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Addressing the Auditor Independence Puzzle: Regulatory Models and Proposal for Reform

By: Martin Gelter & Aurelio Gurrea-Martínez

Auditors play a major role in corporate governance and capital markets. Ex ante, auditors facilitate firms’ access to finance by fostering trust among public investors. Ex post, auditors can prevent misbehavior and prevent financial fraud by corporate insiders. In order to fulfill these goals, however, in addition to having the adequate knowledge and expertise, auditors must perform their functions in an independent manner. Unfortunately, auditors are often subject to conflicts of interest, for example, resulting from the provision of nonaudit services but also because of the mere fact of being hired and paid by the audited company. Therefore, even if auditors act independently, investors may have reason to think otherwise. Policymakers and scholars around the world have attempted to solve the auditor independence puzzle through a variety of mechanisms, including prohibitions and rotation requirements. More recent proposals have also included breaking up audit firms and the empowerment of shareholders. This Article argues that none of these solutions is entirely convincing. Drawing from corporate governance, law and economics, and accounting literature, this Article proposes a new model to solve the auditor independence puzzle. Our proposal rests on four pillars. First, this Article argues that, in the context of controlled firms, auditors should be elected with a majority-of-the-minority vote. Second, while auditors in many jurisdictions are subject to certain temporal prohibitions to be hired by previous clients, the Article proposes that the length of these temporal prohibitions should be extended. Moreover, regulators should also restrict the type of services potentially provided to the audit client. Third, policymakers must pay closer attention to the internal governance and compensation systems of audit firms.

The Article argues that increased transparency of audit firms is essential to enhance the independence of auditors. Finally, studies have shown that audit committees often fail to perform their monitoring functions, a major reason being the influence of corporate insiders on the committee. For this reason, we propose to increase the power and presence of public investors in the audit committee.


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