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Sunday, April 6, 2008

Barrett on Audit Quality

Sarbanes-Oxley, Kermit the Frog, and Competition Regarding Audit Quality, by MATTHEW J. BARRETT, Notre Dame Law School, was recently posted on SSRN.  Here is the abstract:

The regulatory scheme after Sarbanes-Oxley has significantly improved public company audits in the United States, or at least has demonstrated the potential to do so, but the obligation to preserve client confidentially still prevents auditors from competing for new clients on the basis of audit quality. This paper suggests a simple way for the SEC to facilitate such competition within the existing regulatory framework. The SEC should require issuers and registrants to disclose whether their independent audits uncovered any financial fraud and, within specified ranges, the number and amount of all audit adjustments incorporated into the financial statements filed with the Commission. Auditing firms could use this then-public information, plus perhaps data about the infrequency of any restatements to financial statements on which the firm had expressed an unqualified opinion, to evidence the quality of the firm's audits relative to those of its competitors. The PCAOB might also incorporate such information in its inspection reports.

Although audit industry experts agree that we cannot directly observe audit quality, accountants have constructed and deployed empirical proxies for audit quality, such as abnormal accruals, to study aggregate behavior across samples of registrants, rather than to report individual behavior within a single registrant. As another proxy for audit quality, this proposal, which seeks to publicize the actual number and dollar amount of audit adjustments, measures directly what abnormal accruals measure indirectly.

With such data, investors, audit committees, and other participants in our capital markets, could better assess the quality and value of the independent audits that registered public accounting firms provide. Initially, auditing firms could better compete within tiers regarding audit quality. Eventually, the proposal might allow second-tier auditing firms to expand their audit practices and to enhance their reputations sufficiently to compete with the Big Four, potentially reducing concentration in the industry.

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