The impact of Sarbanes-Oxley on auditor independence and corporate governance

Audit Quality and Agency Theory

Auditors have existed since the 1300's and for most of that time, their role remained the same. Auditors were the life-line of governments and businesses, helping establishments maximize profit and efficiency, the benefits of which were enjoyed by everyone. As time passed, auditors were given new roles and worked routinely to assure the maximum profit of the company that employed them.

In the past 50 years, however, a tension arose between the role of the modern auditor and their employer. This tension, known as the agency theory and audit risk concept led initially to much criticism of the role of auditors in the business world. This role was further complicated as companies began giving company share incentives to their auditors to produce desirable reports. The primary case example for this abuse of accounting is the Enron case, in which the company intentionally ignored their internal auditors warnings and continued using high risk accounting practices, leading to their eventual bankruptcy. These reports started a destructive cycle that lost a great deal of money for many publicly held businesses. It is from this issue that the intrusive Sarbanes-Oxley legislation arose and the SEC gained control over the roles of auditors. This new role, known as corporate governance ensured that auditors with concerns about a businesses practices were reporting to someone other than the company and could act in accordance with the good of the company.

In this paper, I will explore the premise that modern globalism and government interference, such as Sarbanes-Oxley has resulted in diminishing the role of the auditor from an adviser to a simple statistical reporter. Further, this change, while giving the federal government an ability to review businesses private information, hindered the once positive relationship between the auditor and the higher executives within a company.

Introduction

Since the 1300's governments and businesses have sought accountability and prevention of errors with regard to business efficiency and financial bookkeeping. This practice, known as auditing, has since grown into more areas than simply finances. In fact, there are currently auditors specializing in environmental, energy, and project audits. With so many audits being completed within companies, larger businesses are now finding it necessary to audit the auditors. This practice, regulated by audit certification companies and upheld by businesses, is a way of ensuring the best data and information. This form of accuracy within auditing, known as a statistical audit is yet the next step in ensuring the utmost accuracy and clarity within a company.

With so much money and time being spent within companies on auditing, it begs the question of whether society has gone too far and whether there is such a need where once there was not. This paper will seek to answer this very question by exploring the historical, legal, and practical applications of modern audit theory and its usefulness in the private and public sectors.

Audit History

Auditing is an old practice initiated in England to hold the royalty accountable for their spending. The earliest recorded audits are from 1314. While the type of audit is not particularly known, there are references made to the Auditor of the Exchequer (Matthews, 2006). Auditing then went out of fashion until the 1500's under Queen Elizabeth. By this time, there was statutory law in place which assigned auditors to the task of auditing royalty. By the 1700's, auditors were well established among Parliament and the royalty, which ensured yet again further clarity of where the rulers and government were spending funds.

Finally, in 1834, the job of Public Accountant became established. The role of the public accountant was primarily bank related. Public accountants were hired by banks to review the books of local businesses and ensure that proper payments were being given on loans (Matthews, 2006). Under William Ewart Gladstone, Parliament and all government offices reached a new level of accountability. In 1866, Gladstone enacted the Audit Departments Act, which required for the first time, that all departments perform an annual audit and submit it to the agency for inspection. This act further created the positions of Comptroller and Auditor General, which for the first time established support staff for what was once a position handled by one person (Matthews, 2006).

As can be seen by this time in history, the role of auditors progressively increased, giving more power to those who hold others accountable. Additionally, history also reveals the fact that the larger the organization, the more auditors and support staff that are needed for an accurate and efficient account. This realization and observation is key to understanding modern audit theory and the role of not just a single auditor in a company, but the entire auditing team.

Jumping across the ocean, the United States has a very different perspective on auditing and auditing practices. While auditors and accountants have existed in the United States for 200 years, it was not until the creation of the Securities Exchange Commission (SEC) that auditors began playing a crucial role in businesses (Auditing, 2010). Whereas in England auditors were initially used to hold the government accountable, America's governmental system eliminated the need for that position initially. Instead, in the United States, auditors were utilized for analyzing and determining the value of private-sector businesses.

The United States, up until recently, has been the ultimate experiment in open capitalism. Companies were left to earn money and produce goods with little to no government interference. However, with the increase in publicly held companies, there was also an increased need for accountability within these once free market businesses. The evolution of the modern business accountant, however, was very slow and typically the role was not changed nor more power given to accountants until there was yet another failure within the business system (Accounting, 2010).

The most recent intrusion into the private sector in the United States, and the one that will prompt examination for this paper, is the Public Company Accounting Oversight Board, established under the Sarbanes-Oxley Act. Drafted in 2002 in response primarily to the Enron case, this department not only oversees the publicly-held companies, but the auditors of those companies. This organization is responsible for creating the standard licensing, training, and examining of public accountants. Additionally, the department disciplines ineffective or dishonest acounting with fines up to $100,000 against a single auditor or $2 million against and auditing company (PCAOB, 2012). This recent measure was created in the United States for one reason, to standardize and form audit quality within the audit system.

Legal Implications and the Need for Auditing

One painful fact in the business world is that businesses exist to make profit and successful companies take risks in order to maximize that profit. Under modern corporate law, those risks are considered legal, so long as they are prudent. This vague legal term is the reason that auditors exist. It is impossible for a board or in more serious cases, a court, to determine prudent actions without numerical evidence. Auditors create that numerical evidence for the decision makers before a risk is ever taken. Should the auditor consider the action too risky and unwise, the auditor's report will say so (Eisenhardt, 1989). In other words, the true final decision maker in modern business is not the CEO, but rather the auditor.

It is for this reason that legal entities have gone a step further and now regulate not only businesses but also auditors. Auditors must pass a rigorous exam and take an oath before being properly licensed to practice. Additionally, auditors are expected to remain disinterested in the affairs of a business and their analysis must remain unbiased. Should a decision be found to have been imprudent, and the auditor had some interest in the decision, they will be punished for their actions (Eisenhardt, 1989).

Modern Audit Quality

Within the confines of classic statistical auditing is the conjunction that audits must be of sound quality. The reason is that the higher the audit's quality and the less mistakes within an audit, the more likely a company is to accept the audit and implement the recommended changes. The greater the errors within the audit, the more likely the audit's advice will be rejected.

This is especially seen in modern government audits. Unlike private business audits where the auditor reports to the CEO of the business, government audits are presented to the congress's supervisory panel and the recommendations determine changes within the law. This is one area where auditing mistakes are often reported in the public media and entire agencies are placed into investigations. It is these forms of tension that lead to the next area of consideration, agency theory.

Agency Cost

While the modern role of the auditor appears of its face to be advantageous to both the public and businesses, there are many who argue that the regulations come at too high a cost for free trade within the business world. Within this argument are two camps of thought, each will be discussed within this section. The first camp is those in favor of government regulation and the other camp is opposed to government interference within businesses.

Government Interference Supporters

The first camp argues that Sarbanes-Oxley is helpful to the business world in that the corporate governance keeps businesses honest. The premise cited for this conclusion is the destruction caused by the Enron case. The damage when the company went bankrupt was much farther reaching then simply the company itself. Rather, thousands of workers lost their retirement funds and were now unemployed. Furthermore, the collapse resulted in what was considered highly profitable and safe stock becoming worthless overnight (Healy, Paul, 2003).

The reason that this camp argues that further regulation is beneficial in preventing these ills is that auditors are now free to do their jobs as needed. Under previous law, auditors could only report their findings as far as the board of a company and then must stop. The concept behind this action was referred to as release of privileged information. Any accountant who went outside of the company with the information could be sued by the company at a later time for releasing the information. This very idea was the reason that Enron collapsed. According to the Congressional Investigation report on the incident, the auditors knew about the questionable accounting practices an entire decade before the collapse of the company. What's more, the auditors reported these non-compliant practices to the board in a full report detailing how risky the practice was and what the results would likely be for the company. The response of the board to this extensive report by the auditors was to ignore their advice and continue reporting the finances as being much higher and more substantial than the situation actually was. In the words of the corporate council during a meeting, "the firm intended to convey to the Audit Committee that Enron's use of highly structured transactions, with multiple special purpose entities and complex overlapping transactions, ran the risk that, if one element failed, the entire structure might fail and cause the company to fall into noncompliance." (The Role, 2002).

Under this camp of thought, the company auditors, whose entire purpose was to supervise the company's compliance with the law and integrity of their financial situation had failed. The reason it failed was a basic legal technicality within the business world placing the freedom and discretion of the business's board above those of the good of the company allowing the board the freedom to increase the company's profits. The result of this failure was the proceeding bankruptcy and criminal charges brought against the board members and attorney.

The solution, according to this camp of thought under Sarbanes-Oxley allows for the auditors to report any ignored findings to the government resulting in a formal investigation. This camp's argument is that the investigation would result in the necessary board members being replaced and charged criminally leaving the company in tact.

Government Interference Opposition

There is a second camp of thought on this issue that is in complete disagreement with the above stated argument. This camp, while entirely in favor of auditing within a company, is opposed to auditors being required to report outside of the company. The reason for their opposition stems back to the market freedom idea that is central to American business practice and structure.

According to this camp of thought, requiring auditors to answer to a higher agency outside of the companies creates a serious tension between the auditors and the business. Where once, auditors had full disclosure and cooperation of businesses, modern auditors are fought and their audits questioned with greater scrutiny by businesses (Ahmed, Hameed, 2005).

This tension has led to yet another problem within companies, that of the board-auditor survivalist issue. Where once, neither board nor auditors were held criminally liable in the event that a risk should prove to be flawed, modernly, both parties could face serious criminal charges. The board members can be charged for making irresponsible decisions and the auditors could be criminally charged for failing to report the board's poor decision to the SEC and halt that decision. With both sets of hands completely tied, the result has now been seen in these recent recession years. Businesses no longer take the high risks that grow the business as a whole and increase profitability.

Agency Theory

Agency theory dictates that it is an unrealistic perception to assume that an agent of a business can remain neutral and purely informative. The reason is that the agent reports to a specific hiring authority and their performance within the company determines their overall pay and longevity with that company.

The principle of agency theory can be best described through a linear model: wages=a+b (e+x+gy). A is the standard wage given to an employee. B is the incentive offered by the company for an agreeable performance. The factors of e, x, g, and y are all determinative variants unseen by the company that play a role in a final outcome. In general, the more unseen time that is spent working, the higher the reward outcome will be. This is true in the case of most professionals, but not necessarily the case with auditors and this is where agency theory deflates.

An auditor will spend countless hours reviewing records and procedures to draft a short memo advising the CEO of what to do in a particular situation. Typically the two people work otherwise independent of one another with the CEO seeing only the reports from the auditor. So, the CEO is unaware of the work that the auditor did to complete the requested memo or the sincerity of that memo.

Over time and being absent of recognition, many auditors become stagnant in their investigations. This results in sloppier work and sub-quality audits. Once this happens, it is only a matter of time before the auditor makes a serious mistake.

The Solution: Or so it Would Seem

Naturally in the business world, one would think that the solution to such a problem is to offer the auditor an increased incentive for their work. What better motivator to gain a flawless audit then to reward perfection with added compensatory rewards.

This was, in fact, attempted by many companies during the 1980's (Webster 2010). In this period, businesses would offer their auditors a share in the company's stock for their services. The auditors were then shareholders within the company and would receive financial payments whenever the company gave a payout. Some of the auditors would take the stock and reinvest any payouts, adding to their interest within the company. All and all, it seemed like an excellent incentive plan for the auditors.

The problem arose, however, with those auditors who started gain large shares within the company after years of dedicated auditing services. Instead of preforming their audits in the interest of the company as a whole, the auditors began making recommendations that would increase their share and profit within the company. These decisions were very destructive for the corporations and resulted in issues such as stock over-inflation and false bookkeeping. So, one again, the agency theory failed the auditors.

Federal Regulation

In order to prevent such damage from happening again inside companies, legislators took it into their own hands to prevent or mitigate the possibility of audit bias. This legislation, known as Sarbanes-Oxley then went a step further and turned the role of the auditor from an internal guide to an internal snitch. The SEC decided that it was time that auditors received a roll similar to that of a corporate attorney. The auditor would not represent the CEO and the CEO's paycheck, but rather the actual corporation and the fabricated entity's best interest. It was this regulation that caused extreme tension between auditors and corporate employees and it is this tension that begs the question as to the effectiveness of modern audit quality and risk taking.

Modern Auditors Role with Risk Taking

The way that I would like to propose many modern businesses have corrected this gap caused by the legislation is to utilize auditors in a new way. Whereas audit memos once contained not only mathematical figures and calculations, but also conclusions, modern reports leave the conclusions to others. This solution gives the auditor the freedom to fully analyse and report without the concern of biases within the company. So long as the figures and calculations are correct, then the audit is a success and the risk decision making is out of the hands of the auditor.

This, of course, begs the question as to who then gives more or less weight to the decisions of the auditor. Unfortunately, most upper management personnel is still lacking the ability to adequately determine risks based on the figures and reports. For those larger businesses with a board, the board typically makes the final decisions and utilizes the data.

Conclusions

The historical role that auditors played in reviewing and interpreting the decisions of leaders is obsolete in this fast-paced global economy. While an annual report is still required of businesses, the true role of the auditor is in the day-to-day reports and analysis of business operations. While agency theory would attempt to explain the modern role of the auditor as an employee of the company, legislation such as Sarbanes-Oxley has prevented such an actual application. Instead, modern auditors, while compensated by a company, work independent of any people and represent the fabricated entity and its overall good. While this role does create tension within the company and prevent extensive risk taking by board members, it allows the company as a whole to remain stable.

While it is unknown where the future of auditing and audit accountability will land, modern politics makes it clear that it will like be with the mandatory release of more private business information and the continued abuse of auditors as carrier pigeons for the SEC instead of critical business advisers.

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