A
WAVE of financial scandals which began with Enron’s bankruptcy and the
revelation of document shredding at Arthur Andersen has prompted
concern that the credibility of leading auditors is fragile. A small number of large firms have special status within the
auditing industry. Currently there are four firms in this group —
Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers — but this
number can vary, it was once as high as eight, (we will call the group
the Big ‘n’).
The
audit industry is effectively divided into two: the Big ‘n’, which has
a higher reputation and charges higher fees; and the rest, which have a
lower reputation and charge lower fees. Although firms can leave the
Big ‘n’, it is difficult to join. Big ‘n’ audits carry more
credibility, which raises the question: would it be better if the group
was to increase its market share or if other auditors raised their
standards? The answer depends on the relationship between auditors,
client firms and financial markets. The auditors’ reputation is used to
win the confidence of investors. But it is the client firms that pay
for them and who could benefit by misleading investors. The auditors
can get away with false reporting as long as the client firm stays
solvent. The separation of users (investors) and purchasers (firms)
creates the possibility that an auditor may be influenced by the client
to gamble, hoping the dishonest behaviour will never be revealed.
If the supply of reputable auditors was to increase, the
premium that the Big ‘n’ could charge would decrease. At some point the
premium is insufficient to deter them from accepting bribes (usually as
continued business or purchase of consulting services).
In other words, there is a threshold size for reputable
auditors beyond which their honest reporting behaviour can no longer be
sustained. It was the slow expansion of the reputable segment of the
sector accompanied by a diminution of the fee differential which led to
a situation in which Arthur Andersen was tempted to risk its
reputation.
This is a summary of a paper by In-Uck Park and Andrew McLennan, The Market for Liars: Why Big Auditors Risk their Reputations, published in the Winter 2005 bulletin of the Centre for Market and Public Organisation. www.bris.ac.uk
