Auditors need to escape the Prisoner’s Dilemma

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Quis custodiet custodes? The Latin phrase is a reminder that the question who guards the guards is hardly new. Now regulatory bodies must take responsibility not just for accounting standards, but for standards of accounting.

Last week, the Japanese arm of PwC was suspended from practising for two months for complicity in fraudulent accounting at Kanebo, the cosmetics company. This is the latest in a series of accounting scandals that have destroyed Arthur Andersen and afflicted every major firm. The common feature is that the auditor is too close to the client. The result for the profession is that business has never been so good and public esteem never so low.

The process of sustaining reputation illustrates the most famous problem in game theory, the Prisoner’s Dilemma – rational crooks shop each other to their own ultimate disadvantage. For a single enterprise in a respected profession, or an individual practitioner in a respected firm, the most profitable strategy is to benefit from the reputation for rigour and integrity established by others without contributing to it oneself. But since free riding is the most profitable strategy for everyone, these reputations are eroded.

The Prisoner’s Dilemma is a powerful and insidious problem because everyone can recognise the undesirable consequences of their behaviour and yet continues to engage in it. Thieves will agree on the need to remain silent, but still confess if the result is a shorter sentence for them. Accountants will pontificate on the need to maintain high ethical standards and return to their offices ready to go the extra mile to please their corporate clients. To see the paradox is not to resolve it.

Economic theory and practical experience show that the only means of escaping the dilemma are repeated trials and changed incentive structures. For organised criminals to stay in business, they must look after their jailed accomplices’ families and seek revenge on those who violate the requirements of honour among thieves. The Mafia needs restrictive agreements to remain viable and for a long time so did the professions.

Professional self-regulation was based on cartels. Firms competed with each other in very gentlemanly ways. The rewards of partners were linked to seniority rather than to personal contribution. With revenue shares fixed, there was no conflict between the interests of the partnership and those of its members, or between the interests of the profession and those of professional firms.

But, as with all restrictions on competition, these arrangements kept prices and salaries high, and discouraged innovation and enterprise. Self-regulation broke down as enthusiasm for market forces was reignited in the 1980s. In professional firms, a more individualistic culture promoted a shift from a partnership ethos to eat what you kill.

The merit of competitive markets is satisfied customers and so it is with supervisory services. If property owners hire the police, policing strategies will suit property owners; if burglars hire the police, policing strategies will suit burglars. Since the audit process is one in which the property owners – the shareholders – pay for the police and the potential burglars – the corporate executives – appoint them, we should expect scrutiny to be costly but not rigorous and frequently this is what we find.

The main solutions proposed have been of the separation of audit from consultancy and the rotation of audit partners or even audit firms. These address some manifestations of the problem, but not the fundamental conflict: as long as managers appoint auditors that conflict is inescapable. A radical approach would deprive them of this power of appointment. A more realistic approach would audit the audit process itself.

Quis custodiet custodes? The phrase is a reminder that the question of who guards the guards is hardly new. Throughout history, the answer has been other guards, charged with this responsibility. Regulatory bodies must take responsibility not just for accounting standards, but for standards of accounting; and acquire powers of inspection that are not dependent on complaint and in which the fact of investigation carries no stigma. The purpose is not to name and shame delinquents, but to give auditors backbone to resist pressure from their clients and to restore the ethos that has been undermined as accounting has shifted from liberal profession to competitive business.

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