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Dimming the lights on SOX: the consequences of perpetuating fraud will always have profound effects on the decision-making conditions of accountants. Internal control did an excellent job of reducing the opportunities. As the shift moves from SOX to IFRS, will the industry lose the merits earned? Or, was SOX too much?

The morality of proper financial reporting has been an ethical dilemma for accountants long before Sarbanes Oxley (SOX) was introduced. Outside influence, internal pressure, and relative consequences of perpetuating fraud will always have profound effects on the decision making conditions of accountants. Internal control did an excellent job of reducing the opportunities, increasing the consequences, and educating the public; however, as the shift moves from SOX to International Financial Reporting Standards (IFRS), will the industry lose the merits earned? Or, was SOX too much?


Utilizing behavioral models, one can try to explain how environmental phenomena played a significant role in decision making during the rise and fall of dot-com, the birth of SOX, and more recently, the move into IFRS.

The first main aspect of moral financial reporting is fairness. As quoted by D.R Scott in 1941, "Accounting rules, procedures, and techniques should be fair, unbiased and impartial. They should not serve a special interest." (1) However, the issue of fairness is called into question as one's definition of fairness is a variable measure. It is the job of upper management to carry out the special interests of the firm. Recognizing this potential mental conflict, it has been the goal of accounting bodies to ensure that fairness, honesty, and social responsibility have been integrated into accounting standards. (2) However, what happens if an accountant is introduced with a dilemma where an alternate solution seems more rewarding? To explain this incongruity, an adaptation of the Schema Incongruity Model is introduced, which is named, "The Accounting Standards Incongruity Model."' (3) Originally used as a model to explain mental arousal reactions to unpredicated events, this model, shown in Figure 1, can be applied to incongruities from past accounting fraud debacles. To demonstrate, the model is split into three separate stages.


Stage one--A deviation from the rules?

During the first stage, the accountant measures a situation to determine whether there is congruity between the accounting principles and the current planned course of action. If congruity exists, then there is no effect on decision making because no further action is needed. However, if there is a form of inappropriateness, the accountant is faced with a dilemma and proceeds to the next stage.

Stage two--A big or small problem?

The degree of incongruity is assessed by determining the problem and the consequence associated with breaking that principle. Once determined, the accountant has a number of alternatives he or she can take given the severity of the situation. If it is a slight deviation from the rules, there are two options. The first is to correct the incongruity. This means that the accountant fixes the problem and "assimilates" the incongruity to proper guidelines. This has an overall positive impact on the conditioning for the individual, as the incongruity was assessed, and corrected to proper accounting standard. The next option under a slight incongruent environment is to take an "alternate" action--a course of action that contradicts what has been prescribed. For an accountant, this can include purposefully hiding debts, or completing questionable journal transactions, overestimating accruals, etc. To develop this choice logic, one can apply the Expected Utility Theory. The definition of this theory is, "The motivation to select a particular goal is based on the goal's utility and estimated probability of being achieved with utility referring to the satisfaction that a goal provides." (4) Therefore, the formula would look like the following, where utility is the personal benefit of breaking the rules and the subjective probability is the possibility of eluding punishment for completing such an action:

Expected Utility = Utility X Subjective Probability

In order to apply this theory, two separate equations are calculated. The first is the positive utility of using an alternate plan multiplied by the possibility of not being caught and punished. Utility can surface in many ways, such as: reduced pressure from upward management, personal financial gain, stock performance, etc. This calculation is compared to the utility of following the rules, with the higher of the two being the path chosen. If one can do something wrong and get away with it, this increases the chances that the "alternate" will be chosen. Overall, this has a greater positive impact on the accountant because he or she will experience personal gain or relieved pressure. It is assumed that, since the incongruity is slight, it will bring about no major repercussions. With this option, the accountant has not escaped from the problem and must return to stage one to deal with the situation again at a later date.

Stage 3--Serve incongruity

In the future, the issue could intensify to a severe problem. For example, Phar-Mor, one of WalMart's competitors, experienced a similar situation where small deviations were hidden on balance sheets. Although a better current situation was presented, they could not escape these deviations as accountants had to readdress the same issue at future periods. (5) If the incongruity is not too obvious, it is easy to hide the problem, yet as time continues, the deviation implodes onto itself and causes the problem to become severe. At this stage, it cannot be solved by simply adhering to accounting guidelines--the accountant accommodates the incongruity instead of correcting it. Again, with Phar-Mor, its course of alternate actions became too large to correct and evidently the accountants could only attempt to continue to hide amounts, rather than fix them. If an accountant is successful in hiding amounts, the mental affects are overall positive because negative consequences such as company bankruptcy or jail time have been averted. If unsuccessful, then the auditors of the firm have caught the severe incongruity and the accountant in a sense will have "crashed."

Timing--Preference Reversal Theory

The effect of timing is important in the decision-making process. As the deadline of one event approaches, it will be weighed more heavily than a potentially more important event that occurs in the future. To outline this further, the final theory. Preference Reversal, is introduced. This theory states:
 People prefer large incentives over small incentives and immediate
 incentives over delayed incentives. When amount and delay are
 combined, however, a person may prefer a small immediate incentive
 over a larger delayed incentive. (6)

To apply this to the decision-making analysis of an accountant, a few clarifications need to be made. The long-term, larger incentive would be to maintain a position in the firm, adhering to legal codes of conduct and freedom. This is classified as the most valuable incentive available. The short-term incentive would be the benefits from utilizing an alternate approach such as personal gain, relief from management pressure, etc. The theory is illustrated in Figure 2--the curved line represents the relationship between the incentive value and timeline when different courses of action are available.


This theory states that there is a specific relationship between incentive value and time. When a choice is available between two courses of action, one will choose the path with the highest overall value. Therefore, as time grows closer to the smaller incentive, one may choose that course of action because of its immediate payoff, as demonstrated by the dashed line. This can be applied to accounting decision-making analysis under the example of making annual targets. As the period is reaching to a close, the pressure of attaining labeled targets will elevate, therefore, increasing the pressure to adjust accounts to reflect an image of sustainability. An accountant is much more likely to take an alternate path of action if the appropriate time pressures are associated, even though the longer-term goal of job sustainability, freedom, etc. is compromised. This theory serves to explain why one would choose an alternative with an overall less positive benefit than a choice with a larger overall benefit.

Applying decision models--Dot-com era

The environment of the dot-com era had a unique impact on decision making. The introduction of the Internet and computer intricacy revolutionized the accounting industry. The market became obsessed with equity-based financing, and the dot-com industry boom was the result. With the shear number of transactions being committed, difficulty of financial tracking developed. As complexity increased, deregulation ensued destroying some of the basic building blocks of good governance." Principles such as clarity, transparency, and fairness outlined as fundamental to the industry were being compromised. As complexity increased, the number of encounters with incongruity increased sharply. Therefore, when applying The Accounting Standards Incongruity Model it is important to outline two major factors that would affect an accountant's decision making. To begin, it would be expected that with increasing complexity of financial reporting there would be an influx of transactions that contradict what has been outlined in governing principles. With an increasing amount of initial dilemmas, accountants would have more opportunities to analyze alternate routes to solution. Next, an accountant's willingness to utilize an alternate approach increased. During the dot-com burst there was a large focus on the value of equity. Therefore, the pressure to ensure that financial statements supported a strong stock-market position and that the company remained profitable was considerable. To match this, the market punished companies that did not meet annual targets. This pressured many to use an alternate approach because the utility of hiding debt or using other techniques increased substantially.

The subjective probability of being caught was being analyzed as quite low. This motivated accountants to manipulate statements. As quoted by John Lorinc," ... Many stock market analysts were contemplating a world in which audited financial statements were a thing of the past." (8) Taking this into account, the Preference Reversal theory must be addressed. First, with increased focus on maintaining targets, the incentive value of using an alternate increased. Second, removing focus on auditing increased the delay factor between alternate and assimilation. Therefore, the new graphic is illustrated in Figure 3.


In Figure 3, the relative probability of taking the alternate action increased significantly over the period. As the alternate incentive increases, delay between short-term payoff and long-term goals increased and the importance of clarity decreased. This is proven through the number of questionable practices carried out during this period. For example: 723 companies alone had to restate and lower their earnings from 1997 to 2001. (9) Eventually, as more companies began to follow alternates to proper financial reporting, more illusions followed. Eventually, lack of substance caused the general crash of the industry.

Applying decision models--The birth of SOX

The fall of the dot-com empire brought the corruption derived from decision making to the forefront of society. The media played a significant role in scrutinizing the accounting industry. Trust became the new focus of discussion. Fraud prevention, fairness, clarity, and deception became regular topics for the industry. Some articles went as far to state human characteristics of what to look for in accounting thieves in the office. An article by Roddy Allan breaks down four basic personalities (which can be applied to almost any one individual) and gives inferences as to how they could be stealing from the company. (10)

This change in accounting culture had a profound impact on decision-making model analysis. By applying the Expected Utility Theory, the subjective probability of being caught deviating from guidelines increased, along with the severity of the consequences. Former WorldCom chief executive Barnard Ebbers was sentenced to 25 years in prison following his involvement in accounting fraud. When this was reported on a poll was issued asking whether this was too harsh. This poll tallied with 81 per cent of 21,610 correspondents stating that the sentence was just right or too lenient." Fear caused conformity, which was a short-term solution to ensure proper financial reporting.

This call for justice was matched by the Sarbanes Oxley Act, which basically made accountants personally liable for the honest interpretation of their financial statements. (It also served as an excellent paycheck for many of us, too!). The act, passed by the U.S. government in 2002, outlined a number of steps associated with correcting the trust issues in North American accounting. Various steps included mandatory changes to audit committees, enforcing liability, and increasing criminal charges associated with purposeful distortion of financial statements. This impacted decision-making models in a number of ways. First, investors required substance behind their statements, and potential equity growth was no longer the main definition of company success. With higher disclosure, the subjective probability of being caught increased. This in turn reduced the incentive value of using the alternate approach. Finally, by enforcing multiple parties to become liable for misappropriation, the accountant received less pressure to purposely misstate earnings.

The previous elements also impacted preference reversal analysis in two ways. First, it immediately reduced the lag between short-term and long-term incentives. The importance of auditing was not only re-affirmed, but it was heightened. Next, it increased the incentive value of long-term goals as fear of civil and criminal lawsuits grew, so did the value of following rules and guidelines. These new combinations created a situation as pictured in Figure 4.


As predicated, the likelihood of people taking advantage of the alternate situation reduced significantly.

The road ahead

The application of psychological decision-making models attempts to explain why accountants would act in the fashion that deviates from the expected norm. Pressure, temptation and greed will always exist in our society, and it is not only the responsibility of regulating bodies to ensure fairness, honesty, and social responsibility, it is our own. However, despite the control put in place, there will always be justification, rationalization and deceit. Therefore, at what point does control and ensuring fairness become unfair? SOX gave CMAs a harsh lesson in fiscal responsibility, burdened our everyday lives, and caused billions in expenses. It is obvious that the SOX era is dimming and IFRS is the new hot topic on the scene. As we begin to loosen the straps we must not allow a repeat of history.

Applying the models above, it is the responsibility of regulating bodies to focus on reducing the value of the alternate incentive (fraud), increase the value of the assimilating to proper guidelines (compliance) and decrease the opportunities to deviate from rules (control). This needs to be done without overburdening the system, and accepting the fact that there will always be the risk of fraud in the accounting society.

John Daley, CMA, CIA, is a senior advisor of International Financial Reporting Standards (IFRS) at the Canadian Air Transport Security Authority.

(1) D.R Scott, "The Basis of Accounting Principles," The Accounting Review, Dec. 1941 p. 341

(2) A. Riahi-Belkaoui, "Morality in Accounting," Quorom Books, 1992.

(3) G. Mandler, "From Mind and Emotion," Norton & Company Incorporated, 1984. p. 202

(4) Arkes, H.R., & Hammond "Judgment and decision making: An Interdisciplinary Reader" Cambridge University press, 1985, p. 1-11

(5) Wood, Andrea "Phar-Mor's Stalking Horse Plan Fails Judge's Smell Test" Business Journal, July 2002 retrieved from

(6) Deckers Lambert, "Motivation: Biological, Psychological and Environmental" Pearson Education, 2005, p. 260

(7) Bruce Nussbaum, "Can you Trust Anybody Anymore?", Business Week Journal, Jan. 28th 2002, p.31

(8) Lorine john, "After Enron", CA Magazine, December 2002, Retrieved from

(9) Brace Nussbaum, "Can you Trust Anybody Anymore?", Business Week Journal, Jan. 28th 2002, p. 31

(10) Allan Roody, "The Human Face of Fraud", CA Magazine May 2003, Retrieved from 1&la_id=1

(11) Crawford Kristen, "Ebber gets 25 years",, July 13th, 2005, retrieved from
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Author:Daley, John
Publication:CMA Management
Date:Apr 1, 2009
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