THE ARTS This PDF document was made available from www.rand.org as a public CHILD POLICY service of the RAND Corporation. CIVIL JUSTICE EDUCATION Jump down to document ENERGY AND ENVIRONMENT 6 HEALTH AND HEALTH CARE INTERNATIONAL AFFAIRS The RAND Corporation is a nonprofit research NATIONAL SECURITY POPULATION AND AGING organization providing objective analysis and effective PUBLIC SAFETY solutions that address the challenges facing the public SCIENCE AND TECHNOLOGY and private sectors around the world. SUBSTANCE ABUSE TERRORISM AND HOMELAND SECURITY TRANSPORTATION AND INFRASTRUCTURE Support RAND WORKFORCE AND WORKPLACE Browse Books & Publications Make a charitable contribution For More Information Visit RAND at www.rand.org Explore Pardee RAND Graduate School View document details Limited Electronic Distribution Rights This document and trademark(s) contained herein are protected by law as indicated in a notice appearing later in this work. This electronic representation of RAND intellectual property is provided for non- commercial use only. Permission is required from RAND to reproduce, or reuse in another form, any of our research documents for commercial use. This product is part of the Pardee RAND Graduate School (PRGS) dissertation series. PRGS dissertations are produced by graduate fellows of the Pardee RAND Graduate School, the world’s leading producer of Ph.D.’s in policy analysis. The dissertation has been supervised, reviewed, and approved by the graduate fellow’s faculty committee. Private Firms Working in the Public Interest Is the Financial Statement Audit Broken? Abigail Bugbee Brown This document was submitted as a dissertation in October 2006 in partial fulfillment of the requirements of the doctoral degree in public policy analysis at the Pardee RAND Graduate School. The faculty committee that supervised and approved the dissertation consisted of Jim Hosek (Chair), Steve Bankes, and Molly Selvin. The Pardee RAND Graduate School dissertation series reproduces dissertations that have been approved by the student’s dissertation committee. The RAND Corporation is a nonprofit research organization providing objective analysis and effective solutions that address the challenges facing the public and private sectors around the world. RAND’s publications do not necessarily reflect the opinions of its research clients and sponsors. R® is a registered trademark. All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from RAND. Published 2007 by the RAND Corporation 1776 Main Street, P.O. Box 2138, Santa Monica, CA 90407-2138 1200 South Hayes Street, Arlington, VA 22202-5050 4570 Fifth Avenue, Suite 600, Pittsburgh, PA 15213 RAND URL: http://www.rand.org/ To order RAND documents or to obtain additional information, contact Distribution Services: Telephone: (310) 451-7002; Fax: (310) 451-6915; Email: [email protected] Abstract The Big Four accounting firms have become the object of much scrutiny following the string of financial statement fraud scandals at the beginning of this century. The apparent involvement of the large auditing firms in the accounting misdeeds comes as a surprise, since the academic literature on auditor incentives predicts that large, reputable firms will not engage in collusion with their clients. The lace of a consensus economic framework to understand the incentives facing the audit firms that reflects the histor- ical reality has hindered consensus building in the policy response to the scandals. This dissertation develops a principal-auditor-agent model that suggests there may well be socially sub-optimal levels of audit intensity, even among the best audit firms. It explores archival historical evidence to identify examples of how these incentives have shaped the profession and develops a more nuanced reading of the root causes of the recent scandals. This work also identifies the gaps in our understanding of the cost and occurrence of fraud that hinders a proper cost-benefit analysis of policy options designed to improve the quality of information available to the market. Acknowledgments Many thanks to Anne and James Rothenberg for their generous funding of both the proposal development award and the dissertation award that made this work possible. Thanks also to Andrea and Andy Ring for their hospitality and generosity that made the historical research portion of this work possible. Thanks to my committee for all of their help: Jim Hosek, Steve Bankes, Molly Selvin, and Eric Talley. Contents 1 Introduction 7 2 Cost-benefit analysis in the context of financial statement fraud 14 2.1 Fraudulent financial reporting vs. misappropriation of assets . 15 Degreesofmisleadingreporting................. 18 2.2 The aggregate cost of financial statement fraud ........ 19 Realizedcostsoffraud...................... 22 Dynamicmarketeffectsoffraud................. 27 2.3Changesintheincidenceoffraud................ 29 2.4Thecostsofareform....................... 32 2.5Conclusion............................. 36 3 Auditors’ responsibilities and institutions 37 3.1 The responsibilities of the independent public company auditor 37 Generally Accepted Accounting Principles ........... 38 Generally Accepted Auditing Standards ............. 40 3.2Theinstitutionsofauditing................... 40 Legalframework......................... 42 Current makeup of the auditing industry ............ 45 1 Self-regulatoryandstandard-settingbodies........... 48 3.3Conclusion............................. 53 4 Strategic interactions between auditors and management 54 4.1Reviewofthetheoreticalliterature............... 55 4.2Themodel............................. 61 Payoffs............................... 65 Equilibriumstrategies...................... 69 4.3PolicyImplications........................ 74 Informationquality........................ 74 Sociallyoptimaloutcome..................... 75 Proportional liability ....................... 79 4.4Conclusions............................ 82 5 Historical evidence: Model validation 86 5.1Auditordiscretion......................... 88 5.2Evidenceofauditintensitycalculations............. 92 5.3Evidenceofthe“compliantmanager”scenario......... 96 5.4Evidenceofthe“opinionshopping”scenario.......... 99 Auditorresignations.......................100 Perceiveddeclineinopinionshopping..............101 5.5Evidenceofthe“collusiveauditor”scenario..........104 5.6Conclusion.............................107 6 Historical evidence: Model extensions 109 6.1Internalfirmincentives......................109 6.2 Model extension: Attracting and retaining clients . 114 Importanceofsizeandexpertise.................117 2 Importanceofpersonalrelationships..............118 Bundlingservices.........................120 Competingonprice........................129 6.3Conclusion.............................130 7 Wilful blindness: A fourth equilibrium scenario 135 7.1 Model extension: Value of future engagements .........137 7.2Modelvalidation:Lackofauditorskepticism..........138 8 Facilitating wilful blindness 145 8.1Expectationgap..........................146 8.2Reducingpenaltiesofauditfailure................152 Legalpenalties..........................154 Lossofprofessionalreputation..................169 Lossofpersonalreputation....................178 8.3Conclusion.............................181 9 Policy recommendations 183 9.1Evaluatingreforms........................184 9.2Sarbanes-Oxley..........................186 Changingthepowertohireandfire...............187 Independentoversightandqualityinformation.........189 Frustratingthefinancingofinducementstocollusion.....190 Internalcontrols..........................191 9.3Furtherpossiblereforms.....................192 FinancialStatementInsurance..................192 Implementing truth-inducing mechanisms ............193 Governmentaltakeover......................194 3 Endmandatoryaudits......................194 9.4Conclusions............................195 A Generally Accepted Auditing Standards 214 B Formal model of auditor-manager strategic interactions 216 Extensiveformofgameandmodelparameters.........218 Equilibriumstrategies......................224 B.1PolicyImplications........................237 Informationquality........................238 Sociallyoptimaloutcome.....................239 Proportional liability .......................246 C Excerpts from the PricewaterhouseCoopers’ archives 254 C.1 Speeches to the Annual Partners’ Meetings given by John Biegler, 1971-1979 .........................255 C.2 Liability crisis excerpts (1926-2006) ...............261 C.3 “Expectation gap” memos by Herman Bevis (1961-1967) . 264 4 List of Figures 4.1Timelineofauditinggame.................... 63 4.2Auditinggame.......................... 66 4.3 Diagram of company outcomes and information quality . 78 6.1 McKinsey grid, reproduced in “Enhancing Firm Profitability: Priorities for Fiscal 1987-88” (Price Waterhouse & Co, 1986, 54).................................128 B.1Timelineofauditinggame....................217 B.2Auditinggame..........................219 B.3Firingsubgameinnormalform..................225 B.4Bribingsubgamesinnormalform.................227 B.5 Reduced extensive form auditing game if the bribing subgame resolvesinthe“compliantmanager”scenario..........231 B.6 Reduced extensive form auditing game if the bribing subgame resolvesinthe“opinionshopping”scenario...........235 B.7 Reduced extensive form auditing game if the bribing subgame