“Where were the auditors?” Current Issues and Perspectives

“Round Trip” revenues, “Swapping” revenues, “Vendor Financed” revenues, “Cookie Jar” reserved revenues, “Channel Stuffing” revenue, Enron’s impenetrably murky and creative accounting, WorldCom’s financial accounting shenanigans, obfuscated financial reporting practice, corporate malfeasances, the list goes on and on.

Abuses in financial reporting have raised a red flag on the efficacy of the audit process and auditors’ objectivity in certifying the credibility of their clients’ earnings statements. The pervasive practice of “earnings management” is threatening the very integrity of financial reporting.

Public criticism of the accounting profession, heard for some time, reached a crescendo in the aftermath of the Enron bankruptcy. “Where were the auditors?” This question has been much asked since Enron, with almost no warning, sought bankruptcy protection a mere four weeks after its announcement of the need to restate its financial statements. The follow-up question: “How could this happen to a company that had received an unqualified auditor’s opinion on its historical financial statements for so many years?”

The Enron and WorldCom scandals have alerted the financial community and regulators to financial reporting abuses. Corporate governance is suddenly front-page news, forcing many corporations to restate earnings and leading to the passage of the U.S. Sarbanes-Oxley Act to hold corporate executives accountable for their companies’ financial reports.

“Why Audit then?” Brief Historical Perspectives

Why there is a demand for auditing services in a free-market economy? What evidence suggests that auditing would be demanded even if it were not required by government regulation?

There is a demand for auditing in a free-market economy because the agency relationship between an absentee owner and a manager produces a natural conflict of interest due to the information asymmetry that exists between the owner and manager.

That is, the manager generally has more information about the "true" financial position and results of operations of the entity than the absentee owner does. If both parties seek to maximize their own self-interest, it is likely that the manager will not act in the best interest of the owner.

As a result, the agent agrees to be monitored as part of his/her employment contract. Auditing appears to be the most cost-effective form of monitoring.

The empirical evidence suggests auditing was demanded prior to government regulation. In 1926, independent auditors audited 82 percent of the companies on the New York Stock Exchange. Additionally, many private companies and municipalities not subject to government regulations such as the Securities Act of 1933 and Securities Exchange Act of 1934 also demand auditing.