Download - Yici Shi Honors Thesis
Introduction
The current global financial crisis began around 2007 and is considered the worst
financial crisis since the Great Depression of the 1930’s. A liquidity shortfall in the
United States banking system is one of the major causes. The collapse of the housing
market also plays a major role that lead to the failure of key businesses, declines in
consumer wealth, and commitments by the government through the use of bailouts and
favorable tax policies. Many economists have debated about the role of accountants in
the financial crisis. More specifically, some economists have tried to pinpoint the role of
auditors. Some economists argue that the lack of transparency in companies’ financial
statements led to the financial crisis. Many companies and banks reach collapse or are
nearly there because of weak financial audits. Indeed, one can say that financial
auditors should have been much more involved in the prevention process. However,
had auditors not been around, the financial crisis would have been even worse. This
paper aims to explain the role of auditors in the economy and how they help to mitigate
the financial crisis.
Thesis Statement
Auditing has played an important role in mitigating the effects of the current
financial crisis. Had auditing not been around, the financial crisis would have been even
worse.
Cause of the Financial Crisis
In order to better understand the role that auditors play, I will first briefly explain
the series of events that lead to the crisis. The most immediate cause of the financial
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crisis was the bursting of the housing bubble. Between 1997 and 2006, the price of the
typical American house increased by 124%. In pursuit of the American Dream,
homeowners were purchasing homes that they could not afford. To make matters
worse, mortgage brokers were giving out sub-prime mortgages and even liar loans. Liar
loans refer to loans given for borrowers who have an unstable source of income, or
have difficulty producing asset verifying documents, such as prior tax returns.1
Subsequently, banks would purchase these subprime mortgages from brokers in order
to resell them to investors. In essence, all the parties involved were passing down the
risk to the next party in line. However, these parties only benefited in the short term. In
2007 housing prices began to decline. Investors no longer wanted to purchase the
securities from banks. Banks and investment companies, mortgage brokers, and
homeowners were stuck with assets that were dramatically losing value.
Consequentially, housing prices declined and unqualified borrowers defaulted on their
mortgages. This series of events caused the downward spiral in the value of mortgage
related assets to drop even further.
Furthermore, FASB released FAS 157 to define fair value, to establish a
framework for measuring fair value in generally accepted accounting principles (GAAP),
and to expand disclosures about fair value measurements.2 Prior to this Statement,
there were various inconsistent definitions of fair value and very little guidance for
application. By developing this Statement, FASB sought to increase consistency and
comparability in fair value measurements and to expand disclosures about fair value
measurements. FAS 157 defines fair value as the price of selling an asset (an exit price)
and not the price of acquiring an asset (an entry price). This statement also emphasizes
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that fair value is a market-based rather than entity-specific measurement.3 This method
of accounting measurement exacerbated the collapse of the economy by causing a
“death spiral”, in which the value of mortgage related assets fall.4 Firms holding
mortgage-backed assets must mark these assets down to the market value, and
consequently, as these firms try to sell their mortgage backed securities, the value of
the assets fell even more.
Another cause of the crisis was the government’s increasingly leniency in
regulating commercial banks. This can be seen from the repeal of the Glass-Steagall
Act of 1933. This act allowed the Federal Reserve to regulate interest rates in savings
accounts and prohibit bank holding companies from owning financial companies. The
repeal of the Glass–Steagall Act effectively removed the separation that previously
existed between Wall Street investment banks and depository banks and partially
caused the collapse of the subprime mortgage market that led to the current Financial
Crisis.5 The government’s increased leniency put more responsibility on auditors to
prevent or detect any potential fraud. In other words, regulators passed down their
responsibilities to the audit profession, which has become the “scapegoat” in many
cases. Some economists ascribed the financial crisis to weak financial audits. For
example, Accountancy columnist Emile Woolf has argued that “[auditors] have
contributed to the crisis by accepting directors’ “mark-to-market” valuation of trading
assets, when …those directors (i) hadn’t the remotest clue what was in the mortgage
they had acquired; (ii) were utterly bemused by the nature of the complex derivatives on
which their asset valuation rested; and (iii) knew that there was no market to “mark” to.”6
The rest of the thesis aims to explain the audit profession’s role in the financial crisis.
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History of Auditing
In order to better understand the role of auditors in the financial crisis, I will first
investigate the history of the profession. The recent global economic meltdown has
revolutionized the business world and placed new demands on accountants. More
evidently, the role of auditors has evolved. This is partially due to the fact that the rules
of business have changed, and accounting is more important in our society than ever.
Auditing services are currently provided to a large number of business and government
units, suggesting that the services themselves are valued highly by consumers.
Statistics show that right before the Securities Exchange Acts of 1933 and 1934, 82
percent of firms trading on the New York Stock Exchange were already audited by
CPA’s.7 Even today, unregulated segments of the economy are voluntarily audited.
The history of audit extends far beyond the emergence of the SEC. Audits are
identified as early as 500 to 300 B.C. in Athens, where the Greek city-state revenues
and expenditures must be verified by the state accountants.8 Later, the auditing
profession developed in Italy as a way of maintaining accountability of ships with riches
returning to Europe from the Old World. In 1066, after the Norman Conquest, merchant
guilds started to appear in England.9 These guilds sought to protect the prosperity of the
merchants. The guilds were the earliest examples of incorporation. Gradually, the
merchant guilds began to require annual audit for the benefit of the merchants. The
auditors were selected from guild members.10 Even back then, auditors had ample
reasons to be independent. They would be heavily fined for not completing the audit in a
timely fashion, or if the quality were below a certain level.11 Nonperformance would also
negatively impact auditors’ reputation, and could possible cause auditors to lose their
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guild membership and share of the guild’s monopoly profits. In other words, the guild
auditors all owned property. In the case that they neglected their duty, the guild could
easily recover damages against them.12 This provided auditors with further incentives to
be independent and report any contract breach they found. Later the use of an audit
committee became a popular method to encourage high performance and
independence. It reduced opportunities of collusion between manager and auditors.
During the Industrial Revolution from 1500 to 1850, auditing expanded as a
profession. In fact, in 1844, Great Britain formalized the already common practice of
voluntary company audits.13 Directors were to keep accounts and have them audited by
persons other than the directors or their clerks. Interestingly, auditors were required to
be shareholders, a practice that today would certainly violate the independence criteria.
This perhaps was done to financially incentivize auditors to act in the best interest of
their clients. Furthermore, the auditors needed not to be outsiders, or even be a
professional firm.14 Going forward, the 1933 Securities Act required corporations subject
to the act to have audits by independent certified public accountants. At that time, many
U.S. audit firms were started by British chartered accountants who came to the United
States to audit American companies selling securities in London.15
This overview of the evolution of audit demonstrates that audit persisted through
time in unregulated environments. Over time, the substitution of professional auditors
for shareholder auditors occurred in both Britain and America even though the law
made no such requirement.16 This trend suggests that the market forces were changing
the demand for audit. As market forces changed, so did the nature of audit. The
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persistence of demand for auditors suggests that audit brings value beyond regulatory
compliance.
Factors that Cause Audits to be Necessary
The Committee on Basic Auditing Concepts presents four conditions that create
a demand for auditing. The four conditions are: conflict of interest, consequence,
complexity, and remoteness.17 Conflict of interest refers to conflict between information
preparer and a user due to potential biased information production and presentation.
Consequence refers to the fact that all information can be of great value to a decision
maker. Complexity refers to how expertise is required for information preparation and
verification. Remoteness points out the disadvantage that most information users face:
that they are frequently prevented from directly assessing the quality of information.18
Audit demand is influenced by factors related to the size and complexity of the
organization. As the structure of an organization becomes more complex, the legal
liability that directors assume also increases. Demand for audits also increases as the
number of corporations in the market increases. The increased complexity changes the
nature of audit. Auditing becomes more specialized to meet the demands of various
industries. This specialization also enhances the growth of professional firms.19 In any
organization, there are multiple stakeholders that endogenously influence the demand
for controls. Each group of stakeholder has its own objectives; some may be unique
while others may be shared. Shareholders’ conflicting objectives increase risk, which
drives demand for control.20
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Another source of risk comes from information problems. Information contributes
to the functioning of the economy. A lack of solid information can weaken a market's
efficiency. Remoteness of information, biases and motives of the provider, voluminous
data, and complex exchange transactions all cause information risk to arise.21 Some
economists believe that information asymmetry contributed to the financial crisis and the
recession. This can be seen from the “lemons theory”. This theory points out the
damage that can be caused by information asymmetry, which occurs when the seller
knows more about a product than the buyer.22 In a market where quality is
unobservable, buyers do not know the quality of the product they are buying and
therefore will not pay the high price that would be required for a high quality product.
Consequently, sellers will refuse to sell high quality products because they know that
they cannot receive a fair price for the products. This causes the market to reach an
equilibrium where only sellers selling the worst quality products are willing to trade and
only buyers interested in buying the lowest quality product are willing to buy. This is an
inefficient outcome. During the financial crisis, the market for mortgage backed
securities became a “market for lemons” when the quality of mortgage backed securities
was called into question. It was difficult for investors to distinguish between high quality
mortgage backed securities (those backed by conforming home loans) and low quality
mortgage backed securities (those backed by subprime home loans). Therefore, market
prices used in fair value valuations were trades of the worst quality mortgage backed
securities, just as predicted by lemons theory.
On one hand investors want as much information as possible, yet in many
situations they have reason to doubt the quality of the information. Assurance service
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improves the quality of information for decision makers.23 An audit promotes confidence
and reinforces trust in financial information, especially during a time of financial crisis.
This can be demonstrated using agency theory. In a corporation, an agency relationship
arises when the shareholders (principal) engage management as their agents (or
steward) to perform a service on their behalf. In order for this process to happen, the
principals must delegate decision-making authority to the agent. This sharing of risk and
delegation of responsibility and authority helps to promote an efficient and productive
economy. On the other hand, such delegation also means the principals need to place
trust in the agent and assume that the agent will act in the principals’ best interest. The
dilemma arises when the principals become concerned about the motives of the agent
and question the trust they place in them. The delegation of responsibility and authority
inevitably leads to some form of information asymmetry. As a result of information
asymmetry and self interest, principals can lose their trust in their agents and may try to
mitigate potential harm by using mechanisms that would coordinate the interests of
agents with principals and to reduce the extent of information asymmetries and
opportunistic behavior.24 An audit is one mechanism that can reduce information
asymmetry. It aligns the interest of the principals and agents and assures that the
financial statements are fairly presented.
A recent survey by The International Federation of Accountants (IFAC) and The
Banker magazine confirms the role of audit in reducing information asymmetry. The
survey was conducted on global banks that to small and medium-sized enterprises
(SMEs) in order to better understand how the accountancy profession can best support
both SMEs and lenders. The survey shows that lenders highly value audited financial
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statements. In fact, two-thirds of the respondents indicated that their lending policies
require some form of assurance on the entity’s financial statements from an external
accountant.25 In addition, another 60 percent of respondents said that auditor
involvement in an SME’s business would significantly and positively influence their
lending decisions. The survey results confirmed the critical role that auditors play in
reducing information risk that influences lender decision making.
Literature in accounting has utilized the “insurance hypothesis” to highlight the
increasing importance of audit.26 This hypothesis argues that managers and other
professionals look to auditors as a source of insurance. Nowadays, auditor’s
involvement is so ingrained in a society that the absence of attestation may be
interpreted as negligence or even fraud on the part of management. In general,
management becomes the ones to be blamed in the event of financial loss from
business failure, misleading disclosure, or any overall poor performance. Auditors
provide protection from business risk of investment since the courts tend to assume that
the auditor is the guarantor of the accuracy of financial statements.27 As mentioned
earlier, higher risks lead to higher demand for insurance, and auditors become the best
sources of insurance.
Role of Audit in the Crisis
In the previous section, I have pointed out the importance of audit in the modern
capital markets to reduce information asymmetry. The crisis would undoubtedly have
been worse were it not for auditors. However, auditors did make mistakes during the
recent financial crisis. An auditor’s role is not to predict the future but to ensure that
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companies’ financial statements give a true and fair view of the fiscal year
performance.28 As L.J. Lopes of the Appeal Court famously states in ReKingston Cotton
Mills, the auditor is “a watchdog but not a bloodhound”.29 The primary role of auditors is
to determine if an entity’s financial statements are free of material misstatements. Their
role is not to detect fraud, but to determine if the company’s financial statements are
true and fairly presented.30 In order to accomplish this, auditors must have an accurate
understanding of asset valuation. However, many auditors failed to recognize the bad
lending practices that led to the housing bubble and collapse.
Furthermore, the audit process is increasing its use of the check list method.
Whereas this approach helped to determine if loans were recorded, it did not force
auditors to look beyond the given number to test the validity of the numbers. In the
process of understanding the business, the auditors should have realized that this type
of lending practice did not have a solid foundation. Many of the companies that received
an unqualified opinion may not have deserved a clean opinion upon closer examination.
However, since the financial statements of those companies were “fairly presented”
according to Generally Accepted Accounting Principles (GAAP), their lending practice
flaws were not brought to light. Audits might have been a better lever to prevent the
wrong course of some companies’ financial situation if its professional standards were
more effectively applied. The economic and financial world needed more transparency
in revealing the basic of financial information.31
Recently, many rules and standards with regard to accounting activity and
reporting systems were issued. The International Federation of Accountants (IFAC)
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issued the International Standards on Auditing (ISA) to provide guidelines to financial
auditors. To assist professional accountants in addressing issues related to the global
financial crisis, IFAC and the International Auditing and Assurance Standards Board
(IAASB) have mainly focused on three activities: to increase awareness among
preparers and auditors of existing and newly developed guidance that can assist them
in reporting on financial instruments; to encourage further convergence in reporting
standards on financial instruments, while at the same time strongly supporting (the
continuation of) fair value accounting since reducing transparency is not in the interests
of investors; and to participate in and promote discussions of best practice with respect
to the audits of financial institutions and other organizations that are affected by the
current crisis.32 Concurrently, many countries have issued recommendations to all
economic and financial organizations on improving their accounting system by
enhancing transparency. But more importantly, these recommendations and guidelines
need to be applied consistently to be fully effective. Many problems encountered in the
audit professions do not arise from the professional standards themselves, but rather,
how they were applied.
Just recently, the House of Lords Economic Affairs Committee has called for a
broad investigation of the UK audit market. It accuses bank auditors of being
“disconcertingly complacent” about their role in the financial crisis. The auditors’
defense is that their audits of major banks are “legally sound and that [they] are not in a
position to raise alarm in markets about their clients' business models.33 It appears that
the auditors have carried out their duties properly in the strictly legal sense. But in the
wider sense, they did not do so.34 The committee points out auditors’ complacency as a
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contributory factor to the banking meltdown. Their criticism draws attention to the
disadvantages of the box-ticking approach to audit. This approach enhances efficiency
but not so much effectiveness. It makes an audit rigidly mechanical and formulaic.35
Auditors exert tremendous efforts to box-ticking rather than actually checking the validity
of client’s business. Their attention is easily constraint by the instructions on a checklist.
Therefore, the audit system needs to be strengthened to the extent that prudence is
reasserted as a guiding principle for auditors.
The current crisis and global shift has brought on new demands for auditors.
Consequently the role of auditors needs to change. Auditors should look beyond the
numbers presented on financial statements and spend more time assessing whether
the company is doing sound business. As mentioned earlier, sub-prime lending
obviously lacked business validity, yet auditors still gave clean opinions. But regardless
of the flaws of the auditors, no other professions could have done a better job in
determining whether a company is doing well. Auditors have the knowledge and
experience to perform the necessary tasks. Above all, they are independent, which
enables financial statement users to trust the validity of the information presented.
Conclusion
Audit is an old and powerful institution. It reduces information asymmetry and
improves the quality of information for decision makers. Modern financial markets could
not function without it. Despite these benefits, auditors made mistakes during the recent
financial crisis. The “box checking” approach is a mistake that prevented auditors from
recognizing bad lending practices. Had they been more conscientious, they could have
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called into question the bad lending practices that led to the housing bubble and crash
that precipitated the crisis.
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References
1. Alan Zibel, “'Liar loans' threaten to prolong mortgage crisis” (2008)
2. “Statement of Financial Accounting Standards No. 157: Fair Value Measurements” (2006) pp. 2
3. http://www.fasb.org/summary
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5. http://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_Act
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14. Ross Watts and Jerold Zimmerman, “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence” (1983) pp. 628.
15. C. A. Moyer, Early Developments in American Auditing, 26 Acc. Rev. 3 (1951)
16. Ross Watts and Jerold Zimmerman, “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence” (1983) pp. 630
17. Committee on Basic Auditing concepts, A Statement of Basic Auditing concepts. Sarasota, Florida: American Accounting Association, 1973.
18. Wanda Wallace, Deborah Shelton, “Auditing Monograph.” Macmillan Publishing Company, pp. 14
19. Ross Watts and Jerold Zimmerman, “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence” (1983) pp. 630
20. Knechel, W. Robert, Marleen Willekens, “The Role of risk Management and Governance in Determining Audit Demand.” Journal of Business Finance and Accounting, November 2005, pp. 1346.
21. Arens, A.A., Elder R.J. and Beasley M.S. (2008), Auditing and Assurance services, Pearson Education Inc.
22. “The Market for Lemons: How Information Contributes to Efficiency.” January 05, 2010.
23. Audit Quality Forum, “Agent Theory and the Role of Audit” May 2005, pp. 7
24. Audit Quality Forum, “Agent Theory and the Role of Audit” May 2005, pp. 9
25. http://www.ifac.org/financial-crisis/smp-sme-resources.php
26. Wallace, Wanda, Deborah Shelton, “Auditing Monograph.” Macmillan Publishing Company, pp. 20.
27. Fama, Eugene F., and Arthur B. Laffer, “Information and Capital Markets.” Journal of Business, July 1971, pp 289-298.
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28. Shakun, Melvin F., “Cost-Benefit Analysis of Auditing. Research Study No. 3, Commission on Auditors’ Responsibilities.” New York: American institute of Certified Public Accountants, Inc., 1978
29. Hamilton, Robert, “An Examination and Clarification of the Role for Auditing in the Production and dissemination of Capital Market Information.” Unpublished D.B.A. dissertation, University of Southern California, 1975.
30. Morgenson, Gretchen (June 25, 2010), "Strong Enough for Tough Stains?", New York times, http://www.nytimes.com/2010/06/27/business/27gret.html, retrieved 2010-06-25
31. Bridget Lyons and Lucjan T. Orlowski, “Transparency in Financial Markets and Institutions: A Catholic Social Thought Perspective” pp 2
32. http://www.ifac.org/About/Publications.php
33. Jones, Adam, “Auditors Criticized for Role in Financial Crisis”, (2011)
34. Mario Christodoulou, “U.K. Auditors Criticized on Bank Crisis “, (2011)
35. Prem Sikka, “Tick-box approach to auditing practice” (2005)
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