Introduction to Managerial

C H A P T E R O N E

Introduction to Managerial

Decision Making

Phar-Mor, Inc., the nation's largest discount drugstore chain, filed for bankruptcy

court protection in 1992, following discovery of one of the largest business fraud and

embezzlement schemes in U.S. history. Coopers and Lybrand, Phar-Mor's former

auditors, failed to detect inventory inflation and other financial manipulations that

resulted in $985 million of earnings overstatements over a three-year period.

A federal jury unanimously found Coopers and Lybrand liable to a group of

investors on fraud charges. The successful plaintiffs contended that Gregory Finerty,

the Coopers and Lybrand partner in charge of the Phar-Mor audit, was "hungry for

business because he had been passed over for additional profit-sharing in 1988 for

failing to sell enough of the firm's services" (Pittsburgh Post-Gazette, February 15,

1996). In 1989, Finerty began selling services to relatives and associates of Phar-

Mor's president and CEO (who has been sentenced to prison and fined for his part

in the fraud). Critics claim Finerty may have become too close to client management

to maintain the professional skepticism necessary for the conduct of an independent

audit.

The Phar-Mor case is just one of many in which auditors have been held accountable

for certification of faulty financial statements. Investors in the Miniscribe

Corporation maintained that auditors were at least partially responsible for the nowdefunct

company's falsified financial statements; at least one jury agreed, holding the

auditors liable to investors for $200 million. In the wake of the U.S. savingsÐ'-andÐ'-

loan crisis, audit firms faced a barrage of lawsuits, paying hundreds of millions in

judgments and out-of-court settlements for their involvement in the financial reporting

process of savingsÐ'-andÐ'-loan clients that eventually failed.

The auditing partners of Coopers and Lybrand, like partners of other firms held

liable for such negligence, are very bright people. In addition, I believe that they are

generally very honest people. So, how could a prominent auditing firm with a reputation

for intelligence and integrity have overlooked such large misstatements in Phar-

Mor's financial records? How could auditors have failed to see that so many of their

savings-and-loan clients were on the brink of failure? Critics of the profession suggest

that auditor neglect and corruption may be responsible. In fact, very rarely do audit

2 Ð'* Chapter 1: Introduction to Managerial Decision Making

failures result fromdeliberate collusion of the auditor with its client in the issuance

of faulty financial statements. Instead, audit failures are the predictable result of

systematic biases in judgment. This book provides the tools to help you avoid these

errors. By eliminating biases from your decision-making patterns, you can become a

better decision maker and protect yourself, your family, and your organization from

avoidable mistakes.

This book (Chapter 4, specifically) will provide evidence that it is psychologically

impossible for auditors to maintain their objectivity; cases of audit failure are inevitable,

even from the most honest of firms. Psychological research shows that expecting

objective judgment from an auditor hired by the auditee is unrealistic. Although

deliberate misreporting can occur, bias more typically becomes an unconscious, unintentional

factor at the stage where judgments are made. When people are called

upon to make impartial judgments, those judgments are likely to be unconsciously

and powerfully biased in a manner that is commensurate with the judge's self-interest.

Psychologists call this the self-serving bias (Messick and Sentis, 1985). When presented

with identical information, individual perceptions of a situation differ dramatically

depending on one's role in the situation. Individuals first determine their

preference for a certain outcome on the basis of self-interest and then justify this

preference on the basis of fairness by changing the importance of attributes affecting

what is fair. Thus, the problemis not typically a desire to be unfair, but our inability

to interpret information in an unbiased manner (Diekmann, Samuels, Ross, and Bazerman,

1997). The self-serving bias exists because people are imperfect information

processors. One of the most important subjective influences on information processing

is self-interest. People tend to confuse what is personally beneficial with what is

fair or moral.

We have begun a new century with a vast amount of knowledge about how to

use technology to integrate data and make routine decisions. However, computers