Centre for Economic Policy Research

3.8
Remedies 
To address the problems of the audit industry and improve its ability to reduce the
information asymmetries between investors and managers, a broad set of 
remedies are necessary. While the details of how the Sarbanes-Oxley Act will be
implemented are in the process of being spelled out, the changes it promotes are
not only insufficient but also in certain cases inappropriate. 
The emphasis on isolating auditing from related financial industries does not
solve the underlying problems. It will reduce the economies of scope that serve
the interests of investors by broader monitoring of companies. Regulation of 
auditor independence that forces elimination of all non-audit work is flawed as it
‘precludes activities that might benefit the public interest by limiting an auditor’s
learning about its clients’ (Wallman, 1996). Regulation and supervision needs to
focus attention on the individual, office or other units of the firm that make 
decisions with respect to a particular audit client (Wallman, 1996). Separation by
activity has not proved to be an acceptable remedy in other parts of the financial
industry. As will be seen in Chapter 5 on universal banking, the separation of
commercial and investment banking and insurance was an unnecessary remedy
for the problem of conflicts of interest. It is unlikely that the proscription of 
non-auditing services, as envisioned by Sarbanes-Oxley, would have prevented
the recent audit failures. Greater transparency about the nature and role of 
non-audit services is valuable, however, to control the temptation to exploit 
conflicts of interest.
Leaving the problem of conflicts of interest to the market in auditing implies
that audit firms’ concern about the maintenance of their reputation is sufficient
to limit the exploitation of conflicts of interest. For reputation to be an adequate
instrument to ensure that auditors’ opinions focus on the ‘true’ financial condi-
tion and performance of companies, however, several actions are needed. First,
the corporate governance structure of companies needs to be altered so that audi-
tors will report to, be hired by, and be compensated by an audit committee 
representing stakeholders other than management. Section 301 of the Sarbanes-
Accounting: Conflicts of Interest in Auditing and Consulting 39

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Oxley Act recognizes the importance of this arrangement, and the PCAOB will
need to adopt regulations to ensure that it is properly implemented. The Smith
Report in the United Kingdom also advocates this strong role for audit 
committees and provides useful guidance.
Second, there needs to be a fundamental shift away from detailed prescriptive
accounting rules that will push companies and auditors’ to be more transparent
about their assumptions and choices made in measuring companies performance,
thereby revealing more clearly any biases in the information. Continued focus on
the codification of accounting and auditing standards, as appears to be implied in
Sarbanes-Oxley, will not improve the quality of auditors’ reports and may lead to
more manipulative innovations to hide companies’ true conditions. This issue
will come to the fore when the SEC reports to Congress on whether accounting
should be principles or rules-based. A specific remedy that has been debated peri-
odically, but always rejected, is to replace the current published audit report with
a more detailed report highlighting all the items addressed by the auditors with
the audit committee. This remedy has its own implications, but seems like a path
worth pursuing. As litigation risk has been a key element in driving auditors to
focus on rules, firms will not be able to respond to changes in governance and
incentives unless this risk is reduced.
The last major change that is required is for audit firms to adjust their internal
governance and compensation structures to limit problems from large client 
dominance of local offices and from competition between audit and non-audit
services. These changes are not ones that can easily be designed and may vary
from firm to firm, depending on their configuration. The penalty for failing to
make adequate changes has been brought home, however, by the stark reality of
the collapse of the once proud firm of Arthur Andersen. While firms will need to
devise their own structures, supervisory oversight from the PCAOB can help in
this process. The PCAOB will need to monitor and encourage best-practice 
compensation and performance measurement structures inside accounting firms.