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Chapter 6. Investigation: Verifying the ... > The Question of Trust: Motives at th...

The Question of Trust: Motives at the Corporate Level

In the days before the fall of Arthur Andersen, close relationships between corporate management and independent auditors were not unusual. Some CEOs and CFOs were recruited from the auditing firms, so they had close ties with the auditing teams from the day they began their job at the corporate level. Auditing firms have a conflict relating to revenue, but there is enough conflict of interest to go around. There are a number of reasons that corporate management has its own conflict of interest in dealings with auditing firms, including

  1. The desirability of influencing an audit's outcome. Corporate executive compensation has historically been tied to earnings levels; the higher the earnings, the more incentive compensation. As a consequence, the executive has had a motive to push earnings as high as possible. This obvious conflict of interest led to many of the irregularities and outright misstatements discovered among many publicly traded corporations in 2001 and 2002. The problem had been building throughout the 1990s, and the range of practices included prebooking revenues, capitalizing expenses, and hiding liabilities in off-book partnerships and subsidiaries. A common thread in the many corporations where such practices took place was executive compensation. Anyone whose annual income included incentive compensation would be tempted to influence the outcome of an audit. Since the CEO and CFO worked directly with the audit team, it was not a problem to exert such influence, and since the audit team leader also had an incentive to produce nonaudit work for the accounting firm, it became increasingly difficult for either side to produce a truly objective, independent audit.

  2. Control over the stock price. The incentive-paid executive also had to contend with the uncertainties of stock prices. If the stock price fell, it was often seen as a failure on the part of the CEO or CFO. An earnings shortfall was a common reason for disappointing stock prices, so here again, the incentive-paid executive has always been tempted to ensure that the outcome of an audit would correspond with the earnings target so that investors, especially institutional investors, would continue holding blocks of stock.

  3. Control over forecasts of earnings. Another part of the equation that has caused problems in the past has been the relationship between corporate executives and institutional analysts. The earnings targets set by analysts were too often based not on any serious analysis of the numbers but on what corporate executives told the analysts. So, the executive had the ability to create earnings in line with forecasts; the auditors went along with accounting decisions that made those forecasts accurate; and analysts often would “predict” earnings that ended up being exactly right. The executive's incentive to ensure that earnings forecasts were accurate—supported by the analysts' own target estimates—made the entire system corrupt.


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