Behavioral Decision Research and Management Accounting:

The Case of Conflicts of Interest

Max Bazerman

Harvard Business School

Based on my collaborations with Mahzarin Banaji, Dolly Chugh, George Loewenstein, Don

Moore and Lloyd Tanlu

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Max and Accounting1) University of Pennsylvania (Wharton), B.S.E. in

Accounting, 1976

2) 1987-1997: Lots of experience teaching employees of the Big X accounting firms

3) Our 1997 paper – Bazerman, Morgan, and Loewenstein – no more work with the Big X accounting firms

4) SEC call in 2000

5) The changes made were weak – focusing on disclosure

6) Bazerman, Loewenstein and Moore 2002 HBR paper

7) A few talks to accounting and psychology departments on the prior work and some initial empirical data

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Max and Accounting1) University of Pennsylvania (Wharton), B.S.E. in

Accounting, 1976

2) 1987-1997: Lots of experience teaching employees of the Big X accounting firms

3) Our 1997 paper – Bazerman, Morgan, and Loewenstein – no more work with the Big X accounting firms

4) SEC call in 2000

5) The changes made were weak – focusing on disclosure

6) Bazerman, Loewenstein and Moore 2002 HBR paper

7) A few talks to accounting and psychology departments on the prior work and some initial empirical data

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Core Argument on Auditor Independence

Psychologists have known for a long time that individuals with a vested self-interest, even honest ones, are incapable of unbiased (independent) judgment.

• a) Auditors have made tremendous profit from selling other services to their audit clients.

• b) Auditors want to be rehired.

• c) The personnel on the audit often take jobs with the client firm.

As long as these other motives are present, auditors are not independent.

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Management Accounting - Wikipedia

Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control functions.

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Bounded Decision Making• Bounded Rationality – March and

Simon

• Bounded Willpower - Thaler

• Bounded Self-Interest – Thaler

• Bounded Awareness – Chugh and Bazerman

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Bounded Decision Making• Bounded Rationality – March and Simon

• Bounded Willpower - Thaler

• Bounded Self-Interest – Thaler

• Bounded Awareness – Chugh and Bazerman

• Bounded Ethicality – Banaji, Bazerman, and Chugh; Banaji and Bhaskar

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Bounded Decision Making

• Bounded Rationality

• Bounded Willpower

• Bounded Self-Interest

• Bounded Awareness

• Bounded Ethicality10

Bounded Ethicality (Chugh, Bazerman, and Banaji, 2005)

Bounded ethicality refers to the systematic and predictable ways in which humans act unethically beyond their own awareness.

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1) Boundedness in your ethicality

2) Boundedness in noticing the ethicality of others

Bounded Ethicality

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A: Boundedness in Your Ethicality(Overviews: Banaji, Bazerman, and Chugh, 2003:

Chugh, Bazerman, and Banaji, 2005)

1) Implicit Attitudes (lots of work by Banaji, Greenwald et al.)

2) In-group/Out-group Biases (Messick op-ed)

3) Discounting the Future (Wade-Benzoni, 1999, 2002; Bazerman and Watkins, 2008)

4) Overclaiming Credit (Ross and Sicoly, 1979; Caruso, Epley, and Bazerman, 2006; Epley, Caruso, and Bazerman, 2006)

5) Moral Disengagement: (Bandura, 1986, 1990; Paharia and Deshpande, 2009; Shu, Gino, and Bazerman, 2010)

6) Greater Unethical Behavior under a Loss Frame than under a Gain Frame (Kern and Chugh, 2009)

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B: Boundedness in Noticing the Ethicality of Others

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B: Boundedness in Noticing the Ethicality of Others

1) Conflicts of Interest (Chugh and Bazerman, 2007; Moore, Tanlu,

and Bazerman, 2010)

2) Outcome bias in judging ethics (Baron and Hershey, 1988; Gino,

Moore, and Bazerman, 2009)

3) Slippery slope (Gino and Bazerman, 2009)

4) Indirect blindness in judging unethical behavior (Paharia,

Kassam, Greene, and Bazerman, 2009; Coffman, in preparation)

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B: Boundedness in Noticing the Ethicality of Others

1) Conflicts of Interest (Chugh and Bazerman, 2007; Moore,

Tanlu, and Bazerman, 2010)

2) Outcome bias in judging ethics (Baron and Hershey, 1988; Gino,

Moore, and Bazerman, 2009)

3) Slippery slope (Gino and Bazerman, 2009)

4) Indirect blindness in judging unethical behavior (Paharia, Kassam,

Greene, and Bazerman, 2009; Coffman, in preparation)

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Surgeons versus Non-Surgeons: Should We Operate?

Lots

0 Lots

0

SurgeonsNon-Surgeon Physicians

Don’t Operate

Operate

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The Case (Moore, Tanlu, and Bazerman, 2010)

E-Settle is an Internet-based dispute resolution firm that is interested in being acquired.

Crilley is an established player in the field of alternative dispute resolution services. Crilley is interested in acquiring E-Settle.

Participants are given a variety of information regarding E-Settle’s revenues, earnings, market share, and competition, as well as information about prices for other pre-IPO Internet-based service firms in related industries.

How much is E-Settle worth?18

The Case

COI

 

Year

E-Settle’s revenues

E-Settle’s earnings

E-Settle’s market share

Price-to-earnings ratio for all

acquisitions of professional service

dot-coms 1997 $854,000 $150,000 44% 6:1

1998 $2,324,000 $400,000 31% 10:1

1999 $6,216,000 $1,100,000 26% 14:1

2000 $11,597,000 $2,000,000 24% 7:1

2001 ? ? ? 4:1

Year

E-Settle’s revenues

E-Settle’s earnings

E-Settle’s market share

Price-to-earnings ratio for all

acquisitions of professional service

dot-coms 1997 $854,000 $150,000 44% 6:1

1998 $2,324,000 $400,000 31% 10:1

1999 $6,216,000 $1,100,000 26% 14:1

2000 $11,597,000 $2,000,000 24% 7:1

2001 ? ? ? 4:1

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Experimental Design (Expt. 1)

• 2 X 2 X 3 between-subjects design:

– Played role of principal vs. auditor

– Represented buyer vs. seller

– Auditors’ pay:

COI2

Fixed fee Pay for perf. Future business

Flat $9 payment Auditors paid like principals: based on negotiated outcomes, $3-18

Base payment of $3. After negotiation, principal can choose to reward auditor with $0-10 in future business

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Experimental Procedure (Expt. 1)

COI2

Principals AuditorsRead case materials Read case materials

1) Complete report appraising E-Settle’s value

2) Review principal’s report, provide recommendations and corrections

3a) Review auditors’ reports, negotiate with other principal

3b) Complete private appraisal. $3 reward for being within $3MM. Bet opportunity.

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0

5

10

15

20

25

Fixed payment Pay-for-performance

Future business

Pri

vate

val

uat

ion

(in

$M

M)

Buyer

Seller

Principals’ Public Valuations

COI2

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Auditors’ Recommendations

COI2

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Fixed payment Pay-for-performance

Futurebusiness

More moderate

Neutral

More extreme

Unconditionalendorsement

0

2

4

6

8

10

12

14

16

18

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Fixed payment Pay-for-performance

Future business

Pri

vate

val

uat

ion

(in

$M

M)

Auditor for Buyer

Auditor for Seller

Auditors’ Private Valuations

COI2COI2

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Use of Experiments

1) Used by fields where causal evidence is central  

2) Primary method of behavioral decision researchers

3) Recent move toward field experiments

4) Early critiques: incentives, sophomores, context

5) Generalizability has been outstanding

6) When you question the generalizability of experiments, I believe that it should be based on the interaction between what the scholar is studying and a difference that you assess between the lab and the real world context that is the focus on the generalization

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Conflict of Interest

How could Arthur Andersen vouch for the financial health of Enron, concealing billions of dollars in debt from its shareholders?

Enron was not unique: Adelphia, Cendant, Global Crossing, Haliburton, Tyco. Xerox, Worldcom, and Lehman (?)

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Chief Justice Warren Burger wrote on behalf of a unanimous U.S. Supreme Court (1984):

By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This “public watchdog” function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.

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Which makes more sense?1)1)In order to maintain auditor In order to maintain auditor

independence, auditors are prohibited independence, auditors are prohibited from establishing durable long-term from establishing durable long-term cooperative partnerships with their cooperative partnerships with their clients, from providing non-audit clients, from providing non-audit services to their clients, and from taking services to their clients, and from taking jobs with their clients.jobs with their clients.

2)2)Start by creating a variety of incentives Start by creating a variety of incentives that lead auditors to want to please their that lead auditors to want to please their clients, and then try to identify a clients, and then try to identify a complex set of legislative and complex set of legislative and professional incentives to counteract the professional incentives to counteract the corrupting influences creating by the corrupting influences creating by the desire to please the client.desire to please the client.

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The Failure of the Sarbanes-Oxley Act of

2002

Auditor rotation – but not firm rotationLimited non-audit services – but some

non-audit services remainLeaders cannot move between firms –

but much of the audit team can

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Conflict of Interest

Other examples:

1) Trusting Audited Financial Statements

2) Trusting Ratings from Security Rating Agencies

3) Investment Advisers

4) Trusting Your Doctor to Give You the Best Possible

Medical Advice

 

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The Misspecification of the Conflict of Interest Problem

Intentional Corruption

Vs.

Intentional and Unconscious Corruption

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Conflict of Interest

Upton Sinclair: “It is difficult to get a man to understand something when his salary depends on his not understanding it."

And, I would add: integrity is not a good enough solution.

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