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 Graduate School of Business The College of William & Mary Williamsburg, VA 23187-8795 November 2000
b

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 combined

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).

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-orwaive 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 employer.

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.

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. For example, settings with a low degree of judgment include auditing a client's petty cash account or
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).

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 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
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).

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 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
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).

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 is

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

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 firmwide 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, rulebased system or incentive mechanism to mitigate independence risk. Yet, the most powerful mitigating factors may be those that are the least well-defined auditing firm culture and
9

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 spectrum of services, and to attract and retain employees. We refer to this perspective as the "client advocacy

13

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 professionalism, while the second focuses on the consequences to the auditor, economic and otherwise, of a breach of public responsibility.

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

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. How Are Stakeholders 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

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 client-preferred 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-capital premium for information risk driven by their inability to rely on the audit process. Therefore,

16

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 additional discussion

18

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 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).
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

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. 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

20

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. 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

21

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 selfregulatory 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. 142143). 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). 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

22

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. 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)

23

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

25

FIGURE 2 CONTINUUM OF AUDITING FIRM CULTURE

26

REFERENCES The Advisory Panel on Auditor Independence. 1994. Strengthening the Professionalism of the Independent Auditor. Report to the Public Oversight Board of the SEC Practice Section, AICPA. (September 13). American Institute of Certified Public Accountants. 1972. Codification of Auditing Standards and Procedures. Statements on Auditing Standards No. 1. American Institute of Certified Public Accountants. 1983. Audit Risk and Materiality in Conducting an Audit. Statement on Auditing Standards No. 47. New York, NY: AICPA. American Institute of Certified Public Accountants. 1999a. Audit Adjustments. Statement on Auditing Standards No. 89. New York, NY: AICPA. American Institute of Certified Public Accountants. 1999b. Audit Committee Communications. Statement on Auditing Standards No. 90. New York, NY: AICPA. American Institute of Certified Public Accountants. 2000. Practice Alert 2000-2. Quality of Accounting Principles - Guidance for Discussions with Audit Committees. (February). Antle, R., and B. Nalebuff. 1991. Conservatism and auditor-client negotiations. Journal of Accounting Research (Supplement): 31-59. Blue Ribbon Committee. 1999. Report and Recommendations on Improving the Effectiveness of Corporate Audit Committees. Braun, K. 2001. The disposition of audit detected misstatements: An examination of risk and reward factors and aggregation effects. Contemporary Accounting Research (forthcoming, Spring 2001, Vol. 18-1). Brown, P. R., J. A. Calderon. 1996. Heightened SEC disciplinary activity in the 1990s. The CPA Journal, Vol. 66 (6): 55-58. Brown, H.L., and K. M. Johnstone. 2000. Accountants' integrity, objectivity, and independence: Evidence from SEC enforcement actions. Working paper, University of Wisconsin Madison. Calegari, M.J., J.W. Schatzberg, and G.R. Sevcik. 1998. Experimental evidence of differential auditor pricing and reporting strategies. The Accounting Review (April): 255-275. Colbert, J.L., M.S. Luehlfing, and C.W. Alderman. 1996. Engagement risk. The CPA Journal (March): 54-56. Committe, B.E. 1989. Independence of accountants and legislative intent. Administrative Law Review (Winter): 33-59. Davis, L.R., and D.T. Simon. 1992. The impact of SEC disciplinary actions on audit fees. Auditing: A Journal of Practice & Theory 11 (1): 58-68. DeAngelo, L.E. 1981. Auditor independence, "low balling," and disclosure regulation. Journal of Accounting and Economics 3: 113-127.

27

Dhaliwal, D.S., J.W. Schatzberg, and M.A. Trombley. 1993. An analysis of the economic factors related to auditor-client disagreements preceding auditor changes. Auditing: A Journal of Practice & Theory (Fall): 22-38. Emerson, J. 1993. KPMG Peat Marwick: Setting the new practice framework standard. Professional Services Review (June): 1. Flory, S.M., T.J. Phillips, R.E. Reidenbach, and D.P. Robin. 1992. A multidimensional analysis of selected ethical issues in accounting. The Accounting Review 67 (2): 284-302. Gibbins, M., S. Salterio, and A. Webb. 2000. Evidence about auditor-client management negotiation concerning client's financial reporting. Working paper, University of Alberta. Hackenbrack, K. and M.W. Nelson. 1996. Auditors' incentives and their application of financial accounting standards. The Accounting Review (January): 43-59. Haynes, C.M., J.G. Jenkins, and S.R. Nutt. 1998. The relationship between client advocacy and audit experience: An exploratory analysis. Auditing: A Journal of Practice & Theory (Fall): 88-104. Houston, R.W., M.F. Peters, and J.H. Pratt. 1999. The audit risk model, business risk and auditplanning decisions. The Accounting Review 74 (July): 281-298. Independence Standards Board (ISB). 1999. Standard No. 1, Independence Discussions with Audit Committees. (July 15). Independence Standards Board (ISB). 2000. A conceptual framework for auditor independence. Discussion Memorandum, DM 00-1 (February). Johnstone, K.M., S.F. Biggs, and J.C. Bedard. 1996. Framing effects and output interference in a concurring partner review context. Proceedings of the 1996 Deloitte & Touche/University of Kansas Symposium on Auditing Problems. Ed. Rajendra P. Srivastava. Johnstone, K.M. 2000. Client-acceptance decisions: Simultaneous effects of client business risk, audit risk, auditor business risk, and risk adaptation. Auditing: A Journal of Practice & Theory 19 (Spring): 1-26. Johnstone, K.M., and J.C. Bedard. 2000. Risk evaluation and risk adaptation in client acceptance decisions. Working paper, University of Wisconsin - Madison. Johnstone, K.M., and J.C. Bedard. 2001. Engagement planning, bid pricing and client response in the market for initial attest engagements. The Accounting Review (forthcoming). Johnstone, K.M., J.C. Bedard, and S.F. Biggs. 2000. Generating financial reporting alternatives: Enhancing and inhibiting roles of task knowledge and task environment. Working paper, University of Wisconsin - Madison. Kirk, D.J. 2000. Experiences with the Public Oversight Board and corporate audit committees. Accounting Horizons 14 (1): 103-111. Koonce, L., U. Anderson, and G. Marchant. 1995. Justification of decisions in auditing. Journal of Accounting Research 33 (2): 369-384.

28

Krishnan, J., and J. Krishnan. 1996. The role of economic trade-offs in the audit opinion decision: An empirical analysis. Journal of Accounting, Auditing, & Finance (Fall): 565-587. Levitt, A. 1999. "Quality Information: The Lifeblood of Our Markets." Remarks at the Economic Club of New York. New York, NY. (October 18). Levitt, A. 2000a. "Renewing the Covenant with Investors." Remarks at the New York University Center for Law and Business (May 10). Levitt, A. 2000b. "A Profession at the Crossroads." Remarks at the National Association of State Boards of Accountancy. Boston, MA. (September 18). Levitt, A. 2000c. "The Public's Profession." Remarks at the Fall Council of the American Institute of Certified Public Accountants. Las Vegas, Nevada. (October 24). Levitt, A. 1998. "The 'Numbers Game'." Remarks at the N.Y.U. Center for Law and Business. New York, NY. (September 28). Libby, R., and W. Kinney. 2000. Does mandated audit communication reduce opportunistic corrections to manage earnings to forecasts? The Accounting Review (October): 383-404. Loeb, S.E. 1989. Ethics committees and consultants in public accounting firms? Accounting Horizons 3 (4): 1-10. Magee, R., and M. Tseng. 1990. Audit pricing and independence. The Accounting Review (April): 315-336. Mason, A., and M. Gibbins. 1991. Judgment and U.S. Accounting Standards. Accounting Horizons 5 (2): 14-24. Matsumura, E.M., and R.R. Tucker. 1995. Second partner review: An analytical model. Journal of Accounting, Auditing, & Finance (Winter): 173-200. Mayhew, B.W., J.W. Schatzberg, and G.R. Sevcik. 2000. The effect of accounting uncertainty and auditor reputation on auditor independence. Working paper, University of Wisconsin Madison. Moore, P.L. 2000. The PWC scandal changes everything. Business Week (February 28): 140-143. New York Times (Anonymous). 2000. S.E.C. inquiry on auditor role. August 9. Palmrose, Z. 1988. An analysis of auditor litigation and audit service quality. The Accounting Review (January): 55-73. The Panel on Audit Effectiveness. 2000. Report and recommendations. (August 31, 2000). Peecher, M. 1996. The influence of auditors' justification processes on their decisions: A cognitive model and experimental evidence. Journal of Accounting Research 34 (1): 125-140. Ponemon, L.A. 1990. Ethical judgments in accounting: A cognitive developmental perspective. Critical Perspectives on Accounting: 191-215. Ponemon, L.A. 1992. Ethical reasoning and selection-socialization in accounting. Accounting, Organizations & Society 17 (3/4): 239-258.
29

Public Oversight Board. 1999. Annual Report: Stamford, CT. Rich, J.S., I. Solomon, and K.T. Trotman. 1997. The audit review process: A characterization from the persuasion perspective. Accounting, Organizations & Society 22 (5): 481-505. Salterio, S. 1994. Researching for accounting precedents: Learning, efficiency and effectiveness. Contemporary Accounting Research 11 (1): 515-542. Salterio, S. 1996. Effect of precedents and client position on auditors' financial accounting policy judgment. Accounting, Organizations & Society 21 (5): 467-486. St. Pierre, K. 1984. Independence and auditor sanctions. Journal of Accounting, Auditing, & Finance (Spring): 257-263. Securities and Exchange Commission. 1999a. SEC Staff Accounting Bulletin: No. 99 - Materiality. (August 12). Securities and Exchange Commission. 1999b. SEC Staff Accounting Bulletin: No. 101 - Revenue Recognition in Financial Statements. (December 3). Securities and Exchange Commission. 2000a. Final Rule: Audit Committee Disclosure. (January 31). Securities and Exchange Commission. 2000b. SEC Concept Release: International Accounting Standards. (February 16). Securities and Exchange Commission. 2000c. Letter from the Chief Accountant: Issues Related to Independence/Quality Control to SEC Practice Section (III). (May 1). Securities and Exchange Commission. 2000d. SEC Press Release 2000-77: All Big 5 Accounting Firms Agree to Participate in Voluntary Program to Address Independence Violations." (June 7). Simunic, D. 1984. Auditing, consulting, and auditor independence. Journal of Accounting Research 22 (Autumn): 679-702. Solomon, I., M.D. Shields, and O.R. Whittington. 1999. What do industry-specialist auditors know? Journal of Accounting Research (Spring): 191-208. Sweeney, J.T., and R.W. Roberts. 1997. Cognitive moral development and auditor independence. Accounting, Organizations, & Society 22 (3/4): 337-352. Trompeter, G. 1994. The effect of partner compensation schemes and generally accepted accounting principles on audit partner judgment. Auditing: A Journal of Practice & Theory (Fall): 56-68. Turner, L.E. 2000. "Shifting Paradigms in Self-Regulation." Remarks at the 27th Anniversary Securities Regulation Institute. (January 27). United States Supreme Court. 1984. United States v. Arthur Young & Co., et al. No. 82-687 (52 U.S.L.W 4355) March 21.

30

Wallman, S.M.H. 1996. The future of accounting, part III: Reliability and auditor independence. Accounting Horizons (December): 76-97. Windsor, C.A., and N.M. Ashkanasy. 1995. The effect of client management bargaining power, moral reasoning development, and belief in a just world on auditor independence. Accounting, Organizations, & Society 21 (7/8): 701-720. Wright, A., and S. Wright. 1997. An examination of factors affecting the decision to waive audit adjustments. Journal of Accounting, Auditing, & Finance Vol. 12 (Winter): 15-36. Zhang, P. 1999. A bargaining model of auditor reporting. Contemporary Accounting Research (Spring): 167-184.

31