The Case for Individual Audit Partner Accountability

Colleen Honigsberg is an Associate Professor of Law at Stanford Law School. This post is based on her recent article, recently published in the Vanderbilt Law Review.

Theory suggests that regulatory oversight, private enforcement, and reputational risk provide auditors with incentives to perform high-quality work. Yet 2018 provided evidence that accounting scandals remain all too common. From the United States, to the United Kingdom, to South Africa, the accounting profession saw a series of high-profile audit failures. Perhaps even more damaging to the integrity of the profession, it was revealed that KPMG cheated on its regulatory inspections by obtaining confidential information from its primary U.S. regulator, the Public Company Accounting Oversight Board (“PCAOB”), leading to a criminal investigation. And these are hardly isolated incidents: from 2005 to 2016, the PCAOB has found that anywhere from 14 to 33% of the audit opinions it inspected should not have been issued. It is time to ask: Despite the best efforts of Congress, regulators, corporate directors, and investors, why do significant audit failures persist?

In my article The Case for Individual Audit Partner Accountability, published in the Vanderbilt Law Review, I argue that the answer to this question lies in part in the lack of accountability the law currently provides for individual auditors. I explain that the current structure of regulatory oversight, private enforcement, and reputation risk are unlikely to induce socially optimal levels of audit quality, and I suggest that we reconsider the role of reputation. To date, the reputational incentives have focused almost exclusively on the audit firm, but recent disclosures make it possible for us to identify the name of the individual partner leading the audit. Using this information, along with additional information that I suggest regulators should make publicly available, we can establish a market for individual audit partners’ brands—a market that can hold individual auditors responsible for their mistakes. I argue that individual reputational sanctions are more likely to give audit partners optimal incentives for care. Thus, lawmakers, corporate fiduciaries, and investors seeking to improve audit quality should focus on developing a market in the reputational brands of individual audit partners.

I argue that focusing on individual accountability would provide four important benefits. First, individual reputation markets for auditors would cause audit partners to more fully internalize the costs of an audit failure. Allowing audit partners to remain anonymous permits them to enjoy a disproportionate portion of the financial benefits provided by an audit client but share the costs of failure jointly with other partners of the firm—and those partners are imperfect monitors of one another’s conduct. Requiring individual partners to take responsibility for their work will better align incentives and induce greater levels of effort.

Second, individual accountability will help mitigate a particular audit risk that has increased over the past decade: the reliance on overseas auditors. Such overseas auditors are termed either “component” auditors or “offshore” auditors. Broadly stated, component auditors are foreign affiliates of the lead accounting firm and audit the issuer’s international operations, while offshore auditors are legally part of the lead accounting firm but located in a different country. For multinational firms, presumably over half of audit hours are frequently performed overseas by a combination of component and overseas auditors. The limited research on the use of overseas audit participants suggests that they are associated with increased risk of audit failure. But studies also suggest that holding the lead partner to a higher level of accountability can, at least in part, counteract the increased risk by giving domestic partners strong incentives to monitor overseas work.

Third, a robust market for individual auditors’ reputation would make it easier for audit committees and investors to choose higher-quality auditors. Prior work has found that there is significant variation in audit partner quality, even among partners at the same firm. Knowing this information would allow market participants to demand higher-quality auditors—while also imposing a penalty on audit partners who fail to protect investors.

Finally, building individual auditor reputation markets could increase competition without the need for aggressive regulatory action. Over 99% of the S&P 500 select one of the Big Four accounting firms,  and commentators have increasingly taken aim at the oligopolistic structure of the industry. Based on lessons from similar industries, such as credit and risk analysts, there is reason to believe that individual reputation markets could increase competition and mobility.

In sum, to help market participants develop a robust market for individual auditor reputation, I propose the use of Auditor Scorecards that describe publicly available information on the lead auditor and the audit design for each public company. Such Scorecards would provide valuable information to the market—but they would be more informative if regulators mandated disclosure of additional information that is currently unavailable. First, PCAOB disciplinary proceedings typically are not publicly available until years after the infraction, minimizing their utility. These should be disclosed in a timelier manner. Second, the current disclosures regarding overseas auditors are incomplete and should be supplemented. Finally, some enforcement actions regarding poor audit practices name the auditor, but others do not. When possible and equitable, the auditor should be named so that the information can be incorporated in individual reputation markets.

The complete article is available for download here.

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One Comment

  1. John Formica
    Posted Wednesday, December 18, 2019 at 9:57 am | Permalink

    The issue is much more complicated than this !