In response to the surge of financial accounting scandals in the late 1990s and early 2000s, Congress passed the Sarbanes-Oxley Act. The implementation of this Act caused several changes in the financial audit industry in an effort to prevent further financial fraud. This Note begins by explaining the process of creating company financial statements and highlights the incentives auditors have to falsify these statements. Financial statements are vital to a capital market because they provide information to investors about the prospective return and risk involved when deciding to invest in a company. Given the importance of financial statements and the risk that they will be falsified, Congress enacted the Sarbanes-Oxley Act in part to place a check on the accuracy of financial statements by requiring auditor independence. After reviewing the Act's provisions regarding auditor independence, the author argues that these provisions are not sufficient. He identifies three elements of the free-market audit industry that place substantial limits on auditor independence. First, audit firms are compensated by the companies they are auditing, which makes the auditors dependent on the company's management. This problem is compounded by the fact that although the independent audits are required, they are only nominally beneficial to a company and one audit firm's product cannot be differentiated from another firm's product. Second, the relationship between a company and an audit firm is at will and can be terminated without much, if any, detriment to a company. The instability of this relationship allows companies to exercise substantial control over audit firms who have to compete for the business. Finally, a problem that coincides with the previous two issues is the high level of competition between audit firms. The author argues that the belief that free-market competition produces the best product at the lowest price does not apply to audit firms because they cannot effectively differentiate their products. Therefore, audit firms rely on the amount of their fees and their personal relationships with management to capture business. The author concludes that auditor independence cannot be achieved in a free-market audit system. In response to the conclusion that auditor independence cannot be accomplished under the current free-market scheme, the author recommends that the government transfer responsibility for financial audits to a governmental agency. Under this proposal, all public companies would contribute to a fund used to compensate the government auditor. A company's contribution to the fund would be determined by the expected complexity of the company's audit. The government agency would be responsible for auditing only publicly traded companies, preventing a mandatory tax on all businesses. The author concludes that creating a government audit agency would remove the shortfalls of the free-market audit scheme by reducing auditor dependence on the client company.
