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

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5. http://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_Act

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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

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25. http://www.ifac.org/financial-crisis/smp-sme-resources.php

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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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