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However the trial of Enron's two top executives turns out, current system all but insures scandals will recur, profs say

February 1, 2006

For more information, contact: Benjamin Haimowitz,

The trial of Enron's two top executives may have a way to go, but, whatever the outcome, key failures that cost investors and employees tens of billions of dollars are likely to happen again, according to a new report in a leading management journal.

Noting that the calamitous scandals at Enron and other companies were possible only because of "a clear lack of independent financial monitoring," the article in the current Academy of Management Review argues that key elements of the system that accounted for this lack remain in place today.

Reforms instituted by the Sarbanes-Oxley Act, passed by Congress in response to the scandals, "are clearly insufficient, focusing on intentional corruption and overlooking the conflicts of interest built into the system," conclude the report's co-authors, Don A. Moore of Carnegie Mellon University, Philip E. Tetlock of the University of California, Berkeley, and Lloyd Tanlu and Max H. Bazerman of Harvard.

"Only through a radical reorganization of the industry," they continue, "will the term auditor independence accurately describe auditors' work in the United States."

According to the authors, Sarbanes-Oxley fails to correct two key shortcomings of the prevailing system: first, the likelihood of what they call "moral seduction of the accounting profession;" and, second, the cyclical pattern in politics whereby scandals trigger Congressional action but "once the outrage wanes, the special interests once again take the political offensive, poking low-visibility loopholes in the high-visibility legislation (e.g., Sarbanes-Oxley Act) that politicians point to as evidence of their responsiveness to the public's concerns."

Moral seduction of the accounting profession, the authors contend, remains highly likely given three features of the auditing system that continue under Sarbanes-Oxley:

1) The fact that managers still have the power to fire auditors, which inhibits the accountants from filing critical audit reports.

2) The fact that Sarbanes-Oxley puts only "minimal restrictions" on auditors' taking jobs with their clients.

3) The fact that the law permits auditors to provide some types of non-audit services, despite concern among former SEC chairmen and others that such services increase auditors' likelihood of yielding to client pressures on auditing issues.A

As for the danger that normal cyclical patterns in Congressional politics will undermine whatever effectiveness the legislation has, the authors cite recent news accounts of  widespread complaints against Sarbanes-Oxley in the corporate sector. One such account quoted the manager of a large public pension fund who said she expected business to try to weaken important provisions of the act, an outcome, she said, "that would not be a good thing."

And such an outcome is entirely predictable, according to Moore et al. With vast resources to lobby Congress, the auditing industry has consistently succeeded in getting its way, and, the authors argue, is highly likely to do so again, once the immediacy of the recent scandals fades. They note that four years after the SEC imposed tight constraints in 1978 on nonaudit activities, the industry succeeded in getting them repealed and that in 2000, when SEC Chairman Arthur Levitt considered imposing significant reforms, "46 members [of Congress] received millions of dollars in campaign contributions from the Big Five accounting firms ...In the face of this political pressure, Levitt backed down from his tough stance, although he later called his decision to back down the biggest mistake of his SEC tenure."

A basic flaw of Sarbanes-Oxley -- and the basic reason why it opens the way to moral seduction -- according to the professors, is that it shares the weakness of many reform efforts that "focus on simple causes of complex problems." Its response to the scandals at Enron and elsewhere has been "to search for a smoking gun," to assume "that the most common threat to auditor independence is intentionally corrupt behavior."

Citing a large body of research during the past decade on the psychological dynamics of conflicts of interest, the professors maintain that "the real threat to auditor independence is unconscious bias," in which case "auditors may never make a smoking-gun statement that reveals corrupt intent, because no corrupt intent exists."

"The Sarbanes-Oxley Act," they continue, "makes a firm's chief executive and chief financial officers personally liable for inaccuracies in financial reports, yet it does little to reform the deeper problems with the institutional structure of auditing" -- the very structure, the authors maintain, that fosters the "moral seduction" of auditors.

In short: "We need to change the system, not simply lock up the guilty parties."

What will it take to fix the system? The authors offer two alternatives:

The first would leave the existing auditor-client relationship largely intact, but government regulators would see to it that 1) auditors performed audits and no other services; 2) an audit firm was hired for a fixed period (perhaps five years), after which it would it would be replaced by another firm; 3) no executive or staff person in the auditing firm could take a job with the audited firm; 4) auditors would make a set of independent assessments rather than simply ratify the accounting of the client firm; and 5) the auditors would be chosen not by company management but by the audit committee of the board of directors.

The alternate solution would rely on market principles rather than regulation. Companies would be required to buy financial-statement insurance, and their insurance companies would hire the auditors. The premiums the insurers charged would be a signal of their confidence in the accuracy of public reports.

The authors acknowledge that their diagnosis of the auditing industry's ills may seem contradictory: how to square the notion that auditors violate their independence principally through unconscious bias with the highly aggressive lobbying by the industry that makes those violations possible? But the inconsistency, they argue, is more apparent than real. As they put it, "It is precisely because individuals are so good at serving their own self-interests while persuading themselves that their actions are perfectly reasonable that firms and individuals can provide sensible explanations for their exploitative behavior. The most effective lies are those we believe ourselves."

Meanwhile, the professors make short shrift of the frequent contention that radical reforms, such as those they advocate for the current system, would be too expensive. That argument, they observe, misses a fundamental point: "Without independence, the auditor is redundant with the firm's own internal accounting staff, and the benefit [of having an auditor] is of questionable value to begin with... [I]f it is not worth the costs to create independence, we need to question why we even have an auditing profession."

The article, entitled "Conflicts of Interest and the Case of Auditor Independence: Moral Seduction and Strategic Issue Cycling," is in the January-March issue of the Academy of Management Review, where it is accompanied by a response from Prof. Mark W. Nelson of Cornell University and a rejoinder to Nelson by the authors. A peer-reviewed publication now in its 31st year, the Academy of ManagementReview is published quarterly by the academy, which, with about 16,000 members in 90 countries, is the largest organization in the world devoted to management research and teaching. The academy's other publications are the Academy of Management Journal,Academy of Management Perspectives, and Academy of Management Learning and Education.

Media Coverage:
Business Week. Outside Shot: SarbOx Doesn't Go Far Enough. (Monday, April 17, 2006).

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