The Challenge of Auditor Independence
Max H. Bazerman, Harvard Business School
and George F. Lowenstein, Carnegie-Mellon University
In January, the story broke that partners at PriceWaterhouseCoopers were regularly violating auditing standards by holding investments in the firms they audited. Auditing standards are quite straightforward and unambiguous in forbidding this practice, and partners had been given advanced warning that their investments would be subjected to close regulatory scrutiny. Nevertheless, few partners brought their investment portfolio into conformity with these standards. Investors, lenders, suppliers, customers, and strategic alliance partners depend on independent and impartial audited financial statements. Yet scarcely a month goes by without new revelations of auditing improprieties among the "Big Five" firms. Other scandals have come to light, for instance, because firms were also providing consulting services to their auditing clients. Such services have displaced auditing as the major profit source for the "Big Five" firms, responsible in some cases for up to 70 percent of revenues. As a result of these interdependencies, auditing firms now face the delicate task of monitoring the books of the very firms they depend on for profit.
In response, the SEC issued a series of statements suggesting the need to reconsider the current structure of the auditing industry. As is often the case when issues of auditor independence arise, however, the problem was defined in terms of intentionally corrupt behavior. This framing of the problem implies that it can be solved through moral suasion or the threat of sanctions or both. Unfortunately, this perspective fails to account for the fundamental human cognitive biases that lie at the core of the auditing function.
People are not impartial information processors. Psychological research on judgment and decision making shows that when people have a stake in the interpretation of information, they process it in a biased fashion that leads them to the conclusion they wish to reach. The human mind ignores, or discounts as unimportant, information that is inconsistent with what a person believes or wants to believe, and pays disproportionate attention to information that is consistent with the person's beliefs and desires.
Thus, plaintiffs and defendants are overly optimistic about their chances of winning a lawsuit, because they ignore evidence that is inconsistent with their desired outcome. This bias is all the more pernicious because people are typically unaware of it . Research shows that even when they are confronted with overwhelming evidence of the strength and pervasiveness of biased information processing, people will often continue to maintain that these findings don't apply to them.
Because this bias is inherently unintentional and unconscious, attempts to deter people from succumbing to it are doomed to failure. The current structure of auditing firms makes the creation of auditing independence impossible even among honest and well-intentioned auditors. Publicizing potential conflicts of interest is likewise unlikely to be an effective solution because the public, like auditors themselves, either fails to recognize or underestimates the extent of the bias.
Some Big Five firms have attempted to reduce conflicts of interest by spinning off their consulting operations into independent units. Such changes are helpful. In addition, it is likely that negative publicity surrounding the situation at PriceWaterhouseCoopers has led many auditors to eliminate certain clients from their investment portfolios. However, these adjustments have failed to address a critical structural element of the auditing process: Auditors are hired and fired by the companies they audit. Like all professionals, they are eager to please the people who have hired them Beyond that, in an increasingly competitive marketplace, they often socialize with the people they are auditing. Needless to say, the prospect of writing a negative report on a friend is not very appealing to most people. In contrast, auditors are unlikely to have any ties that bind them to the investors, lenders, and others who are likely to be hurt by an inaccurate report.
Given the powerful economic interests involved, and the complexities and uncertainties of reform, the SEC faces a very difficult task as it considers making fundamental changes to the auditor-client relationship. Yet such reforms are required to provide the public with the quality information it needs to make informed financial decisions. We urge the SEC to make sure it considers the natural biases of the human mind as it contemplates system-wide reforms. Forget about the likes of better training or stronger sanctions. The only way to solve this problem is to eliminate the conflicts of interest.
Max Bazerman is a Marvin Bower Fellow at Harvard Business School. George Loewenstein is a professor at Carnegie-Mellon.