Private Firms Working in the Public Interest: Is the Financial Statement Audit Broken?

Publication Date: October 2006

Publisher: Pardee Rand Graduate School

Author(s): Abigail Bugbee Brown

Research Area: Business

Type: Report

Abstract:

The Big Four accounting firms have become the object of much scrutiny following the string of financial statement fraud scandals at the beginning of this century. The apparent involvement of the large auditing firms in the accounting misdeeds comes as a surprise, since the academic literature on auditor incentives predicts that large, reputable firms will not engage in collusion with their clients. The lace of a consensus economic framework to understand the incentives facing the audit firms that reflects the historical reality has hindered consensus building in the policy response to the scandals. This dissertation develops a principal-auditor-agent model that suggests there may well be socially sub-optimal levels of audit intensity, even among the best audit firms. It explores archival historical evidence to identify examples of how these incentives have shaped the profession and develops a more nuanced reading of the root causes of the recent scandals. This work also identifies the gaps in our understanding of the cost and occurrence of fraud that hinders a proper cost-benefit analysis of policy options designed to improve the quality of information available to the market.