Lingering lessons of Enron fiasco: Auditors' concern for reputation can backfire

New research shows that concern about preserving their good reputation can lead auditors to conceal the kind of irregularities that brought down not only Enron but the auditing firm Arthur Anderson, according to the Management Insights feature in the current issue of Management Science, a flagship journal of the Institute for Operations Research and the Management Sciences (INFORMS).

"The Auditor's Slippery Slope: An Analysis of Reputational Incentives" is by Carlos Corona of the University of Texas and Ramandeep S. Randhaw of the University of Southern California.

Management Insights, a regular feature of the journal, is a digest of important research in business, management, operations research, and management science. It appears in every issue of the monthly journal.

The authors consider whether the auditor-client contract should be subject to term limits.

The WorldCom and Enron debacles at the turn of the last century were a black eye for Arthur Andersen and the auditing community and led to the auditing restrictions included in the Sarbanes-Oxley Act of 2002, which requires auditors to remain more autonomous.

Auditors' concerns about their reputation are commonly perceived as having a positive effect on execution of their monitoring and attesting functions. The authors demonstrate that this concern can actually have the opposite effect.

Using game theory to analyze manager and auditor relationships, they illustrate how reputational concerns can actually induce an auditing firm to misreport.

Early undetected or unreported slight misconduct by a manager places the auditor in a bad position in future periods, when admission of prior transgressions tarnishes the auditor's reputation. They find that a strategic manager can lead the auditors down a slippery slope, with managerial fraud increasing as the length of the audit firm's contract progresses. In this scenario, as company fraud increases, the probability that the auditor will report it decreases. Ironically, the stronger the auditor's current reputation, the stronger is the incentive to misreport after the reporting omission of initial malfeasance.

The authors' lesson for management is that long-term relationships between auditing firms and clients can lead to inaccurate reporting despite - or perhaps because of - the auditing firm's good reputation.