Trust is important in all economic transactions. Without trust, parties to transactions pay substantial costs to execute transactions. In some cases, transactions simply do not take place. The lack of trust impedes the flow of resources in an economy.

Here is an example. Many years ago, an automobile accident seriously injured my father. The accident broke his neck, fractured several bones and permanently injured his brain. At the time, he was a rancher who owned a cattle ranch near the intersection of the Idaho-Oregon-Nevada state lines. With his incapacity, it fell to me to deal with the ranch.

As a full-time college professor with a family in Davis, I was in no position to be a hands-on ranch manager. So I set out to find someone who would purchase the animals and machinery and lease the land. Fortunately, a trustworthy neighbor agreed to lease the ranch and purchase the machines and animals. We were able to execute the deal with a handshake. We contracted with an attorney (just one for both of us) to prepare the documents that included a note payable without security. The attorney was shocked that both of us were so trusting.

In the end, my Dad's neighbor and I were able to transact a deal worth a few hundred thousand dollars with no independent appraisers, no accountants and a legal bill of only a few hundred dollars. As expected, all has worked out well for both parties to the transaction. Imagine what would have happened if there had been no trust between us. We would each have had an attorney, a cattle appraiser and likely a lawsuit or two. The transaction might have become so difficult that the deal would not have been done.

How does this story relate to the recent corporate scandals-Enron, WorldCom, Andersen, and others? Capital markets are characterized by substantial information asymmetry-corporate managers have much more information about what is going on in their organizations than do shareholders. Shareholders know this. So why do they give over their money to managers? Shareholders trust managers to use the funds in the shareholders' interests. Without that trust, shareholders would not provide resources to companies; capitalism would fail.

The recent wave of corporate scandals reduces trust in capital markets. I expect two consequences if these scandals continue. First, prospective shareholders will demand a higher return on their investment to justify the higher risk of stock investment because trust in corporate management will go down. This will increase the cost of capital to companies, which will be passed on to consumers in the form of higher prices for goods and services. Second, in some cases, economic transactions that are for the good of society will not occur because investors will demand a return that exceeds the economic return on the investment.

Safeguards: Real and Imagined

Investors believe they are safeguarded against managerial malfeasance. Some of the safeguards in place are real; some are imagined. Here is an examination of some of those safeguards.

The Auditors

In an ideal world, auditors are independent from managers and are expert in accounting. But the real world economic structure does not promote as much independence as shareholders might think. Start with the fact that corporate executives hire and fire auditors. If auditors balk at the management's preferred accounting methods because they think the methods are wrong, then managers have the right to fire the auditors. If the auditors are fired, they might well lose both the audit fee and the fee from their consulting services, which might be higher than the audit fee. (For the year 2000, the Arthur Andersen's audit fee and the consulting fee for Enron were each approximately $25 million.)

One would think that auditors would be at the frontier of knowledge about accounting issues. In fact, it is difficult for auditors to keep up with accounting practices in emerging industries, such as high-tech, or rapidly changing industries, such as energy. Auditors are always playing catch-up to corporate financial managers who develop the accounting methods of which the auditors audit.

Because audit fees are competitive, auditors must manage their time carefully to keep audit costs low. Sometimes, auditors cut corners (perhaps without even realizing that they are doing so) to save time on audits.

Because audit firms pay lower salaries, on average, than many companies, investment banks and consulting firms, they often have trouble attracting the best and brightest students out of business schools. During the high-tech boom in the 1990s, audit firms faced particular difficulty getting good entry-level people. Even if the audit firms hire good people, turnover in these firms is high. Auditors find many good alternatives in industry and audit firms, which make it difficult for audit firms to staff jobs with experienced auditors. The economic structure of the audit business makes it quite different from the ideal of independent auditors who are expert in accounting and who have adequate time for a thorough audit.

The Scope of Audits

Lay people often think auditors should find fraud, if it exists. In fact, auditors attempt to ascertain whether a company's financial statements comply with Generally Accepted Accounting Principles, not whether the statements are free of fraudulent reporting. Anybody who has done auditing can attest to how difficult it is to find fraud, or intentional deceit, in financial reporting. Employees and/or managers of companies commit fraud. If they want to hide their fraud from auditors (which they would, of course), then auditors will have the devil to pay to find it. Sometimes auditors come across fraud in their normal investigations, but in my experience, auditors rarely detect fraud. A company's Board of Directors can hire a firm to conduct a special fraud audit, but fraud audits are expensive. Because most Board members owe their membership to corporate executives, they are reluctant to initiate a witch-hunt of their benefactors.

Generally Accepted Accounting Principles

One of the most challenging aspects of an accounting professor's job is to convince students that accounting is more an art than a science. Somehow, financial statements look scientific-quantified, orderly and balanced. In reality, a great deal of judgment goes into measuring, recording and reporting transactions. Should money spent on research that will benefit the company for many years be expensed, thereby reducing net income, or treated as an asset? When should the revenue from a software installation for a customer be recorded? When the customer signs the contract? When the customer pays the cash? When there is no chance that the customer will ask for the cash back? Generally Accepted Accounting Principles put some boundaries on transactions, but cannot possibly deal with all of the complexities of real-world business transactions. It's like this. The Commandment says, "Thou shalt not kill." But what about self-defense? Abortion? Capital punishment? War? Like the Commandments, Generally Accepted Accounting Principles lay out good guidelines, but they do not cover all specific situations. Further, different people interpret these principles differently. There is a saying, "If 12 people agree on an accounting issue, then it becomes a generally accepted principles.

Audit Committees

In many respects, the audit committee of the Boards of Directors is where the accountability buck is supposed to stop. Members of audit committees are supposed to be independent outsiders who are not beholden to management and who have expertise in accounting. The audit committee has a responsibility to ascertain whether managers have been good stewards on behalf of shareholders.

Members of the audit committee rarely are independent. They generally owe their Board membership to management. While they cannot be employees of the company or have other obvious commercial interests in the company, they might well have a personal relation with insiders. (In one company that I studied, the audit committee was made up of the company President's golfing partner and the President's next-door neighbor.)

Members of the audit committee who are truly independent (sometimes called the Mother Teresa types) often don't have the expertise to work out the accounting for complex business transactions. Even if they have the expertise, they don't have the time to make a thorough analysis of financial reports, accounting methods and auditing procedures. Audit committees generally meet for a few hours per meeting, and meet only four times per year or less.

Remedies

The remedies proposed in the Oxley-Sarbanes legislation appear to be mostly window dressing. These remedies do not address fundamental problems with auditor independence-corporate executives still hire and fire auditors. Nor do these remedies address auditor expertise or time on the job. These remedies do not fix the audit committee problems. Nor do these remedies improve Generally Accepted Accounting Principles. In short, corporate executives have much work to do to improve trust on the part of their shareholders and assure the free flow of shareholder investment at a reasonable cost of capital.