Strengthening Auditor Independence: Reestablishing Audits as Control and Premium Signaling Mechanisms

Abstract: As recent scandals have demonstrated, ensuring the independence of auditors from the publicly traded clients whose books they inspect is one of the most vexing problems in the financial world today. Arguably, the imposition of a mandatory audit system through the 1930s federal securities laws created the modern problem of auditor independence. The core issue is that the statutory audit is simply a commodified cost of doing business for issuers that imposes an impossible obligation to serve an unspecified "investing public" on the auditors. Yet, this investing public neither hires, fires, nor controls the auditors. Instead, the audit relationship is managed by the board of the company being audited. The resultant conflict of interest has proven to be insurmountable even after multiple reform efforts. The conceptual solution is to both "decommodify" the audit and place control of it squarely in the hands of shareholders. To achieve this, the author proposes a tripartite remedy: first, the SEC should retire its "statutory audit" rules under the 1934 Securities Exchange Act (while retaining the public offering audit requirements of the 1933 Securities Act) in favor of market-driven private audits; second, state corporations law or federal Securities law should be altered to give an express audit right to shareholders that they would exclusively control, with expenses reimbursed by the company; and third, the licensing and regulation of CPAs must be strengthened and either harmonized or unified. INTRODUCTION Auditors must be independent from the individuals whom, or businesses which, they have been hired to audit. This may not be self-evident at first glance, but it becomes axiomatic when one considers that the long history of audits-reaching across feudal, municipal, and business precedents-is based on the simple notion that a master/principal needs a highly trusted agent on whom she can rely to verify the activities of her other servants/agents.1 An auditor who is dependent in some way on these other servants/agents would intuitively seem to be more susceptible to corruption by the latter than an auditor who is fully independent of them. This simple concept is the heart of the surprisingly complicated issue of "auditor independence" that has been a major focal point of reform efforts, such as the Sarbanes-Oxley Act of 2002 ("SOX"),2 which seek to prevent the next wave of corporate accounting scandals. As I have argued elsewhere, the problem of auditor independence was created by the imposition of a mandatory audit system under the 1930s federal securities laws.3 The laws' drafters erred in adopting certain portions of the British Companies Act, 1929 out of context. The Companies Act, 1929 was a comprehensive set of provisions for corporate, securities, and business bankruptcy laws in the United Kingdom that had no analogue in U.S. state or federal law.4 In addition, the accounting profession at the time was less well organized and regulated.5 Unlike the accountants in the United Kingdom, accountants in the United States had relatively low professional status and were not chartered by the government.6 For several reasons, many accountants advocated for the new mandatory audit system in the U.S. federal securities laws. They hoped that the system would elevate their profession to the status of other learned professions such as law or medicine.7 These accountants and others also supported the mandatory audit system because it seemed to be an important feature of the highly regarded "British system," as codified in the Companies Act, 1929.8 Finally, because the British audits were usually performed by highly prestigious "chartered accountants," the U.S. accountants hoped to cement in the public's mind that U.S. certified public accountants (CPAs) were every bit the equal of U.K. chartered accountants.9 In seeking this prestigious government franchise, however, the accounting profession got more than it bargained for. …