Audit Failure and the Crisis of Auditing

European Business Organization Law Review 5: 635-643 2004 T.M.C.ASSER PRESS DOI10.1017/S1566752904006354

635

Benito Arruada*

1. Audit failure and regulation . . . ....................................635

2. The proposed European regulation .................................637

3. Three pillars of auditing..........................................637

4. Non-audit services ..............................................639

5. Auditor rotation ................................................640

6. The real crisis of auditing: is mandatory auditing necessary? .............641

Abstract Legislators have been using audit and financial crises as excuses to introduce additional regulation into an industry that is already over-regulated. This practice is questioned here because of the ability of the free market to punish audit failures, the dynamism shown by participants in relation to the voluntary adoption of new self-regulatory policies and the high costs and dubious effectiveness of the new regulations adopted. A more prudent approach that would give the market time to discover the efficient mix of services, quality safeguards and firm structures is advised. Current regulatory tendencies, the main element of which is mandatory auditing, risk condemning financial auditing to triviality and increasingly ineffective regulation.

Keywords: auditing, regulation, non-audit services, auditor rotation, crisis.

1. Audit failure and regulation

Auditing has changed greatly in recent decades, and these changes aggravate the difficulties usually faced by legislators in weighing the costs and benefits of regulation. More than ever, legislators should therefore give the market time to develop more efficient guarantees and find out by trial and error which systems and products are the most valuable. Instead of showing patience, however, leg-

* Professor of Business Organisation, Universitat Pompeu Fabra, Barcelona. E-mail: benito. [email protected]. Authors homepage: <http://www.econ.upf.es/~arrunada>.

Audit Failure and the Crisis of Auditing

636 Benito Arruada EBOR 5 (2004)

islators are keen to use audit and financial crises as excuses to introduce additional regulation into an industry that is already over-regulated.

The ability of the market to punish audit failures and the dynamism shown by the market in the Andersen case confirm this. Soon after the Enron bankruptcy, not only did Andersens partners and employees suffer heavy losses, but new policies were also adopted voluntarily by all kinds of players. Many companies replaced their auditors, and some disallowed the purchase of non-audit services from them. Some institutional investors also promoted more active involvement of shareholders meetings in controlling external auditors. Audit firms themselves were soon busy separating...