaller) limits
of coverage and smaller (higher) premiums would distinguish (reveal) themselves in the
eyes of the investors as companies with higher (lower) quality financial statements. Every
company would be eager to get higher coverage and pay smaller premiums. Thus, FSI is
supposed to provide an incentive to firms to improve the quality of their disclosures volun-
tarily. The insurance company, in order to adequately determine the terms of the insurance
policy, would appoint and pay auditors. The insurance company needs auditors to attest to
the quality and accuracy of the financial statements of the prospective insurance client. In
this mechanism, the auditors interests are aligned with those of the insurance company
which are aligned with those of investors and other market participants such as creditors
and employees. The auditors are not dependent upon their auditees for their appointment
and fees. More than that, the auditors now identify with the parties who would suffer a loss
in case of an audit failure.
The FSI system indeed provides an alternative solution to the current market inefficien-
cies that result from auditors agency problem. However, as with any proposal, it presents
challenges. Dontoh et al. (2004) claim there is a need to align the interest of shareholders
with the auditors reward structure through an intermediary who does not benefit from the
price at which securities are traded. To make sure that the intermediary (the insurance com-
pany) does not benefit from the price at which securities are traded, the FSI model should
include a condition that the insurance company cannot invest in securities of companies
whose financial statements it insures. Existing investments in potential insured companies
would have to be immediately sold. This condition restricts insurance companies ability
to profit from their financial resources, thus eliminating part of the income provided by the
new business of FSI.
The FSI model should also include a condition according to which auditors appointed by
the insurance company cannot provide non-audit services to FSI clients they audit. How-
ever, having met these conditions, there is still the question whether involving insurance
companies as intermediaries between shareholders and auditors is practical. Would insur-
ance companies really want to get into this new risky business? Even if auditors interests
are no longer aligned with those of their auditees, an audit failure can still occura new
risk to the insurance company. In addition, the cost of an audit process can be extremely

12 The amount of insurance that covers the financial statements and the related premiums will be disclosed in a

special paragraph in the auditors opinion.


460 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

high13 much higher than the amounts paid by insurance companies to other professionals
(such as medical doctors, real estate appraisers, etc.) as part of the process of determining the
terms of an insurance policy. Notably, the more reputable the auditor and the larger and/or
complex the audited company, the higher is the cost of an audit engagement. In these
cases, FSI policies might be relatively expensive (i.e., higher related premiums) in order
for them to be profitable for the insurance company. This outcome contradicts the central
purpose of the FSI model, which is that the terms of the insurance policy would directly
signal financial statements quality. For example, the financial statements of a company
may actually be of high quality; however, this company might have to pay higher premiums
needed by the insurance company to cover high audit fees. In another case, the auditor may
recommend not insuring the audited financial statements (a signal that financial statements
are of very low quality) based on information that was not revealed, or could not be revealed,
in the preliminary review of the potential insured company14 ; in such a case the audit fees
paid by the insurance company would become sunk-costs. This is part of the inherent
risks of insurance companies. However, given the scale of an audit process and price, the
burden of audit costs may drive insurance companies out of the FSI business.
Finally, according to the FSI model, higher limits of insurance coverage with smaller
related premiums would signal higher quality financial statements, in comparison to smaller
coverage with higher premiums. It should be noted that the FSI policy terms are comparable
between similar firms. That is, the amounts of coverage and related premiums are not just a
function of financial statements quality, but also of other factors such as size and industry.
The size effect on insurance coverage can be demonstrated as follows. In the case of an
accounting fraud and/or an audit failure, the total amounts of losses suffered by stakeholders
(mainly shareholders, creditors and employees) in absolute dollar terms in a large company
would be higher than those suffered by stakeholders in a small company. Thus, the amount
of insurance coverage of a large company is expected to be higher than of a small company.
In order to compare between companies (operating in the same industry) based on their FSI
policy terms, the amount of coverage needs to be scaled by firm size.
Cunningham (2004) deals with the challenges and hurdles of FSI from law perspective
and attempts to show how certain limitations can be overcome.
Another perspective to remedy financial statement frauds is presented by Rezaee (2005).
Rezaee presents strategies for prevention and detection of financial fraud. These strate-
gies are mainly based on the willingness of corporate governance participants (including
external auditors)15 to fulfill their responsibilities for preventing and detecting fraud. For
example, Rezaee suggests that corporations should consider and implement fraud vulner-
ability reviews and fraud hotlines that can be used by insiders (e.g., employees, internal
auditors) and outsiders (e.g., customers, suppliers) to report fraudulent activities. Rezaees
strategies also rely on the efficiency of enhanced legal liability and criminal penalties for

13 Audit fees of a large-scale corporation may reach up to tens of millions of dollars.


14 According to the FSI model, the audit process takes place only after a preliminary review of the potential
insured company has been conducted, and the latter was not found disqualified for insurance. The reviewer can
be the same auditor who will eventually audit the financial statements (Ronen and Cherny, 2002).
15 In Rezaee (2005), corporate governance participants include board of directors, audit committee, top manage-

ment team, internal auditors, external auditors and governing bodies.


I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 461

cooking the books. As stated above, enhanced legal liability and punishment may only
have a partial impact, not enough to solve the auditing dilemma. The motivation to commit
the crime needs to be lowered, more than criminal penalties need to be increased. Based on
this premise, an alternative regulatory framework for auditors is presented below.

5. An alternative regulatory framework for auditors

The U.S. SECs mission, by definition, is to protect investors and maintain the integrity
of the securities markets.16 The recent financial scandals prove that investors are in dire
need of protection from fraudulent managements, especially those that have their auditors
collaboration, directly or indirectly. Even after Sarbanes-Oxley and the new SEC rules,
investors still fear compromized auditors independence (Nixon, 2004b). They feel existing
rules are not sufficient to strike at the core of the problem of auditors dependency upon
their auditees. The insufficiency of the Sarbanes-Oxley Act and the need for additional
SEC regulations is also echoed by Rezaee (2005). SECs involvement in the relationship
between auditors and auditees is both essential and natural. Who is more appropriate to
intervene as an objective intermediary than the SEC? In contrast to insurance companies,
which are suggested by Ronen (2002) as an intermediary, the SEC is not a business entity;
thus, its considerations are truly aligned with the interests of investors and other market
participants, and perceived as such by the public.
Sarbanes-Oxley Act, FSI model and Rezaees 2005 strategies for prevention and detec-
tion of financial fraud are the main perspectives to deal with auditors agency problem thus
far. Further regulations still need to be adopted by the SEC to minimize auditors agency
problem. In what follows, changes to main provisions of Sarbanes-Oxley Act related to
auditors are presented along with new regulations aimed at dealing with possible risks of
the proposed framework.

5.1. Audit-rm rotation

Auditors natural interest to maintain the stream of revenues from audit services (and
preferably to increase it) may drive them to comply with audit-clients wishes, particularly
long-term clients,17 in order to assure audit engagement continuity. Had auditors known in
advance that an audit engagement is short-termed, the incentive to collaborate with the short-
term audit-client in financial statements misrepresentations would be reduced dramatically.
In addition to economic interests, long-term audit engagements tend to generate personal
attachments and loyalties, which weaken the objectivity, impartiality and independence
required from auditors. The new SEC rules, mandated by the Sarbanes-Oxley Act, acknowl-
edge the problem of a long-term relationship between an auditor and an auditee and thus
require audit partners rotation off the audit engagement after a few years and a time-
out provision before returning to the engagement. However, rotation of partners within an

16 The U.S. SECs Internet Home Page.


17 In a study from 2003, GAO Kills Mandatory Auditor Rotation, it is shown that auditor tenure for Fortune
1000 companies is, on average, 22 years (see also, Arel et al., 2005).
462 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

accounting firm does not adequately deal with the core of the problem, as interests in an
audit-client may not be specific to a partner. Each partner in an accounting firm represents
the interests of that firm. Thus, to disengage mutual interests between the accounting firm
and the audit-client, focus should not be put on a specific audit partner (or partners) but on
the accounting firm as a whole.
Long-term audit engagement may also cause staleness, with auditors relying too heavily
on prior-years working papers and work plans. According to Arel et al. (2005), staleness in
the audit process affects auditors response to managements subjective judgments, because
they tend to rely on the judgments of prior auditors.
Supposedly, rotation of firms rather than partners within a firm would better achieve the
goal of auditors independence. This issue has been examined, as required by the Sarbanes-
Oxley Act (Section 207). In November 2003, a study entitled Public Accounting Firms:
Required Study of the Potential Effects of Mandatory Audit Firm Rotation, was released
by the General Accounting Office (today the Government Accountability Office). Its main
conclusion is that the benefits of mandatory firm rotation are still uncertain. In an experi-
mental audit context, Arel et al. (2005) found that rotation did have an impact on the audit
process . . . auditors in a nonrotation condition were more likely to agree with the client on
a questionable accounting issue than were auditors in the last year of a rotation situation.
This study suggests that an audit engagement between an accounting firm and a cer-
tain company should be limited in time. In any case, an audit engagement should not
exceed this time limit, e.g., seven consecutive years. The seven-year requirement herein
is extended relative to the five-year lead and concurring partners rotation requirement in
the new SEC rules, acknowledging the problems embedded in rotation of firms (discussed
hereafter). The SEC needs to ensure an effective oversight of the implementation of this
requirement. Further, the SEC should consider instructing on a termination of an audit-
engagement prior to the seven-year time limit, so that at a given point in time both the
auditor and the auditee have no certainty regarding the future of their relationship. Such
instruction need not be frequent and should not have a pattern; its benefit is in creating uncer-
tainty effect on both audit firm and audited company. This uncertainty further decreases the
dependency and weakens the ties between the two parties. Time-out provision before
returning to a former audit engagement with a certain auditee would be at least five
years.
Significant accounting frauds are usually committed throughout a prolonged period of
time. Managers and auditors that engage in fraudulent financial reporting, many times
are driven to do so to conceal the companys true (distressed) financial status. The main
consideration in such cases is to survive the years of distress. This may be achieved by
deliberately employing accounting techniques, within or not within GAAP, to achieve a
desired level of reported accounting numbers. Misstating the companys financial statements
can buy time during which the company recovers. It is hard to predict how long it will take the
company to get back on track, allowing auditors to clean the table and get back to honest
reporting. Given this uncertainty, a short-term audit engagement would lower the incentives
of both sides managers and auditors to manipulate accounting numbers, especially if
both parties may find themselves prematurely disengaged by SEC ruling. Having to replace
an audit firm exposes the accounting fraud to the new auditor, risking both collaborative
auditors and managers. However, even if managers and their auditors are not reluctant to
I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 463

commit the fraud, limiting their engagement in time limits the damage caused to market
participants.
Naturally, mandatory audit-firm rotation has its embedded risks. The main risk is the
chance of an audit failure resulting directly from the rotation. Management cooperation with
new auditors may be lower than that with long-term auditors. Auditors ability to sense the
audited management tends to build over time and their access to sensitive information could
depend on the closeness of their relationship. Hence, this closeness between auditors and
auditees can either improve or damage audit quality. Also, according to Arel et al. (2005),
the complexity of corporations today makes it difficult for auditors to understand the audited
companys business in a short period of time. Setup cost should also be taken in account. Arel
et al. (2005) also point to the risk that in the final year of the audit, audit firms consideration
of the client as lame-duck could impair the quality of its audit.
Another risk is that of increased fees. Limiting audit engagements in time may create
incentives for management to influence auditors during the short-termed engagement into
collaborating with them through higher audit fees. The debate on the issue of mandatory
audit-firm rotation is still unsolved because it is still not clear whether the benefits outweigh
the risks of such a requirement. Hence, risks need to be decreased through additional reg-
ulations. Sections 5.2 and 5.4 propose regulations to reduce the risk of audit failure and
increased fees, respectively.

5.2. Communication with retiring audit rm

To deal with the risk of an audit failure, it is suggested that the retiring audit firm
would accompany the entering audit firm until completion of the first annual financial
statement audit and provide it with all information necessary for as smooth a transition as
possible. This is equivalent to medical doctors changing shifts; it would be unthinkable that
the retiring doctor would not provide the entering doctor with all information needed by
the latter to make the right decisions and perform best treatment. The retiring audit firm
needs to provide the entering firm with background and information on the audit-clients
business, institutional characteristics, key risks, accounting policies and practices to be used,
explanation on the choice of a certain accounting treatment, etc. The entering firm should
be free to turn to the retiring firm for additional information needed for the audit case. Most
importantly, the rotation must not take place as a clear cut. Regulating communications with
retiring firms farther exposes the retiring firms accounting practices and audit procedures
to their colleges. The Israeli Securities Authority (Israeli SEC), for example, has regulated
a collegial audit, in which audit firms are subjected to an examination by their colleagues.
The purpose of this regulation is to ensure that audit firms work and audit procedures are
scrutinized. This scrutiny aims to improve transparency and audit quality and thus restore
public confidence in audited financial statements.

5.3. Non-audit services

In addition to their interest in audit fees, auditors are also interested in maximizing non-
audit fees. Recognizing the risk to auditors objectivity and independency, the new SEC
rules prohibit the provision of non-audit services contemporaneously with audit services
464 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

to a client. However, given that economic interests and loyalties are built over time, and
may not be terminated instantly by the time a non-audit or audit engagement is terminated,
contemporaneously may be too short a time-window to disengage economic interests
that may spill over from one type of service to another. For example, last years non-audit
engagement may affect this years audit engagement, even if this year non-audit services are
no longer supplied; similarly, in an opposite situation, current years audit considerations
can be affected by the anticipation of a profitable non-audit service expected next year, even
if audit services are to be terminated. The members of such an engagement (management
and accountants) are aware that they may possibly reengage in the future, and this possibility
can affect their current engagement. To minimize this affect, both parties have to know that
a future engagement will not occur soon. Thus, the time period separating provision of audit
services and non-audit services should be extended. For example, appointment of an audit-
firm may be conditioned on it not providing non-audit services18 to the auditee during the
past five years. In addition, the audit-firm would be prohibited to provide non-audit services
to the auditee for at least five years following the termination of the audit engagement.

5.4. Scrutinizing audit fees

In a setting where audit engagements are time-limited and non-audit services are severely
restricted, audit-clients may try to influence their auditors through higher audit fees. To deal
with this possibility, audit fees need to be scrutinized and monitored by the SEC. The SEC
in collaboration with AICPA should determine scales of tariffs per audit hour starting from
an apprentice rate up to a senior partners rate. These scales would be used by the SEC
as benchmarks to determine whether audit fees are suspiciously high. The accounting firm
will report to the SEC at the end of the audit process the total amount of hours invested
in the audit (by levels of employees who served on the audit engagement up to the lead
and concurring partners), tariffs per audit hour (in firms that charge fees using an hourly
rate), and total audit fees. The hours report, the tariffs per hour by levels of employees (if
available), and an estimation of the weighted average audit fee per hour (total audit fees
divided by total amount of hours invested in the audit) will be checked for reasonability
using as benchmarks the predetermined scales of tariffs, reports from prior years as well as
reports by other accounting firms that audited similar auditees. It is important to emphasize
here the term reasonability (as opposed to accuracy). When checking for reasonability,
it must be taken into account that the total amount of audit fees and audit hours invested in a
certain case may be influenced by other factors, such as differences in audit-firm reputation,
audit efficiency, competence, etc. Most importantly, accounting firms need to know that
their audit fees are observed and monitored by the SEC. In case of a significant upward
bias in the time invested in an audit engagement, the accounting firm will have to provide
evidence to the satisfaction of the SEC for the essentiality of this excess investment.
AICPAs role is in assisting SEC to determine reasonable scales of tariffs. It does not take
part in scrutinizing audit fees. SEC is the legitimate organization for this task. However,
AICPAs involvement in the determination of what is a reasonable fee for audit services

18 Prohibited non-audit services as defined by the new SEC rules.


I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467 465

is essential for the legitimacy of such a regulation and its acceptance by the accounting
community.
Naturally, the proposed scrutiny of audit fees by the SEC should not and cannot be
applied to all audit engagements, but to a sample of engagements chosen by SEC each year.
In its legislated form, such a regulation needs to include a definition of the scale of public
companies to which it applies.
As discussed in Section 3, the new SEC rules require accounting firms to disclose their
fees by categories of audit and non-audit fees. The main weakness of the fees disclosure
requirement stems from the possibility that non-audit fees may spill over to the audit and/or
audit-related fees category. SEC scrutiny of audit fees would reduce accounting firms ability
and motivation to spill non-audit fees over to the audit and audit-related fees categories.
Further, the audit hours report submitted by the accounting firm to the SEC is not expected to
be biased upward due to spill-over of non-audit services, given the strict separation between
audit and non-audit services in the proposed regulatory framework.

6. Summary and concluding remarks

The Sarbanes-Oxley Act of 2002 was enacted in response to massive financial statement
frauds that had cost market participants hundreds of billions of dollars. It aims to improve
management accountability and auditors reliability regarding financial statements quality
and integrity. However, the Act has been criticized by practitioners and academicians for
being too ambiguous and for inadequately addressing the core problemauditors agency
problem. This problem has enabled fraudulent management, sometimes backed by com-
plying auditors, to mislead the market for years.
Auditors agency problem is a product of the current institutional mechanism, in which
auditors are being appointed and paid for their services by the managements they audit.
This creates a dependency of auditors upon their audit-clients; auditors may feel pressured
to comply with their clients wishes in order to not risk discontinuation of the audit engage-
ment. The incentive to collaborate with fraudulent management stems from this economic
dependency. Ronen (2002) claims that this incentive would not be eliminated as long as
auditors are being appointed and paid by the management they audit. Hence, he proposes
a revolutionary change in the current institutional mechanism, according to which compa-
nies no longer appoint and pay auditors; instead, companies purchase financial statement
insurance. In this setting, the insurance company is the one to appoint and pay auditors
in order to adequately determine the terms of the insurance policy; these terms will signal
the quality of the financial statements. Dontoh et al. (2004) claim that adding layers of
supervision and monitoring by the SEC and increasing criminal penalties do not free audi-
tors from their dependency upon their clients. They assert that instead of trying to cultivate
ethical personalities, perverse incentives should be eliminated through market mechanisms.
On the contrary, Rezaees (2005) strategies for prevention and detection of financial fraud
rely on the essentiality of enforcement procedures in assuring managements and audi-
tors fulfillment of their responsibilities for preventing and detecting the fraud. According
to Rezaee, Perpetrators of financial statement fraud, from top executives to employees,
should understand that cooking the books is a crime that will be prosecuted.
466 I. Gavious / Critical Perspectives on Accounting 18 (2007) 451467

This paper presents an alternative perspective to deal with auditors agency problem.
It proposes a new regulatory framework for auditors aimed to decrease the ability and
incentives of both management and auditors to collaborate in financial statement fraud. The
premise is that auditors need to operate in a framework that discourages immoral behavior.
Under this premise, the main provisions of the Sarbanes-Oxley Act relating to auditors
independence are addressed, requiring audit-firm rotation instead of audit-partner rotation,
and expending the time-window between provision of audit and non-audit services. It is
recognized that in such a framework, where non-audit services are prohibited during a
time-window surrounding the audit engagement and the audit engagement is limited in
time, audit-clients may try to influence their auditors through higher audit fees. Hence, it is
suggested that SEC scrutinize and monitor audit fees. This paper discusses implementation
of such a regulation and the positive affect on reliability of accounting firms disclosure
of their fees by categories of audit and non-audit fees. In addition, mandatory audit-firm
rotation may increase the likelihood of audit failure. To deal with this possibility, it is
suggested that retiring audit firms accompany entering audit firms until completion of
the first annual financial statement audit and provide it with all relevant information for a
smooth transition.
The proposed framework does not require a radical change in the current institutional
mechanism and does not require increased criminal penalties. It further weakens auditors
dependency upon management and hence managements influence over auditors.

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