Audit Pricing and Independence

Audit Pricing and Independence
Author(s): Robert P. Magee and Mei-Chiun Tseng

Source: The Accounting Review, Vol. 65, No. 2 (Apr., 1990), pp. 315-336
Published by: American Accounting Association
Stable URL: http://www.jstor.org/stable/247627 .
Accessed: 28/09/2013 18:44
Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp
.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.
American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to The
Accounting Review.
http://www.jstor.org
This content downloaded from 136.167.3.36 on Sat, 28 Sep 2013 18:44:49 PM

All use subject to JSTOR Terms and Conditions
THE ACCOUNTING REVIEW
Vol. 65, No. 2
April 1990
pp. 315-336
Audit Pricing and

Independence
Robert P. Magee
Northwestern University
Mei-Chiun Tseng
National Sun Yat-sen University
(Republic of China)
SYNOPSIS: Previous researchers have identified the pricing phenomena of

"low-balling" and "price-cutting" in the market for audit services. One
branch of this research has empirically estimated the magnitude of these
pricing phenomena, while the other has hypothesized that they are caused
by transaction costs incurred when a client firm switches to a new auditor.
A principal concern of those who oversee the market for audit services is
that the same forces that produce low-balling and price-cutting give the
incumbent auditor a positive expected payoff from retaining the client.
Such an interest in the client (called the "value of incumbency") could
reduce the auditor's independence from the client, thereby affecting the
quality of financial reporting.
In this article, a multiperiod model of the audit market for a single
client is presented, with the introduction of a reporting issue over which
the auditor and the client may disagree. For instance, the client may prefer
not to recognize an estimated liability, while the incumbent auditor believes
that not recognizing the liability could be regarded as an audit failure at
some point in the future. Under the assumptions that contingent audit fees
are not allowed and that auditors and clients cannot make binding multi-
period commitments, the research shows that the auditor's value of incum-
bency presents a threat to independence only under limited circumstances.
One condition that must be fulfilled for the client to put pressure on the
auditor is that auditors in the market must disagree among themselves as to
the appropriateness of the reporting policy desired by the client. If all audi-
The comments of Linda DeAngelo. Ronald Dye, Bruce Johnson, Thomas Lys, Siew Hong Teoh,
Lynda Thoman, and two anonymous referees, and the financial support of the Ernst & Whinney
Faculty Fellowship and the Accounting Research Center of Northwestern University are gratefully
acknowledged.
Submitted June 1988.

Revisions received January, June, and September 1989.
Accepted October 1989.
315

316 The AccountingReview,April 1990
tors agree that the reporting policy desired by the client could be regarded
as an audit failure, then a positive value of incumbency should not cause an
auditor to compromise his or her independence. Another condition iden-
tified is that the reporting issue must affect the client for more than one
reporting period. Otherwise, the auditor's positive value of incumbency will
not produce any incentives to compromise independence. In addition, a
positive value of incumbency will not compromise independence on report-
ing issues that are regarded as very important by either the client or the
auditor.
One of the interesting results of the analysis is the identification of a
link between auditor independence and the nature of financial reporting
standards. Auditor independence is easier to maintain when financial re-
porting standards leave less room for disagreement among auditors regard-
ing the proper application of those standards to client circumstances.
Indeed, such "cut-and-dried" reporting standards may be preferred by
accountants with an established client base and large values of incum-
bency. Finally, the research describes some of the difficulties in defining
auditor independence in a market environment.
Key Words: Auditing, Independence, Pricing, Low-Balling.
I NCREASING attention is being focused on the links between the pricing of

audit services and the independence of the auditor. A number of concerns
have been raised by legislative committees, the Securities and Exchange
Commission, the Federal Trade Commission, as well as by the AICPA. One focal
point of this discussion is the pricing of audit services (including "low-balling")
and the possibility that the auditor's expected economic benefits from keeping a
client may affect the auditor's independence toward that client.
DeAngelo analyzed an auditor-client model with low-balling as part of a com-
petitive equilibrium and with an incumbent auditor able to exploit his or her
position and earn positive "quasi-rents." She states that "an auditor who expects
to earn client-specific quasi-rents from a given relationship is not indifferent to
client termination, and is therefore not perfectly independent with respect to that
client" (1981a, 117 n. 6), subject to the caveat that "the auditor must perceive
the expected gains from 'cheating' exceed the expected costs" (117, n. 7). Audit
pricing issues have also been addressed by empirical researchers who have
looked for evidence of price-cutting (defined as the difference between the first-
year audit fee and either the prior auditor's fee or an estimated fee based on a
cross-sectional model). Francis (1984), Simunic (1980), and Palmrose (1986)
found no significant evidence of price-cutting, but Francis and Simon (1987),
Simon and Francis (1988), and Baber et al. (1987) found evidence of price-cutting
in first-year audits.
We extend DeAngelo's model to find conditions under which a client-specific
quasi-rent (as defined by DeAngelo) may lead an auditor to compromise indepen-
dence on a single reporting issue. The primary assumptions used in the model
are that the audit fee does not depend on the audit report (no contingent fees or

Magee and Tseng-Audit Pricing 317
bribes), that no binding multiperiod agreements are possible between clients and
auditors, and that all auditors are identical in their cost structure and abilities,
though not necessarily identical in their judgments as to how Generally Accepted
Accounting Principles (GAAP) apply to a particular client's circumstances.1
To examine the independence question, we introduce a single reporting issue
and define independence as an auditor's making reporting decisions consistent
with his or her beliefs as to whether the reporting decision may be regarded as an
audit failure. That is, an auditor compromises his or her independence when he
or she allows the client to use a reporting policy that he or she believes would be
viewed as an audit failure. The analysis then clarifies the hypotheses underlying
DeAngelo's (1981a, 113) statement that "the existence of client-specific quasi-
rents to incumbent auditors ... lowers the optimal amount of auditor indepen-
dence." We show that each of the following conditions is necessary for this
reduction in independence: (1) auditors must disagree among themselves on a
client's reporting issue, e.g., some auditors believe that a reporting strategy will
be regarded as an audit failure while other auditors do not; (2) at the time of initial
engagement, auditors do not know their own positions on the reporting issue; (3)
when the reporting issue arises, the client must not know the incumbent
auditor's position on the reporting issue; (4) the reporting issue must affect the
client for more than one reporting period; and (5) the client must benefit from the
preferred reporting strategy even after an auditor switch. If all five conditions
hold, then a compromise of independence would be possible, though the analysis
shows that no compromises will occur on accounting issues that either the client
or the auditor regards as important.
The most interesting conclusion is the apparent link between auditors' inde-
pendence and the characteristics of reporting standards. When GAAP are specific
enough that all auditors agree as to how they should apply to a given client, the
client's (threats of) "opinion-shopping" will be ineffective, and the incumbent
auditor will have no incentive to approve a reporting policy that might be con-
strued as an audit failure. Yet, there are many accounting standards that require
auditor judgment to determine the appropriate method for a given client, and the
potential for different judgments by different auditors gives rise to the possibility
that a positive value of incumbency could lead an auditor to approve a report
that, in his or her judgment, may be viewed as an audit failure.
The article is organized in the following way. A simple model of pricing is
presented in section I to examine the amount of price-cutting and value of in-
cumbency in a competitive setting. A reporting disagreement between the client
and the auditor is introduced in section II, followed by an examination of condi-
tions that produce auditor independence even in the presence of client-specific
quasi-rents (section III). Sufficient conditions for a compromise of independence
are identified in section IV, and section V contains a summary and discussion of
the implications.
' This last assumption Implies that clients cannot use the choice of auditor as a signaling mech-
anism (Titman and Trueman 1986). Schatzberg (1989) has shown that low-balling can occur even
without transactions costs when auditors have differing costs and abilities, although he finds, as we do,
that transactions costs are necessary for a compromise of independence.

318 The AccountingReview,April1990
I. A Simple Audit-Pricing Model

We assume that there is one client firm that is required to purchase the ser-
vices of an auditor in each period. The life of the client firm is N periods, and as is
typical in dynamic programming, we number the periods in reverse order.2 That
is, period n occurs when there are n periods left in the client firm's life. We
assume that there are many auditors and that they all have the same reputation
for independence, though they may sometimes disagree on how GAAP apply in
particular client circumstances. Each auditor is assumed to have the same cost
structure for providing an audit to a given client.3 These costs, including oppor-
tunity costs of resources used in the audit, are as follows.
v + e if auditor is not the incumbent,
Cost of Audit in period n=
l v if auditor is the incumbent.
That is, an additional learning cost of e is incurred when an auditor takes on a
new client. The auditor must become familiar with the new client's businesses,
accounting methods, internal control system, and so on. In addition, the client
must incur costs by switching to a new auditor, including the costs of helping a
new auditor learn the internal control system, and so on. These costs will be
represented by the variable c.
Initially, we want to find the prices that will be charged by the incumbent
auditor (i.e., the auditor from the previous period) and by the candidate auditors
(i.e., those auditors in the market who are not the incumbent). These prices will
depend on the value of incumbency, i.e., the value of being the incumbent audi-
tor. (The one-period discount factor is assumed to be 6.)
p,, =price bid by the incumbent auditor for the period n audit.
pR,=price bid by the candidate auditors for the period n audit.
Writhe present value of being an incumbent auditor with n periods left,
assuming optimal pricing (and reporting) decisions over the remaining
horizon, and is measured by (period n audit price-period n audit
cost + 6OV,-,).
In setting up the pricing relations, we assume that auditors and the client firm
cannot make any binding multiperiod agreements and that the incumbent audi-
tor will charge as high a price as possible, consistent with remaining the
incumbent.4 There is a sufficient number of outside candidate auditors that they
2
Finite client firm life is assumed for expositional convenience. As shown in the proof of the
Lemma, the results also hold if a firm has an infinite life.
I We abstract from differences in cost structures among auditors that may be caused by technolog-
ical specialization, by costs of establishing and maintaining a reputation, and by investments in assets
such as branch offices and expertise with SEC compliance. (See Dopuch and Simunic 1980; Eichen-
seher and Danos 1981; DeAngelo 198 lb; Johnson and Lys 1989.) In effect, we assume that the client
has considered his or her own characteristics and has identified those auditors who possess a cost
structure and reputation for independence that would be efficient for those characteristics. Our anal-
ysis then focuses on the choice among those efficient auditors.
4 At this point in the analysis, all auditors are identical, so there are no signaling considerations in
the bidding strategies. The assumption that the auditor can charge the highest price consistent with
retaining the client ignores the possibility of bargaining between the client and incumbent auditor by
assigning all the bargaining power to the auditor. If the bargaining power rests entirely with the client,
then the value of incumbency will be zero and there will be no low-balling and no incentive to compro-
mise independence to retain the client.

Mageeand Tseng-Audit Pricing 319
will bid an amount to break even in present value. The value of incumbency at
the end of the client firm's life is normalized to zero (V0 = 0), and we assume that,
if the client is indifferent between the incumbent and a candidate auditor, the
client will retain the incumbent. This "tie-breaker" assumption has no substan-
tive effect on our conclusions because the incumbent auditor could ensure that
he or she retains the client by charging an amount ever so slightly less than the
cost of switching to the external candidate. Such marginal amounts do not
influence the conclusions that follow.
Lemma: In the audit-pricing model without reporting disagreements:
(i) Except at the start and at the end of an audit-client relationship, the
value of incumbency is independent of the discount rate and the
number of periods left in the incumbency.
0, n=O
V"= qf+c, N<n<O
0, n=N
(ii) The prices bid by the incumbent auditor and the external candidate
auditors for the period n audit (n <N) are, respectively,
v+f+c, n=1
Pn=V(_S)=+),nl
rv+f, n= 1
= {v+(1-6).-(fc, n>1.
(iii) At the start of period N, when all auditors are external candidates,
the price bid is:
PN=V+(1 -6).e-6.c<V+e,
so low-balling does occur.
(iv) Price-cutting (as defined in the empirical studies) occurs because
PN-1 -PN=C. That is, the price of the second-year engagement is
higher by an amount equal to the client's cost of switching auditors.
Proof: See the Appendix.
Although the pricing conclusions of the Lemma are essentially the same as
DeAngelo's (1981a) results, the analysis used to derive them is based on a dy-
namic programming approach that is more amenable to considering the problem
of independence in later sections. Both types of transactions costs, e and c, affect
the pricing of audit services, albeit in different ways. When the auditor incurs the
onetime learning costs of e, he or she raises the audit price by (1 -6) of in each
period to recoup this investment. When the client incurs a cost of c, the auditor
provides a price discount of 6.c in the first period, and then increments the price
in subsequent periods by (1 -6) sc.5 Therefore, the first-period price cut observed
I In the infinite horizon case, the auditor's net cash flow in period I is t - S.( e+ c)] followed by an in-
finite series of annual net cash flows equal to 1(1 - 6)*( e+c)J. If the discount factor is 6, the discount rate
Is t(1 -6)/6J, and the period 1 present value of the future cash flows is equal to [65(f+c)J. Therefore. the
auditor breaks even in present value.

320 The Accounting Review, April 1990
by Simon and Francis (1988) should be correlated with the client's costs of
switching to a new auditor, not with the auditor's learning cost. Price cuts
beyond the client's cost would lead to a situation in which the client would bene-
fit by switching to a new auditor every year, reducing the value of incumbency to
zero and putting upward pressure on audit prices. Price cuts less than c could not
be sustained because each candidate auditor would be willing to cut price further
to obtain the engagement's positive net present value. It should be noted that
low-balling and price cuts equal to c are predicted to occur even in settings where
auditors are required to rotate everyj -2 periods.
The preceding model is based on the assumption that the auditor and client
contract for one period, with no multiperiod commitments. If the auditor and
client commit to contract with each other for, say, two periods, then there would
no longer be a unique price for the first-year audit. For example, the difference
between the first- and second-year audit prices could exceed the client's switch-
ing cost, c. Simon and Francis (1988) find that fees in initial engagement years
averaged 23 percent lower than the normal fees for ongoing engagements. If
client switching costs are not of this magnitude, this result could be evidence of
implicit multiyear commitments between the auditor and the client.6
II A Reporting Disagreement and Definition of Independence

Although the model in the previous section provides some empirical predic-
tions concerning the pricing of audit services and the existence of an auditor's
value of incumbency (DeAngelo's quasi-rents), it is not yet rich enough to con-
sider the independence issue. Moreover, there will never be any switches be-
tween auditors. Therefore, we expand the model by allowing for the possibility of
a single reporting disagreement between the auditor and the client. In some
cases, the results extend to multiple reporting disagreements, as noted below.
In period k (i.e., when there are k periods left in the client's life), a reporting
issue arises, and the auditor observes a signal yE yI1, Y21 and must choose a re-
porting policy, yj y). For instance, y may result from an estimate of the useful life
of the client's depreciable assets, or from an assessment of the likelihood of a suc-
cessful resolution of some impending litigation All auditors (and the client)
agree that the probability of observing Y2 is equal to p, and all auditors, if en-
gaged, would observe the same outcome (either yi or Y2). We assume that Y2 is a
more favorable signal from the client's point of view and that the client would re-
ceive benefits if the auditor reported y = y2, perhaps from contracts based on the
signal outcome. The client-preferred (CP) reporting policy is defined as reporting
Y2, regardless of the value of y actually observed, while the not-client-preferred
(NCP) reporting policy is defined as reporting the actual value of y. If the client
6 Of course, the observed price-cutting could be caused by a change in the quality of the audit pur-
chased from the new auditor. Simon and Francis (1988) control for this possibility by incorporating a
variable that takes on different values depending on whether the auditor is a Big Eight firm.
' For expositional simplicity, we assume that y is observed by the auditor at no incremental cost. If
the auditor must incur an incremental cost Av to observe the outcome of y, the analysis becomes more
complex, but the conclusions on auditor independence are not affected in any substantive way as long
as Av <e (defined later in the text), The interested reader may obtain an analysis of this case from the
authors.

Table 1
Effects of Reporting Policy
Incremental
Expected
Disutilityfor
Auditor Type Incremental
Expected Benefit
Reporting Policy D A to Client
NCP: (y.)=yy;y(y2)=y2 0 0 0
CP: (y.2)y2; (yA)=y2 E 0 b
receives benefits of B when y2 is reported, the client's incremental expected bene-

fit from the CP policy is equal to b (1 -p).B.
At the start of period k, we assume that each auditor can be one of two possi-
ble types. Type A auditors agree with the client on this reporting issue, believing
that there is not a material difference between yi and y2, or that both yi and y2 are
permitted by GAAP. Alternatively, type D auditors disagree with the client on
this reporting issue, and believe that there is a material difference between the
two signals. An auditor of type D would experience a disutility of E from reporting
a value of y2 after observing yi, while a type A auditor would not.8 This disutility
could be very large (arising from the perceived expected costs of future litigation)
or quite small (resulting from the personal discomfort of having issued a report
believed to be materially different from his or her observation), depending on the
nature and magnitude of the reporting issue.9 The effects of the reporting policies
are shown in table 1, where e (1 - p)-E.
It is important to note the distinction between an auditor's type and his or
her reporting policy. Auditors' types depend upon their beliefs and the institu-
tional environment of auditing. Since all auditors are assumed to have the same
cost structure and competence, any disagreements will be on an issue-by-issue,
client-by-client basis. Depending on the reporting issue and the client character-
istics, auditors' judgments may be exactly the same or they may differ. For in-
stance, there may be circumstances under which every auditor believes that a
client firm's failure to recognize an estimated liability may lead to future litiga-
tion, and other circumstances under which every auditor believes that no
liability recognition is necessary. Assuming that the client firm prefers not to
recognize the liability, all auditors are type D in the first set of circumstances and
type A in the second set of circumstances. Yet other client circumstances could
6
The effect of this disutility is to reduce the auditor's monetary outcome by an amount E. That Is, if
the type D auditor is paid an amount p and incurs a cost of v, the expected one-period payoff received if
the CP policy is approved isp-v-E, where E-[(1 - o)-EJ.
9 The expected incremental disutilities could be modified by letting a type A auditor experience a
disutility Of(A for both reporting policies, perhaps reflecting auditor A's belief that the likelihood of suit
is unrelated to his or her choice or reporting policy. Our results concerning the effect of a positive value
of incumbency on an auditor's independence would be unchanged, though the results on auditor
changes would be modified, depending on the relative sizes of e and EA.

lead some auditors to judge that the estimated liability recognition is necessary
to avoid the possibility of future litigation, while other auditors don't believe that
future litigation will arise from not recognizing the liability. If there are clear pro-
fessional statements against (allowing) the CP reporting policy, then all auditors
would be type D (type A).10 Although auditors' judgments are reflected in their
type, all auditors are assumed to make their reporting decisions so as to maxi-
mize their perceived economic self-interest. Therefore, neither auditor type is
more "ethical" or more "competent" than the other; they simply disagree about
the effects of different reporting policies for this particular client.
DeAngelo (1981a, 116) defines the "level of auditor independence" as "the
conditional probability that, given a breach [in the accounting system] has been
discovered, the auditor will report the breach." Our definition of independence is
similar, though the auditor's type will determine whether he or she believes that
reporting y2 after observing yi would constitute a breach of the accounting sys-
tem. That is, we make a distinction between an auditor's beliefs or judgments (as
reflected in type) and his or her decisions (which are reflected in the chosen re-
porting policy); and a lack of independence is taken to mean that an auditor's
decisions are not consistent with his or her beliefs about a reporting policy.
Therefore, we define independence as a type D auditor's choosing an NCP report-
ing policy (or a type A auditor's choosing a CP reporting policy), but a type D
auditor who chooses a CP reporting policy is considered to have compromised his
or her independence. 1' It is important to recognize that independence cannot be
defined in terms of reporting decisions only, because independence is a relevant
concept only when the auditor must exercise some professional judgment rather
than simply apply a well-specified set of rules.'2 In addition, the analysis pre-
sented here is concerned with a single reporting issue, so a type A auditor need
not always agree with the client. Rather, he or she happens to agree on this single
reporting issue.'3
The sequence of events is depicted in figure 1. The reporting issue arises at
the start of period k, the auditor's judgment determines whether he or she is type
D or type A, he or she bids on the audit engagement for period k, and the client
chooses an auditor. We assume that contingent fees are not allowed, so the audi-
tor's period k compensation cannot depend on the report ', although his or her
10
It will be shown later that when all auditors are of one type, there is no opportunity for clients'
opinion-shopping and, therefore, no loss of independence arising from a positive value of incumbency.
" This definition is consistent with that in Schatzberg's (1989) analysis of a similar problem. It also
seems consistent with the SEC's (1988, par. 3851) statement that the "auditor must be free to decide
questions against his client's interests if his independent professionaljudgment compels that result"
(emphasis added).
12 In this latter case, we would be analyzing auditor "competence" or "compliance" rather than.
auditor "independence." If independence is defined by a particular action (e.g., a given reporting
policy), then all auditors will be type Ds (if the action is prohibited) or type As (if the action is allowed).
Therefore, analysis of independence must focus on those areas where GAAP/GAAS leave room for
auditor judgment (as on issues of materiality).
13 This single-issue agreement/disagreement is consistent with the assumption in footnote 3 that
the candidate auditors all have the same cost structure, reputation, etc. An auditor who always agrees
with the client's reporting preferences would eventually lose a reputation for independence.

Figure 1
Sequence of Events in Period k
Beginning of End of
period k period k
l l l l time
Incumbent auditor Client engages Auditor chooses a Auditor sees y and

bids p,; external incumbent auditor or reporting strategy reports y(y).
candidates bid pk. an external candidate
auditor.
continued employment could depend on y.14 Once engaged, the auditor chooses a
reporting policy from the two options, observes the outcome y, and reports the
corresponding y. We assume that the client cannot discharge the auditor until
after the auditor has reported y (at the end of the period).'5
Several aspects of the model are still unspecified. How many auditors are
there of each type? How many periods does the reporting issue continue? How
much information does the client have regarding the incumbent auditor's type
and that of the external candidates at different points in time? As we will show,
the specification of these factors plays a significant role in the relationship be-
tween the value of incumbency and the auditor's incentives to remain indepen-
dent.
III. Conditions Under Which Independence is Maintained

In this section, we identify conditions under which a positive value of incum-
bency does not lead to a reduction in auditor independence. The critical assump-
tions in these results are that clients cannot offer report-contingent contracts
(including bribes) to auditors and that clients and auditors cannot commit to
multiperiod actions. In particular, the client cannot commit, in advance, to firing
an auditor who reports y1. Such a threat is credible only if it will be optimal to fire
the auditor after he or she has made the report.
The analyses in this section are based on a simple comparison that a type D
auditor makes in deciding on a reporting strategy. Consider the position of such
an auditor who has been hired for period k at a price of p; he or she incurs a cost v
to perform the audit and observes y l. 16 The present value of future cash flows for
'4 In particular, we do not allow the client to offer the auditor a bribe to report y2. Bribes are cur-
rently considered to be breaches of the Code of Ethics, but low-balling and quasi-rents are not, so we
believe it more interesting to examine whether the auditor has an economic incentive to compromise
independence if each period's contract is uncontingent but future engagements may be contingent on
the report. Moreover, a client's promise to pay the auditor an extra amount for the CP reporting policy is
not credible because once the report is made, the auditor cannot enforce the payment without implicat-
ing himself or herself. Therefore, the auditor would not modify the reporting strategy because the client
would not be expected to deliver on the bribe. See Dye et al. (1989) and Baiman et al. (1989), for
analyses of the contingent fee issue for auditors.
'5 See Dye (1989) for an examination of the client's decision to replace an auditor prior to disclosure
of the report.
16 If the auditor is an incumbent, v = v, but if the auditor is newly engaged in period k, v = v+ e.

this auditor depends on his or her report as follows:17

Payoff [ yi] =p- v +6*Vk-l [y I].
Payoff [y2] =p- v-E+65Vk-1[y2].

It is clear from these comparisons that the auditor must make a trade-off between
the cost E and the incremental future payoff from reporting Y2, Vk1 [Y2]
- Vkl [ y j. But in the settings that follow, Vk, [ Y2] = Vk-l [ y ii, so this incremental
payoff is zero. Therefore, the incumbent auditor will always choose the NCP
reporting policy, and thereby remain independent, as long as E>0. We begin
with the case in which all auditors agree that the CP reporting policy might be re-
garded as an audit failure.
Proposition 1: If it is common knowledge that all auditors are type D, then an
auditor will never compromise his or her independence and the observa-
tions about the price path and value of incumbency found in the Lemma
will hold.
The proof of Proposition 1 is straightforward. If k is the last period of a reporting
issue, it will always be optimal for the auditor to choose the NCP reporting policy
once he or she has been awarded the engagement. The client realizes this fact, as
do the external candidates in the market. The prices bid will be identical to those
in part (ii) of the Lemma, so the value of incumbency at the start of period k
remains equal to f+c, and the client cannot effectively opinion-shop among ex-
ternal candidates. An auditor might promise (prior to conducting the audit) to
use the CP policy, but such a promise is not credible. The client could threaten to
fire an auditor who reports y1, but that threat is not credible when the only re-
placements for the incumbent auditor would behave in the same manner. 18 Since
the prices and value of incumbency in period k are unaffected by the reporting
issue, we could go back a step and ask what effect a reporting issue in the period
prior to k would have. It is clear that again the prices and value of incumbency
are unaffected, so a multiperiod reporting issue would not change the conclusion
that a positive value of incumbency would not lead to a compromise of indepen-
dence.
It is important to note that this conclusion does not depend on the magni-
tudes of the variables e, c, (p, B, or E because the auditor is not required to make
any tradeoffs among these variables. In particular, E may be very large (reflecting
possible litigation losses) or very small. It isn't even necessary that all auditors
experience the same incremental disutility from choosing a CP reporting policy
as long as all the disutilities are positive. One interpretation of this result is that
disagreement among auditors (i.e., some type Ds and some type As) is a neces-
sary condition for the value of incumbency to lead to a lack of independence. (The
" Two obvious cases may be disposed of immediately. If e= c = O, then all values of incumbency are
equal to zero and the type D auditor will choose the NCP policy. Alternatively, if all auditors are type A
(E = 0), because CP is expressly permitted by professional standards, then all auditors will allow the CP
policy.
18 Chow and Rice (1982) find that clients who switch auditors following a qualified opinion are no
more likely to receive an unqualified opinion for the succeeding year than are clients who remain with
the same auditor following a qualified opinion.

concept of independence becomes difficult to define in a market setting in which

auditors disagree among themselves, but we defer such issues to the end of the
article.) An alternative interpretation is that reporting standards that require
more subjective judgment in their application are more susceptible to compro-
mises of independence.
Since a positive value of incumbency will not affect auditor independence if
there is a consensus among auditors on the reporting issue, we assume that at
the beginning of period k, there is a probability (1 - q) that an auditor will be type
D, and a probability q that an auditor will be type A. Each auditor's type realiza-
tion is independent of all others, and the auditor observes his or her own type
before submitting a bid for the period k audit. (The sensitivity of our results to
this assumption is explored in a subsequent subsection.) We assume that there
are enough auditors in the market that the probability of fewer than two type As
or fewer than two type Ds among the external candidates is negligible. 19 If the re-
porting issue will last for only one period, then the following propositions show
that a positive value of incumbency will not cause the auditor's independence to
be compromised.
Proposition 2: If auditors disagree over a single-period reporting issue
(O< q < 1) and the client cannot observe auditors' positions prior to en-
gagement, then:
(i) the prices bid and the value of incumbency are as in the Lemma, and
(ii) there is no compromise of independence by the incumbent auditor.
A one-period reporting issue may revolve around a one-time transaction, or a
period k accrual decision that determines all future accruals. For instance, if an
unusual expenditure in the current year could be expensed immediately or
accrued to the following year, the auditor's decision in the current period will
determine the second-period treatment. For such one-period reporting issues, the
value of incumbency after period k, Vkl, is equal to (+c regardless of the events
in period k. Therefore, a type D auditor, once engaged, will always choose the
NCP reporting policy. An incumbent type A auditor is indifferent in his or her
choice between the two reporting policies, so we assume he or she would choose
the policy preferred by the client; however, this does not represent a compromise
of independence for this type of auditor. The client is better off than in Proposi-
tion 1 because there is a probability q that the incumbent auditor is type A, with
expected incremental benefits of b to the client. It is possible for a CP reporting
policy to be chosen by a type A incumbent auditor, but never by a type D incum-
bent auditor, who believes that the CP policy could be viewed as an audit failure
at some time in the future; hence, independence is never compromised. A
corollary to Proposition 2 is that there will be no compromise of independence if
there are reporting issues in more than one period as long as every auditor's
19 This condition allows us to assume that competitive pricing will prevail in the external candidate
auditor market, rather than having to deal with bilaterial negotiations between the client and a single
auditor.

judgments about each period's reporting issue is independent of all other

periods' issues.
The same logic for auditor independence holds when the client can observe
the types of auditors prior to the engagement, perhaps from their submissions to
the FASB, testimony at hearings, etc. However, a client who finds the incumbent
auditor to be a type D may opinion-shop by firing that auditor and hiring an ex-
ternal candidate type A auditor if the expected benefits b exceed the costs f+c.20
A critical assumption in this analysis is that the client's benefit from the CP
reporting policy is unaffected by the switch to an external candidate known to be
a type A auditor. The observability of an auditor switch could allow financial
statement users to adjust their interpretations of the reports, perhaps "undoing"
the benefits desired by the client. In the extreme, these benefits might go to zero,
with the result that a client's threat to replace the auditor is never credible and
independence would never be compromised. We assume that the client's benefit
comes from contracting arrangements that are not adjusted for the change in
auditor. For example, the existing debt covenants (on working capital, debt-to-
equity ratios, or unrestricted retained earnings) and executive compensation
plans are not likely to be changed when the client switches auditors.
Proposition 3: If auditors disagree over a single-period reporting issue
(O< q < 1), the client can observe all auditors' positions prior to engage-
ment, and the client's expected benefit b is unaffected by a switch to a
known type A auditor, then:
(i) either an incumbent type D auditor will reduce the price bid for the
engagement, or the client will switch to another auditor, but
(ii) neither the incumbent auditor nor a replacement would choose a re-
porting policy that compromises independence.
Proposition 3 shows that the client may opinion-shop for a new auditor, en-
gaging one who not only agrees with the client, but who actually believes that the
client's position is consistent with GAAP. Further, the impending reporting issue
will affect the pricing of audit services in periods prior to period k, depending on
the time the auditors and the client become aware of auditor types. If auditors
can observe their own types at the start of period N, type A auditors will have a
higher value of incumbency and will offer a lower price for the period N audit, as
long as the client will observe the auditors' types prior to the period k engage-
ment. If the client will not observe the auditors' types before the period k engage-
ment, we have the situation in Proposition 2.21
20 In effect, type D auditors are "driven out" of the external candidate market for this particular
client. This result is similar to that of Dye et al. (1989), who find that allowing contingent fees causes
"flexible" auditors to drive out "rigid" auditors when investors cannot observe the type of auditor en-
gaged by the client.
21 It might appear that if ec<b, a type D auditor would prefer to choose the CP policy rather than
reduce the price for the audit, i.e., in DeAngelo's terms, "the expected gains from 'cheating' exceed the
expected costs. " However, there is no way for the auditor to commit to the CP policy prior to performing
the audit, and once engaged, the auditor has a clear incentive to choose the NCP policy. Therefore, the
client would not be expected to believe the auditor's promise to choose the CP policy in return for the
higher audit fee.

The results of Propositions 1, 2, and 3 show that if a positive value of incum-

bency is to lead to a compromise of auditor independence, then it is necessary
that the reporting issue extend beyond a single period (or that the auditor's
position on the period k reporting issue be indicative of his or her position on the
period k-1 reporting issue) and that auditors disagree among themselves over
the client's reporting issue. We now show that it is also necessary that the client
not know the auditor's type prior to the audit engagement for the period in which
the reporting issue first arises.
As before, we assume that there are enough auditors in the market that the
probability of fewer than two auditors of either type is negligible. The reporting
issue arises in period k and continues until period m (m < k because the periods
are numbered in reverse order). The signal in period n (k - n 2 m) is denoted yn,
and it is assumed that these signals are independently and identically distributed
over time. The client has an expected incremental benefit of b in each period that
the auditor chooses the CP reporting policy, n( by) = 'n( y2) = y2. An auditor of
type D is assumed to incur an expected cost of e (1 - so) .E in each period that he
or she chooses the CP reporting policy. If the client can observe all auditor types
at the start of period k (just before the period k engagement) and auditor types do
not change over time,22 then the results of Proposition 3 can be extended to a
multiperiod reporting issue as defined previously.
Proposition 4: When auditors disagree over a multiperiod reporting issue,
(O< q < 1), the client can observe all auditors' positions prior to engage-
ment, and the client's expected benefit b is unaffected by a switch to a
known type A auditor, then:
(1) either an incumbent type D auditor will reduce the price bid for the
engagement, or the client will switch to another auditor, but
(ii) neither the incumbent auditor nor a replacement would choose a re-
porting policy that compromises independence.
Thus far, we have shown that a positive value of incumbency does not lead to
a decrease in auditor independence if (1) all auditors have the same assessment of
a reporting issue, or (2) the reporting issue affects only one period, or (3) auditors'
positions on the reporting issue can be observed by the client prior to engage-
ment, or (4) the client no longer benefits from the CP policy after a switch to a
known type A auditor. If none of these four conditions holds, then it is possible for
independence to be compromised, as we demonstrate in the following case.
IV. Conditions Under Which Independence May Be Compromised

We now assume that the client cannot observe auditors' types directly, but
can observe the reports of an incumbent auditor and any differences in the prices
charged by different types of auditors. The reporting issues begin in period k and
last through period m, and at the start of period k, the client assesses a probabil-
22 If auditor types were independently distributed over time, the analysis would be the same as in
Propositions 2 and 3 because each period's reporting issue is independent of any other period's report-
ing issue.

ity q that each auditor (incumbent or external candidate) is type A. After period
m, there are no more reporting issues, so VM, = C+ c for all auditor types.
As before, we begin the analysis after the auditor has been engaged in period
m. Since future periods do not depend on the reporting policy chosen in period
m, a type D auditor would choose the NCP reporting policy and a type A auditor
would choose the CP reporting policy. But the price structure at the beginning of
period m depends on the amount of information available about auditor types,
i.e., information that has been revealed in prior periods. We assume that the
client has a good memory (or records), so if an auditor reveals his or her type in
period n, the client would know this type in all following periods. The question
we address is whether an incumbent type D auditor would find it advantageous
to conceal his or her type by choosing the CP reporting policy in period m + 1.
There are four possible pricing scenarios at the start of period m, depending
on the amount of information the client possesses about the types of the incum-
bent and external candidate auditors. The prices bid and the values of incum-
bency for each of these scenarios are presented in exhibit 1. For the moment, we
assume that b < C+c; that is, the client's expected incremental benefits from the
CP reporting policy are less than the auditor's value of incumbency at the start of
period mr-1. This implies that the incumbent auditor will prefer to remain as
auditor even if his or her type is known to be D and type A external candidates
have been identified. The significance of this assumption is discussed shortly.
The objective of the analysis that follows is to determine the behavior (pric-
ing and reporting policies) of external candidates and incumbent auditors in the
period preceding period m. We first focus attention on the external candidates at
the start of period m + 1 to see whether the client can distinguish different auditor
types from their bids.
Proposition 5:
(a) At time m + 1, the types of all external candidate auditors can be dis-
tinguished from the bids submitted for the audit in period m + 1.
(b) If all auditors know their own types at the start of the firm's life (i.e.,
at the beginning of period N), then low bids will be submitted by type
A auditors and there will be no compromise of independence.
Part (a) of the proposition relies on the fact that type D auditors are at a rela-
tive disadvantage to the A type in pricing the period m + 1 audit, regardless of
their period m + 1 reporting decisions. If they choose the NCP policy, there is a
chance that they will have to lower their price for the next period's audit, and if
they choose the CP policy, they believe that they might have to bear the cost E.
This result implies that Scenarios 1 and 3 in exhibit 1 cannot be part of an equi-
librium and that the external type D candidate auditors will be driven out of the
market (for this particular client) because the client would not hire such an audi-
tor. Part (b) of the proposition shows that a fifth necessary condition for a com-
promise of independence is that the auditors discover their types after an incum-
bent auditor is already established.
The fact that the client can identify type A external candidate auditors would
have an influence on the incumbent's position at the start of period m + 1. Sup-

Exhibit 1
Pricing Strategies and Values of Incumbency for Period m
under Various Informational Assumptions
Scenario 1: The client has not observed the types of the incumbent or any external candidates.
This is equivalent to the situation in Proposition 2, so the prices and value of incumbency will be the
following:
pA= pD= V+(1 -6)4f-60C
PP= PD=v+(l-6).(f+c)
VA= VD=f+c.
Scenario 2: The client has observed the types of all external candidate auditors, but has not observed
the type of the incumbent.
The probability that the incumbent is type A is equal to q. In this setting, the external market will be
dominated by type As with a breakeven price of:
)M=v+(1-6).f-60c.
External type Ds would also break even at this price, but the client would not receive the expected in-
cremental benefit b, so a type D auditor would not be hired.
The incumbent must bid an amount that retains the business, knowing that the client believes
that he or she will receive expected benefit b with probability q. The price and value of incumbency
are:
pm= pD=V+(j )(+)(-~
V= VD=f+c-(1 -q).b.
Scenario 3: The types of external candidate auditors are unknown to the client, but the incumbent
auditor's type is known.
The external candidates (both types) will bid a breakeven amount:
PM PM=V+(1-6)4-6,-c.
If he or she hires an external candidate for period m, the client has a probability q of receiving ex-
pected benefit b. If the incumbent from period m + 1 is known to be a type A, he or she can charge a
higher price and still retain the engagement.
VA=f+c+(1 -q),b.
However, if the incumbent is known to be a type D, he or she must charge a lower price than an
incumbent type A to retain the engagement.
pmV + (1 - )o( +c)-q-b
M=f+c-qb.
Scenario 4: The client knows everyone's type at the start of period m.
As in Scenario 2, the type D external candidates are effectively excluded from this client engagement
because they cost as much as type As and produce fewer benefits. Therefore, the price for viable ex-
ternal candidates will be:
fPm=v+( 1 -l)*f-5.
An incumbent type A auditor will bid as in the Lemma, but an incumbent type D must reduce his or
her bid by an amount b to retain the engagement, as in Proposition 3.
OM=v+(l -5)0(f+c)
V/M=f+c
VM=e+c-
1VM f+c- b.

pose that at the beginning of period m + 1, the client assesses a probability q that
the incumbent is type A and probability (1 -q) that he or she is type D. If the
incumbent is type A, he or she will choose the CP reporting policy in period m + 1.
But if the incumbent is type D and has been engaged for the period m + 1 audit for
a price Prn+i, the auditor can choose either the NCP or the CP reporting policy
during period m + 1. If the auditor observes Y2, there is no problem for the type D
auditor: he or she reports Y2. But if the auditor observes yl and reports yl, his or
her type is revealed, resulting in Scenario 4 at the start of period m. On the other
hand, the auditor could conceal his or her type by reporting y2 after observing yi,
and enter Scenario 2 at the start of period m. (We assume that the client also
observes the realization of Y.) Once the type D auditor observes yi, the payoffs
from these two strategies are the following:
Payoff[y1] = pm+i-v+bV'= pm+i-v+65((+c-b).
Payoff[y2] = pm+ vE+6@Vm
D
= Pm.+-v-E+6.(i+c-(1 -q).b).
Payoff [y2] -Payoffl [ y1
= -E+6.(C+c-(1 -q).b)-6 .(f+c-b).
=-E+8bqob.
From this expression, we can see that the incumbent type D auditor will have an
incentive to compromise his or her independence if 6.q b is greater than E. That
is, if the discount rate is low enough, the probability of type A auditors and bene-
fits to the client (from the CP reporting policy) high enough, and the expected
cost to the auditor of reporting y2 after seeing yi low enough, then a type D
auditor would have an economic incentive to compromise the independence of
his or her report.
Proposition 6: If
(i) auditors disagree over a multiperiod reporting issue,
(ii) auditors cannot observe their own types until after period N,
(iii) the client's expected benefit b is unaffected by a switch to a known
type A auditor, and
(iv) auditors' positions cannot be directly observed by the client,
an incumbent auditor may have incentive to compromise independence.
These conclusions are based on the assumption that b is smaller than f+c;
that is, that the client's expected benefit from the CP reporting policy is smaller
than the auditor's learning cost plus the client's cost of switching to a new audi-
tor. If b is larger than (C+c) /(1 - q), then there will not be any compromise of in-
dependence because the client will be able to identify type A external candidates
from the prices they bid, and b is so large that the client will immediately switch
to one of these auditors. The incumbent will not be engaged, so there is no chance
for a type D incumbent to compromise independence. Alternatively, if E is large
enough, the incumbent auditor will not compromise independence.23 Therefore,
23 If E > ( f+
c), then a type D auditor will always choose the NCP reporting policy in period m + 1 be-
cause the maximum value of incumbency is exceeded by the expected cost of the CP reporting policy.

the conditions in Proposition 6 may lead to a compromise of independence, but

not necessarily so. The magnitudes of E, 6, 2, c, q, B, and spdetermine the trade-off
made by the incumbent auditor who disagrees with the reporting policy desired
by the client. If the reporting issue is very important to the client (i.e., the benefit
B is very large) or to the auditor (i.e., E is very large), there will be no opportunity
for a type D incumbent to compromise independence.
As noted in the previous section, this analysis assumes that the client's ex-
pected benefit from the CP reporting policy, b, is not affected by a change in audi-
tors. Such an assumption is consistent with the notion that b derives from con-
tractual arrangements that may require an auditor, but lack contingencies for
auditor switches. Conversely, if b is reduced by a client's switch to a new auditor,
say to b', then the incumbent type D auditor will choose the CP reporting policy
only if (6q b' ) is greater than E, making it less likely that the auditor's inde-
pence will be compromised. (In the extreme, if b' = 0, an incumbent type D audi-
tor will always choose the NCP reporting policy.)
Realization of Auditor Type upon Engagement

Our analysis has been based on the assumption that auditors know their own
types before the start of the period in which the reporting issue arises. Yet, this
knowledge may depend on details of the client's situation that external candi-
dates may not know. Of course, an opinion-shopping client may disclose this
information to external candidates, yet our results do not depend on the assump-
tion that all auditors know their own types. In Proposition 2's single-period
setting, the client could not identify the types of any auditors, and that would not
change if the external auditors did not know their own types. Propositions 3 and
4 are no longer relevant because the client's knowledge of the auditor cannot
include that which the auditor does not know.
Proposition 5 is changed because Scenarios 2 and 4 are no longer possible,
and no subset of the external auditors is driven out of the market for this client.
But the conclusions of Proposition 6 hold (continuing to assume that the client
observes the realization of y). If the period m + 1 auditor discovers that he or she
is of type D and observes yl, he or she can report y l (and be identified as a type D
auditor to the client) and enter Scenario 3 in period m. The auditor's payoff
would be equal to pm+,-v+68(f+c-q-b). However, if such auditors report y2
(incurring cost E), the client does not learn anything about the incumbent audi-
tor's type (leading to Scenario 1), and the auditor's payoff would be pmal - V -E
+3.(f+c). Accordingly, such auditors will choose to report y2 over yI if E<6.q b,
and this condition is identical to that found when auditors could observe their
types prior to being engaged by the client.
This similarity of results notwithstanding, the process by which auditors
form their judgments may deserve further attention. Our analysis assumes that a
type A auditor's judgment is unaffected by the knowledge that he or she is being
hired by the client to replace a type D auditor. That is, the type A auditor con-
tinues to believe that E = 0 even when he or she knows that another auditor be-
lieves that E > 0. A model under which external candidate auditors learn from the
dismissal of the incumbent auditor could produce greater consensus among
auditors and result in greater auditor independence.

332 The AccountingReview,April 1990
V. Summary and Implications

The objective of our analysis was to explore the impact of an auditor's value
of incumbency (DeAngelo's quasi-rents) on the reporting decision of the auditor.
The usefulness of our results depends on the definition of auditor independence.
We might equate "independence" with "proper application of GAAP to the
client's financial statements," but such a definition assumes that "proper appli-
cation" is always well-defined. Our results show that when all auditors agree as
to whether a reporting decision is consistent with "proper application of GAAP,"
a positive value of incumbency should not lead to a compromise of indepen-
dence. A client might threaten to switch to another auditor, but that threat is not
credible because all auditors agree on the effects of the reporting issue. When
auditors disagree about the proper application of GAAP for a client, this defini-
tion of independence is no longer workable, and we find competition among audi-
tors on reporting policies as well as on price. One implication of this result is that
established auditors (i.e., those with an existing client base) would prefer
accounting standards that leave less room for auditor judgment (disagreement)
because these standards would protect their values of incumbency.
This interesting interplay between the reporting issue characteristics and the
auditor's independence is also evident in the finding that a reporting issue (i.e., a
potential reporting disagreement between auditor and client) that lasts for a
single reporting period will never lead to a compromise of independence under
the assumptions of our analysis. If the accrual process smooths out the reporting
issue over a number of periods, then it is more likely to lead to a compromise of
independence. For instance, a disagreement over the useful life of an asset would
affect the reported depreciation for a number of years, while a disagreement over
the treatment of a one-time transaction could be viewed more as a single-period
issue. In an extreme case of reporting issues arising in one period that are unre-
lated to the reporting issues in other periods, a positive value of incumbency
would not lead to any compromises in auditor independence. Finally, if the re-
porting issue is very important to the client (b is very large relative to all other
variables), there will be no compromise of independence because the client will
switch to an auditor who believes that the CP reporting policy is appropriate.
Although these results enable us to understand the type of reporting issues
that could lead to a compromise of independence, the entire notion of indepen-
dence is difficult to pin down in a market where auditors disagree among them-
selves as to the appropriateness of alternative reporting policies. We have defined
independence as an auditor's approval of a reporting policy that he or she be-
lieves to be consistent with proper application of GAAP to the client's circum-
stances, without regard for the beliefs of other auditors. An alternative approach
might consider GAAP to be defined by accepted practice and a lack of indepen-
dence to be defined as an auditor's approval of financial statements that are not
in accordance with GAAP. According to these definitions, a type D auditor's inde-
pendence would be compromised only if he or she approved the CP policy and
there were not enough type A auditors to make the CP policy an "accepted
practice." If, as in Proposition 6, the value of q is high enough to get the type D
auditor to approve the CP policy, it may imply that there are enough type A
auditors that the CP policy is not considered a breach of independence. At any

rate, the notion of independence in a market setting may need further refine-
ment.
These conclusions are based on the assumption of the existence of an en-
forceable ban on contingent contracts between the auditor and client. If the
auditor's compensation can be tied to his or her reporting policy choice, then the
client would have much more control over this choice, and independence would
be more easily compromised.24 It should be noted that contingent contracts can
appear in subtle ways, e.g., where an unfavorable financial report may lead to
client bankruptcy and loss of the auditor's value of incumbency.
We have also assumed that the auditor's reporting policy choice is not af-
fected by prior periods' choices. Auditors' ability to commit to future reporting
policy choices could reduce the set of conditions under which independence is
maintained. Future research might include the client's benefits from the report-
ing policy as an endogenous aspect of the model, and recognize that the client's
benefits might be affected by a switch of auditors. In addition, auditors could con-
ceivably learn about each other's estimates of the costs of the CP policy by
observing the client's firing of an incumbent auditor or through some form of
"rational expectations" framework. While we conjecture that such enhance-
ments would increase agreement among auditors and thereby reduce the possi-
bilities for compromises of independence, future work might explore this possi-
bility and its implications for the audit environment.
Appendix
Proof of Lemma
The pricing results and value of incumbency in the Lemma depend on three
conditions: external candidates bid to break even in present value; incumbent
auditors charge as high a price as possible while still retaining the engagement;
and the definition of the value of incumbency. These three conditions may be
stated in the following way:
Pn-( v+ e) +6asv,, l =0o

Pn =pn +c
Vn= Pn V+6eVn n1
Collectively, these three conditions imply:

pn=v+(l -5)4-6.c
Pn=v+(l -6)(e+C)
vn=f+C.
The only exception to these prices occurs in period 1 (i.e., the last period of the
client's life). There is no value of incumbency at time 0 (V0 = 0), so p' = v + e and
p,=v+f+c (and V,=f+c).
Proof of Proposition 2
The client knows the probability q, but can observe neither the incumbent's
2 See Dye et al. (1989) for an analysis of contingent fees in the market for audit services; Baiman et
al. (1989) for an analysis of incentives for auditor-manager collusion.

type nor the external candidate's type. Since this is a one-period reporting issue,
the value of incumbency after period k, Vk,, is equal to f+c, regardless of the
events in period k. Therefore, a type D auditor, once engaged, will always choose
the NCP reporting policy. In contrast, the type A auditor is indifferent between
the reporting policies, so we assume he or she would choose the policy preferred
by the client, i.e., the CP reporting policy. External auditor candidates will bid a
price that lets them break even, including the value of incumbency after period k,
but this amount is identical for both type D and type A external candidates.
Therefore, they will bid the same amount (shown in part (ii) of the Lemma), and
the client will not be able to distinguish their types based on their bids. The
incumbent auditor, whose type is also unknown, will bid an amount that will re-
tain the business as shown in the Lemma. The client may discover the incum-
bent auditor's type during period k, but that type is irrelevant for future periods
and should not affect the auditor's incumbency. Therefore, the value of incum-
bency at the start of period k remains ?+c since neither type of auditor would
incur E.
Suppose that the client can observe the types of all auditors, perhaps from
their submissions to the FASB, testimony at hearings, etc. Working backward
from period k- 1, we see that the auditor's period k reporting decision is the same
as in Proposition 2. A type A auditor will find it optimal to use the CP policy,
while a type D auditor will choose the NCP policy. The external candidate audi-
tors will make breakeven bids at the start of period k, pk=v+(1 -6)f-6.c, but
the client's net expected cost is reduced by an amount b (1 - ').B if he or she
hires a type A auditor. Therefore, if the client switches auditors, he or she will
choose a type A and have a net expected cost in period k of pk+c-b=v+
(1 -6).(f+c)-b.
The incumbent auditor will bid as high a price as is consistent with retain-
ing the engagement. If the incumbent is known to be a type A, he or she can bid
A
P =pk + c = v +( -6) (+ c), as in the Lemma. The client's net cost in period k is
identical to that with a type A external candidate, so the incumbent will be re-
tained and the value of incumbency remains unaffected, VA = f+ c. However, if
the incumbent is known to be type D, the price charged must satisfy p D =pk + c-b
for the incumbent to be retained. That is, an incumbent auditor who disagrees
with the client on the reporting issue, and who wishes to retain the engagement,
must reduce his or her price by an amount equal to the client's expected benefit
from the CP reporting policy.
p2=v+(1-6).(f+c)-b and V2=f+c-b.
If b is larger than e+c, then the value of incumbency is negative at the start of
period k, and the auditor would withdraw from the engagement.
We assume that the client can observe all auditor types at the start of period
k (just before awarding the period k engagement) and that auditor types do not
change over time. After period m, there are no more reporting issues, so the

analysis in section II implies that Vmi = e+ c, regardless of the auditor's type. The
analysis of period m parallels that in Proposition 3, so either type of auditor will
be independent in period m, with VI = (+ c and VI= max IO, f+ c - b.
Going to the prior period, m + 1, the client will again favor type A auditors
among the external candidates, and these auditors still will bid p'+1 = v + (1 -a6) .4
-s6c. If the incumbent auditor is also type A, he or she bids p'+, = v +
(1-6).((+c), and the value of incumbency remains at V+l =(+c. For these
auditors, the reporting issue is unimportant, and the pricing and value of incum-
bency remains as in the Lemma. But if the incumbent auditor during period
m + 1 is a type D auditor, his or her future value of incumbency does not depend
on the period m + 1 report, so the auditor will choose the NCP reporting policy. If
the incumbent auditor wishes to retain the engagement, he or she can bid only
p,+1=v+(1-6).(e+c)-b, and the value of incumbency becomes Vn+1=(+c
-(1 +6).b. Of course, if this value of incumbency is negative, the auditor will
withdraw from the engagement, so the value of incumbency is more accurately
written as VD+%= maxO 0; (+c - (1 + 6) b 1 Or, in general, VI+, = f+c for a type A
auditor and VD+, = max IO; (+c-( 16 +. ++ )b j for a type D auditor. Note that
V?+n is a nonincreasing function of n, so it is a minimum at the start of period k
when the reporting issue first arises. Therefore, if an incumbent type D auditor
does not withdraw (or is not replaced) at the start of period k, he or she retains the
engagement until the end of the client firm's life.
Could there be an equilibrium in which both type D and type A external can-
didates bid the same amount at time m + 1? Suppose so and consider the report-
ing decision of the type D auditor if he or she is hired for period m + 1. If it were
optimal for him or her to choose the NCP reporting policy in period m + 1, there is
a (1 - so) probability that he or she will be revealed to be type D by the beginning
of period m, resulting in Scenario 3, with a value of incumbency equal to f+c
- q *b. A type A auditor, if hired, will choose the CP reporting policy, and there is
a probability o that the type D auditor would observe y2 and, therefore, make the
same report as a type A auditor. If the client observes a report y2 for period m + 1,
he or she revises the probability that the auditor is of type A from q to j > q . The
resulting value of incumbency at the start of period m is equal to f + c + ( q - q ) *b.
Now, consider the breakeven prices for types A and D at the start of period m + 1.
(v + f) + 6
-A+ + c + (-q) b =0.
P+l -(v+C)+6.[(1-p).(e+c-q b) +s(o(+c+(i-q).b)]=O.
Comparing the terms shows that the breakeven price for type A external candi-
dates at time m + 1 would be lower than that of type D external candidates.
On the other hand, the type D auditor who is hired for period m + 1 could con-
ceal his or her type in period m + 1 by choosing the CP reporting policy. If it were
optimal for him or her to do so, the reporting decision in period m + 1 would not
be informative to the client about the (new) incumbent's type. Therefore, the
auditors would find themselves in Scenario 1 at the start of period m, and the
breakeven prices would be the following.

Since VI = VI in Scenario 1, but E> 0, the breakeven price for type D external can-
didates at time m + 1 must be higher than that of the type A external candidates.
Therefore, type A external candidates are able to signal their type by the price bid
in period m + 1, and type D external candidates are effectively removed from the
market for this particular client. As a result, Scenarios 1 and 3 cannot be part of
an equilibrium because the client discerns the types of all external auditors from
their bids at the start of period m + 1, and we assume that the client can
remember those types in period m.
Given this analysis, part (b) of the proposition follows easily. At time N, all
auditors are external candidates, and if each auditor knows his or her own type at
that time, the expected value of incumbency will be higher for type As than for
type Ds. Therefore, type As will be able to bid a lower price, and the type Ds will
not be engaged by this client, leaving no possibility for a compromise of indepen-
dence.
References
Baber, W., E. Brooks, and W. Ricks. 1987. An empirical investigation of the market for audit
services in the public sector. Journal of Accounting Research (Autumn): 293-305.
Baiman, S., J. H. Evans III, and N. Nagarajan. 1989. Collusion in auditing. Working paper,
University of Pittsburgh.
Chow, C., and S. Rice. 1982. Qualified audit opinions and auditor switching. The Account-
ing Review (April): 326-35.
DeAngelo, L. 198 la. Auditor independence, "low-balling," and disclosure regulation. Jour-
nal of Accounting & Economics (August): 113-27.
198 lb. Auditor size and audit quality. Journal of Accounting & Economics (Decem-
ber): 183-99.
Dopuch, N., and D. Simunic. 1980. The nature of competition in the auditing profession: A
descriptive and normative view. In Regulation and the Accounting Profession, edited
by J. Buckley and J. Weston, 77-94. Lifetime Learning.
Dye, R. 1989. Auditor replacement. Manuscript, Northwestern University.
, B. Balachandran, and R. Magee. 1989. Contingent fees for audit firms. Manuscript,
Northwestern University.
Eichenseher, J., and P. Danos. 1981. The analysis of industry-specific auditor concentra-
tion: Towards an explanatory model. The Accounting Review (July): 479-92.
Francis, J. 1984. The effect of audit firm size on audit prices: A study of the Australian mar-
ket. Journal of Accounting & Economics (August): 133-5 1.
, and D. Simon. 1987. A test of audit pricing in the small-client segment of the U.S.
audit market. The Accounting Review (January): 145-57.
Johnson, B., and T. Lys. 1989. The market for audit services: Evidence from voluntary audi-
tor changes. Journal of Accounting & Economics (forthcoming).
Palmrose, Z. 1986. Audit fees and auditor size: Further evidence. Journal ofAccounting Re-
search (Spring): 97-1 10.
Schatzberg, J. 1989. A multiperiod model of independence and "low-balling" with incom-
plete information. Manuscript, University of Arizona.
SEC (Securities and Exchange Commission). 1988. SEC Accounting Guide. 1 June 1988.
Chicago: Commerce Clearing House.
Simon, D., and J. Francis. 1988. The effects of auditor change on audit fees: Tests of price
cutting and price recovery. The Accounting Review (April): 255-69.
Simunic, D. 1980. The pricing of audit services: Theory and evidence. Journal of Account-
ing Research (Spring): 161-90.
Titman, S., and B. Trueman. 1986. Information quality and the valuation of new issues.
Journal of Accounting & Economics (June): 159-72.


Audit Pricing and Independence

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Audit Pricing and Independence

Uploaded by

Copyright:

Available Formats

Audit Pricing and Independence

Author(s): Robert P. Magee and Mei-Chiun Tseng

This content downloaded from 136.167.3.36 on Sat, 28 Sep 2013 18:44:49 PM