In the conventional view of auditing, the government should regulate financial disclosure because investors cannot easily distinguish honest from dishonest companies. The government, in effect, vouches for the company. But in an unregulated world, businesses would have a strong incentive to use voluntary methods to convince others of the quality of their investments.
Otherwise, investors would not buy stocks or bonds. People forget that auditing was first used voluntarily by corporations in the early 20th century to persuade a skeptical public to invest in them.
With the collapse of Enron, companies will now have to go to extra lengths to convince investors of their financial integrity. And auditors will need to rebuild the public trust they have lost. But increased government regulation is unnecessary.
Current Securities and Exchange Commission regulations and mandatory auditing play little, if any, role in revealing company profitability and the integrity of financial information. For example, statistical analyses of stock-market data suggest that positive audits don’t increase share prices. Nor do auditing and SEC regulations prevent companies from failing.
In fact, SEC auditing requirements may actually facilitate fraud and failure because the regulations themselves suppress the supply of and demand for better alternatives in information reporting. For example, the SEC in 1975 designated only three rating agencies — Fitch, Moody’s and Standard & Poor’s — as acceptable evaluators of corporate debt. This restriction has inhibited the development of competition and innovation in the evaluation of corporate financial health.
The public should be wary of regulations enacted to prevent future Enrons. If history is any lesson, the new policies are likely to hurt rather than enhance fraud detection. New regulations will reduce the incentives for companies to develop private plans to certify the integrity of their financial information, and lower the incentives for investors to monitor their behavior.
If Congress and the SEC can refrain from new laws and regulations, companies will actually have to go to greater lengths to regain investor confidence. And investors will learn to rely less on government regulation and more on other voluntary mechanisms to ensure economic integrity.