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AUDIT MARKET FAILURE

Benedikt Koehler

The auditing profession has called for the current regime of unlimited liability to be replaced with liability caps. The Department of Trade and Industry has tabled proposals to reform the structure of the market for audit services. These proposals fall short of meeting the demand for liability limitation but modify he current regime inasmuch as auditor liability, though uncapped, would be proportional to the damage caused by audit failure. This step is unlikely to reme dy audit market failure. This article argues the distortion of market ncentives in audit markets can be traced to government intervention and the re me dy lies in re placing government interve ntion with c ompetition.

Introduction

Proponents of audit lia bility reform argue that the c urre nt weight of obligations is untena ble. A re gime of unlimited lia bility, coupled with the doctrine of joint and se veral liability, implies that every c orporate insolvenc y can trigge r litiga tion by plaintiffs arguing tha t auditors are c ulpa ble for not spotting trouble in time. Worse, auditors can not only be he ld to acc ount by a compa ny’s mana ge me nt, but by third parties as well. Auditors feel tha t providing an a udit opinion in effect is ta nta mount to underwriting the solve ncy of their clients.

The Ge neral Acc ounting Office (GAO) finds in a surve y of c orporate failures that auditors had qualified their opinion in only half of all cases. Therein lies the crux. Auditors attest whether a compa ny’s accounts are dra wn up in accordance with auditing standards. That is not the same thing as to vouc h for a company’s solve ncy. Auditors argue it is wrong to confla te audit failure and c orporate failure.

In 1992 the Big Six US a uditors state d that without c hec ks to third-party litigation, it would only be a question of time until their number dwindled (Arthur Ande rsen et al., 1992). US le gisla tion passe d in 1995 se t hurdles for filing claims a nd for a while seeme d to ste m the tide of litigation. Yet the de mise of Arthur Andersen ga ve urge ncy to the

calls for a udit market reform. Auditors a ver that insolve ncies are a fact of life and the next major corporate c olla pse is like ly to start a nother round of musical c hairs in the audit sector. Another reduction in the number of auditors with global reach would contra vene the public interest in sta ble fina ncial markets.

Not e veryone is c onvince d of the nee d to cap a uditor lia bility. EU Commissioner Frits Bolkestein, for exa mple, has little sympa thy for the auditing profession’s pleas. First, users of fina ncial accounts are reassure d by knowing a uditors back their attest with unlimited lia bility. Unlimited lia bility concentrates the mind. Sec ondly, argues Bolkeste in, the threat to a udit market struc ture is entirely self-inflicte d. Auditors pursue d a strategy of global growth by leve raging the re putation earne d in na tional marke ts. They could hardly c omplain that the threat of conta gion from partic ular markets might affect the entire operation. Bolkestein is but one of those who belie ve that cappin g claims against auditors is a cure worse tha n the disease (Bolkestein, 2003). Bolkestein ta bles two issues: one is market structure, the other is unlimited third-party lia bility.

Market structure

In almost e very country, the Big Four a uditors enjoy a virtual monopoly in a uditing the large compa ny sector. The ga p separa ting the Big Four and the vast majority of a udit service providers is enormous. The auditing sector is marke d by a stark c ontrast betwee n four globa l firms accounting for the bulk of ind ustry re venue, and small firms with up to four pa rtners accounting for the bulk of industry numbers. The ga p see ms unbridgea ble. The question of ideal c ompany size in a uditing, and why there is little migra tion betwee n segments, is unse ttle d. George Stigler (1958) suggeste d segme nting a n industry into layers of compa nies of similar size and c omparing the ir returns on ca pital. Over time, firms will gravitate towards a size that maximises returns. Stigler’s ana lytical tools do not expla in the peculiar structure of the audit sector.

We cannot be sure whether, in the audit sector, firm size can be divided into a continuous or ste pped c ontinuum. The firm-size dic hotomy in a uditing raises the question of whether la rge a nd sma ll firms are in the sa me market at all.

Within the large-firm segme nt, howeve r, Ge orge Stigler’s forecast that compa nies gra vitate towa rds ideal c ompany size holds true. Sulliva n (2002) e xa mines the pricing