Issue of Self-Serving Bias and the Role of International Ethics Standards Boards

Table of Contents

INTRODUCTION

SECTION B

A Critical Appraisal of the Role of International Ethics Standard Board for Accountants

SECTION B

Self-Review threat

Intimidation threat

Practice Management Issues

CONCLUSION

REFERENCES

INTRODUCTION

This paper tends to look into behaviour known as “self-serving bias” trying to look at the implications of the behaviour as provided that “Whenever individual’s face a trade-off between what is best for themselves and what is morally correct, their perceptions of moral correctness are likely to be biased in the direction of what is best for themselves. It seems likely that the judgments of auditors, who ultimately represent the interests of the shareholders but are hired and fired by the people they audit, are likely to be blinded to some degree by the incentive for client retention.  Therefore the sole reliance on professional ethics to ensure desirable behaviour is a questionable resource for audit management¹.”

This paper is divided into three sections with in-depth research and knowledge carried out on each section. The paper starts with an in-depth research into the behaviour known as “self-serving bias” and, using relevant examples, with the application of the research to the special problems of auditor’s objectivity.

Furthermore, the role of the International Ethics Standards Board for Accountants (IESBA) is critically discussed and the paper comes to a conclusion with a demonstration of the application of knowledge in a case study situation which identifies and explains the ethical, professional and practice management implications with regards to the case study.

SECTION B

Self-Serving Bias

Given the advent of recent accounting scandals and their distressing effects on workers and investors, it’s not surprising that the public assume that the underlying problems are corruption and criminality. However, the bigger problem with corporate auditing, as it’s currently practiced, is its vulnerability to unconscious bias (Bazerman etal, 2002)

Self-serving bias refers to people’s tendency to behave inequitably when it benefits them, and they think they can get away with it (Prentice, 2000). It affects how people gather and process information, it is influenced by people’s perceived best interest and existing beliefs (Prentice P. R., 2014). (Bazerman, Morgan, & Loewenstein, 1997) opined that whenever people are faced between what is best for themselves and what is morally right, their discernment of moral righteousness is likely to be biased in the direction of what is best for themselves.

(Bazerman, Morgan, & Loewenstein, 1997) believe audit failures are the natural product of auditor-client relationship and that it is psychologically impracticable for auditors to maintain their fairness and thus cases of audit failure would always occur. For instance, in the case of Enron, Enron was one of Andersen’s largest clients and Duncan’s career essentially hung on the success of Enron. Andersen was making a healthy $25 million a year auditing Enron and $27 million annually by providing non-audit services. Andersen also hoped to soon double that revenue to $100 million a year. In other words, Andersen put itself as a firm, Duncan as a key audit partner, and Duncan’s subordinates in a position where it was in all their best interests to conclude that Enron was in good financial shape and to keep this key client happy by approving Enron’s various financial window dressing as consistent with good accounting practices. In the shadow of such a strong self-interest, it would have been very difficult for even an auditor with the best of intentions to make objective judgments, as (Prentice R. A., 2000) has indicated.

According to (Prentice R. A., 2000), self-serving bias is both cognitive and motivational. Thompson and Loewenstein (1992) suggest three cognitive mechanisms to explain why judgments of fairness are biased in a self-serving direction.

(Moore, Tetlock, Tanlu, & Bazerman, 2006) opined that factors that causes self-serving bias are: (1) auditors are hired and fired by the client (2) auditor taking sides with clients and (3) auditors providing non-audit services. (Prentice R. A., 2000) also believes that the fact that auditors are hired and fired by their clients and incentives for client retention often make the auditors sympathetic towards the activities of the clients and thus turn a blind eye. The public tend to believe that the performance of non-audit services such as legal, advisory etc. will weaken the objectivity and independence of the audit industry.

(Prentice R. A., 2000) posits that self-serving bias is both cognitive and motivational.  (Loewenstein, 1992) suggest three cognitive mechanisms to explain why judgments of fairness are biased in a self-serving direction. Firstly, people perceiving information in a prejudiced manner for example the 1960 Kennedy-Nixon debate, where audiences who were pro-Kennedy tended to perceive that he won the debate while audience who were pro-Nixon tended to think that Kennedy lost (Prentice R. A., 2000).

Also, self-serving bias is displayed through selective recollection of activities performed. For instance, members of organizations tend to overvalue their contributions to its success, perhaps because they can remember their own actions more clearly than those of their colleagues.

(Moore, Tetlock, Tanlu, & Bazerman, 2006) opined that people evaluate evidence in a selective fashion when they have a stake in reaching a conclusion. Thus, they tend to focus on evidence that agrees with the conclusion or decision they would like to reach and assess that evidence in a biased way.

Tetlock (1983) argued that when the preferences of the audience are known, the probability of the decision maker’s judgement will be in accordance with the known preferences. Thus, in an audit, the effect of management’s preference as to wanting to get an unqualified audit report indirectly affects the auditor’s judgement (Moore, Tetlock, Tanlu, & Bazerman, 2006).

(Moore, Tetlock, Tanlu, & Bazerman, 2006) believed that when a certain interpretation of the evidence will benefit people materially, they tend to align their though process towards the interpretation even when they hold a clear goal of being impartial and are unaware that they are processing the information in a self-serving fashion and thus bias. For instance, in auditing Enron’s books, the auditors would be prone to searching for information that supported the conclusion that they accurately represented Enron’s financial condition and to ignoring evidence that contradicted that conclusion (Prentice R. , 2004).

A Critical Appraisal of the Role of International Ethics Standard Board for Accountants

A major feature of the accounting profession is the recognition and approval of the obligation to act in public interest. Thus, a professional accountant’s duty is to satisfy not only the needs of the individual client but also that of the public/stakeholders. In carrying out this duty, a professional accountant shall observe and conform with the Code of Ethics (IESBA, 2014)

The International Ethics Standards Board for Accountants is an independent standard-setting body that develops internationally appropriate Code of Ethics for Professional Accountants.  The Code is subdivided into – (1) the fundamental principles of professional ethics for professional accountants as well as the conceptual framework. (2) the safeguards addressing threats to compliance.

The fundamental principles as proposed by (IESBA, 2014) include:

1. Integrity: this is the attribute of being forthright, truthful and honest in all professional and business relationships. The accountant is not to be involved with reports or information that contains statements provided carelessly. He should not also be involved with reports that contain ambiguous information which could be misleading.
2. Objectivity: to not allow prejudice, unfairness, conflict of interest or undue influence of others to override professional or business judgements. He should not undertake services if the professional or business dealings will overly sway his professional findings or conclusions.
3. Professional Competence and Due Care:  to be vast and have updated knowledge and skill at the level required to ensure that a client receives proficient and expert professional services based on current developments in practice, legislation and techniques and act meticulously in accordance with applicable technical and professional standards. He should act in accordance with the needs of a task carefully, thoroughly and timely.
4. Confidentiality: to respect the privacy of information acquired during business and professional relationships and, hence, not reveal any such information to others without proper and explicit approval, unless there is a legal or professional right or duty to divulge, nor use the information for the personal benefit of the professional accountant or third parties. The accountant should consider the following when determining whether to disclose confidential information:

-          The type of communication required and the recipients of such information

-          Whether the interest of all parties could be negatively affected if information is divulged.

5. Professional Behavior: to conform with important laws and regulations and avoid any action that ill reputes the profession. He is to be honest and truthful and not make reproachful references or unproven comparisons to the work of others.

The conceptual framework was developed to enable professional accountants detect, estimate and address threats to compliance with the fundamental principles. In doing this, he considers whether the threat would compromise his conformity to the principles. If the threat is significant he further decides whether safety measures in place can adequately reduce the threat or eliminates the threat by refusing such service (IESBA, 2014).

Threats may be caused by dealings with the client or circumstances which could compromise the professional accountant’s adherence to the fundamental principles.  The threats include:

1. Self-interest threat – the threat that a financial or other interest will unsuitably affect the professional accountant’s findings, conclusions, decisions or deeds. For instance, a member of the audit team having employment arrangement with the audit client ow when a firm is so worried about the possibility of losing a high-profile client.
2. Self-review threat – the threat that a professional accountant will not appropriately assess the results of an existing judgement made, or properly review tasks carried out by the professional accountant himself or that of his team member, on which he will rely when forming his opinions and conclusions. For instance, a firm issuing an assurance report on the efficiency and effectiveness of the financial operation system which was designed and implemented by the audit firm on behalf of the client.
3. Advocacy threat – the threat that the professional accountant will enhance and elevate a client’s or employer’s position to the extent wherein his fairness and independence will be compromised. For instance, a firm promoting the sales of their client’s shares.
4. Familiarity threat – this is caused by long or close dealings with the client to the extent that the professional accountant becomes too supportive of their interest and agrees with their terms and works. For instance, the senior manager of the client having a long association/relationship with an audit partner.
5. Intimidation threat – the threat that a professional accountant will be prevented from acting fairly and accurately because of actual or perceived pressures from parties around him. For instance, an audit firm being threatened with litigation by the client.

There are safe measures that may eliminate or reduce the threats to the barest minimum. According to (IESBA, 2014), there are two major classes of protection that helps to reduce or terminate the threats faced by the auditors. They are:

1. Safeguards created by the profession or regulations – continuing professional development requirement, professional or regulatory monitoring and disciplinary procedures and corporate governance regulations.
2. Safeguards in the work environment: This is further subdivided into two forms of safeguards.

-          Firm-wide safeguards: for instance, audit firms emphasizing the relevance of adherence to fundamental principles, putting in place disciplinary process and systems to promote adherence with policies and procedures. as well as using different partners and engagement team with separate reporting lines for the provision of non-assurance services to an assurance client.

-          Management-specific safeguards: this includes; rotating senior assurance team members, discussing ethical issues with those charged with governance of the client organization.

Other factors that may affect auditor’s independence and objectivity as opined by (IESBA, 2014) are: gifts and hospitality, fees and remuneration, second opinion as well as marketing professional services. It is important to note that there would always be threats to an auditor’s independence and objectivity. However, the auditor in carrying out tasks should ensure or strive to maintain his neutrality by avoiding things that may easily sway his decisions.

SECTION B

The International Ethics Standards Board for Accountants (IESBA) is an independent standard-setting body that develops an internationally appropriate Code of Ethics for Professional Accountants (the Code). Any firm of professional accountants will have to ensure that the guidelines provided in the code are followed in order to ensure that they act in compliance in with the code.

When a professional accountant identifies threats to compliance with the fundamental principles and, based on an evaluation of those threats, determines that they are not at an acceptable level, the professional accountant shall determine whether appropriate safeguards are available and can be applied to eliminate the threats or reduce them to an acceptable level

In the case of Deluxe Ltd, the firm Queens and Co a firm of certified chartered accountants will have to ensure that whatever they do is in line with the IESBAs code. A business opportunity has arisen to the firm, but this opportunity has to be properly evaluated by the firm in order to view any Ethical, professional or practise management issues. The following issues have been discovered.

Self-Review threat

A threat to the independence and objectivity of the firm will arise if the firm decides to go into business with the client as this creates a financial interest in the client and this leads to a self-interest threat as the company will not be able to act objectively and with independence as they will put themselves first when auditing the financial statements of the company as they will want to ensure they make profit.

Another self-interest threat will arise if the company will provide investment to the company as this investment is in the form of convertible debentures and this form of finance is regarded as a loan to the company, the IESBA code is very particular about the issue of firms providing loan to their client and has stated firms should not provide loans to their clients except in extraordinary cases where such client is a bank or financial institution. As stated earlier the accountant is allowed to evaluate appropriate threats and provide appropriate safeguards, but in a situation no safeguard is appropriate and therefore such arrangement should not be made.

Furthermore, another self-interest threat arises as a result of the convertible debentures, as this turn to equity at maturity which will mean queens company holding a stake in Delux ltd. This gives rise to another financial interest in the company as the company will want to ensure tier investment is secure and the market value of the company does not drop so the audit of the company will not be properly done and level of materiality will be increased and hence less detection or risks and less detection of errors and fraud in the firm.

Intimidation threat

This threat to objectivity and independence of the audit firm will arise if the company does business with the client firm as the will not be able to properly function and will not be able to act independently as whatever the audit firm does in the audit of the firm inadvertently affects the client firm and will want to ensure they are in line with the management of Delux ltd.

Practice Management Issues

The audit firm can decide to look into the business and see how long the product will last i.e. the life span of the product and compare this to the period of the retention of the audit client. If the retention period is short they can provide the finance and continue such audit or just resign if the period is not substantial

It is also important to note that the audit firm might not be able to provide the finance needed because of the falling revenues of the company and might want to get a loan to provide the client firm with the funds needed and this will lead to a lot of quality and practise issues which should be entirely avoided by the company in order to ensure they are not in a position they cannot get out of or that they regret or that will make them act unprofessionally.

CONCLUSION

This paper was divided into three sections with in-depth research and knowledge carried out on each section. The paper started off with an in-depth research into the behaviour known as “self-serving bias” and, using relevant examples, with the application of the research to the special problems of auditor’s objectivity.

Furthermore, the role of the International Ethics Standards Board for Accountants (IESBA) are critically discussed and the paper comes to a conclusion with a demonstration of the application of knowledge in a case study situation which identifies and explains the ethical, professional and practice management implications with regards to the case study.

Hopefully a demonstration of relevant knowledge in line with the International Ethics Standards Board for Accountants (IESBA) the standard-setting body that develops an internationally appropriate Code of Ethics for Professional Accountants (the Code) has been demonstrated and questions have been answered to the best standards.

REFERENCES

• Bazerman, M. H., Morgan, K. P., & Loewenstein, G. F. (1997). Opinion:The Impossibility of Auditor Independence. Sloan Management Review, 38, 89-94.
• IESBA, I. E. (2014). Handbook of the Code of Ethics for Professional Accountants. New York: International Federation of Accountants. Retrieved from www.ethicsboard.org
• Loewenstein, L. T. (1992). Egocentric Interpretation Of Fairness and Interpersonal Conflict. 176, 180-181.
• Moore, D. A., Tetlock, P. E., Tanlu, L., & Bazerman, M. H. (2006). Conflicts of Interest and the Case of Auditor Independence: Moral Seduction and Strategic Issue Cycling. HBS Working Paper, 03(115).
• Prentice, P. R. (2014). The Case of the Irrational Auditor: A BehaviouralInsight into Securities Fraud Litigation. UT-Austin: McCombs School of Business.
• Prentice, R. (2004). Teaching Ethics, Heuristics, and Biases. Journal of Business Ethics Education, 1(1), 57-74. Retrieved from www.senatehall.com
• Prentice, R. A. (2000). The SEC and MDP: Implications of the Self-Serving Bias for Independent Auditing. Ohio State Law Journal, 61(1597), 1597-1670.