In the midst of the greatest economic crisis of the post-war era, Bernard Madoff was forced to reveal the Ponzi scheme he had been running for years, when there weren’t enough funds to pay off the flood of redemption requests during this time of financial market turmoil. In fact, the trustee supervising the bankruptcy of Madoff’s funds recently revealed that “not a single investment had been made on behalf of clients in 13 years” (1). But how could such a fraud occur? Similarly, how could Enron and WorldCom manage to hide losses for years, fooling investors and law enforcement regulators? Answering these questions is tricky, but preventing such events from happening is easy: there needs to be a change in the relationship between a firm and its accounting auditor.
Last month, the new head of the U.S. Securities and Exchange Commission (SEC), Mary Shapiro, promised U.S. Congress « to act aggressively to revitalize the embattled agency’s enforcement efforts » in order to protect investors’ interests and prevent scandals such as the Bernard Madoff’s Ponzi scheme. She argued that the SEC must be given the needed resources « to investigate and pursue those who cut corners, cheat investors and break the law » (2). Unfortunately, even with all of Mary Shapiro’s good intentions, the SEC will never be able to prevent all financial frauds and corporate scandals. Why? Because what the SEC can do is limited to tightening the screening of firms and investment funds, increasing the probability that a “thief” will be caught. Simply put, stronger law enforcement decreases the expected payoff of committing a crime. However, Bernard Madoff (and the people at Enron and WorldCom, for example) probably did not build their companies with the intention of stealing from investors. These perpetrators often behaved properly until something went wrong and decided (probably irrationally) to conceal it in their financial statements, sincerely believing they would make it up in the near future when returns or profits turned better. But this practice often becomes a self-reinforcing process of deceit as efforts to cover the previous period’s losses lead to a downward spiral, ultimately resulting in major corporate scandals.
Changing the relationship between a firm and its accounting auditor
There is a much better way to prevent Madoff-type Ponzi schemes and corporate scandals such as those of Enron and WorldCom. The key lies in the way auditing is done. Currently, all firms have an auditor that they usually deal with for long periods of time, likely due to the fact that these relationships evolve and create learning experiences that help managers increase their efficiency at running their businesses. This synergy raises productivity and long-term growth, and thus is good for the economy. However, that is what normally happens. Normality means that once in a while, there is going to be an outlier, and it is hard for the average investor or regulatory body to see it coming. Conflicts of interest can arise when the auditors of very large firms (like Arthur Andersen which audited both Enron and WorldCom) are paid millions of dollars per year in fees. Once in a while they might accept small irregularities to keep their important clients happy, especially if they think it will be corrected in the next period. In the case of Bernard Madoff, a three-person accounting firm was in charge of certifying his company’s books. Such a small accounting firm does not have any bargaining power and may have found it tempting to overlook discrepancies in the financial statements to ensure that their largest client would continue to retain their services.
So how do we prevent such scandals that create billions of dollars in losses, and damage investor confidence? The solution requires setting the accounting firms’ incentives appropriately to mitigate the conflicts of interest that currently exist. The intuition is simple: each institution involved with investors (i.e. stock-issuing companies, savings or investment funds (such as mutual or hedge funds), etc) should have to change their auditor every five years. At the end of a contract between a firm and an auditor, the company would have to get back into the pool of auditing agencies and choose another one. In this manner, the firm-auditor matches would stay efficient (i.e. the richest firms could still choose from the best accounting agencies, at higher fees). Furthermore, the new system would balance the incentives of both the company and the auditor correctly. Since another accounting firm would take over the work of the current auditor, each accounting firm would have a strong incentive to do its job properly. Consequently, this new system would be « self-regulatory », in the sense that it would monitor itself, with very little need for government intervention. The government could simply assist when a new auditor finds an inconsistency in the previous audited statements.
People invest their savings in stocks and various types of funds. They are at an informational disadvantage as to whether or not a firm and its auditor are acting appropriately, or if the investment fund and its auditor are running a Ponzi scheme à la Madoff. This proposed new system would ensure that auditors would have incentives to always stick to the Generally Accepted Accounting Principles to protect their reputation, reducing the likelihood of their cooperation with firms whose managers act unethically. More importantly, it would save the enormous cost on society that a Madoff or Enron-type scandal causes. Granted it would be a drastic and expensive change in the way business is conducted in the U.S.; however, changes of this magnitude occur only in tough times, which we are in now. Robert Shiller, Professor of Economics at Yale University and author of the book “Irrational Exuberance” (3), claimed that « Financial innovation only comes in times of crisis. [...] We are in a revolutionary period of profound change. »(4) Indeed, we are.
(3) Shiller, Robert J., “Irrational Exuberance”, Princeton University Press, 2nd edition, 2005, 344 pages.
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