Saturday, March 20, 2010

Sytem of Perverse Incentives


Categories: Paradigm descriptor

Definition: An analytical account of the institutional dynamic underlying information age culture rather than an example of info speak itself. A system of perversive incentives is an arrangement where the actual incentives of participants are designed to undermine the aims which they obstensibly serve.

Individual examples are numerous, but the most striking in current headlines at time of this writing may be those related to recent developments in Lehman Brothers bankruptcy proceedings.

In brief, the primary alleged accounting irregularities were a series of transactions intended to mislead financial statement users into believing that certain Lehman assets had been sold at favorable market conditions. In substance, however, the assets had not been so disposed. Lehman appears to have previously agreed to repurchase the assets in question after the date of the financial statements. Therefore such assets should have been included in that company's financial statements--along with the corresponding changes in market value. In this case, serious losses.

A regrettable series of events, no doubt about it. But the particular implication which I wish to explore under the heading "System of Perverse Incentives" lies deep within the subtext of the reply of Lehman's original hired auditors. The following is a response from a spokesman of the auditing firm, as quoted by the marketwatch story link above.

". . . . Our last audit of the Company was for the fiscal year ending November 30, 2007. Our opinion indicated that Lehman's financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view."

On the surface this appears to be an entirely unremarkable statement, as I suspect the spokesman intended. It ostensibly makes no claim other than that the auditor's work product attested to Lehman's fulfillment of the technical letter of the law.

Let us not scorn to ask, "How would an auditor's work product come to make such an attestation?" A host of simple and technically correct but superficial answers spring immediately to mind: "As a standard part of their audit work product"; "In accordance with regulatory and professional association standards (S.E.C., G.A.A.S., et alia)"; so on and so forth. True though these answers may be , as far as they go, they ultimately serve the standard info speak strategems of partial truth and fragmentation. They prevent an appropriate comprehension of the system's gestalt.

The more complete truth, I suspect is a "System of Perverse Incentives", the framework of which begins to come into view when we consider the following elementary, unspoken mundane facts:

1.) The ostensible goal of audits of publicly traded entities is protect the nation against counterfeiting. The securities of such entities form a significant component of the money supply, as defined by M3. No nation will indulge the sustained infringement of its national sovereignty by individuals for their private gain.

2.) Auditors, however, are hired by the Company's board of directors, and not by any governmental authority.

3.) It is in the shared interest of both management and the board of directors to present positive financial results to capital markets.

4.) The business model of auditing firms makes them dependant upon the patronage of the companies whom they audit.

5.) As currently structured, satisfaction of regulatory requirements by auditors does no more than allow them entry into the auditing market. True competitive advantage lies in the auditing firm's management of public perception according to the info speak paradigm. There is no real advantage for one firm to be "more compliant" than its competitors. Under the strictures of a resource optimization theory, "minimum compliance" is the most rational choice.

While the urgent short-term interests of completing the legal proceedings related to Lehman's bankruptcy cannot be reasonably expected to address this systemic perversity, it is definitely in society's long-term interest to take this sober look at what it has made of itself. Can we imagine a more virtuous set of incentives?

Etymology: Unknown

* Readers, please feel free to submit synonyms from your own experience to expand the discussion!

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