Realigning Auditor's Incentives

Anne Dailey, University of Connecticut School of Law

Abstract

... In the past year, accounting scandals have dominated the headlines, even rising to the status of New Yorker cartoons. ... In a strategic model, auditors would weigh the anticipated payoffs from a clean opinion versus a going concern opinion against the expected penalties from making a mistake. ... Conditioned on hiring the auditor, the client's payoff structure essentially becomes the payoff structure of its management. ... Conditioned on the company's continued survival, if the auditor (either the original auditor or a replacement) issues a clean opinion, management's payoff will consist of the present value of future compensation from managing a going concern, including salary, stock, stock options, and improved reputation. If, on the other hand, the auditor issues a going concern opinion, management will suffer a reduced payoff in the form of stock losses, lost salary, possible job loss, and a damaged reputation. ... The audit committee must give advance approval to all accounting firm services that are provided to the company and is directly responsible for the appointment, compensation, and oversight of outside auditors. ... Nothing in the Act addresses the two major causes of accounting lapses in the late 1990s, i.e., GAAP's susceptibility to manipulation and the employment tie to management. ...