Waiting for Enron: The Unstable Equilibrium of Auditor Independence Regulation

AuthorDavid Kershaw
DOIhttp://doi.org/10.1111/j.1467-6478.2006.00364.x
Publication Date01 Sep 2006
JOURNAL OF LAW AND SOCIETY
VOLUME 33, NUMBER 3, SEPTEMBER 2006
ISSN: 0263-323X, pp. 388±420
Waiting for Enron: The Unstable Equilibrium of
Auditor Independence Regulation
David Kershaw*
A primary function of auditor independence regulation is to ensure that
any financial incentives auditors may have to approve misleading or
inaccurate accounting are outweighed by market and regulatory
deterrents to compromising an auditor's independence. This article is
an inquiry into the current state of this incentive equilibrium in the
United Kingdom: the possible costs and benefits that may be incurred
by auditors if they elect to acquiesce to management's demands to
accept problematic accounting. It argues that the equilibrium position
currently incentivizes a rational auditor to acquiesce. On the one hand,
the article demonstrates that the recent evolution of audit firm revenue
streams has provided auditors with a substantial incentive to com-
promise their independence and provided management with credible
sanctions to pressurize them to do so. On the other hand, the article
shows that regulatory and market costs of acquiescence do not
counterbalance the benefits of acquiescence.
INTRODUCTION
A central concern in the Enron post-mortem has been to explain why Enron's
auditor, Arthur Andersen, failed to act as an independent gatekeeper of reliable
and transparent financial information. In this regard, John Coffee has proposed
a `general deterrence' theory of audit failure. This theory looks at the costs and
benefits to auditors of compromising their independence by acquiescing to
managements' demands to massage the financial statements. Coffee argues
that the potential costs to auditors of approving accounting treatments that
benefit their client's management but which could mislead investors decreased
388
ß2006 The Author. Journal Compilation ß2006 Cardiff University Law School. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA
* Law Department, London School of Economics and Political Science,
Houghton Street, London WC2A 2AE, England
R.D.Kershaw@lse.ac.uk
My thanks to Marlies Braun, Alison Kershaw, Jorge Guira, Richard Moorhead, Bo
Rutledge, and the anonymous referees for comments on earlier versions of this paper. Ben
Grebe and Nadia Saggi provided excellent research assistance.
in the United States during the 1990s. During the same period the financial
benefits of making these client-pleasing judgements increased dramatically.
This, Coffee argues, resulted in an increase in auditor acquiescence.
1
Following Coffee, the function of auditor independence regulation is to
ensure that the incentives to acquiesce are outweighed by the incentives to
maintain independence. The incentive equilibrium must tilt towards indepen-
dence. If the equilibrium tilts towards acquiescence, the likelihood of audit
failure increases. This article attempts to assess the current state of this
incentive equilibrium in the United Kingdom and submits that its post-Enron
equilibrium favours acquiescence, not independence. On the one hand, the
evolution of audit firm revenue sources in the United Kingdom over the past
two decades has not only increased the financial dependence of audit firms
on particular clients but, more importantly, has provided management with
credible sanctions to ensure that audit firms do their bidding. On the other
hand, the article shows that the costs of acquiescence do not provide an
effective deterrent. The article shows that neither litigation, reputation costs
nor disciplinary sanctions generate significant costs to acquiescence.
United Kingdom regulators and reform bodies have responded to Enron
with increased regulatory complexity and fragmentation. To improve audit
quality and ensure auditor independence and objectivity, there are now more
regulators,
2
with a more intrusive mandate
3
and with enhanced resources.
However, the equilibrium framework adopted in this article reveals that this
increased complexity and fragmentation has not rebalanced the equilibrium
in favour of independence. In the auditor independence arena, complex,
fragmented, and opaque regulatory responses have obfuscated the root
causes of the problem. The incentive equilibrium framework set forth in this
article provides clear sight of these causes.
THE INCENTIVE EQUILIBRIUM
1. Mapping the equilibrium
Management has strong incentives to present the company's financial
position in its best light.
4
Accordingly, the capital market would be highly
389
1 J.C. Coffee, `What Caused Enron? A Capsule Social and Economic History of the
1990s' (2004) 89 Cornell Law Rev. 269, 288±93. The concept of auditor acquie-
scence refers in this article to a conscious decision by an auditor (with or without
resistance) to accept an accounting approach that the auditor recognizes may
mislead readers of the financial statements.
2 For example, the introduction of the Financial Reporting Council's Audit Inspection
Unit.
3 For example, the Financial Reporting Review Panel now takes a proactive rather
than a reactive approach. See text to footnotes 95±101.
4
Good financial information, for example, increases performance-related compensation.
ß2006 The Author. Journal Compilation ß2006 Cardiff University Law School
suspicious of financial information that is presented as compliant with the
applicable accounting standards when the only party interpreting and
applying those standards is the company's management. An objective and
independent third-party arbiter is required. This role of an independent third-
party arbiter is taken by the company's auditor who must attest to the fact
that the financial statements provide a true and fair view of the company's
financial position.
5
The true and fair attestation is generally understood to
require compliance with applicable accounting standards.
6
However, the
incentives to place a company-favourable spin on the financial statements do
not evaporate on the appointment of an independent aud itor. These
incentives are transformed into pressure directed by management at the
auditors to encourage them to acquiesce to management's interpretation of
the standards.
Auditor independence regulation's function is to limit the likelihood that
auditors will succumb to such pressure. The task of auditor independence
regulation is, however, complicated by the fact that although UK regulation
demands auditor objectivity and independence,
7
it permits the auditors to
have financial conflicts of interest that ostensibly bind them to the company
and not to the investor or public interest. These financial conflicts arise from
the fact that the auditor is appointed
8
and paid by the company and is not
prohibited from having ce rtain other business rela tionships with the
company in addition to the audit relationship.
9
Auditor independence
regulation is, therefore, about getting the balance of incentives right:
ensuring that the financial incentives to acquiesce to management pressure
never outweigh the disincentives or deterrents to acquiesce.
The primary pressures to acquiesce, set forth in Figure 1, are revenue
factors, which are split up into audit fee incentives and non-audit fee
incentives. The weightings attributed to these revenue streams are a function
of: value; management's incentives to ensure that their preferred accounting
treatment is adopted; and the extent to which management can credibly
threaten the audit firm with the loss of a revenue stream if it refuses to
acquiesce. The primary incentives to remain independent relate to: first, the
loss that the audit firm would incur directly as a result of an award of
damages or settlement following litigation or as a result of the imposition of
disciplinary penalties by regulatory authorities; secondly, the loss of firm
revenue arising from reputational damage to the firm if it becomes known
390
5 s. 235(2) Companies Act 1985.
6 M. Arden QC, Accounting Standards Board, The True and Fair Requirement,
Opinion (21 April 1993). Accounting standards include the Financial Reporting
Standards and Statements of Standard Accounting Practice promulgated and
adopted by the Accounting Standards Board.
7 Auditing Practices Board (APB) Ethical Standard No. 1, Integrity, Objectivity and
Independence (2004) para. 6.
8 Companies Act 1985, s. 384.
9 See text to footnotes 16±30.
ß2006 The Author. Journal Compilation ß2006 Cardiff University Law School

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