Financial markets are in crisis again and quite certainly on their way
to an added layer of regulation. Only a few years ago, at the start of
the twenty-first century, a massive wave of corporate fraud revealed
the failure of corporate gatekeepers. The Sarbanes-Oxley legislation
accordingly targeted gatekeepers, primarily auditors, with strict
regulation and enhanced independence guidelines. This legislative
remedy has proven to be of disputable benefit while its costs have been
huge. This paper argues that a certain type of auditor incentive
compensation could work better than regulation. Under the proposed
alternative scheme, auditors would defer a portion of the payment they
receive from the client firm, which would be used to purchase shares in
the client once their tenure as auditors has ended. Instead of making
them simply independent, this compensation structure would cause
auditors to guard against inflated share prices. This type of auditor
compensation could serve to counterbalance recent trends in executive
compensation that cause managers to overstate earnings. Modern
accounting standards that broaden management’s scope of discretion add
to the benefits of this compensation scheme. Thus, the paper calls for
the Securities and Exchange Commission to promulgate a safe harbor that
would facilitate such schemes, which current independence guidelines do
not allow.
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