After Enron imploded and WorldCom bit the dust, one question topped investors' minds: Where were the auditors?
Granted, we all remember that team from Arthur Andersen, shredding documents as if preparing for some ticker-tape parade of shame. But what about the rest of them? Weren't auditors on the job, checking every check, rooting out fraud, no matter how small?
Not necessarily. Rooting out small or "immaterial" fraud isn't really an auditor's job -- at least that's what public accountants would likely tell you. Judges and law students, who could be judges someday, will tell you differently, and so will MBA students, the business leaders of tomorrow.
That expectations gap is one of the problems facing auditors today, according to researchers at the W. P. Carey School of Business. Not only do auditors hold different views of their roles than judges, the scholarly team also found that judges' attitudes toward the accounting profession have taken a hit in recent years. Such findings don't bode well for accountants facing liability litigation.
Mind over matter
"For the big auditing firms, around 12 to 15 percent of gross revenues -- not net income -- relate to legal fees," says Philip Reckers, professor of accountancy at the W. P. Carey School of Business. Where there are legal disputes, there could very well be judges, deciding what evidence gets admitted, which witnesses speak and what instructions go to the jury.
Considering their power, "the public would like to believe that judges are better than the rest of us, that they view things totally objectively," Reckers says. When judges put on those black robes, they consider only facts and evidence, right? They don't allow personal feelings or opinions to come into play. "That's simply not true," he adds.
This is part of the reason why Reckers teamed with two W. P. Carey School colleagues -- management Professor Marianne Jennings and accountancy Professor Kurt Pany -- and a colleague from the ASU west campus, Jordan Lowe, to examine judges' attitudes toward public accountants and their responsibilities as auditors. According to these researchers, many studies have shown how a judge's mindset affects decisions. The correlation has born out in cases involving the legal liability of auditors, as well as other legal questions, Reckers notes.
And, for better or worse, attitudes tend to be relatively stable. "If you go into behavioral literature, it says that attitudes are learned opinions that develop over time," he explains. "People's attitudes don't change easily unless there's a major stimulus -- something big happens."
Reckers and his colleagues have been tracking judge's attitudes toward public accounting since 1990 and, as it turns out, something big did happen during this time. In fact, several things happened in the early 2000s.
Age of upsets
According to the researchers, the number of financial restatements by publicly held companies averaged 49 per year between 1990 and 1997. That number jumped to 91 in 1998, 156 in 2000 and 270 in 2001. Meanwhile, two auditor liability suits settled in the 1990s topped $100 million each. By 2004, there were eight mega-cases in that financial ballpark.
Over this same period of time, the researchers have been surveying judges about auditor liability. Professor Jennings suggests that "Twenty-five years ago, for a judge to have heard or been a participant in a case like this was very rare," she says. "Now, every single one of them has a comment after they do the survey: 'This is like the Enron case, or I lost a bundle on WorldCom,' they might say. Judges have seen these kinds of cases time and time again."
Jennings also points out that today's judges are likely to be stock market participants, so spectacular corporate meltdowns can take a personal toll.
With this in mind, were the accounting scandals earlier in this decade enough of a stimulus to erode judges' views of auditors? Would judges hold auditors more accountable in the wake of financial scandals? Those were questions the W. P. Carey School's team sought to answer.
"We went back and looked at judges' views before and after the disasters surrounding Enron, WorldCom and others," Reckers says.
"Conditions were ripe for major attitude changes, and we found them," he adds.
Using a 10-point scale, with the score of "one" representing "strongly disagree" and 10 standing for "strongly agree," the research team asked judges a series of questions aimed at gleaning their audit knowledge, as well as their views on the role of the auditor and general attitudes toward the auditing profession.
The team used eight agree/disagree statements to gauge judges' viewpoints, and found that the adjudicators' views remained essentially unchanged in surveys conducted during 1993 and 1997. However, by 2003, judges' answers to the questions reflected a cooler stance toward accountants in general and a more stringent view of the auditor's role.
One perspective that shifted significantly was agreement with this statement: "The current standards of the audit practice are very high." In earlier surveys, judges expressed mild agreement with that claim. Their scores on that 10-point scale averaged 6.1 in 1993, but had dropped to 4.7 by 2003.
Asked whether auditors should share corporate losses during hard times, judges' agreement went from an average score of 2.9 in 1993 to 4.3 in 2003. In other words, judges felt more strongly that this was true in post-Enron days.
The researchers also surveyed views on auditor independence by testing agreement with the statement, "The big corporations and their big auditors (CPAs) work hand in glove and only tell the public what they want to tell them." In 1993, judges still scored below midpoint on that statement, giving an average agreement level of 4.8. By 2003, the views were closer to the "strongly agree" end of the scale, coming in at 6.2. According to Reckers et al., such responses signal an increased distrust of auditor independence.
By 2003, judges also felt more strongly that auditors should be watchdogs for the public good, that they should insure the market against large shareholder losses, and that they search for fraud, no matter how small the amount.
It's disconcerting for auditors that judges' views of them have taken a dive, but the more important issue is the divergence between "the auditor mentality and the judicial mentality" when it comes to liability, Jennings says.
She maintains that judges want more from auditors. They want the auditors to tell the truth, probe deeper, uncover more problems, find everything that should be found.
But auditors, she continues, "tend to have a computerized approach. There are sampling techniques that they use," rather than looking at every single transaction.
"If you look at every transaction, costs will go through the roof," Reckers says. "and, there aren't enough auditors out there to do it."
Auditors traditionally have looked for "material" fraud, which might be defined, for example, as anything more than 5 percent of net income or a particular percentage of total assets.
"What's happened over the last five years is that the Securities and Exchange Commission has said that what definitely matters are the bigger dollar items, but auditors also have to worry about qualitative characteristics," says Pany.
For example, if management pockets a few thousand dollars and, therefore, "is involved in fraud of financially immaterial amount, that's considered more important than if Joan, the bookkeeper, ran off with $2000. Management integrity issues must go to the audit committee, a subset of the board," he explains.
Management fraud "speaks volumes about the character of the people running the company," Jennings adds.
Because such qualitative issues now count to the SEC, the line between material and immaterial fraud has blurred. Auditors no longer can hide behind tidy equations.
"If the line between material and immaterial fraud is not clearly defined, you don't know where the court will go. It could go anywhere," Reckers says.
And, it just might go against auditors' best interest.
When the researchers surveyed third-year law students and second-year MBA students, they were testing the waters in which tomorrow's judicial and business leaders will swim. The team also surveyed second-year auditors, who are young, but already navigating their way through the corporate world.
What the researchers found was that judges shared almost identical opinions with law and business students, while the young auditors' views were dramatically different.
For instance, auditors "strongly agree" that auditors rely on samples because "they cannot look at every client transaction." In fact, auditors scored 9.5 on that 10-point scale. The others surveyed only scored 5.8 to 6.0.
Similarly, auditors strongly believe financial statements are primarily management's responsibility. However, the rest of the survey respondents were lukewarm in their agreement response.
There also are dramatic disagreements in views of the auditing profession. Auditors believe their standards are very high, and they average a score of 7.5 on that question. Judges, law students and MBA candidates give them no more than a 4.8. Similar divergence shows up in responses to statements that auditors maintain professional independence, and that they should share in corporate losses.
Although Pany says such diverging views between auditors and judges are long-standing, they are still of concern given today's business climate. "The number of lawsuits against CPA firms is lower than it used to be, but they're still sitting on about 20 blockbuster cases that potentially are so big, they could make a CPA firm fail," he says. In each case, damage claims top $1 billion.
Facing that much legal vulnerability, are auditors taking note of the shift in judges' attitudes? Are they working harder to be watchdogs for shareholders? "If their costs are any indication, they are," Jennings says.
She adds that in the post-Enron world, auditors are less likely to be influenced by corporate managers or let controversial items go. "They've been burned," she says. "They're asking tougher questions and showing more backbone."
- Contrary to popular belief, judges aren't completely objective on the bench.
- Research shows that judges bring personal experiences and opinions into the courtroom, and established attitudes affect their decision-making.
- The attitudes judges hold toward auditors have eroded since the accounting debacles of Enron, WorldCom and others earlier in the decade.
- Not only do judges have lesser views of auditors, they also have conflicting views with auditors. In fact, auditors see their roles and standards differently than those in both legal and business communities.