Summary of Intended Public Testimony re: Comment File S7-13-00
Don N. Kleinmuntz, Ph.D.
Professor of Business Administration, University of Illinois at Urbana-Champaign
My perspective is that of an expert on the psychology of judgment and decision making in business organizations. Over the last 20 years, I have become increasingly interested in the relationship between accounting and financial decision making. In addition, I have extensively read and contributed to academic research on auditor judgment and decision making both as an author and an editor.1
At the outset, I need to disclose three facts: First, I have been retained as a consultant by three firms (Arthur Andersen, Deloitte & Touche, and KPMG) as well as the AICPA to provide insight and guidance on the issue of audit independence. Second, at different times a number of accounting firms, including all of the Big 5, have supported and continue to support some of my research either directly or indirectly. Finally, I am a founder of and hold a substantial ownership interest in a successful privately held software firm that competes with the accounting firms for certain types of non-audit services.
The primary focus of my testimony is the issue of audit firms supplying non-audit services to audit clients and what psychological research is (or is not) able to conclude regarding how such arrangements influence auditor independence. The underlying rationale for the proposed restriction on the scope of non-audit services is a common-sense argument that a persons decision might change when they have a stake in the outcome of that decision. The sole published academic literature cited to substantiate this claim is a single article that argues that auditors are likely to suffer from a well-known psychological phenomenon known as a "self-serving bias."2 The assertion is that auditors unknowingly process information in a way that leads them to favor the opinion that serves their own self-interest. The implicit presumption in this argument is that the auditors self-interest is aligned with that of the audit clients management.
I do not disagree with either common sense or with the argument that auditors can unknowingly bias their opinions in a self-serving manner. Rather, I believe that in applying these principles, it is important to recognize several important and distinctive features of the audit environment that greatly limit their relevance to issues of audit independence. First, auditors face a more complex set of incentives, including self-interests that run counter to managements interests. Second, even if individual auditors are subject to a bias towards management-favored positions, given the presence of other intervening factors, such as established review protocols, it is not clear that this bias will ultimately affect the audit opinion.
What exactly constitutes the auditors self-interest? The fact that auditors are paid by the audit client creates a direct economic relationship. However, the fees for a current audit engagement are not at stake, since contingent fees are prohibited under AICPA rules. Of course, there is always an economic interest associated with securing additional fees from the audit client. However, this interest is present whether the fees are for non-audit services or for audit fees for subsequent years. Limiting or restricting non-audit services will not remove this relationship.
On the other hand, the audit firms, the accounting profession, and regulators have created powerful incentives that pull auditors in the opposite direction, making them accountable for their judgments. These sources of accountability are both internal and external to the firm. Internally, auditors (whether partners or other professional staff) are accountable to their colleagues and their superiors. Like many other business organizations, accounting firms have developed sophisticated performance measurement systems that do far more than simply tally the revenue generated from client engagements. Thus, engagement partners and other professional staff are going to be concerned with how they score on a whole range of performance metrics. All of the large accounting firms have divisions dedicated to firm-wide risk management, professional and regulatory matters, independence monitoring, and dissemination of targeted independence-related training. To the extent that the firms explicitly measure performance relative to professional quality standards, compliance with firm policy and guidelines, and compliance with risk management procedures, accounting firms reinforce rather than undermine independence.
There are also many external sources of accountability including, but not limited to: (a) peer review by the AICPA SEC Practice Section, (b) reviews by the Quality Control Inquiry Committee and the AICPA Ethics Division, (c) the threat of SEC enforcement investigations, and (d) the very real possibility of litigation. These factors provide powerful incentives for the firms to enforce audit quality, including compliance with independence standards. A final and significant source of external accountability is the anticipated negative impact of adverse publicity on a firms reputation, which influences a firms ability to attract and retain clients over the long run.
One could argue that the probability of review, enforcement action, or litigation in any specific audit engagement is statistically remote, and may be ignored by individual auditors. However, across a large firms entire portfolio of audit clients, the aggregate risk exposure can be substantial, even when the individual exposures are miniscule. These external incentives are likely to be felt most keenly at the top of a firms chain of command, where the focus is on the portfolio rather than any single engagement. Consider as a case in point the considerable costs associated with litigation that the firms pay year in and year out. Concern with managing these risk exposures in turn provides the rationale for the implementation of systems to create internal accountability, which are likely to be quite salient further down the chain of command.
To summarize my first point: An auditors self-interest is more complicated than it looks, and auditors are accountable in ways that counter the influence of their economic relationship with the audit client. More importantly, there is a growing body of research that shows that these sources of internal and external accountability can have a powerful influence on decision making both in auditing as well as in other managerial and social contexts.3 While there is much that we do not yet understand about how auditors balance their conflicting objectives, it is simplistic to reduce the auditors incentives to a single economic dimension.
This brings me to my second point: Even if individual auditors do fall prey to a self-serving bias that unknowingly favors the client, I do not believe that the outcome of an audit will necessarily be affected adversely. In order to understand this point, it is vital to understand some critical features of the environments in which psychologists typically study human judgment, in contrast to the environment in which auditors exercise their professional judgment.
Psychologists typically study judgment in a static, one-shot experiment, in which they present information and ask study participants to review the information and arrive at an evaluation, prediction, or choice. Typically, the judgments involved can be completed in a short period of time (e.g., minutes rather than hours or days). As an example, consider the published studies of the self-serving bias in legal settings.4 Experimental participants had either 30 minutes or a week to read 27 pages of testimony and other case materials. Pairs of subjects then engaged in a negotiation exercise that lasted exactly 30 minutes, at which point the experiment concluded. The financial stakes were typically less than $10. By the standards of psychological experiments, these were relatively complex procedures, with a contextually rich set of experimental stimuli.
However, contrast this environment with the typical external audit, where the stakes are much higher and the audit engagement goes on for weeks or months. An audit consists of an extended series of judgments, assessments of further evidence, and subsequent reviews, with plenty of opportunity for the auditor to uncover previous errors and take corrective action. Auditors, like many other professionals, make judgments that are embedded in a series of judgment-action-outcome feedback loops. An initial judgment need not be perfectly accurate, if there are plenty of opportunities to catch and correct subsequent errors. As long as early decisions do not irrevocably commit the auditor to a course of action, initial judgment errors need not produce undesirable outcomes.5
Furthermore, psychological research on self-serving biases (cited above) provides only a limited opportunity for interaction between participants. In contrast, auditors interact with both clients and other members of their profession over extended periods of time. They are likely to be very much aware both of the past history of their interactions as well as the anticipated effect of their decisions on their future interactions. We simply do not know very much about how factors like the desire to protect ones reputation affect the prevalence of biased decision making in long-term group or organizational interactions.6
Also in contrast to the general psychological research on self-serving and similar biases is the fact that teams of professionals perform audits, with other teams of professionals available to consult, review, and provide close supervision. Notably, some of the auditors involved are reviewers explicitly charged with catching errors and oversights. For SEC engagements, there are concurring partner reviews and, for members of the AICPA SEC Practice Section, firm level peer reviews. These extensive review and quality control processes, in combination with the accountability considerations mentioned above, enhance an audit firms ability to catch and correct biased judgments made by individual auditors.
Given this analysis, I do not believe that restrictions on non-audit services are likely to contribute in any real way to auditor independence. On the other hand, I do believe that there are elements of the proposed rule that will enhance independence. Proxy disclosure of non-audit services may enhance accountability by permitting all parties to have the clearest possible picture of the auditors incentives. I also welcome the recent move towards strengthening corporate governance by making audit committeeswho have management oversight responsibilitiesdirectly responsible for appointment and removal of the auditor, as well as communications with the auditor on financial reporting matters. Similarly, steps that encourage the enhancement of accounting firms internal quality control mechanisms reinforce those firms current efforts to create appropriate internal incentives and correct problems before they affect audit quality.
I would be pleased to respond to any comments or questions.
email@example.com (217) 333-0694
Footnotes1 See Ashton, R. H., Kleinmuntz, D. N., Sullivan, J. B., and Tomassini, L. A. (1988). Audit decision making. In A. R. Abdel-khalik & I. Solomon (Eds.), Research Opportunities in Auditing: The Second Decade (pp. 95-132), Sarasota, FL: American Accounting Association. As past chair of the Society for Judgment and Decision-Makings Publication Committee, I played a significant role in shaping the volume Judgment and Decision-Making Research in Accounting and Auditing, R. H. Ashton & A. H. Ashton (Eds.), (1995), Cambridge University Press. 2 Bazerman, M. H., Morgan, K. P., and Loewenstein, G. F. (1997). "The impossibility of auditor independence." Sloan Management Review, 38, 89-94. 3 In auditing, see for example: Peecher, M. E. (1996). "The influence of auditors justification processes on their decisions: A cognitive model and experimental evidence." Journal of Accounting Research, 34, 125-140; and Kennedy, J., Kleinmuntz, D. N., and Peecher, M. E. (1997). "Determinants of the Justifiability of Performance in Ill-Structured Audit Tasks." Journal of Accounting Research, 35 (Supplement), 105-123. More generally, see Garud, R. and Shapira, Z. (1997). "Aligning the residuals: Risk, return, responsibility, and authority." In Z. Shapira (Ed.), Organizational decision making (pp. 238-256), Cambridge University Press; and Tetlock, P. (1985). "Accountability: The neglected social context of judgment and choice." Research in Organizational Behavior, 7, 297-332. 4 Babcock, L., and Loewenstein, G. (1997). "Explaining bargaining impasse: the role of self-serving biases." Journal of Economic Perspectives, 11, 109-126. 5 Hogarth, R. M. (1981). "Beyond discrete biases: Functional and dysfunctional aspects of judgmental heuristics." Psychological Bulletin, 90, 197-217; Kleinmuntz, D. N. (1985). Cognitive heuristics and feedback in a dynamic decision environment. Management Science, 31, 680-702. 6 Davis, J. H., Kameda, T., and Stasson, M. F. (1992). "Group risk taking: Selected topics." In J. F. Yates (Ed.), Risk-taking behavior (pp. 163-199), Chichester, England: John Wiley & Sons; Payne, J. W. (1997). "The scarecrows search: A cognitive psychologists perspective on organizational decision making." In Z. Shapira (Ed.), Organizational decision making (pp. 353-374), Cambridge University Press.