Auditor Independence

Author(s): Rick Antle

Source: Journal of Accounting Research , Spring, 1984, Vol. 22, No. 1 (Spring, 1984), pp.
1-20
Published by: Wiley on behalf of Accounting Research Center, Booth School of
Business, University of Chicago

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Journal of Accounting Research
Vol. 22 No. 1 Spring 1984
Printed in U.S.A.

Auditor Independence

RICK ANTLE*

Independence is considered an important attribute of external auditors.

Both the AICPA and the SEC have rules which require auditors to
maintain their independence. In fact, the entire debate over whether
audit firms should supply nonaudit services centers on the argument that
the provision of these services impairs the auditor's independence.1
Recently, Watts and Zimmerman [1981] have argued that auditors have
incentives to maintain their independence, even in the absence of gov-
ernmental regulations, so that self-monitoring might be sufficient. At
least since the Securities Acts, independence has been the focus of almost
constant controversy, debate, and analysis.2
Yet the phrase "auditor independence" traditionally has had no precise
meaning. The AICPA and SEC rules on auditor independence are lengthy
and subject to constant reinterpretation, and both bodies have abandoned
attempts to provide a concise definition. In fact, in January 1962, the
AICPA adopted a rule on independence in their Code of Ethics which
read, in part, "Independence is not susceptible of precise definition." The
academic literature on the subject also seems hopelessly ambiguous.
This lack of a useful definition of independence stems from the fact

* Assistant Professor, University of Chicago. Comments by Amin Amershi, Joel Demski,

Ronald Dye, Robert Holthausen, David Kreps, Richard Lambert, Mark Wolfson, and
workshop participants at various universities are gratefully acknowledged. Financial sup-
port was generously provided by the Ernst & Whinney Foundation and the Institute of
Professional Accounting at the University of Chicago. [Accepted for publication September
1983.]
'Accounting Series Release No. 264, subsequently rescinded, presented the Security and
Exchange Commission's position on the provision of nonaudit services by independent
accountants. The Commission was concerned about the effects of the provision of such
services on the auditor's independence and raised the issue of judging the auditor's
dependence on nonaudit services by comparing the revenues generated by them to those
generated by the supply of audit services.
'2 For example, see DeAngelo [1981].
i

Copyright ?), Institute of Professional Accounting 1984

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2 JOURNAL OF ACCOUNTING RESEARCH, SPRING 1984

that previous attempts at definitions were not made within the context
of formal, articulated models. The purpose of this paper is to formulate
and explore two plausible definitions of auditor independence within
such a model. The keys to the analysis are the explicit modeling of the
auditor and manager as expected utility maximizers and the characteri-
zation of the auditor's investigative and reporting activities. Since auditor
independence concerns the relationship between the auditor and man-
ager, this modeling of the auditor and manager is necessary to address
meaningfully the concept of auditor independence. The crucial issue is
the extent to which the auditor cooperates with the manager in pursuit
of their self-interests. The extremes of collusion and no cooperation are
delineated, as well as an intermediate form of auditor-manager cooper-
ation. The extent of such cooperation has a dramatic impact on the
optimal compensation scheme for the auditor. The game-theoretic foun-
dations of the model employed here are presented in Antle [1982].
Section 1 introduces the model and the definitions of independence;
section 2 is devoted to discussing these definitions; and section 3 sum-
marizes the paper.

1. The Model

The essence of auditing is verification. Hence, a rich model of auditing

should contain something to verify. Usually we think of this "something"
as the financial reports that the management of the firm provides to the
owners. The basic issue is why there exists a demand for the confirmation
of these reports. A main reason is that in the absence of verification,
management has incentives to misrepresent the financial condition of
the firm. These incentives arise because the financial reports are used to
evaluate management's performance, which is costly to observe directly.
This suggests modeling auditing in a decision setting involving moral
hazard, with agency theory providing a natural basis for the model.
Agency theory models the contractual relationship between a principal
and an agent, which in this case consists of the owner-principal and the
manager-agent.
Within this setting, I assume that the owner hires an auditor to produce
information used in contracting with the manager. Thus, the auditor is
also an agent and is modeled as such. This auditor-agent is assumed to
behave as if s/he maximizes expected utility while taking investigative
acts and making reports under conditions of moral hazard.
In sections 1.1 and 1.2, respectively, I present the structure of the
model and describe the strategy spaces, after which I introduce the
representation of behavior (section 1.3). Section 1.4 provides a specifi-
cation of the equilibrium concept, the definitions of independence, and
the mathematical programs which become the focus of study.

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 AUDITOR INDEPENDENCE 3

.1 STRUCTURE

The model presented in this section closely resembles those of Chris-

tensen [1981], Ng and Stoeckenius [1979], and Gjesdal [1981]. The owner
of a production process wishes to hire a manager to perform duties that
affect the outcome of that process. The owner can attract a manager to
the firm if and only if the terms of employment provide benefits in excess
of the opportunity cost to the manager of accepting the position. If the
manager joins the firm, s/he is to take some action, a1 E A1 C _N, that
influences the outcome x E 2. The outcome, x, may be interpreted as
some amount of cash to be received by the owner, and is also dependent
on a state, w E Q, where Q is some abstract state space. Formally, let (Q,
F12, A )3 be a probability space. For every a, E Al, x(ai, -) is a random
variable on (Q, FQ, ,u).
The manager's action induces another random variable, denoted m(al,
w) E M C _WN. m might be thought of as net earnings under some set of
generally accepted accounting principles which is statistically related to
the outcome, x.
To this structure, add a set A2 5 -N of possible actions for the auditor.
A2 might represent possible levels of effort for the auditor or the sample
sizes available for substantive tests. Call an element of A2, denoted a2,
the auditor's "investigative act." Whatever the interpretation, a2 creates
a random variable, y E Y C WN' whose realization is observed by the
auditor. y can depend on a, as well as a2, that is, y = y(a1, a2, w). This
provides a wide range of possible interpretations for y. For example, y
might be interpreted as "monitoring" information about a,. Or, to co
tinue the analogy with financial reporting, y might be statistically related
to m, consisting of the results of an examination of the accounting
records of the firm.4
Finally, it will be convenient to allow for some commonly observable
(ex post) information. Let z = z(a1, a2, w) E Z denote a variable that the
owner, manager, and auditor observe. Some examples are that z repre-
sents a general economic indicator such as GNP, or a variable capturing
local market conditions, or even the product of litigation against the
manager and auditor (see Antle [1980]).
These are the basic structural aspects of the model. I now turn to a
description of the strategy spaces.

3A probability space is a set, Q, which represents the state space, a sigma-algebra of

subsets of Q, Fq, which represents the set of events, and a measure, 4t, on those events.
more details, see almost any text on probability theory.
4Note that a2 is not included in the domain of x. Auditors are not directly productive
(or destructive). Their values derive from the information they produce and their willingness
to bear risk. The information produced by an auditor will be used only to provide the
manager with "better" incentives. A more general model would give the owner some
investment or allocation decision.

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4 RICK ANTLE

1.2 STRATEGY SPACES

An important feature of the model is that only the manager observes

the realization of m. After observing m, the manager announces some
purported value of m, call it mr E M. The manager's reporting decision is
modeled as the selection of a function, denoted M (.), from M, the space
of all functions' from M to M. Note that m and m'(m) are both elements
of M. This is consistent with calling m'(m) "a purported m." To continue
the analogy of m and net income, m'(m) could represent the reported net
income, which all individuals in the model can observe.
Recall that the manager also selects the productive act, a1. Therefore,
a move by the manager is a pair (a], t (.)) E Al X M.
The auditor faces a reporting problem similar to the manager's. The
auditor chooses a function 5( ) from Y, the space of functions from Y to
Y. The value 5(y) represents the auditor's report and is assumed to be
observable by the owner, manager, and auditor. So, similar to the man-
ager's move, the auditor's move is a pair (a2, Y(.)) E A2 x Y.
The owner chooses a schedule of cash amounts to pay the manager
and auditor. The amounts paid may depend on all variables that are
mutually observable: mr, Y, and z. Thus, the owner chooses a pair of
functions, denoted (s, t), where s: Y x Z x M -> M is the schedule of
cash paid to the manager, and t: Y X Z x M -* 9is the schedule of cash
paid to the auditor. s and t are called the manager's contract and the
aLuditor's contract, respectively. A pair (s, t) is called an incentive plan.
The set of manager's (auditor's) contracts, which is the set of functions
from Y X Z X M -> A, is denoted S(T). The set of variable incentive
plans is S X T, and is denoted I.
The owner is assumed to move first, and the manager and auditor
observe this move. Thus, the owner begins the game by selecting an
incentive plan. Knowing this incentive plan, the manager and auditor
first decide whether to accept a position with the firm, and if they accept,
they then simultaneously select their (respective) acts and reporting
strategies.6 The analysis will focus on only those equilibria in which the
employment is accepted. Therefore, the discussion of the manager's and
auditor's strategies is confined to productive acts, investigative acts, and
reporting strategies. The following "time line" represents the extensive
form of the game:

' For ease of exposition, I omit a formalization of measurability restrictions. Note that
all of the abstract spaces will be defined with accompanying sigma-algebras, and all
functions introduced will be appropriately measurable with respect to these sigma-algebras.
6 Obviously, other assumptions about sequencing are possible (e.g., the auditor observes
the manager's report before taking an action). I assume that the auditor and manager play
simultaneously because it is reasonable and results in a more tractable formulation. See
Antle [1982] for further discussion.

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 AUDITOR INDEPENDENCE 5

owner manager x, y, z, m realized;

chooses I chooses (a1, m' )); m, y reported; s (, z,
auditor transferred from owner to
chooses (a2, y(.)) manager; t(5, z, mr) transferred
from owner to auditor

So, in the parlance of game theory, the strategies of the players in the
normal form of the game consist of: (i) an incentive plan (owner's
strategy); (ii) a function from I to A1 x M (manager's strategy); and (iii)
a function from I to A2 x Y (auditor's strategy). Notice that no mention
has been made of randomized strategies. An important limitation of the
analysis is that I shall restrict attention to "pure" or nonrandomized
strategies. This has some precedent (see, e.g., Harris and Raviv [1981]),
but the reader is referred to Antle [1982] for an example of its restric-
tiveness in the current context.

1.3 BEHAVIOR REPRESENTATION

Each individual behaves as if s/he maximizes the expected value of a

von Neuman-Morgenstern utility function. The owner's tastes are rep-
resented by the function U0: -> A~P, with the interpretation that the
relevant consequence for the owner is the net cash received. Accordingly,
U() is strictly increasing and (weakly) concave, reflecting the owner's
positive marginal utility for cash and (weak) risk aversion.
The manager's behavior is represented by U1: 9 X A1 -* _q. U1 is
strictly increasing and (somewhere) strictly concave in the first argument
and decreasing in the second. The first argument of U1 captures the
relevance of cash received by the manager, and the second provides a
vehicle for including nonpecuniary returns. One interpretation is tha
is effort expended by the manager, and supplying effort is an undesirable
activity. The important point is that the agent's action affects the return
to the owner and also is the source of private consumption by the agent.
The auditor behaves as if s/he also maximizes the expected value of
the von Neuman-Morgenstern utility function U2: 9 x A2 -A 9, which
again is strictly increasing and concave in the first argument and decreas-
ing in the second. As such, the first argument captures the relevance of
cash received, and the second allows consideration of nonpecuniary
returns to the auditor.
To summarize, for any' (s, t) I E I, (a,, m (.)) E A1 X M and
(a2, y(.)) E A2 x Y, the owner's expected utility is:

EIUU(; (a,, mr()), (a2,y(.)), I}

Uo[x(al, w) - s(5(y(al, a2, w)), z(al, a2, w), h(m(a1, w)))

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6 RICK ANTLE

-t(5(y(al, a2, w)), z(al, a2, w), r(m(al, w)))] do;

the manager's expected utility is:

E IUj; (a,, m' ) (a2, (),I

= f Ui[s(5(y(aj, a2, w)), z(a,, a2, w), Mr(m(al, w))), a,] dA;

and the auditor's expected utility is:

E$U2; (ai, m( .)), (a2, 5( )), I}

= at U2[t('(y(aj, a2, w)), z(al, a2, W), mr(m(al, w))), a2] d1.

1.4 EQUILIBRIUM CONCEPT AND DEFINITIONS OF AUDITOR

INDEPENDENCE

Having described the structure of the model, the strategy spaces, and
behavior representation, I now introduce the equilibrium concept. The
notion of auditor independence is immediately encountered. Game-the-
oretic equilibrium concepts are of two distinct types: cooperative and
noncooperative.7 Cooperative equilibrium concepts assume that the play-
ers can make binding commitments before the game is played. It is
obvious that a completely cooperative concept is not appropriate here,
since if the owner and manager could make any binding agreement they
wished, there would be no incentive for hiring an auditor.8 An element
of noncooperative play is therefore essential for my purposes and, indeed,
is usually present in agency analyses. Hence, it is assumed that all
agreements that the owner can make with the auditor and manager are
embodied in the incentive plan, which is consistent with the level of
detail of the model. That is, it would be senseless explicitly to model the
owner as choosing s(.) and t(.) and then use an equilibrium concept that
assumes the possibility of binding preplay commitments.
The behavior of the auditor and manager vis-a-vis one another now
needs to be specified, and this is where independence issues arise. At the
very least, an independent auditor would not collude with the manager
to the detriment of the owner. On the other hand, even an independent
auditor would not be expected to act against his/her own best interests
in carrying out his/her duties for the owner. But this self-interested
behavior must stop short of collusion. Exactly where the line is drawn

These are technical terms. The reader should not infer that the auditor or manager is
not "cooperative" in the colloquial sense.
8 One solution might be to have another party with whom risk may be shared-but the
there is no reason to call this other party an auditor.

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 AUDITOR INDEPENDENCE 7

between merely self-interested and collusive behavior is the crucial

question confronted in an attempt to define auditor independence. To
address this issue, I first formalize the notion that the auditor is self-
interested, and progress from a mild form of collusion to an extreme
form involving side-payments between the auditor and manager. Two
definitions of auditor independence are formulated.
Minimal self-interest on the part of the auditor would be reflected in
an assumption that his/her behavior is a best response to the behavior
of the other players in the game. That is, if the owner chooses an incentive
plan, I, and the manager chooses the strategy (a,*, mr*(.)), the auditor's
strategy, (a2*, y*(.)), should maximize the auditor's expected utility given
the incentive plan I and given that the manager chooses (a,*, mn *(.)). In
terms of now familiar notation,9 the auditors strategy must satisfy:

(a2*, y*( )) E argmax E{U2; (a,*, m*g,(a2,y ))I4

A2xY

Similarly, the manager must be expected to act according to his/her

self-interest, given the strategies of the other players. Therefore, if the
owner chooses an incentive plan, I, and the auditor chooses the strategy
(a2*, y*(.)), the manager's strategy must satisfy:

(al *, m'() E argmax E IUj; (a,, m" ) (a2*, y*(),I

A1XM

For any incentive plan, I, the subgame defined by I is the game between
the auditor and manager whose strategies are A1 x M and A2 x Y and
whose payoffs are defined by I. Given an incentive plan, the above self-
interest assumptions imply that the auditor and manager play a Nash
(best response) equilibrium in the subgame defined by that plan. How-
ever, even if side-payments between the auditor and manager are ignored,
these self-interest assumptions do not completely specify the auditor's
and manager's behavior. It is well known that there are often multiple
Nash equilibria in games, and that these equilibria do not necessarily
provide the players with the same expected utility levels. This means
that for a given incentive plan, there may be several pairs of strategies
for the auditor and manager that meet the self-interest tests, and that
the auditor and/or manager may be worse off with some of these pairs
than others. The auditor and manager thus face the problem of which of
these alternative subgame equilibria they are going to play.
The problem of choosing among alternative equilibria is a familiar one
to most economists. It is often suggested that this selection is accom-
plished by adopting conventions or establishing institutions (see Demski
and Kreps [1982]). The concept and enforcement of auditor independence
may be one such convention. One reasonably stringent definition of
auditor independence would be to require that the auditor be willing to

'The notation "argmax f (v)" means the set of v's that maximize the function, f(.).

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8 RICK ANTLE

play any Nash equilibrium in the auditor-manager subgame that the

owner desires. This implies that the auditor will not coordinate his/her
play with the manager in such a way as to harm the owner. This leads
to the following definition.
DEFINITION 1. The auditor is strongly independent if s/he plays the
Nash equilbrium most preferred by the owner in the subgame defined
by I.
In an earlier paper (Antle [1982]), I argue that the owner's problem
with a strongly independent auditor may be simplified by restricting
consideration to those incentive plans which induce truthful communi-
cation.1"' Let idM E M and idy E Y denote identity functions. Then on
strategies of the form (a,, idM) and (a2, idy) need be considered, and
owner's problem becomes:

Problem 1.1

Find I E I, ai* E Al and a2* E A2 to maximize:

E I Uo; (ai*, idM), (a2*, idy), II (1.1)

subject to:

EIUi; (ai*, idM), (a2*, idy), I} > Oi, i = 1, 2 (1.2, 1.3)

(a,*, idm) Eargmax E Ul;(a1,, )), (a2*, idy),II (1.4)
AlxM

(a2*, idy) E argmax E U2; (a, *, idm), (a2, Y'( )), II (1.5)
A1xY

Conditions (1.2) and (1.3) require that the incentive plan provides the
manager and auditor with expected utilities at least as great as those
offered by their most favorable (un)employment alternatives. That is,
the parameters, 0, i = 1, 2, are the highest expected utility levels of the
manager and auditor if they do not accept employment with the owner.
Conditions (1.2) and (1.3) then merely reflect the assumption that the
owner employs both an auditor and a manager. Conditions (1.4) and (1.5)
reflect the private nature of the (a,, r (.)) and (a2, y(.)) choices. They
require that the manager and auditor choose actions and (truthful)
reporting strategies that are best responses given the incentive plan that
the owner selects.
Problem 1.1 is the owner's contracting problem with the manager and
a strongly independent auditor. It is essentially a multiperson agency
problem (see Holmstrom [1982a; 1982b]) and has the same economic
nature. The owner's goals are to motivate the auditor and manager to
take the proper actions and to share risk with them efficiently. Typically,
there is a trade-off between efficient risk sharing and motivation (see
Holmstrom [1979]).

10 This is a standard application of the revelation principle. See Myerson [1979]

Harris and Townsend [1981].

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 AUDITOR INDEPENDENCE 9

Problem 1.1 reflects the strong independence of the auditor by allowing

the owner to select any incentive plan for which (a,*, idM) and (a2*, idy)
constitute a Nash equilibrium in the subgame defined by that plan. Of
course, there is a real question here about the auditor's willingness to
play any subgame Nash equilibrium that the owner desires, even when
there may exist subgame Nash equilibria in which both the manager and
auditor receive higher expected utilities. It could be argued that strong
independence implies that the auditor's behavior is not self-interested,
being subverted in favor of gains accruing to the owner. A somewhat
weaker assumption is that the auditor, in choosing among several
subgame equilibria in which s/he receives the same expected utility, will
select the one that the owner most prefers, regardless of the effects on
the manager. This is modeled by requiring that the owner design the
auditor's incentives so that, no matter which strategy the manager takes,
the auditor is willing to take (ai*, idy).11 That is, (1.5) is replaced by:

(a2 id y) E argmax E IU2; (a,, m' ()), (a2, 9'( ),

A1xY (1.5*)

V(al, m- ) Al X M.
I refer to the problem of maximizing (1.1) subject to (1.2)-(1.4) and (1.5*)
as problem 1.2.
(1.5*) requires the auditor's strategy to be dominant, and problem 1.2
is the owner's problem when the auditor is independent as defined below.
DEFINITION 2. The auditor is independent if s/he is willing to play any
dominant strategy in the subgame induced by I.
While independence is weaker12 than strong independence, it still
embodies an element of noncooperative behavior of the part of the
auditor. The fact that the independent auditor's strategy is dominant in
the subgame defined by I does not imply that the auditor and manager
could not both be strictly better off by colluding. To sharpen this
distinction, I shall define the lack of independence. An auditor who is
not independent is one who would engage in side-payment schemes with
the manager. The following definitions formalize these ideas.
DEFINITION 3. A feasible scheme of side-payments from the manager to
the auditor is a function p: Y x Z x M -* R such that:
(i) If p(5, z, rm) > 0, then p(5, z, mr) c s(5, z, mi).
(ii) If p( ', z, mr) < 0, then -p(5, z, mr) c t(5, z, m).
In addition, p(., *, 0 is always considered feasible.

" See Mookherjee [1982] for another (apparently less tractable) formulation of con-
straints to eliminate dominated subgame equilibria. Also, in a restricted setting, Sappington
and Demski [1983] have shown that inducing one agent to play a dominant strategy is the
least costly way to eliminate such equilibria.
l2 Independence is weaker in the sense that it does not presume that the auditor will
always play the Nash equilibrium that the owner desires, especially even when there exists
an alternate equilibrium in which the auditor is better off.

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10 RICK ANTLE

Restrictions (i) and (ii) are necessary to ensure that the party from
whom wealth is transferred has sufficient resources to fulfill his/her
obligation.
DEFINITION 4. A nontrivial side-payment scheme is one which is not
identically zero.
DEFINITION 5. The auditor is not independent if the auditor and
manager choose a feasible, nontrivial side-payment scheme, p(., , ),
and strategies, (a&, rh(.)) and (62, rh(.)), that do not solve problem 1.2.
Several authors (e.g., Mautz and Sharaf [1961], Nichols and Price
[1976], Rittenberg [1977], and Watts and Zimmerman [1979]) have
discussed independence in terms of an auditor's resistance to managerial
pressure or interference. This notion of independence (refusing to ac-
quiesce to the manager's attempted influence) is captured here by the
independent auditor's refusal to engage in side-payment schemes with
the manager. It is important to note that in terms of the model, this
refusal is once again a denial of completely self-interested behavior. The
pressures on auditors to maintain their independence are not modeled
here, but I do discuss several possibilities later.
The three definitions of strong independence, independence, and lack
of independence form the basis for the rest of this paper. In the next
section I discuss these definitions and their implications, using examples
to point out the distinctions among them.

2. Discussion of Independence

2.1 THE ROLE OF THE AUDITOR

Now that I have specified the model and defined strong auditor
independence, it is worthwhile to digress for a moment, before probing
auditor independence further, and discuss the role of the auditor. To
simplify the discussion, I assume that the owner is risk-neutral. This
implies that fully efficient risk sharing calls for the owner to bear all
risk.
To begin, consider the owner's problem of contracting with the man-
ager in the absence of an auditor. The owner would like to motivate the
manager to supply an appropriate level of effort, a,. If the effort level is
not mutually observable, the owner must resort to indirect means of
motivating the manager. Usually, this involves basing the manager's
compensation on some possibly noisy and often costly measure of man-
agerial input. To the extent that the measure is noisy, risk is placed on
the manager, for which s/he must be compensated. Thus, inefficient risk
sharing arises for motivational purposes.
In the model presented here, there is more detail than the discussion
above takes into account. The source of one of these "input measures"
has been explicitly modeled. That is, the accounting report, m4, might be
used to motivate the manager. Put aside the problem of getting the

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 AUDITOR INDEPENDENCE 11

manager to report truthfully for a moment and just assume that m is

mutually observable. The owner might like to tie the manager's payment
to the accounting report so as to give the manager incentives to supply
effort. This may imply that the manager bears some risk of accounting
"measurement error." It may also imply that the manager has incentives
to distort the accounting report, and this is where the auditor enters.
The owner may purchase information from the auditor who possesses
the requisite information production function. This information allows
the owner to contract more efficiently with the manager in the sense
that a lower expected payment to the manager is needed to motivate any
particular action. Loosely speaking, by purchasing the audit report and
basing the manager's compensation on it (in addition to the other
mutually observable variables), the owner can motivate a given level of
effort and impose less risk on the manager. But note that if there is
"measurement error" in the audit report, the manager will bear some risk
because of it.
Of course, the owner faces a similar motivation problem with the
auditor. If the auditor's input, a2, is not mutually observable, indirect
means must be used to give the auditor proper incentives. This may
involve tying the auditor's compensation to noisy measures of input, thus
placing risk on the auditor. And the auditor's incentives to report
truthfully must be maintained in this formulation.
The following example, in which the auditor is assumed to be strongly
independent, illustrates these ideas. It also serves to motivate further the
definition of auditor independence.

Example 2.1

The manager and auditor have work/no work choices represented by

Al = A2 = 10, 1}. Output, x, is normally distributed with mean ka1, w
k a positive constant which is large enough so that it is optimal for the
owner to induce the manager to supply a, = 1.
The information and message spaces, M, Y, and Z are all 10, 1[. The
stochastic relationships among these variables and the auditor's and
manager's acts are given in the matrices below.

m 0
a,
0 .75 .25

1 .125 .875

The ij entry in the above matrix is the probability that m is equal to the
first entry in column j when a, is equal to the first entry in row i. For
example, when a1 = 0, m = 0 with probability .75 and m = 1, with
probability .25. Similarly the matrix giving the distribution of z, which
is independent of m and y, is:

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12 RICK ANTLE

z 0 1

a2~~~~~~.
0 .7, .3

l l 4 .6

Notice that the distribution of z depends only on a2. Finally, the distri-
bution of y depends both on m and a2. When a2 = 0, y is independent of
m and equals 0 with probability .125 and 1 with probability .875. In
contrast, when a2 = 1, y depends on m as follows:

y 0 1
m

0 .8 .2

1 .1 .9
The intuition behind this specification is that the signal y is informative
about m only when the auditor works.
To complete the description of the example, assume that the owner is
risk-neutral and the auditor and manager are risk- and work-averse as
follows:

Ui(c, a) = -- V(ai) i = 1, 2,

where V1(0) = V2(0) = 0, V1(I) = 30, V2(1) = 20. The minimum utility
requirements are 230 for the auditor and 200 for the manager, that is, 01
= 200 and 02 = 230.
Optimal contracts can be found using quadratic programming
techniques13 on the appropriate version of problem 1.2. The optimal
contract for the manager does not depend on z and is given below:

(0, 0) $35,344
(0,1) 30,376
(1, 0) 35,344
(1, 1) 58,980

The expected payment to the manager with this contract is $53,523.

Note how this contract varies with both the auditor's report and the
manager's report. Consider the manager's situation given that s/he
observes and reports 1. The payment is then either $30,376 (with prob-
ability .1 in this truthful equilibrium) or $58,980 (with probability .9).
Thus, the auditor's report is a source of risk for the manager. This risk

13 Grossman and Hart [1983] analyze the mathematical properties of problems such as
the one contained in this example.

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 AUDITOR INDEPENDENCE 13

is placed on the manager because it is the most efficient way for the
owner to motivate hard work and truthful reporting.
Similar observations apply to the auditor's contract, which is given
below:

(9 z, rm) t( 5, z, m)
(0, 0, 0) $70,480
(0, 1, 0) 73,436
(0, 0, 1) 44,719
(0, 1, 1) 65,310
(1, 0, 0) 10,219
(1, 1, 0) 50,187
(1, 0, 1) 55,202
(1, 1, 1) 68,785

The expected payment to the auditor with this contract is $62,964, and
the owner's expected utility with this incentive plan is k - 116,487.
Note how the variables 5, z, and mr affect the payments to the auditor.
For any given pair of reports by the manager and auditor, the auditor
receives more if z = 1 than if z = 0. This reflects the fact that observing
z = 1 is more likely when the auditor works than when s/he does not
work. For any given z, the auditor receives more when the audit report
substantiates the manager's report (i.e., mr = ') than when the reports
conflict (5 # m). This is because, given that the manager reports truth-
fully, the audit report is more likely to substantiate the manager's report
when the auditor works than when s/he does not work. The optimal
contract for the strongly independent auditor utilizes these relationships
efficiently to motivate the auditor and induce truthful reporting.

2.2 STRONG INDEPENDENCE VERSUS INDEPENDENCE

Although this use of the manager's and auditor's reports in determining

the payments to the auditor is efficient, provided that the auditor is
strongly independent, it invites auditor and manager coordination. Sup-
pose that the owner believes that the auditor is strongly independent and
implements the manager's and auditor's contracts given in example 2.1.
Then if the auditor and manager supply no effort and always report 1's,
they are both strictly better off than if they were to work hard and
truthfully communicate their information. The auditor's and manager's
expected utility when they do not work and always report 1 are both
approximately equal to 243, compared with 200 for the manager and 230
for the auditor when they both work and tell the truth. In addition, given
that the manager does not work and always reports 1, the auditor's best
response is to not work and always report 1. And anytime the auditor
always reports 1, the manager's best response (under the contract in the
example) is to not work and report 1. So there is another Nash equilib-
rium in the subgame defined by the incentive plan that both the manager

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14 RICK ANTLE

and auditor prefer, and absent some other consequences of deviating

from the owner's desires or some form of innate honesty, it is reasonable
to expect them to play it. The owner's expected utility in this other
equilibrium is -118,257.
In example 2.2, presented below, the owner assumes that the auditor
is independent, but not strongly independent. This will have quite an
impact on the optimal compensation scheme for the auditor.

Example 2.2

Assume the same structure as in example 2.1, except that now assume
that problem 1.2, not problem 1.1, is the appropriate formulation. There
is no effect on the optimal contract for the manager, so it is as presented
in example 2.1. However, the optimal auditor's contract now depends
only on z. When z = 0 the payment to the auditor is $44,100, and when
z = 1, s/he receives $76,544. The expected payment to the auditor is
$63,566, and the owner's expected utility is k - 117,089.
The owner's expected payment to the independent auditor is $602
higher than the expected payment to the strongly independent auditor.
This reflects the fact that problem 1.2 is generated by adding (in this
case binding) constraints to problem 1.1.'4
It is intriguing that the auditor's contract given in example 2.1 could
also have been generated by adding to problem 1.1 constraints which
require that the auditor's contract not depend on either the manager's
or the auditor's report.'5 This is consistent with AICPA and SEC rules
which forbid independent auditors from owning shares of their clients'
stock and from possessing any direct financial interest or material
indirect financial interest in their clients. It would appear that these
rules are perverse, because an auditor with a healthy stake in a client
would have an incentive to conduct a thorough, cost-effective audit. This
line of thinking no doubt contributed to the regulations in England circa
1850 that required auditors to hold shares in clients (see Berryman
[1974]). But the logic behind the AICPA and SEC rules, as I understand
it, is that the auditor's financial interest in the client affects his/her
incentives to report truthfully because the audit report affects the value
of the client firm. Example 2.1 demonstates that if the auditor were
strongly independent, efficient auditor's contracts (which induce truthful

14 This observation implies that the owner is always at least as well off with a strongly
independent auditor as with an independent auditor.
15 As of this writing, I am investigating the extent to which this result generalizes.

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 AUDITOR INDEPENDENCE 15

reporting) might well depend on the manager's16 and auditor's'7 reports.

Example 2.2 indicates that these prohibitions may have arisen to reduce
the auditor's incentives to coordinate his/her actions and reporting
strategy with the manager to the owner's detriment.
Example 2.1 in Antle [1982] is interesting in this regard. In that
example, the only mutually observable variables are y and m'. The
report then plays a crucial role in motivating the strongly independent
auditor. In that example, no contract which does not depend on the audit
report can motivate the auditor to supply other than minimal effort, and
the auditor would be valueless unless strongly independent.

2.3 LACK OF INDEPENDENCE

As a final point about example 2.2, note that the owner can be made
strictly worse off by the auditor's failure to be independent.'8 There are
several ways that auditor-manager cooperation can be detrimental to the
owner. The auditor may ensure the manager by not truthfully reporting
as the owner expects. For example, the manager could pay the auditor to
"smooth" his reports. In example 2.2, the manager would be willing to
pay the auditor up to $18,980 in return for a guarantee that the audit
report is 1. (This is the amount that leaves the manager indifferent
between working and telling the truth when the auditor works and reports
truthfully, and not working and always reporting 1 when the auditor
always reports 1.) If the manager can induce the auditor into accepting
the side-payment, s/he will supply no effort, and the owner's expected
utility would fall to -122,546. This illustrates the consequences to a
naive owner who does not anticipate the auditor's lack of independence.
When choosing the incentive plan, the owner has presumed that the
auditor and manager will play noncooperatively in the subgame induced
by the incentive plan. An intelligent owner would not make such an
assumption unless it were justified.
Conventional wisdom goes a step further. In the context of example
2.2, if the owner realized that the auditor and manager were going to
cooperate, s/he would not hire the auditor. It would be optimal merely
to accept the fact that the manager could not be induced to supply more

16 The contract might depend on the manager's report if it was informative (see Chris-
tensen [1981] and Holmstrom [1982a]) about the auditor's effort or information.
17 The issue of when this use of the audit report is optimal is formally equivalent to that
of when participation in the setting of performance standards is of value (see Christensen
[1982], Baiman and Evans [1983], Dye [1983], and Penno [1984]). For example, in a model
endowed with much continuity, Dye demonstrates results which imply the following in
problem 1.1: if in the presence of y, z and m are not marginally informative with respect to
a2, then there is some gain to including the auditor's report of y in the audit contract.
18 Because the owner can directly implement any scheme that the auditor and manager
can achieve via side-payments, the owner is at least as well off with an independent auditor
as with an auditor that is not independent.

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16 RICK ANTLE

than the minimal effort and just shut the firm down.'9 In this sense,
independence is a necessary attribute of any auditor that the owner would
be willing to hire in the context of this example. However, my conjecture
is that this "necessity" flavor of independence is far from generally true.
If the owner could monitor the transactions between the auditor and
manager, the owner could more effectively orchestrate their interaction.
If the owner had any means other than the auditor to control the
manager, perhaps the gains to the manager from making side-payments
to the auditor could be greatly reduced.20 The consequences of a lack of
independence depend on the owner's opportunities to detect and penalize
the auditor and manager for shirking and/or not telling the truth.

2.4 THE AUDITOR'S INCENTIVES TO MAINTAIN INDEPENDENCE

The analysis thus far indicates that the owner would prefer an inde-
pendent auditor to one that is not independent. However, given an
incentive plan, the auditor would be at least as well off by foregoing
independence as s/he would be by maintaining it. The model contains
no forces that induce the auditor to maintain independence. This raises
the issue of the mechanism(s) by which independence might be guaran-
teed.
There are several possibilities, and casual empiricism suggests that all
play a role. First, there may be opportunities to monitor the transactions
between managers and auditors. The concern over management advisory
service contracts may have arisen, at least in part, from the fear that
managements could use these contracts as a vehicle for side-payments.
Also, witness the movement toward audit committees to interface with
external auditors.2' Finally, any auditor caught taking a direct bribe from
management would certainly be punished (e.g., through lawsuits).
Another possibility is the role of multiperiod effects. Two distinct types
of effects may be isolated. First, if owners and auditors could write
multiperiod contracts and if the auditor is independent, one could expect
a distribution of the various audit reports in the long run.22 If the observed
long-run frequency of audit reports indicates that the auditor has prob-
ably not worked and truthfully revealed his/her information, the contract
could call for penalties to be imposed on the auditor (see Radner
[1981]).

"9Another alternative is to sell the firm to the manager and endure the resulting
suboptimal risk sharing. The assumption that x is not observable precludes this in the
context of the example. See Antle [1982] for further discussion.
20 Another possibility is that the owner could purchase information about the auditor's
information. This could be used to impose costs on the auditor for deviating from the
truthful communication of y and, thus, raise the cost of inducing the auditor to lie.
21 This, however, creates another layer of incentive problems.
22 This effect could be used to provide incentives for auditors with multiple clients in a
single period as well. In such a setting, the percentage of the various types of audit reports
issued could provide information about whether the auditor was independent.

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 AUDITOR INDEPENDENCE 17

The second type of multiperiod effects involves changes in the market

value of the auditor's services (02 in the model presented earlier) due to
adverse effects of evidence of nonindependence on the auditor's reputa-
tion (see Fama [1980] and Holmstrom [1982b]). The basic idea here is
that O0 may change through time as a function of observations on the
auditor's prior behavior, perhaps due to changes in the demand for his/
her services. These changes would obviously impact the auditor through
changes in the optimal one-period contracts with the auditor.
There have been recent breakthroughs in developing formal models of
reputation development. Using an infinite horizon model, Dybvig and
Spatt [1980] show that reputation effects can induce firms to produce
high-quality products, even though the quality is not observed until after
the product has been consumed. In finite horizon models, Kreps and
Wilson [1982] and Milgrom and Roberts [1982] have shown that if there
is only slight uncertainty about the incentives of an economic agent in
the short run, the agent may forego short-run gains to acquire a reputa-
tion. For example, if there is some chance that the auditor enjoys work
and is always honest, all auditors might mimic this behavior to capture
the rents that the honest, industrious auditor would reap. Datar [1983]
pursues the finite horizon approach. Given the nature of audit-firm
partnerships, an infinite horizon approach might also be appropriate.
Of course, the task of defining independence must be faced, even in a
multiperiod model. Further, repeated play may be a double-edged sword
in the sense that it may foster auditor-manager cooperation rather than
preclude it. I have not discussed the means by which the auditor and
manager make binding commitments, and repeated play may provide the
auditor and manager with effective methods for enforcing their agree-
ments (see Telser [1980] and Kreps et al. [1982]).

3. Summary

Two definitions of auditor independence were formulated and explored

within a model of auditing in a setting of production under moral hazard
with financial reporting. A key aspect of the analysis is the assumption
of moral hazard on the part of the auditor. To see this, consider what
would occur if the auditor's investigative actions and information were
mutually observable. The owner could then contract with the auditor in
such a way as to eliminate any concern over independence by writing a
contract that penalizes the auditor for shirking or lying more than the
maximum amount by which the manager could gain by inducing the
auditor into such behavior.
As is obvious from the definitions, the owner (at least weakly) prefers

23 In fact, reputation effects may help explain the partnership structure of these firms.
See Fama and Jensen [1983a; 1983b] for more discussion of possible determinants of this
structure. Also, Wilson [1983] discusses the market for auditing services and raises several
interesting issues regarding auditor's reputations.

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18 RICK ANTLE

a strongly independent auditor to an independent one to one that is not

independent. However, given an incentive plan, the auditor is always at
least as well off by foregoing independence (or strong independence) as
s/he is by maintaining it. This raises two issues. First, what are the
mechanisms that provide auditors' incentives to maintain independence
in practice? The most likely possibility is that in multiperiod settings,
reputation effects are such that short-term gains to recontracting are
offset by losses in clients due to reduced auditors' reputations. Second, a
partial equilibrium model (such as presented here) has limited potential
for the analysis of all of auditors' incentives to maintain independence
because many of these develop from the impact of a lack of independence
on equilibria in the market for auditors. If the lack of independence
reduces the demand for auditors, the opportunity cost to the auditor of
auditing any particular client will fall (i.e., 02 depends on whether the
auditor is or is not independent). The reputation argument is similar. If
auditors suffer a loss in reputation, fewer clients demand their services
and 02 again falls. I hope that this partial equilibrium analysis can serve
as a forerunner to a more general equilibrium approach.
Finally, a series of examples illustrated the effects of strong auditor
independence and independence on the owner's welfare and on the
optimal compensation scheme for the auditor. If the auditor is strongly
independent, the optimal contract with the auditor in the example
depended on the manager's and the auditor's reports. When the auditor
was assumed to be only independent, the optimal auditor's contract
depended only on the exogenously generated information (z). Although
the generality of this result was not explored, it is interesting in the light
of the AICPA and SEC rules which prohibit auditors from owning shares
in their clients. It also points to the importance of explicitly considering
the degree to which auditors are independent when studying their com-
pensation schemes.

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