The Impossibility of Auditor Independence

In 1992, Phar-Mor, Inc., the largest discount drugstore chain in the United States, filed for bankruptcy court protection following discovery of one of the largest business fraud and embezzlement schemes in U.S. history. Coopers & Lybrand, Phar-Mor’s former auditors, failed to detect inventory inflation and other financial manipulations that resulted in $985 million of earnings overstatement during a three-year period. A federal jury unanimously found Coopers & Lybrand liable to a group of investors on fraud charges. The attorney for one investor argued that “this sends a strong signal to the accounting community that investors take very seriously the role of audited financial statements and rely on them for their integrity.”1

The investors who successfully sued Coopers & Lybrand contended that Gregory Finerty, the Coopers & Lybrand partner in charge of the Phar-Mor audit, was “hungry for business because he had been passed over for additional profit-sharing in 1988 for failing to sell enough of the firm’s services.”2 In 1989, Finerty began selling services to relatives and to associates of Phar-Mor’s president and CEO (who has been sentenced to prison and fined for his part in the fraud). Critics claim that Finerty may have become too close to client management to maintain the professional skepticism necessary to conduct an independent audit.

The Phar-Mor case is one of many in which auditors have been held accountable for certifying faulty financial statements. Investors in the Miniscribe Corporation maintained that auditors were at least partially responsible for the now-defunct company’s falsified financial statements; at least one jury agreed, holding the auditors liable to investors for $200 million. In the wake of the U.S. savings and loan crisis, audit firms faced a barrage of lawsuits, paying hundreds of millions of dollars in judgments and out-of-court settlements for their involvement in the financial reporting process of savings and loan clients that eventually failed.

The accounting profession maintains that it is being unfairly assaulted by plaintiffs looking for a convenient “deep pocket” from which to recover losses that may result from their own poor investment decisions. The investing and lending public, on the other hand, has become cynical about the accounting profession and its role in the financial reporting process.

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References

1. Adapted from M. Murray, “Coopers & Lybrand Is Found Liable by Jury to Investors,” Wall Street Journal, 15 February 1996, p. A-8.

2. Adapted from M. Pitz, “Jury Finds Phar-Mor’s Auditors Negligent,” Pittsburgh Post-Gazette, 15 February 1996, pp. A1-A6.

3. American Institute of Certified Public Accountants Code of Professional Ethics, 1988.

4. W. Burger, U.S. Supreme Court: 1984, United States v. Arthur Young & Co., U.S. Supreme Court Reports, 26 April 1984, 79 L Ed 2d, 826–838.

5. J.C. Robertson, Auditing (Homewood, Illinois: Irwin, 1990).

6. E. Waples and M.K. Shaub, “Establishing an Ethic of Accounting,” Journal of Business Ethics, volume 10, 1991, pp. 385–393.

7. C.E. Jordan and J.G. Johnston, “Auditor’s Independence: A Proposal to the Profession and the Public,” The Woman CPA, volume 49, July 1987, pp. 3–9.

8. D.M. Messick and K.P. Sentis, “Fairness and Preference,” Journal of Experimental Social Psychology, volume 15, 1979, pp. 418–434.

9. K.A. Diekmann, S.M. Samuels, L. Ross, and M.H. Bazerman, “Self-Interest and Fairness in Problems of Resource Allocation,” Journal of Personality and Social Psychology (in press).

10. D.M. Messick, “Equality, Fairness, and Social Conflict,” Social Justice Research, volume 8, 1995, pp. 153–173; and

D.M. Messick and A.E. Tenbrunsel, eds., Codes of Conduct (New York: Russell Sage Foundation, 1996).

11. L. Thompson and G. Loewenstein, “Egocentric Interpretations of Fairness and Interpersonal Conflict,” Organizational Behavior and Human Decision Processes, volume 51, 1992, pp. 176–197;

G. Loewenstein, S. Issacharoff, C. Camerer, and L. Babcock, “Self-Serving Assessments of Fairness and Pretrial Bargaining,” Journal of Legal Studies, volume 22, 1993, pp. 135–159;

L. Babcock, G. Loewenstein, S. Issacharoff, and C. Camerer, “Biased Judgments of Fairness in Bargaining,” American Economic Review, volume 85, December 1995, pp. 1337–1342.

12. K. Jenni and G. Loewenstein, “Explaining the Identifiable Victim Effect,” Journal of Risk and Uncertainty (forthcoming, 1997);

D.M. Messick, and M.H. Bazerman, “Ethical Leadership and the Psychology of Decision Making,” Sloan Management Review, volume 37, Winter 1996, pp. 9–22; and

L. Babcock and G. Loewenstein, “Explaining Bargaining Impasse: The Role of Self-Serving Biases,” Journal of Economic Perspectives (in press).

13. See G. Loewenstein and J. Elster, Choice over Time (New York: Russell Sage Foundation Press, 1992);

G. Loewenstein, “Behavioral Decision Theory and Business Ethics: Skewed Trade-offs between Self and Other,” in Messick and Tenbrunsel (1996).

14. See J.C. Corless, R.W. Bartlett, and R.J. Seglund, “Psychological Factors Affecting Auditor Independence,” The Ohio CPA Journal, volume 49, Spring 1990, pp. 5–9.