Audit Confidence Auditing and Investment

Audit Confidence

Auditing and Investment Risk

Trust is essential to auditing, and even the incremental erosion of that trust would likely be disastrous for the auditing profession and detrimental to the capital markets. As such, a reprisal of the confidence-destroying scandals of 2000-2002 would be extremely unwelcome and should be guarded against by the surviving Big Four firms.

In effect, trust is the value that auditors add to the corporate environment and the investment process. Since management has a privileged insider's perspective on the company's operations, outside investors looking for a comparable level of transparency into those organizations rely the audit process to assure them that management's claims accurately reflect reality. While management may not misrepresent the truth, the temptation to do so is still too strong to ignore:

[Because] those seeking capital want to raise it on the most favorable terms to themselves [and] also have the ability to mislead capital providers about the issuer's prospects for future success, capital providers are inherently disadvantaged in their ability to control, negotiate, or evaluate the terms of offerings and trading prices in public capital markets (Johnstone 1).

By bridging this inherent conflict of interest, the auditor is able to level the field and give investors confidence in management's assertions about the company. This ability is generally considered an inextricable component of the auditor's independent role vis-a-vis both management and investors; free of inherent interest, the auditor is better positioned to certify that information is accurate. As Arthur Levitt, then chairman of the Securities & Exchange Commission, summed up in 2000, well before Enron's failure, "Independence is at the core of the profession, the very essence that gives an auditor's work its value" (2).

Auditors can maintain this independence in the face of increasingly close or long-term working relationships with the enterprises they audit; significant research indicates that even accounting firms that generate significant consulting revenue from a company will choose their reputation over their near-term receivables and report errors in its results (DeFond et al., 1250). However, this independence must be apparent to the investors in order to be meaningful. While close relationships between auditor and enterprise may not threaten the accuracy of the audit in itself, the perception that these relationships contaminate the results threatens the entire value proposition of the auditing process; as Levitt warned a decade ago, "to be suspected is to be convicted" (2).

This suspicion seems to have become more prevalent in the wake of the collapse of the dot-com sector and Enron. Long-term investors polled about earnings accuracy for companies in 1990 and 2000 indicated that trust in the audit process had slightly eroded, while 34.1% of respondents said auditors had become less independent over that period (Hodge 42, 45). This, in turn, contributed to the generalized crisis of confidence that accelerated the equity market's declines in the summer of 2002 (Ramirez 68) and eventually drove the adoption of the Sarbanes-Oxley regulatory environment.