Centre for Economic Policy Research

Session 2: Auditors and rating agencies
Edward J Kane 
Boston College
According to Ed Kane the key word in this debate is ‘disinformation’. The issue is
to get disinformation out of what is called the information flow. Disinformation
is not just misinformation but information that has been cleverly designed to 
persuade people that adverse developments will not occur. The issue is then how
hard the watchdogs dig to find the disinformation and to what extent they are
willing to keep things to themselves. In truth, incentives for revealing disinfor-
mation are weak. The premise of the Report is that corporate managers, 
accountants and credit rating agencies are responsible to all stakeholders, but feel
no compunction to treat all interests equally, especially in the short run.
The first line of defence has to be the personal ethics of the watchdogs and the
people being watched. A common belief is that the trade-off between feeling good
about the cleverness of exploiting others and the sense of shame for doing it has
worsened over time. The second line of defence is the watchdogs, who must be
known for both barking and biting. The concern is that the bark of the watchdogs
is much greater than their bite. The importance of auditors has already been
stressed; that of rating agencies is to provide an outside check on the reliability
and economic meaning of the information that rating agencies produce. Auditors
and rating agencies are subject to bias and coercion, euphemistically called 
conflicts of interest in the Report. Formal standards of accountability for estimates
produced by both types of firms are incomplete and statistically shallow. 
The next question, therefore, is to ask what the internal and external watch-
dogs really do. Internally, a firm’s board of directors and auditing team have a
duty to impose sound reporting safeguards and to detect deviations from these
standards. This duty is not adequately performed in many cases and this is why
external watchdogs are needed. External watchdogs include outside auditors,
stock analysts, credit-rating agencies, standard-setting professional organizations, 
regulators, government examiners, law-enforcement personnel and information
media (the ‘press’). The first session emphasized the force of reputational penal-
ties for watchdog dishonesty. These penalties can be overcome if insiders can 
temporarily deflect market prices from their full-information or ‘inside’ value
through deceptive accounting reporting. Counterincentives can be created against
disinformation activity through compensation that lets insiders and formally
‘independent’ external watchdogs profit extravagantly from temporarily boosting
a firm’s accounting condition or performance.
In principle, watchdog institutions that have no kinship ties to, or important
commercial dealings with, insiders help outside investors to identify and ignore
disinformation. In practice, however, managers can and do increase their firm’s
perceived profitability by concealing unfavourable information, and watchdogs
are often fooled or persuaded to cooperate in the concealment. Accountants are
also persuaded to participate by earning substantial profits from certifying 
loophole-ridden measurements that temporarily conceal adverse developments
from outside stakeholders. Similarly credit-rating agencies can earn handsome fees
for not challenging accounting information reported by contractual clients as
Discussion and Roundtables 89

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conscientiously as figures reported by other firms. The ethics of watchdog profes-
sions limit their accountability for producing ‘unsafe’ informational products. The
major weakness in the information production system lies in the link between 
the internal corporate governance of firms and the ethics of the watchdogs. The 
profession needs new codes to take away some of the protection that they have in
courts to lessen the temptation of selling and cooperating in disinformation. 
The major problem is the narrow defence that is provided by the so-called 
‘safe-harbours loophole’. The Sarbanes-Oxley Act of 2002 continues to assume
that the formal independence of watchdogs is key to reliable authentication. The
Act ignores the dangers of leaving US accounting rules riddled with safe-harbour
loopholes. The Act asymmetrically imposes stronger disclosure obligations on
CEOs, CFOs, attorneys and investment analysts but not on accountants. Auditors
only need to confirm that specified procedures were followed without having to
express an opinion about the accuracy of the information being transmitted.
Standard-setting agents know very well that such safe-harbour loopholes limit
accountants’ professional obligations, and their exposure to both reputational
damage and civil and criminal penalties. Corporate fraud, bribery and illegal-
gratuity statutes limit this exposure even further by setting hard-to-prove 
standards for punishing deceitful reporting. Persuading accountants to certify
misleading reports proved to be easy in scandalous cases such as Enron. 
The greater scandal is the survival of safe-harbour loopholes and the difficulty
of assembling evidence that can prove auditor or rating-agency malfeasance.
These phenomena testify to the effectiveness of these professions’ lobbies and to
the strength of the incentive conflicts these lobbies transmit to government 
officials. Sooner or later, the practical ethics of the accounting and credit-rating
professions must make their members more energetically embrace their twin 
common-law duties of rejecting corrupting forms of compensation and assuring
the economic meaningfulness of the income and net-worth figures their clients
publish.