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HARVARD BlISINLSS RLVIEW

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Why Good Accountants Do Bad Audits

The Roots of BiasPsychological research shows that our desires powerfullyinfluence the way we interpret information, even whenwe're trying to he objective and impartial. When we aremotivated to reach a particular conclusion, we usuallydo. That's why most ofus think we are better than aver-age drivers, have smarter than average children, andchoose stocks or funds th at will outperform the m ark et-even if there's clear evidence to the contrary. Withoutknowing it, we tend to critically scrutinize and then dis-count facts that contradict the conclusions we want toreach, and we uncritically embrace evidence that sup-ports ou r positions. Unaware of our skewed informationprocessing, we erroneously conclude tha t our judgmentsare free of bias.

Many experiments have demonstrated the power ofself-serving bias and shown, for example, how bias can

distort legal negotiations.̂ In one series of experiments,which we describe in a 1997Sloan Management Reviewarticle, pairs of participants were given police and med-ical reports, depositions, and other materials from alawsuit involving a collision between a motorcycle anda car and were assigned to the role of either the motor-cyclist plaintiff or the car-driving defendant. They weregiven the task of negotiating a settlement and were toldthat if they couldn't reach o ne, a judge would decide theaward amount, and hoth parties would pay substantialpenalties. Finally, before starting the negotiation, eachparticipant was asked to predict the amount the judge

would award the plaintiff if negotiations stalled. Tofurther eliminate bias, each member of the pair wasassured tha t the other p arty wouldn't see his or her esti-mate and that the estimates would not influence thejudge's decision.

The results were striking. Participants playing the mo-torcyclist plaintiff tended to predict that they'd receivedramatically larger awards than the defendants pre-dicted. This is an example of self-servingbias: Armed withthe same information, different people reach differentconclusions-ones that favor their own interests. In addi-tion, the degree to which thetwo hypothetical awards dif-

fered was an excellent predictor of the likelihood tha t thepair would negotiate a settlement.The greater the differ-ence in the nego tiators' beliefs, the h arder itwas for themto come to agreement.

Max H. Bazerman is the Jesse Isidor Straus Professor of Busi-ness Administration at Harvard Business School in Boston.He is the author of Judgment in Managerial Decision Mak-ing (John Wiley & Sons, fifth edition,2001). George Loewen-stein is a professor of economics an d psychology at CarnegieMelton University in Pittsburgh. Don A. Moore is an assistantprofessor of organizational behavior and theor y at Carnegie

Mellon's Graduate School of Industrial Administration.

How can such an impulse toward self-serving bbe moderated? In follow-up experiments, the samesearchers tried to reduce participants' bias by paythem to accurately predict the amount of the judaward and having them v^rite essays arguing the oside's point of view. Neither strategy reducedbias; partipants consistently thought that the judge would awdamages that favored their side. And what about eduing the subjects, alerting them that they were likelyreach biased conclusions? That didn't work, either. Ateaching participants about bias and testing themmake sure they understood the concept, the researcfound that the participants concluded that their negating opponents would be highly biased but refusebelieve that they themselves would be.

In yet another of these experiments, participants wpresented with 16 arguments-eight favoring the sthey had been assigned (plaintiff or defendan t) and e

favoring the o ther - and were asked to pred ict howa

netral third party would rate the quality of the argum eIn general, study participants found arguments thatvored their own positions more convincing than ththa t supported the othe r side. But when participants wassigned to the role of plaintiff or defendant only athey'd seen the case m ateria ls-and so were unbiasetheir evaluation of the data-their degree ofbias was snificantly less. Taken toge ther , these findings suggest thunconscious bias works by distorting how people inpret information. •

Accoun ting for Bad AccountingProfessional accountants might seem immune to sbiases (after all, they work with hard numbers and guided by clear-cut standards). But the corporate auing arena is a particularly fertile ground for self-servbiases. Three structural aspects of accounting create stantial opportunities for bias to influence judgment

Ambiguity. Bias thrives wherever there is the pobility of interpreting information in different wayswe saw in the study involving the collision, people tto reach self-serving conclusions whenever ambig

surrounds a piece of evidence. While it's true that maccounting decisions are cut-and-dried-establishinproper conversion rate for British pounds, for instaentails merely consulting daily foreign exchange ramany others require interpretations of ambiguous inmation. Auditors and their clients have considerable way, for example, in answering some of the most bfinancial questions; What's an investment? What'sexpense? When should revenue be recognized? interpretation and weighting of various types of inmation are rarely straightforward. As Joseph BerardArthur Andersen's former chief executive, said in

congressional testimony on the Enron collapse, "M

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people think accountingis a science, where one number,namely earnings per share, isthe number, and it's sucha precise num ber tha t it couldn'the two pennies higher ortwo pennies lower. I come from a school tha t says it reallyis much more of an art." (See th e sidebar "Ambiguity inAccounting and Auditing.")

Attachment. Auditors have strong business reasons toremain in clients' good graces and are thus highly moti-vated to approve their clients' accounts. Under the currentsystem, auditors are hired and fired by the companiesthey aud it, and itis well known that client companies fireaccounting firms that deliver unfavorable audits. Evenif an accounting firm is large enough to absorb the lossof one client, individual auditors' jobs and careers maydepend on success with specific clients. Moreover, in re-cent decades, accoun ting firm s have increasingly trea tedaudits as ways to buiJd relationships that allow them tosell their more lucrative consulting services. Thus, from

the executive team down to individual accountants, an

auditing firm's motivation to provide favorable auditsruns deep.As the collision case also showed, once peopleequate their own interests with another party's, they in-terpret data to favor that party. Attachment breeds bias.

Approval. An audit ultimately endorses or rejects theclient's accounting~in other words, it assesses the judg-

ments tha t someone in the client firm has already made.Research shows that self-serving biases become evenstronger when people are endorsing others' biased judg-ments-provided those judgments align with their ownbiases-than when they are making original judgmentsthemselves.^ In one series of studies, researchers foundtha t people were more willing to endorse an overly gen-erous outcome that favored them than theywere to maketha t judgm ent themselves. For example, if someone saysthat you deserve a higher raise than facts might suggest,you are m ore likely to come to agree with this view tha nyou are to decide on your own that you deserve a higher

raise.This kind of thinking implies that an au ditoris likely

Ambiguityin Accounting and AuditingEach year. Money magazine sends the financial records ofahypothetical fam iiy to30 to 50 professional tax preparers andasks,"How much does this family owe in taxes for the year?"No two preparers ever agree. The range ofanswers is shocking.In 1998, the range varied from$37,715 to $68,912,a differenceof 83%.However, these tax professionals couid be proud th at

they agreed far more than did their colleagues who performeda similar exercise in i9 9o : That group's results ranged from$6,807 to $73,247.a 976% difference.

How could experts disagreeso vastly on something thatseems as objective as accounting? It turns ou t that d ecidingwhat is income, what is deductible, and what is an appropriatedepreciation schedule is subjective.Judgment calls are part ofa tax preparer's work . Similarly, ata corporate level, a myriadof ambiguous accounting questions,such as when to recognize

revenue and which items to expense, opens the door forself-serving interpretations.An item such as late-stage R&D thatone auditor might regard as an investment can be seen byanother as an expense. W ith executives deciding how to stateearnings, the two treatmentscan significantly affect the bot-tom line reported to the public.

Another indication of ambiguity in accounting is the com-mon prartice of negotiating about accounting rules. In onestudy by Michael C ibbins, Steven Salterio, and Alan Webb of93 audit partners working for international accounting firms,67% reported that they commonly negotiated with50% or moreoftheir clients. These negotiations, for example, might involve

the timing o frevenue and expenses recognition. Executives areoften in a hurry to recognize revenue but prefer to delay recog-nizing an expense. If there were sucha thing as"correct" tim -ing, these negotiations wouldn't take place. Another indicationof auditing a mbigu ity is the tendency of clients to opinion-sh op -th at is,to ask multiple auditors to interpret specific ac-coun ting problems before deciding whom t o h ire. Because no"right" conclusion exists, different auditing firms can have dif-ferent opinions.

Finally, in the current political discussion about expensingoptions, opponents of expensing often argue that an option'svalue is too ambiguous to assess. They proffer am biguity as ajustifica tion fo r ignoring the value of options executives receive

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to accept more aggressive accounting from her client thanwhat she might suggest independently.

In addition to these structural elem ents that promotebias, three aspects of human nature can amplify uncon-scious biases.

Familiarity. People are m ore willing to harm strangers

than individuals they know, especially when those in-dividuals are paying clients with whom they have ongo-ing relationships. An auditor who suspects questionableaccounting must thus choose, unconsciously perhaps,between potentially harming his client (and himself)hy challenging a company's accounts or harm ing facelessinvestors by failing to object to the possibly skewednum bers. Given this tension, auditors may unconsciouslylean toward approving the dubious accounting.And theirbiases will grow stronger as their personal ties deepen.The longer an accounting partner serves a particularclient, the more biasedhis judgments will tend to be.

Discounting. People tend to be far more responsive toimmediate consequences than delayed ones, especiallywhen the delayed outcomes are uncertain. Many hum anvices spring from this refiex.We postpone routine dentalcheckups hecause of the cost and inconvenience and thelargely invisible long-term gain.In the same way, auditorsmay hesitate to issue critical audit rep orts because of theadverse immediate consequen ces-damage to the relation-ship, potential loss of the contract, and possible unem-ployment. But the costs of a positive report when a nega-tive report is called for- protecting the accounting firm'sreputation or avoiding a lawsuit, for example-are likely

to be distant and uncertain.Escalation. It's na tural for peop le to conceal or explain

away minor indiscretions or oversights, sometimes with-out even realizing that they're doingit. Think of the man-ager who misses a family dinner and blames the traffic,though he simply lost track of tim e. Likewise, an auditor'sbiases may lead her to unknowingly adapt over time tosmall imperfections in a client's financial practices. Even-tually, though , the sum of these small judgm ents may be-come large and shemay recognize the long-standing bias.But at tha t point, correcting the bias may require adm it-ting prior errors. Rather than expose the unwitting mis-takes, she may decide to conceal the problem. Thus,unconscious bias may evolve into conscious corruption-corruption representing the most visible end of a situa-tion that may have been deteriorating for some time. It'sour belief thatsome of the recent financial disasters we'vewitnessed began as minor errors of judgment and esca-lated into corruption.As Charles Niemeier, chief accoun-tant for the SEC's enforcement division, put it; "Peoplewho never intend to do something wrong end up findingthemselves in situations where they are almost forced tocontinue to commit fraud once they have started doingthis. Otherwise, it will be revealed that they had used im-

proper accounting in the earlier periods."

Putting Theory to the TestBias, by its very n ature ,is typically invisible: You can't review a corporate audit and pick out errors attribu table tbias. Often, we can't tell whether an error in auditing idue to bias or corruption . But you can design experiment

that reveal how bias can distort accounting decisions. Wrecently did just tha t, with telling results.We gave undergraduate and business students a com

plex set of information about the potential sale of a ftional company and asked them to estimate the companyvalue. Participants w ere assigned different roles: buyeseller, buyer's auditor, or seller's auditor. All subjectread the same information about the company. As wexpected, those who hoped to sell the firm though t thcompany was worth more than the prospective buyerdid. More interesting were the opinions offered by thauditors: Their judgments were strongly biased towar

the interests oftheir clients.These auditors displayed role-conferred biases in tw

ways. First, their valuations judgments) were biased ithe clients'favor: The sellers' auditors publicly concludethat the firm was worth more than the b uyers' auditosaid it was. Second, and moretellingly, their private judgments about the company's value were also biased itheir clients'favor: At the end of the experiment, the auditors were asked to estimate the company's true valuand were told that they would he rewarded according thow close their private judgments were to those of impartial experts. Despite this incentive for accuracy, th

estimates of the sellers' auditors averaged 30% highethan those of the buyers' auditors. This exemplifies thpersistent influence of self-serving biases: Once particpants interpreted information about the target companin a biased way, they were unable to undo the bias late

Earlier this year, we ran a study with Lloyd Tanlu th afocused on professional auditors themselves. The studof 139 auditors employed full time by one of the big Uaccounting firms, illuminated the professionals' v ulneability to bias and their tendency to be infiuenced bclients'biases. Each p articipantwas given five ambiguousauditing vignettes and asked to judge the accounting feach. Half the participants were asked to suppose thathey had been hiredby the company they were auditingthe rest were asked to suppose they had been hired bydifferent company, one thatwas conducting business withthe company that had created the financial statemen ts. Inaddition, half the participants in each of thosetwo groupsgenerated their own auditing num bers first, then statewhether they believed that the firm's financial reporcomplied with generally accepted accounting principl(GAAP), while the o ther half did the two tasks in the rverse o rder.

For all five vignettes, the auditors were on average30%more likely to find hat the accounting behinda company's

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financial reports complied with GAAP if they were play-ing the role of auditor for that firm. Furthermore, the par-ticipants who generated their own auditing numbersafter first passing judgmenton the company's financial re-ports tended to come up with numbers that were closerthan the other participants' to the client's num bers. Thestudy showed both that experienced auditors are not im-mune frombias and tha t they are more likely toaccede toa client's biased accounting numbers than to generatesuch num bers themselves.

These experiments show that even the suggestion ofahypothetical relationship with a client distorts an audi-tor's judgments. Imagine the degree of distortion tha t mustexist in a long-standing relationship involving millions ofdollars in ongoing revenues.

Problems with Proposed Reforms

Because the reforms in the Sarbanes-Oxley Act and thoseproposedby othersdo not address the fundamental prob-lem ofbias,theywill not solve thecrisis in accountingin theUnited States. Some of the reforms,in fact, may well make it worse.

Consider the provisions dealingwith disclosure. They require indi-vidual auditors or their firms toreveal conflicts of interest to inves-tors. But to counteract bias, suchdisclosure must either inhibit biasoutright or allow investors to adjust

for it. Neither is likely. With regardto inhibiting bias, we saw earlierthat a person's conscious efforts toreduce bias have limited effect. Andthe latter idea, that disclosure wouldhelp investors interpret auditors'reports, would be of little benefitunless investors knewhow a disclos-ed conflict of interest biased an au-ditor's judgment. Imagine an inves-tor who readsa positive audit reportcontaining the caveat that the audi-tor receives $60 million in annualfees from the audited company. Byhow much should the investor adjustthe com pany's self-reported earningsper share? Without specific guid-ance, people cannot accurately fac-tor conflict of interest into theirInvestment decisions.

More worrisome is evidence tha tdisclosure could actually increasebias. If auditors suspect that disclo-sure will lead investors to discount

or make adjustments for the audi-

Because of the tightrelationships between

accounting irms and their

clients, even the mosthonest

and meticulous of auditors

can unintentionally

distort the num bers.

tors'public statements, they may feel less duty bound tobe impartial and may make judgments more closelyaligned with their personal interests. Researchby DaylianCain, Don Moore, and George Loewenstein paired par-ticipants and assigned one member of each pair to therole of estimator and the other to that ofadviser. The es-timator viewed several jars ofcoins from a distance, esti-mated the value of the money in them, and was paid according to how close the estimates were to the jars'truevalues. The adviser, who could study the jars up close,gave the estimator advice. The adviser, however, was nopaid according to the estimator's accuracy but accordingto how high the estimator's guesses were, ln other wordsadvisers had an incentive to mislead the estimators sotha t they would guess high.

In addition,we told half of the estimators about the ad-visers'pay arrangement; we said nothing about it to therest. Disclosure had two effects. First, advisers whose mo

tives were disclosed provided much more biased guesses(i.e.,high estimates of coin jar values) than did adviserswhose motives were not disclosed; second, disclosure

did not cause estimators to substan-tially discount their advisers' advice.As a result, disclosure led advisers tomake much more money and esti-mators to make much less. Appliedto auditing, this finding suggeststha t auditors who are forced to dis-close conflicts m ight exhibit greaterself-serving bias.

One other proposed policy war-rants mention: the move to imposestricter accounting standards. Thisremedy, too, is unlikely to improvethe situation. Research shows thatit takes very little ambiguity to pro-duce biased judgments.' In onestudy, some participants were askedto imagine that they had workedseven hours on a task and thatanother person had worked tenhours on the same task. Other par-

ticipantswere asked to imagine th eopposite scenario: They'd workedten hours on the project whilethe other person worked seven. Ineach case, it was specified thatthe person who had worked sevenhours would be paid$25; the ques-tion was how much the personwho had worked ten hours shouldhe paid. Ten-hour participants, onaverage, thought that they shouldbe paid about $35 for their ten

hours of work, while those who

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had worked seven hours thought that the to-hour personshould receive less - about$30. Here,all it tookwas a tinybit of ambiguity-whetherthe fair solutionwas equalhourly pay (as the ten-hour people thought) or equal totalpay (asthe seven-hour people thou gh t)- to producedif-ferent self-serving assessmentsof fairness. Note,too, thatthe incentivesfor being biased in this study were awfullyweak hecausethe question was hypothetical;in the realworld, incentivesfor bias are far stronger. It seemsim-plausible that stricter accounting rules could eliminateambiguity-and thus theyare unlikely to reduce self-serving bias.

Radical RemediesThe key to improving audits, clearly,is not to threatenorcajole.It must beto eliminate incentives that createself-serving biases.This means tha t new policies must reduce

an auditor's interestin whether a client is pleasedby theresultsof an audit.One provisionof the Sarbanes-Oxley Act prohibitsac-

counting firms from providing certain consulting servicesto companies they audit. This isa step in the right direc-tion, but it doesn'tgo far enough. Clearly, accounting firm sthat advise their clientson how to boost profits, whileatthe same time tryingto impartially judge their books,face an impossible conflictof interest. This reform hothreduces this confiict andeases the pressure on auditorstoact as salespeoplefor their firm's other services. Unfortu-nately, whilethe new law limits the consulting services

auditing firmscan provide, it doesn't prohibit themen-tirely, andit gives the new oversight board createdby theSarbanes-OxleyAct the option of overriding this provision.

True auditor independence requires,as a start, fulldivestiture of consulting and tax services. And even then,a fundamental problemwill remain: Because auditors arehired and fired by the companies they audit, theyare inthe position of possibly casting negative judgmentson those who hired the m -an d whocan cut them loose.Therefore, even withthe eliminationof consulting,thefundamental structureof the auditing system virtuallyensures biased auditing.To eliminate this sourceof bias,

we must remove the threa t of being fired for delivering anunfavorable audit. Auditors must have fixed, imited con-tract periods during which they cannotbe terminated.All fees and other contractual details shouldbe specifiedat the beginningof the contract and must be unchange-able, ln addition,the client mustbe prohibited fromre-hiring the auditing firmat the end of the contract;in-stead, the major accounting firms wouldhe required torotate clients. Current legislation requires auditor rota-tion;however, this is defined as a change in the lead part-ner withinan auditing firm. Thereis no provisionto ro-tate the firms conductingthe audit, and there is no

provision to prevent a client from firing an auditor. Thus,

auditors will continueto have powerful incentivestokeep their c lients happy.

Audit clients must also be prohibited from hiring ividual accountants away from their audit firms.As theEnron scandal unfolded, the common practiceof ArthuAndersen employees taking positions with Enron,andvice versa, cameto light. Clearly,an auditor can'tbe im-partial whenhe or she hopes to please a client in ordeto develop job options. We believe that auditors shobe barred from taking positions with the firms hey audifor at least five years.

Less tangibly, auditors must cometo appreciatetheprofound impactof self-serving biaseson judgmenProfessional schools have begunto take ethics seriousin recent years,but teaching auditors about ethics wnot havean impacton bias. What's neededis educatiothat helps auditors understandthe unconscious errothey make and the reasons they make them. That kn

edge alone won't solvethe problem,but once memberof the auditing profession understandthe role of bias intheir work, honest and visionary leadersin the professiocan help change the conduct of accounting to preventconflicts of interest that promotebias.And audit leadewho say that so-called professionalismis a sufficient safguard against audit err or -a claim that's inconsistent the weightof empirical evidenceon human judgmenmight abandon that claimif they truly understoodtherole of biasin auditing.

Our proposals are not perfect. Indeed, it's hard to imine any practical system that could eliminate allbias.Even

with our remedies,for instance,it's still possible thatau-ditors'social contact with clients could introduce subiases.But we envision a system in which clients regarauditorsas more liketax collectors than partnersor ad-vise rs-a system that couldbe expected to at least ame-lioratebias. Devising a more robust separation of audand client,one that might go further to reduce biaswould require approaches-suchas turning overthe au-diting function to government-that could create prolems as serious as those theysolve.We see our proposaas both realisticand effective. In the absenceof radicaand innovative reform, we believe, further accountindi

sasters are inevitable. 0

1. This and subsequent studies aboutthe collision mentionedin this articwere conductedby Linda Babeock, Colin Camerer,Sam Issacharoff, andGeorge Loewensteinand are sununarizedin L. Babeockand G. Loewenste"Explaining Bargaining Impasse; The Roleof Seif-Serving Biases,"Joumal ofEconomic Perspectives, winter 1997.

2. K.A. D i e k m a n n ,S.M. Samuels , L. Ross, and M.H. Bazerm an, "Seif- lntereand Fairness in Prob lems of Resource Allocation: Allocators Versus Recents,"/oiirnci/of Personality and Social Psychology,May 1997.

3. D.M. Messick and K.P. Sends , "Fairn essand Preference," your/ia/of Experimental Social Psychology, July 1979.

R e p r i n t R 0 2 11 GTo order reprints, seethe last pageof Executive Summaries.

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