Auditors Cheating on Ethics Exams – Who’s Surprised?
Here's a guest post from my friend and colleague in critiquing the accounting profession, Jim Peterson. I've added a few notes and references to his essay.
This is a guest entry from Jim Peterson, an American lawyer whose practice focuses on financial and accountancy related issues, and who is a 19-year veteran of Arthur Andersen’s in-house legal group. He launched his column, “Balance Sheet” in the business section of the International Herald Tribune in 2002 – evolving to his blog, “Re:Balance”.
“The past is never dead. It’s not even past.” William Faulkner
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Pious dissections of the SEC’s record-setting $ 100 million fine levied this summer against EY for widespread staff cheating on ethics and other exams, and the firm’s delays and misdirections in its regulatory reporting, have missed three points:
They did it because they could, and had their reasons.
The reasons evaded the understanding and best intentions of leadership, so compliance efforts were bound to fall short.
Those reasons are based on pervasive human characteristics, shared by members of the accounting profession with the general population.
Here is a link to the SEC’s press release and complaint in the EY matter from June 29.
On the heels of the SEC’s 2019 fine of $50 million for KPMG’s not dissimilar behavior and more, how did things go so wrong? How could there not have been a learning effect?
Finger-pointing and calls for accountability will lie elsewhere — not here — because the basic reasons lie in human nature, and are not complex. It’s the harder challenge to reduce the predictable cases of future failure.
Drawing on a career filled with scrutiny of financial and professional break-down and misfeasance, I teach a course in business and law schools that explores the reasons for bad decisions and behaviors. There is a core theme in the shortcomings of the supposed “smart guys” — whether during the credit crisis of 2007-2008, the halting and inconsistent reactions to the COVID pandemic, the recurrent scandals from Enron to Wirecard, or the persistent outbreaks — that, every time, trigger the familiar cry, “Where were the auditors?”
Namely, as fallible humans, all of us are prone to the quick and instinctive decisions that activated “fight or flight” for our primitive ancestors whose DNA we inherit. It was good enough to safeguard a prehistoric tribe, but ill-suited to the complexities of modern life where, through bias and error, we are led to undesirable judgments and decisions.
A note on resources -- a body of research and literature both broad and extensive. The seminal scholarship is the concise and much-cited 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases.” Kahneman’s “Thinking, Fast and Slow”(2011) brought the themes forward. Applications to policy-setting and personal choices are examined, e.g., in Richard Thaler and Cass Sunstein’s “Nudge”(2008) and Thaler’s “Misbehaving: The Making of Behavioral Economics”(2015).
McKenna note: You may also consider a textbook that I contributed a chapter to, one that asked the question of whether the increase for credit hours required to qualify for the CPA exam to 150-hours improved ethics in the profession. (The extra hours were intended to be focused on ethics training but instead created the ubiquitous Masters in Accounting degree.) Short answer? No.
The accounting profession has contributed to a public expectation of auditor performance that exceeds its failure-avoidance capabilities, eliding the inevitable break-downs that inhere in any complex system of human design and operation. As context for this latest outbreak of test-cheating, the entire model for financial information assurance, designed in the Victorian era and largely unevolved since, has yet to recognize and apply a half-century of insightful scholarship into the complexities of human behavior.
The themes have specific application to the errant test-takers. However well-schooled they may have been in the standards and literature in judgment, independence and skepticism, fresh university graduates newly arriving to the profession have basic DNA no different — for better or worse — than their peers elsewhere. Although eventually sporting a new appliqué — CPA — in real-world practice they are not bestowed with any special aptitude for skepticism beyond the normal, nor a super-human capacity to overcome the universal susceptibility to non-benign influence.
In short, no amount of on-the-job training can eliminate the impairing effect of compromising influences such as the stresses of budgets and workloads, peer pressures, or “go along” signals from their immediate supervisors.
Which means that staff personnel in the audit firms will pursue their interests under the most immediate incentives, in spite of and over-riding whatever earnest and sincere exhortations may come down from on high.
Because there will be cheaters in any human-run system, the search in the current exam-gaming context should turn to affirmative support for failure reduction. Checks and barriers should be inserted; misbehavior and non-compliance should be made as difficult as possible.
That means invoking the authorities in testing integrity. Far be it from my limitations as a late arrival to academia, but two examples: I have used plagiarism detectors, and experienced a law school that required annual instructor certification that all exam questions were unique and not repeated from prior years.
Because misaligned incentives and skewed decision influences are ubiquitous in society’s institutions, they no less pervade the entire ethos of the accountants’ world. The stage for misbehavior is always set.
The refreshed examples of questionable performance reflect the auditors’ too often ill-fated client-oriented decisions, under the most salient if undesirable influences; skepticism, conservative judgments and challenges to clients are subjected to powerful influences including over-confidence, success bias and management pressure.
Broadly speaking, the profession’s limited grasp that these behavioral principles are pervasive is seen in its two defensive messages: that the vast majority of its personnel act in complete honesty and good faith and that most of its audit engagements are carried out in conformity with standards and expectations.
True enough, but insufficient and unresponsive to the ubiquity of the exceptions — growing in number and consequences — reflecting, in effect, the inability to grasp the implied downside in the ineffective messaging, as captured in the simple truth, often delivered to unruly adolescents: “When you do good, nobody remembers. When you do bad, nobody forgets.”
Fortunately, opportunities for improved risk assessment and mitigation are readily at hand. Effective strategy and tactics for business and professional leaders would start with the acknowledgement that much of high-level standards, regulation and guidance falls somewhere between wasted and futile.
The fiasco at the 2017 Academy Awards, when the presenters announced the wrong Best Picture because the PwC partner carried two envelopes and handed over the wrong one under the distraction of a selfie, was avoidable. Break-down of the flawed no-phones-on-stage policy, observed in the partner’s breach, would have been avoided by a simple requirement that a monitor confirm he was empty-handed before handing him the next envelop.
To be sure, trade-offs of cost and resources attach to choices about policy enforcement and society’s acceptable level of tolerance for deviant behavior:
The carnage of teenage drunken driving could be dramatically reduced by two simple if draconian steps –- raising to age thirty the threshold for a license, and immediate mandatory ten-year prison sentences for violators –- neither of which society would tolerate.
Mass shootings, likewise, would be considerably less likely under a prohibition on civilian possession of assault weapons and severe controls on access to ammunition –- achievable in theory but tragically not in American practice.
Returning to the accountants, there are multiple implications:
The prospect that a re-setting of the bar for auditor performance may dilute the auditors’ claims for professional status.
The potential that unresolved continuation of performance quality issues may lead to public withdrawal of the credibility bestowed on the profession.
Broadened demand for new and evolved forms of assurance may attract new suppliers with fields of expertise beyond the ability of the accountants to evolve and adapt.
The dialog on these is for another time. As for the present case, recent events have shown that zero defects in ethics testing did not follow from a fine of $50 million, even with associated prosecutions of the principal partner violators. Neither will $100 million suffice. The pace of human evolution is not so responsive.
This counsels neither cynicism nor despair. Instead it’s a challenge that calls for strategies that are better informed and designed.
fm footnote: In addition to the recent fine for EY US, PwC Canada was also cited by the PCAOB and Canadian authorities for test cheating violations. In addition to the PCAOB fine of $750K for PwC Canada, the Canadian Public Accountability Board (CPAB) fined them another $200,000, for a total fine just shy of $1 million. Why the relatively small fine (50 times less than KPMG, and 100 times less than EY)?
In contrast to EY — which the SEC said mislead its investigators — and KPMG — where there was the compound case of stealing regulatory data from the PCAOB that resulted in criminal charges and guilty pleas/verdicts for partners — PwC Canada voluntarily stepped forward and self-confessed to these embarrassing happenings within the firm! There has also a $450,000 fine paid by KPMG Australia for similar cheating incidents (US watchdog fines KPMG Australia over ‘widespread’ cheating on online training tests | Business | The Guardian)
In my previous writing, I have criticized the hall pass the audit firms and auditors get from everyone, as if they are better angels or capitalist eunuchs. From February 2014:
One of the most difficult things anyone suing an auditor has to prove is that the audit firm and/or its partners had anything to gain by being an aider, abettor, or co-conspirator in a fraud perpetrated by a client.
In the Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 496 (7th Cir. 1986) case which involved the old Ernst & Ernst firm, the judge observed that the case “against an aider, abettor, or conspirator may not rest on a bare inference that the defendant ‘must have had’ knowledge of the facts. The plaintiff must support the inference with some reason to conclude that the defendant has thrown in his lot with the primary violators.”
Later, in 1990, in the DiLeo v. Ernst & Young case related to the failure of Continental Illinois National Bank, the judge accepted this argument and took it “to the bank”, expressing a strong belief that an audit firm and its partners will, above all, think about the firm’s and their own reputations first. Almost every case that touts the auditors’ sacred reverence for reputation as a defense cites DiLeo v. EY:
“An accountant’s greatest asset is its reputation for honesty, followed closely by its reputation for careful work. Fees for two years’ audits could not approach the losses E & W would suffer from a perception that it would muffle a client’s fraud. And although the interests of E & W’s partners and associates who worked on the Continental audits may have diverged from the firm’s, see AMPAT/Midwest, Inc. v. Illinois Tool Works, Inc., 896 F.2d 1035, 1043 (7th Cir.1990), covering up fraud and imposing large damages on the partnership will bring a halt to the most promising career. E & W’s partners shared none of the gain from any fraud and were exposed to a large fraction of the loss. It would have been irrational for any of them to have joined cause with Continental.”
I don’t buy it.
Is it irrational to believe that auditors are capable of acting capriciously, in a self-interested manner and, perhaps, like any other human being, against the law? Are auditors the market eunuchs in our capitalist system, immune from the influence of financial incentives? I think we’ve seen enough auditor-blessed Chinese frauds and audit partner inside traders just in the last five years to force reconsideration of such a Pollyannaish view. It’s time to stick a fork in this anachronistic idea of our profession and say, finally, that it’s done.
© Francine McKenna, The Digging Company LLC, 2022
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