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  A Suggestion to Reduce Compromised Audit Reports
by John MacMullin
November 2002

How to avoid another Arthur Andersen-Enron situation.

In recent years, we have heard much about the failures of the auditing firms, particularly, but not limited to, Arthur Andersen & Co., in the performance of their audit function. Numerous critics over the years have pointed to the conflict of interest that exists within an auditing firm with respect to the promotion of a firm's consulting practice and, in a lesser regard, tax practice, which appears to compromise the independence of the auditing firm.

Additionally, the direct employment by the client contributes in a large part to the compromise of an auditing firm's independence. With the large fees at stake and a competitive desire to preserve client relationships, a risk exists that auditing firms will compromise their audit reports. The existence of this risk is shown by the history of litigation over compromised audit reports against numerous defendant auditing firms.

The cost of a compromised audit is enormous. Shareholders, creditors, and employees suffer enormous losses when auditing firms compromise their reports. Indirect effects can be seen on the value of the stock market as a whole. Additionally, compromised reports reduce the trust in the financial system as a whole.

Sometime back, we experienced the same kind of loss of trust with respect to real estate appraisers. Federal legislation, also adopted by the states, reduced this risk of loss by adopting uniform standards and barring the direct employment of appraisers by buyers and sellers in lending related transactions. By altering the employing entity to lenders, and barring the direct employment of appraisers, more conservative appraisals resulted.

The same notion should be applied to auditing services. As in appraisal services, auditing services should be assigned by an independent group, which could, for all publicly traded companies, include the SEC, or perhaps the exchange on which the company is listed. For state level audits, the independent group could include a state agency or perhaps the lender requiring audited statements.

A suggested procedure follows. First, the individual company pays the estimated cost of the audit to the independent group, which holds the money in trust for eventual payment to the auditing firm. The independent group then selects an auditing firm and bars that auditing firm from receiving audit engagements where consulting or tax services are performed. Third, when an auditor finds a problem requiring an increase in audit scope, the independent group should have the power to compel the increase in scope and the payment from the company of the necessary fees to cover the increase. Finally, the auditing firm should provide not only their audit report to the independent group and the public, but also their work papers. Immediate and public examination of the work papers should also help reduce the risk of a compromised audit.

In summary, a reduction of the risk of a compromised audit is achievable by simply having someone other than the company employ the auditing firm. Given the cost and impact of a compromised audit, Congress and the states should consider the foregoing approach.

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