Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Auditing Main Page | Creative
Accounting Main Page
This is a very interesting article from both the auditing perspective and the investing perspective. The authors begin with a short discussion of the Sarbanes-Oxley Act of 2002 that addresses corporate accountability. The provisions of the act include new legal constraints on executives and expands the protection for whistle-blowers. It creates a regulatory board to monitor accounting firms and establishes penalties for accounting fraud. George W. Bush even proclaimed that "The era of low standards and false profits is over." But the authors say its not that easy. A more destructive problem with corporate auditing is unconscious self-serving bias that can cause even honest meticulous auditors to unintentionally distort audits. As a result, the provisions of the Sarbanes-Oxley Act will not solve the problem, and might even make the problem worse. The purpose of this paper is to discuss the various causes of unconscious self-serving bias, to provide some supporting evidence from various experiments, and to provide some recommendations related to systemic changes needed to help reduce the problem.
The Roots of Bias
In this section the authors explain that psychologically people interpret information in ways that benefit their self interest even when they are trying to be objective and impartial. People tend to discount the facts that contradict the conclusions they want and embrace the facts that support their own viewpoints. The authors discuss some of their experiments to support the idea of self-serving human behavior.
Accounting for Bad Accounting
This section includes a discussion of three structural aspects of accounting that create substantial opportunities for bias to affect judgment and three behavioral aspects that amplify the unconscious bias.
The structural aspects of accounting include:
Ambiguity - When the possibility to interpret information in different ways exist, people tend to reach self-serving conclusions. Accounting is full of ambiguity. In a side bar they mention Money Magazine's annual survey of 30-50 tax professionals who always provide a wide range of opinions related to a hypothetical tax return. They also mention that corporate accounting is full of ambiguous questions related to revenue and expense recognition. In one survey 67% of audit partners reported that they negotiated with 50% or more of their clients on how to account for various items.
Attachment - Two main points. Companies fire accounting firms that deliver unfavorable audits. Audits are frequently used to build relationships that lead to consulting services. Attachment breeds bias.
Approval - The bias to approve of a clients accounting methods. Self-serving biases increase when people are endorsing other biased judgments that equate with their own biases.
The behavioral aspects that amplify unconscious bias include:
Familiarity - People are much less willing to harm individuals that they know, particularly paying clients.
Discounting - Immediate consequences tend to receive more emphasis than delayed outcomes, particularly when the delayed outcomes are uncertain. Critical audit reports produce immediate adverse consequences, but the cost of an unjustified positive report is distant and uncertain.
Escalation - Minor indiscretions and errors created by unconscious bias may evolve into conscious corruption.
The authors also discuss evidence showing that people cannot control their biases even when they try to eliminate the effects of bias.
Problems with Proposed Reforms
The authors argue that the Sarbanes-Oxley Act does not address the problem of bias and will not solve the accounting crisis. Although the new rules require auditors to disclose conflicts of interest to investors, people cannot accurately factor this information into their investment decisions and disclosure could actually increase bias on the part of the auditors who make the disclosures. Stricter accounting standards are also unlikely to improve the situation since research shows that it takes very little ambiguity to generate biased judgments.
Radical Remedies
In this last section Bazerman, Loewenstein and Moore make a number of recommendations related to systemic changes needed to solve the auditing crisis. Penalties are not the solution. What is needed is a new set of policies that eliminate the incentives that create the self-serving biases - the impossible conflicts of interest. The fundamental structure of the auditing system ensures biased auditing and must be changed.
Their recommendations include:
1. Full divestiture of consulting and tax services.
2. Fixed, limited audit contract periods during which they cannot be terminated, with fees set at the beginning of the contract period.
3. Prohibit clients from rehiring the auditing firm at the end of the contract period.
4. Require that the major auditing firms rotate clients.
5. Prohibit audit clients from hiring individual accountants away from the audit firms.
6. Prohibit auditors from accepting positions with audit clients for at least five years.
7. Require education to help auditors understand unconscious bias and resulting errors. So-called professionalism is not enough.
Without radical and innovative reforms, further accounting disasters are inevitable.
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