Abigail Brown — Institutional Corruption of the Audit Profession

The October 13, 2010, seminar was led by Edmond J. Safra Lab Fellow Abigail Brown, whose research focuses on institutional corruption in the audit industry. Abigail opened the seminar by describing the social costs of misleading financial statement reporting, and providing an overview of how such misrepresentation or fraud occurs, even in the absence of any illegal act on the part of an auditor. Participants then discussed possible alternative structures for the audit industry, as a way to address the improper dependencies that have enabled misreporting to flourish.

While there are some in academia who would claim that there are no social costs to fraudulent reporting, Abigail presented evidence to suggest that not only are there significant costs, but that there is potential to extract a large amount of value in an economy by increasing the accuracy of financial reporting. Unfortunately, the current system is not structured to incentivize accurate financial reporting. On the contrary, the nature of the relationship between managers and auditors is such that there are few incentives for the manager to report accurately, and there are plenty of disincentives for an auditor to detect fraud. The primary disincentive for the auditor is the implicit threat of the loss of a future stream of revenue through the discontinuation of their contract with the company. This situation is facilitated by the fact that auditors have a limited responsibility for detecting fraud, and therefore do not necessarily commit an illegal act by not detecting it.

In light of this information, seminar participants again returned to the idea of proper vs. improper dependencies as a way to describe corruption in the audit industry. Rather than being primarily concerned with representing economic reality, auditors are more concerned with doing their job in such a way that it will ensure the continuation of the contract with their client. That is, they are improperly dependent on their client. Participants exchanged ideas for how to address this issue, with several suggestions that we provide greater incentives for auditors to detect fraud, or at least more stringent disincentives for managers to provide fraudulent reports. However, given that auditors do not define themselves as having a responsibility to detect fraud, it was suggested that there may be room for a new profession to fill that role. It was also suggested that the government could create an organization to distribute auditors, making the auditors less immediately dependent on their clients. However, given the already questionable relationship between the government and the financial industry, several participants noted that this may not be an ideal solution.

In summary, participants discussed how the current structure of the audit industry creates the improper dependencies that enable misreporting. They discussed the difficulties of incentivizing auditors to detect fraud, and provided suggestions for alternative professions or structures that would be better equipped to provide the kind of regulation and incentives that are currently lacking in the audit profession.