New accounting regulations in the United States are merely a series of Band-Aids that creates a "false comfort" until the next wave of scandals, predicts a senior Canadian academic.

"My opinion is that Sarbanes-Oxley is inadequate and we should not be surprised when the next wave of auditor scandals surfaces," Karim Jamal, a business professor at the University of Alberta, said of the U.S. law enacted in 2002 in the wake of accounting scandals at Enron Corp. and other companies.

U.S. energy trader Enron filed for bankruptcy in December, 2001, amid revelations of off-the-books partnerships that hid debt and enriched certain executives.

Mr. Jamal told a U.S. audience at a business ethics conference in Minnesota the sophisticated type of fraud perpetrated by Enron is "a consequence of regulation" and that the "highly regulated U.S. market is more (not less) vulnerable to sophisticated and large frauds."

In his speech, Mr. Jamal criticized the bevy of new corporate governance rules introduced in the United States and Canada in recent years as "misguided and counterproductive."

He said that although they are well intentioned, they often exacerbate the conditions that lead to accounting fraud.

The role of regulation in markets is to promote efficiencies that prevent cheating, he told his audience of U.S. business people, accountants, regulators and legislators. Still, he said the preponderance of rules and laws, especially in the U.S. market, has not protected it from widespread earnings restatements and fraud, such as those that engulfed WorldCom Inc., Tyco International Ltd. and Nortel Networks Corp.

"Managers do not passively modify their behaviour to carry out the intent of regulators," he told the conference in mid-May. "Instead, they actively look for ways around the new rules."

As a result, he said, "We appear to be getting into a game of escalating rule-writing by regulators, followed by creative games by management to get around the rules. This is a destructive game and we are veering towards more and more improper behaviour."

Making matters worse, Mr. Jamal said there is no accountability demanded from such regulators as the U.S. Securities and Exchange Commission and the Ontario Securities Commission, and virtually no examination of the role they may have played in restraining or encouraging fraud in the aftermath of these scandals.

"While it is easy to demand even more regulation, one at least has to ask whether we might be better off by reducing regulation in accounting," he said.

Mr. Jamal, whose work has been published by the prestigious Cato Institute in Washington, urged regulators to refrain from writing any new specific rules with severe penalties. Instead, he advocated the creation of principles-based laws that set higher standards to help restore the reputation the accounting industry enjoyed during its 30-year golden age, which ended in the 1960s.

In order to do that, Mr. Jamal suggested there are fundamental problems with the existing laws that need to be addressed.

For one, he says, managerial misbehaviour and questionable ethics of corporate senior executives are as much to blame for illegal activities as poor auditing by accounting firms.

There is tremendous pressure on corporate management to meet its financial targets and numerous incentives, such as stock options, that tempt executives to cheat.

As a result, Mr. Jamal says auditors are also under incredible pressure to agree with management's aggressive accounting judgments.

In the 1960s, scandals, lawsuits and widespread criticism of the industry tarnished the accounting industry's reputational lustre. He says business executives were influenced by the winner-takes-all mantra. Although the markets created incentives for them to work hard and take risks, it also created incentives for them to cheat, he said.

As a result, Mr. Jamal argued that "auditors came under increasing pressure to agree with aggressive and questionable accounting judgments of business executives."

In the 1970s, accounting firms were transformed into advocates for their clients, helping them to find ways around rules and regulations. During the 1980s and 1990s, he said accounting firms became more commercially oriented and ruthlessly competitive, rewarding partners based on how much revenue they brought into the firm.

Not only that, the pressure to increase revenues made the large audit firms even more dependent on large publicly traded companies that paid very high audit fees, such as Enron, which paid US$25-million to Arthur Andersen in 2001.

The result, warned Mr. Jamal, is auditors are more tempted to side with corporate management instead of public shareholders.

"The amounts of money at stake for senior executives are so large, that they will devise many sophisticated schemes to meet their reporting targets," he said. "Telling executives to 'be good' and asking them to sign certifications pales in comparison to the hundreds of millions of dollars at stake each year."

Rather than introduce more rules to rein in executive pay, Mr. Jamal urged regulators continue to force companies to develop more effective internal governance beginning at the board level. As well, he suggested that publicly traded companies should not be allowed to hire their own auditors.

"Unless this conflict of interest is resolved, we will not have an independent auditor," he said.

His solution to secure an objective and independent auditor is to have companies retain a third-party intermediary, such as the New York Stock Exchange or the Toronto Stock Exchange, to hire the external auditor.

At the same time, audit firms should be forced to assume more responsibility for fraud detection and should be obliged to report suspected frauds to any outside government agency.

© National Post 2004

[CLB] Aha... I agree with Professor Jamal. This is a standard problem with all game-theoretic systems. A 'game' has three essential parts as well as players: starting condition; rules of play; winning conditions. I'm thinking of Monopoly while typing this, but substitute any game, like poker, managing your stock portfolio, playing peak-a-boo with your nephew, or running a business in any legislated environment. As soon as you have these elements, you also have optimal ways to win. And in every sufficiently interesting game (read here that the rules themselves are open in some manner to interpretation or even to change), these using optimal ways themselves become games. Lawyers and legislators are game players by nature.

What's the issue?

For every rigidly structured game, there are emergent paradoxes within. Perhaps the most commonly known and recognized paradox of this sort is within democratic voting structures. How can one person win the common / popular vote, and the other the election victory - the paradox arising from representative democratic systems.

There's a fascinating game floating around called Nomic serving as a study of at least one such paradox in games: The Paradox of Self-Amendment, that a legal "rule of change" such as a constitutional amendment clause may apply to itself and authorize its own amendment.

In the story above, Professor Jamal has highlighted a different paradox, that which I'd like to call the paradox of legislating bsuiness in a free market economy.