SYNOPSIS: To achieve orderly capital markets around the world, corporations must provide investors and creditors with relevant, reliable, and timely information. Accounting, auditing, and the structure of corporate governance that they operate within are essential components in the flow of information to capital market participants. However, recent accounting failures have pointed out the need for substantive improvements in these components. The academic accounting community can play a role in stimulating change aimed at enhancing market efficiency through commentary and scientific-based research that provide direction for change.
The purpose of this commentary is threefold. First I review the historical development of accounting, auditing, and corporate governance in an effort to identify and understand salient features of the past that have led to the current state of affairs. I then propose changes in accounting, auditing, and governance that I believe will address the current problems with the underlying quality and integrity of the financial reporting process. The third purpose of these comments is to stimulate further debate and empirical research aimed at enhancing the future quality and integrity of the financial reporting process.
Demand for Auditors
The 18th century industrial revolution stimulated the formation of capital markets and the separation of owners and managers. (1) With this separation came the potential for opportunistic management behavior. This, in turn, created a market for independent auditors, voluntarily hired by some to provide a way to check on managements' performance with the owners' resources. However, the publicly owned corporation survived for well over a century without any requirements regarding auditing, guided only by the financial reporting rules of the stock exchanges. But when the market crashed in 1929 Congress became convinced that it was due, in part, to the lack of meaningful reporting requirements to protect investors and creditors. (2) They believed economic conditions would not improve until the public regained confidence in the financial markets and the Securities Act of 1933 and the Securities Exchange Act of 1934 were passed to address these concerns.
The SEC was given the responsibility for establishing financial reporting standards and began issuing standards in 1937. They also required all publicly traded corporations to have an independent audit each year. The independent auditors would attest to the fairness of management's financial reports to the shareholders, would note any deviations from the acceptable accounting rules (Generally Accepted Accounting Principles, or GAAP), and would perform their audits in accordance with established auditing practices and procedures (Generally Accepted Auditing Standards, or GAAS). In essence, the SEC handed the public accounting industry a franchise to serve every single public corporation on behalf of the investing public.
The Role of Corporate Boards
Shareholders understood the limitations of the corporate structure from its inception, and often appointed representatives to serve their interests. (3) These shareholder advocates took the form of the "Corporate Board of Directors" whose responsibilities were to meet with and oversee the managers of the entity and look out for the interests of the owners. Boards eventually added refinements such as subcommittees to address some of the more sensitive governance issues. During the 20th century the "audit committee" was established to provide an interface between the independent auditor and management. Normally made up of outside directors, the audit committee was designed to add to the quality and integrity of management's financial reports, serving as a liaison with the independent CPAs and eventually the internal auditors in most corporations. The board of directors also made sure managers received appropriate compensation for their efforts. …