Now I wanted to elaborate a little bit about
why it's hard to step into investors' shoes,
and there's some really good reasons.
One reason is that,
auditors must be independent,
and we'll get more into what exactly that means in different parts of the course,
but one implication of having to be
independent is that you cannot invest in the auditee company.
It's against the regulations, against standards.
So if you were an investor, the idea is,
if you were an investor,
it wouldn't be so hard, would it,
to step into investors' shoes.
You may be surprised to learn that in England,
a little over 100 years ago,
not only could auditors invest in companies whose books they were checking out,
examining, they had to.
They had to be investors,
and the idea there is that regulators wanted the auditors to have
skin in the game, to be able to think like other investors.
And of course, you'd want to put some sort of limitations
on how fast they could buy and sell shares in businesses,
maybe have them buy shares and not be able to
sell them until a long period of time goes by.
That's not the approach current regulators take.
Current regulator say, no stock,
not even one share, or you can't do the audit.
That's all well and good and I get the intent.
But what it does,
it makes it hard to really
think like the investors would for the company that you're auditing.
So that means you have to keep a very good pulse on how
investors view key performance indicators of the companies that you audit,
because you can't invest.
So when target, the big box store,
reports an increase not only in revenues that
appear on the income statement of the financial statements,
but also an increase in same store sales.
Now same store sales, stores don't appear in
the financial statements directly, or sales per square foot,
and we're probably moving to a world, you know, sales per click on a link.
As you see these performance measures mattering to investors,
you need to take stock of that as an auditor.
Because if management is manipulating numbers to make those performance indicators,
both those on the financial statements, but those that are not directly on,
that's going to help you realize if
you're dealing with a potential material misstatement.
So it's hard to take the investor's perspective.
You can't invest.
When you try really hard,
what you end up doing as an auditor often, is
what things would matter to you if you were an investor.
But see, auditors are a little bit different.
We've self-selected into this profession.
We tend to be a little bit more reserved and conservative than some investors, right?
So keep that in mind.
Now, one result of auditing seems to be that auditors
develop larger materiality thresholds than investors.
So, this is another issue with trying to step into investors' shoes.
There is survey evidence that auditors for a given company think that you
need a bigger misstatement to be material
before the investors who look at that same company, and they would say,
no, a much smaller amount would be material to me,
it would affect my investment judgment.
So, what you have here is something called motivated reasoning at play in the auditor.
And here's what that is, in a nutshell.
We would like to, in many aspects of life, to reason objectively and even handedly.
We want to have only accuracy goals drive our decision making,
but there are other kinds of goals and
the literature in psychology calls these directional goals.
Let me give you an example.
If you've ever bought a house,
you will know early on in that process, as you're looking at homes,
you are a critic of every home.
You are only motivated...or primarily motivated by accuracy.
You want to find the home,
or maybe it's a car for you.
But as you look for homes, or for cars,
or maybe for you it's a college,
there are all of these attributes. Where is it ranked?
Who are the professors?
Do they really seem to care whether I learn?
Is the car, if it's a car,
what kind of miles per gallon?
What kind of car? What kind of warranty?
What kind of maintenance?
If it's a home, square foot, location, resale value.
At first, you're only looking at this from an accuracy perspective.
But as you go into the search process entire,
you start wanting to find that perfect car,
or home, or college.
Because of your desire to find that fit,
you start wanting to find evidence consistent with this being the college,
this being the car,
and this being the home.
That's called directional motivated reasoning.
In the case of the auditor,
the concern is that they have directional goals to please management, not investors.
We are asking auditors to be a superhero,
and there are some real superhero auditors out there,
but they are the ones who understand this
temptation to be always behold into management's preferences.
Management wants income to be just above consensus analysts forecasts,
well let's work with management to make that happen.
That's called directional reason,
and the bad thing about it,
in particular, it's often occurring subconsciously.
It's not, if you're looking at the car,
college, or home in your own world right now,
you wouldn't recognize necessarily that I'd been
looking for colleges for a long time, or cars a long time,
or homes a long time, so now I'm ready to completely punt on
objective reasoning and I just want to find the one that works for me.
If management really pushes back on the auditor,
the auditor has an incentive to say,
Why do we keep fighting with management?
They're the ones who pay us the audit fee,
and isn't it great to say that we are,
pick your favorite Fortune 100 company's auditor?
Don't we get some reputational capital from that?
So you see to be an auditing professional,
it takes a deep amount of reasoning.
You got to avoid motivated reasoning and you have to be honest about what investors,
and creditors, and other reasonable users, care about.
