Enron Auditors Failure by Kershaw

JOURNAL OF LAW AND SOCIETY
VOLUME 33, NUMBER 3, SEPTEMBER 2006

ISSN: 0263-323X, pp. 388±420
Waiting for Enron: The Unstable Equilibrium of

Auditor Independence Regulation
David Kershaw*
A primary function of auditor independence regulation is to ensure that

any financial incentives auditors may have to approve misleading or
inaccurate accounting are outweighed by market and regulatory
deterrents to compromising an auditor's independence. This article is
an inquiry into the current state of this incentive equilibrium in the
United Kingdom: the possible costs and benefits that may be incurred
by auditors if they elect to acquiesce to management's demands to
accept problematic accounting. It argues that the equilibrium position
currently incentivizes a rational auditor to acquiesce. On the one hand,
the article demonstrates that the recent evolution of audit firm revenue
streams has provided auditors with a substantial incentive to com-
promise their independence and provided management with credible
sanctions to pressurize them to do so. On the other hand, the article
shows that regulatory and market costs of acquiescence do not
counterbalance the benefits of acquiescence.
INTRODUCTION
A central concern in the Enron post-mortem has been to explain why Enron's
auditor, Arthur Andersen, failed to act as an independent gatekeeper of reliable
and transparent financial information. In this regard, John Coffee has proposed
a `general deterrence' theory of audit failure. This theory looks at the costs and
benefits to auditors of compromising their independence by acquiescing to
managements' demands to massage the financial statements. Coffee argues
that the potential costs to auditors of approving accounting treatments that
benefit their client's management but which could mislead investors decreased
* Law Department, London School of Economics and Political Science,

Houghton Street, London WC2A 2AE, England
R.D.Kershaw@lse.ac.uk
My thanks to Marlies Braun, Alison Kershaw, Jorge Guira, Richard Moorhead, Bo
Rutledge, and the anonymous referees for comments on earlier versions of this paper. Ben
Grebe and Nadia Saggi provided excellent research assistance.
388
ß 2006 The Author. Journal Compilation ß 2006 Cardiff University Law School. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA
in the United States during the 1990s. During the same period the financial
benefits of making these client-pleasing judgements increased dramatically.
This, Coffee argues, resulted in an increase in auditor acquiescence.1
Following Coffee, the function of auditor independence regulation is to
ensure that the incentives to acquiesce are outweighed by the incentives to
maintain independence. The incentive equilibrium must tilt towards indepen-
dence. If the equilibrium tilts towards acquiescence, the likelihood of audit
failure increases. This article attempts to assess the current state of this
incentive equilibrium in the United Kingdom and submits that its post-Enron
equilibrium favours acquiescence, not independence. On the one hand, the
evolution of audit firm revenue sources in the United Kingdom over the past
two decades has not only increased the financial dependence of audit firms
on particular clients but, more importantly, has provided management with
credible sanctions to ensure that audit firms do their bidding. On the other
hand, the article shows that the costs of acquiescence do not provide an
effective deterrent. The article shows that neither litigation, reputation costs
nor disciplinary sanctions generate significant costs to acquiescence.
United Kingdom regulators and reform bodies have responded to Enron
with increased regulatory complexity and fragmentation. To improve audit
quality and ensure auditor independence and objectivity, there are now more
regulators,2 with a more intrusive mandate3 and with enhanced resources.
However, the equilibrium framework adopted in this article reveals that this
increased complexity and fragmentation has not rebalanced the equilibrium
in favour of independence. In the auditor independence arena, complex,
fragmented, and opaque regulatory responses have obfuscated the root
causes of the problem. The incentive equilibrium framework set forth in this
article provides clear sight of these causes.
THE INCENTIVE EQUILIBRIUM
1. Mapping the equilibrium
Management has strong incentives to present the company's financial

position in its best light.4 Accordingly, the capital market would be highly
1 J.C. Coffee, `What Caused Enron? A Capsule Social and Economic History of the
1990s' (2004) 89 Cornell Law Rev. 269, 288±93. The concept of auditor acquie-
scence refers in this article to a conscious decision by an auditor (with or without
resistance) to accept an accounting approach that the auditor recognizes may
mislead readers of the financial statements.
2 For example, the introduction of the Financial Reporting Council's Audit Inspection
Unit.
3 For example, the Financial Reporting Review Panel now takes a proactive rather
than a reactive approach. See text to footnotes 95±101.
4 Good financial information, for example, increases performance-related compensation.
389
ß 2006 The Author. Journal Compilation ß 2006 Cardiff University Law School
suspicious of financial information that is presented as compliant with the
applicable accounting standards when the only party interpreting and
applying those standards is the company's management. An objective and
independent third-party arbiter is required. This role of an independent third-
party arbiter is taken by the company's auditor who must attest to the fact
that the financial statements provide a true and fair view of the company's
financial position.5 The true and fair attestation is generally understood to
require compliance with applicable accounting standards.6 However, the
incentives to place a company-favourable spin on the financial statements do
not evaporate on the appointment of an independent auditor. These
incentives are transformed into pressure directed by management at the
auditors to encourage them to acquiesce to management's interpretation of
the standards.
Auditor independence regulation's function is to limit the likelihood that
auditors will succumb to such pressure. The task of auditor independence
regulation is, however, complicated by the fact that although UK regulation
demands auditor objectivity and independence,7 it permits the auditors to
have financial conflicts of interest that ostensibly bind them to the company
and not to the investor or public interest. These financial conflicts arise from
the fact that the auditor is appointed8 and paid by the company and is not
prohibited from having certain other business relationships with the
company in addition to the audit relationship.9 Auditor independence
regulation is, therefore, about getting the balance of incentives right:
ensuring that the financial incentives to acquiesce to management pressure
never outweigh the disincentives or deterrents to acquiesce.
The primary pressures to acquiesce, set forth in Figure 1, are revenue
factors, which are split up into audit fee incentives and non-audit fee
incentives. The weightings attributed to these revenue streams are a function
of: value; management's incentives to ensure that their preferred accounting
treatment is adopted; and the extent to which management can credibly
threaten the audit firm with the loss of a revenue stream if it refuses to
acquiesce. The primary incentives to remain independent relate to: first, the
loss that the audit firm would incur directly as a result of an award of
damages or settlement following litigation or as a result of the imposition of
disciplinary penalties by regulatory authorities; secondly, the loss of firm
revenue arising from reputational damage to the firm if it becomes known
5 s. 235(2) Companies Act 1985.

6 M. Arden QC, Accounting Standards Board, The True and Fair Requirement,
Opinion (21 April 1993). Accounting standards include the Financial Reporting
Standards and Statements of Standard Accounting Practice promulgated and
adopted by the Accounting Standards Board.
7 Auditing Practices Board (APB) Ethical Standard No. 1, Integrity, Objectivity and
Independence (2004) para. 6.
8 Companies Act 1985, s. 384.
9 See text to footnotes 16±30.
390
Figure 1: The scales of auditor independence
Key
AV: Value of future audit fees
NV: Value of future non-audit fees
CT: Credible threat filter
MP: Managerial pressure
L: Litigation risk
RD: Reputational damage
DS: Disciplinary sanctions (firm)
PS: Personal sanctions
that the audit firm has compromised its independence for the benefit of an
individual client; and thirdly, the individual cost to the audit partner resulting
from external personal sanctions such as disciplinary penalties and criminal
liability.
In order for the incentive equilibrium to incentivize audit firms to ensure
that, in relation to a particular client, their audit partners do not acquiesce to
management's accounting demands:
MP CT AV MP CT NV < L RD DS:
In order for the incentive equilibrium to incentivize audit partners to resist
management pressure to acquiesce:
MP CT AVP MP CT NVP < LP RDP DSP PS:10
2. Do auditors engage in cost benefit balancing?10
To analyse auditor independence regulation through an incentive equilibrium

framework assumes that auditors are responsive to the financial incentives
10 `P' represents the proportionate benefit or cost to the individual partner.
391
and disincentives to acquiesce. It assumes that auditors will value, allocate
occurrence probabilities, and balance the costs and benefits of acquiescence
in reaching a decision as to whether or not to acquiesce, and that a change in
the balance of assessed costs and benefits could alter that decision. US
experimental accounting research supports the assumption that auditors will
be responsive to incentives and deterrents.11 In addition, there are several
reasons why in the context of auditor behaviour such assumptions have
practical traction. First, the nature of the auditor independence problem is
inextricably linked to a cost-benefit analysis. Auditors faced with acquie-
scence pressure will implicitly, if not explicitly, be presented with a choice
to acquiesce or lose revenue which foregrounds the price of independence.
Second, where the auditor resists and experiences pressure to accept manage-
ment's preferred interpretation of the accounting treatment, the auditor will
necessarily be aware that such treatment may be viewed by third parties as
inconsistent with the applicable accounting standard and that its acceptance
could result in formal or informal sanctions. Third, personal experience, the
financial and accounting press, professional training and continuing profes-
sional education as well as intra- and inter-firm conversation and storytelling
will ensure that the auditor is made acutely aware of both the possible risks
and the formal and informal sanctions associated with acquiescence. Fourth,
auditors are repeat players who are regularly faced with management
pressure to adopt a different interpretation or application of accounting
standards. The consequences of prior personal decisions to acquiesce or
maintain independence allow auditors to develop an informed sense of the
probability that possible costs or benefits will be realized. Fifth, although an
auditor may be under considerable pressure to accept management's pre-
ferred treatment, the auditor will, in most instances, have time to contem-
plate her response and, if necessary, consult with colleagues about her
response. The decision will be a considered and not a reflex response.
Accordingly, the context of auditor independence regulation makes it par-
ticularly well suited to a rational choice cost-benefit analysis.
Simply because auditors are likely to think through a cost-benefit frame-
work in a relatively well informed manner does not mean that auditors
process cost-benefit information like the expected utility maximizers of
neoclassical economics. Behavioural psychology has taught us that, in
practice, actors' valuations and their probability assessments may depart from
what would be viewed as objective rational valuations and assessments.12 For
11 See, for example, H. Falk, B. Lynn, S. Mestelman and M. Shehata, Àuditor

Independence, Self-interested Behaviour and Ethics: Some Experimental Evidence'
(1999) 18 J. of Accounting and Public Policy 395; L.A. Ponemon and D.R.L.
Gabhart, Àuditor Independence Judgments: A Cognitive-Development Model and
Experimental Evidence' (1990) 7 Contemporary Accounting Research 227.
12 See, generally, D. Kahneman, P. Slovic, and A. Tversky (eds.), Judgment Under
Uncertainty: Heuristics and Biases (1982). For a useful summary, see C.R. Sunstein,
`Behavioural Analysis of Law' (1997) 64 University of Chicago Law Rev. 1175.
392
example, valuations may vary according to the decision-maker's sense of
entitlement to an object; probability assessments may be filtered through
cognitive biases that generate systematic errors. It also teaches us that these
departures themselves may be widespread and predictable. Where
applicable,13 this article incorporates behavioural psychology's modifications
to the rational choice approach. Whilst, as noted above, the article contends
that rational choice assumptions themselves have considerable practical
traction in the context of auditor behaviour, these modifications move the
article's analytical framework and its observations closer to reality.
The fact that auditors are responsive to the financial costs and benefits of
acquiescence does not exclude other decision-making frameworks which
may interact with, and in some instances displace, financial incentives. In
particular, scholarship on the interaction of incentives and moral frameworks
in both accounting and corporate crime14 shows that decision makers with
high levels of moral development are likely to make decisions according to
moral frameworks isolated from the incentives of financial reward and the
deterrents of regulatory sanctions. At the same time this scholarship shows
that decision makers with lower levels of moral development are more likely
to be responsive to financial incentives and regulatory deterrents.15 As the
auditing profession cannot exclude members with lower levels of moral
development, the balance of incentives matters.
Neither financial incentives nor moral development can fully account for
any decision-making space, which can include, amongst others, an audit
firm's organizational culture, an auditor's confidence, her experience, the
nature of the auditor-client employee friendships, even how she feels on a
particular day. The array of considerations present in any specific decision-
making context could generate an independence-compromising decision in a
pro-independence equilibrium setting or an independent decision in an anti-
independence equilibrium. The important point which gives the equilibrium
framework explanatory power is that the balance of incentives makes a
considerable contribution to many accounting decisions even if it cannot
predict the outcome of any particular decision.
13 A considerable body of scholarship identifies many persistent digressions from what

one would expect of the rational actor, including, amongst others, loss aversion,
overconfidence, ambiguity aversion, self-serving bias, status quo bias, and avail-
ability bias. This article relies on those digressions that are viewed as empirically
well founded and directly relevant to an assessment of the acquiescence equilibrium,
namely, prospect theory and the availability bias.
14 R. Paternoster and S. Simpson, `Sanction Threats and Appeals to Morality: Testing a
Rational Choice Theory of Corporate Crime' (1996) 30 Law and Society Rev. 549.
15 See Ponemon and Gabhart, op. cit., n. 11, p. 246; Falk et al., op. cit., n. 11, p. 424.
393
ACQUIESCENCE INCENTIVES
Acquiescence incentives are a function of three factors: first, the value and
make-up of the fees received from an audit client; second, the extent to
which management can credibly threaten auditors with the loss of or a
reduction in those revenues if they fail to capitulate; and third, the extent to
which management is incentivized to exert pressure on the auditors to accept
their accounting approach.
1. Audit client revenue
An audit firm has two primary revenue streams: the audit fee and fees from
the provision of non-audit services, which include services such as tax
planning, corporate finance, information technology, and human resources
services.16 The importance of non-audit service fees to United Kingdom
audit firms increased exponentially in the 1980s and 1990s. Reliable pre-
1991 data on the make-up of non-audit fee revenue is not available, although
press reports during the mid-to-late 1980s indicate rapid expansion of non-
audit service provision.17 As of 1991±92 they amounted to 73 per cent of the
value of audit fees. By 1999 this ratio had increased to 210 per cent and by
2001 to 300 per cent.18 The regulatory regime that enabled this trans-
formation of audit firm revenue sources was light of touch. Demand-side
regulation set forth in the Combined Code recommended that the audit
committee should keep the auditor's independence and the `nature and
extent' of non-audit services under review. Supply-side regulation was
provided by the professional associations' ethics rules, for example, the
ICAEW's Code of Professional Ethics, which delegated to the auditor the
determination of whether providing a non-audit service would threaten the
auditor's independence. In making this assessment the auditor was directed
to consider possible threats19 that could arise from the provision of non-audit
services and the available safeguards that could mitigate such threats. These
16 A considerable body of scholarship has attempted to assess empirically whether the

provision of non-audit fees increases the probability of compromised independence.
The scholarship is inconclusive and suffers from serious methodological problems.
For a summary of several of these studies and their methodological problems, see V.
Beattie and S. Fearnley, Àuditor Independence and Non-Audit Services: A
Literature Review' at <http://www.icaew.co.uk/publicassets/00/00/03/64/
0000036464.PDF> 34±45.
17 In 1996 Accountancy magazine refers to the èxplosion of non-audit work' for larger
firms (`Looking Ahead' Accountancy, May 1996). See, also, `Consultants outstrip
auditors in fee income' Accountancy, January 1990.
18 Data taken from Beattie and Fearnley, op. cit., n. 16, pp. 28±9.
19 Clause 1.201 (section 2A) of the ICAEW's Professional Code for Ethics (1997)
identifies five threat categories: self-interest threat; self-review threat; advocacy
threat; familiarity or trust threat; and intimidation threat.
394
guidelines, however, contained very few explicit prohibitions on the
provision of any such services.
Recent accounting scandals in the United States have focused the UK
regulator's attention on the relationship between non-audit services and
independence. This has resulted in more onerous demand- and supply-side
regulation as well as a public relations-driven response by certain audit firms
involving the sale of branches of their consulting divisions.20 The revised
Combined Code now recommends that audit committees `develop and
implement' a company's non-audit services policy. The regulation of the
provision of non-audit services by auditors has been transferred to the
Auditing Practices Board (APB) which is now within the Financial
Reporting Council (FRC) umbrella. In December 2004, the APB issued
revised ethical guidance which, although adopting the same delegated
auditor self-assessment approach, places much clearer limits on an auditor's
ability to accept a non-audit engagement.21 However, the APB guidelines
remain rooted in the idea that it is the nature of the service and the circum-
stances surrounding service provision rather than the financial benefits of the
service which have the potential to compromise independence. For example,
the auditor should not provide valuation services where the valuation is
material to the financial statements and involves à significant degree of
subjective judgment'.22 Although the APB's ethical guidelines identify the
self-interest threat that is generated by the value rather than the nature of the
non-audit services,23 the guidelines explicitly see this as a problem requiring
a response by the audit firm only when either the combined audit and non-
audit fees exceed 5 per cent of annual audit firm revenues in relation to a
listed company and 10 per cent of annual audit firm revenues in relation to a
private company,24 or where `the fees for non-audit services are significantly
greater than the annual audit and audit-related fees' (emphasis added).25
Accordingly, the revised guidelines leave considerable scope for non-audit
services to act as a financial incentive to acquiesce.
20 For example: the sale of PwC's consulting arm to IBM for $3.5 billion; Ernst &
Young sold its consulting arm to Cap Gemini for $11 billion.
21 APB Ethical Standards 5, Non-Audit Services Provided to Audit Clients (2004).
22 id., para 54.
23 id., para 18.
24 APB Ethical Standard 4, Fees, Remuneration and Evaluation Policies, Litigation,
Gifts and Hostpitality (2004) paras. 23, 24 (the audit engagement should be
terminated if fees exceed 10 per cent for a listed company and 15 per cent for a non-
listed company). Safeguards should be considered if the fees exceed 5 per cent for a
listed company (para. 27) and an external review process should be commenced if fees
exceed 10 per cent for a non-listed company (para. 31). Note that in year to June 2004
PwC's revenue was £1.568 billion (see Professional Oversight Board, Key Facts and
Trends in the Accountancy Profession (updated report, 2006) (`POB Report') 38.
25 APB, Ethical Standards 5, para. 19, requiring an assessment of audit firm
independence.
395
In the year to June 2004 non-audit service fee income to audit clients as a
proportion of Big Four aggregate income declined from 35 per cent to 25 per
cent. An unspecified fraction of this decline is attributable to the divesture by
three of the Big Four of their IT consulting divisions. It is also clear that in
the post-Enron environment, certain public companies and their empowered
audit committees wish to be seen to be monitoring non-audit service provi-
sion. Some companies, for example, have imposed percentage or monetary
thresholds on the value of such services which can be provided by the
auditor.26 However, although non-audit fee revenue for the Big Four has
declined, it remains substantial. For PwC, KPMG, Deloittes, and Ernst &
Young for the year to June 2004, non-audit fee revenue from audit clients
was equal to 95 per cent, 88 per cent, 68 per cent, and 69 per cent of the
revenues from audit fees, respectively.27
Whether the value of a client's audit and non-audit fee revenue to the
audit partner is equal to its value to her fellow non-engagement partners is a
function of the audit firm's internal reward structures. Where a partner's
income is unrelated to her contribution to the firm's gross revenue, the audit
partner's financial interest in, and valuation of, one of her client's fees is
aligned with those of her fellow partners. However, her financial interest in
the fees from a particular client is multiplied if the audit firm's internal
reward structures link the partner's compensation to her contribution to
overall earnings.28 When contribution dependent compensation (eat what
you kill) structures are in place, the loss of the audit fee and/or non-audit fee
revenue will result in a greater reduction in the audit partner's earnings than
would have been the case had such partner's earnings been unrelated to her
contribution.29 Whilst it is clear that a partner's revenue contribution in UK
audit firms plays a role in determining her profit share,30 insufficient
26 For example, Investec PLC have imposed a 30 per cent of audit fee threshold; HSBC
have imposed a £2.5 million threshold (see `Putting a Cap on Non-audit Fees
Doesn't Fit All' Finance Week, June 2005, 10).
27 POB Report 38.
28 Such non-aligned incentives can also arise where office or country-firm
compensation is contribution dependent.
29 The extent to which such pay structures result in non-aligned partner incentives will
be alleviated by regulation of audit partner±client tenure which reduces the partner's
expected future value of a particular client's fees. In the United Kingdom, pursuant
to APB, Ethical Standard 3: Long Association with the Audit Client, engagement
partners should not act for a client for a continuous period of more than five years
(para. 12). Such regulation has no effect on the future expected value of fees to the
audit firm.
30 The Audit Inspection Unit, 2004/05 Audit Quality Inspections Public Report 11
notes that `the documented goals and objectives established for partners, against
which their performance is measured, focused mainly on commercial considera-
tions, such as revenue growth and profitability'. PwC LLP's Annual Report 2004 38,
for example, notes that a member's performance-based income `typically represents
less than 25 per cent of their profit share'.
396
information is publicly available to make a detailed assessment of the extent
to which partner remuneration policies result in non-aligned valuation of
client revenue for engagement and non-engagement partners.
2. Credible threats
Whether management can use these revenue streams to incentivize auditors

to acquiesce to their reporting demands depends upon whether management
can credibly threaten auditors with the loss of, or reduction in, these revenues
in the event that they fail to acquiesce.31
In theory, the loss of future audit fee revenue represents a notable
financial incentive to compromise independence. In practice, as John Coffee
has persuasively argued,32 a threat by management to terminate an audit
relationship suffers from credibility problems. Although dismissing the
auditor results in financial loss for the audit firm, it may also damage the
company and its management. If the market learns that the auditor was fired
for resisting management pressure to massage the financial information, this
could impact negatively on the company's share price and management's
individual reputations.33 This analysis is consistent with empirical evidence
that suggests that a change of auditor is relatively rare.34 However, the extent
to which these market sanctions reduce the credibility of the audit fee threat
is a function of the information made available to the market surrounding the
dismissal. In the United States, item 304 of Regulation S-K provides for
extensive disclosure regarding the dismissal as well as any information about
disagreements relating to the financial statements.35 By contrast, s. 394 of
the Companies Act 1985 requires only that the auditor files a statement
regarding any circumstances that should be brought to the members' or
creditors' attention or a statement that there are no such circumstances.36
Recent revisions to the Combined Code complement this market-driven
dilution of any threat to dismiss the auditor. By recommending that an audit
committee of independent directors make an appointment or removal
31 P. Grout, I. Jewitt, C. Pong, and G. Whittington, Àuditor Professional Judgment:

Implications for Regulation and the Law' (1994) 9 Economic Policy 308, at 324.
32 J. Coffee, Ùnderstanding Enron: `Ìt's About the Gatekeepers, Stupid''' (2002) 57
Business Lawyer 1403, at 1411.
33 Grout et al., op. cit., n. 31, p. 325; J. Eichenseher, M. Hagigi, and D. Shields,
`Market Reaction to Auditor Changes by OTC Companies' (1989) 9 Auditing: A J.
of Practice and Theory 29, at 39.
34 For example, Grout et al., id., p. 324 looked at 577 United Kingdom listed
companies in the Times 1000 companies between 1980 and 1988 (resulting in 3,349
observations) and found that there were only 82 changes of auditor and 3,267 cases
in which there was no change.
35 Item 304, Regulation S-K, Changes in and disagreements with accountants on
accounting and financial disclosure.
36 The Company Law Reform Bill 2005 requires in relation to a quoted company a
statement about the circumstances connected to the resignation (clause 509(3)).
397
recommendation to the board, which if not accepted must be explained in the
annual report, the revised Combined Code further undermines any claim that
the audit relationship is within the gift of management.37
Although the probability of losing the audit relationship for failing to
acquiesce is low, retaining the audit provides no guarantee of non-audit fee
income. Coffee argues that non-audit service fees provide management with
a `low visibility' sanction.38 The decision to award or not to award such
contracts to the auditors is an operational decision in relation to which
management plays a leading role. If auditors do not comply with manage-
ment demands, management can retain them as auditors but refuse to grant
future non-audit fee service contracts. Management can easily explain to the
market and the company's audit committee the selection of other providers
who tendered to provide the service on plausible, legitimate grounds, for
example, better product, pricing or, ironically, independence. Accordingly, a
threat by management to reduce future non-audit service income is very
credible.
3. Acquiescence incentives and prospect theory
Kahneman and Tversky's `widely accepted'39 prospect theory provides that

a common pattern of decision making under conditions of risk involves two
key departures from what we would expect of rational decision makers. First,
an aversion to loss whereby `the disutility of giving up an object is greater
than the utility associated with acquiring it'.40 One consequence of this
aversion to loss is that a person will overvalue an object if she has a sense of
entitlement to or ownership of that object.41 Second, a decision maker is
likely to underweigh high-to-moderate probabilities and overweigh low
probabilities, although the former effect is `more pronounced' than the
latter.42
The effect of these decision-making biases is often set forth in the
language of risk appetite: whether the decision maker is risk-seeking or risk-
averse. One is commonly viewed as being risk-seeking if one is more willing
to accept possible risk of loss in order to increase the likelihood or the value
of a gain. For an actor who acts according to a cost-benefit calculus43 in the
context of a complex decision involving several probabilistic positive and
37 Combined Code, para. C.3.6 (2003).

38 Coffee, op. cit., n. 32, p. 1411.
39 C. Guthrie, `Framing Frivolous Litigation: A Psychological Theory' (2000) 67
University of Chicago Law Rev. 163, at 166.
40 D. Kahneman, J.L. Knetsch, and R. Thaler, `The Endowment Effect, Loss Aversion
and the Status Quo Bias' (1991) 5 J. of Economic Perspectives 193, at 194.
41 id., pp. 194±7.
42 A. Tversky and D. Kahneman, `The Framing of Decisions and the Psychology of
Choice' (1981) 211 Science 453, at 454.
43 Prospect theory does not problematize this assumption.
398
negative financial outcomes, to be risk-seeking in relation to a particular
financial outcome is to overweigh benefit-value or to underweigh cost-value.
To be risk-averse is to underweigh benefit-value or to overweigh cost-value.
Such effects may or may not result in a change in the decision-choice.
Whether they do so will depend on the magnitude of the distorted value
outcome and the other cost-benefit outcomes that determine the equilibrium.
From the perspective of the auditor independence incentive equilibrium,
therefore, a bias that renders the decision maker risk-seeking in relation to a
particular financial outcome is one that tips the equilibrium towards
acquiescence and a bias that renders the decision-maker risk-averse is one
that tips the decision-maker towards independence.
The combined effect of prospect theory's two empirically verified
premises is a `fourfold pattern of risk attitudes'.44 Decision makers will
commonly behave in a risk-averse fashion in relation to high-to-moderate
probability gains and a risk-seeking fashion in relation to low probability
gains. They will commonly behave in a risk-seeking fashion in relation to
high-to-moderate probability losses and in a risk-averse fashion in relation to
low probability losses.
As decision-makers' risk appetite varies in relation to gains and losses,
how a decision-maker frames a value outcome (as a loss or a gain) will affect
and, depending on its significance, possibly alter the decision. For
Kahneman and Tversky:
Outcomes are commonly perceived as positive or negative in relation to a
reference outcome that is judged neutral. Variations of the reference point can
therefore determine whether a given outcome is evaluated as a gain or a loss
. . . The reference outcome is usually a state to which one has adapted; it is
sometimes set by social norms and expectations.45 (emphasis added)
In a commercial context potential financial benefits from service transactions,
such as audit or non-audit relationships, could be framed as gains or losses.
The reference point according to which such benefits are framed as gains or
losses will, it is submitted, primarily be a function of whether or not the
service provider develops an expectation that such transactions will be
repeated in the future. Such an expectation will be formed by, amongst others,
prior transaction history, market practice, and the nature of the service.
Prospect theory enables us more accurately to map an auditor's probable
response to audit fee and non-audit fee acquiescence incentives. Given that
audit firms commonly have long tenures with their clients, audit firms will
have an expectation that the relationship will not be terminated and that they
will continue to receive audit fees. Accordingly, they are likely to frame an
acquiesce-or-lose-the-audit-relationship threat as involving a possible loss.
For the reasons discussed above, however, such a threat has limited
44 A. Tversky and D. Kahneman, Àdvances in Prospect Theory: Cumulative

Representation of Uncertainty' (1992) 5 J. of Risk and Uncertainty 278, at 307.
45 Tversky and Kahneman, op. cit., n. 42, p. 456.
399
credibility. It is, therefore, a low probability threat of loss in relation to
which prospect theory tells us that auditors are likely to act in a risk-averse
fashion, which will result in an effective underweighting of the incentive to
acquiesce arising from the audit fee threat. Accordingly, prospect theory
supports the position that the audit fee itself generates an inconsequential
incentive for an auditor to compromise her independence. Non-audit service
fees are more complex. As shown above, a threat that failure to acquiesce
will result in loss of non-audit fee revenue is highly credible. However, will
an auditor frame such a threat as a gain or a loss? It seems plausible that this
framing decision will depend on the nature of the service. Recurring
services, such as tax services or outsourced human resources services, in
relation to which continuing service provision generates an expectation of
future service provision, will be framed as high probability losses in relation
to which the auditor will act in a risk-seeking fashion, effectively over-
weighting these incentives. One-off services, such as an IT services project,
will be framed as high-probability gains which will be underweighed by the
auditor. Accordingly, understanding the incentive balance to acquiesce faced
by any auditor in relation to a particular client is a function not only of the
value of the non-audit services but the proportion of such services which are
recurring. Recent reports suggest that in the United Kingdom, tax advice
makes up the bulk of non-audit fee revenue.46
4. Managerial pressure to acquiesce
The probability that auditors will experience an acquiesce-or-lose-revenue

threat is a function of how important it is for management that the auditors
accept their preferred accounting treatment. Management have several
incentives to manage financial information and to pressurize auditors to
accept such accounting. Company related incentives would include ensuring
compliance with financial covenants imposed by credit agreements or main-
taining or improving the company's credit rating. Personal incentives would
include, amongst others, compensation arrangements which are tied to
accounting-based financial targets. United States research has looked at
whether such company and personal incentives are linked to financial
information management. Fields, Lys, and Vincent's review of the literature
concludes that `the literature suggests that managers exploit their accounting
discretion to take advantage of the incentives provided by bonus plans'.47
46 In 2004 they amounted to 73 per cent of audit fee revenue for the top 50 firms (£1.78
billion compared to £2.42 billion): D. Wild, `Crushing Regulation Drives Audit Fee
Windfall' Accountancy Age, 30 June 2005.
47 T.D. Fields, T.Z. Lys, and L. Vincent, Èmpirical Research on Accounting Choice'
(2001) 31 J. of Accounting and Economics 255, at 271. See, also, P. Healy, `The
Impact of Bonus Schemes on the Selection of Accounting Principles' (1985) 7 J. of
Accounting and Economics 85.
400
United States accounting scholarship also details that auditors faced with
attempts by management to manage financial information believe that
management were motivated by compensation and debt covenant incentives
and, amongst others, by the need to meet analysts' expectations.48 Com-
mentators have also linked recent audit failures such as Enron to, amongst
others, performance-based compensation.49
Care must be taken in assuming that United States evidence has traction in
the analysis of the United Kingdom's incentive equilibrium. Executive
compensation arrangements here differ from those in the United States and,
accordingly, the extent to which they incentivize acquiescence pressure will
also differ. A comparative study by Conyon and Murphy of UK and US CEO
compensation arrangements in 1997 identified significant differences in both
value and structure, including, in particular, the greater emphasis on
performance-based compensation in the United States.50 Accordingly, as of
1997 one would have expected the incentives for management to manage
financial information and to pressurize auditors to accept their accounting
approach to have been much higher in the United States than in the United
Kingdom. More recently Conyon and Sadler have analysed developments in
the structure and value of UK and US executive remuneration in the top 200
UK companies between 1997 and 2003.51 They conclude that ÙK CEO
compensation is changing to more closely match that of the US' and that `the
structure of CEO pay in the UK is becoming much more like the US'.52
The increasing importance of performance-based remuneration for UK
CEOs may be a legitimate attempt to correctly incentivize them and to
reward their productivity.53 From the perspective of the auditor indepen-
dence incentive equilibrium, however, this convergence towards United
States compensation arrangements suggests that the personal incentives for
management to pressurize auditors to acquiesce have been increasing over
the past few years.
48 M. Nelson, J.A. Elliot, and R.L. Tarpley, Èvidence from Auditors about Managers'
and Auditors' Earnings Management Decisions' (2002) 77 Accounting Rev.
(Supplement) 175, at 176 and 189.
49 W. Bratton, Ènron and the Dark Side of Shareholder Value' (2002) 76 Tulane Law
Review 1275.
50 Performance-based compensation in the United States amounted to an average of
£2.25 million compared with £218,000 in the United Kingdom. M.J. Conyon and
K.J Murphy, `The Prince and the Pauper? CEO Pay in the United States and United
Kingdom' (2000) 110 Economic J. F640, F646.
51 M.J. Conyon and G.V. Sadler, `How Does US and UK CEO Pay Measure Up?'
(2005), working paper on file with the author, 14.
52 id., p. 6. They find that there has been a 77 per cent increase in total executive pay
over this period which amounts to reduction in the ratio of United States to United
Kingdom pay from 2.8 to 1.7. In 2003 average performance-based compensation in
the United Kingdom's top 200 companies amounted to £903,800.
53 This may also be viewed as responsive to the emphasis on performance-based pay in
the Combined Code (2003) para. B1.
401
MARKET AND REGULATORY DETERRENTS
The primary auditor acquiescence deterrent is the expected financial cost to

the audit firm and the audit partner of the acquiescent behaviour. There are
three categories of audit firm financial exposure: civil liability; lost revenue
resulting from reputational damage; and disciplinary sanctions. The deterrent
effect for the individual audit partner is viewed as a function of, first, her
proportionate share of the expected financial cost to the audit firm and
second, the external personal sanctions that may be imposed on the audit
partner herself.
1. Litigation exposure
Acquiescent auditing may expose an audit firm to litigation for failing to take
reasonable care. In this regard available private law remedies in contract and
tort can be viewed as having the regulatory function of deterring acquiescent
behaviour. However, one has to be careful to distinguish private law's
regulatory effects from its autonomous internal logics.54 The attribution of a
regulatory function to contract or tort law in the context of auditor
independence regulation is an external attribution which the internal opera-
tions of tort and contract law may not take account of in their development.
Indeed these autonomous developments may distort, even extinguish, this
regulatory function. Although, as accounting scholarship confirms, private
law litigation has the potential55 to act as a deterrent to acquiescent auditing,
we need to understand the key drivers of such a deterrent effect and the extent
to which private law accommodates such drivers.
The primary driver of a litigation deterrent effect are the rules which
structure the probability of suit and the liability exposure where suit against
the audit firm is successful. These, in turn, are a function of which parties
benefit from a legal duty of care owed by the auditors; whether such
beneficiaries are likely to suffer loss as a result of the breach of duty; and
whether that loss is a type of loss for which auditors will be held responsible.
(a) Who benefits from an auditor's duty of care?
That a duty of care could be owed to third parties who suffered pure
economic loss as a result of negligent misstatement by a professional advisor
was established by Hedley Byrne & Co Limited v. Heller & Partners Ltd 56
which approved of Lord Denning's dissenting judgment in Candler v. Crane,
54 P. Cane, Ùsing Tort Law to Enforce Environmental Regulations? (2002) 41

Washburn Law J. 427, at 435±6 and 466.
55 See n. 11 above. Accounting scholarship dealing with the deterrence effect of
litigation tells us that litigation exposure may deter, but does not address the legal
rules that determine the actual extent of that exposure.
56 [1964] A.C. 465.
402
Christmas & Co.,57 a case involving accounting negligence. However, Lord
Denning's judgment took a restrictive view of the parties to whom a duty of
care could be owed. A duty could only be owed where the accountants knew
that a third party would be showed the accounts and only in relation to the
specific transactions for which they knew the third party would use the
accounts.
In the late 1970s, an extension of the categories of financial statement
users who could benefit from an auditor's duty of care was threatened as a
result of Lord Wilberforce's judgment in Anns v. Merton Borough Council in
which he set forth a general foreseeability principle58 for determining
whether a person was owed a duty of care. Woolf J's judgment in JEB
Fasteners v. Marks,59 the Outer House's decision in Twomax Ltd. v.
Dickson,60 and the New Zealand Court of Appeal's decision in Scott Group
Ltd. v. McFarlane61 took steps towards realizing this threat. These cases
represented a substantial litigation deterrent to acquiescent auditing as their
reliance on the forseeability principle held out the possibility of further
extensions of duties of care to other parties, including existing shareholders or
investors, who foreseeably rely on audited financial statements. Importantly,
however, the deterrent effect provided by these cases was not the product of a
regulatory concern to ensure independent auditing. It was the product of
lower courts' attempts to apply the House of Lords' short-lived dalliance with
a general principle of foreseeability in the context of economic loss.
By the mid 1980s the House of Lords had expressed concern about the
approach adopted in Anns v. Merton Borough Council.62 It was not until
Caparo Industries plc v. Dickman63 that the House of Lords had an
opportunity to address these concerns in the context of alleged auditor
negligence. Caparo Industries plc brought suit against Touche Ross in relation
to their audit of Fidelity plc which had been taken over by Caparo. Caparo
claimed that, due to accounting irregularities, they had paid more for the
shares than they were actually worth. The Court of Appeal held that a duty
was owed to existing shareholders who lost value as a result of selling or
purchasing additional shares but not to non-shareholding investors.64 Had the
57 [1951] 2 K.B. 164.

58 [1978] A.C. 728.
59 [1981] 3 All E.R. 289 (duty owed to takeover bidder when reasonably foreseeable
that third party financing would be required).
60 [1982] S.C. 113 (duty owed to investors although auditor did not know about their
interest in the company at the time it issued its audit report).
61 [1978] 1 NZLR 553 (majority of the court held that a duty could be owed where the
auditor was not aware that a particular third party would be provided with the
financial information).
62 Yuen Kun Yeu v. Attorney-General of Hong Kong [1988] A.C. 175.
63 [1990] 2 A.C. 605.
64 Bingham LJ did, however, hold out the possibility that `time and experience may
show such an extension to be desirable or necessary' ([1989] Q.B. 653, 692).
403
House of Lords adopted this position, the scope for tort to act as a deterrent
would have remained considerable: any successful bidder who had purchased
shares prior to making the actual bid would have had a strong claim for
damages in the event that accounting irregularities overstated the value of the
company. Importantly, a successful takeover bidder, through control of the
target, is particularly well placed to identify and prove such negligent
accounting. The House of Lords, however, rejected the Court of Appeal's
analysis. Their Lordships held that the determination of whether a duty of
care was owed should be made according to what Jane Stapleton has called a
`pocket of case law' approach65 and not according to any general principle. In
the `pocket of case law' approach, the duty of care is divided into distinct
categories within which the analysis of whether or not there is a duty of care is
confined to specific authorities. In the context of economic loss resulting from
negligent misstatement the cases are Hedley Byrne and Lord Denning's
dissenting judgment in Candler v. Crane. Caparo, therefore, was owed no
duty of care either as a shareholder66 at the time of the bid or as an investor.
Subject to two exceptions, post-Caparo, an auditor is only exposed to
litigation by its client. The exceptions are: first, if the auditors prepare the
audit report with the knowledge67 that it will be used by a third party for a
specific purpose and in relation to a specific transaction;68 and secondly, if
after issuing the audit report they represent the reliability of the audited
financial statements to a specific third party in relation to a specific trans-
action.69 These exceptions are in the complete control of the auditor and are
clearly foregrounded risks that can be taken into consideration when carrying
out the audit or making any post-audit representation.
(b) Is the company ever injured by acquiescent auditing?
Auditors may owe a duty of care to their clients in both contract and tort, but
in order for any breach of duty to expose the auditor to litigation risk, such a
breach must cause a loss which falls within the scope of such duty. And
herein lies the problem: acquiescent auditing that allows misleading or
inaccurate accounting will rarely result in a legally cognizable loss for the
company. Where compromised independence can generate no loss for the
company, private law cannot have any rational70 deterrent effect. Indeed, in
65 J. Stapleton, `Duty of Care and Economic Loss: A Wider Agenda' (1991) 107 Law
Q. Rev. 249.
66 The House of Lords held that any duty owed to shareholders was limited to ensuring
that shareholders could exercise their rights in general meeting.
67 Including both actual knowledge and knowledge attributable to a reasonable person
in such a position ([1990] 2 A.C. 605, 638 per Lord Oliver).
68 Reeman v. Department of Transport [1997] 2 Lloyd's Rep. 648, per Lord Bingham,
685.
69 Morgan Crucible Co. Plc v. Hill Samuel & Co. Ltd [1991] Ch. 295.
70 On an irrational deterrent effect, see text to nn. 83±88 below.
404
many instances, a company will benefit from accounting misstatements that
inflate its financial wellbeing. Such misstatements may reduce the cost of its
debt and equity capital until the disclosure of the irregularities. There are,
however, two important exceptions to the rule that acquiescent auditing will
not result in a loss for a company. The first is where the misleading financial
statements result in an illegal distribution, by dividend or otherwise, which
reduces the company's legal capital. The second is where a company incurs
trading losses when, but for the negligent financial statements, it would have
ceased to trade at an earlier date. Here the most common types of claim
would be for the trading losses from the date when trading should have
ceased or, if the accounting irregularities diverted attention from the need to
take radical action within the company at an earlier date, lost opportunities to
realize the highest value for the company or the company's assets.71
Importantly, however, in the space where auditor activity is not at risk from
such claims, the probability of suit by the company is effectively zero.
Furthermore, the extent to which the possible losses identified above
generate litigation risk should not be overstated. Whereas the above analysis
has focused on the existence of any loss that is caused in fact by the auditor's
negligence, such losses are not necessarily, in law, losses for which the
auditor could be held responsible. During the past decade English law has
curtailed the types of loss for which audit clients can hold auditors
responsible.
In South Australia Asset Management Corp. v. York Montague Ltd
(SAAMCO),72 the House of Lords used the concept of the scope of the duty
of care to limit the types of loss for which a negligent surveyor could be held
accountable. The question for the court was whether the defendant, who had
negligently valued property, could be held liable for the decline in value of
that property that resulted from a downturn in the property market where,
had the valuation not been negligent, the plaintiff would never have entered
into the transaction at all. Lord Hoffman held that a plaintiff must show that
the duty owed `was a duty in respect of the kind of loss which he has
suffered'73 and that a person who makes a negligent misstatement is not
`generally regarded as responsible for all the consequences of that course of
action'.74
It is clear from SAAMCO that auditors are not exposed to liability for but
for losses. What is less clear from this approach is how to determine what
types of loss an auditor is responsible for. In this regard, Lord Hoffman held
that `normally the law limits liability to those consequences which are attri-
butable to that which made the act wrongful' which, in the case of negligent
71 See, for example, Equitable Life Assurance Society v. Ernst & Young [2003] EWCA
Civ 1114.
72 [1997] A.C. 191.
73 id., p. 211.
74 id., p. 214.
405
misstatement, meant `liability for the consequences of the information being
inaccurate'.75 This, however, simply reformulates the question. There are
many direct and indirect consequences of the information being inaccurate.
What we need to know is which `consequences' is an auditor responsible
for? Here Lord Hoffman offers two approaches. The first is to look for a
close and direct causal relation between inaccurate information and con-
sequence; what Lord Hoffman refers to as a `sufficient causal connection'.76
The second, of particular relevance for determining the scope of a con-
tractual duty of care, is to look at the risks which were assumed by the
auditor. Lord Hoffman put it as follows:
The scope of the duty, in the sense of the consequences for which the [service
provider] is responsible is that which the law regards as best giving effect to
the express obligations assumed by the [service provider].77
It seems highly probable that issuing an illegal dividend would fall within
the consequences for which the auditor could be held liable. The
determination of the dividend payment is a direct function of the information
in the financial statements.78 Here the loss would amount to the illegal
reduction in the company's capital: the payments in excess of the amounts
that the company could have lawfully distributed. However, the extent to
which a dividend payment is unlawful is a direct function of the extent to
which the accounting entries are inaccurate. That is, liability exposure for
illegal dividends is in the auditor's control. Furthermore, given that directors
could be held liable for the whole of the dividend not just the extent to which
it is illegal,79 it is unlikely that auditors would face resistance from
management to ensure that the dividend is legal even if any questionable
accounting should subsequently be revised. Accordingly, the possibility that
acquiescent auditing could result in liability exposure for an illegal dividend
can be managed by the auditor.
To determine whether an auditor could be held liable for losses arising
from continued trading80 or a lost sale opportunity, SAAMCO directs us to an
analysis of the types of risk of loss which the auditor in fact assumed.81
These will normally be set forth in the audit engagement letter. It seems
unlikely that an auditor would assume the risk of trading losses that result
75 id., p. 213.
76 id., p. 214.
77 id., p. 212. See, also, Aneco Reinsurance Underwriting Ltd. v. Johnson & Higgins
[2002] 1 Lloyd's Rep. 157, 163.
78 ss. 263, 264 Companies Act 1985.
79 P. Davies, Gower & Davies' Principles of Modern Company Law (2003, 7th edn.)
287.
80 Galoo v. Bright Grahame Murray [1994] 1 W.L.R. 1360 where the auditors were
held not to be liable for trading losses although using a causation rather than a
SAAMCO scope of duty approach.
81 Aneco Reinsurance Underwriting Ltd. v. Johnson & Higgins [2002] Lloyd's Rep.
157, 183.
406
from the continued existence of the firm or a missed sale opportunity. A
well-drafted engagement letter is more likely to explicitly exclude
responsibility for these types of risk of loss.82 The important point, however,
is that the assumption of risk is within the auditor's control and where an
auditor assumes additional risk exposure it can be factored into accounting
decisions.
(c) Proportionate liability and the deterrent effect of the availability heuristic
The Company Law Reform Bill 2005 proposes the introduction of propor-
tionate liability for auditors. The Bill, if enacted in its current form, would
allow shareholders to approve a limit on the auditor's liability to an amount
that is `fair and reasonable in all the circumstances of the case', having
regard to the auditor's responsibilities, the auditor's contractual obligations,
and applicable professional standards.83 It is submitted that, given the
attenuation of liability exposure over the past sixteen years, the actual
reduction in liability exposure introduced by such a proportionate liability
regime would be marginal. Nevertheless, it is clear, in light of the lobbying
efforts by the accountancy profession, that such a system of liability is highly
valued by auditors.84 The reason for this, it is submitted, is that it will
partially address the problem of very public, high-value but arguably
frivolous litigation, brought not on the basis of an assessment of the likeli-
hood of success but rather with an eye to settlement in light of the huge costs
incurred in defending such actions. Following the introduction of propor-
tionate liability, it will be more difficult to bring headline grabbing litigation
attributing several billion pounds of loss to the auditor where loss has been
contributed to by several participants.85 Even in relation to claims that the
auditor assumed responsibility for a broad range of losses, the plaintiff will
have to consider the auditor's proportionate responsibility for the loss within
that range which, in most instances, will considerably reduce the headline
litigation figure and thereby reduce the value range of any possible nuisance
settlement.
What, if any, effect will the proposed proportionate liability regime have
on an auditor assessing the costs and benefits of acquiescence? For a rational
auditor, although liability exposure would be reduced by the enactment of
such a provision, as liability exposure for auditor acquiescence is so limited,
the introduction of a proportionate regime is unlikely to significantly alter
82 For example, Ernst & Young's engagement letter with Equitable Life (Equitable
Life v. Ernst & Young [2003] EWCA Civ 1114 para 115).
83 Company Law Reform Bill (2005) clauses 524±8.
84 See, for example, A. Nixon and B. Reynolds, `Last Dash for Liability Limitation'
Accountancy, October 2004, 11.
85 In the wake of the Equitable Life settlement, Ernst & Young's General Counsel is
reported as making this point (B. Jopson and N. Tait, Àccountants' nightmare ends
as case focuses minds on threat to big four' Financial Times, 23 September 2005).
407
the current balance of acquiescence/independence incentives. However, this
assumes that an auditor is capable of processing and attributing litigation
exposure probabilities to acquiescence decisions under the current rather
complex body of law. Indeed, as a result of continuing education require-
ments and professional self-interest, auditors are likely to have an informed
understanding of the legal regulation of their profession. Some auditors may,
therefore, have such a rational assessment of litigation exposure. However,
behavioural psychology teaches us that, when faced with complexity, deci-
sion makers rely on heuristics that reduce complexity and facilitate
decisions. Research suggests that auditors are also likely to rely on such
heuristics.86
Of particular relevance to an assessment of litigation exposure is the
availability heuristic which suggests that we assess the probability of the
occurrence of an event according to `the ease with which [the occurrence of
such an event] can be brought to mind'.87 If comparable events are easy to
bring to mind, the decision maker may overweigh the probability of such an
event occurring again. The salience or vividness variation of this heuristic
means that the more salient or vivid a particular event, the more readily it
will be brought to mind when assessing the probability of occurrence. Such
events are `more available and hence exert a disproportionate influence on
the judgment process'.88 Applying these heuristics to the context of auditor
independence, the more readily an auditor brings to mind high-profile, high-
value litigation that may be viewed through the lens of acquiescence, the
more likely such an auditor will consider that her acquiescence could result
in suit. Accordingly, even if, as the defendants contended, recent high-profile
auditor negligence suits such as Equitable Life and BCCI were highly
unlikely to succeed, their existence and media profile when combined with
the availability and salience heuristics results in auditors subsequently
overweighing the probability of litigation thereby increasing the deterrent
effect of litigation. If a proportionate liability regime reduces the frequency
and salience of such frivolous litigation, the indirect benefit for auditor
independence regulation from flawed probability assessments will be
reduced.
86 See, for example, J.C. Anderson, S.E. Kaplan, and P.M.J. Reckers, `The Effects of
Interference and Availability from Hypotheses Generated by a Decision Aid Upon
Analytical Procedures Judgments' (1997) 9 Behavioral Research in Accounting
(Supplement) 1.
87 A. Tversky and D. Kahneman, Àvailability: a heuristic for judging frequency and
probability' in Kahneman et al., op. cit., n. 12, pp. 163, 164.
88 S. Taylor, `The Availability Bias in Social Perception and Interaction' in Kahneman
id., pp. 190, 192.
408
2. Reputational damage
Whilst managers of companies may pressurize auditors to compromise their

independence, they have no need for an audit firm which has lost its
reputation for independence. An audit firm which compromises its reputation
for independence for a client will find it difficult to retain other clients and
obtain new clients as the market will treat the financial statements verified by
that auditor as less reliable. Accordingly, this theory of reputational capital
tells us that rational auditors will never sell their reputation to a particular
client by compromising their independence for an increased reward. If they
do so, lost rents from existing and future clients will far exceed any amount
paid by a single client for the compromised independence.89
It is commonly assumed by United Kingdom scholars and regulators that
this theory of reputation is an empirical fact.90 The theory, however, assumes
first, that there is a high probability that errant behaviour will be discovered
and second, that its identification will be clearly reported to the market. To
the extent that this is not the case in practice, the effectiveness of a reputation
for independence as a disciplinary device will be undermined. Even if the
cost to an auditor of damage to its reputation for independence is high, an
audit partner will discount these costs by the probability that any acquiescent
behaviour will publicly and unequivocally be disclosed. As DeAngelo points
out, if the probability of being caught is zero there are no reputation costs to
compromising independence.91
There are three mechanisms for identifying and informing the market
about acquiescent auditing: first, litigation which alleges negligent auditing;
second, investigations and reports by governmental or quasi-governmental
bodies into financial statement and audit quality; and third, the investigations
and publicly disclosed findings of accountancy disciplinary bodies.
(a) Litigation
As shown in the previous section, developments in English law over the past
sixteen years have markedly reduced an auditor's exposure to litigation both
to third parties and the company itself. In most instances, auditor acquie-
89 The classic statement of this hypothesis is provided in L.E. DeAngelo, Àuditor Size
and Audit Quality' (1981) 3 J. of Accounting and Economics 183, at 189±90.
90 In a statement to the House of Commons relating to director and auditor liability on
7 September 2004, Patricia Hewitt MP, the Secretary of State for Trade and
Industry, concluded that `no change to the law on financial liability could protect
one of an auditor's greatest assets ± its reputation'. See S. Fearnley and V. Beattie,
`The Reform of the United Kingdom's Auditor Independence Framework after the
Enron Collapse: An Example of Evidence Based Policy Making (2004) 8
International J. of Auditing 117, at 121; and B. Arrunda, `The Provision of Non-
Audit Services By Auditors: Let the Market Evolve and Decide' (1999) 19
International Rev. of Law and Economics 513, at 523.
91 DeAngelo, op. cit., n. 89, at p. 191 and fn. 21.
409
scence will not expose auditors to a viable law suit. This of itself undermines
the role that litigation can play as a policeman and information channel for
the market in a reputation for independence. Furthermore, in determining the
likely future costs of compromising the auditor's independence, a rational
auditor would consider not only the likelihood that litigation would be
commenced alleging or inferring compromised independence but also the
probability that such a claim would be a clear signal to the market that the
auditor had in fact compromised its reputation for independence.92
Reputational costs of acquiescence are a function of the clarity or noisiness
of the signal of compromised independence: noisy signals reduce
reputational costs. In relation to litigation commenced by the company at
the behest of new management or a liquidator or, where possible, third-party
litigation, the signal is noisy:93 a successful bidder may be looking for a
party to blame for the failure to effectively integrate the two companies, or
new management or liquidators may be looking for a deep pocket to
compensate the company for losses that may well be the product of audit
failure but could equally be the product of business failure or general
economic decline. Such suits may be instigated in the belief that the nuisance
effect of the suit, rather that the legal basis of the claim, may generate a
settlement. Furthermore, in relation to both well-founded and unfounded
litigation, auditors will usually issue categorical denials of any respon-
sibility. Whereas a court judgment against the auditor provides a relatively
clear signal of audit failure, in most instances the claim will be confidentially
settled prior to a court hearing with no public acknowledgment of audit
failure.94 The market is thus left with the noisy signals of claim, denial,
counterclaim, and confidential settlements.
(b) Financial statement and audit review
The second mechanism which can identify and inform the market about an
auditor's compromised reputation is financial statement and audit review by
the regulatory bodies responsible for supervising financial statement and
audit quality. In the United Kingdom there are two such regulatory bodies:
the Financial Reporting Review Panel (FRRP) and the Audit Inspection Unit
of the Professional Oversight Board (POB).
The FRRP was established in 1991 to ensure that public and large private
companies prepare their accounts in compliance with United Kingdom
accounting standards. The FRRP has no authority to regulate the audit
profession. To the extent its activities identify and report on accounting
92 Lennox argues that `the reputation hypothesis relies upon there being a reliable
signal of auditor accuracy' (C.S. Lennox, Àudit Quality and Auditor Size: An
Evaluation of Reputation and Deep Pockets Hypotheses' (1999) 26 J. of Business
Finance & Accounting 779, at 800).
93 Lennox argues that litigation is a noisy signal, id.
94 Lennox, id., p. 793.
410
irregularities, however, it has the potential to discover and inform the market
about acquiescent auditing. Prior to reforms introduced following the DTI's
Review of the Regulatory Regime of the Accounting Profession in 2003 (`the
DTI Review'), the FRRP took a reactive approach to its regulatory role: it
did not actively review company accounts in the absence of any indication of
accounting failure. To identify non-compliance, it relied upon the qualifica-
tion of reports by auditors, referrals from individuals and corporate bodies,
and reports of accounting problems in the financial press.95 These conduits
to regulatory action do not present a significant risk that an FRRP investi-
gation will identify accounting irregularities connected to acquiescent
activity. Where the auditor has qualified a report, in relation to the qualifica-
tion upon which the FRRP focuses, the auditor has refused to acquiesce. The
parties who are aware of and understand the decision to acquiesce do not
have any incentive to refer the case to the regulatory authorities as such a tip-
off could expose that person to formal or informal sanctions.96 The financial
press will have similar difficulty in finding informed sources and will be
reliant primarily on a face review of the published accounts which are
unlikely to reveal the types of accounting irregularities to which the auditors
have acquiesced.97
Following the DTI Review, the FRRP has adopted a proactive approach to
its regulatory role which involves the review of certain company accounts
prior to any indication of, or tip-off regarding accounting irregularities. The
FRRP has also adopted a risk-based approach which results in focusing its
proactive review on industries and companies which it considers to be at
greater risk of generating irregular accounting.98 This means, however, that
the probability of review is unaltered for those companies that do not fall
within these risk parameters.
For those companies that do fall within the FRRP's risk parameters, the
adoption of a proactive approach does not significantly increase the
probability that the accounting irregularities to which an auditor acquiesces
will be discovered. Prior to the introduction of proactivity, Fearnley, Hines,
McBride, and Brandt argued that `the FRRP can only normally deal with
non-compliance, or creative compliance which is visible in a company's
published accounts'.99 FRRP proactivity does not address this problem as it
95 S. Fearnley, T. Hines, K. McBride, R. Brandt, `The Impact of the Financial

Reporting Review Panel of Aspects of the Independence of Auditors and their
Attitudes to Compliance in the United Kingdom' (2002) 34 British Accounting Rev.
109, at 111.
96 D. McBarnet and C. Whelan, Creative Accounting and the Cross-Eyed Javelin
Thrower (1999) 38±9.
97 id., p. 37, noting that òne of the inherent characteristics of creative accounting is
that it is difficult to spot . . . even sophisticated readers of accounts might miss
them'.
98 See <http://www.frc.org.uk/frrp/press/pub0718.html>.
99 Fearnley et al., op. cit., n. 95, p. 113.
411
relies on the published accounts. The accounting irregularities to which the
auditors have acquiesced that are not identifiable from a face review will not
be at risk from FRRP investigation. FRRP proactivity will disincentivize
acquiescent behaviour that cannot be hidden without implicit disclosure or
suspicion-raising inconsistency. This effect, however, may be marginal as an
essentially identical deterrent is already in place through financial press and
research analyst activity.
Where a FRRP investigation does reveal problematic accounting, the
FRRP's self-understanding as a regulator that works with business to raise
the standards of financial accounting, rather than a regulator that raises
standards through the deterrent effect of catching the wrongdoers,100 results
in an enforcement approach that does not clearly signal the causes of the
failure. In most instances, companies with non-compliant accounts are
required merely to agree that they will make the required changes in sub-
sequent years. The action that the company agrees to take is invariably
issued in concurrent press releases by the company and the FRRP.101
Importantly, the press notices do not provide a comprehensive record of the
investigation and the background to the accounting treatment decision. The
public is not given access to FRRP investigation documentation or minutes
of its meetings. Accordingly, the public informational output of FRRP
investigations do not reveal whether the accounting failure resulted from a
difficult and uncertain application of accounting standards to economic
reality, incompetence or acquiescence.
Prior to the implementation of the DTI Review's reforms, the regulation
of audit quality control took place through the Joint Monitoring Unit (JMU),
which was responsible for periodic review of audit firms' systems and
procedures. Its ambit however did not extend to a review of the judgments
made in individual audits. Following the DTI Review, the audit review
function has now been transferred to a separate unit, the Audit Inspection
Unit (AIU) of the POB. In addition to the systems and procedures review
carried out by the JMU, the AIU will also be required to review audit
judgements. Such a judgement review function means that the AIU has the
potential to identify acquiescent auditing as, in contrast to the FRRP, the
AIU looks at the judgements that are often hidden beneath the surface of the
published accounts.
Two problems undermine the ability of the AIU to facilitate the operation
of the market for reputational capital. First, the probability of discovery will
inevitably remain low given the enhanced, but limited, resources available to
100 See comments made by Sir Bryan Nicholson, FRC Chairman (Ìnsider Tough Road
Ahead' Accountancy Age, April 2004, 15). See, also, McBarnet and Whelan, op. cit.,
n. 96, pp. 49±54.
101 McBarnet and Whelan, id., pp. 51, 53.
412
the AIU.102 Second, the AIU cannot operate as an information conduit to the
market for audit services because it `will not publish individual inspection
reports'.103 The reports will be passed to the Audit Registration Committees
of the accountancy bodies such as the Institute of Chartered Accountants in
England and Wales (ICAEW). These registration committees will then make
decisions about what, if anything, is the appropriate sanction.104 A review of
the recent sanctions imposed by the ICAEW's Audit Registration Committee
shows that a very limited amount of information is made available regarding
the nature of the sanctioned audit failure.105 Unless the Audit Registration
Committee alters its approach to the amount of disclosure given when
sanctions are imposed on the auditor, the informational outcome of AIU
judgement review is not sufficiently informative to facilitate an audit market
in a reputation for independence.
(c) Professional disciplinary bodies
The third mechanism that has the potential to act as an information conduit
between acquiescent behaviour and the market in reputational capital is
provided by the regulatory bodies responsible for disciplining errant audi-
tors. Importantly, whereas in the United Kingdom many parties who make
business and investment decisions based on the audited financials of a
company have no legal claim against the auditors, those same disgruntled
parties may make a complaint to the relevant professional body about the
auditor's performance. A disciplinary process has the potential to filter these
complaints and provide the market with a clear indication of whether or not
an auditor's independence was compromised. The extent to which it does
this depends on the nature of the filter. If the disciplinary process sets the
sanction bar too high then much of the activity which undermines the
reliability of financial statements will not fall foul of the disciplinary system,
indeed it could be cleansed by this process.
Following the implementation of the reforms recommended by the DTI
Review, responsibility for conduct and discipline is split between the
Accountancy Investigation and Discipline Board (AIDB), which falls within
102 The number of accounting staff devoted to these reviews is currently fourteen. See
<www.frc.org.uk/poba/audit/>. Between June 2004 and March 2005, the AIU
reviewed 27 audit engagements; see 2004/5 Audit Quality Inspections, Public
Report (2005) 14.
103 See <www.frc.org.uk/poba/audit/>. This contrasts to post-Enron United States
regulation where the US Public Company Accounting Oversight Board's inspection
reports are, subject to certain restrictions, made public.
104 An assessment of the probability that AIU Report information about compromised
independence will result in a disciplinary sanction by the Audit Registration
Committee will be impossible without public access to the reports.
105 For example, <http://www.icaew.co.uk/index.cfm?route=135162> no. 11 (as of 10
May 2006) 22.
413
the FRC umbrella, and the professional conduct branch of the applicable
professional association such as the ICAEW's Professional Conduct
Directorate.106 The first port of call for any person wishing to lodge a
complaint is with the Professional Conduct Directorate. The Directorate will
first assess the complaint and, where there are grounds for disciplinary
action, refer the matter to the Investigation Committee.107 The Investigation
Committee may either: dismiss the claim; issue a non-publicized caution;
agree the terms of the sanction with the ICAEW member or member firm
through a consent order; or refer the matter to the Disciplinary Committee.
According to the AIDB Scheme, an investigation must be referred to the
AIDB where the relevant professional organization considers that the matter
raises ìmportant issues' of possible misconduct which affect the public
interest.108 Referrals to AIDB's predecessor, the Joint Disciplinary Scheme
(JDS), were a function of whether the matter raised issues of `public
concern'.109 In practice the `public concern' test resulted in referrals of only
the highest profile corporate failure and fraud. Over ten years of JDS activity
resulted in the commencement of investigations into only eighteen
companies, including such infamous contemporary corporate and accounting
failures as the Maxwell Group, Polly Peck, Barings, and BCCI.110 One can
expect the `public interest' test to result in similar types of referral to the
AIDB. After over two years in operation, the AIDB has initiated
investigations into two high-profile failures.111 Accordingly, in the absence
of high-profile corporate failure, the AIDB will not function as a reliable
source of information about auditor acquiescence.
To what extent do the publicized112 disciplinary findings of the ICAEW's
Investigation and Disciplinary Committees function as a reliable source of
information about acquiescent auditing? The probability of a complaint
being made is, relative to the probability of suit, FRRP investigation or AIU
review, high. Parties who are not owed a duty of care or, where they are,
have suffered no legally cognizable loss can still make a complaint. The
ICAEW estimates that approximately 1,600 complaints are made each
year.113 However, the vast majority of cases that result in Investigation
Committee consent orders or Disciplinary Committee sanctions cannot be
viewed through an acquiescence frame and where they can it is not possible
106 This analysis uses the ICAEW as the representative professional association.
107 See, generally, <http://www.icaew.co.uk/index.cfm?AUB=TB2I_62>.
108 AIDB Scheme, clause 6(2).
109 Joint Disciplinary Scheme, clause 6(b).
110 See, generally, <http://www.castigator.org.uk>.
111 Mayflower plc (<http://www.frc.org.uk/aidb/press/pub0593.html>) and MG Rover
(<http://www.frc.org.uk/aidb/press/pub0909.html>).
112 For the publicized findings of the Disciplinary Committee and Investigation
Committee see: <http://www.icaew.co.uk/index.cfm?route=127834&catID=47337>.
113 See ICAEW, op. cit., n. 107.
414
to determine whether these cases are the product of incompetence or a
conscious choice to acquiesce.114
Any assessment of the implications of the insignificant number of
potential acquiescence cases is necessarily speculative. One available
interpretation would be that there is little acquiescence activity and, to the
extent that it exists, the likelihood of referral, public disclosure, and
punishment is high. Another interpretation, however, is that the disciplinary
offences provide a threshold which would catch only the most egregious of
acquiescence activity. That is, the nature of much acquiescent behaviour is
such that in most instances it does not amount to what the Professional
Conduct Directorate views as malpractice.115 As acquiescent activity rarely
results in accounting treatments that are patently false, an argument that the
auditor correctly applied the applicable standards will invariably be found,
even if an independent third party would find it unpersuasive. Such
arguments may render the attribution of professional misconduct difficult in
acquiescence cases.
Two factors suggest that the latter interpretation may be correct and that
the disciplinary regime is unlikely to connect with most acquiescent
auditing. First, the limited number of cases that could be viewed through the
lens of acquiescence often involve egregious failings. For example, the
Disciplinary Committee recently considered a case involving an audit report
issued by PKF LLP which neither contained a going-concern qualification
nor expressed any concern about the company's going-concern status, even
though the engagement partner was aware of the considerable financial
difficulties of the firm and of the fact that the company's main source of
working capital finance had placed the company in ìntensive care'.116
Secondly, although the FRRP itself imposes no sanctions on auditors, where
114 A review of the published ICAEW cases involving consent orders and disciplinary
sanctions found that only eight cases of the Disciplinary Tribunal cases between
January 2002 and July 2005 and 30 of the Investigation Committee cases between
January 2002 and June 2005 raised issues that could be viewed though the
acquiescence lens. As identifying acquiescence cases is problematic, care should be
taken in relying on these figures. Acquiescence cases were equated with any
evidence of failure to apply audit or accounting standards or other regulation
properly. Clearly many of these cases could be more appropriately classified as
incompetence cases. Where incompetence appeared incontrovertible from the public
record, it was not treated as an acquiescence case. Several cases arising from the
same audit were treated as one failure. Failure to report the failure to file accounts
was not treated as an acquiescence case, although a case could be made for their
inclusion. Please note that this analysis is based on web based information available
at <www.icaew.co.uk> as of August 2005.
115 ICAEW member firms are liable for disciplinary action in the cases set forth in
Clause 5 of ICAEW Disciplinary Bye-Laws (as amended). Member liability is set
forth in Clause 4.
116 See op. cit., n. 112, 6 May 2005, no. 5. See, also, for example, id., 1 December 2004,
L.J. Hughes No. 7.
415
it identifies defects in a company's accounts and those accounts were not
qualified in that respect, it will refer the auditors to the applicable
professional body. However, as detailed by Fearnley et al., in the seven years
after the FRRP's first press notice, the ICAEW took no disciplinary action
against any of the auditors involved in FRRP referrals.117 This was the case
even in relation to the more high-profile judgement-related problems
addressed by the FRRP.118 Although the FRRP identified audit practice that
could be viewed through the lens of acquiescence, this was insufficient to
result in a finding of professional misconduct. This failure of the ICAEW,
until recently,119 to take action following an FRRP referral has led some
commentators to conclude that only `widespread defects in firm's
procedures, or serious incompetence or lack of integrity' will result in
disciplinary action.120 If this is correct, the probability that acquiescent
behaviour will fall within the disciplinary trap is very low and the
disciplinary process will not provide a reliable information source about the
audit firm's reputation for independence.
There is, therefore, no effective public or private mechanism for
identifying and signalling clearly to the market compromised independence.
Accordingly, the informational prerequisite to the use of reputation as a
mechanism for disciplining auditors who acquiesce is not present in the
United Kingdom. This analysis is consistent with Lennox's work on the role
of reputation as a disciplinary device between 1987 and 1994. Lennox found
that where questions were publicly raised about an auditor's reputation, this
did not have any impact on that auditor's ability to expand its client portfolio
nor did it result in a decline in its revenue.121 Lennox concluded that the
reason for this is that litigation does not provide a signal for market
failure.122 A conclusion that neither litigation nor any other regulatory
device provides such a signal is, however, more consistent with his empirical
findings. As demonstrated in this section, post-1994 regulatory develop-
ments have not provided the market for reputational capital with an effective
signal. Any faith placed in an auditor's reputation for independence as a
significant disincentive for a rational auditor to acquiesce is, therefore,
misplaced.
117 S. Fearnley, T. Hines, K. McBride, R. Brandt, `The Problems and Politics of

Regulatory Fragmentation: The Case of the Financial Reporting Review Panel and
the Institute of Chartered Accountants in England and Wales' (2000) 8 J. of
Financial Regulation and Compliance 16, at 22.
118 See, for example, the FRRP investigation into Trafalgar House in 1992 (id., p. 27).
119 In 1999 disciplinary proceedings were initiated in relation to three FRRP referrals:
Concentric, H&C Furnishings, and Stratagem.
120 A. Jack, À Review of the New Financial Reporting Structures' in Financial
Reporting 1993±94: A Survey of United Kingdom Reporting Practice, ed. L.
Skerratt (1993), quoted in Fearnley et al., op. cit., n. 117, p. 27.
121 Lennox, op. cit., n. 92, pp. 788±99.
122 id., p. 800.
416
(d) Enron and reputation costs
The absence of any signalling mechanism does not, however, mean that
potential reputation costs are zero. The recent case of Enron and its auditors,
Arthur Andersen, provides an example of a relatively clear signal of
compromised independence and the resulting reputation costs. However, the
clarity of the signal of compromised independence in the context of Enron is
the product of unique circumstances, involving, amongst others: high-profile
public failure; a company independent investigation that publicly disclosed
in considerable detail both accounting failures123 and auditor independence
concerns; and the criminal prosecution and conviction124 of Arthur Andersen
based on the shredding of audit documentation. Whilst it is clear that
Andersen's collapse was linked to reputation costs as their clients sought less
tainted auditors,125 the probability of such a signal being generated again is
low. Arthur Andersen's demise does not, therefore, significantly alter a
rational auditor's assessment of the acquiescence equilibrium. However, its
impact on reputation costs is likely to be more significant than such a
rational actor assessment. As noted above, actors may overweigh the
probability of the occurrence of an event, and the incurrence of costs related
to that event, due to the prominent availability or vividness of recent similar
events. In the wake of Enron and, for any auditor in the United Kingdom, the
salient absence of Arthur Andersen from the auditing and business world, it
seems highly probable that an auditor's assessment of the reputation costs
that could be incurred if she elects to acquiesce are higher than a rational
actor would determine. As Enron's wake ebbs, one would expect the
overweighing of these costs to become less pronounced.
3. The deterrent effect of disciplinary sanctions
The previous section established that the probability that the disciplinary
procedures of the AIDB or the ICAEW would identify and sanction acquie-
scent activity is low. However, even if the probability of being caught is low,
the sanctions imposed on those who are caught may have an impact on an
auditor's cost-benefit analysis of the acquiescence decision. The imposition
of harsh sanctions, even when discounted by low discovery probability,
could still have an impact on a rational cost-benefit assessment. In addition,
the salience effect of well publicized harsh sanctions may generate a bias
which overweighs an auditor's assessment of the probability of discovery
and sanction.
123 The report of Enron's Special Investigation Committee (`the Powers Report').
124 The conviction was subsequently overturned: Arthur Andersen LLP v. United States
544 US 696.
125 S.Y. Rauterkus and K. Song, Àuditor Reputation and Equity Offerings: The Case of
Arthur Andersen' (2005) 34 Financial Management 121.
417
The sanctions that can be imposed on a firm where its auditor's acquie-
scent behaviour results in a finding of misconduct by the ICAEW's
Disciplinary Committee are potentially burdensome. The Disciplinary
Committee may impose an unlimited fine on the firm or prohibit a member
firm from using the description `Chartered Accountants' for a specified time
period.126 Where the AIDB makes an adverse finding in relation to a
member firm, it has the authority to impose an unlimited fine and order the
suspension or the withdrawal of the audit firm's licence.127 The JDS had
similar sanctions at its disposal. In relation to individual auditors, both the
AIDB128 and the ICAEW's Disciplinary Committee129 have the power to
impose unlimited fines and to withdraw the auditor's practising certificate.
In relation to audit firms, the rational cost-benefit impact and salience
effect of these sanctions is undermined by the fact that in practice the fines
are, as compared to the audit firms earning capacity, very low and no large or
medium-sized firm has ever had its licence withdrawn solely for misconduct
that could be viewed through the acquiescence lens. Even where the JDS
identified egregious failings, for example, in relation to Coopers &
Lybrand's audit of the Maxwell Group, the sanction imposed on the firm
was only a £250,000 fine and costs of £2.1 million, a fraction of the earnings
generated through the long-term relationship with the Maxwell Group. More
recently, in the PKF example outlined above, the ICAEW's Disciplinary
Committee fined PKF £50,000 and ordered them to pay £60,000 of costs.
Accordingly, for the audit firm, not only is the probability of discovery very
low, the nature of the probable sanction following an adverse disciplinary
finding is inconsequential.
In relation to individual auditors, the ICAEW Disciplinary Committee
cases which may be viewed through the lens of acquiescence and that result
in the imposition of sanctions do not result in heavy fines or the auditors
being excluded from membership. For example, in the PKF LLP example
considered above, the engagement partner received a reprimand, a fine of
£5,000, and was ordered to pay £2,850 costs. Exclusion from membership,
however, is not unusual in relation to other types of misconduct such as the
misuse of client monies. The AIDB's predecessor, the JDS, excluded an
auditor from membership for the first time in 2001 in relation to Bird
Luckin's audit of Queens Moat Houses plc and again in 2002 in relation to
Nunn Hayward's audit of the Versaille Group. In no other case where serious
audit failings were identified was the responsible audit partner excluded
from membership by the JDS. A Coopers & Lybrand partner who admitted
twenty complaints relating to the Maxwell Group audits was censured and
126 Disciplinary Bye-Laws of the ICAEW, clause 22(4).

127 AIDB Scheme, Clause 8(5) and Appendix 1.
128 AIDB Scheme, Clause 8(5), Appendix 1.
129 ICAEW Disciplinary Bye-Laws, clause 22(3).
418
fined. Accordingly, not only is most acquiescent activity unlikely to fall
within the disciplinary bodies' radar, where it does so the sanctions, although
doubtless embarrassing, appear manageable.
4. Criminal liability
The proposal set forth in the Company Law Reform Bill 2005 to introduce
criminal liability for individual auditors who `knowingly or recklessly'
provide a misleading, false or deceptive audit opinion130 clearly has the
potential to make up for some of the deterrence deficit in auditor
independence regulation. However, several caveats regarding its
effectiveness can be raised. First, the introduction of a criminal offence
does not resolve the fundamental deterrence problem in the United
Kingdom, which is that there is a low risk of discovery and that auditors
are well placed to identify when discovery becomes more likely. If the
probability of being caught remains low, the shadow of the criminal law
will contract.131 Second, the irregular accounting to which the auditor
acquiesces is unlikely to ignore the applicable accounting standards, rather,
it will benefit from an interpretation of the accounting standard and the
facts of the transaction. The existence of such an interpretation, even if
weak and unpersuasive, and an accompanying factual record will render it
most difficult to show that the auditor knew, or was reckless to the fact,
that the standard was incorrectly applied. This problem is exacerbated
when one considers that in a criminal trial the burden of proof is beyond
reasonable doubt. Only the most egregious and fraudulent of accounting
practices will, therefore, fall within the scope of application of such a
provision. Third, although the government was reported to have considered
imprisonment as an available sanction for conviction of this offence,132 the
Bill only provides for an unlimited fine on conviction on indictment.133
Accordingly, not only is the probability of conviction low, the sanction is
no different than that currently available under the existing professional
disciplinary regime.
130 Company Law Reform Bill (2005), clause 497.

131 See P. Robinson and C.S. Diver, `Does Criminal Law Deter? A Behavioural Science
Investigation' (2004) 24 Oxford J. of Legal Studies 173.
132 `Negligent auditors escape jail in last minute reprieve' Financial Times, 4
November 2005, reporting that the government had considered a seven-year jail
sentence.
133 Company Law Reform Bill (2005), clause 497(4)(a). On summary conviction, the
fine is limited to a fine not exceeding the statutory maximum (clause 497(4)(b)).
419
CONCLUSION
To ensure that auditors act as independent gatekeepers of relevant, reliable,

and comparable information, the financial incentives for auditors to
compromise their independence and to do management's bidding must be
outweighed by the costs of compromising that independence. This article has
shown that there is considerable cause for concern about the United
Kingdom's auditor independence balance of incentives. On the one hand,
developments in sources of audit client revenue have enhanced the incentive
sticks that management can deploy to encourage auditors to accept their
accounting point of view. Changes in managerial compensation
arrangements have increased the likelihood that management will forcefully
deploy those incentive sticks. On the other hand, the financial disincentives
for audit firms to prevent acquiescent activity have diminished: exposure to
litigation has declined; the costs of reputational damage as a disincentive is
undermined by the absence of a reliable signal of audit failure resulting from
compromised independence; disciplinary sanctions for audit firms and
individual auditors are insignificant. Currently this article submits that:
MP CT AV MP CT NV < L RD DS;

and,
MP CT AVP MP CT NVP < LP RDP DSP PS:
This analysis makes clear, however, that the balance can easily be rectified
by stipulating that audit firms cannot provide any non-audit services.
The United Kingdom's incentive equilibrium is but one of several
potential inputs into any decision-making process. Whilst the scope of its
impact will vary according to, amongst others, professional culture, personal
ethical standards, and levels of moral development, regulators should not be
reliant upon counterbalances that are variable and difficult to measure,
control or influence. Regulators can rebalance the incentive equilibrium to
incentivize independence. If they fail to do so, the United Kingdom may not
have to wait too long for its Enron.
420

Enron Auditors Failure by Kershaw

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Enron Auditors Failure by Kershaw

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JOURNAL OF LAW AND SOCIETY

VOLUME 33, NUMBER 3, SEPTEMBER 2006

Waiting for Enron: The Unstable Equilibrium of

A primary function of auditor independence regulation is to ensure that

* Law Department, London School of Economics and Political Science,

THE INCENTIVE EQUILIBRIUM

1. Mapping the equilibrium

Management has strong incentives to present the company's financial

5 s. 235(2) Companies Act 1985.

MP CT AVP   MP CT NVP  < LP  RDP  DSP  PS:10

2. Do auditors engage in cost benefit balancing?10

To analyse auditor independence regulation through an incentive equilibrium

10 `P' represents the proportionate benefit or cost to the individual partner.

11 See, for example, H. Falk, B. Lynn, S. Mestelman and M. Shehata, `Auditor

13 A considerable body of scholarship identifies many persistent digressions from what

1. Audit client revenue

16 A considerable body of scholarship has attempted to assess empirically whether the

Whether management can use these revenue streams to incentivize auditors

31 P. Grout, I. Jewitt, C. Pong, and G. Whittington, `Auditor Professional Judgment:

3. Acquiescence incentives and prospect theory

Kahneman and Tversky's `widely accepted'39 prospect theory provides that

37 Combined Code, para. C.3.6 (2003).

44 A. Tversky and D. Kahneman, `Advances in Prospect Theory: Cumulative

4. Managerial pressure to acquiesce

The probability that auditors will experience an acquiesce-or-lose-revenue

The primary auditor acquiescence deterrent is the expected financial cost to

54 P. Cane, `Using Tort Law to Enforce Environmental Regulations? (2002) 41

57 [1951] 2 K.B. 164.

Whilst managers of companies may pressurize auditors to compromise their

95 S. Fearnley, T. Hines, K. McBride, R. Brandt, `The Impact of the Financial

117 S. Fearnley, T. Hines, K. McBride, R. Brandt, `The Problems and Politics of

3. The deterrent effect of disciplinary sanctions

126 Disciplinary Bye-Laws of the ICAEW, clause 22(4).

130 Company Law Reform Bill (2005), clause 497.

To ensure that auditors act as independent gatekeepers of relevant, reliable,

MP CT AV   MP CT NV  < L  RD  DS;

You might also like

MP CT AVP MP CT NVP < LP RDP DSP PS:10

MP CT AV MP CT NV < L RD DS;