The Weight of the Relation

THE PERSONAL RELATIONSHIP ESTABLISHED BETWEEN MONITOR AND SUPERVISEE CAN BE A DOUBLEEDGED SWORD IN TERMS OF THE QUALITY OF ACCOUNTING CONTROLS. FOR THIS REASON, A STUDY SUGGESTS THE COMPULSORY ROTATION OF CORPORATE AUDITORS, SO AS TO REDUCE AUDITING MALPRACTICE RESULTING FROM UNETHICAL BEHAVIOR FUELED BY CAPTIVE RELATIONSHIPS

by Alessandro Iorio, assistant professor at Department of management technology

In December 2001, Enron Corporation filed for bankruptcy protection in a New York court, triggering one of the largest corporate scandals in U.S. history. Such an event happened just months later analysts and investors began to scrutinize Enron’s financial statements. In a nutshell, Enron's leadership fooled regulators with fake holdings and off-the-books accounting practices. Arthur Andersen—Enron’s accounting firm at the time and one of the five largest audit and accountancy partnerships in the world—contributed to such a disaster by failing to have its client establish and enforce its own internal control, and it was dissolved right after.
Although the word “monitoring failure” may not immediately ring a bell with you, I am sure that, at some point in your life, you have read or heard about the Enron scandal and discussed many other similar cases with your social circle; for example, the infamous oil spill that involved British Petroleum and the Minerals Management Service. Such instances represent monitoring failures, that is, situations in which monitoring agents failed to detect or report infractions by the firms they were monitoring.

Why might someone charged with monitoring a firm fail to do so? In a study with Brandy Aven (Carnegie Mellon University) and Lily Morse (West Virginia University), we shed light on this question by arguing that monitoring agents, despite being tasked with detecting and reporting infractions, often fail to do so given their potential challenges and competing concerns. In particular, we theorize that personal relationships between monitoring agents and those they oversee—naturally emerging as people work with each other—are a double-edged sword for monitoring quality. On the one hand, as relationships between parties grow stronger and incorporate trust, monitoring quality improves due to monitoring agents being able to acquire critical information, absorb tacit knowledge, and secure cooperation from their counterparts, thus enhancing their ability to detect issues and errors. On the other hand, these very same relationships that grow stronger may impair monitoring quality by encouraging undesirable behaviors, such as positive bias toward the monitored firm, a lack of due diligence, and an increased willingness to collude.

To reconcile these seemingly divergent predictions for the effect of relationship strength and trust on monitoring quality, we proposed that relationship strength has a non-linear effect on monitoring quality, which we operationalized as financial restatements. Revisions of previous financial statements are more likely to occur for very weak or very strong relationships between parties, whereas relationships of moderate strength are associated with few monitoring errors. Weak relationships exhibit low trust, lack of coordination, and reduced information sharing, which makes them susceptible to monitoring failures in the form of unintentional errors. As monitors develop strong and trusting relationships with members of firms, the risk of unintentional errors diminishes, but regulated firms can potentially take advantage of the relationship strength, whether by exploiting the monitor’s complacency or through outright collusion leading to intentional errors.

Triangulating results from a longitudinal archival study of U.S. commercial banks and their auditors, a survey of certified public accountants (CPAs), and an experimental audit simulation, we find strong evidence in support of our arguments. In particular, the archival study indicated that, as a bank and an auditing firm start working together, tenure initially reduces monitoring failures, but restatements begin to increase after approximately 5.7 years in the relationship. Surveying CPAs and manipulating variables in a controlled lab setting helped us to further nail down the causal mechanisms at play.
This study offers some interesting policy implications. For example, it suggests that the mandatory auditor rotation programs favored by government agencies may reduce audit failures stemming from unethical behavior fueled by strong relationships, while inadvertently increasing audit failures overall due to coordination challenges at the onset of auditing relationships. Policy makers should therefore design programs that weigh the trade-offs stemming from variation in relational strength.