The Mother of All Conflicts: Auditors and Their Clients

Abstract

This Article examines three major problems that contributed to the wave of corporate audit failures that ravaged investors in recent years: (1) auditing firms are too cozy with corporate management to provide a truly independent check on management's abuse of corporate financial reports, (2) auditors have further compromised their independence by offering nonaudit services to audit clients, and (3) audits have failed to uncover colossal frauds and major financial misstatements. After explaining the nature of each of these three problems, the Article considers and evaluates the responses of the Sarbanes-Oxley Act of 2002 - namely, mandatory rotation of partners within the audit firm, restrictions on client hiring of audit firm personnel, prohibition of certain nonaudit services, allowance of other nonaudit services (including tax advice) with prior approval, regulation of accountants by a new oversight board, and formulation of audit standards by an organization not dominated by accountants. The Article concludes that the Sarbanes-Oxley Act represents a largely missed opportunity for serious reform of the auditor-client relationship, adopting half-hearted measures that are unlikely to make a significant difference in the vital function of providing credibility to corporate financial reporting.

JEL Classification: G34, M49, G39, M41