Why Accounting/Auditing Collapsed

Political Economy of Corporate Governance/ Accounting Failures

Shyam Sunder, YaleSchool of Management

Two ways of looking at what has happened in accounting and auditing in past two years
2002-3 Media focus on failures of individuals and organizations
1977-2003 Look at the policies of the past quarter century to understand the root causes
1890’s / US Antitrust laws (Sherman Act, unreasonable restraint of trade, reducing competition made illegal)
Till mid-1970s / Antitrust laws not applied to “learned” professions for the fear of collapse,
Clark, George Ackerlof (market for lemons), history of guilds, codes of ethics (advertising, soliciting, touting, price competition), clients, not customers
1960s to 1970s / 1975 Survey: more than 100 professions with self-regulatory powers from states, generally high income and prestige, service or just self-interest,
Blair and Rubin (“extraordinary inefficiency in the delivery of professional services”)
Rise of reputations argument, robustness of competition, economic efficiency argument overtakes professional conception
FTC begins to challenge professional codes
1977 / US Supreme Court in Bates vs. Bar of Arizona rules against ban on advertising by lawyers
Late 1970s / US Department of Justice and the FTC force professional associations to remove anticompetitive provisions from their “codes of ethics”
1979 / AICPA’s new Code of Ethics: allows advertising, solicitation of competitors’ clients and employees
Early 1980s / Sharp drop in the price of audit services due to competitions, disappearing profits in audit firms
Special problems of observing the quality of audit service
Early 1980s / New business model of audit firms to maintain profitability:
New production function: shift from substantive to analytical tests
New product Mix: Use audit relationships to sell more consulting (consulting as a consequence, not cause, of the collapse)
New internal compensation: Transfer between audit/consulting partners
New labor market policy: Cut wages of new hires
Early 1980s / Growth of university accounting majors and CPA candidates stops

Mid-1980s

/ Many business and audit failures and law suits (S&Ls), auditors pay hundreds of millions in settlements, worries about profitability resume
Later-1980s / Goal to change the legal environment of auditors
Federal: Switch from joint-and-several to proportionate liability
State: Switch to Limited Liability Partnerships, 150 hour (five-year) qualification for CPAs to reduce supply
1988-90-92-94 / Large scale organized contributions to elections from auditors
1993 / FASB’s attempt to write a standard for executive option accounting is beaten back by business and Congress (role of CT senator)
1994 / US Supreme Court (Central Bank vs. First Interstate Bank of Denver) rules that corporate advisors cannot be held liable to third parties for aiding and abetting fraud
1995 / Private Securities Litigation Reform Act gives proportionate liability to auditors plus a gift under pressure from the Silicon Valley: safe harbor for forward looking (speculative) information
1999 / SEC misdiagnoses audit problems (consulting as the cause); attempts to have auditors divest consulting; is beaten back with support from Congress, settles for disclosure of fees
2001-3 / Accounting and audit failures surface in the wake of economic slow down and stock market drop

Number of Settlements of Claims Against Auditors

Amounts of Settlements Against Auditors

Accountants’ Contributions to Political Campaigns

Why Accounting/Auditing Collapsed? A Policy Story

Shyam Sunder, YaleSchool of Management

June 2003

Mid-1980s

/ Many business and audit failures and law suits (S&Ls), auditors pay hundreds of millions in settlements, again worries about profitability
Later-1980s / Goal to change the legal environment of auditors
Federal: Switch from joint-and-several to proportionate liability
State: Switch to Limited Liability Partnerships
1988-90-92-94 / Large scale organized contributions to elections from auditors
1993 / FASB’s attempt to write a standard for executive option accounting is beaten back by business and Congress
1994 / US Supreme Court (Central Bank vs. First Interstate Bank of Denver) rules that corporate advisors cannot be held liable to third parties for aiding and abetting fraud
1995 / Private Securities Litigation Reform Act gives proportionate liability to auditors plus a gift under pressure from the Silicon Valley: safe harbor for forward looking (speculative) information
1999 / SEC misdiagnoses audit problems (consulting as the cause); attempts to have auditors divest consulting; is beaten back with support from Congress, settles for disclosure of fees
2001-3 / Accounting and audit failures surface in the wake of economic slow down and stock market drop