Addressing the Auditor Independence Puzzle: Regulatory Models and Proposal for Reform

32 Pages Posted: 29 Oct 2019 Last revised: 18 Dec 2019

See all articles by Martin Gelter

Martin Gelter

Fordham University School of Law; European Corporate Governance Institute (ECGI)

Aurelio Gurrea-Martínez

Singapore Management University - School of Law

Date Written: October 28, 2019

Abstract

Auditors play a major role in corporate governance and capital markets. Ex ante, auditors facilitate firms’ access to finance by fostering trust among public investors. Ex post, auditors can prevent misbehavior and financial fraud by corporate insiders. In order to fulfill these goals, however, in addition to having the adequate knowledge and expertise, auditors must perform their functions in an independent manner. However, auditors are often subject to conflicts of interest, for example, resulting from the provision non-audit services, but also because of the mere fact of being hired and paid by the audited company. Therefore, even if auditors act independently, investors may have reason to think otherwise. Policymakers and scholars around the world have attempted to solve the auditor independence puzzle through a variety of mechanisms, including prohibitions and rotation requirements. More recent proposals have also included breaking up audit firms and the empowerment of shareholders. This paper argues that none of these solutions is entirely convincing. Drawing from the corporate governance, law and economics, and accounting literatures, we propose a new model to solve the auditor independence puzzle. Our proposal is based on four pillars. First, we argue that, in the context of controlled firms, auditors should be elected with a majority-of-the-minority vote. Second, while auditors in many jurisdictions are subject to certain temporal prohibitions to be hired by previous clients, we propose that the length of these temporal prohibitions should be extended. Moreover, regulators should also restrict the type of services potentially provided to the audit client. Third, policymakers must pay closer attention to the internal governance and compensation systems of audit firms. We argue that increased transparency of audit firms is essential to enhance the independence of auditors. Finally, studies have shown that audit committees often fail to perform their monitoring functions, a major reason being the influence of corporate insiders on the committee. For this reason, we propose to increase the power and presence of public investors in the audit committee.

Keywords: auditing, accounting, Big 4, Enron, Sarbanes-Oxley, EU Audit Directive, EU Audit Regulation, gatekeepers, quasi-rents, auditor rotation, non-audit services, majority-of-the-minority approval, auditor compensation, transparency reports, audit firm governance

JEL Classification: K22, M42

Suggested Citation

Gelter, Martin and Gurrea-Martínez, Aurelio, Addressing the Auditor Independence Puzzle: Regulatory Models and Proposal for Reform (October 28, 2019). Vanderbilt Journal of Transnational Law, Forthcoming, Fordham Law Legal Studies Research Paper No. 3476683, European Corporate Governance Institute - Law Working Paper No. 479/2019, Available at SSRN: https://ssrn.com/abstract=3476683 or http://dx.doi.org/10.2139/ssrn.3476683

Martin Gelter (Contact Author)

Fordham University School of Law ( email )

150 West 62nd Street
New York, NY 10023
United States
646-312-8752 (Phone)

HOME PAGE: http://www.fordham.edu/info/23135/martin_gelter

European Corporate Governance Institute (ECGI)

HOME PAGE: http://ecgi.global/users/martin-gelter

Aurelio Gurrea-Martínez

Singapore Management University - School of Law ( email )

55 Armenian Street
Singapore, 179943
Singapore
(+65) 6808-5160 (Phone)

HOME PAGE: http://https://law.smu.edu.sg/faculty

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