ANTECEDENTS AND CONSEQUENCES OF INDEPENDENCE RISK:

FRAMEWORK FOR ANALYSIS

Karla M. Johnstone a
Assistant Professor of Accounting
Michael H. Sutton b
Former Chief Accountant, United States Securities and Exchange Commission
Visiting Professor of Business Administration
Terry D. Warfield a
Associate Professor of Accounting

University of Wisconsin-Madison
School of Business
Grainger Hall
975 University Ave.
Madison, WI 53706-1323
kjohnstone@bus.wisc.edu
b

Graduate School of Business

The College of William & Mary
Williamsburg, VA 23187-8795
November 2000

Acknowledgements: We thank practitioners and faculty who attended the 1999 Auditor
Independence Conference at the University of Wisconsin - Madison, research workshop
participants at the University of Wisconsin - Madison, participants at the 2000 University of
Wisconsin - Madison Ph.D. Alumni Conference, and participants at the Boston Area Research
Colloquium. We especially appreciate the comments of Jean C. Bedard, Karen Braun, Brian
Mayhew, Larry Rittenberg, and two anonymous reviewers. The research assistance of Marie
Nelson is also gratefully acknowledged.

ANTECEDENTS AND CONSEQUENCES OF INDEPENDENCE RISK:

FRAMEWORK FOR ANALYSIS
SYNOPSIS:
This paper presents a framework that explains how certain incentives affecting independence risk
interact with situational factors to affect actual or perceived audit quality. We articulate the
combined effects of direct incentives, indirect incentives, and judgment-based decisions
involving difficult accounting issues, materiality, and audit conduct. We then identify a variety of
factors that may mitigate independence risk, including corporate governance mechanisms,
regulatory oversight, auditing firm policies, auditing firm culture, and individual auditor
characteristics. Finally, we discuss the effects of independence risk on various stakeholders, and
propose actions that should be taken by the auditing profession, auditing firms, regulators, and
researchers.

KEY WORDS: Auditor, Independence risk, Conceptual framework

ANTECEDENTS AND CONSEQUENCES OF INDEPENDENCE RISK:

FRAMEWORK FOR ANALYSIS
INTRODUCTION
This paper examines certain incentives that may affect independence risk and proposes a
framework for analyzing how these incentives interact with situational factors to affect actual or
perceived audit quality in the public capital markets. Fundamental to this framework is the
notion of independence risk, which we define as the risk that an auditor's independence may be
compromised or may be perceived to be compromised.1 The framework also explains how
various factors may mitigate the effect of independence risk on actual or perceived audit quality,
and identifies how stakeholders may be affected should these mitigating factors fail. Developing
this framework should provide direction for further research to assist the auditing profession,
auditing firms, and regulators as they address auditor independence issues.
This paper contributes to the literature on auditor independence in the following ways.
First, it presents the antecedents and consequences of independence risk in a unified framework.
In so doing, the framework provides insight on the multi-faceted factors affecting independence
risk and the factors that might potentially mitigate it. One temptation in discussing independence
risk is to focus on just a single factor in isolation. For example, a discussion might focus on how
family relationships could affect independence risk or on whether regulation is an appropriate
method of mitigating independence risk. However, only by considering concurrently the various
antecedents and consequences of independence risk can insights be gained about their combined
effects. Although regulation alone might not effectively mitigate independence risk, regulation

This definition is consistent with the definition offered by Committe (1989), which states that independence is a
condition in which the auditor is "free from relationships that a reasonable person would expect to increase the risk
of the accountant examiner losing judgment-making impartiality" (p. 53). The Independence Standards Board (ISB)
to date has adopted no formal definitions of independence risk or auditor independence. However, the definitions we
use are consistent with those proposed in the ISB's conceptual framework (see ISB 2000).

combined with professional training and high ethical standards might be effective. Second, the
framework demonstrates how various areas of literature relate to one another. For example, the
framework addresses the relationship between auditor incentives, including the literature on
"lowballing" begun by DeAngelo (1981), and judgment-based decision situations in auditing as
in book-or-waive decisions as discussed by Wright and Wright (1997).
Developing a framework for understanding independence risk is important because
independence is the most fundamental and vital asset possessed by the auditing profession.
Without unquestioned independence, audits have little value. In the context of public capital
markets, the value of an audit arises from its role in addressing an inherent conflict of interest in
those markets. This conflict is between those seeking capital in the market place and those
providing capital. Those seeking capital want to raise it on the most favorable terms to
themselves; those providing capital want to do so on the most favorable terms to themselves. In
public capital markets, capital seekers generally possess inside information about the issuing
company and the prospects for its future success that are not available to capital providers.
Because those seeking capital also have the ability to mislead capital providers about the issuer's
prospects for future success, capital providers are inherently disadvantaged in their ability to
control, negotiate, or evaluate the terms of offerings and trading prices in public capital markets.
By being independent of capital seekers in both fact and appearance, auditors add value in public
capital markets by protecting the interests of capital providers.
Additionally, a framework for understanding independence risk provides a basis for
discussing factors affecting independence risk and the market responses undertaken to mitigate
that risk. Evaluating all of these factors within a single framework provides insights into their
combined and inter-related effects. Our framework provides perspective on how incentives and

other situational factors might allow independence risk to affect audit quality and how actions by
stakeholders might, individually or in combination, mitigate independence risk. Furthermore, by
concurrently evaluating incentives, other situational factors, and mitigating actions, we provide
insights for motivating and guiding future actions by the auditing profession, auditing firms,
regulators, and accounting researchers.
INDEPENDENCE RISK FRAMEWORK
The independence risk framework begins by specifying the environmental conditions that
create independence risk. First, some actual or perceived incentive to the auditor is necessary for
independence risk to exist. For example, an audit partner might have a client with whom the
auditor or the auditing firm has a good, long-term working relationship, and whose fee
constitutes a significant portion of the local office revenue. Such conditions could create
incentives that increase independence risk. Second, judgment-based decision situations are
necessary for independence risk to adversely affect actual or perceived audit quality. In the
situation described above, if the client faces a complex revenue recognition issue for which
authoritative guidance either does not exist or is unclear and presses for an aggressive reporting
treatment, independence risk might affect audit quality. The presence of incentives and
judgment-based decision situations increases the risk that the auditor might allow a revenue
recognition treatment that is more aggressive than the auditor believes is appropriate in the
circumstances.
Still, these environmental conditions do not necessarily mean that independence risk
results in reduced audit quality. A variety of factors can mitigate the effect of the environmental
conditions. For example, an auditing firm policy that requires consultation with a firm industry
expert, or a partner with higher decision-making authority, might encourage the partner and the

firm to insist on a more appropriate accounting treatment, despite incentives to do otherwise.

Possible exposure to litigation brought by shareholders misled and injured might have a similar
effect. Because these types of mitigating factors might not be effective, considering how
independence risk affects various stakeholder groups helps assess the potential consequences of
that risk.
Impacts on stakeholders caused by acceptance of an overly aggressive revenue
recognition policy include overly optimistic estimates of future cash flows with concurrent
inappropriate valuation of the client's stock. When the truth emerges and the stock price falls, the
shareholders that suffer losses might sue the individual auditor and the auditing firm, in the
process damaging the auditing profession as a whole. Evaluating the effects on stakeholders
within the context of the antecedent and mitigating factors known about independence risk can
influence the preventive and reactive policies adopted to ameliorate independence risk.
Researchers can facilitate this effort by gathering evidence on the causes and effects of the
related factors that point toward effective solutions to the independence risk problem. The
independence risk framework is summarized in Figure 1. Below we more fully discuss the
components of the framework.
Insert Figure 1 About Here
Environmental Antecedents of Independence Risk
Increased independence risk can have negative consequences for various stakeholders in
the audit environment. Thus, understanding the specific factors -- incentives and judgment-based
decisions -- that contribute to or result in increased independence risk is critical.

What Incentives Create Independence Risk?

There is a potential downside risk to the auditor if an independence violation is alleged or
discovered, in terms of both litigation and impaired reputation (e.g., Davis and Simon 1992;
Palmrose 1988). Therefore, a necessary antecedent for increased independence risk is the
presence of an incentive that leads an auditor (either knowingly or unknowingly) to assume that
downside risk, or that leads a third party user of the financial statements to conclude that the
auditor will assume that downside risk. Incentives that affect independence risk can be
characterized as direct or indirect incentives. Direct incentives involve actual or potential
monetary benefit, or the potential that such benefit will be withdrawn. Indirect incentives arise
from other circumstances that could make it difficult for the auditor to maintain objectivity.
Direct incentives include investments in the client's securities or mutual funds, contingent
fees, potential employment with the client, and financial dependence. Financial dependence
includes the source, relative magnitude, and continuity of fees, "lowballing" effects, and the
reputational value of a relationship with a successful, high-profile client.2 Investments in the
client might cause an auditor's financial interests to align with the interests of management,
possibly to the detriment of the interests of other investors or creditors. Client's fees to auditors
that are contingent upon specific opinions can, if allowed to occur, result in the auditor's financial
interests becoming dependent upon whether audit judgments coincide with management's
preferences. Potential employment with the client, particularly if agreed-to during the audit (but
also if implied), might dictate auditor decisions intended to obtain approval from a future

The term "continuity of fees" refers to an auditor's desire not to lose a client, either for the firm or the auditor. For a
general discussion of the notion of auditor dependence and its relationship to auditor independence, see Wallman
(1996). Academic research concerning incentive effects on auditor independence focuses primarily on the effects of
providing consulting services to clients (see Simunic 1984 and subsequent studies) and the effects of "lowballing"
(see DeAngelo 1981 and subsequent studies). However, other incentives are relatively less well-explored.

employer. Financial dependence introduces incentives that threaten the auditor's ability to resist
management pressure, out of concern that a financial relationship will be terminated.
Indirect incentives occur when the auditor possesses a personal, family, or professional
relationship with the client. These incentives also arise when auditors audit their own work,
including financial statements they prepared, valuations they recommended for financial
statement items such as in-process research and development, outsourced internal audit services
they did, and management decisions they advised on. Interpersonal relationships might cause the
auditor to favor personal over professional objectives and also might affect the auditor's ability to
exercise an appropriate level of professional skepticism. Self-review might create a situation in
which the auditor is unable to critically evaluate his or her own work. It might also create a
situation in which the auditor is unwilling to impair a relationship with other members of the
auditing firm or the client, thus reducing the auditor's ability to evaluate audit evidence
objectively.
What Judgment-based Decisions Allow Independence Risk to Affect Audit Quality?
In addition to direct and indirect incentives, another environmental condition necessary
for independence risk to affect actual or perceived audit quality is a judgment-based decision that
emerges from a client-auditor resolution process.3 Judgment-based decisions are those in which
there is uncertainty regarding the appropriate decision or valuation judgment that an auditor
should make. For example, settings in which there might be a high degree of judgment include
deciding on the appropriateness of a clients revenue recognition policy or judging the adequacy
of a clients allowance for doubtful accounts. Without a judgment-based decision, no mechanism
other than compromised integrity enables an auditor's incentive to result in reduced audit quality.
3

Models and experiments that support this notion can be found in Calegari et al. (1998), Magee and Tseng (1990),
and Mayhew et al. (2000). Models detailing client-auditor resolution processes can be found in Antle and Nalebuff
(1991), Gibbins et al. (2000), and Zhang (1999).

For example, settings with a low degree of judgment include auditing a client's petty cash
account or checking for cut-off errors. Since little or no judgment is required in these
circumstances, it is unlikely that incentives to compromise independence will result in reduced
audit quality.
We focus on three broad categories of judgment-based decision situations that affect
independence risk: difficult accounting issues, audit conduct decisions, and materiality decisions.
Difficult accounting issues are those that allow for alternative interpretations, including
accounting principles that require significant estimates or alternative measurement criteria, such
as establishing valuation allowances or estimated restructuring liabilities. Difficult accounting
issues also include emerging issues that are ambiguous or non-authoritatively defined, such as
the accounting for hybrid securities. The independence concern regarding these accounting
issues is that an auditor might acquiesce to management's preferred, and possibly inappropriate,
accounting treatment.4
Audit conduct decisions involve judgments about the nature and extent of audit evidence.
The concern regarding these decisions is that an auditor might compromise the nature or extent
of evidence collected because of an independence-related incentive. For example, an auditor
seeking future employment with the client might not aggressively pursue errors discovered
during audit sampling out of a desire not to offend client management.
Materiality decisions call for judgments about the magnitude of the omissions or
misstatements of financial information that will impair the judgment of a reasonable user of the
financial statements. The concern regarding materiality decisions is that an auditor might
4

We acknowledge that there is a continuum along which the outcome of difficult accounting issues could be
characterized as "appropriate" or "inappropriate" (see e.g., the Panel on Audit Effectiveness 2000, Chapter 3). For
related research that examines the economic and cognitive influences underlying the resolution of difficult
accounting issues, see Dhaliwal et al. (1993), Hackenbrack and Nelson (1996), Johnstone et al. (1996), Johnstone et
al. (2000), Krishnan and Krishnan (1996), and Trompeter (1994).

improperly conclude that an item is immaterial, and thus not subject the item to evaluation or
adjustment during the conduct of the audit. Thus, materiality decisions can be embedded in
judgments involving difficult accounting issues and audit conduct decisions. Often materiality
decisions are made in combination with book-or-waive decisions regarding whether the auditor
will require the client to record a proposed adjusting journal entry or waive that requirement. The
concern is that the auditor will waive a proposed adjustment by improperly rationalizing that the
adjustment is immaterial.5
In summary, the framework to this point identifies the environmental conditions
--incentives and judgment-based decisions -- that are antecedent to increased independence risk
and that may reduce actual or perceived audit quality. However, the existence of these
environmental conditions does not guarantee that heightened independence risk results in
reduced audit quality. Certain factors may mitigate the effects of the environmental conditions.
What Factors May Mitigate Independence-related Environmental Conditions?
The mitigating factors that we examine are corporate governance mechanisms,
regulation, auditing firm policies, auditing firm culture, and individual auditor characteristics.
While any one factor in isolation may not be sufficient to mitigate independence risk, in
combination these factors can have a powerful mitigating effect.
Corporate Governance and Regulatory Oversight
The first two mitigating factors, corporate governance mechanisms and regulation, are
institutional mechanisms applied at the company and market levels to provide assurance to third
party users that independence risk is being controlled. Corporate governance mechanisms
5

For recent regulatory attention on the materiality issue, see SEC (1999a). For recent AICPA attention on the audit
adjustments issue, see SAS 89 (AICPA 1999a). For related research that examines the processes surrounding the
book-or-waive decision, see Braun (2001) and Wright and Wright (1997). For recent research related to SAS 89, see
Libby and Kinney (2000).

include board of director and audit committee involvement in establishing and maintaining the
appropriate client-auditor relationship and in overseeing the conduct of the audit. Appropriately
functioning boards of directors and audit committees should provide a neutral, well-informed
buffer between auditors and management.
Recognizing the importance of corporate governance, regulators play a major role in
setting governance standards. For example, the combined activities of the SEC (2000a), the
Independence Standards Board (ISB 1999), the Auditing Standards Board (1999a, 1999b), and
the stock exchanges (Blue Ribbon Committee 1999) focus on improving the effectiveness of
audit committees and the public disclosure of information about audit committee activities.6 In
addition, the SEC and state boards of accountancy enforce independence violations and sanction
the auditors involved, although these proceedings can take time and enforcement rates are
relatively low. Finally, rules regarding prohibited relationships are in place to address some of
the incentives relating to independence risk, including prohibitions against direct investments
and contingent fees.

For a discussion of contemporary issues relating to the operation of corporate audit committees, see Kirk (2000). In
addition, the Panel on Audit Effectiveness (2000) proposes a governance structure that is comprised of public and
private oversight (see Chapter 6). For related research that examines regulatory sanctions and their effects on
auditors, see Brown and Calderon (1996), Brown and Johnstone (2000), Davis and Simon (1992), and St. Pierre
(1984).

Auditing Firm Policies

Examples of auditing firm policies are concurring partner reviews, peer reviews, withinfirm consultations, auditor competence programs, and compensation plans. Policies are
established by the auditing profession, auditing firms, and individual auditors, at least in part, to
mitigate independence risk because of its association with litigation and declines in reputational
capital (e.g., Davis and Simon 1992; Palmrose 1988). Although the auditing profession, auditing
firms, and individual auditors have incentives to mitigate independence risk by prescribing
policies, the effectiveness of those policies is a matter that needs further investigation. For
example, regulators worry that the self-regulatory mechanisms of the profession are not as
effective as possible (e.g., see Turner 2000). Further, there is a movement to reorganize the
profession's self-regulatory process under the Public Oversight Board (Levitt 2000a; Public
Oversight Board 1999; Panel on Audit Effectiveness 2000).
Concurring partner reviews involve a second look at significant audit decisions by a
partner with appropriate technical expertise and without direct involvement in the conduct of the
engagement. In the context of this paper, concurring partner review can mitigate independence
risk prior to the review by creating the expectation of review and can mitigate independence risk
during the review by empowering the concurring partner to provide fresh insight and unbiased
judgment on significant engagement decisions.7 Peer reviews include an evaluation of the system
of audit quality control, including independent review of audit engagements by a peer auditing
firm. Similar to concurring partner reviews, peer reviews are intended to mitigate independence
risk by creating the expectation of review. Peer reviews call for subsequent action if a deficiency

For related research that examines the audit review process in general, see Rich et al. (1997). For an analytical
model of the concurring partner review process, see Matsumura and Tucker (1995).

10

is uncovered, such as corrective action plans and continuing professional education for the
auditors involved.
Policies that require within-firm consultations on difficult accounting issues can mitigate
independence risk by providing the expertise to identify critical issues and develop appropriate
bases for resolving judgment-based decision situations. As an example, consider a situation in
which an auditor encounters a revenue recognition question for an e-commerce client and
management proposes a reporting treatment that the auditor believes is too aggressive. Further
assume that there is no explicit authoritative guidance for the transaction. On one hand, the
auditor may feel pressure to accept the client's proposed treatment. That pressure becomes more
intense when the client relationship has significant growth potential in audit or non-audit services
revenue. On the other hand, the decision can be precedent-setting for the firm and can increase
the firm's risk of litigation or loss of reputational capital. By requiring the auditor to engage in a
within-firm consultation with industry experts, the firm enables the auditor to gain valuable
insight on the relevant technical issues. In addition, because the decision-making process and
outcome are seen by the client as involving the entire firm and its experts, the individual auditor
can deflect personal criticism and focus the client's attention on the analysis of solutions
acceptable to the firm or regulators, thereby increasing the auditor's bargaining power.8
Auditor competence programs are another potentially useful means of mitigating
independence risk. These programs include both general audit training and the development of
industry-specific expertise. Being well-trained in general and highly knowledgeable in a specific
8

This type of independence risk mitigation strategy might be particularly useful if the firm is very large and has a
significant number of similar clients. As one reviewer noted, however, such policies may not always be effective.
For related research on within-firm consultations and justification processes in general, see Koonce et al. (1995),
Peecher (1996), Salterio (1994), and Salterio (1996). For analyses of negotiation and bargaining power in judgmentbased decision situations in accounting, see Gibbins et al. (2000) and Windsor and Ashkanasy (1995).

11

industry can increase the auditor's bargaining power with the client. Regarding the revenue
recognition issue, an auditor with industry expertise might be better able to counter the clients
aggressive preferences with persuasive arguments based upon industry precedent compared to an
auditor without such industry expertise.9
Compensation plans, particularly at the partner level, are another important tool in
potentially mitigating independence risk, as discussed in Chapter 4 of the report by the Panel on
Audit Effectiveness. Compensating auditors based on firm-wide performance, as opposed to
individual auditor or individual office performance, reduces the individual auditor's direct
financial incentive to make a decision in management's favor. Thus, under structures that
emphasize firm-wide performance, auditors might be expected to make decisions that reduce
independence risk (see e.g., Trompeter 1994). Other compensation issues relate to the effects of
economic sharing arrangements among different functions of the firm, whether an audit partner
is compensated for referring consulting services, as well as the nature of a firm's performance
evaluation system. While not addressed by prior research, these issues likely affect independence
risk. Properly structured, compensation plans might reduce independence risk, particularly if
they diminish the relationship between certain incentives and judgment-based decisions.
Auditing Firm Culture and Individual Auditor Characteristics
Each of the mitigating factors discussed above involves some external, well-defined,
rule-based system or incentive mechanism to mitigate independence risk. Yet, the most powerful
mitigating factors may be those that are the least well-defined
9

auditing firm culture and

Most large auditing firms are now organized with industry specialization in mind (Emerson 1993). For a discussion
on the generally beneficial effects of industry expertise on auditor performance, see Solomon et al. (1999). However,
it is important to note that industry specialization also has a potential downside. "It may result in a loss of objectivity
if the specialists get so close to the industry that they fail to challenge industry practices that fall short of providing
the most relevant and reliable accounting information" (The Advisory Panel on Auditor Independence 1994, p. 9).
As such, the Panel recommends that industry expertise be supplemented by consultation with the auditing firm's
national technical office.

12

individual auditor characteristics, including auditor ethical orientation and professionalism.

Explicit and implicit auditing firm messages regarding appropriate conduct within the firm and
the ethical characteristics of individual auditors likely have a significant impact on independence
risk.
Auditing firm culture can be thought of as the message that a firm conveys to its auditors
regarding the party to whom they owe primary duty. In the context of public capital markets, we
identify three types of firm culture that occupy places along a continuum (see Figure 2).
Insert Figure 2 About Here
The first type of firm culture emphasizes the auditors duty to capital providers, including
investors and creditors. We refer to this perspective as a "public duty culture." In addition to a
disclosure system that requires capital seekers to provide certain information to capital providers,
the securities laws require that independent auditors examine and attest to the credibility of
information provided by capital seekers. From the SEC's perspective, the goal of that attestation
is to give confidence to capital providers that the information they receive is reliable and not
misleading. Therefore, the essential ethical obligation of the auditor is to step into a conflict of
interest between capital seekers and capital providers and assume a role that protects the interests
of capital providers by helping to mitigate the information asymmetry between capital seekers
and providers. Courts and auditing standards espouse this perspective by emphasizing auditors'
public duty role (e.g., see United States Supreme Court 1984 and AU 220.02, AU 230.09 in
AICPA 1972).
A distinctly different type of firm culture encourages auditors to view themselves as
business partners with their clients, the capital seekers. Auditors may move toward this end of
the continuum out of a desire to "add value" to the businesses of their clients, to sell a broad

13

spectrum of services, and to attract and retain employees. We refer to this perspective as the
"client advocacy culture" (also see Haynes et al. 1998). This culture focuses primarily on the
financial interests of capital seekers and auditors, potentially to the detriment of capital providers
and other financial statement users. On the continuum of auditing firm cultures that might be
present in the financial reporting process, this culture is potentially most at odds with public and
regulatory expectations of the independent auditor. Thus, moving along the continuum from a
public duty culture to a client advocacy culture likely heightens independence risk and an
auditing firm that fosters a public duty culture rather than a client advocacy culture is more likely
to effectively mitigate independence risk.10
Between the two extremes exists a continuum of firm cultures, including one that
suggests that auditors are neutral

not affirmatively obligated to capital providers, yet

independent of capital seekers. This perspective focuses on the interests of the auditor and how
risks to the auditor arising from representations made to capital providers, and from the resulting
reliance on those representations, are managed and controlled. We refer to this perspective as a
"risk management culture."11 The ways in which the public duty culture differs from the risk
management culture are not always clear, but they are not the same. The first focuses on the
affirmative ethical obligation of the independent auditor, which might be described as

10

For example, there is an ongoing SEC investigation of Pinnacle Holdings dealing with this issue. In a recent press
article, the COO of the company defended its audit firm, referring to them as "good partners" (New York Times
2000).
11

For example, the AICPA uses the term "business risk" to refer to the risk that "the auditor is exposed to loss or
injury to his professional practice from litigation, adverse publicity, or other events arising in connection with
financial statements that he has examined and reported on" (AICPA 1983). More recently, the "business risk"
concept is expanded to include auditing firms' fee realization concerns (Colbert et al. 1996), and client acceptance
and continuance decisions. Research demonstrates that auditors consider business risk when making client
acceptance decisions (Johnstone and Bedard 2000; Johnstone 2000) and audit planning decisions (Johnstone and
Bedard 2001; Houston et al. 1999).

14

professionalism, while the second focuses on the consequences to the auditor, economic and
otherwise, of a breach of public responsibility.
Auditing firm culture likely interacts with individual auditor characteristics, particularly
ethical and moral characteristics (Ponemon 1992). For example, an auditor with high ethical
standards and a developed sense of moral reasoning operating in a firm with a client advocacy
culture might still be able to effectively mitigate independence risk, but mitigating that risk
seems less challenging in a firm that fosters a public duty culture. Indeed, any actions that
auditing firms can take to foster the ethical and moral development of their auditors will help
mitigate independence risk.12 But to the extent that an individual auditor's orientation moves
away from public duty toward client advocacy, it is likely that more reliance must be placed on
other mitigating factors, such as regulation and corporate governance, to effectively mitigate
independence risk.
In summary, the independence risk framework indicates that independence risk is a
function of antecedent environmental conditions derived from direct and indirect incentives
operating in judgment-based decision situations. It is the combination of these factors through
which independence risk may result in lower quality audits. However, these factors represent
necessary but not sufficient conditions for independence risk to adversely affect audit quality.
The mitigating factors of corporate governance, regulation, auditing firm policies, auditing firm
culture, and auditors' ethical and moral characteristics may effectively preserve audit quality,
even in the presence of auditor incentives and judgment-based decision situations. We next
discuss the implications of this framework for the various stakeholders potentially affected by
independence risk.
12

For discussions of ethical and moral reasoning and their relationship to auditor independence, see Flory et al.
(1992), Loeb (1989), Ponemon (1990), Sweeney and Roberts (1997), and Windsor and Ashkanasy (1995).

15

How Are Stakeholders Affected by Independence Risk?

Concerns about independence risk are based on the potential effects that lack of
independence, actual or perceived, has on the value of audits to various stakeholders. As
discussed above, a number of mitigating factors exist to reduce the likelihood that independence
risk results in lower actual or perceived audit quality. Yet, independence-related audit quality
problems do surface with some frequency (Brown and Calderon 1996; Brown and Johnstone
2000). Therefore, understanding how increased levels of independence risk affect various
stakeholders is valuable. We consider the following groups of stakeholders: auditees,
shareholders, creditors, individual auditors, the auditing profession, and regulators.
Auditees can benefit in the short run from increased independence risk because of
increased likelihood that the auditor will acquiesce to the auditee's financial reporting
preferences. Potential benefits could include inflated stock prices and inappropriately low cost of
capital. In the short run, shareholders and creditors bear the burden of the benefits accruing to
auditees. Shareholders' and creditors' interests are compromised by increased independence risk
if that risk leads to inappropriate financial reporting, the potential ex-post discovery of which
results in a decline in the value of debt or equity investments in the company. Individual auditors
may benefit from increases in independence risk to the extent that the price received for a clientpreferred auditor decision compensates them for the downside risk that their actions will be
discovered. For example, individual auditors may over-emphasize maintaining the client
relationship for economic reasons, and may de-emphasize or discount the future probability of
litigation or reputation declines associated with their behavior.
In the long run, and to the extent that auditors lacking independence are associated with
misrepresentations by auditees, shareholders and creditors are expected to impose a cost-of-

16

capital premium for information risk driven by their inability to rely on the audit process.
Therefore, auditees ultimately also bear a cost related to independence risk. Thus, the effect on
auditees is the net of the benefits accruing for inflated stock prices/low cost of capital in the short
run versus the independence-related cost-of-capital premium in the long run. More generally, as
independence risk increases, the audit becomes less valuable to shareholders and creditors in
assessing the credibility of auditees financial representations. The auditing profession is harmed
by increased independence risk, even when only some auditors are viewed as lacking
independence. In the long run, the ability of the profession to extract singular benefits from
conducting audits is diminished by increases in independence risk. This is so because
independence is critical to the auditors ability to add credibility to the financial statements.
Related to this point, regulators (and society overall) bear costs associated with
heightened independence risk. For example, to the extent that regulators cannot rely on auditors
to provide a reliable third-party check on financial statements because they lack independence,
regulators may resort to more costly mechanisms to ensure investor confidence in the financial
reporting process. Indeed, regulators maintain professional reputations for being able to
competently manage market risks to shareholders and creditors, including independence risk.

17

DISCUSSION AND CONCLUSIONS

In light of the preceding discussion, the next logical question becomes: What actions
should be taken by the auditing profession, auditing firms, regulators, and researchers to address
independence risk? We address this question for each of these groups by acknowledging and
discussing actions already being undertaken, and then by suggesting possible extensions or
improvements evident from our framework.
The Auditing Profession
The auditing profession actively addresses independence risk, mainly by prohibiting
certain activities and instituting quality control programs. For example, the AICPA's Rules of
Conduct address both direct and indirect independence incentives, including rules on direct
investments, contingent fees, interpersonal relationships, and self-review. Quality control
programs include licensing requirements, continuing professional education requirements, and
ethical rules.
However, two areas receive limited attention by the profession. First, the profession has
not fully addressed the financial dependence issue relating to the source, relative magnitude, and
continuity of fees, "lowballing" effects, and the reputational value of a relationship with a
successful, high profile client. In fact, the profession seems to be pursuing service expansion
strategies that could increase financial dependence concerns. For example, a recent promotional
letter from the AICPA addressed to one of the authors states that "today's CPA is a valued
financial professional looked upon as an integral part of any business' success." This statement is
consistent with the AICPA's support of initiatives to expand services beyond the traditional attest
function. It is also consistent with the AICPA's lack of attention to the issue of emerging
organizational forms of firms, including the H&R Block acquisition of McGladrey & Pullen (for

18

additional discussion of this point, see Kirk 2000, p. 104). Given the importance of financial
dependence as a direct incentive related to independence risk, the profession needs to more fully
consider these issues.
Second, the profession should increase its focus on judgment-based decision situations
that allow independence risk to affect audit quality. One effective method that the profession has
at its disposal is in the domain of accounting standard-setting. We believe that the profession
needs to continue to encourage and actively support standard-setting initiatives that quickly
resolve emerging accounting issues and that reduce the extent to which ambiguous application of
those standards is possible.13 Encouraging standard-setters to eliminate alternatives for measuring
and recording transactions can be helpful, particularly when alternatives are used to account for
economically similar transactions in different ways. Examples of these types of transactions
include revenue recognition, lease accounting, business combinations, and off-balance sheet
financing.
Auditing Firms
Auditing firms are in a potentially powerful position to influence independence risk
because they can establish firm policies and foster firm cultures that better support individual
auditors' efforts at mitigating independence risk. A number of recent developments respond to
independence risk concerns. For example, some firms are selling their consulting practices, while
others are reorganizing their audit and consulting practices. Such developments may be seen as
efforts to mitigate actual or perceived threats to independence risk. In addition, the SEC Practice
Section member firms adopted independence monitoring systems as part of their membership

13

For additional discussion of this point, see Mason and Gibbins (1991). Differences in both financial accounting
and auditing standards at an international level compound this problem. For recent discussion on the implementation
of international accounting standards, see SEC (2000b).

19

requirements (SEC 2000c), and all of the Big 5 accounting firms have agreed with the SEC to
participate in a voluntary program to review past independence violations (SEC 2000d).
Important issues still to be addressed include the nature of the economic interests retained
by partners in the attest segments of firms selling their consulting practices and the actual and the
perceived effectiveness of the reorganizations in mitigating independence concerns. At the same
time, fostering a firm culture that values and rewards professionalism, emphasizes the public
duty of the independent auditor to third parties, and sends the appropriate firm-wide messages to
promote that culture, is important (e.g., see the Panel on Audit Effectiveness report, 2000,
Chapter 4 p. 99-101).
Firms also are more actively training their professionals to recognize independence risk
issues. However, our discussions with a number of large firms suggest that much of this training
is focused on avoiding certain violations of current independence rules, such as those relating to
stock ownership and family relationships. Based on the independence risk framework presented
here and in Chapter 4 of the Panel on Audit Effectiveness report, it seems clear that this type of
training, while valuable, is not sufficient. Given the broad range of independence risk
antecedents, future training of professionals should emphasize the relationship between
independence risk incentives and situations that allow independence risk to affect audit quality.
For example, professionals need explicit training on how to deal with situations where financial
incentives exist and the client exerts pressure on a judgment-based decision. This training needs
to convey not only technical knowledge, but also effective negotiation skills and tactics. In
addition, industry specialization programs and firm-wide consultation practices should be
continued and strengthened.

20

Finally, firms should consider and incorporate the findings of research on how
compensation structures affect auditors' decisions. Trompeter (1994) finds that audit partners
make more conservative judgments when their compensation is based on firm-wide performance
as opposed to individual-office performance. Given that auditors at all levels of the firm face
independence risk, compensation structures at all levels of the firm need to reinforce and foster
the firm's professional responsibilities. In addition, evaluation, retention, and promotion criteria
should be structured to support firm policies that reduce independence risk (also see the Panel on
Audit Effectiveness 2000, p. xiv).
Regulators
Regulators recently increased the intensity of their focus on auditor independence. The
SEC expressed its concerns in speeches given by SEC Chairman Arthur Levitt, by its recent
enforcement actions, and by proposed new auditor independence rules (see Levitt 1999; Levitt
2000a; Levitt 2000b; Levitt 2000c; Moore 2000). In addition, the SEC issued new rules aimed at
improving communications between auditors and audit committees (SEC 2000a). The Public
Oversight Board (POB) demonstrates similar concerns as evidenced by its auditor independence
initiatives and its support of the activities of the Panel on Audit Effectiveness (POB 1999). Other
examples include recent actions by the Auditing Standards Board (AICPA 1999b) and formation
of the Independence Standards Board (ISB). The ISB issued final standards relating to
discussions with audit committees, the audits of mutual funds and related entities, and
employment with audit clients. The ISB recently published a discussion memorandum detailing
its conceptual framework and discussion memoranda and/or exposure drafts for issues involving
family relationships, appraisal and valuation services, legal services, and evolving firm structures
that address the direct and indirect incentives outlined in our framework.

21

When considering how these regulatory actions fit in the context of the independence risk
framework, it is clear that regulators are focusing on enhancing the visibility of regulation, on
increasing the effectiveness of corporate governance and self-regulatory mechanisms, and on
setting rules that address incentives that increase independence risk. Regulators also have
focused attention on the judgment-based decision situations that allow independence risk to
affect audit quality. For example, the recent SEC Staff Accounting Bulletins on materiality (SEC
1999a) and revenue recognition (SEC 1999b), and the recent AICPA actions concerning
accounting adjustments and how to convey information about those adjustments to audit
committees (AICPA 1999a; AICPA 2000) are all steps in this direction.
As Levitt (1998) notes, judgmental "gray area" issues can lead to financial reporting
problems, yet these issues are sometimes the most difficult to regulate. One possibility would be
to look more closely at judgment-based decision situations, perhaps as part of the profession's
self-regulatory process. A step in this direction involves the Panel on Audit Effectiveness' Quasi
Peer Review project, in which the audits of 130 SEC registrants were reviewed to assess selected
audit quality issues, including risk evaluation, personnel allocation, audit procedures, and audit
review activities. In addition, a greater degree of public disclosure of POB findings, such as
problems identified, reasons underlying problems, and outcomes, might provide an effective
means to discourage inappropriate audit decisions (see e.g., the Panel on Audit Effectiveness
2000, pp. 142-143). Strengthening the peer review system is another possibility. For example, the
SEC Practice Section executive committee re-evaluated the requirements for firms' peer review
processes in 1999. One recommended change is that "particular emphasis should be given by the
Board to identify areas of high risk to be included in peer reviews" (POB 1999, p. 9). Also, see
the recent recommendations of the Panel on Audit Effectiveness (2000; pp. 146-148).

22

Researchers
Researchers are in a unique position to inform the aforementioned decision-makers about
key aspects of the independence risk framework. As noted throughout this paper, a significant
amount of research examines various components of the framework. Although the framework
provides insights regarding how prior research fits into the overall theme of auditor
independence, further analysis within the framework provides insights on fruitful avenues for
additional research. First, research should continue to address the individual components of the
framework. For example, research on how auditors resolve judgment-based decision situations
with their clients involving difficult accounting issues and materiality decisions is clearly needed.
Moreover, while we demonstrate how prior research relates to the concept of auditor
independence presented in the framework, much prior research does not explicitly link its
findings to the auditor independence literature. We believe that future research should do so.
Second, some areas of the framework have received limited research attention. For
example, while the incentive effects of financial dependence are well-explored (Simunic 1984
and subsequent studies), other incentives involving personal relationships and potential
employment received less attention, although they are likely as important. For example,
examining differences and the implications of differences between various incentives, both
economically and cognitively, on auditor decision-making will provide valuable insights. Also,
there exists emerging research on the judgment-based decision situations that allow
independence risk to affect audit quality, such as research on book-or-waive decisions by Braun
(2001) and research on client-auditor negotiation by Gibbins et al. (2000); additional research in
this area is needed.

23

Third, the effectiveness of factors that may mitigate independence risk, individually or in
combination, is not well-explored in the academic literature. Research on the effectiveness of the
mitigating factors identified in the independence risk framework should be pursued.
Fourth, future research should examine the relationships between the components of the
independence risk framework outlined in Figure 1. Specifically, research should focus on (1)
understanding how direct and indirect incentives interact with judgment-based decisions, (2)
understanding how the combined effects of incentives and judgment-based decisions interact
with mitigating factors, and (3) understanding how stakeholders are affected when mitigating
factors fail.
In summary, the independence risk framework presented in this paper provides a unified
analysis of the antecedents and consequences of independence risk and identifies the factors that
can mitigate this risk. By identifying the factors and their relationships within this unified
framework, the auditing profession, auditing firms, regulators, and researchers should be better
able to respond to the practice and policy implications of independence risk.

24

FIGURE 1
A FRAMEWORK FOR UNDERSTANDING THE ANTECEDENTS AND
CONSEQUENCES OF INDEPENDENCE RISK

What incentives create independence risk?

Necessary
Environmental
Conditions

Direct Incentives

Indirect Incentives

Direct investments Contingent fees

Potential employment
Financial dependence

Interpersonal relationships
Auditing work of self or firm

What judgment-based decisions allow independence risk

to affect audit quality?
Pressure on difficult
accounting issues

Pressure on
materiality judgments

Pressure on audit
scope and conduct

What factors may mitigate independence-related

environmental conditions?

Mitigating
Factors

Corporate Governance Mechanisms

Boards of directors
Audit committees
Auditing Firm Policies
Concurring partner reviews
Within-firm consultations
Auditor competence programs
Compensation plans

Regulatory Oversight
Standards setting
Enforcement

Auditing Firm Culture and

Individual Auditor Characteristics
Auditing firm emphasis on
its public duty
Auditors ethical and
moral characteristics

How are stakeholders affected if mitigating factors fail?

Stakeholder
Analysis

Auditees

Shareholders
and creditors
Auditing
profession

Suggested
Actions

25

Individual
auditors
Regulators

What actions should be taken by the auditing profession/

auditing firms/regulators/researchers?

FIGURE 2
CONTINUUM OF AUDITING FIRM CULTURE

Public
Duty
Culture

Capital
Seeker

26

Capital Provider

Auditor

Risk
Management
Culture

Capital
Seeker

Auditor

Client
Advocacy
Culture

Capital
Provider

Capital Seeker

Auditor

Capital
Provider

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