In a recent paper in Administrative Science Quarterly, Aharon Mohliver looks at an even
more interesting part of this relationship by doing research on the role that auditors
played in first condoning, then spreading, and finally extinguishing a
questionable practice firms began to use when changes in the tax code affected their
ability to pay managers above a $1 million cap without subjecting them to significant
tax liabilities. At first the practice was questionable but not illegal, and auditors
in some local offices helped their client firms start using it. The findings
tell a very informative story of how auditors pay close attention to the
interests of the managers who hire them, and also to the fine line between
legal and illegal.
The questionable
practice is called stock-option backdating. Stock options are often given to
managers because they let managers earn higher income if the value of the firm
increases, and to make them fair they are often given (for free, of course) at
the exact value of the firm on the day they are given. In MBA-speak, those
options have upside potential, no downside potential, and are incentive
compatible. In plainer words, they reward managers for effective management but
don’t punish failure. Firms report the costs of stock options as compensation
expenses.
What I just
explained is a regular stock option, without backdating. A backdated stock
option looks just the same, but in reality it has been assigned an earlier
formal date than when it was given, and that formal date somehow turns out to
be a day just before the firm had a big increase in value. Through what seems
like a very lucky dating of the option, the managers getting the backdated
stock option earn significant sums of money not taxed as regular income. Backdated
stocks are a trick for compensating managers at the expense of investors. They
are a form of fraud, and though they were unethical from the start, initially there
were no laws or rules against backdating so they were not yet illegal. (There
were no rules because no one making rules had thought of backdating stock options.)
So the
auditors stepped in. They spread knowledge of backdating from one client to the
next, especially if clients were part of their local and dense communication
networks. They were also sensitive to lawmakers, however, so this spreading of
backdating was strongest when the uncertainty about the legality of backdating
was greatest. When it became more certain that backdating would be made
illegal, the auditors stopped spreading the backdating trick, and when it
actually became illegal they stopped its use in the firms that had already
started using backdating. So, auditors follow written law very well, are
neutral to law that will soon happen, and are willing to help management profit
from legally questionable conduct. Nice to know if you happen to be a manager,
investor, or lawmaker. If you are an auditor you probably know it already.
