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Friday, February 24, 2006

When familiarity fails to find fraud

Just how independent should auditors be from their clients? Should they do only audits, or is it acceptable for them to perform other services for audit clients or for related companies?

Those are issues that have divided auditors from regulators for years. Auditors in the United States lost some, but not nearly all, of their other activities under the Sarbanes-Oxley law, passed in 2002 in response to the Enron fraud, but that reflected their decreased political influence more than it did a careful analysis of real- world results.

One argument that auditors have long advanced is that the closer they are to their clients, the more they know. A chief executive of a major accounting firm once presented to me a graph, reproduced here, that looked suspiciously like the curve invented by Arthur Laffer.

For those without fond memories of the Reagan years, Laffer argued that governments would collect the most money from moderate tax rates, and that there was a point at which receipts would fall if rates were raised, presumably because people did less work at their jobs and more work to evade taxes.

The auditor's version of the curve argued that an auditor with no independence would produce a bad audit, but so would one who was so independent that he did not understand the company and its industry. Consulting services, he argued, provided badly needed knowledge.

posted by Brian Moran @ 9:00 AM   0 comments

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