Redressing the fundamental conflict of interest in public company audits

Abstract

The goal of various audit industry reforms is to better align the interests of the auditor with external stakeholders. These proposed reforms ignore the fundamental conflict of interest—‘the client’ hires, fires and determines the compensation for the auditor. This problem is fundamental in that ‘the client’ is normally the management or board of the firm who, on occasion, have reason to want to take advantage of the inherent imprecision in accounting for their benefit and subtlety pressure the auditor to achieve this. My evidence‐based proposal takes advantage of the well‐known aversion of managers and boards to government intervention. It incentivizes management and boards to demand rigorous audits by requiring regulatory bodies impose their choice of auditor on public companies that meet well‐specified criteria that indicate poor‐quality reporting (e.g., restatement of financial statements). This proposed reform retains the ‘on average’ benefits that extant research shows the current system of private sector auditing provides while stimulating greater managerial and director self‐interest in high‐quality financial reporting.