Conflict of Interest Essay Example for Free

fight of Interest EssayAbstractInformation about the pecuniary health of unrestricted companies wind by auditors ideally allows investors to contrive informed decisions and enhances the efficiency of financial markets. However, under the current system auditors are hired and fired by the companies they audit, which introduces bonuss for parti prises that favor the audited companies. Three experiments demonstrate bias in auditors judgments, and show that these biases are non easily corrected because auditors are not fully aware of them. The source experiment demonstrates that the judgments of professional auditors tend to be sloped in favor of their invitees. The here and now and three experiments explore to a greater extent than closely the psychological processes underlying the bias. The answers apprise that the closeness of the relationship between auditor and client may pretend a particularly strong biasing define on auditors private judgments.Key linguistic communication Conflict of chase Auditor independence Self-serving bias actuate argumentAuditor Independence, Conflict of Interest, and the Unconscious Intrusion of Bias By certifying the public reports that collectively depict a corporations financial status, the self-supporting auditor assumes a public responsibility transcending any employment relationship with the client. The independent public controller performing this special function owes ultimate allegiance to the corporations creditors and stockholders, as well as to the investing public. This public watchdog function demands that the accountant chief(prenominal)tain total independence from the client at all times and requires complete fidelity to the public trust. -Chief Justice Warren Burger, writing on behalf of a unanimous United States Supreme Court in the case of United States v. Arthur Young Co. (1984)Independence is central to the function served by auditors. Although man progressrs may have an interest in ex aggerating, misre prefaceing, or falsifying reports of their sures performance, an independent audit report is supposed to provide a credible, un dark-skinned appraisal of the firms financial status. The grandeur of auditor independence is reflected in the Code of Professional Ethics of the Ameri flowerpot Institute of Certified Public Accountants (AICPA) and has been reinforced by numerous legal decisions, more(prenominal) as that rendered by the U.S. Supreme Court in the opening quote. Recent level(p)ts, however, have led many to question whether the modern practice of public story is independent enough. In the wake of a number of accounting scandals, the U.S.Securities and Exchange Commission ( entropy) conducted a series of hearings on auditor independence in 2000. The SEC instituted modest changes to disclosure rules after the 2000 hearings and the issue receded from the public agenda until the failure of the Enron Corporation and the function of its auditor, Arthur Ande rsen, in that failure b neart the issue of auditor independence to the fore. In analyzing the problem of auditor independence, twain(prenominal) the academic accounting literature and the mass media have implicitly adopted what could be considered an scotch perspective on the problem. speculative papers, empirical analyses, and media discussions of the Conflict of Interest 4 issue of independence assume, slightlytimes explicitly and sometimes implicitly, that auditor bias is a matter of deliberate woof (Antle, 1984 DeAngelo, 1981 Simunic, 1984). Auditors are assumed to have the ability to complete high-quality, independent, un coloured audits if they spot to do so. Bias, to the extent that it is thought to exist, is bring d stimulaten as a deliberate response to incentives.This economic account of independence and bias is challenged by psychological research which suggests that biased entropy processing is not exclusively pervasive, wholly if is typically unconscious and unplannedi.e., seldom a matter of deliberate choice. Applied to auditing, this research suggests that auditors who face conflicts of interest may find it difficult, if not unrealistic, to avoid bias even if they blast to do so. Whether auditor bias is a matter of conscious choice or is unintentional and unconscious has wide-ranging implications for policy, because conscious corruption and unconscious bias respond to different influences. In this paper, we low gear review findings from empirical research on biased information processing. Then we report results from three experiments. The archetypal experiment documents biased judgment among professional auditors. The second and third experiments delve deeper into the psychological processes at work and examine the causes of biased judgment. Finally, we discuss the implications of our findings for the practice of and rules surrounding auditing.Motivated Information Processing Research shows that people evaluate evidence in a sel ective fashion when they have a take a chance in hit a particular purpose. They tend to focus on evidence that supports the conclusion they would like to r all(prenominal) and evaluate that evidence in an uncritical fashion (Holyoak Simon, 1999 Koehler, 1991 Lord, Ross, Lepper, 1979 Russo, Medvec, Meloy, 1996 Russo, Meloy, Medvec, 1998, see Rabin Schrag, 1999 for a theoretical model). When evidence conflicts with their pr nonpareilnessd conclusions, people tend to either ignore it or subject it to particularly critical scrutiny (Ditto Lopez, 1992).This selective information processing ready is so strong that when people on different sides of an issue are exposed to the homogeneous information they can all emotional state that the information supports their position. As a result, they may even hold more strongly disparate opinions after receiving the same information (Lord et al., 1979). One important influence on how people evaluate information is answer ableness. When people know that they will be accountable for their decisions, they show more concern for how their decisions will be received. When they do not know the preferences of their audience, this heightened concern leads to more systematic cognitive processing and a more thorough justification of the conclusion (Tetlock, 1983).However, when the preferences of the audience are cognise, accountability need not lead to more thoughtful processing, but can instead increase the likelihood that the decision-makers judgment will be consistent with the known preferences of the audience (Tetlock, 1983). In an audit, there can be little doubt regarding the preferences of the management of the client firm They want to get an unqualified audit report. The effect of accountability cannot be easily explained by simple opportunism, because most of the research on accountability has not holdd any rewards for agreeing with the individual to whom hotshot is accountable (Tetlock, 1992). But this is not to say that self-interest does not influence judgment.When a particular interpretation of the evidence will benefit them materially, people gravitate toward that interpretation, even when they hold an explicit goal of being artless. For example, people tend to think that the allocation of resources that benefits themselves is fair (Messick Sentis, 1979), and take that early(a)s will share their perspective (Diekmann, 1997 Diekmann, Samuels, Ross, Bazerman, 1997 Messick Sentis, 1983). Moreover, they are typically unaware that they are processing information in a selfish fashion and, thus, are unaware that they are biased. Thompson and Loewenstein (1992) found evidence of a self-serving bias in negotiators reports of fairness. In their experiment, participants played either the role of management or union in a wage negotiation, and both roles were given the same information about the details of the situation. Before they negotiated, both parties were asked what they believed a fair out nonplus to be from the vantage point of a neutral third party.Their responses were egotistally biased individuals representing the union tended to believe that a high wage was fairer, whereas those representing management tended to report that a lower wage was fairer. The parties and then proceeded to trade bids until they came to settlement, and delay was costly to both parties. The magnitude of the egocentric biasthe difference between the dickens sides perceptions of a fair wagepredicted the length of time it took parties to come to agreement The more egocentric the parties ex ante perceptions of fairness were, the longer strikes tended to last. Later research demonstrated the same result in real negotiations between union and school batting arrange presidents in Pennsylvania (Babcock, Wang, Loewenstein, 1996).In the studies cited above, the pre-negotiation fairness judgments had no direct consequence for the negotiators, so it is unlikely that the bias resulted f rom strategic misrepresentation. However, subjects were not given any incentive to report their judgments accurately, so the studies do not reveal whether people are able to provide impartial judgments when they are motivated to do so. Two studies (Babcock, Loewenstein, Issacharoff, Camerer, 1995 Loewenstein, Issacharoff, Camerer, Babcock, 1993), however, offered a clear incentive to participants to be accurate in their private fairness judgments.Participants whose judgments came close to the determinations of an impartial judge were given a cash bonus. This incentive did not eliminate egocentrism in participants reports, suggesting that their roles influenced their assessments of fairness in looks they could not disregard even when it was in their interest to do so. Kunda (1990) argued that this motivated reasoning leads to biased conclusions whenever there is sufficient ambiguity in the evidence to allow for a biased interpretation. Thompson and Loewenstein (1992) explicitly ma nipulated ambiguity and confirmed Kundas prediction Greater ambiguity leads to more bias. In general, as Babcock and Loewenstein (1997 120) concluded on the basis of the aforementioned studiesAs soon as asymmetries are introduced between the partiesfor example, different nonagreement nurtures or be of non-settlement, or subtle differences in rolesboth parties notions of fairness will tend to gravitate toward settlements that favor themselves. They will not only view these settlements as fair, but believe that their personal conception of fairness is impartial. In sum, research on information processing and bargaining suggests both that people process information in a biased, self-interested, fashion, and that this bias is strong, automatic, and unconscious.Implications of Motivated Information Processing for Auditor Independence The research on motivated information processing has significant implications for auditor bias. actually few auditors begin their work hoping to find a c lient has br for each oneed accounting standards. Rather, auditors typically start with a desire to reach a positive conclusion about their clients and issue an unqualified audit report. Auditors generally want to be rehired by their clients, and it is often the case that an un gilded audit report is likely to result in a client firm changing auditors (Levinthal Fichman, 1988 Seabright, Levinthal, Fichman, 1992). Even if the accounting firm is large enough that one account is a trivial fortune of its revenues, individual auditors jobs and careers may depend on success with specific clients.Perhaps more importantly, accounting firms often treat auditing work as a way to build relationships that will allow them to sell other services including management consulting, information technology assistance, or tax accounting. Although some have argued that the contingent rents purchasable through consulting services should not influence audit quality (Antle, Griffen, Teece, Williamson, 1997 Dopuch, King, Schwartz, 2001), other recent evidence suggests that it may (Frankel, Johnson, Nelson, in press). An auditors job is complex, involving the accumulation and synthesis of a great deal of information about a client firm. The information available to auditors often includes the kind of ambiguity that facilitates motivated information processing.Joseph Berardino, Arthur Andersens former chief executive, in his congressional try outimony on the Enron collapse, commented that Many people think accounting is a science, where one number, namely scratch per share, is the number, and its such a precise number, that it couldnt be two pennies higher or two pennies lower. I come from a school that says its really much more of an art (as quoted in Harris, 2001). This imprecision allows motivated reasoning to insinuate itself into auditors judgments. Historically, those who have defended auditors against charges of bias have emphasized their high honorable standards and pro fessional values. For example, at the SEC hearings on auditor independence, Gary Shamis, Chairman of the Management of an Accounting Practice Committee at the AICPA, stated thatConflict of Interest 9 We take the existing independence rules quite seriously, and consequently abide by all the existing rules. We are professionals that follow our code of ethics and practice by the highest moral standards. We would never be influenced by our own personal financial well being (Shamis, 2000) While it is likely that most auditors attempt to remain independent, incomplete ethical codes nor training are likely to be effective remedies against a bias that is unconscious and unintentional. Undoubtedly, the bulky majority of auditors do not deliberately author biased reports. Instead, auditors roles influence their professional assessments so that their private beliefs become consistent with the interests of their clients. Although it is possible that auditors sometimes intentionally misrepres ent their findings in public, it is more likely that self-interest operates indirectly, by unconsciously influencing auditors assessments of a clients financial condition.The Studies The three experiments reported here bring together research on motivated reasoning and accountability to study the psychology auditors judgments. Experiment 1 presents data from professional auditors and strains the hypothesis that their judgments may be biased in favor of client firms (Hypothesis 1). The second and third studies examine the causes behind this effect they examine factors that could moderate the magnitude of bias, and test the extent to which the bias can be consciously undone. Participants were asked to produce two judgments one public and the other private. For the public judgments, subjects were given an explicit incentive to be biased. For the private judgments, they were given an incentive to be unbiased they were paid on the basis of how close their judgments came to those provide d by an impartial panel of experts. If participants were fully aware of the bias in their public reports, and if properly motivated to do so, they should have been able to adjust their evaluations to eliminate the bias in their private judgments. If they were not fully aware of the bias, as the research on motivated information processing would suggest, then their private estimates should have been biased as well (Hypothesis 2).Experiment 2 specifically tests the consequences of financial incentives on bias. To the extent that financial incentives affect the strength of the auditors desire to reach a particular conclusion, one might expect to observe parallel changes in the magnitude of bias. Experiment 2 tests the hypothesis that the greater ones financial interest in a particular outcome, the more biased one will be in the direction of that outcome (Hypothesis 3). The third study examines the effect of the relationship between the auditor and the principal. Material interests are not the only factors that can undermine the impartiality of judgments. Personal relationships and affiliations can have a similar effect. The power of affiliations is evident in sports fans questionable referee calls often provoke outrage by the fans of the calls loser, but rarely by fans on the winning side. Indeed, one of the first studies that documented the self-serving bias involved sports teams.In their classic study of a particularly rough football game, Hastdorf and Cantril (1954) showed that fans from each side blamed the other team for behaving more aggressively this result in any case held for fans who had not seen the game live but only watched a film of the game. These fans obtained no material benefit from their energetic advocacy but nevertheless do judgments that favored their own teams. The self-serving bias does not require the powerful affiliations associated with sports teams. Thompson (1995) has shown, in a simulated labor dispute, that it takes only a whiff of affiliation with a partisan to create sympathetic leanings. Naturally, this aptness is only strengthened when people feel accountable to the partisan (Lerner Tetlock, 1999 Tetlock, 1992). Most auditors are likely to have frequent close contact with a client, creating much stronger affiliations. Indeed, it is the cooperation of the client that makes it possible for auditors to do their jobs. Thus, Experiment 3 tests the hypothesis that the closer ones personal relationship with a particular individual, the more biased one will be in that persons favor (Hypothesis 4).EXPERIMENT 1 Role-Conferred Biases MethodParticipants were 139 professional auditors employed full-time by one of the Big Four accounting firms in the United States. Their ages ranged from 23 to 55, with a mean of 29 years (SD = 6.2). Fifty-six percent of the participants were male. They had a mean of fiver years (SD = 5.7) working as an auditor. Nine participants requested, after they had handed in their questionna ires, that their responses be excluded from subsequent data analyses. Participants were given five different auditing vignettes and asked them to come to a judgment regarding the proper auditing in each case. The problems were intentionally chosen to be somewhat difficult accounting problems for which generally accepted accounting principles (GAAP) did not provide an unambiguous solution.Each of the vignettes depicts a situation in which accounting issues that are not clearly addressed by current rule-based accounting standards. The issues addressed include the recognition of intangible assets on the financial statements (vignette 1), the restructuring of debt with dilutive securities (vignette 2), the recognition vs. deferral of revenues (vignette 3), capitalization vs. expensing of expenditures (vignette 4), and the treatment of research and development costs on the financial statements (vignette 5). Subjects were told that these cases were independent of each other and hypothetic al, although are intentionally realistic. It was our goal to design these vignettes such that the issues that are described are more general and do not particularly sustain to any oneindustry, to ensure that auditors specializing in one industry will not have a specific advantage or disadvantage in answering any of the questions.All participants saw all five vignettes in the same order. The five vignettes are listed in Appendix A. The experiment had a 2 (role hired by issuer or by outside investor) X 2 (question order make accounting valuation first vs. evaluate others accounting first) between-subjects factorial design. The role manipulation varied whom participants were told they were working for. Half the participants materials informed them that they had been hired as the external auditor for the firm in question.The other half of participants were told that they were working for an outside investor considering investing money in the firm. The question order manipulation varied the order of the questions that followed every vignette. Those in the choice-first condition were first presented with (1) the firms unaudited accounting, and were asked whether they would accept it as complying with GAAP and (2) what the right accounting would be. Those in the valuation-first condition got these two questions in the reverse order. All participants were also asked how assured they were about their judgments.Results Neither age nor years of auditing experience affected the dependent measures reported below. Therefore, we do not report them in any of the subsequent analyses. We hypothesized that participants would be more likely to come to the conclusion that the accounting behind a firms financial reports complied with GAAP if they were working for the firm than if they were not (Hypothesis 1). To test this hypothesis, we conducted a 2 (role hired by issuer or by outside investor) X 2 (question order make accounting valuation first vs.Conflict of Interest 13 evalua te others accounting first) MANOVA using the five approval decisions as dependent variables. The results show a significant main effect of role. Consistent with Hypothesis 1, those working as external auditor for a firm were significantly more likely to approve its accounting (M = 29%, SD = 24%) than were those who represented outside investors (M = 22%, SD = 21%), F (5, 107) = 2.9, p .05. Neither the main effect of question order nor its interaction with role is significant. We also expected, consistent with Hypothesis 1, that in addition to being more willing to endorse the firms own accounting, participants would be more likely to come to valuation decisions that were favorable to the patsy firm when they were considering the problem from the perspective of an outside auditor then when they had taken the perspective of a potential investor.To test this prediction, we first generated standardized scores for each item by computing a zscore of the valuation and reverse-scoring ite ms as appropriate so that higher scores indicated valuations more favorable to the target firm. We then computed an average valuation for each participant and submitted these valuations to a 2 (role hired by issuer or by outside investor) X 2 (question order make accounting valuation first vs. evaluate others accounting first) ANOVA. The results show a main effect of role Those vie the role of outside auditor came to more favorable valuations (M = .08, SD = .56) than did those working for a potential investor, (M = -.11, SD = .50), F (1, 134) = 4.07, p .05. Neither the main effect of question order nor its interaction with role is significant.DiscussionThe results of Experiment 1 are broadly consistent with research on accountability that shows that people tend to be proactively antiphonal to those to whom they expect to be accountable. When people are accountable to others with known preferences, then their judgments tend to be consistent with the preferences of those to whom th ey are accountable (Tetlock, 1983). An auditor who feels accountable to the client is more likely to issue a clean, unqualified audit report than one who feels accountable to an audit partner within his or her own firm (Buchman, Tetlock, Reed, 1996). However, it is worth noting that the accountability manipulation used in Experiment 1 was weak compared with the standard accountability manipulations in which people are led to believe that they will actually be meeting with a real person to whom they will need to justify their decisions. In Experiment 1, no mention was made of such accountability and participants were not required to justify their opinions.Nevertheless, this weak manipulation had an effect. We speculate that one reason for its effectiveness may be that the participants were familiar with the role of auditor, and so were able to easily put themselves in the role of being employed by, and accountable to, the client firm. One notable feature of the results of Experiment 1 is the low levels of endorsement. Nearly three quarters of the time, participants rejected the accounting proposed in the vignette as not complying with GAAP. This fact stands in contrast to the fact that the vast majority of all audit reports are unqualified. Two facts can explain the low endorsement rates in Experiment 1.First, the proposed accounting we gave participants in each vignette was intentionally designed to be fairly aggressive. Second, participants general suspiciousness was heightened because (1) before they responded to the questionnaire, participants had to sign the consent form which, according to the rules of the institutional review jump on that approved it, had to include the name of the study Auditor independence and bias and (2) the participants had all been recently hired away from Arthur Andersen, and several expressed the concern that their ex-employers pot would be assumed to reflect badly on them. It is, perhaps, striking that the experiments manipul ation worked despite participants heightened suspiciousness. Experiment 1 leaves a number of important theoretical questions unanswered.What, exactly, is it in the relationship between auditor and client that leads it to have the power to sway auditors judgments, given the clear ethical standards of their professions prohibiting such influence? Experiments 2 and 3 test two possible answers to this question financial incentives and personal relationships. Because these two factors are confounded in actual auditor-client relationships, the experiments are conducted with participants who are not professional auditors. However, due(p) to the fact that these non-auditor participants were unfamiliar with GAAP and so could not judge compliance with it, we created a slightly different experimental paradigm.EXPERIMENT 2 The Role of financial Incentives Method Participants. One hundred twelve individuals participated for pay. Participants were recruited with advertisements in local newspape rs and with flyers posted on the campuses of Carnegie Mellon University and the University of Pittsburgh. Forty-nine percent of the participants were male. They ranged in age from 20 to 41, with an average age of 24 years (SD = 5.18 years). Procedure. Participants were run in groups of four. They were assigned to one of four roles the buyer, the buyers auditor, the seller, or the sellers auditor. Principals (the buyer and the seller) were seated side by side(p) to their auditors. All four participants received the same packet of information about the target firm, named E-Settle (see Appendix B).After reading through these materials, the principals made public reports on the value of the firm. The auditors then reviewed these reports and offered either an unqualified endorsement of the principals assessment or offered their own assessments that could include suggestions for revision. In addition, all auditors were asked to specify both the most they thought the buyer should consider paying and the least they thought the seller should consider accepting. Both the principals and the auditors public reports were viewed by both principals. Armed with their own estimates and those of their auditors, principals then negotiated the purchase of the firm. The principals were paid based on their negotiated outcomes. In addition to the auditors public reports, which went to both principals, the auditors each completed a private report that went only to the experimenter. This private report instructed auditors to report their true belief in the value of the target firm, and told them, Your goal is for this assessment to be as impartial as you can make it.Participants were told that their estimates of the firms value would be compared with the opinions of nonpartisan experts. The panel of experts consisted of eight professors of accounting and finance at Carnegie Mellon Universitys Graduate School of industrial Administration. The experts had assessed the value of the firm at $14 meg. If a participants valuation were within $3 million of the experts, he or she would receive an supernumerary $3 allowance. Participants were then asked to express how confident they were in the accuracy of their private appraisals. They were given the opportunity to bet on their private appraisals. If they chose to take the bet, they stood to win more money ($6 instead of $3, but their appraisals had to be more accurate (within $1.5 million instead of $3 million). Finally, participants answered questions designed to assess the degree to which they believed their own appraisals of the target firm (E-Settle) may have been biased by the roles they playedConflict of Interest 17 1) To what extent do you believe your private appraisal of the value of E-Settle was biased by your role? The response scale ran from 0 (no bias whatsoever) to 10 (powerfully biased). 2) To what extent do you think your role interfered with your ability to give an impartial estimate of E-Settles val ue in your private assessment? The response scale ran from 1 (it did not influence me at all) to 7 (I found it impossible to make an impartial assessment). 3) How do you believe your role influenced your estimate of E-Settles value in your private appraisal? The response scale ran from -$3,000,000 (It led me to make an appraisal that was at least $3 million below what it would otherwise have been) to +$3,000,000 (It led me to make an appraisal that was at least $3 million above what it would otherwise have been).Design. The experiments manipulation of incentive structures included three conditions Fixed fee, Pay for performance, and Future business. In the fixed fee condition, auditors were paid a fixed $9 fee regardless of their reports and regardless of the principals outcomes. In the pay for performance condition, auditors received a $3 base payment plus the same contingent payments as their principals $.50 per $1 million in sale price either above $0 (for the seller) or below $3 0 million (for the buyer).This manipulation was designed to mirror a practice that the SEC has made illegal in which auditors have a direct financial stake in the success of a client firm. In the future business condition, auditors received a $3 base payment after the negotiation was complete, principals could choose to award future business to the auditor, worth anywhere from $0 to $10. The decision of how much business to give to the auditor did not influence the principals own earnings. This manipulation was designed to mirror the incentives present for auditors who would like to continue offering profitable services to a client who has the choice of hiring them or some other firm.Results Public reports. After reading about the target firm, principals provided estimates of its value. A 2 (role buyer vs. seller) X 3 (pay fixed, pay for performance, future business) ANOVA revealed a main effect for role. Sellers estimated the value of the firm to be higher (M = $21.5 MM, SD = $8.5 MM) than did buyers (M = $12.3 MM, SD = $12.3 MM), F(1, 49) = 18.94, p .001. After having seen this report, auditors had the option of either unconditionally endorsing the principals report or suggesting changes. A logistic regression reveals that neither role nor the extremity of the principals valuation influenced the frequency of endorsement. However, pay condition was a significant predictor of the tendency to endorse, B = -.75, p .05. Auditors in the fixed payment and pay for performance conditions were about equally likely to issue unconditional endorsements (50 percent and 47 percent respectively).However, auditors in the future business condition were less likely to issue an unconditional endorsement (17 percent) and instead tended to offer suggestions for revision (see Table 1), 2(2) = 4.89, p .05. In professional auditing, issuing a conditional endorsement of a clients financial statements suggests that the auditor believes there are problems. However, participants in t he present experiment were not constrained in this way. In their reports, about 12 percent of auditors suggested that their principals had been too extreme in their valuation of the company, and advised moderation (lower prices recommended to sellers and higher prices to buyers).