Article 090ad - 1424502201
Article 090ad - 1424502201
Article 090ad - 1424502201
Wanda A. Wallace
ABSTRACT
In 1980, The Economic Role of the Audit in Free and Regulated Markets
described market evidence, how the demand for auditing services can be
explained and predicted by agency, information, and insurance dimensions,
by-products of the audit, the nature of the audit process, and the effects of
regulation. In 1987, research since 1980 was described and discussed as to
implications for future research. In 2004, the time has arrived to look back
and look forward to reassess the body of evidence accumulated since 1987
regarding key sources of demand for the audit, supply issues, and regulatory
activities, while offering a roadmap for future inquiry.
INTRODUCTION
The Economic Role of the Audit in Free and Regulated Markets was written over
two decades ago to articulate the theoretical framework in which demand, supply,
and regulation have influenced the audit. In 1987, in the inaugural issue of Research
in Accounting Regulation, I revisited the original work in light of subsequent
developments in my article entitled The Economic Role of the Audit in Free and
Regulated Markets: A Review (Vol. 1, 1987, pp. 734). I am pleased to have the
opportunity to do so once again. Other than the 1930s, there may be no other time
in history that has accorded such attention to our accounting profession. One might
suggest that during the 1990s, a combination of technological advances, a hot
market, and scarce human resources combined in a manner that clouded traditional
demarcations between public accounting firms and consulting firms. Demand for
information systems predictably reached out to the information specialists who
speak the language of business accounting to help in the design and implemen-
tation of technological resources that would be relied upon to manage the business
and prepare financial statements and information required by generally accepted
accounting principles, securities regulators, and other third parties. As they did so,
the public accounting firms began hiring professionals who had not followed the
traditional educational track of an accounting major, which had always included
an understanding of the professional obligations of a certified public accountant.
A bright line had always existed between a client relationship and a public
obligation. Indeed, the attractiveness of public accounting firms to purchasers
of information system and consulting services was acknowledged, in part, to be
their candor, directness, objectivity, independence, and long-term accountability.
Unfortunately, as the technological and market-related demand functions grew,
the public accounting firms blurred into consulting firms through hiring, training,
promotion, and compensation practices that apparently could and should have
accorded more attention to the traditional hallmarks of the profession throughout
their practice.
Individually, many of us recoiled as we heard assertions made that auditing
was a commodity or that auditing was a loss leader and that the only manner
in which the best and brightest would be attracted was via other professional
endeavors beyond the attestation services. All of those assertions were signs of a
problem that should and could have been corrected by the profession on a timely
basis that might have avoided the high profile debacles that have been attributed,
in part, to shortcomings of the audit community. The fact of the matter is that
auditing is a profession that is highly tailored to context by necessity. It ought to
be priced to reflect risk and to ensure effective audit scope. Any individual who
fails to find an audit both interesting and challenging simply fails to understand
the essence of the audit process. The reality is that an auditor must understand
the economic entity being audited, be able to explain the information systems
and technological infrastructure in which information is generated, recorded,
aggregated, and interpreted, and skeptically consider the interplay of inherent,
control, and detection risk factors that involve a combination of controllable and
uncontrollable elements including the ingenuity of the human race. The eclectic
nature of the typical professionals portfolio of audit clients, the ability to bring to
bear industry experiences from a cross-section of client settings, and the number
The Economic Role of the Audit in Free and Regulated Markets 269
one obligation to the public combine to make the profession both admirable and
fulfilling. Recent events have proven once again the importance and value of
the attestation function. The steps taken by the public accounting firms toward
the audit function also clearly speak to the central role, importance, and primary
product position of the audit.
The objective of this analysis is to provide added perspective on the auditing
research that has taken place since 1987, to reflect once again on how the Wallace
(1980) monograph could be updated to describe more effectively our current
understanding of the audit function. In like manner to my earlier review, to
facilitate the integration of this update into the materials developed in the original
monograph and in Wallace (1987), this analysis is organized into ten parts
corresponding to the ten chapters of the monograph. In other words, familiarity by
the reader with the original monograph (available on the Internet) or the concepts
developed therein is assumed, although care is taken to make this treatment lucid
as a stand-alone contribution. Particular focus is placed on lines of inquiry for
future research and the manner in which the sections can be linked to provide an
integrated picture of the auditing environment.
evidenced by the result that the financial statements are no longer on public record
and stakeholders such as employees, labor unions, special interest groups, and
members of the public no longer can readily access financial statement information
for these economically significant companies.
Future research should explore whether alternative public information sources
evolve for such entities and whether any of these entities migrate back toward
attestation services. For example, we could hypothesize that an elimination
of a regulation may result in rewriting of future contracts to invoke certain
requirements at a transaction level. Of related interest is the observation that the
number of public company registrants in the United States has declined from
approximately 10,500 in 1999 to below 9,000 by the end of 2002 (Huron, 2003).
Movement overseas has likewise been reported (Zielenziger, 2003), at a time when
corporate governance questions are being raised globally (The Economist, 2003).
Beyond the market evidence pre-regulation, in unregulated sectors (Abdel-
Khalik, 1993; Barefield et al., 1993), and in the international community (Chow
et al., 1988; Roussey, 1992), a new strain of evidence on demand for audits has
emerged, associated with transaction-based contracts and pools of investors. In
particular, special-purpose entities (SPEs) and what have been dubbed variable
interest entities (VIEs) by the Financial Accounting Standards Board are legal
entities that may not be consolidated into a single companys financial statements
(see Batson, 2003 for a discussion of those involved in the Enron debacle).
As a result, these economic entities in which various parties have risks and
returns have been a testament to free-market demands by capital providers for
varied attestation services. The SPE type of organization often isolates certain
cash flow streams with fiduciaries involvement and contractual specification
of controls and property rights. The scope of reporting and control, as well as
related discretion, is tailored to the special-purpose nature of the entity (Beckett,
2003). The use of multiple funds has evolved in the investment management
industry with a single holding company often having over 100 funds. The
investment management industry decentralizes its funds and often uses third-party
entities for numerous operating responsibilities. They have decentralized boards
and managers.
Outsourcing of services of these organizations as well as diverse governmental
units from local to federal levels has grown. Attendant to this phenomenon has
been attestation of third-party providers service organizations and negotiation
of diverse rights to audit clauses.
Anecdotal accounts of control practices, fiduciary responsibilities, tailored
legal letters and attestations merit systematic inquiry to assess the degree to
which audits, reviews, compilations, or other CPA services are accessed in the
comparatively unregulated sector that has evolved from outsourcing, SPEs, VIEs,
The Economic Role of the Audit in Free and Regulated Markets 271
and similar financing/hedging vehicles. The parent companys audit role identified
in the Canadian research raises questions of materiality assessment relative to
private company ownership, as well as related to unconsolidated entities such as
VIEs. Manry et al. (2003) provide evidence that timely quarterly reviews increase
the likelihood that accounting earnings reflect economic events contempora-
neously with returns. Such research suggests that both the review engagement
distinct from the audit and the timing thereof influence the market for
attestation services.
likewise changes the market enforcement mechanisms that can sanction public
accounting firms.
Much debate has occurred as to how Sarbanes-Oxley (2002) will affect capital
markets, global competition, information quality, and legal liability. Predictable
reactions to the tort reform of 1995 were addressed by further reform in 1998, and
debate continues on means of limiting unintended consequences of malpractice
litigation and alternative legislative solutions. Research suggests that U.K. firms
cross-listed on U.S. markets incur audit fees reflecting risk differences across
liability regimes, i.e. higher fees than non-U.S. capital market firms (Seetharaman
et al., 2002) in contrast to evidence in Canada (Anderson & Zeghal, 1993),
Hong Kong (Gul & Tsui, 1998), New Zealand (Johnson et al., 1995) and Norway
(Firth, 1997a, b) of little or no support for litigation-adjusted audit fees. Also see
Gietzmann and Quick (1998) and Taylor and Simon (1999). The consequences
of both the Treasury ruling and Congressional legislation of the past and related
actions in the future merit monitoring and analysis by the research community.
Analytical models consider the relationship of auditing standards, legal liability,
auditor wealth (Dye, 1993; Schwartz, 1997) and incorporation (Dye, 1995).
Strategic auditor behavior in terms of effort exerted and its association with
strategic errors is considered in Lee and Gu (1998) who consider low balling,
liability, and auditor independence. Auditor choice has been modeled as a signal
of audit quality in valuing new issues (Datar et al., 1991). Experimental markets
research has explored how institutional settings, such as alternative negligence
liability rules and reputation formation, can affect the quality of audit services
(Dopuch et al., 1997; King, 1996; Wallin, 1992 who report the lowest settlement
frequencies in joint and several allocation settings and the most adverse effects
on defendants wealth; Dopuch et al., 1994; Gramling et al., 1998; King &
Schwartz, 1998, 2000; Zhang & Thoman, 1999 who explore pre-trial settlement
dimensions; Pae & Yoo, 2001 who also consider internal controls). Grant et al.
(1996) find that voluntary self regulation in multi-person coalitions can provide
incentives for sustaining high quality services. Such research must continue,
hopefully informing legislators before the fact of likely outcomes of proposed
changes.
discuss the ethical issues associated with internal auditing particularly outsourc-
ing. An unanswered question includes: why did the profession not circumscribe its
own involvement in outsourced internal audits for its own audit clients? No dearth
of warning signals existed, yet even the SEC stopped short of such proscriptions
until Sarbanes-Oxley. Reportedly, internal auditing has become involved in the
review of the Form 10-Q in 40% of a survey of 89 of the Fortune 1000 sized
companies in April of 2003, relative to the September 2002 level of involvement
reported of 27% (Schroeder, 2003, p. C7). This portends a shift of internal auditing
resources toward the financial reporting function, implying less operational audit
emphasis the traditional focus. This apparent change, in tandem with the newly
created internal audit departments across corporate America, call for further
research as to their costs and benefits. Product attributes may likewise be altered
by the increased attention to internal control, stemming in part from widely
publicized shortcomings associated with high-profile debacles (Kirkpatrick &
Lockhart, 2003).
How auditor independence is affected by the provision of varied non-audit
services is considered in experimental research by Mauldin (2003) as a basis for
concluding that the General Accounting Offices principles-based approach to
limiting non-audit services may be preferable to the standards-based approach
used by Congress and the SEC. Chung and Kallapur (2003) find no statistically
significant association between abnormal accruals and any client importance
measures that consider nonaudit fees and firm revenues, including tests of samples
partitioned based on corporate governance and auditor expertise considerations.
Past research reports no association exists between firms going concern opinions
and the magnitude of nonaudit services; however, a positive association is
observed between the likelihood of issuing a going concern opinion and audit
fees (DeFond et al., 2002 see Chen & Church, 1992, for a description of the
relationship of going concern opinions to default). Carcello and Neal (2003)
find that audit committees with greater independence and governance expertise
as well as lower stockholdings are more effective in shielding auditors from
dismissal after a going-concern modification is initially issued. Future research
will have a new environment to explore certain expectations: will the Big Four
merely trade client portfolios, will rotation of auditors prescribed by the SEC as
reaching to other auditors affect CPA firm cultures and/or performance, and how
will audit committee approval requirements influence usual product attributes?
Will synergies be lost to clients from unavailability of certain services? All of the
Big Four continue to offer certain consulting services, although three have sold
or divested portions of their consulting businesses PricewaterhouseCoopers
to International Business Machines Corp. and Ernst and Young to Cap Gemini
Group SA, with KPMG becoming BearingPoint (GAO, 2003b, p. 9). The effects
278 WANDA A. WALLACE
of such firm changes and the comparison of these firms strategies to that of
Deloitte and Touche will provide a research opportunity to better understand the
interplay of consulting services with the provision of the audit.
The manner in which the audit is performed may have implications for legal
liability. In an experiment, Lowe et al. (2002) find that jurors propensity to
hold auditors liable decreases when such auditors rely on decision aids (Scott &
Wallace, 1993) thought to be highly reliable, even when they were ineffective in
the particular circumstances (also see Anderson et al., 1995; Eining et al., 1997).
INFORMATION ECONOMICS
A key vein of research has considered the quality of information and its asso-
ciation with enforcement actions and audit practices. The accruals research has
attempted to define discretionary accruals and distinctions between expected and
unexpected accruals in a manner that proxied quality (Bartov et al., 2000; Beneish
& Press, 1997; Dechow et al., 1995, 1996; DeFond & Subramanyam, 1998;
Francis et al., 1999; Francis & Krishnan, 1999; Geiger & Raghunandan, 2002;
Heninger, 2001; Jiambalvo, 1996). Others have considered the relationship of
specific types of adjustments to reported earnings, comparing recurring items to
nonrecurring components (UBS, 2003). Yet, real challenges arise in the empirical
proxies, including their meaning within industry and specific company settings.
The empirical complexities of the questions posed have begun to be explored,
such as the apparent preferability of cash flow inputs, relative to balance sheet
measures. Future research should study reliability measured more finely, with
attention to the overall effects of rapidly changing accounting measures and
business practices. Audits reduce measurement error in information used in
monitoring (Eilifsen & Messier, 2000; Kinney & Martin, 1994). Fineness, bias,
and noise are elements of proxies that require like attention to ensure the infor-
mation quality of research findings (Ashbaugh et al., 2003 explain that reported
results by others are sensitive to research design choices, leading to erroneous
inferences; also see Kinney & Libby, 2002 and Klein, 2002; Bell & Wright,
1995, describe examples of effective collaboration of practice with research
and education).
Assertions that preparers have gamed accounting standards has posed questions
of whether auditors are permitted to focus on substance rather than form. Kadous
et al. (2003) through experimental research suggest that changes in regulation
requiring auditors to make quality assessments of accounting methods will
lower objectivity of auditors, thereby having the opposite effect to that intended.
Recent changes to accounting for variable interest entities (VIEs) may offer an
The Economic Role of the Audit in Free and Regulated Markets 279
example of how the standards, when revised, nonetheless, fail to achieve their
described purpose. Many view the FIN 46 as a move to place onto balance sheets
what would otherwise be off-balance sheet financing vehicles, such as special
purpose entities (SPEs). FASB (2003) states The objective of this Interpretation
is not to restrict the use of variable interest entities but to improve financial
reporting by enterprises involved with variable interest entities. Yet, the media
has explained that banking entities with as much as $55 billion in SPEs are
working to restructure with additional outside investors dollars in order to
maintain off-balance-sheet arrangements (Goldstein, 2003; also see Bryan-Low,
2003). Future inquiry is needed as to how the principles and rules distinction
in standard setting (Burns, 2003; SEC, 2003b) has influenced the auditability of
financial statements in line with substance relative to form (Schuetze, 2003 see
Nelson et al., 2002). Moreover, the emphasis on intent within certain standards
(Wallace, 1999) has been cited as precluding an ability to independently audit
certain facets of management representations (Wallace, 1992). How information
quality has been affected by standards that have auditing implications merits
study.
Pricing of audits has continued to be explored. Smieliauskas (1996) points
out the inconsistency of archival findings on individual countries experiences
to date regarding litigation risk and audit pricing (Simunic & Stein, 1996). Most
of that literature has focused on a single country at a time (e.g. Woo & Koh,
2001). Big 5 brand name premium over non-Big 5 auditors averages around 30%
(a finding inconsistent with an analysis of UK fees in 1900 (Matthews & Peel,
2003)); audit fee literature is reviewed and the agency cost basis for expecting
quality-differentiated audits is described, as is the cost-benefit framework for
determining optimal audit quality choice from among monitoring mechanisms
(Craswell et al., 1995). Banker et al. (2003) explain that merger and acquisition
activities among accounting firms increased profitability in the last half of the
1990s attributing this to favorable economies of scale and pointing out that
partners contribute nine times more to generating revenues than professionals
and about 20 times more than other employees. The relationship of partner
compensation to judgments by partners is explored by Trompeter (1994).
Copley and Doucet (1993) find a negative association between competitive
bidding and audit fees, as do Raman and Wilson (1992) and Ward et al. (1994).
Low-ballings association with independence is explored by Schatzberg and
Sevcik (1994) also see Craswell and Francis (1999). Raman and Wilson (1992)
do not observe lower fees in the initial audit engagement or the two years fol-
lowing, but do find that independent auditor reports on legal compliance (internal
controls) significantly affect audit fees. Hackenbrack et al. (2000) find audit fees
in Florida cities exceed fees of municipalities in seven other southeastern states
280 WANDA A. WALLACE
and characterize the evidence as consistent with better auditor performance in the
Florida government setting. They point to the audit restriction on bidding creating
an emphasis on auditors qualifications, thereby enhancing audit quality in the
local government audit market. Deis and Giroux (1992) report a direct relationship
between oversight agency quality review and audit effort as measured by hours.
Deis and Giroux (1996) explore the relationship of auditor changes (also see
Eichenseher et al., 1989), audit fees, audit hours, and audit quality. Johnson et al.
(2003) report that audit hours and fees are higher for audits of local governments
in Florida than in other states and draw the inference that the quality of local
government audits in Florida is greater, though at higher cost. They likewise find
similar effort on government clients by Big Six and non-Big Six firms. Audit
pricing and its relationship to independence is modeled by Magee and Tseng
(1990) also see Beck et al. (1988) for a treatment of audit tenure and management
advisory services.
The interaction of fees and risk is further explored by Pratt and Stice (1994)
who examine their relationship with likelihood of litigation. Walker and Casterella
(2000 also see Ettredge & Greenberg, 1990) find that discounting of new engage-
ments continues in 1993, similar to the earlier 1980 evidence and that profitability
influences fees, with loss clients not provided discounting. They infer that firms
change their business practices in response to risk through portfolio management.
Client acceptance decisions are described by Asare et al. (1994) and Johnstone
(2000), as simultaneously affected by client business risk, audit risk, auditor
business risk, and risk adaptation behavior (also see Johnstone & Bedard, 2003;
Walo, 1995). OKeefe et al. (1994) explain that a clients financial condition can
affect audit risk and vice versa. The relationship of pre-engagement factors with
lawsuits is described by Stice (1991). Bloomfield (1995) investigates strategic
interactions and audit reliance. Kinney and McDaniel (1993) empirically describe
the delay that accompanies firms correction of quarterly earnings. Wallace
(2000) discusses lessons from Cendant. These types of research contributions
explain how key events of a client interact with both risk and the audit process
(GAO, 2002; Kreutzfeldt & Wallace, 2000 this analysis of restatements
has spawned numerous working papers and will add insight as to how such
events interact with the market and the attestation process; as one example, see
Wallace, 2004).
One of the regulations to which firms have adapted is required cold reviews.
Matsumura and Tucker (1995) report an economic rationale for concurring
partner reviews with an analytical model and, in turn, test the implications using
experimental economics in Tucker and Matsumura (1997) to find a reduction in
reporting bias when a concurring partner is involved. Schneider et al. (2003) find
that the degree of concurring partners agreement with an engagement teams
conclusion was unaffected by prior involvement in audit planning; in other words,
the objectivity of the concurring partner appears unaffected, suggesting that such
consultation does not detract and might be beneficial. Leuhlfing et al. (1995)
report a lack of agreement as to the second partners role in the review process,
as well as significant differences in their extent among the large CPA firms.
Evidence regarding workpaper preparation and reviewers responses is reported
by Tan and Trotman (2003; also see Tan & Jamal, 2001, regarding the interaction
of perceived competence with the evaluation of subordinates work).
The professions responsibilities to plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement, whether caused by error or fraud, increasingly broaden attention
to sources of information, particularly to fraud risk factors. The Committee of
Sponsoring Organizations (COSO, 1999) provides archival evidence as to the
profile of entities identified as fraudulent reporters, including the nature of more
common problems also see Bonner et al. (1998). These permit a debriefing
process that can enhance the audit process (Report and Recommendations, 2000)
however, consideration of auditor and auditee interaction is also essential
(Newman et al., 2001).
Domestic auditing standards can vary in terms of the requirements for achieving
certification and performing an audit (Magill et al., 1998), as well as the steps
282 WANDA A. WALLACE
required by the auditor regarding such primary aspects of the audit as planning
materiality (Price & Wallace, 2001) and risk assessment (COSO, 2003). Krogstad
and Smith (2003) provide evidence that research has continued to build on
core inquiries concerning error characteristics, litigation, audit methods, and
auditors reasoning in such areas as materiality and risk assessment. With the
advent of the Public Companies Accounting Oversight Board (PCAOB), it is
possible that a public/private generally accepted auditing standard (GAAS)
dichotomy will be created, with standards being promulgated by multiple bodies
creating complexity and a lack of comparability as two apparent by-products
(e.g. PCAOB, 2003). McEnroe and Pitman (2003) argue that a jurisdictional
claim the claim before the public for the legitimate control of a particular work
by the Auditing Standards Board has resulted in standards being promulgated
that define the services over which the profession has been granted a monopoly,
and likewise result in a legal defense. They propose a reorganization toward an
independently funded, full-time board and argue that past concurrent membership
by firm representatives had resulted in firm rather than individual points of view
driving voting patterns, in order to legitimize respective audit firm approaches.
Research should evaluate the theoretical, analytical, and empirical ramifications
for markets of a proliferation of diverse auditing standards for private and public
markets, as well as the potential alternative of a single standards setter being
recognized to design a single GAAS framework. The role of international auditing
standards should likewise be integrated with that research agenda. The advent
of Parmalat an Italian dairy-foods giant debacle, apparently involving $12
billion in missing assets, $4.9 billion of which was supposedly held in a bank
account determined nonexistent, has raised numerous questions about the manner
in which primary auditors work with other firms, outside of their home country.
In addition, questions have been raised as to the actual execution of such core
audit procedures as the confirmation process (Edmondson & Cohn, 2004; Norris,
2003) see Wallace (1998) for a relevant earlier discussion.
Not only must firms adapt their audit technology (Manson et al., 1998) to
changing standards and regulatory processes, the entire labor market must likewise
adapt (Mian, 2000). Provisions of quality reviews, limited liability and continuing
class (whereby a second class of licensed accountants is recognized beyond the
CPA license, easing entry to the services sector) appear to have induced entry of
accountants into the professional services sector, while quality review and limited
liability appear to be positively associated with self-employment (Schaefer &
Zimmer, 2003). Laboratory market experiments suggest that audit quality and
pricing are associated with the timing of the peer review process, suggesting that
such timing affects an auditors willingness to provide consistent high quality
services (Payne, 2003). State Boards regulation of the profession is discussed by
The Economic Role of the Audit in Free and Regulated Markets 283
Colbert and Murray (2003), suggesting that a relation exists between an outcome
of a Colorado sunset review and the political ideology of the governor, as well as
the interaction between the regulated profession and the regulators. A description
of the profession, its legal, regulatory, and social environment, as well as the
marketplace for CPA services is provided by Magill et al. (1997). Peer reviews
do not appear to affect the amount or price of credit that loan officers extend to
potential borrowers (Schneider & Ramsay, 2000), although their confidence in
both the auditors report and the financial statements is enhanced. A number of
measures of audit quality are reported to be associated with peer reviewed firms
(Deis & Giroux, 1992; Krishnan & Schauer, 2000).
As with any time of change and debate, a number of proposals for change have
appeared in the literature, such as the Healy and Palepu (2003) suggestion that
the stock exchanges take over the contracting of auditors for all public companies
listed. There is a certain irony to such a proposal, in light of the later call by
Securities and Exchange Commission Chairman William Donaldson for the New
York Stock Exchange to provide full and complete details on its $140 million
pay package to New York Stock Exchange Chairman Richard Grasso, and his
subsequent resignation, as it has raised questions about the way in which the
exchange is governed and how funding and operations of its regulatory program
might be affected (Reuters, 2003). Nonetheless, the research community should
be vigilant to appraise proposals as they appear, carefully analyze their respective
benefits and costs, and inform decision makers, lest hasty change create larger
problems themselves than they are intended to address.
A LOOK AT REGULATION
Legitimacy theory describes a systems orientation that permits the enterprise to
be influenced by and, in turn, to influence the society in which it operates (Taylor
et al., 2001). Legitimacy theory recognizes an implicit social contract between
enterprises and their broad constituency in society, including community expecta-
tions embracing ethical norms, informed consent ideas buttressed by the right of
exit, and widely acknowledged rights (Taylor et al., 2001). The aim of enterprises
has been described as legitimizing behavior through managing perceptions of
stakeholders through educational efforts as well as information exchange. Sheikh
and Wallace (2003) describe the comment letter process of the certification
requirement associated with Sarbanes-Oxley as an illustration of one type of
information exchange common in todays regulatory setting. The implications of
legislative and SEC rulings such as the prohibition on misleading auditors, new
buckets for disclosure of fees paid to the auditor, prohibitions on compensation
284 WANDA A. WALLACE
parties with knowledge of the relevant facts and circumstances to conclude that
the auditors are not able to maintain independence and, thus, are not capable
of exercising objective and impartial judgment on all issues associated with
conducting and reporting on the work. (p. 15, para. 3.04). Government auditors
have expressed some concern as to how to proceed with operational audits and
yet respect the essence of para. 3.04, suggesting that the effects of such evolving
standards warrant evaluation, as to their consequences. A look backward may
also be informative: why did the Public Oversight Board choose to disband, in
what ways is the PCAOB similar or dissimilar from this former body, what are
the implications of the PricewaterhouseCoopers independence-associated SEC
censure and did the firms clients experience a market penalty, how have clients
of Andersen been affected by the elimination of that firms auditing services, and
were the tax-related services to executives as well as those involving tax shelters
by auditors firms examples of advocacy and/or imprudence?
Campbell and Parker (1992, p. 297) analyzed the 415 SEC releases associated
with enforcement actions from 1972 to 1989 and found a consistent SEC
conclusion that the primary purpose of the independent audit is to enhance the
efficiency of the capital markets and help protect the investing public by providing
reasonable assurance concerning the integrity of the financial statements and
related disclosures. Audit failures asserted were tied to auditors judgments and
the gathering of audit evidence, as well as the relationship with management
either over-reliance on management or deception by management. Related party
transactions were cited in 37% of the actions examined. This likewise permeates
the international scene (Landler, 2003 observes Parmalat is not unusual in that
Germany, France, and other countries companies are often controlled by families
or have close ties to the state). A line exists between allegations and reality, and
research must recognize the import of settlement practices that neither admit
nor deny. Future research ought to consider exploring how initial complaints
compare to legal outcomes as a means of improving understanding of regulators
enforcement actions.
Fines are ordered for violations of securities and futures laws, to help ensure
the accountability of violators and to deter future violations. The GAO (2003c)
describes the 1997 to August 2002 fines imposed and collection rates for
example, open and closed cases involve levies by the SEC of $480,375,353 (p. 21,
Table 2), 40% of which was reported to have been collected. The magnitude of
such fines creates questions of their role in deterrence and the incentive effects
linked not merely to violators but likewise to regulators (Bayot, 2003; Jones
& Wallace, 2003; Maremont & Solomon, 2003). For example, if a problem is
permitted to fester and lead to a large debacle, such as Enron and WorldCom, is it
the case that much larger fines can be imposed as a revenue source for government
286 WANDA A. WALLACE
SUMMARY
Williamson (2002) calls for the development of a theory capable of prediction
that incorporates asset specificity, disturbances, frequency considerations,
associated costs and competency of alternative governance structures including
reputation effects and contract law regime, and when hierarchies are used. Such
hierarchies are described to weaken incentives, yet extend controls, facilitating
the exercise of fiat that cannot be achieved in markets. Increasingly, our economy
involves bilateral dependencies, meaning that the identity of parties matter, as
does the continuing of the relationship; this departs from the concept that an
instantaneous exchange (MacKie-Mason & Varian, 1994) at equilibrium price
between faceless buyers and sellers is the primary market of interest. Indeed, the
result of recognizing that simple market exchanges have been transformed into
multiple-party long-term strategic alliances in diverse settings helps to explain the
role of credible contracting, which includes penalties for premature termination,
mechanisms for information disclosure and verification, specialized dispute
settlement procedures and the like. (Williamson, 2002, p. 176). The entire
phenomenon of partnering has been at the heart of many controversies. The
independence of auditors, the meaning of arms length transactions, the import
of barter transactions, the asymmetry of accounting treatments among parties to a
transaction, the assumption of risks and returns among such parties, and the nature
The Economic Role of the Audit in Free and Regulated Markets 287
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