Companies lure auditors to walk slippery road of irregularities
By IANSTuesday, June 15, 2010
WASHINGTON - Concern about preserving their reputation can cause auditors to travel on the slippery road of irregularities that ruined not only Enron but auditing firm Arthur Anderson, says a new study.
The authors’ lesson for management is that long-term relationships between auditing firms and clients can lead to inaccurate reporting despite - or perhaps because of - the auditing firm’s good reputation.
Ironically, the stronger the auditor’s current reputation, the stronger is the incentive to misreport after the reporting omission of initial malfeasance.
They find that a strategic manager can lead the auditors down a slippery slope, with managerial fraud increasing as the length of the audit firm’s contract progresses.
In this scenario, as company fraud increases, the probability that the auditor will report it decreases.
Carlos Corona and Ramandeep S. Randhawa of the Universities of Texas and Southern California conducted the study.
The WorldCom and Enron debacles at the turn of the last century were a black eye for Arthur Andersen and the auditing community and led to the auditing restrictions included in the Sarbanes-Oxley Act of 2002, which requires auditors to remain more autonomous.
Auditors’ concerns about their reputation are commonly perceived as having a positive effect on execution of their monitoring and attesting functions. The authors demonstrate that this concern can actually have the opposite effect.
Using game theory to analyse manager and auditor relationships, they illustrate how reputational concerns can actually induce an auditing firm to misreport.
Early undetected or unreported slight misconduct by a manager places the auditor in a bad position in future periods, when admission of prior transgressions tarnishes the auditor’s reputation, said a Texas and Southern California release.
These findings have been published in the current issue of Management Science, an Institute for Operations Research and the Management Sciences (INFORMS) journal.
