There has been criticisms made of the failure of external audits to detect finan

Question

There has been criticisms made of the failure of external audits to detect financial fraud. Such failures have resulted in increased oversight and regulation of the audits. Federal legislation such as Sarbanes-Oxley was a reaction to the fraud that was not disclosed by audits. It has been noted that there is an inherent conflict of interest between auditors and the businesses they audit in that the businesses hire the auditors. There have been reform proposals such as requiring that the business insure against fraud through the purchase of insurance and the insurance company would then hire the auditors.

Explanation / Answer

Sarbanes Oxley Act was inacted in 2002, by US Congress in response to the scandals in early 2000's such as ENRON, Tyco etc. It required strict regulation of financial disclosures and prevention of fraudulent activities which the earlier external auditors failed to address. It has two key provisions Sec 302 and Sec 404.

Sec 302 mandates that the management must verify or guarantee the accuracy of financial statements.

Sec 404 requires management and auditors to establish internal controls and reporting methods on the adequacy of those controls. This was very costly for the publicly traded companies.

SOX till now is the most far reaching legislation it has responded with the investots concerns majorly in 2 areas:

1. CFO and CEO responsibility for regulatory frame work and financial reporting disclosures.

2. Strong Corporate Audit Committee and work ethics.

But after its enactment there was 2008 subprime mortgage crisis which resulted into the great recession world wide.

Therefore many governing bodies have now introduced reforms in audit such as EU reform which mandates auditor rotation, limiting the services provided by external auditor. The most popular among all the reforms proposed is Financial Statements Insurance where the companies get insurance done of their financial statements, the premium is small for companies with high quality earnings and the coverage is big and the most important thing is premium is made public which tells the investors which company is trustworthy and which is not.

The company paying larger premium and having smaller coverage is definitely the one with lower quality earnings.

The insurance company then hires the auditors which are completely independent and their interest align properly with that of shareholders.

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