Conflicts Of Interest & The Case Of Auditor Independence: Moral Seduction & Strategic Issue Cycling
I know what you’re thinking, sexy title… This paper is co authored by one of Michael Mauboussin’s favorite thinkers, Phil Tetlock. The paper covers many interesting topics such as conflict of interests, failure of auditing firms, and so on.
Abstract (Via Berkely)
A series of financial scandals revealed a key weakness in the American business model: the failure of the U.S. auditing system to deliver true independence. We offer a two-tiered analysis of what went wrong. At the more micro tier, we advance moral seduction theory, explaining why professionals are often unaware of how morally compromised they have become by conflicts of interest. At the more macro tier, we offer issue-cycle theory, explaining why conflicts of interest of the sort that compromise major accounting firms are so pervasive.
Excerpts (Via Berkely)
People rely extensively on the advice of experts. Often, these experts face conflicts of interest between their own self-interest and their professional obligation to provide good advice. Conflicts of interest played a central role in the corporate scandals that shook America at the turn of the twenty-first century. Many companies have joined Enron and WorldCom in issuing earnings restatements as a result of inaccuracies in published financial reports. Adelphia, Bristol-Myers Squibb, FastTrack Savings & Loan, Rocky Mountain Electric, Mirant, Global Crossing, Halliburton, Qwest, AOL Time Warner, Tyco, and Xerox are some of the firms that have come under scrutiny for potentially corrupt management and a clear lack of independent financial monitoring. At the root of both this mismanagement and the failure of monitoring systems lie conflicts of interest. For example, stock options give upper management incentives to boost short-term stock prices at the expense of a company’s long-term viability. And auditors charged with independently reviewing a firm’s financial reports have often been found to be complicit with firm management in this effort (Levitt & Dwyer, 2002). Accounting firms have incentives to avoid providing negative audit opinions to the managers who hire them and pay their auditing fees.
At large investment banks, research departments have become intertwined with sales departments; stock analysts seeking new business have recommended the stocks of current or potential clients to others. Happy clients boost the investment bank’s business, but members of the public who heed the analysts’ recommendations may not be served as well. The public receives lots of “strong buy” recommendations from analysts, a trend that increases short-term stock value at the expense of long-term investment safety (Cowen, Groysberg, & Healy, 2003). According to Laura Unger (2001), member of the Securities and Exchange Commission (SEC), in the year 2000, a period during which the stock market was in broad decline (the Dow Jones Industrial Average dropped 6 percent, the Standard & Poor’s 500 index dropped 10 percent, and the NASDAQ dropped 41 percent), 99 percent of brokerage analysts’ recommendations to their clients remained “strong buy,” “buy,” or “hold.”