Auditors, Lawyers and the Lack of “Independence” — Bias and Financial Incentives
We are surrounded by bias in a variety of contexts – news, politics, books and Internet information. Given the overwhelming amount of information, some find comfort in information supplied by sources with a bias. We have become comfortable with some level of bias. The key is to understand the bias, the lack of objectivity and then filter the information.
Given the highly-charged political and news discourse, it is always important to seek objective information or take the information in with a discount. The increased acceptance of a “bias” source of information may be affecting our overall judgment as to certain “independence” and objectivity requirements in the professional context.
To understand this phenomena, let’s look at a few important areas where objectivity is important but more often it is ignored or discounted.
Financial Auditors: Financial auditors often have multi-year relationship with large corporate clients requiring preparation and filing of financial reports in accordance with Sarbanes-Oxley. The financial audit industry was big prior to Sarbanes-Oxley but mushroomed to even greater importance in the business world. Corporate audit committees provide critical oversight and monitoring of the auditing process, and internal auditors play a vital and important role in managing a company’s internal financial controls.
Going back to the “outside” auditor function, there is an inherent conflict in the client-auditor relationship. Auditors earn large fees for reviewing a company’s financial results. These audits include critical audit standards relating to “material” transactions, an overall assessment of the company’s internal controls, and accurate recording of financial accounts and results. Auditors have professional standards that apply to their work.
The Public Company Accounting Oversight Board is charged with oversight and regulation of auditors and financial audits of public companies. In reaction to the 2002 financial reporting scandals, the PCAOB’s authority was enhanced. Unfortunately, the PCAOB has an uneven record of enforcement and continues to “regulate” the industry with questionable vigor and impact.
The record of the auditing industry, particularly surrounding scandalized companies, reveals the important bias or lack of objectivity. For example, in the case of Wirecard, E&Y allegedly failed to account for $2.3 billion (with a B) missing from Wirecard’s accounts. The road of auditor failures continues this year with Luckin Coffee and NMC Health. Of course, auditor failures have an ugly history during the early 2000s with enron, Lehman Brothers, WorldCom and others.
The litigation landscape is littered with large numbers of liability cases against auditors for audit failures. At its core, the fundamental bias problem exists – large audit clients pay millions in annual fees to auditors. The PCAOB has not yet instituted a requirement that a company switch auditors every 10 years or some defined time period. But such a requirement does not do much to diminish the fundamental conflict of interest underlying the auditors’ objectivity.
Law Firm “Independent” Investigations: In response to potential misconduct or a government-launched investigation, companies will often initiate a so-called independent investigation to determine the facts surrounding the potential misconduct. Once the investigation is completed or as preliminary findings are reached, the company can take important steps to address the consequences and remediate the problem. Companies will often cite the engagement of a law firm to conduct an “independent” investigation.
The definition of “independent” in this context is important. Some companies take a narrow view and interpret independence to mean “not done by corporate staff.” Depending on the context, other companies will retain a law firm with which they have an existing client relationship but hire the firm, sometimes because the firm is already familiar with the company’[s business and its operations. A third alternative is a truly independent investigation by a law firm with which the company has no pre-existing relationship.
The danger of bias with a law firm can be significant. A law firm that depends on its relationship with the company-client may hold back or look for innocent explanations of evidence that can be interpreted in a negative way. If you read through FCPA and OFAC enforcement actions, the government often cites internal investigation or internal audit miscues and failures to detect the misconduct. This reflects a poor record of serving a client, meaning the firm held back from discovering and reporting the actual truth or engaged in a slip-shod investigation. These are troublesome occurrences and reflect again a bias to favor the company, possibly because the law firm wants to maintain an existing relationship with the company.