Private Firms Working in the Public Interest

Is the Financial Statement Audit Broken?

by Abigail Bugbee Brown

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Abstract

The Big Four accounting firms have become the object of much scrutiny following the string of financial statement fraud scandals at the beginning of this century. The apparent involvement of the large auditing firms in the accounting misdeeds comes as a surprise, since the academic literature on auditor incentives predicts that large, reputable firms will not engage in collusion with their clients. The lace of a consensus economic framework to understand the incentives facing the audit firms that reflects the historical reality has hindered consensus building in the policy response to the scandals. This dissertation develops a principal-auditor-agent model that suggests there may well be socially sub-optimal levels of audit intensity, even among the best audit firms. It explores archival historical evidence to identify examples of how these incentives have shaped the profession and develops a more nuanced reading of the root causes of the recent scandals. This work also identifies the gaps in our understanding of the cost and occurrence of fraud that hinders a proper cost-benefit analysis of policy options designed to improve the quality of information available to the market.

This document was submitted as a dissertation in October 2006 in partial fulfillment of the requirements of the doctoral degree in public policy analysis at the Pardee RAND Graduate School. The faculty committee that supervised and approved the dissertation consisted of Jim Hosek (Chair), Steve Bankes, and Molly Selvin.

This report is part of the RAND Corporation dissertation series. PRGS dissertations are produced by graduate fellows of the Pardee RAND Graduate School, the world's leading producer of Ph.D.'s in policy analysis. The dissertations are supervised, reviewed, and approved by a PRGS faculty committee overseeing each dissertation.

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