Checks & Balances - Who checks and Who balances

Integrity in reporting of accurate matrices for measurement of risk and return of traded instruments and checks and balance that ensure this reporting are critical requirements for any decent financial market. But when we follow the events that have been unfolding the world over, it appears that there is still some way to go.

The most critical issue with respect to the Satyam saga in India has also been this. The company had good people, a respected client base, history of high quality delivery and a profitable and growing business. But the owners milked the company for their personal greed and misreported the financial status. The behavior of the venerable audit firm Price Waterhouse as the company auditor has raised questions about how independent were these independent outside auditors.

This is not a one-off incident. Neither is it something peculiar to India or doings of some small time firms. Enron, WorldCom, and Xerox are recent history.

Arthur Anderson was accused of improper audits in financial scandals in a number of cases in USA and had to go in for settlement in many of them. Enron was the icing on the cake, which took the audit firm along with it to extinction.

SEC took action against KPMG with respect to violation of anti fraud provisions with its audit of Xerox. E&Y was also accused by SEC of violating independence rules.

This problem was not just with respect to collusion by independent auditors in perpetuating financial frauds. It has been pointed out that one of the root causes of the collapse of world financial markets in the recent past has been the failure of credit rating agencies in reflecting the true nature of risks associated with many structured products that have been rated by them.
Why do we see such irresponsible behavior from a large cross section of professionals and professional organizations? When we go a little deep into the reasons behind this, we see that the one of the main reasons has been the failure of the checks and balances in avoiding conflicts of interest.

There are two serious contributors to this conflict of interest with respect to the independent auditors. One is the extent of multi-disciplinary non-audit related services these firms offered to their clients like legal, consulting services etc. Realizing the conflicts associated with such practices we have seen a number of regulatory restrictions on such multi-disciplinary offers.

The other issue is that the audit firm is selected and their remuneration is fixed by the company management. Robert Prentice, professor of business law at the McCombs School of Business after exploring literature in psychology, decision theory, behavioral finance, and behavioral economics has suggested that auditors works are significantly affected by ‘self serving bias’. Based on behavioral experiments, Professors Bazerman, Loewenstein and Moore suggests that because of the subjective nature of accounting, and the close financial and personal ties of auditors and corporate managers, even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company’s true financial status. They have also referred to a study of 139 auditors employed at large U.S. accounting firms in which half of the participants were asked to assume that they were auditors hired by the company while the other half were asked to assume they were hired by another company that conducts business with the audited company. With respect to five given ambiguous auditing vignettes, auditors who were hypothetically hired by the audited company were on the average 30% more likely to find the financial reports complied with GAAP

Same is the case with incentive structure in the credit rating agency. The agency is paid by the entity who is getting its instruments rated and not by the investor who uses this rating for their investments. The criticality of these ratings are quite high because the regulators of capital market, banking , pension funds and mutual funds use these ratings to specify the asset quality mixture that brokers / banks / pension funds were allowed to hold. As Frank Partnoy a professor at the university of San Diego school of law observed “rather than selling opinions to investors, the credit rating agencies were selling licenses to borrowers”.


While stronger regulatory oversight can address these issues, more efforts are needed to develop models where the incentive structures would ensure better checks and balances.
Models suggested by Professor Joshua Ronen of New York University and Peter K M chan of US SEC are thought provoking in this direction.

The basic structure of Prof Ronen’s Financial Statement Insurance (FSI) may be described as follows :

‘Instead of appointing and paying auditors, companies would purchase financial statement insurance that provides coverage to investors against losses suffered as result of misrepresentation in financial reports. The insurance coverage that the companies are able to obtain is publicized, along with the premiums paid for the coverage. The insurance carriers then appoint and pay the auditors who attest to the accuracy of the financial statements of the prospective insurance clients. Those announcing higher limits of coverage and smaller premiums will distinguish themselves in the eyes of the investors as the companies with higher quality financial statements. In contrast, those with smaller or no coverage or higher premiums will reveal themselves as those with lower quality financial statements. Every company will be eager to get higher coverage and pay smaller premiums lest it be identified as the latter. A sort of Gresham's law in reverse would be set in operation, resulting in a fight to quality’.

The model suggested by Peter MK Chan is as follows:

‘The interests of auditors with those who have the greatest interest in accurate financial reporting and the investing public should align, making use of advances in Internet technology. The companies should be required to make available over the net significant amount of raw financial data on a real-time basis. Using these raw data the investor-hired auditors should be able to perform meaningful audits or reviews of corporate financial data. Regulations should also be directed toward ameliorating any negative effects associated with such increased access, including regulations designed to reduce litigation risks. The market will take care of the rest’.

I am not trying to analyze the pros and cons to the above proposals nor do I suggest that one of the above be adopted. The simple point I am making is that we should modify the regulatory framework to ensure that the checks and balances are built with no/ minimum conflicts of interest. And today is a good time to debate, indentify and implement such reforms, as we are in a world which has been rudely awaked to the risks of these conflicts of interest. Strike when the iron is hot.

The above is not just a case of public policy. It is also a lesson for any entity who is actively involved in defining or refining business processes in any organization.