In the wake of the collapse of Espirito Santo Group, a 150-year-old Portuguese multi-billion dollar corporate dynasty, questions emerge about why the company’s auditor, KPMG, did not detect financial problems. The Wall Street Journal reports that Espirito was the largest client of KPMG’s Lisbon office, and provided substantial work for KPMG throughout Europe.
The question raises an important issue: Does auditor self-interest blind the accountants to problems with a client’s books?
It is the job of company management to provide investors and the public with company books prepared in accordance with accounting principles—Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS) for the rest of the world. As with any other sets of complicated rules, the accounting principles present gray areas requiring judgment calls. Because management has a natural bias to make judgments that apply accounting principles in the best possible light for the company, companies are required to hire outside, objective, independent auditors to review the books and confirm that the accounting principles are properly applied.
The problem is, the CPAs who are called upon to make independent judgments are hired, paid, and re-hired by the company’s whose books they are auditing. Human nature being human nature, this creates an enormous and often blind bias that is difficult to overcome. Over the years business school professors have run studies testing the ability of auditors to exercise truly independent judgment when their own self-interest is involved. Despite the fact that most auditors are honest, diligent, hard-working individuals, the influence of self-interest on decision making is so strong it is almost impossible to avoid.
Harvard professor Max Bazerman conducted a series of studies showing CPAs making judgment calls in favor of their hypothetical clients, despite their best efforts to exercise independent judgment. If the pull of self-interest is so strong in a hypothetical situation, imagine the influence in real life. In numerous contexts, time and time again, neuroscientists have shown that when one’s self interest is in conflict with the interest of others, a very strong unconscious bias influences decision making. Independent auditors are not immune to this influence.
Over the years the SEC has attempted to counter this impact with rules that would require auditor rotation. The idea is that if accounting firms know that in a few years they will rotate off the client, they are less likely to form biased attachments to the company. The accounting industry, however, has been successful in lobbying Congress to block moves by the SEC to strength auditor independence in the U.S.
In a future post, I will explore this issue in greater depth. But for now it is enough to note that the question of how much an audit firm’s decision making is influenced by its self-interest in retaining large clients is one that will asked again, the next time a big company’s financial problems go undetected by the watchdogs the public depends upon.