Re:Balance -- Jim Peterson

Accountants and Their Biases: Human Nature Will Not Be Denied -- Part I

Updating the syllabus and reading list for my graduate-level course this spring in Risk Management and Decision-Making provides a reminder: the members of the accounting profession are just as susceptible as anyone else to the kinds of bias and error that, if avoided, allow for better performance and results. Here the first of a three-part series I am pleased to have written for Caleb Newquist at Gusto:

 

“You can’t expect to improve, if you can’t tell whether you’re good or not.”

Maxim of consultants in decision-making

Trustworthy, high-quality service lies at the heart of the accountants’ claim for public confidence and professional legitimacy. Rigorous standards and high expectations are set for independence of judgment, skepticism, and ethical behavior. 

Yet, to the frustration of the profession, its leaders, and its public critics, undesirable behaviors continue to erupt:

• Large-scale financial failures and scandals that prompt the popular outcry, “Where were the auditors?” –- revealing problems that have been repeated for decades. 
• Corruption of regulatory inspection and oversight through falsification and back-dating of documents and misuse of confidential agency information. 
• Answer-sharing and other cheating on professional examinations.
• Individual violations of trading rules, use of inside information, and breaches of independence rules.  
• Doubts over the profession’s ability to recruit and retain a growing number of properly qualified and skilled personnel, in the context of concerns for academic preparation and workplace environments. 

This despite intense attention and massive investments of time, money, and energy in education, training, messaging from senior leaders, and the development of tools and methodology 

The challenges may seem intractable. But if issues that extend over judgment, skepticism, ethical behavior, and operating priorities are really so hard, are there ways to improve? 

Although the search for simple solutions to complex questions can lead down the road of faulty analysis and wrong answers, a more optimistic perspective is proposed here. Fortunately, we have a half-century of research in the cognitive sciences to open a window into the complexities.

The premise is that accountants share common characteristics with all other fellow humans –- for better or worse. They are not unique or special, differently equipped, or uniquely skilled. They are no less subject to all the influences and pressures that affect and expose the human condition with its frailties and weaknesses.

Which means the news is not all bad. The very opportunities identified in that research have adaptations to the accounting profession’s particular needs. 

Biases, Pressures, and Human Frailty

A rich body of relevant literature sets the stage. A sampling for those interested: 

• The ground-breaking 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases” (Science V. 185)
• Kahneman’s own encyclopedic book, “Thinking, Fast and Slow”(2011)
• Contributors such as Philip Tetlock, “Super-Forecasting: The Art and Science of Prediction” (2015) and Richard Thaler – with Cass Sunstein, “Nudge” (2009 and later editions), and his own “Misbehaving: The Making of Behavioral Economics” (2015)
• A generation of sharp economists, including Steven Levitt and Stephen Dubiner of the University of Chicago, e.g.,”Freakonomics” (2005) and the UK’s Tim Harford, e.g., “The Undercover Economist” (2005) and “How to Make the World Add Up” (2021). 

Greatly simplified, all modern humans carry the legacy of our prehistoric ancestors’ DNA. An early hunter, armed with a spear and hearing the rustling underbrush, faced a critical moment that required an instant reaction: if it were an animal he could kill, the tribe would eat that day, but if a tiger or a wild boar, he was at deadly peril. A stranger emerging from the forest with outstretched hand –- was it in friendship or with a weapon? 

For our ancient predecessors, the fast instincts of “fight or flight” and “friend or foe” were essential to the tribe’s safety and survival, whether against hostile adversaries or vicious predators. Their judgments carried life-or-death consequences for the hunters, although the tribe survived provided they were mostly right, most of the time. 

Those same triggers serve today in many simple cases. When a traffic light changes from green to yellow, no analytic energy goes into a driver’s non-rational “go or no” reaction. Likewise, quick and low-salience consumer choices at a Starbucks counter or a grocery shelf are mostly simple, fast, and non-demanding. 

But these examples show that our DNA has not evolved. The very simplicity of our ancestors’ instinctive reactions means they are maladapted to complex modern challenges. Decisions such as how to allocate an investment portfolio, calculate a reserve provision, where to open a new office, or which candidate to hire are better made with research, deliberation, and consultation.

Like the ancient tribes, today’s society still operates, for better or worse, as programmed for overall survival under normal conditions. This means that decision-making often defaults to oversimplification or resists recognition of the consequential exceptions:

• The very essence of the long-standard auditor’s report, expressed in non-technical terms, conveys a message filled with multiple qualifications — that the client’s information “is generally right, for the most part, over this time period, so far as we can tell within the limits of our work.”
• Likewise, practices and programs for personnel hiring, evaluation, promotion, and management are designed on the assumption that those affected will behave as expected. They act honestly, in good faith, and respond appropriately to guidance and leadership. 

For both of these, the general rules work just fine. Until, under conditions that may seem unusual or unpredictable, they don’t.

The dissonance emerges in both performance and management, because it is the exceptional cases, not the normal and expected ones, that cause the problems (e.g., the white-collar fraudster for whom an audit is an inconvenience to be evaded, the abusive supervisor, the rogue employee).

And that’s when the consequences kick in. Reactions to this bad behavior –- from the profession, its clients, the general public –- can be put in the terms used to discipline unruly children, “when you do right, nobody remembers; when you do wrong, nobody forgets.”

The Ubiquity of Human Bias

The literature has cataloged an entire vocabulary of human bias and error that pervades the accountants’ environment as much as any other area of business or professional services. The irresistible human impulse to simplify complex problems leads to narrowed questions that, by default, are often answered with little time and energy –- and too frequently answered incorrectly. 

Examples from a long list will illustrate.

                                                     In General            In the Profession

The Induction Fallacy (Mistakenly believing that past experience is a complete guide to the future)	It’s only the flu	The CFO has never misled me before
The Planning Fallacy (Over-confidently disregarding the likelihood that unforeseen changes will affect a project’s execution)	The opera house will be finished on time and on budget	Our report is on schedule –- we don’t expect any disruptions
The Anchoring Effect (Over-weighting quantitative information that is visible although not complete or relevant)	“Buy three tires, get fourth free” -  bargain	Receivables  look light–bump of 5% should do it
The Optimism Bias (Ignores evidence inconsistent with desired outcome or narrative)	Our troops will occupy Kiev within two weeks	Client growth 15% last year, so 20% this year is a lock
The Inertia Effect (Continuing past practice, whether or not in a changed environment)       The Bias of Representativeness (Extending an assumption based on limited information)	NASA shuttles launched for years –Challenger good to go     Dressed like that, he surely doesn’t belong here	Scope was fine last year -- SALY     We don’t send recruiters to schools with that ranking

These examples — illustrative and by no means comprehensive -– are common throughout the profession, as they are in society as a whole. And they share a common theme. They all arise out of the natural default to quick, simple, and intuitive reactions inherited from our ancestors that are ill-suited for modern life’s complexities.  

The guidance of the research is best summarized by Richard Thaler (Misbehaving, pp. 355-56): 

"It is time for everyone –- from economists to bureaucrats to teachers to corporate leaders –- to recognize that they live in a world of humans and to adopt the same data-driven approach to their jobs and lives that good scientists use.

"Good leaders must create environments in which employees feel that making evidence-based decisions will always be rewarded, no matter what outcome occurs. The ideal organization encourages everyone to observe, collect data, and speak up."

A word of caution: perfection is not within the grasp of fallible humans with our in-built limitations. “Zero defects” is not achievable, nor does the awareness of our sources of bias assure consistent use of the tools available. But the deliberate aspiration to improve, being the best we can do, has promise.  

Installments to follow will suggest some means to take these thoughts forward to practical application.

 

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Auditors Cheating on Ethics Exams – Who’s Surprised?

It's my pleasure to offer this guest post on the substack of my friend Francine McKenna, with her added annotations, at The Dig -- to which readers here are referred and invited.

 

“The past is never dead. It’s not even past.”

           -- William Faulkner

Pious dissections of the SEC’s record-setting $ 100 million fine levied this summer against EY for widespread staff cheating on ethics and other exams, and the firm’s delays and mis-directions in its regulatory reporting, have missed three points:

• They did it because they could, and had their reasons.

• The reasons evaded the understanding and best intentions of leadership, so compliance efforts were bound to fall short.

• Those reasons are based on pervasive human characteristics, shared by members of the accounting profession with the general population.

On the heels of the agency’s 2019 fine of $ 50 million for KPMG’s not dissimilar behavior, how did things go so wrong? How could there not have been a learning effect?

Finger-pointing and calls for accountability will lie elsewhere –- not here –- because the basic reasons lie in human nature, and are not complex. It’s the harder challenge, to reduce the predictable cases of future failure.

With career-long scrutiny of financial and professional break-down and misfeasance, I teach a course in business and law schools that explores the reasons for bad decisions and behaviors. There is a core theme in the shortcomings of the supposed “smart guys” –- whether in the credit crisis of 2007-2008, the halting and inconsistent reactions to the COVID pandemic, the recurrent scandals from Enron to Wirecard, or the persistent outbreaks that, every time, trigger the familiar cry, “Where were the auditors?”

Namely, as fallible humans, all of us are prone to the quick and instinctive decisions that activated “fight or flight” for our primitive ancestors whose DNA we inherit –- good enough to safeguard a pre-historic tribe, but ill-suited to the complexities of modern life, where through bias and error we are led to undesirable judgments and decisions.

A note on resources -- a body of research and literature both broad and extensive. The seminal scholarship is the concise and much-cited 1974 essay of Daniel Kahneman and Amos Tversky, “Judgment Under Uncertainty: Heuristics and Biases.” Kahneman’s “Thinking, Fast and Slow”(2011) brought the themes forward. Applications to policy-setting and personal choices are examined, e.g., in Richard Thaler and Cass Sunstein’s “Nudge”(2008) and Thaler’s “Misbehaving: The Making of Behavioral Economics”(2015).

As context for this latest outbreak of test-cheating, the entire model for financial information assurance, designed in the Victorian era and largely unevolved since, has yet to recognize and apply a half-century of insightful scholarship into the complexities of human behavior. Instead, the accounting profession has contributed to a public expectation of auditor performance that exceeds its failure-avoidance capabilities, eliding the inevitable break-downs that inhere in any complex system of human design and operation.

The themes have specific application to the errant test-takers. However well-schooled they may have been in the standards and literature in judgment, independence and skepticism, fresh university graduates newly arriving to the profession have basic DNA no different –- for better or worse –- than their peers elsewhere. Although sporting a new appliqué -- CPA -- in real-world practice they are not bestowed with any special aptitude for skepticism beyond the normal, nor a super-human capacity to overcome the universal susceptibility to non-benign influence.

In short, no amount of on-the-job training can eliminate the impairing effect of compromising influences -- the stresses of budgets and workloads, peer pressures, or “go along” signals from their immediate supervisors.      

Which means that staff personnel in the audit firms will pursue their interests under the most immediate incentives, in spite of and over-riding whatever earnest and sincere exhortations may come down from on high.

Because there will be cheaters in any human-run system, the search in the current exam-gaming context should turn to affirmative support for failure reduction. Checks and barriers should be inserted; misbehavior and non-compliance should be made as difficult as possible.

That means invoking the authorities in testing integrity. Far be it from my limitations as a late arrival to academia, but two examples: I have used plagiarism detectors, and experienced a law school that required annual instructor certification that all exam questions were unique and not repeated from prior years.

Because mis-aligned incentives and skewed decisional influences are ubiquitous in society’s institutions, they no less pervade the entire ethos of the accountants’ world. The stage for misbehavior is always set.

The refreshed examples of questionable performance reflect the auditors’ too often ill-fated client-oriented decisions, under the most salient if undesirable influences; skepticism, conservative judgments and challenges to clients are subjected to powerful influences including over-confidence, success bias and management pressure.

Broadly speaking, the profession’s limited grasp that these behavioral principles are pervasive is seen in its two defensive messages –- that the vast majority of its personnel act in complete honesty and good faith, and that most of its audit engagements are carried out in conformity with standards and expectations.

True enough, but insufficient and unresponsive to the ubiquity of the exceptions –- small in number but enormous in their consequences –- reflecting, in effect, the inability to grasp the implied downside in the ineffective messaging, as captured in the simple truth, often delivered to unruly adolescents: “When you do good, nobody remembers. When you do bad, nobody forgets.”  

Fortunately, opportunities for improved risk assessment and mitigation are readily at hand. Effective strategy and tactics for business and professional leaders would start with the acknowledgement that much of high-level standards, regulation and guidance falls somewhere between wasted and futile.

• The fiasco at the 2017 Academy Awards was avoidable, by which the presenters announced the wrong Best Picture because the PwC partner carried two envelopes and handed over the wrong one under the distraction of a selfie. Break-down of the flawed no-phones-on-stage policy, observed in the partner’s breach, would have been avoided by a simple requirement that a monitor confirm he was empty-handed before handing him the next envelop.

To be sure, trade-offs of cost and resources inhere in choices about policy enforcement and society’s acceptable level of tolerance for deviant behavior:

• The carnage of teenage drunken driving could be dramatically reduced by two simple if draconian steps –- raising to age thirty the threshold for a license, and immediate mandatory ten-year prison sentences for violators –- neither of which society would tolerate.

• Mass shootings, likewise, would be considerably less likely under a prohibition on civilian possession of assault weapons and severe controls on access to ammunition –- achievable in theory but tragically not in American practice.

Returning to the accountants, there are multiple implications:

• The prospect that a re-setting of the bar for auditor performance may dilute the auditors’ claims for professional status.

• The potential that unresolved continuation of performance quality issues may lead to public withdrawal of the credibility given to the profession.

• Broadened demand for new and evolved forms of assurance may attract new suppliers with fields of expertise beyond the ability of the accountants to evolve and adapt.

The dialog on these is for another time. As for the present case -- recent events have shown that zero defects in ethics testing did not follow from a fine of $ 50 million, even with associated prosecutions of the principal violators. Neither will $ 100 million suffice. The pace of human evolution is not so responsive.

Which does not counsel either cynicism or despair. Instead it’s a challenge that calls for strategies that are better informed and designed.   

 

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Clorox, UV and Coronavirus – Trump’s Ignorance Stirs A Toxic Cocktail

“So, supposing we hit the body with a tremendous — whether it’s ultraviolet or just very powerful light…. supposing you brought the light inside the body, which you can do either through the skin or in some other way….

 “I see the disinfectant that knocks it out in a minute, one minute. And is there a way we can do something like that by injection inside, or almost a cleaning? Because you see it gets inside the lungs, and it does a tremendous number on the lungs, so it would be interesting to check that.”

 - Remarks by President Trump, Vice President Pence, and Members of the Coronavirus Task Force in Press Briefing, April 23, 2020

 This dangerous display of the boundless ignorance of POTUS 45 was also the day of my last class for the spring semester -- “Risk Management and Decision Making,” by ZOOM with a group of smart and curious law school students at CY Cergy Université in Paris.

That coincidence lets me appreciate and say thank you to my students – the experience was as rich for me as I hope it was useful and fulfilling for them. With brief context setting, it also tees up the punch line lesson offered here.

Our course examines how humans with all our foibles and limitations make decisions under complex and uncertain conditions. The contexts are broad – personal and social, but especially professional, business and political; the processes are often sub-optimal, and the outcomes frequently somewhere between poor and disastrous.

Topping a multi-disciplinary reading list is the pioneering work of Daniel Kahneman and Amos Tversky, whose landmark 1974 paper essentially invented the field of behavioral economics – recently brought down for public accessibility by Kahneman’s own encyclopedic “Thinking, Fast and Slow” (2011) and Richard Thaler’s “Misbehaving” (2015).

Together we explore the many sources of recurrent but avoidable decision-making bias, flaws and error -- among them are herding, over-confidence, proximity bias, anchoring and frame blindness, hindsight, rationalizations, and leadership over-ride and disregard for non-confirming evidence.

Toward the end of the semester, the students take up with enthusiasm the Dunning-Kruger effect – that the less you know about a complex topic, the more likely you are to display your ignorance in flawed but over-confident actions and decisions that reveal – often with tragic and highly destructive consequences -- how little you actually know.

That trait is conspicuously displayed by POTUS 45. His egregious invitation to ingest or inject toxic household cleansers or internalize UV radiation is only the latest. Recall his allusions to nuclear weapons against hurricanes and wind turbines as cancer agents, a weather map re-drawn by sharpie, his challenges with the basics of aircraft catapults and domestic and international geography. The list seems endless of his stunning disregard and disrespect for technical, scientific and professional knowledge and expertise.    

In an affectionate joint biography of Kahneman and Tversky, “The Undoing Project” (2016), author Michael Lewis includes a version of Kahneman’s single sly metric for intelligence: “the smarter you are, the faster you realize that Amos Tversky is smarter than you are.”

To their credit, my agile students will recognize that this maxim honoring the brilliance of Kahneman’s friend and collaborator can be inverted:

“The extent of someone’s stupidity can be measured -- how long does it takes to realize how stupid Donald Trump truly is?”

 

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“Younger Next Year”? He Should Have Lived So Long!

The recent untimely death at age 58 of Dr. Henry Lodge, who achieved a cult following and built an author’s franchise with his 2004 book, “Younger Next Year” (Workman), struck a personal note and also inspired some refreshing of the syllabus for my graduate-level course for business and law students, “Risk Management and Decision-Making.”

My own copy had arrived as a gift from a proselytizing colleague. Lodge’s core message was light-heartedly simple, and resonated with a sizable sub-group of the vast cohort of baby boomers – namely, those seeking not to age into overweight, sedentary and unhealthy decline -- that is:

• Shift from eating the junk food that you know is crap, to a readily available diet both tasty and nourishing.

• Get a lot more exercise, of whatever kind you can.

• Have a source of engagement and commitment to someone or something important in your life, rather than withdraw into reclusive and self-destructive isolation.

Lodge was cut down by a deadly prostate cancer, before he could live to fulfill his proposition – that while the length of that “last one-third” of a full lifespan is never assured, because subject to fatal events that are both unpredictable and unpreventable – notably random fatal illnesses and accidents – the opportunity to extend and enhance the quality of an active life, right up to the end, is within the influence of disciplined and deliberate choice-making.

Fans of Lodge with sufficient remaining long-term memory may find his cancer to reprise the massive heart attack that in 1984 felled James Fixx at the age of 52. Best known for “The Complete Book of Running” (Random House, 1977), Fixx was influential in the nationwide spread of jogging – having started running himself out of concern for his family history of coronary disease and his father’s early death – also stopping smoking and losing over sixty pounds.

Which said, Fixx’s obituary noted that an autopsy showed that he had two blocked and untreated coronary arteries. So while an examination of the choice-making of Lodge and Fixx in these irony-tinged deaths might impel those more cynical or less motivated to skip their next spinning class altogether in favor of a stop at McDonalds, a careful comparison might criticize the latter’s level of attention to his knowable at-risk condition.

Or as the wisdom attributed to Thomas Jefferson puts it, "I am a great believer in luck, and I find the harder I work, the more I have of it.” In other words, manage what you can. And also realize that you can never manage it all.

As my students explore, the very best of decision-making in contexts of complexity and uncertainty cannot avoid the real possibility of an intensely undesirable outcome. In a world comprehensively illuminated by the scholarship of Daniel Kahneman and the late Amos Tversky, going back to 1974 and their seminal essay, “Judgment Under Uncertainty: Heuristics and Biases” (Science, New Series, Vol. 185) and rolling forward to the former’s encyclopedic work, “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011), simple “bad luck” will on occasion overwhelm all care and deliberation.

Which means that those tempted to view Lodge’s premature death as proof of the futility of good choice-making – who would toss aside their jogging shoes in favor of a simultaneous reach for both the television remote and the platter of cheese nachos -- are pursuing sub-optimal strategies with fully predictable negative consequences.  

 

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“Bonehead” – “Wrongway” – “Moonlight” : Defining Moments and Their Lessons

            “When I do good, nobody remembers; when I do bad, nobody forgets.”

This space will not use the name of the PwC partner who re-wrote the Best Picture finale of the February 26 Academy Awards ceremonies by handing the wrong envelope to Warren Beatty. That poor bastard is going through enough, and no good is served by giving the search engine voyeurs any further satisfaction.

History’s list is lengthy of accomplished, good-faith professionals whose extended records of success are instantly dissolved into public notoriety:

• Dodger pitcher Ralph Branca became defined by Bobby Thompson’s walk-off home run, the “shot heard ‘round the world,” as the Giants won the 1951 National League play-off.

• Mercury astronaut Gus Grissom was saddled thereafter with the loss of Liberty Bell on July 21, 1961 -- flooded and sunk when the explosive hatch bolts blew on landing.

• Age 19, Fred Merkle became forever “Bonehead” for his failure to tag second base and the Giants’ resulting loss to the Cubs on September 23, 1908.

• Aviator Douglas Corrigan may well have been deliberate in his 1938 solo flight from Brooklyn to Ireland, but the sobriquet “Wrongway” was applied and stuck.

Up through the ranks, a twenty-year partner with firm-wide leadership at PwC – now to be known as the guy who had an inopportune Twitter moment. It is seriously unfortunate that if past patterns hold, his career clock is ticking -- nor would it be a great surprise if he were shortly to crawl under the team bus rather than wait at risk of being thrown there.

Unfortunate, because the meticulous methodology by which PwC has for decades gathered and counted and protected the identity of the Oscar winners – including the ego-boost of blinging up and marching the briefcases down the glamorous red carpet -- was wholly irrelevant in the few seconds that demonstrated once again that any system designed and run by fallible human beings has a non-zero chance of catastrophic failure.

Which means that – whatever his own conduct -- the potential for failure was inherent and unsolved at the firm’s level of design and execution.

Behavioral psychologists going back to the pioneering work of Daniel Kahneman and Amos Tversky in the 1970s have laid out the necessity of failure-mitigating techniques to deal specifically with the human factor – mainly by acknowledging explicitly and dealing with the inevitability of sub-optimal individual actions.

As the students in my class in Risk Management could design as a classroom exercise – the unmanaged risk of an envelope switch starts with the basic failure to recognize that the messenger should be prevented from access to more than one at a time.

“Take the one correct envelope in hand, and pass it to the ageing and near-sighted former movie idol” – who by the way was demonstrably useless as a fail-safe or means of quality control.

For which, secure and control each last-used envelope, before moving on to the next award. Get both copies out of reach and out of harm’s way. Keep the courier from touching any but the next one in the queue -- perhaps clamping a controlling minder to his elbow off-stage.

Business and industrial processes provide examples of such safety checks – physical distance between machinery switches, forcing an operator to take two separate actions to activate a hydraulic press or a cutting tool; “dead-man” cut-offs to disable a run-away vehicle; assembly lines and hospital surgeries and nuclear missile silos with dual controls to prevent a solo mishap.

Withal, there may be three sources of comfort for PwC’s sorry point man in this firm-based debacle:

First, because the delivery of audit services to the world’s large companies is completely dominated by the Big Four -- among which, with their 2016 global revenues either side of $ 36 billion, PwC vies with Deloitte as the largest -- the likelihood of negative, reputation-driven impact is constrained by the absence of client choice. And as PwC’s threatening exposures are paralleled among both the other Big Three and their smaller colleagues, that would caution against any exercise of competitive schandenfreude. In other words, to those actually choosing among the cartel of providers, the Oscars fubar is already old news.      

Second, the leader of PwC’s engagement for the Academy would not be listed on the PCAOB’s new Form AP, which identifies lead partners only on the audits of US public companies.

That exercise, in its first year, is of no use in spotting potential performance issues with large-firm personnel other than the lead partner – both because of the mobility of partners among various functions and also because of the team nature of large-company engagements – and so has yet to demonstrate any value.

And third, in any event, enjoying the handsome returns of a senior partner, when average annual Big Four partner profits are running well above $ 1 million, should cushion whatever personal impact may be imposed by the lifetime label, “Moonlight.”

 

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“Rise of the Robots” – Part Two -- And They’ll Audit Better, Smarter, Cheaper

“The ‘smarter’ machines get, the more and more jobs they’ll replace. Including mine. And yours.”
    -- Reader Comment

Martin Ford’s prize-winning “Rise of the Robots” (2015) underlies this three-part set of guest posts for Caleb Newquist's Going Concern, looking at the prospects that drones, robots and cognitive technology will rapidly displace jobs and careers at all levels of the Big Audit model, and that the speed with which those learning organisms will surpass that of even high-judgment humans is dramatically under-appreciated.

The span of initial reader reactions included the expected denial and resistance -– “the obligatory weekly robot article” and “tired of this argument” –- part of the automation dialog since the dawn of the Industrial Age when artisanal weavers led by Ned Ludd burned factories and destroyed looms in England out of their anxiety over an uncertain future.

More substantively, this part starts with the comment (compressed and emphasis added) that “Automation has been here forever… Since we who are still here have adapted in the past, I assume the majority of us will continue to adapt in the future.”

That’s a reader stating the “induction fallacy” -– namely, that past conditions are not only expected to continue, but provide guidance as to the likelihood that conditions will not change -– both a common and instinctive human reaction, and in general quite misleading. (For those so inclined, see the insightful if eccentric Nassim Nicholas Taleb in “The Black Swan” (2007) and, better, Daniel Kahneman’s brilliant "Thinking, Fast and Slow” (2011).)

    Not “This time it’s different” –- but “The future is already arriving”

To start, the MOTS skepticism needs to be dispelled. The fatal accident on May 7, 2016 involving a Tesla Model S in “autopilot” mode, where the car’s system was somehow blinded and unable to recognize a white truck turning across its path, will not slow down the arrival of driverless vehicles. Quite the contrary -– now unleashed, the genii of technology will not be re-captured. The discussion has already shifted from capability to liability and responsibility. It’s no longer “if?” -- but “how?” and “how soon?”

For the rest of the piece, please continue here at Going Concern for August 11.

 

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Guest Post: “Where Were The Auditors?” –- Addressing the Inevitability of Behavioural Risk

 It was my pleasure this week to write this guest post for my friend in London, Anthony Fitzsimmons, the Chairman of Reputability -- the UK consultancy firm that educates and instructs corporate boards and senior leaders on behavioral, organizational and reputational risks. It is posted on their blog here, and in full below.

 Three immediate predictions were available, when British food retailer Tesco announced in September that its first-half profits were over-stated by some £ 250 million, because of irregular accounting for supplier discounts and rebates:

• The number would grow.
• The affected time period would extend.
• The four company executives promptly suspended would soon be joined by others.

It is still early days, but in addition to an investigation by the Serious Fraud Office and the predictable start of shareholder class actions in the United States, news from the company is that:

• The number is now at least £ 263 million.
• The accounting issues extend back at least to last year.
• The casualty count of suspended executives is up to eight, plus the announced resignation of chairman Sir Richard Broadbent.

And as shouted yet again, by the Financial Times, no less – “Where were the auditors?”

It’s the same hue and cry that has been raised with every outbreak of serious financial scandal since independent audit was invented in the Victorian era.

The business, legal and regulatory structure under which the Big Four accounting tetrapoly – Deloitte, EY, KPMG and PwC -- provides statutory assurance on the financial statements of the world’s large companies – the model of Big Audit – remains firmly in place. But with much current exploration of corporate governance and board effectiveness, the notion of “auditor effectiveness” faces this fundamental question:

Is the traditional form of audit assurance – a “true and fair view,” or its American cognate, “fairly presented in all material respects” – fit for purpose, if it only works generally well, most of the time – up to the point, as in Tesco, when it seems not to work at all?   

Lessons from my graduate-level business and law school course in Risk Management and Decision-Making are useful, going to the very nature of the core expectations and limitations of Big Audit, at levels deeper than have been plumbed to date.

Recent progress on the subject of corporate risk has been considerable -- chiefly on the company side of the complex relationships among issuers of financial information, the communities of information users both inside and outside those companies, and the auditors themselves – to identify such systemic threats as risk blindness, ambiguous leadership attitudes about ethos and culture, defects in communications, and skewed performance and compensation incentives.

Behavioural scholarship suggests that these concerns are no less present in the audit function – with its execution dependent on the behavioural limitations of fallible human beings. Which in turn suggests that, if deeper insights into the causes of financial failures were credibly brought forward into the standards and practices of Big Audit, progress might be made in areas that have long defied improvement.

That is – forty years of research have identified sources of bias that are hard-wired into our human DNA, because of which they are pervasive, inevitable and unavoidable. These are shared along with the rest of humanity by auditors who are no better genetically designed or equipped than anyone else to address them. As an effect or consequence, they work to suppress the exercise of professional skepticism, to inhibit the delivery of negative or critical messages and, conversely, to default in favor of confident agreement with management’s upbeat assertions. 

Inquiry quickly goes beneath the customary charge that auditors are incentivized to accommodate long-standing clients – a facile assertion yet to be supported by anything like credible research or evidence. Examples among the catalog of broadly-observable instinctive and dangerous shortcuts  -- “heuristics,” to use the term explored since the 1970s by, e.g., Nobel economics prize-winner Daniel Kahneman and his late lamented research partner Amos Tversky -- are:

• Confirmation bias: The readiness to accept that premises are valid as presented, rather than do the harder work of seeking out and evaluating disaffirming or contrary evidence – in the audit context, the too-ready willingness to agree with submissions and judgments of management.

• Over-Confidence: Good news is simply preferred over bad; as John F. Kennedy quoted the Duke of Wellington, “Victory has a thousand fathers; defeat is an orphan.” So too, a bullish quarterly earnings estimate or a Goldilocks reserve calculation will be preferred over the pessimistic alternatives.

• Representativeness: Giving credence to that which is familiar and ready to hand – e.g., “this year’s results look much like last year’s – so the trends and estimates can be taken as acceptable.”

• Herding and Groupthink: The convergence of individual conclusions with those of the group, especially as led from the top – influenced, for example, by pressures from peers or superiors of time, budget, and engagement evaluations – perniciously seen in the message unsubtly conveyed to junior staff, that “If you raise a problem, then you become the problem!”

From the persistent ubiquity of these influences it would follow – and the regular recurrence of financial irregularities over the decades would confirm – that Big Audit as now designed and performed is of seriously diminished value and effectiveness.

But, with the auditors apparently fated to operate under seemingly universal human behavioural constraints, it is not either necessary or helpful to demonize them by ascribing either malign intent or corrupt motives.

If they are instead doing as well as their human limitations allow, even if not to the level of expected systemic satisfaction, then whole conferences and symposia should be convened, to design and explore the application of new tools and approaches, and to bring these limitations out from the academic shadows into the realms of daily inter-actions among the auditors, their clients, users and the regulators. 

In other words, auditors may very well be able to bring their competence and expertise to bear on issues of real importance. But not while they – and all the other players involved in Big Audit – are shackled to a model that demonstrably fails to allow for the ever-present and increasingly well-recognized frailty of human beings – a group that (sometimes reluctantly acknowledged) does include the auditors.

 

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In Print: Professionally Responsible Decision-Making

Although I do not have a classroom this fall, with the graduate-level course “Risk Management and Policy Decision-Making” that I have been teaching in business and law schools in Chicago and Paris, I have just made a modest offering.

The short piece below appears in the October 2014 issue of the Revue Internationale de la Compliance et de L’Éthique Des Affairs (International Review of Compliance and Business Ethics).

The Revue is a bi-lingual journal led by Roxana Family, the formidable dean of the law school at the University of Cergy-Pontoise, where I have taught the last three years – published as a supplement to La Semaine Juridique – Enterprises et Affaires. (For subscription access, see  LexisNexis out of Paris.)

My central theme is that the modes of rapid instinctive decision-making inherited from our ancestors – "fight or flight" and "friend or foe," which were good enough for the survival of the tribe, most of the time -- are gravely unsuitable for the complexities of modern life.

In context of the Revue, that theme illuminates the limitations on training and incentives for ethical behavior and good governance.

It also extends to such areas, within the core topics of this blog, as the ways in which the pressures and incentives that constrain the basic audit model operate to suppress the exercise of professional skepticism, and the crying need to re-engineer assurance processes to overcome the “good enough” approaches that are inherently both inefficient and ineffective to detect or prevent serious financial irregularity or manipulation. 

Congruence between academic theory and potential practical applicability being a sometimes elusive proposition, I aim – with my students’ help – to continue giving attention to these themes.

Readers are invited to chime in. 

A link is here, as formatting and reproducing the image is proving a bit complex -- Download Actualite -- or print a version, which should work, or drop me a line and I will send a copy.

 

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RIP Daniel Pirron -- Deloittes Mourns the Loss of a Partner -- And We Should Too

What internal demons impel a suicide?

No reaction but sorrow seems appropriate, for the self-inflicted gunshot death on August 13 of New York-based Deloitte partner Daniel Pirron.

Limited attention has been paid in the accountancy media (here and here). Of which, some comments are tracking his family’s suggested linkage to Deloitte’s UK client Standard Chartered Plc, and the Iran-related money-laundering scandal in which, the week before, the bank had agreed with the New York Department of Financial Services to a $ 340 million fine.

That speculation is unfortunate, for reasons only starting with Pirron’s scope of work itself, in the office of Deloitte’s general counsel, and the firm’s statement that “he was not involved in any way” with its work for Standard Chartered.

Focus here on suicides proximate to financial and corporate wrong-doing – an area of my concern long-predating my unhappily accurate prediction on December 16, 2008, that it was a "safe but unfortunate bet…that at least one remorse-driven suicide will further color the already tawdry (Madoff) tale” – coming only too true a week later with the suicide in his Madison Avenue office of Rene-Thierry Magon de la Villehuchet, the founder of a fund whose investors lost millions with Bernard Madoff. 

That context is difficult enough – initially because the sample size is miniscule, making attempts at meaningful generalizations intensely hazardous. The conditions are, however, readily distinguishable from the impulsive acts of the emotionally immature – fortunately most often not effective – or the reasoned acts of the gravely ill – movie director Tony Scott’s recent fatal leap being perhaps explicable by a report (since disputed) of his terminal brain cancer.

A non-comprehensive survey of scandal-related suicides starts with one point of interest – that with the exception of the recent failed attempt by Peregrine CEO Russell Wasendorf Sr, those driven to act are not the principal perpetrators.

Which should be no surprise. The necessary level of introspective regret and remorse would not be in the DNA of the typical white-collar criminal. Think of the egos both of those actually brought to book – a sample including Bernie Cornfeld, Bernie Ebbers and Bernie Madoff – and those of tattered moral fabric although escaping the formalities of prosecution – “Chainsaw Al” Dunlap and Donald Trump and Angelo Mozilo and Dick Fuld.

Instead it’s the secondary players – the lower-level executives and the gate-keepers – Frank Shuch, the least of the accused triumvirate at Connecticut’s Colonial Realty (1992); Cliff Baxter at Enron (2002); Bernie Madoff’s son Mark (2008); or the reported attempt by Satyam CFO Srinivas Vadlamani (2009).

Even so noted, extreme personal acts are not in character for those choosing careers in professional services, particularly accountancy – there being perhaps some dignifying comfort behind the tradition of ill-founded ridicule of the bean-counters’ brown shoes and green eye shades.

True enough that accountants are neither saints nor angels. As with any fallible system of human design, the firms’ best-tuned screens for personal quality will let slip the rare exceptions – those challenged by intelligence or discipline, the addict or the abuser, the venal or the pliable. And while public accounting is not a vehicle for great wealth accumulation, those shifting to entrepreneurship or the executive suite are on occasion seduced or suborned.

But in the four decades of my broad experience across the profession, only a handful have met the defined standards of the criminal mind. Practitioners of independent assurance -- first delivered to Victorian-era public companies starting in 1850 with the report by William Welch Deloitte himself on the accounts of the Great Western Railway -- have overwhelmingly been people of stability, intelligence, good faith and honorable intentions.

The best scholarship on human behavior and choice-making counsels us to resist the instinctive impulse to construct simplistic stories in a futile search to comprehend the irrational.

So – rather than press an inexplicable coincidence, genuine mourning by the profession is in order – joining with his family, friends and colleagues – for the sad death of troubled Dan Pirron.

 

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Review -- Book of the Year: Daniel Kahneman, "Thinking, Fast and Slow"

One of my students in Risk Management at the University of Chicago beat me to a reading of Daniel Kahneman’s recently-released “Thinking, Fast and Slow” (Farrar, Straus and Giroux, 2011, 418 pp.). 

A young man of few words but crystalline insights, he brought to class this terse review of Kahneman’s reprise of four decades of ground-breaking research into the flaws and fallacies embedded in judgments and choice-making:

“Too long” – he was typically pithy. “But brilliant.”

Right, on both counts. Start with the second: 

Modern English literature would have been impossible without the works of Shakespeare, if few others. The same, going back to the 1970’s: Kahneman and his late collaborator, Amos Tversky, opened whole new fields of inquiry and perception into human behavior.

Thanks to their pioneering work, we have the means to be both entertained and informed by the lessons in “Moneyball” (both the movie and Michael Lewis’s book), such as the stubborn clinging to soon-to-obsolesce folk verities by the talent scouts gathered in Billy Beane’s baseball clubhouse in Oakland.

And we can appreciate being rightly agog at the singular slogan of the credit crisis, the feckless pronouncement of Citigroup’s Chuck Prince in the summer of 2007, that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”   

More broadly, Kahneman and Tversky gave us the means to identify – and desirably to comprehend, although that is subject to much doubting skepticism – whole categories of sub-optimal decision-making. Consider such influences as:

• Herd behavior – and the entire population of mutual fund advisors, unable to distinguish the dubious quantity of talent in their performance from the simple effects of random luck.

• The compulsion to construct compelling if entirely unreliable stories based on tiny bodies of data – and the daily flood of the commentators’ vacuous “explanations” for insignificant price moves in the securities markets. 

• The whole industry of prediction models that are blind to their in-built exposures to rare but catastrophically destructive events – thinking, with sorrow and anger, of the graveyard population of financial structures, from Bear Stearns and Lehman Brothers to the Icelandic banks and the Irish real estate market, right on down to the “repo-to-disaster” at MF Global.

As for my student’s first words – Kahneman’s editor falls into the genre’s too-familiar pattern of over-stuffing between the covers. To be sure, the book is worth its price for its two appendices alone – Kahneman and Tversky’s landmark papers on the irresistible reliance on heuristics and biases, and the assessments of risk appetite and aversion in decision-making under conditions of uncertainty.

But it fails to distill and sharpen, for just one example, the unappreciated significance of regression to the mean in cases where hindsight attribution of causation is a cause of systemically erroneous decision analysis. 

That’s by way of quibble, for Kahneman has brought about a worthwhile trade-off: in exchange for any loss of readers deterred by an over-weight hundred pages, he has gained the achievement of a career-spanning reference work, to become dog-eared on the desks of those of us who will hope in small ways to pass his genius on to the next generation of the students of risk.  

  

This will be by way of valedictory to a difficult and challenging year -- to wish all readers a healthy and peaceful 2012 – even if the new year bids fair to be no less volatile and unpredictable than the old.

January marks this blog’s fourth birthday – celebrated in anticipation that inevitable new eruptions of corporate malfeasance, the capacities of regulators for continued mischief-making, and their continuing and frustratingly ineffective inter-actions with issuers and auditors, will all continue to provide material worth addressing. 

   

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