Audit Failures: Why and What
Can We Do?
Shyam Sunder
Yale School of Management
Ross Institute Forum on Auditor Independence
May 10, 2004
(c) Copyright 2004 Shyam Sunder
Serious Problems
• We have seen serious problems in auditing, financial
reporting, and corporate governance
• New laws and institutions created to address the
problems
• I do not believe that we have correctly diagnosed the
source of these problems
• Issues are bigger and more fundamental, and call for
structural changes, out-of-box thinking
• Natural resistance: use veil of ignorance principle to
prevent narrow self-interests from blocking wider, longerterm reform
• Need leadership in thinking ahead
(c) Copyright 2004 Shyam Sunder
Three Questions
• Why the failures?
• What are the chances that the solutions
proposed by Congress and others will
work
• What can and should be done?
(c) Copyright 2004 Shyam Sunder
Why the Auditing Breakdown
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Antitrust laws and professions
– Unobservability of quality, restraint, Akerlof (market for lemons, Nobel
Prize)
1960-70s: the cult of competition, Stigler (robustness of competition),
misapplication of economic theory
1977-78: Supreme Court (Bates vs. Arizona Bar)
US D of Justice and FTC: new professional codes of ethics for doctors,
lawyers, accountants etc.
AICPA implements it in 1979
1980: sharp drop in audit prices begins, no profit, new business model
(analytical review, consulting, internal transfer payments, and wage
adjustments for recruits)
Consequences played out for two decades (don’t have time for the details,
see my book soon)
Sharp drop in stock market exposes the accumulated skeletons in the closet
None of the problems, especially the impossibility of attaining market
equilibrium in a market where the quality of the service essentially
unobservable to the customer has been addressed yet
PCAOB has been handed an impossible task
(c) Copyright 2004 Shyam Sunder
Creation of FASB as a Full Time
Rule Making Body
• Generated the demand dynamics of accounting
rules (why argue with the client and risk losing
business, just call Norwalk to make the rules
“clearer”)
• FASB’s dependence on revenue from sale of
publications generated incentives even worse
than academic “publish or perish”
• Every additional rules creates several new
loopholes (Can-Spam law as a license to spam
legally)
(c) Copyright 2004 Shyam Sunder
Chances of Success of Recent
Reforms and Proposals
• I am pessimistic
• None of the fundamental problems have been
addressed
• Nothing structural has been changed
• PCAOB: With all due respect, a few years later,
we shall be looking for the person who can be
blamed for inventing the idea that a few
hundred, or thousand, people can figure out if
auditors are doing their job right
– Can we reduce the number of bank robberies by
appointing watchmen to watch the guards?
• Let me move to what can be done
(c) Copyright 2004 Shyam Sunder
What Can We Do?
• Solutions need to fundamental, structural and
robust
• One is already on the table: Prof. Ronen
– Integrate insurance and audit
– Firm decides how much, if any, financial fraud
insurance to buy
– Insurance firm decides on audit and the premium to
charge (insurance and premium are made public)
– No need for government oversight, except an
accounting court (Leonard Spacek’s idea from more
than four decades ago)
• I shall present a second idea of my own
(c) Copyright 2004 Shyam Sunder
Tax and Financial Reporting
• Ninety years of drift between financial and tax
reporting
• Separate optimization: minimize taxes,
temptation to boost performance reported to
shareholders
• Increasing audit burden on IRS
• Increased incentives to lobby Congress for
corporate tax breaks
• Falling effective tax rates for corporations
• Push, push, push for lower taxes, even as IRS
budgets get tighter
(c) Copyright 2004 Shyam Sunder
Financial Reporting on the Other
Hand
• Push, push, push for better quarterly
performance driven by high powered
compensation contracts
• Financial reporting and governance failures
• Difficulties of auditors faced with managers who
might lose millions because the auditor says no
• Rock bottom audit fees driven by competition do
not allow much resources for substantive testing,
so “analytical review” would have to do
• Auditor incentives and independence problems
(c) Copyright 2004 Shyam Sunder
Management Plays Two Games
• One to the IRS, who must spend resources it
does not have to get the revenue the exchequer
deserves
• The other to the shareholders to persuade them
what a great job they have done to deserve a
pat on the back and a tidy bonus (stock options)
• Integrate two games into one
• Congress could see this in 1947 (LIFO)
– Gave that up in the seventies
(c) Copyright 2004 Shyam Sunder
Tax Return = Income Statement
• Tax returns of public corporations are
public
• Financial reports = tax return + balance
sheet + cash flow statement +
management discussion + footnotes
• Could the two bookends of tax and
financial reporting lean on each other to
yield outcome which are better?
• What would happen?
(c) Copyright 2004 Shyam Sunder
Consequences
• By managerial choice
– Tax returns would be less aggressive
– Financial reports would be less aggressive
• Save on significant auditing costs
– By IRS
– By independent auditors
• Less Government regulation in financial reporting
• Less corporate lobbying on the Hill
• Scaling down of FASB and SEC Chief Accountant’s
Office
• A smaller auditing profession
(c) Copyright 2004 Shyam Sunder
Critique Welcome.
Thank You
Shyam.sunder@yale.edu
http://www.som.yale.edu/faculty/
sunder/research
(c) Copyright 2004 Shyam Sunder
(c) Copyright 2004 Shyam Sunder