The regulation of auditor ethical behaviour in Australia: the problem of conflicts of interest and proposal for structural reform

Accounting scandals have shaken the foundations of investor confidence in the transparency, integrity and accountability of corporations and capital markets more generally. The accounting profession and more specifically auditors are claimed to have played a role in these events in Australia. Public disquiet about the audit role has surfaced amongst allegations that these gatekeepers have helped facilitate financial accounting irregularity. While the narrative behind each instance of corporate failure comprises a complex array of facts and relationships, questionable ethical auditor behaviour stands as a significant chpater of each story. For the audit profession, these developments highlight the gap between public expectations and the reality of what the auditor’s role entails. Public perception finds the auditor either incapable of detecting, or choosing not to control, unscrupulous management practices. The conclusion reached by many members of the community and corporate regulators is that auditors have failed in their responsibility, and that their independence from auditee management has been compromised in many instances of corporate collapse. These types of perceptions must be acknowledged and addressed by the audit profession for it to restore trust in both the capital markets and itself more importantly. Conflicts of interest are allowed to develop and flourish within auditor-client relationships. The current regime relies upon auditor legal liability to ensure truth telling in financial reporting; however this approach has not delivered the level of assurance required by financial statement users. This situation could be markedly improved through the introduction of financial statement insurance (‘FSI’). This insurance approach offers a market-based solution to more effectively deal with bias existing in financial statements, to ensure fewer misrepresentations arise and smaller shareholder losses are incurred. Financial statements insurance is shown by this thesis to be an effective market mechanism, that if introduced would bring about significant change to the structure of financial reporting relationships and auditor incentives. This shift would align auditor and manager incentives with those of shareholders to ensure better quality audits, and produce higher quality financial statements. Although the FSI model is not perfect, it does promise considerable advantages over the current auditor liability model. While some existing imperfections are sustained or reappear in different guises under FSI, none of these are aggravated and most are mitigated. While FSI does hold considerable promise, it is a bold and somewhat radical proposal given the present entrenched nature of audit stakeholder relationships and the significant change needed to realign these. No matter what the future holds for the audit function, in the end, there should never be a black box of unquestioned audit processes or conflicted relationships. Regulators and researchers must be vigilant and question concepts and discourse that might otherwise restrict the market for auditor services at the expense of information users.