In his 2009 paper titled ?Market and Political/Regulatory Perspective on Recent Accounting Scandals?, Ray Ball discusses accounting scandals in 2001 and 2002. Provide a summary of the market consequences of misreporting and the auditors? conflicts of interests as explained in the article.

DOI: 10.1111/j.1475-679X.2009.00325.x Journal of Accounting Research Vol. 47 No. 2 May 2009 Printed in U.S.A. Market and Political/Regulatory Perspectives on the Recent Accounting Scandals R AY B A L L ABSTRACT Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of the political/regulatory process and of the market for corporate governance and financial reporting. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, and the events are recent and not well researched, so untangling their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who killed Arthur Andersenthe Securities and Exchange Commission, or the market? Did fraudulent accounting kill Enron, or just keep it alive for too long? What is the social cost of financial reporting fraud? Does the United States in fact operate a \"principles-based\" or a \"rules-based\" accounting system? Was there market failure? Or was there regulatory failure? Or both? Was the SarbanesOxley Act a political and regulatory overreaction? Does the United States follow an ineffective regulatory model? 1. Introduction The tsunami of accounting scandals at the beginning of the millennium is well known. A partial list of companies involved includes AOL, The University of Chicago Booth School of Business. Helpful comments were gratefully received from Sudipta Basu, John Coates, Ron Dye, Bob Jensen, Clive Lennox, Steve Orpurt, Sam Peltzman, Sarah Zechman, participants at the 2008 Journal of Accounting Research Conference, and especially Christian Leuz (the editor). Financial support from the University of Chicago, Graduate School of Business also is gratefully acknowledged. 277 C , University of Chicago on behalf of the Institute of Professional Accounting, 2009 Copyright \u0003 278 R. BALL Bristol-Myers Squibb, Cendant, Computer Associates (CA), Conseco, Dynegy, Enron, Federal Home Loan Mortgage Corporation (\"Freddie Mac\"), HealthSouth, Peregrine Systems, Qwest, Rite Aid, Sunbeam, Tyco, Waste Management, WorldCom, and Xerox, with Enron and WorldCom being the most familiar due to the scope and audacity of their deficient reporting. 1 In Europe, ComROAD AG (Germany), Lernout & Hauspie Speech Products (Belgium), Parmalat (Italy), and Royal Ahold (Netherlands) achieved similar notoriety during the period, and the United Kingdom earlier had been rocked by scandals in the 1960s and again in the late 1980s and early 1990s (notably, Polly Peck). Nevertheless, the clear epicenter of the 2001 to 2002 scandals was in the United States. The scandal waves spread widely and quickly. Resulting damage included: a decline in the worldwide reputation of a wide variety of U.S. institutions, including U.S. generally accepted accounting principles (GAAP), auditors, security analysts, regulators, and financial markets generally; the conviction of over 1,000 executives; extensive private litigation and damages awards against companies, managers, auditors, and complicit banks; the most substantial increase in the regulation of U.S. public financial reporting in 75 years, under the Sarbanes-Oxley Act of 2002; creation of a Public Company Accounting Oversight Board (PCAOB) with almost unfettered powers to adopt and enforce rules governing the audit industry and to discipline audit firms and employees; 2 the demise of a once-proud accounting firm; and a forest of largely unhelpful literature. A variety of press and academic commentators have tried to make sense of the scandals and the events that ensued. What caused them? Why did they occur then? What were the consequences? Was more regulation the optimal response? Will they happen again? Not surprisingly, these questions have been addressed from many different perspectives. For example, there has been discussion of the roles of social norms, morals, ethics, corporate culture, corporate governance, incentive-based compensation, emphasis on short-term profits, audit committees, audit standards, audit firm conflicts of interest due to non-audit revenues, reporting rules, securities laws, and regulatory oversight. Differences in perspective can enrich a debate butif not made clearthey also can add confusion to it. The objective of this essay therefore is to consider the scandals and several of the important ensuing events from two important and contrasting perspectives: the perspective of the political/regulatory process and the perspective of the market for corporate governance and financial reporting. The general intent is to clarify our understanding of the events and their consequences. 1 The precise extent of accounting fraud over the period is unclear. Lists tend to include nonaccounting illegalities (such as insider trading, obstruction of justice, and money laundering), bankruptcies, and unproven allegations. See http://www.trinity.edu/rjensen/Fraud.htm and http://en.wikipedia.org/wiki/Accounting scandals. 2 Sarbanes-Oxley Act of 2002, Pub.L. 107-204, 116 Stat. 745, also referred to as the Public Company Accounting Reform and Investor Protection Act of 2002. RECENT ACCOUNTING SCANDALS 279 The difference between the market and political/regulatory perspectives on the scandals has more than historical significance: It substantially affects how one interprets not just the scandals, but also the substantial regulation of U.S. corporate governance and financial reporting that ensued. A specific objective of this essay therefore is to assist in the debate on whether the Sarbanes-Oxley Act's historical increase in regulation was a good idea, in terms of both its scope and its form. We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, so untangling their separate effects is difficult at best. Further, the events still are recent and not well understood. Insufficient time has passed to allow a distanced perspective or to conduct definitive research, the implication being that opinions tend to be based on only anecdotal or small-sample evidence. Thus, while the following analysis is based where possible on the evidence and on hopefully valid reasoning, much of it is conjectural. A further caveat is in order. When comparing the political/regulatory and market views of the accounting scandals, I am much influenced by the Stigler [1964, 1971]-Peltzman [1976] skepticism for regulation. 3 From this perspective, the political process that creates and monitors regulation tends to be captured by the regulated industry and organized special-interest groups, so it typically does not promote general social welfare. Further, even if it attempts to, regulation does not always succeed in promoting social welfare, in part because it is enforced by poorly informed and incented government employees. Hopefully, this skeptical perspective will provide some counterpoint to the post-scandal rush to regulate governance and reporting. The following section describes and interprets the scandalous events of 2001 to 2002. Section 3 and section 4 analyze the political/regulatory and market responses to the events, in an attempt to assess their relative roles. Section 5 argues that regulation encourages a rules-based approach to U.S. financial reporting, and the concurrent belief that technical compliance with codified GAAP is sufficient, whereas markets demand compliance with the wider concept of the accounting principles that are generally accepted. Section 6 examines the principal political/regulatory response to the scandalsthe Sarbanes-Oxley Act of 2002from a market perspective, and section 7 speculates on the long-run consequences of the Act. Section 8 offers some conclusions. 2. The 2001 to 2002 Accounting Scandals The analysis of market and political/regulatory perspectives that follows is unavoidably influenced by my interpretation of these scandalous events, including my views on what the scandals were, why they were scandalous, what 3 See also Benston [1969, 1973], Posner [1974], Coffee [1984], Coates [2001], Romano [2002], and the public choice theory of Buchanan and Tullock [1962]. 280 R. BALL caused them, and why they occurred when they did. This section attempts to make those views more transparent. 2.1 REPORTING NEGLIGENCE AND FRAUD VERSUS EARNINGS MANAGEMENT The term \"earnings management\" is used to describe managers intervening in the reporting of their own financial performance. It encompasses a range of practices, including: r Practices that are legal, violate no accounting rules or principles, and r r r r are generally viewed as ethicalsuch as structuring transactions with regard to their effect on the financial statements (leasing being a prominent example); Practices that are legal, violate no accounting rules or principles, and are viewed by many as ethicalsuch as timing asset sales to book gains in years with lower profits, and to book losses in years with higher profits (Bartov [1993]); Practices that are legal, violate no accounting rules or principles, but might violate accepted standards of disclosuresuch as giving yearend quantity discounts to major customers, generating sales \"pull forwards,\" but failing to disclose that they inflate current earnings and borrow against future earnings; Negligent or grossly negligent financial reportingsuch as unwittingly failing to comply with GAAP; Fraudulent financial reportingsuch as knowingly failing to comply with GAAP. Earnings management is a generic term for all of these practices. 4 While they differ in economic, legal, and ethical severity, they all undermine the quality of financial reporting to some degree. Earnings management therefore is analogous to a suite of financial system viruses: Some are more severe than others, but all weaken the efficiency of the system. This paper addresses financial reporting that is negligent or fraudulent. Negligence involves managers or auditors making unintentional errors due to factors such as inadequate experience, training, knowledge, supervision, or effort. Negligent behavior involves failing to do what is considered reasonable and prudent for a person in their position under the circumstances: in the context of financial reporting, failing to meet accepted accounting, disclosure, or auditing standards. Gross negligence involves reckless disregard for accepted standards. Negligence that can be proven to harm others, such as investors, gives rise in law to an actionable tort. Fraud is a more 4 The term \"earnings management\" appears to be popular because most financial statement manipulation involves earnings. Nevertheless, some manipulation affects balance sheets or operating cash flow, without affecting earnings. RECENT ACCOUNTING SCANDALS 281 serious transgression, because proving fraud requires establishing scienter , defined loosely as intentional wrongdoing. 5 In contrast, much academic research on earnings management establishes such a weak burden of proof that earnings management appears almost universal, perhaps reflecting the Hobbesian outlook that has overtaken accounting academe, its limited knowledge of accrual accounting, and the ease with which correlated omitted variables can produce the result one is looking for. 6 The advantages of focusing on negligent and fraudulent reporting include: a proven case of negligent or fraudulent financial reporting is an institutional \"fact,\" as distinct from an error-prone academic estimate; reporting negligence and fraud have been shown to have substantial adverse effects on firm values (Palmrose, Richardson, and Scholz [2004]); and the sight of executives being led away in handcuffs under indictment for reporting fraud created more scandal than a whole literature of Jones-model discretionary accrual estimates. 7 2.2 WHY WERE THE EVENTS SCANDALOUS? James Q. Wilson opens The Moral Sense with the insightful observation that two conditions must hold for a public scandal to occur: the events must be unusual (i.e., relatively infrequent in occurrence) and they must be shocking (i.e., counter to our norms) (Wilson [1993, p. 2]). The public pays little attention to frequent events and there is no scandal arising from infrequent but morally acceptable events. The events of 2001 to 2002 certainly were unusual. The relative frequency of negligent or fraudulent reporting in the United States is difficult to estimate precisely, mainly because it is unclear how to define the exact population of reports from which it is drawn, in terms of both the total number of firms in existence and the length of the time period used for reference. Nevertheless, the reference population undoubtedly is large relative to the number of convictions for malfeasance, and the relative frequency is correspondingly low, despite the extraordinarily large number that came to light 5 The legal standard of proof is subjective. For securities cases, the Private Securities Litigation Reform Act of 1995 set the standard as \"strong inference\" of scienter . In Tellabs, Inc. v. Makor Issues & Rights, LTD (21 June 2007), the Supreme Court interpreted this as a requirement to prove \"cogent and compelling evidence\" of scienter . 6 \"Discretionary\" accruals are estimated as the residual component of accruals that cannot be explained by accruals models. These models typically are mechanical, perfect-certainty descriptions of \"nondiscretionary\" accruals, and are not built on credible economic models of why firms hold working capital (e.g., to absorb shocks in production, demand, and cash receipts). They thus are so poorly specified that they explain only a minor proportion of accruals. They seem likely to substantially overestimate the amount of even the mildest (and presumably most frequent) type of earnings management: Practices that are legal, violate no accounting rules or principles, and are viewed as ethical. 7 On the other hand, an unobserved quantity of negligence and fraud goes undetected or unproven, even though it is argued below that material financial misreporting is difficult to conceal for an extended period. 282 R. BALL over two years. For example, if 4,000 public companies on average file quarterly reports over 50 years, the population is 8 million total filings. 8 As noted above, an unknown amount of negligence and fraud goes undetected, so the true incidence undoubtedly exceeds the observed. Nevertheless, even a generous allowance for undetected malfeasance in past years seems unlikely to alter the conclusion that the events of 2001 to 2002 were scandalous in large part because they occurred with such a low relative frequency. 9 The events of 2001 to 2002 also were scandalous because they clashed so strongly with the norm. Common law countries, chief among them the United States, have built large debt and equity markets, and correspondingly large public corporate sectors, by following a model founded on high-quality financial reporting and disclosure. This allows lenders, shareholders, suppliers, and customers to transact at arm's length with corporations, across a public market, without private (insider) access to information about them. Consequently, high-quality financial reporting has long been viewed as a foundation of the U.S. financial system. 10 In contrast, public financial reporting has not played such an important economic role in code law countries, including most of continental Europe. Under the code law model, access to information has been more on a relationship basis, public financial reporting has been lower in quality by observable measures, large corporations have been more likely to be private, and public capital markets have been a comparatively smaller part of the economy (Ball, Kothari, and Robin [2000]). The reporting transgressions that came to light in 2001 to 2002 therefore were scandalous both because negligent or fraudulent reporting is infrequent and because it so strongly violates expected standards of behavior. 2.3 TO WHAT CAUSED SUCH A RASH OF SCANDALS TO COME TO LIGHT IN 2001 2002? How can the notion that scandals are infrequent be reconciled with such a large number of cases coming to light in such a short period? There is limited evidence on what was different about this period, so the following 8 In the United States, a public company is defined for regulatory purposes as one that is required to register its securities (including stocks and bonds) for sale to the public on a major stock exchange such as the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ), or \"over the counter\" through quotation services such as the OTC Bulletin Board and Pink Sheets. In addition, small companies are publicly traded without being required to register. 9 A similar point was made in a speech by Thomas J. Donohue, the President of the U.S. Chamber of Commerce (U.S. Chamber of Commerce [2003]): \"There are more than 17,000 publicly traded companies in the U.S., and only a couple (of) dozen of them have been accused of wrongdoing.\" http://www.uschamber.com/press/speeches/2003/030714tjd hitachi.htm. 10 In one of several untimely remarks, then Deputy Secretary of the Treasury Lawrence Summers wrote in the Financial Times, London, on 11 March, 1998 (cited by Beresford [1998, p. 151]): \"If one were writing a history of the American capital market, it is a fair bet that the single most important innovation shaping that market was the idea of generally accepted accounting principles.\" RECENT ACCOUNTING SCANDALS 283 is uncomfortably conjectural. The closest supporting theory and evidence is in Harris and Bromiley [2006] and Kedia and Philippon [2007], and is consistent with the following hypothesis that the economic cycle was a major factor. 11 The longest boom in U.S. history ended in March 2001. Bearing this in mind, the following sequence of cycle-related events seems plausible. First, in an extended boom, high growth becomes built into performance expectations: into earnings and revenue forecasts, budgets, share prices, option values, investment decisions, and debt commitments. Managers therefore come under peer and financial pressures to deliver strong earnings growth and share market performance. Second, lax practices likely develop in a long boom: Corporate monitors (boards, internal and external auditors, analysts, rating agencies, the press, and regulators) come to accept high growth as normal, and there is a risk of \"falling asleep at the switch.\" Third, the boom \"busts,\" growth suddenly falters, and around the same time many managers are unable to meet expectations. Fourth, some managers resort to either faking transactions or adopting unaccepted accounting methods to disguise their faltering performance. Fifth, with some probability, the reporting malfeasance is detected. 12 Sixth, after a series of malpractices are uncovered, they reach widespread public attention, and become scandalous. 13 Other factors surely were at play. A \"rule-checking\" mentality appears to have crept over the accounting profession, including the Financial Accounting Standards Board (FASB, a fittingly named successor to the Accounting Principles Board), audit firms, researchers, and educators. Under this narrow world view, financial reporting requirements are embodied in rules, not principles, and compliance with rules-based GAAP is sufficient. In several of the scandalous cases (Enron in particular), investors were alleged to have been mislead by financial statements that were in technical compliance with GAAP but that did not reflect the economic substance of the transactions they were reporting. Regulation downplays the basic common law principle 11 See also Alexander and Cohen [1996], Strobl [2008], and Davidson [2008]. The likelihood of detection decreases with postmalfeasance performance. Many schemes to overstate revenues (e.g., \"channel stuffing\" and \"sales creep\") involve borrowing revenue from future periods, thereby increasing present earnings and correspondingly reducing future earnings. They are less likely to be detected if future revenues recover. Further, companies such as Enron and WorldCom, whose false reporting temporarily disguised financial insolvency, are forced into bankruptcy if real performance does not improve, at which point managers acting on behalf of creditors can examine the books. 13 The above is uncomfortably close to Galbraith's [1961, p. 153] account of the embezzlement scandals that came to light after the 1929 market crash, and contributed to the creation of the Securities and Exchange Commission (SEC): \"In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous.\" 12 284 R. BALL that market participants are expected to behave according to the standards that are generally accepted and practiced by informed, competent market participants (here including financial statement users as well as preparers). In contrast, regulators prefer to administer rules. 14 I conjecture that regulation played a substantial role in fostering this rules-based perspective, and hence played an important role in setting the stage for the accounting scandals. This conjecture lies in contrast with the more orthodox view that the scandals occurred in spite of regulationa view that is difficult to reconcile with the fact that the U.S. financial reporting market is highly regulated by international standards (Coffee [2007]). A widely viewed culprit in the scandals was conflicts of interest arising from audit firms performing non-audit work for clients. To many observers, auditors had incentives to appease their clients by giving them favorable audit treatment, in order to retain lucrative consulting engagements. I return to this issue in section 4.3, and conclude that conflicts of interest most likely are not a major factor in the scandals. Nevertheless, user trust in financial reporting requires perceived as well as actual audit independence, so the issue is unlikely to go away. A less obvious but possibly more important culprit in the scandals was a subtle drift in the auditor-client relationship over time. The relationship always has been unusual in a legal sense. Auditors supply a certification that is used by investors and the public at large, and it is to them that they owe a standard of care. However, they are engaged and compensated by client firm managers, who are interested parties (i.e., prefer a clean audit certificate). The argument here is not that non-audit revenues create a potential conflict of interest, but that audit fees themselves do. Perhaps related to this issue, anecdotal evidence suggests that over time auditors have drifted from a skeptical, adversarial interaction with clients toward a cooperative approach. The drift possibly accelerated as a consequence of the lax practices that developed in the prolonged economic expansion of the 1990s. It needs emphasizing that this argument is based only on anecdotal evidence; salient elements of the auditor-client relationship are not readily observable, and research on the issue tends to use proxies, such as length of auditor tenure, that are correlated with important omitted variables. Further, the argument ignores reputational and other mechanisms that constrain such conflicts of interest, as discussed in section 4.3 below. Coffee [2005] argues that dispersed share ownership makes the United States more prone to financial reporting problems than the concentrated ownership systems of continental Europe, where scandals are more likely to involve appropriating private benefits of control. 15 While this argument has some legitimacy, it is not consistent with much evidence. First, the argument implies that, if anything, financial reporting should be of higher quality in private companies than public companies, because they have more 14 15 This point is developed further in section 5.7 below. A similar argument is made by Zingales [2009]. RECENT ACCOUNTING SCANDALS 285 concentrated ownership. The evidence supports the opposite view (Ball and Shivakumar [2005], Burgstahler, Hail, and Leuz [2006]). Second, the dispersed ownership argument makes no allowance for the evidence that common law countries such as the United States generally set a higher standard for financial reporting. Many of the scandalous U.S. cases involved practices that historically have fallen within legitimate managerial discretion in many code law countries, such as drawing on \"cookie jar\" reserves to inflate profits in bad years. In that regard, attributing the scandals to dispersed ownership also seems inconsistent with the evidence on international differences in reporting quality (Ball, Kothari, and Robin [2000], Leuz, Nanda, and Wysocki [2003]). Increased use of stock options in executive compensation in the United States was blamed by several commentators, including Coffee [2005] and, notably, Alan Greenspan [2002]. While the argument has merit, in that performance-based compensation provides an additional motive to misrepresent performance and was found to be a factor in at least one case (Computer Associates), there is evidence that stock options were not a major factor. 16 While the number of cases that came to light over 2001 to 2002 is astonishing, and while additional cases presumably went undetected, there are reasons to suspect that the press exaggerated the scandal. The press generally overreports risks. Bailis and MacCoun [1996] document that the press overrepresents the frequency of tort litigation generally, the frequency of disputes going to court without prior settlement, the frequency of trials won by plaintiffs, and the average size of jury awards. During the scandal period, accounting-related issues were unusually newsworthy, and the press reported even minor issues that previously would not have made the news. 17 This bias was fed by panicking companies that, in a post-Enron \"witch hunt,\" combed their books for the slightest hint of an accounting issue, which the press duly reported as scandalous. 18 The press thereby exaggerated the extent of an already substantial scandal. 2.4 WHY DO MANAGERS COMMIT FINANCIAL REPORTING FRAUD? Managers face a variety of well-known financial incentives to meet performance expectations. These include: gaining earnings-based bonuses; 16 Compare Erickson, Hanlon, Maydew [2006] with Burns and Kedia [2006] and Efendi, Srivastava, and Swanson [2007]. Option backdating became a separate scandal several years later. 17 Similar reporting behavior occurs for small earthquakes and plane crashes, which are more likely to be covered immediately after a large earthquake or crash brings the issue to public and press attention. 18 For example, the Wall Street Journal Online ran the exaggerated and misleading headline \"Tyco's Internal Report Finds Extensive Accounting Tricks\" over a story that actually reported \"the problems weren't large enough to be 'material' to the company's overall profits\" and \"many of the maneuvers fell within accounting rules and didn't require any correction\" and also \"the report said these were relatively minor and didn't amount to a 'systemic fraud.'\" 286 R. BALL increasing their promotion prospects; avoiding termination; avoiding a decline in the value of their stocks, stock appreciation rights, and options; avoiding a downgrade of the company's debt, which could result in higher borrowing costs and further reductions in earnings; avoiding debt covenant violations that could lead to restrictions on dividend payments, new investment, and further borrowing, or accelerated debt repayment; avoiding corporate bankruptcy; and hiding some other fraud (e.g., stolen assets, including cash). My view, based on mainly anecdotal experience, is that nonfinancial motives are more powerful than is commonly believed, and sometimes are the dominant reason for committing accounting fraud. An important motivator seems to be maintaining the esteem of one's peers, ranging from coworkers to the public at large. Enron executives reportedly were celebrities in Houston, and in important places like the White House. 19 Much of this celebrity derived from the firm's reputation as an extremely successful innovator in the postderegulation energy market. Much apparently was purchased using shareholders' seemingly abundant money to support a wide range of charitable causes. Either way, the celebrity would have evaporated if the company's poor profitability and weak financial condition had been truthfully revealed. 20 In general, there appear to be substantial private nonmonetary benefits of controlling a company for managers committing fraud, even though they presumably are more difficult to prove in court than monetary benefits from bonuses, options, etc. Financial frauds appear to share three properties: 1) Inability to meet performance expectations, 2) Personal costspecuniary or nonpecuniaryof failing to meet expectations, and 3) Being able to convince oneself that real performance will improve soon. The last property arises for several reasons. First, if real performance does not subsequently improve, the deception must be repeated to disguise the continuing performance shortfall. Second, fraud is very difficult to conceal for an extended period. Fraud typically requires cooperation among several employees, or involvement by parties on the other side of a fraudulent transaction. Financial reporting fraud usually leaves a document trail that is subject to internal and external audit. Third, if real performance does not increase and the deception must continue, its effects cumulate in the accounts 19 In addition to providing substantial employment and stock gains to Houston residents, Enron's name was on Enron Field and it generously supported the Alley Theater, the Houston Ballet, the Houston Symphony, and the Museum of Fine Arts, among others. See Kinzer [2001] and Yardley [2002]. 20 Painter [2002] and Brudney and Ferrell [2002] discuss legal issues. After heavy lobbying by charities, the final version of Sarbanes-Oxley dropped requirements in early drafts that corporations disclose their charity recipients. RECENT ACCOUNTING SCANDALS 287 and the probability of being detected rises. 21 Fourth, many schemes that overstate current earnings involve accelerating revenue recognition (incorporating revenues in earnings too early), and hence only \"borrow\" revenue and earnings from future periods. This increases reported performance in the current period, but reduces it in future periods, apparently in the hope or belief that future real performance will increase and will allow the deception to be covered up. Convincing oneself that real performance will improve before the fraud is discovered would be assisted by an excessively strong belief in oneself and in one's company. 22 Thus, committing accounting fraud frequently involves a \"gambler's mentality.\" 23 This is an important point in assessing whether the increased penalties under the Sarbanes-Oxley Act are likely to deter future financial reporting fraud, discussed below. 3. Political/Regulatory Reaction to the Scandals The political and regulatory response to the scandals has two branches: criminal proceedings against companies and individuals accused of acting negligently or fraudulently in the past and legislative proceedings aimed at reducing the incidence of future negligence and fraud. 3.1 CRIMINAL PROCEEDINGS Criminal law is created, administered, and prosecuted by governments. In criminal law, defendants found guilty in securities cases can be punished with prison sentences, fines, asset seizures, or disbarment from practice. Additional costs borne by defendants include legal fees, loss of reputation, loss of employment prospects, time, and stress on themselves and their families. Criminal proceedings were initiated by the United States against a range of individuals and corporations involved in the accounting scandals. The audit firm Arthur Andersen was indicted and convicted with astonishing speed. The SEC opened its investigation of Andersen on November 29, 2001. On January 9, 2002, the Department of Justice upgraded it to a criminal investigation. Andersen first attracted widespread public attention the following day, January 10, 2002, when it announced it had destroyed certain Enron audit documents the previous year, some after learning of the 21 Parmalat reported fake sales for decades, the cumulative effect being that by 2002 it reported 3 billion in fake bank accounts. The alternativefaking uncollected accounts receivablewould more likely have been detected by auditors (verifying individual receivables) or analysts (noticing an unusually high receivables/sales ratio). 22 Kenneth Lay and Jeffrey Skilling (Enron), Richard Scrushy (HealthSouth), and Bernard Ebbers (WorldCom) claimed in their trial defense that their companies were fundamentally sound, despite compelling evidence to the contrary. The link between financial fraud and excessive self-belief is explored by Schrand and Zechman [2008]. 23 The diagnostic criteria for pathological gambling of the American Psychiatric Association (APA [2000]) include: \"after losing money gambling, often returns another day to get even ('chasing losses').\" 288 R. BALL SEC investigation. On May 6, 2002, in the U.S. District Court for the Southern District of Texas, the United States charged Andersen with obstruction of justice by failing to retain audit documents. After a widely covered trial, Andersen was convicted by a jury on June 15, barely five months after the allegation of destroying documents initially surfaced. Andersen then lost an appeal against the conviction, in the U.S. Court of Appeals for the Fifth Circuit, and because federal regulations disbar convicted felons from auditing public companies, it surrendered its license to practice on August 31. Three years later, on May 31, 2005, the conviction was unanimously overturned by the U.S. Supreme Courta Pyrrhic victory for Andersen, which had long since closed its doors. 24 I hold no brief for Arthur Andersen. In fact, I argue below that, in the absence of government involvement, the market most likely would have closed Andersen by itself, because its reputation for independent professional auditing was in tatters due to a series of poor audits, and its financial viability was threatened by pending damage claims. It also is possible that Andersen would have been convicted in the criminal case even if the District Court had shown greater objectivity. But the fact that Andersen's conviction was unanimously overturned by the U.S. Supreme Court, in an opinion written in such strong language by the Chief Justice, does raise substantial concerns about federal prosecution in high-profile cases. The District Court judge in Andersen's Houston trial was placed under substantial pressure by a press baying for conviction, by politicians denouncing Andersen, by a local Houston public deeply affected by the Enron bankruptcy, and by aggressive federal prosecutors. Prosecutors enjoy considerable power in such cases, because a high-profile prosecution played out in the world presshowever unwarranted it may beis a crippling penalty per se for the company and its managers. Compared with the Andersen case, the criminal prosecution of individuals involved in the scandals has taken longer and been more successful. Acting under intense political pressure to \"fix the problem,\" President Bush created the President's Corporate Fraud Task Force on July 9, 2002, \"to restore public and investor confidence in America's corporations following a wave of major corporate scandals.\" Department of Justice statistics for prosecutions between July 2002 and June 2007 record 1,236 convictions attributed to the Task Force, including 214 CEOs and presidents, 129 vice presidents, 53 CFOs, and 23 corporate counsels. Penalties included over $2 billion in 24 The court ruled that Andersen's original conviction was marred by the judge instructing the jury to the effect that criminal intent need not be proven (Andersen claimed it had followed normal policy of retaining important audit documents but discarding volumes of unimportant documents, and was unaware it was taking any illegal action). Chief Justice Rehnquist wrote the opinion, which included (Oyez Project [2005]): \"Indeed, it is striking how little culpability [on the part of Andersen] the instructions [to the jury] required.\" RECENT ACCOUNTING SCANDALS 289 restitution and fines. 25 These figures include convictions for securities fraud, insider trading, market manipulation, wire fraud, obstruction of justice, false statements, money laundering, Foreign Corrupt Practices Act violations, stock option backdating, and conspiracy, and are not limited to financial reporting, but they give an indication of the aggressive and effective criminal prosecution by the U.S. Government in response to the scandals. 3.2 LEGISLATIVE PROCEEDINGS: THE SARBANES-OXLEY ACT OF 2002 The legislative response to the accounting scandals was straight out of the Stigler [1964, 1971]-Peltzman [1976] playbook. Applying Peltzman's [1976] theory, Watts and Zimmerman [1986, p. 229-31] argue that the political process has an incentive to avoid perceived responsibility for investor losses, and that legislative action is a political attempt to escape blame. Spurred on by the White House and the press, by declining U.S. prestige, by a declining dollar, by declining share prices, by the events of September 11, and by an economic downturn, Congress rushed to pass the Sarbanes-Oxley Act. The House vote was 423 to 3 and the Senate vote was 99 to 0. President George W. Bush immediately signed it into law, on July 30, 2002. The extensive provisions of the Sarbanes-Oxley Act include: r CEOs and CFOs must certify their financial statements and internal r r r r r r r r controls, with substantial criminal penalties (notably, 20-year prison terms) for reckless certification; An independent audit committee of the board must be responsible for hiring and overseeing auditors; Fraudulently influencing or misleading auditors is prohibited; Non-audit work by the company's auditor that would compromise its independence is prohibited (such as bookkeeping, internal audit, and legal work); Rotation of audit engagement partners is mandated; Increased disclosure of a variety of matters is required, including companies' internal controls, codes of ethics, and off-balance-sheet transactions; Security analysts are prohibited from publishing reports on companies where conflicts of interest exist (notably, due to investment banking work); Corporate loans to officers are prohibited; and The PCAOB is created to oversee the audit industry. The PCAOB is a regulator with daunting powers. It is empowered to promulgate rules that affect almost all aspects of the audit industry, including auditing standards and procedures, audit firm practices, and client 25 Figures are from U.S. Government [2007]. 290 R. BALL firms' internal controls. It monitors compliance with its own rules. Further, it enforces its own rules: It is empowered to take disciplinary action against audit firms and their employees. In many ways, the PCAOB is legislator, policeman, judge, and jury. It is given wide-ranging discretion and is subject only to supervision by the SEC. In the long run, it has the capacity to regulate the audit industry with an iron fist. Overall, the Sarbanes-Oxley Act provides the most extensive regulation of the securities markets since the Securities Act of 1933 and the Securities Exchange Act of 1934, which among other things created the SEC. That legislation also was a response to a political crisis: the Great Crash of 1929 and the Great Depression. The Sarbanes-Oxley Act substantially expands government and regulatory involvement in the securities markets, and financial reporting in particular. It represents a major move toward a continental European securities market model and a substantial abandonment of a model that served the United States well for a century. Yet the SarbanesOxley Act was drafted, debated, voted upon, and signed into law within seven months of the SEC opening its investigation into Arthur Andersen. And this by a Congress that takes decades to address Social Security reform. 4. Market Reaction to the Scandals We do not have the opportunity to observe a world in which either market or political/regulatory processes operate independently, so it is only possible to conjecture what the response of a completely unregulated marketplace would have been. Even if we could observe market forces separately, Hayek [1945, 1988] continually reminds us that they are complex, dispersed, difficult to fully identify, and easy to underestimate. Nevertheless, it is possible to identify some market mechanisms that operated, and to attempt an assessment of their effectiveness. In parallel to the political and regulatory response to the scandals, the market response had two branches: penalties assessed against those accused of past negligence or fraud and adaptive changes in institutional arrangements aimed at reducing its future incidence. 4.1 CIVIL PROCEEDINGS AND DAMAGES AWARDS While the criminal prosecution cases attracted most worldwide public attention, a blizzard of private litigation was launched against firms, managers, board members, audit firms, insurance companies, and any parties alleged to have been complicit in financial reporting malpractices. Civil litigation is prosecuted by private litigants who allege they were harmed by the actions of others. Litigants included stockholders, creditors, bondholders, employees, labor unions, and pension plans. Defendants found guilty in securities cases are punished by the courts awarding monetary compensation to the litigants for the damages they have incurred as a consequence of the harmful actions. Unlike criminal proceedings, civil litigation is a private, market RECENT ACCOUNTING SCANDALS 291 process of enforcing explicit and implicit contracts among firms, managers, auditors, creditors, shareholders, and other contracting parties. 26 The press attention given to the criminal trials makes it easy to overlook the scale of the market-based penalties that have been meted out. Total damages settlements in securities litigation over 2000 to 2007 exceeded $50 billion (Simmons and Ryan [2008]). In the Enron case alone, extensive private litigation against banks alleged to have been complicit in just some aspects of Enron's financial misreporting has been settled for a total of approximately $9 billion (for comparison, Enron's total assets peaked at approximately $70 billion). WorldCom settlements exceeded $6 billion, and Cendant settlements exceeded $3 billion. Some litigation arising from the 2001 to 2002 scandals is still ongoing. 4.2 REPUTATION, BONDING, AND INSURANCE EFFECTS: WHO KILLED ARTHUR ANDERSEN? Reputation effects have long been viewed as a powerful market mechanism, imposing penalties on parties found to have acted inappropriately (for example, Telser [1980] and Kreps and Wilson [1982]). Karpoff and Lott [1993] document substantial reputational costs to firms committing fraud generally. In the audit industry, the audit firm's reputation for independent, professional work is central to performing its economic role of verifying financial statements for use by uninformed outsiders (see Jensen and Meckling [1976], Watts [1977], and Watts and Zimmerman [1983, 1986]). DeAngelo [1981] argues that large audit firms, like Arthur Andersen before its demise, earn substantial quasi-rents, which they stand to lose if they perform poor-quality work. Research has shown that audit firm reputation is associated with audit fee premiums (Simunic [1980], Francis [1984], Francis and Simon [1987], Palmrose [1986], Craswell, Francis, and Taylor [1995]) and with the market valuation of their clients (Kellogg [1984], Beatty [1989]). Palmrose [1986, 1987] links litigation risk to audit quality. Events that could reduce auditors' reputations, such as regulatory action or private litigation against them, are associated with stock price reductions for clients (Loebbecke, Eining, and Willingham [1989], Firth [1990], Moreland [1995], Franz, Crawford, and Johnson [1998]), with loss of clients (Firth [1990], Wilson and Grimlund [1990]), and with reductions in audit fees (Davis and Simon [1992]). By the time it ceased business as an auditor, Andersen's reputation for quality, independent auditing was in tatters due to a series of deficient audits. These included its audits of Enron, Sunbeam, Waste Management, and WorldCom, which garnered international attention. But there were lower-profile transgressions, including its audit of the Baptist Foundation of Arizona, which became the largest bankruptcy of a religious nonprofit in 26 While it is a fundamentally private (market) process, civil litigation is subject to regulation (notably, via the Private Securities Litigation Reform Act of 1995) and is affected by the existence of securities laws (notably, private lawsuits citing the violation of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934). 292 R. BALL U.S. history. Further, there was evidence (discussed below) that Andersen's responsibility for deficient audits was not due to isolated rogue engagement partners, but was systemic and reached the top of the company. Based on prior research on the economic role of auditor reputation, one could expect that by the time Andersen's clients digested the implications of its deficient audits and had been able to negotiate a replacement auditor, reputation effects alone would have caused it to shed much of its client base. A related market mechanism for enforcing discipline on audit firms is bonding. Audit firm partners are jointly and severally liable for partnership debts, and hence in principle the entire pool of capital in the audit firm is available to satisfy damages arising from the actions of individual partners. 27 This acts as a bonding mechanism, giving the audit firm incentives to create high standards of behavior for individual partners, monitor their performance, and enforce compliance. Andersen's capacity to bond itself to provide high audit quality was impaired by another market mechanism, civil litigation. As discussed in the previous subsection, civil litigation is a market process for recovering damages from parties who do not follow accepted standards of behavior. Investors and lenders are owed a duty of care by audit firms which, if not performed, can trigger lawsuits to recover damages. Because litigation is on behalf of damaged parties, it usually occurs in relation to client firms whose stock prices have fallen substantially (Lys and Watts [1994]) and whose capacity to pay therefore is limited. Audit firms then are named as defendants. Andersen was deluged with lawsuits. Its settlements included: Sunbeam for $110 million, the Baptist Foundation of Arizona for $217 million, Waste Management for $27 million including fines, WorldCom for $65 million, and Enron for $40 million. These amounts do not include legal expenses. Andersen currently is named as a defendant in more than 100 suits still pending in the courts (Wikipedia Contributors [2008]). Settlements and legal expenses depleted Andersen's resources, to the point where its ability to credibly bond itself to investors and lenders against future financial reporting negligence and fraud would have been severely impaired. A market mechanism closely related to bonding is a form of insurance provided by auditors. Kellogg [1984], Wallace [1987], Chow, Kramer, and Wallace [1988], and Kothari et al. [1988] develop the hypothesis that, because audit firms are named as codefendants in corporate financial reporting cases, their resources provide insurance to investors and lenders against financial reporting negligence and fraud. Whether they self-insure against this potential liability or can purchase insurance, a competitive audit market should allow audit firms to pass this insurance cost on to their client firms as a component of their audit fees (Dye [1993]). The depletion of Andersen's resources from litigating and settling past cases would have impaired 27 The Private Securities Litigation Reform Act of 1995 restricted audit firm joint and several liability. In addition, audit firms are organized with limited liability, so individual partners' liabilities are limited to their invested capital. RECENT ACCOUNTING SCANDALS 293 its ability to insure investors and lenders against future financial reporting negligence and fraud. Given its loss of both reputational and monetary capital, it is not surprising that Andersen started shedding clients. It lost a net 21 clients in 2000 and 73 clients in the first three quarters of 2001, while during the same intervals the other Big 4 audit firms had net gains of 44 and 14 clients. 28 These defections preceded the Enron and WorldCom scandals, suggesting that the losses were due primarily to the Waste Management case. Barton [2005] studies Andersen's subsequent post-Enron client losses. He reports that the earliest defections were by clients that were more visible in the capital markets, in the sense that they attracted more analysts and more press coverage, had larger institutional ownership, had larger turnover, and issued more securities. By the time Andersen surrendered its license, it had lost its client base. 29 Barton [2005, p. 549] concludes: \"Overall, my study suggests that firms more visible in the capital markets tend to be more concerned about engaging highly reputable auditors, consistent with such firms trying to build and preserve their own reputations for credible financial reporting.\" There is some debate about the relative contributions of reputation, insurance, and bonding effects in the demise of audit firms. Menon and Williams [1994] study the fraud-induced 1990 bankruptcy of Laventhol and Horwath, then the seventh-largest U.S. audit firm. They conclude that the insurance hypothesis explains the negative stock price reaction of its clients to its bankruptcy. However, Baber, Kumar, and Verghese [1995] conclude that the Laventhol and Horwath clients' price movements are consistent with both insurance and reputation effects. Sinason and Pacini [2000] and Khurana and Raman [2004] reach a similar conclusion from wider samples. Chaney and Philipich [2002] attribute the stock price behavior of Arthur Andersen clients around the time of the Enron scandal to reputation effects, but Nelson, Price, and Rountree [2008] document confounding effects. Weber, Willenborg, and Zhang [2008] study the interesting German accounting scandal involving ComROAD AG, which is informative because damages awards are both rare and minor in Germany, so bonding and insurance effects are not substantial. They report that clients of KPMG, ComROAD's audit firm, experienced negative abnormal returns and tended to change auditors. They conclude that reputation effects are important. The most likely explanation is that reputation, insurance, and bonding effects cannot be separated, either logically (because the concepts overlap) 28 Numbers supplied in private communication by Clive Lennox. As Barton [2005, p. 566] observes, we know only the dates when a change in auditor was announced, which would have substantially lagged the decision to change. Most clients had December 31 fiscal year-ends, and the earliest they could have terminated their Andersen engagements would have been after the Annual Report and 10-K were completed and filed, several months after the year-end. In addition, it takes time for managers to locate alternative auditors (e.g., to explore potential conflicts of interest is a detailed, complex task), and to request and review the audit programs proposed by replacement candidates, and for the audit committee to meet and vote on the replacement. 29 294 R. BALL or empirically (because their effects are correlated). This seems particularly likely in common law countries, where loss of reputation is associated with litigation and consequential loss of monetary capital. Nevertheless, all are market mechanisms. While it is impossible to completely untangle the effects of market and political/regulatory processes in the demise of Arthur Andersen, there appears to be ample evidence that the audit market would have closed Andersen on its own accord, because the firm's greatest asset (a reputation for quality, independent auditing) and its financial viability (hence, its capacity to bond the quality of the accounts it audited and to insure against harm to users) were in ruins. In addition, even if it had won its criminal trial, the flurry of private civil lawsuits ensuing from the Enron collapse surely would have bankrupted it. It seems reasonable to conclude that market forces, left to their own devices, would have closed Andersen. Finally, it is worth reflecting on what the closure of an audit firm implies, and why an audit firm is not closed whenever a single negligent or fraudulent audit comes to light. It is important to distinguish between the actions of an individual partner, those of a regional office, and those of an audit firm as a whole. Individual partners acting alone in negligence or fraud typically lose future employment prospects, lose personal assets in damages settlements, and can be disbarred, fined, or jailed. Some financial and reputational losses also are suffered by those who are not directly implicated. Financially, under joint and several liability, the partnership as a whole is responsible for fines and damages awards, which normally exceed individual partners' wealths. Firm-wide financial and reputational losses due to the actions of a rogue partner provide an incentive for partners to monitor each other (though this mechanism apparently was not sufficient in Andersen's case). When a scandal is due to poor oversight or a corrupt audit culture in an entire regional office, but is clearly contained within that office, the penalties fall more heavily on partners in that office, but here too they typically do not threaten the entire firm. 30 30 In the May 2007 ChuoAoyama PricewaterhouseCoopers (PwC) scandal in Japan, the regional office was closed and many auditors were dismissed, but those not associated with the scandal were retained in a newly created firm under the PwC global network, with new management and 30% fewer clients. Parmalat S.p.A. is a similar case. In December 2003, it was revealed that an Italian audit firm associated with the U.S. auditor Grant Thornton had accepted a faxallegedly from the Bank of America, but faked by Parmalat managers to conceal large lossesas confirming the existence of accounts totaling approximately 4 billion held on behalf of a Parmalat subsidiary. Dianthus S.p.A., an Italian audit firm associated with the U.S. firm Deloitte & Touche, audited Parmalat's accounts, and relied on the Grant Thornton associate's audit of the subsidiary. Web sites and other public statements made it clear that both U.S. audit firms accepted no responsibility for their Italian associates' work (possibly in recognition of Italy's reputation for lax enforcement of audit procedures). Nevertheless, there were spillover effects on the U.S. firms. Deloitte & Touche paid $149 million to settle a 13.2 billion lawsuit by Parmalat, Grant Thornton is still defending a similar suit for 10 billion, and Grant Thornton experienced U.S. client losses almost immediately (Michaels [2004]). RECENT ACCOUNTING SCANDALS 295 So why was Andersen forced to close its doors when this normally does not happen? Presumably because in Andersen's case there was clear evidence that culpability did not simply lie with individual audit engagement partners, or even with a single regional office, but involved managers at the very top. The firm itself was tainted. In the Waste Management scandal that preceded Enron, the following top-level Andersen people were directly implicated in a blatant attempt to disguise improper accounting, while at the same time Andersen was issuing clean audit opinions: Andersen's managing partner, the practice director for its central region, its director of global risk management, and the audit division head of its Chicago head office (SEC [2001]). When this firm-level culpability was discovered, Andersen was fined a thenrecord $7 million, and consented to a permanent injunction against further violations. The Enron and WorldCom cases, which broke soon thereafter, flew in the face of this injunction. 31 It is reasonable to conclude that Arthur Andersen's firm-wide capacity to credibly perform independent audits was severely damaged by its firm-level culpability in these events, and that this explains why the firmand not just individual rogue partners or branch officeswent out of business. 32 4.3 AUDIT FIRM CONFLICTS OF INTEREST Part of the adverse public and political reaction to the accounting scandals was the revelation that audit firms conduct substantial non-audit work for their clients, thereby creating at least the appearance of conflicts of interest. Conflicts of interest were given at least partial blame for the scandals by the press (e.g., Herrick and Barrionuevo [2002]) and by some researchers (e.g., Coffee [2002]). In response to the adverse reaction, the Sarbanes-Oxley Act prohibits the type of non-audit work by the company's auditor that would compromise its independence in performing the audit. Examples include the provision of bookkeeping and internal audit services, where as an external auditor it would in effect be auditing its own work. The SarbanesOxley Act sensibly does not prohibit other services, such as tax advice. There are several reasons to doubt whether this statutory prohibition was advisable or necessary. 31 Two Andersen partners banned from auditing public companies for three years were not fired, but reassigned to non-audit jobs. Robert V. Kutsenda, the Director of Global Risk Management, was banned for a year but reassigned to revising Andersen's document retention policy. Ironically, this revised policy received widespread adverse publicity when the Enron scandal broke. Asked why they had not been fired, Andersen's managing partner Joseph F. Berardino said: \"You need to be fair to people who are trying to do a good job\" (Norris [2002]). 32 Eisenberg and Macey [2004] show that the frequency of financial restatements by Andersen clientsa measure of financial reporting qualitywas not significantly different from that of clients of other large audit firms, controlling for important variables such as size. This is consistent with the hypothesis that Andersen closed its doors because its culpability in several important cases reached the top of the company, not because of audit failures per se. 296 R. BALL First, the hypothesis that audit firms allow their audit judgment to be compromised by non-audit revenues does not make as much sense as one might initially believe. Why would audit firms attach such a low value to their reputations as independent auditors? Why would they willingly place the entire capital of the partnership at risk by cutting audit quality? The hypothesis might seem to make sense if one accepted the premise that they were earning quasi-rents on non-audit business, but none on audits. They then might seem to have little to lose by reducing audit quality to attract lucrative non-audit engagements. But even if one accepted that premise, the argument still would make no sense. Why would they willingly risk losing quasi-rents on their non-audit work by gaining a reputation for poor audit quality? Would not the existence of quasi-rents earned from non-audit business imply that firms with substantial non-audit revenues put up a larger bond to guarantee their audit quality and hence are less likely to compromise it? All things considered, the motives of audit firms are not as clear-cut as many commentators portray them. Second, if client firms view their reputations as valuable assets, one would expect them to voluntarily avoid contracting for the audit firm to provide any non-audit services that could compromise audit independence. Kinney, Palmrose, and Scholz [2004] test this hypothesis, using the need to subsequently restate previously issued financial statements as an indicator of low-quality financial reporting and auditing. They do not find a pervasive relation between non-audit services fees and restatements. Third, one should not lose sight of the benefits non-audit work brings to clients. The accounting firms have built substantial businesses in areas such as consulting, systems, taxation, and litigation support. They have done so in a competitive market. Their comparative advantage appears to lie in a combination of training, cost, and specific client and industry knowledge. Excessive restrictions on using their comparative advantage can impair economic efficiency. Fourth, there is substantial evidence that non-audit business in fact does not lead to audit firms compromising their audit judgments (Craswell, Francis, and Taylor [1995], DeFond, Raghunandan, and Subramanyam [2002], Frankel, Johnson, and Nelson [2002], and Larcker and Richardson [2004]). If anything, the evidence in these studies points to non-audit revenues being associated with less favorable audit treatment, most likely because financially weaker firms exhibit greater use of consultants and also receive harsher audit opinions. 33 Fifth, before the passage of the Sarbanes-Oxley Act and in response to the scandal-induced perception that conflicts of interest influence audit 33 Coffee [2006, p. 147-8, 322-5] counters that non-audit revenues create industry-wide, not firm-specific, incentives and hence audit firms cater to all clients, independent of clientspecific non-audit fees. While this argument has some validity, it does not seem plausible that industry-wide catering would coexist with audit firms catering equally to clients, independent of the amount of their non-audit revenues. RECENT ACCOUNTING SCANDALS 297 judgment, all but one of the major accounting firms decided to cease providing internal audit and audit-related technology consulting services to clients where they are the external auditor. This decision was made by Arthur Andersen (it was still operating at the time), Ernst & Young, KPMG, and PricewaterhouseCoopers. Deloitte & Touche alone among the then Big 5 audit firms resisted the change, arguing with some justification that the issue was one of perception arising from \"the level of hyperbole in the debate\" (Glater [2002]). Nevertheless, perceptions do matter, and it is not clear that Deloitte would have been able to hold out on this position for long. In any event, the Sarbanes-Oxley Act codified the standard that the market had largely moved to in response to the scandals. The Sarbanes-Oxley Act also restricts public companies from hiring directly from their audit firms. More specifically, Section 206 prohibits a company from employing a former auditor of its accounts in a senior accounting or financial position until at least a year has elapsed since that person left the audit firm. The principal concern with \"revolving door\" appointments is that they induce various conflicts of interest, including those that could occur when audit firm employees have to audit a former colleague or supervisor. This Sarbanes-Oxley prohibition was fueled by public outcry upon news that former Andersen auditors had been employed by Enron, Waste Management, and other companies with deficient financial reporting. But here too, the need for such prohibition is far from clear. Lost in the argument is the potential benefit a former auditor can bring to a company, stemming from specialist skills and specific knowledge of the company. Consistent with such benefits, Geiger, Lennox, and North [2008] report a positive share market reaction to pre-Sarbanes-Oxley revolving door appointments, in excess of the price reaction to other appointments. They also report that revolving door appointments are not associated with lower scores on measures of financial reporting quality. In sum, there is reason to believe, and some supporting evidence, that market forces can resolve potential auditor conflicts, in the absence of regulatory prohibitions. This