The Strategic Equilibrium Between Auditors And Managers

The Sarbanes-Oxley Act of 2002 is a United States federal law enacted on July 30, 2002, as a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. These scandals, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation's securities markets.Five Chinese government authorities and regulatory bodies have jointly issues a circular on June 28th 2008 on the release of the Basic Standard for Enterprise Internal Control. This Basic Standard outlines the regulatory requirements for Chinese enterprises to establish, evaluate and assess effectiveness of their internal controls and for accounting firms to audit the effectiveness of Chinese enterprises'internal controls. The release of the Basic Standard signifies a unified and recognized internal control framework to strengthen the internal controls of Chinese enterprises. All listed companies established within the territory of mainland China will be required to comply with the Basic Standard with effect from July 1st 2009. Non-listed large and medium-sized Chinese enterprises are encouraged to adopt the Basic Standard. The Basic Standard will have direct impact on over 900 companies listed on the Shanghai Stock Exchange and about 800 companies listed on the Shenzhen Stock Exchange.I try to figure out how the Basic Standard affects the auditing and internal control strength. First I want to describe the current situation of the internal controls in China's listed firms. Then I propose a model of strategic auditing in which the auditor can use resources for both internal control tests and substantive tests, while the manager can choose the strength of internal controls and the amount of fraud. The conclusion I get from this model is that control tests are a valuable tool for the auditor when control strength is informative about the likelihood of fraud. I think that the Basic Standard has the desired effect of inducing stronger internal control systems and less fraud and that audit risk increases as a result of the Basic Standard.