Why Do Auditors Fail? What Might Work? What Won't?

48 Pages Posted: 12 Jan 2019 Last revised: 11 Apr 2019

See all articles by John C. Coffee

John C. Coffee

Columbia Law School; European Corporate Governance Institute (ECGI); American Academy of Arts & Sciences

Date Written: January 11, 2019


Auditing failures and scandals have become commonplace. In response, reformers (including the Kingman Review in the U.K and a recent report of the U.K.’s Competition and Market Authority) have proposed a variety of remedies, including prophylactic bans on auditors providing consulting services to their clients in the belief that this will minimize the conflicts of interest that produce auditing failures. Although useful, such reforms are already in place to a considerable degree and may have reached the point of diminishing returns. Moreover, this strategy does not address the deeper problem that clients (or their managements) may not want aggressive auditing, but rather prefer a deferential and perfunctory audit. If so, auditors will realize that they are marketing a “commodity” service and cannot successfully compete based on their quality of services. Rationally, they would respond to such a market by seeking to adopt a cost-minimization strategy, competing by reducing the cost of their services and not investing in new technology or higher-priced personnel.

What could change this pattern? Gatekeepers, including auditors, serve investors, but are hired by corporate management. To induce gatekeepers to better serve investors, one needs to reduce the “agency costs” surrounding this relationship by making gatekeepers more accountable to investors. This might be accomplished through litigation (as happens to some degree in the U.S.), but the U.K. and Europe have rules that discourage collective litigation. Thus, a more feasible approach would be to give investors greater ability to select and remove the auditor. This paper proposes a two part strategy to this end: (1) public “grading” of the auditor by the audit regulator in an easily comparable fashion (and with a mandatory grading curve), and (2) enabling a minority of the shareholders (hypothetically, 10%) to propose a replacement auditor for a shareholder vote. It further argues that both activist shareholders and diversified shareholders might support such a strategy and undertake it under different circumstances. Absent such a focus on agency costs, however, reformers are likely only re-arranging the deck chairs on the Titanic.

Keywords: Keywords: auditing, auditor, audit quality, audit regulator, auditor rotation, Financial Reporting Council, gatekeeper, proxy advisor, proxy contest, Public Company Accounting Oversight Board, reputational intermediary, shareholder activism, and shareholder voting

JEL Classification: D43, G01, G18, G28, G30, G32, K22, M40, M42, M48

Suggested Citation

Coffee, John C., Why Do Auditors Fail? What Might Work? What Won't? (January 11, 2019). Columbia Law and Economics Working Paper Number 597, European Corporate Governance Institute (ECGI) - Law Working Paper No. 436/2019, Available at SSRN: https://ssrn.com/abstract=3314338 or http://dx.doi.org/10.2139/ssrn.3314338

John C. Coffee (Contact Author)

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