The Idea in Brief
What’s really behind corporate-accounting scandals? They stem less from deliberate corruption than from a deeper, more pernicious problem: unconscious biases built into our auditing system.
Due to the often subjective nature of accounting and tight relationships between accounting firms and their clients, even honest, meticulous auditors can unintentionally distort the numbers—misleading investors, regulators, and even management.
But new “corporate accountability” laws and threats of jail time won’t solve the problem. The situation demands far more aggressive action than the U.S. government has taken.
True auditor independence requires fundamental changes in how the accounting industry operates. Companies must acknowledge the existence of bias—and embrace practices and regulations that temper its ill effects. Only then can all players trust companies’ financial reports.
The Idea in Practice
Because of the self-serving bias, we tend to reach conclusions we’re highly motivated to reach. We unconsciously discount facts contradicting our position and uncritically embrace evidence supporting it.
Three structural aspects of accounting produce bias among auditors:
- Ambiguity. People tend to reach self-serving conclusions whenever ambiguity surrounds evidence. Many accounting decisions—such as what constitutes an expense, when revenue should be recognized—require subjective interpretations of ambiguous information.
- Attachment. Auditors are highly motivated to remain in clients’ good graces and approve their accounts. Why? Clients can fire them for delivering unfavorable audits. Also, long-term relationships enable auditing firms to sell more lucrative consulting services.
- Approval. Bias intensifies when people endorse others’ biased judgment—provided it aligns with their own bias. Thus, auditors may accept more aggressive accounting from clients than what they themselves might suggest independently.
Three aspects of human nature amplify bias:
- Familiarity. People are more willing to harm strangers (such as anonymous investors) than individuals they know (long-term clients, for example). The deeper the auditor/client ties, the stronger the tendency toward approving dubious accounting.
- Discounting. We tend to be much more responsive to immediate consequences than to delayed, uncertain ones. Auditors may hesitate to issue critical reports because of possible immediate damage to the relationship, loss of the contract, or unemployment.
- Escalation. People often explain away minor indiscretions—then conceal the growing problem. In accounting, unconscious bias can evolve into conscious corruption.
Radical Remedies
Current government reforms—stricter accounting standards, conflict-of-interest disclosure—don’t address the roots of self-serving bias. Instead, we must eliminate the incentives that spawn bias—by reducing auditors’ interest in whether clients are pleased with their reports. Some suggestions:
- Completely bar auditors from providing consulting and tax services to clients. Accounting firms that advise clients on how to boost profits, while trying to impartially judge their books, face an impossible conflict of interest.
- Remove the threat of being fired for delivering unfavorable audits: Design limited auditor/client contracts through which auditors cannot be fired. Prohibit rehiring auditors at the contract’s end. Instead, require major accounting firms to rotate clients.
- Prohibit clients from hiring accountants who have audited them. Auditors can’t be impartial while trying to please prospective employers.
On July 30, at a ceremony in the East Room of the White House attended by congressional leaders of both parties, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002 addressing corporate accountability. A response to recent financial scandals that had begun to undermine citizens’ confidence in U.S. business, the wide-ranging act flew through the House of Representatives and Senate in record time and passed in both chambers by overwhelming majorities. The act places new legal constraints on executives and gives expanded protections to whistle-blowers. Perhaps most important, though, it puts the accounting industry under tightened federal oversight. It creates a regulatory board—with broad powers to punish corruption—to monitor accounting firms, and it establishes stiff criminal penalties, including long jail terms, for accounting fraud. “The era of low standards and false profits is over,” Bush proclaimed.
