Auditors Are the Most Effective Gatekeepers in Preventing Corporate Scandals

Introduction

In the past few decades, we have witnessed a lot of corporate scandals that have implicated the auditing profession. As a result, various players in the auditing profession have deemed it necessary to reexamine the issue of ethics.1 The role of auditors has repeatedly been questioned as most people contend that corporate scandals cannot happen without the full knowledge of the auditors. Previous studies have implicated auditors in unethical practices, including white-collar crimes and fraud. There is growing demand for the auditing professionals to put their act together as a way of mitigating future scandals, and also in order to win the trust of the public. Some of the most notable corporate scandals in recent years include Worldcom, Enron, and Global Crossing, among others. The occurrence of these scandals has brought forth the need to enlist different gatekeepers-auditors, underwriters, lenders, stock analysts, and lawyers- to prevent corporate fraud.2 Gatekeepers are very important in that they help organizations to promote corporate governance.3 They also protect the interests of shareholders and investors by reporting the organization’s corporate performance in an unbiased and accurate manner. This allows for objective valuation of the organization. In addition, auditors are also called upon to monitor the behavior of various corporate ‘insiders’ who are likely to engage in corporate scandals.

The aim of the dissertation study is to explore whether auditors are the most effective gatekeepers in preventing corporate scandals.

Review

Coffee has defined gatekeepers as “reputational intermediaries who provide verification and certification services to investors.”4 In his earlier publication, Coffee (2001) has also defined gatekeepers as “the independent professionals who verify and analyse the disclosures of publicly held companies”.5

Hypothetically, gatekeepers are in a position to provide their services to the firm either internally or externally.6 From a legal context, firms involved in business transactions have the freedom to decide if they should rely on the market to provide gatekeeping services. Characteristically, most firms decide to go for external gatekeepers.7 One of the distinguishing characteristics of gatekeepers is that they offer security to organizations. Gatekeepers also act on behalf of investors in trying to verify corporate disclosure. By taking part in the verification procedure, gatekeepers provide investors with an assurance that the level of corporate disclosure is accurate.8

One of the problems facing corporations today is the issue of securities fraud, often regarded as intentional wrongdoing. Individuals are best advised to ensure that their avoid securities fraud at all costs.9 Through precautionary measures, gatekeepers are able to exercise their ability to scrutinize and control the firm’s conduct. Gatekeepers are at liberty to exercise this authority over corporate employees or the management. From a practical point of view, some of the precautions that gatekeepers need to take consider during their involvement in business transactions include fraud-prevention measures and fraud detection.10 Such precautions may entail shutting the “gate” to a given transaction, such as declining to issue a written opinion on how a given transaction need to be executed.11

The gatekeeper model

Coffee opines that auditors act as gatekeepers and in this role, they are charged with the responsibility of perfecting shareholders’ interest by taking part in monitoring activities within a firm. In addition, auditors also act as gatekeepers to a firm by providing a financial representation of the firm in an accurate and unbiased manner.12 The above perspective of the auditors as reported by Coffee (2001) appears to concur with the sentiments expressed by Tuch who has described an independent auditor as a “public watchdog”.13 From a theoretical point of view, an insider to an organisation stands to gain more that the gatekeeper in facilitating an illegal transaction. This is because the financial status of such an insider is often tied to the firm and as such, he/she would end up losing more by participating in fraudulently activities. The gatekeepers cannot for example, take a bribe from the insider of the firm in order to allow a questionable transaction to take place. According to Millon, the issue of trustworthiness is crucial in as far as the gatekeepers’ reputation is concerned. This is because it does not make sense to have a gatekeeper at a firm who has lost his/her credibility and trust.

Millon has defined gatekeepers as “independent professions who serve investors by preparing, verifying or accessing the disclosures that they receive”.14 Some of the most common gatekeepers in the firm include debt rating agencies, investment bankers, security analysts, and auditors16. For purposes of this paper, a ‘gatekeeper’ shall be defined as an independent third party who is committed to upholding his/her reputation while certifying or verifying information, and who abides by legal requirements in trying to reduce excessive transactional costs. An auditor is an independent third party who upholds his/her reputation in certifying or verifying the financial statements of a company. Moreover, in case an auditor decides to withhold his support, the entire unlawful transactions as reflected by such statements are disrupted.

Analysis of Auditors as Gatekeepers

As gatekeepers, auditors are normally charged with the responsibly of enhancing corporate governance practices in firms. Because of their crucial role in ascertaining the integrity of financial information of a firm, auditors are commonly referred to as gatekeepers because in doing so, they are able to ‘keep the faith’ of regulators, investors, and other stakeholders. In the past decade, the SEC and the accounting profession have been embroiled in a heated debate with regard to the causes of auditing failures.15 The accounting profession maintains that there are “expectations gap” on the ability of auditors to detect errors within an organization. The profession further claims that although auditors might be aware of the progress of earnings management, they do not have enough incentives to execute their duties. This is indicative of a problem with corporate governance. The occurrence of a corporate scandal is usually a sign that corporate governance in a firm has failed.16

Corporate governance involves control, monitoring, and directing of a corporate entity/personality.17 Based on the jurisdiction of choice, various bodies are charged with the responsibility of ensuring that the corporate governance of an organization is maintained. They include the Board of Directors, the supervisory committee, and the auditing committee. The utmost allocation and utilization of capital is the hallmark of sound corporate governance in a firm. However, even the most well designed governance system cannot fully prevent dishonest and greedy individuals from prioritizing on their personal interest at the expense of those of the organisation.18 The auditing professionals play a crucial role in reducing accounting fraud. Although the auditor may lack direct corporate governance responsibility, nevertheless he has the capability to examine information components related to governance system. In addition, they can ensure that the audited financial reports are presented in a way which ensures transparency.19

Corporate governance entails accountability, decision making, and monitoring. Making the right decisions calls for reliable and accurate information. In contrast, accountability involves reporting, measuring, and transparency, while monitoring entails systems and feedback. As noted by Mayson et al., transparency plays an integral role in wellbeing and functioning of an organization.20 One of the key responsibilities of an auditor is to ensure that investors are provided with the most reliable financial information.21 Ideally, an auditor should aim to provide his/her expert opinion regarding the fairness with which he/she presents a company’s financial position and cash flow in line with the GAPP requirements.22 Investors rely heavily on auditors to provide them with the most accurate financial information as they depend on such information while making economic decisions. Auditors reduce risk and uncertainty, in addition to enhancing investor confidence. When the financial statements of a firm fail to conform to the GAAP either due to fraud or an error, it is the responsibility of the auditor to detect such misstatements.

The board requires often requires the input of an auditor in order to fulfill its role to shareholders and as such, auditors have to provide the board with reliable and relevant information.23 However, in order for this to happen, there must be frank and open dialogue between the board and auditors. Auditors need to be very candid in communicating with the audit committee and the board. At times, they might be forced to say things that the client would rather not hear and sometimes, they could back the client’s position. In communicating with the boards, auditors are required to exercise completeness of the disclosures and transparency.

On the other hand, external auditors are charged with the responsibility of auditing the financial statements of the firm. In addition, they also provide updates to the management and shareholders of a firm on the financial position of the firm in a fair and truthful manner.24 As a result, they offer comfort to the various stakeholders of the firm, including shareholders, by assuring them that no material errors, omission or incidences of fraud have been identified. In many cases, external auditors provide integrity to financial reports, in addition to lowering the risks of misleading, inaccurate, biased, and incomplete reports. Based on internal management principle25, the internal management matters are settled by majority decisions, which include financial reports made available by auditors.

In case auditors are unable to detect audit failures in an organization, a governance issue transpires. In the past, the assumption was that the threat of litigation would act as a driver to the auditing process, dissuading individuals who might otherwise be influenced to participate in fraudulent activities. Litigation rarely works and in any case, it is a very costly affair. In the 1990’s, auditors were faced with high costs of litigation, prompting them to pursue political relief. This was eventually granted in the form of the 1995 Private Securities Litigation Reform Act. Since litigation risks have now subsidized, it is important to consider other realistic enforcement mechanisms.

Without incentives to tell the truth, managers are likely to issue false reports. Thus, investors need an assurance that the financial reporting has been conducted in an accurate and fair manner.26 However, we also have managers who are able to uphold high ethical standards in their work. Such managers are likely to try and improve the value of their shares by advertising their “righteousness”. At the same time, managers with low ethical standards might try to falsely advertise their “righteousness’. First-rate managers always try to appoint auditors who can confirm the authenticity of their revelations. In this case, the auditors will affirm that the client’s financial statements have not been misrepresented. If an organisation has many unethical agents, it needs to invest more in external audit resources.27 For the above mentioned reasons, auditors remain crucial gatekeepers. In order to ensure the credibility of the above attestations, auditors should be perceived as ‘neutral’ and ‘objective’ qualified outsiders.

Auditors should also endevour to perceive probable misrepresentation and then try to persuade investors that they have accomplished this goal. In case auditors are unable to fulfill their job, they could face penalties.28 After all, we have watchdog organisations charged with the responsibility of policing auditors so that they fulfill their duties as required. In the absence of such penalties, auditors might try and pursue their individual interests and in the process, collude with ‘poor quality’ managers, thereby weakening the reliability of official reports. In all likelihood, in trying to reduce such penalties, auditors may be inclined to adopt procedures that allow them to perceive bias in management representation. These penalties comprise of civil suits as issued by stockholders, as well as SEC suits and enforcement action.29 The 2002 Sarbanes-Oxley Act inflicts ruthless punishments on officers, directors, and auditors as well. Thus far, the current deterrents appear to be somewhat ineffective in preventing abuses. The media is awash with a lot of accounting and auditing irregularities, a further testament that indeed, the current system of auditing is far from perfect. In any case, we cannot assume that the increased prison terms and increased fines as introduced by the Sarbanes-Oxley Act shall in the long-haul discourage auditors from reporting misrepresentations, such as incidents of cooked books of accounts.

Conclusion

Based on the definition of a gatekeeper as provided for in this research paper, auditors have emerged as effective gatekeepers in preventing corporate scandals. This is because auditors are charged with the responsibility of ensuring that firms follow the established corporate governance practices. Furthermore, it is the responsibility of an auditor to ascertain the integrity of the financial information of a firm so that cases of misrepresentation and fraud do not occur. Auditors are able to keep the faith of different stakeholders such as shareholders, investors, and regulators. To ensure that organisations achieve and uphold corporate governance, auditors check on information components that might have an effect on corporate governance practices in such an organisation. By detecting accounting misstatements such as errors and uncertainty through cross examining of financial statements, auditors are able increase investors’ confidence and add value to the enterprise. In addition, auditors reaffirm that firm’s financial statements conform to the GAAP by detecting any form of financial errors and fraud. Lastly, auditors carry out auditing of the financial statements of an organisation and give reports to shareholders and management in a transparent manner.

Bibliography

Coffee, J C, ‘Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence the Governance of Accounting ‘ (2001). Web.

Coffee, J C, “Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms,” 84 B.U. L. Rev. 301, 309 (2004).

Coffee, J C, ‘Understanding Enron: It’s About the Gatekeepers, Stupid’ (2002). Web.

D. Milton, ‘Who “Caused” the Enron Debacle?’ [2003] 60 WLLR 309, 309-330.

Dignam, A and John Lowry, Company Law (6th, Oxford University Press, Oxford 2010).

Ferreira-Gomes J J M, ‘Auditors as Gatekeepers: The European Reform of Auditors’ Legal Regime and the American Influence’ [2005] 11(3) TCJEL 1, 1-42.

Hamdani A, ‘Gatekeeper liability ‘ [2003] Harvard Law School 1, 1-64.

Thomas F, Choy, Amy K and King, Ronald R, ‘Social Responsibility of the Auditor as Independent Gatekeeper: An Experimental Investigation’ (2008). Web.

Langevoort, D.C, ‘Managing the Expectations Gap in Investor Protection: The SEC and the Post- Enron Reform Agenda’ 48(4) [2003] VLR 1139, 1139-1165.

Marnet O, Behaviour and Rationality in Corporate Governance (1st, Routledge, London 2008).

Mayson, S W, French, D & Ryan C L, Mayson, French & Ryan on Company Law (28th, Oxford University Press, Oxford 2012) 399.

Moriarity, S, ‘Trends in Ethical Sanctions within the Accounting Profession’ [2000] 14 AH 427, 427-439.

Radtke R R, ‘Auditors as Gatekeepers for the Public Interest’ (2004). Web.

Reffett A, ‘Can identifying and investigating fraud risks increase auditors’ liability?’ (2007). Web.

Tuch A, ‘Multiple Gatekeepers.’ (2010). Web.

Footnotes

  1. John C. Coffee, ‘Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence the Governance of Accounting ‘ (2001) Web.
  2. Assaf Hamdani , ‘Gatekeeper liability ‘ [2003] Harvard Law School 1, 1-64.
  3. Coffee, ‘Understanding Enron: It’s About the Gatekeepers, Stupid’ (2002) Web.
  4. John C. Coffee, ‘Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence the Governance of Accounting ‘ (2001).
  5. Coffee, ‘Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence the Governance of Accounting ‘ (2001).
  6. Alan Dignam and John Lowry, Company Law (6th, Oxford University Press, Oxford 2010).
  7. Andrew Tuch, ‘Multiple Gatekeepers.’ (2010) Web.
  8. José João Montes Ferreira-Gomes , ‘Auditors As Gatekeepers: The European Reform Of Auditors’ Legal Regime And The American Influence’ [2005] 11(3) TCJEL 1, 1-42.
  9. John C Coffee, “Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms,” 84 B.U. L. Rev. 301, 309 (2004).
  10. Langevoort, D.C, ‘Managing the Expectations Gap in Investor Protection: The SEC and the Post- Enron Reform Agenda’ 48(4) [2003] VLR 1139, 1139-1165.
  11. Alan Dignam and John Lowry, Company Law (6th, Oxford University Press, Oxford 2010).
  12. John C. Coffee, ‘Acquiescent Gatekeeper: Reputational Intermediaries, Auditor Independence the Governance of Accounting ‘ (2001) Web.
  13. Oliver Marnet , Behaviour and Rationality in Corporate Governance (1st, Routledge, London 2008).
  14. John C Coffee, “Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms,” 84 B.U. L. Rev. 301, 309 (2004).
  15. Fields, Thomas, Choy, Amy K and King, Ronald R, ‘Social Responsibility of the Auditor as Independent Gatekeeper: An Experimental Investigation’ (2008) Web.
  16. Andrew Reffett, ‘Can identifying and investigating fraud risks increase auditors’ liability?’ (2007) Web.
  17. Stephen W. Mayson, Derek French & Christopher L. Ryan, Mayson, French & Ryan on Company Law (28th, Oxford University Press, Oxford 2011-2012) 399
  18. Reffett, ‘Can identifying and investigating fraud risks increase auditors’ liability?’ (2007).
  19. Stephen W. Mayson, Derek French & Christopher L. Ryan, Mayson, French & Ryan on Company Law (28th, Oxford University Press, Oxford 2011-2012) 399.
  20. Mayson, Mayson, French & Ryan on Company Law (28th, Oxford University Press, Oxford 2011-2012).
  21. Reffett (2007).
  22. Ibid.
  23. Robin R. Radtke, ‘Auditors as Gatekeepers for the Public Interest’ (2004) Web.
  24. Radtke, ‘Auditors as Gatekeepers for the Public Interest’ (2004).
  25. Stephen W. Mayson, Derek French & Christopher L. Ryan, Mayson, French & Ryan on Company Law (28th, Oxford University Press, Oxford 2011-2012) 546.
  26. Moriarity, S, ‘Trends in Ethical Sanctions Within the Accounting Profession’ [2000] 14 AH 427, 427-439.
  27. Andrew Reffett, ‘Can identifying and investigating fraud risks increase auditors’ liability?’ (2007) Web.
  28. José João Montes Ferreira-Gomes , ‘Auditors As Gatekeepers: The European Reform Of Auditors’ Legal Regime And The American Influence’ [2005] 11(3) TCJEL 1, 1-42.
  29. Alan Dignam and John Lowry, Company Law (6th, Oxford University Press, Oxford 2010).