structure executive compensation in such a way as to reduce the incentives for executives to engage in unproductive activities. However, managements’ compensation is, of necessity, tightly tied to success—as reported by management! A board of directors’ decision to renew the executive’s contract, the movement of stock prices, and the achievement of stated criteria for performance bonuses are all functions of corporate data; corporate data that are prepared by management. Certainly, there are other sources of information (news reports, independent analysts’ reports, direct observation of products and traffic at stores, etc.) but most of the information about most corporations comes from insiders whose current compensation and career prospects are directly tied to the content of that information. That so much of a manager’s prospects is reliant on information that the manager is responsible for providing creates a strong temptation for the manager, if the truth is not flattering, to manipulate the information that is released. Even managers who do not wish to mislead the public can make self-serving judgments and estimates (accounting is a far less concrete and definite art than most outsiders recognize) without fully recognizing their own biases (Bazerman and Tenbrunsel, 2011; Moore et al., 2006; Bazerman et al., 1997; Kunda, 1990). To reduce the ability of managers to report incomplete, misleading, or even fictional accounts of their company’s performance, modern corporate governance systems use several mechanisms. The primary explicit mechanism is the financial audit, the focus of this paper. Before the company’s financial reports are issued to shareholders and the market, an independent, external accounting firm is hired to audit the financial statements prepared by the issuer. The task of the auditors is to assure that items are
of improbably smooth earnings growth, no one has accused them of any illegal accounting, though they did settle a suit in 2009 by the SEC for accounting violations for accounting violations that occurred earlier in the decade. KPMG, the auditor, has not been charged in the case (Norris, 2009). Note that both GE’s earnings smoothing and Lehman’s Repo 105 transaction were both deliberately misleading. Nevertheless, neither action unequivocally violates GAAP or the law. Given this discretion and the fact that management oversees the audit, why don’t auditors always report as management would like? How can audits be, in any real sense, “independent”? We are hardly the first to have noted the potential problems induced by management overseeing the “independent audit” (see Healy and Palepu, 2001, for a review). The received literature includes four lines of argument as to why the private market might deliver high-quality, independent audits even when the conflicted manager is responsible for contracting for the service: (i) commitment to professionalism; (ii) the market disciplining effects of reputation; (iii) the deterrence of legal liability; and (iv) owner oversight of auditors. We now discuss, in turn, each of these lines of argument, considering the basic theories and their potential weaknesses. Professionalism The rhetoric of the accounting profession surrounding issues of independence has traditionally emphasized the notion of professionalism and character. Thus, for example, representing the accounting profession, Gary Shamis testified before the SEC in 2000 that rules limiting the ability of auditors to cross-sell consulting services were unnecessary because: “We are professionals that follow our code of ethics and practice
of studies would be down-weighted. Perhaps only evidence from “independent evaluations” would be accepted. Definition Requiring an “independent evaluation” is only meaningful if that term is defined and in some way limits how a study is run. In part, this corresponds to the “rules” of the accounting profession. Such “rules” should be crafted—as much as possible—so that evaluators would serve policy makers rather than the agency being evaluated. To consider how to do that, we return to the four strategies identified in the accounting literature--professionalism, reputation, liability, and owner control—but in a different order. For each strategy, we consider to what extent they are currently applicable and reforms that might make them even more effective. “Owner” Oversight Current evaluation practice has only minimal “owner oversight.” The “evaluation shop” of the agency being evaluated usually runs the evaluation. That shop chooses the evaluator—sometimes putting current or past staff of the operating agency on the proposal review committee—and reviews and approves the evaluator’s plans. It controls the flow of information—what and when—to the Technical Working Group (TWG). That shop reviews and approves the evaluator’s report and any public discussion of evaluation results—orally at conferences, and in writing in journal articles and position papers. As a consequence, simple refusal to release project reports is the most common form of agency interference. Personal experience and discussion with other evaluators suggests that the threat of refusal to release will often induce an evaluator to accede to all but the most egregious requests/demands.