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Business
The psychology of accounting fraud

Wednesday, December 11, 2002

By Frank Reeves, Post-Gazette Staff Writer

Three years ago, Don Moore was wrapping up his work as a doctoral student in psychology at Northwestern University's Kellogg Graduate School of Management.

Carnegie Mellon University professor Don Moore and colleagues wrote in Harvard Business Review: "Because of the often subjective nature of accounting and the tight relationships between accounting firms and their clients, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company's true financial status, thereby misleading investors, regulators and sometimes management." (Annie O'Neill, Post-Gazette)

Now, in his first post-graduation job as an assistant professor at Carnegie Mellon University, Moore, 32, is caught up in a major policy debate: How to prevent the kind of accounting fraud that led to the collapse of such New Economy icons as Enron Corp. and WorldCom Inc.

Along with his CMU colleague, George Loewenstein, and Max Bazerman of the Harvard Business School, Moore has sought to bring the insights of psychology to the vexing problem of auditor independence.

Their somewhat unsettling conclusion, as they recently wrote in the Harvard Business Review, is that most of the proposed reforms, including recently enacted legislation, ignore "the deeper, more pernicious problem with corporate auditing, as it's currently practiced -- its vulnerability to unconscious bias."

The new law, reflecting the legal and moral traditions of the West, is based on the assumption that human beings are rational creatures, capable of knowing right and wrong, and that their misdeeds are based on a conscious decision to break the rules.

But Moore and his colleagues, backed by psychological studies, contend that unconscious forces often work to distort our judgment and lead us astray.

"Because of the often subjective nature of accounting and the tight relationships between accounting firms and their clients, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company's true financial status, thereby misleading investors, regulators and sometimes management," they wrote.

Congress approved a corporate accountability bill last summer, which President Bush signed into law in July. The drive to pass the new legislation sprang from revelations, starting with Enron and continuing with WorldCom and Adelphia Communications Corp., that liabilities and debts were hidden from investors with unusual accounting practices. Such irregularities suggested a cozy relationship between auditors and their corporate clients that many found troubling.

The law, co-authored by Sen. Paul Sarbanes, D-Md., and U.S. Rep. Michael G. Oxley, R-Ohio, established an independent board to oversee the accounting profession, set new penalties for securities fraud and document shredding, and requires corporate executives to certify their companies' financial statements -- but it applies to only publicly traded firms, not privately owned ones.

Even before the recent spate of corporate scandals, psychologists have been trying to apply their research insights into the practical problem of auditor independence, Moore said.

In 1997, Loewenstein, Bazerman and Kimberly Morgan, then a University of Pittsburgh doctoral student, tried to understand how bias can unconsciously affect an auditor's decisions. But Moore said no one paid much attention to the work.

Three years ago, Moore, Bazerman and Loewenstein received a grant from the American Accounting Association to study auditor independence. Their experiments found that an auditor's judgment is likely to be biased and that these biases aren't easily corrected because an auditor might not be fully aware of them.

Sitting down in his small office in Posner Hall on the CMU campus, Moore explained some of the implications of his and his colleagues' research.

Auditors aren't evil people. Most don't set out to break the law or mislead investors or the public. Indeed, their profession already has high ethical standards.

But Moore said there was ample research showing that our desires influence the way we interpret information even when we try to be objective and impartial. If people want to reach a certain conclusion, they usually do.

Moore said auditing procedures were ripe for biased thinking. Contrary to popular opinion, auditing isn't an exact science but an art.

Besides, auditors have powerful incentives to please their clients -- that is to come up with a report that supports the claims of a company's management.

As he and others have noted, companies hire and fire the auditors, whose services they use. In addition, accounting firms often sell consulting and financial services to the companies they audit. They know they're unlikely to retain or obtain the business of a firm whose books they've found wanting.

Auditors often are recruited by the company they've audited to become part of the firm's management team -- another incentive to slant their judgment in favor of the company.

The fact that auditors work closely with corporate executives increases the chances of biased thinking, since they will be less likely to harm those with whom they are familiar than they would be with strangers.

Moore said he and his colleagues doubted that increasing jail time or fines would deter the problem of biased thinking. He said any reforms must go beyond the Sarbanes-Oxley Act.

He said auditors should be hired to serve a firm for a fixed term, with no chance of being laid off during their term of service or being rehired at the end.

He said government regulators should bar companies from hiring auditors for a certain length of time after they have completed the audit of a particular firm.

Moore said that unless such checks and balances were put in place, we could expect a recurrence of the problems that have dominated the headlines and undermined investor confidence.


Frank Reeves can be reached at freeves@post-gazette.com or 412-263-1565.

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