Auditor independence revisited The effects.pdf

International Journal of Disclosure and Governance Vol. 5, 2, 112125 2008 Palgrave Macmillan Ltd. 1741-3591 $30.00112www.palgrave-journals.com/jdg

Asokan Anandarajan is a professor of accounting at the School of Management, New Jersey Institute of Technology. He is a British-quali ed Chartered Management Accountant. He has a Master s degree in Business Administration and a Master s degree in Philosophy from Cran eld University in the UK. He obtained a PhD in accounting from Drexel Univer-sity, Philadelphia. His research interests are in the area of earnings management and developing models to detect earnings overstatement fraud by corporations.

Gary Kleinman earned his PhD in Management from Rutgers University. He has co-authored articles in the areas of international accounting, pensions, tax forecasting, audit group decision-making, accounting education and auditor independence. He co-authored a very well-received book enti-tled Understanding Auditor-Client Relationships: A Multi-faceted Analysis in 2001 (Markus Weiner Publications, Inc.). He is currently a full professor at the Touro Graduate School of Business, located in New York City, NY.

Dan Palmon received his PhD from New York University. He is the Chair of the Accounting, Business Ethics, and Information Systems Department at the Rutgers Business School. His publications appear in The Accounting Review , Journal of Accounting Research , Journal of Business, Journal of Banking and Finance, among other journals . He has served as a Director and Chair of the Audit Committee for several corporations.

EXECUTIVE SUMMARY KEYWORDS: Sarbanes Oxley Act , auditor independence , corporate governance

Following a wave of accounting scandals, the Sarbanes Oxley Act (SOX) was enacted on 30th July, 2002. The objective of the Act was to provide investors with better protection by establishing a new oversight board, improving corporate governance and internal controls, enhancing fi nancial disclosure, and strengthening auditor independ-ence.In this paper, we question the extent to which SOX actually improved auditor independence. We seek to shed some light on auditor independence-related issues by asking: What has the academy learned about SOX s impact on auditor independence in the fi ve years since its enactment? Have researchers even examined key ramifi ca-tions of SOX s requirements? If not, what areas need scrutiny? These are the issues considered here. In essence, we examine whether there is a gap between what regula-tors want to see addressed and what researchers have actu-ally looked at with regard to auditor independence in the post-Sarbanes Oxley period. The Securities and Exchange Commission (SEC) requirement to enhance auditor inde-pendence has been far reaching. It involves providing guidelines on matters relating to the provision of nonaudit services, partner rotation, audit engagement teams, auditor compensation and the role of the audit committees. There-fore, we expected to fi nd a large number of academic research papers on this topic. Surprisingly, the number of such papers is very small, with the results inconclusive. Overall, the academy falls short of providing detailed guidance to the SEC and other regulators on the effectiveness of their guide-lines in enhancing auditors independence. We hope that, after reading our paper, regulators and academicians will agree with us that much more research is needed before assessing the impact of SOX. A recent FEI survey shows that 78 per cent of fi nancial executives agree that the cost of implementing SOX exceed its benefi ts. We hope fi nan-cial executives, whether they hold this view or not, may

Auditor independence revisited: The effects of SOX on auditor independence

Asokan Anandarajan , Gary Kleinman and Dan Palmon * Received (in revised form): 25th January, 2008

* Rutgers Business School, Rutgers University , 180 University Avenue , Newark , NJ 07102 , USA ; Tel: + 1 973 353 5472; Fax: + 1 201 586 0218; E-mail: [email protected]

Anandarajan, Kleinman and Palmon

2008 Palgrave Macmillan Ltd. 1741-3591 $30.00 Vol. 5, 2, 112125 International Journal of Disclosure and Governance 113

also fi nd an interest in reading our paper.Given strong trends toward globalisation of business and the concomitant easing of cross-border stock exchange listing requirements, we also suggest to regulators that insights into the structure of US auditing may be gleaned by examining apparently successful auditing innovations overseas. International Journal of Disclosure and Governance (2008) 5, 112 125. doi: 10.1057/jdg.2008.3; published online 28 February 2008

INTRODUCTION The issue of auditor independence is not new. Mayhew and Pike 1 state that the problem stems from a lack of clarity about one issue; namely for whom does the audit fi rm really work? They pose the question, does the auditor work for the investing public as intended by the securi-ties acts of 1933 and 1934, or alternatively, does the auditor work for the client fi rm? According to the authors, this lack of clarity has resulted in auditors independence being impaired. It is diffi cult, however, to point to tangible evi-dence supporting this view. For example, there are no Securities and Exchange Commission (SEC) enforcement cases addressing independ-ence as an issue in the recent fi nancial reporting failures including WorldCom. There remains, however, a general perception that impaired auditor independence is partially responsible for recent fi nancial reporting failures and investor losses. Concerns have long been expressed that auditor provision of consulting services to cli-ents results in actual, as well as perceived, loss of independence (eg, see Kleinman, Palmon and Anandarajan 2 ). Arthur Andersen, the eponymous founder of the Arthur Andersen accounting fi rm, pithily summarised the con-cerns raised about auditor provision of con-sulting services in 1934. He said,

Some regard [this] movement as wholly unsound, the opening of a territory into which the accountant could not venture except at great risk of loss of professional standing. Others saw in the movement an opportunity for greater and more construc-tive service to business. (cited by Sweeney 3 ).

Whether from the auditor s or society s van-tage point, the fundamental problem remains the same, that is, what is the trade-off between service to the society as refl ected by high-quality audits and the real or perceived threat to that independence arising from, or being exacerbated by, auditor provision of nonau-diting services. Such threats are in addition to those stemming from long auditor client asso-ciation, incentive structures within CPA fi rms that reward client retention, and the like (eg, Kleinman, Palmon and Anandarajan 2 ). It has also been argued that the fundamental problem of auditor independence arises from the fact that, in the United States at least, the client hires, pays and can displace the auditor. While this freedom is somewhat restricted by poten-tially negative publicity owing to SEC-required auditor change reporting requirements and sus-picions as to why the auditor may have been displaced, the fact that the auditor serves at the pleasure of the client remains, despite recent reforms regarding the much greater empower-ment and restructuring of audit committees.

As Norris 4 documents, alleged breaches of independence due to profi table business rela-tionships with clients can be costly to the CPA fi rm (Ernst and Young, in this case). As the Enron and WorldCom episodes further docu-ment, independence loss may be catastrophic for client employees, shareholders, creditors, and the markets and society generally. The collapse of these two huge fi rms further sensitised the audit world (see Sweeney 3 ), the corporate world, 5 and the SEC to the risks to auditor independence that are posed by consulting practices. In 2000, then SEC chairman Arthur Levitt instigated a renewed evaluation of auditor independence. 6 This led to the SEC s issuance of new inde-pendence rules and disclosures in November 2000. 7 After the collapse of Enron, and the fury over the level and nature of the involvement between Arthur Andersen and Enron, as well as revelations about the internal processes at Andersen with regard to retaining Enron as a client, this issue was revisited in both houses of the US Congress. The subsequent accounting

Auditor independence revisited

International Journal of Disclosure and Governance Vol. 5, 2, 112125 2008 Palgrave Macmillan Ltd. 1741-3591 $30.00114

scandals involving WorldCom became the trigger for adoption of the allegedly draconian, but important, Sarbanes Oxley Act (SOX).

Much has been written about Section 404 of the SOX, especially the great expense that it infl icts upon SEC registrants preparing their annual reports. We note that it is not the prepa-ration of the reports, however, that increases the expenses, rather it is the requirement to docu-ment the controls over fi nancial reporting and the concomitant certifi cation that has impacted the corporate bottom line. Had the manage-ment been carefully monitoring its control systems previous to the enactment of Sarbanes Oxley, the expense incurred to improve the impacted systems would not have resulted. Less remarked on, though, is whether the restrictions that SOX imposes on the auditing profession in its relationship to its clients have signifi cantly improved auditor independence. It is diffi cult for researchers to address this question because researchers require empirical evidence rather than intelligent surmise to support a position.

The real question then is whether the fi rms acted to shore up independence, and if so, what actions were taken. Useful studies here could involve researchers examining (by means of case studies) the steps audit fi rms took to enhance independence. A major criti-cism by practitioners is that the independence discussed in the academic literature relates to perceived independence . Clearly, a perception of impaired independence may not mean actual independence impairment. Also, clearly, studies documenting the behaviours of CPA fi rms with regard to independence maintenance should shed useful light on this issue. Currently, no research to date has attempted this, perhaps due to the politically charged nature of the issue.

We seek to shed some light on auditor inde-pendence-related issues by asking: What has the academy learned about SOX s impact on auditor independence in the fi ve year s since its enactment? Have researchers even exam-ined key ramifi cations of SOX s requirements? If not, what areas need scrutiny? These are the issues considered here. In essence, we examine

whether there is a gap between what regulators want to see addressed and what researchers have actually looked at with regard to auditor inde-pendence in the post-Sarbanes Oxley period. We also suggest that insights into the structure of US auditing may be gleaned by examining apparently successful auditing innovations over-seas. We reserve this for the end because the focus of our paper is on the domestic audit market, its opportunities and constraints. In terms of future research however, developments overseas offer a rich source of potential alterna-tive structures that may be worth investigating for application here.

We fi rst defi ne and discuss the importance of auditor independence. The SEC defi ned inde-pendence in a November 2000 release that provided general guidelines with respect to tasks auditors could undertake for their clients. These guidelines were designed to eliminate practices and service lines of business that con-strain auditor independence. SOX then focused on and addressed what auditors could do with respect to nonaudit services. The time between passage of SOX and this writing is brief. It remains important, however, to examine the extent to which accounting researchers have provided insight into the SEC and other regu-lators on the effi cacy of these guidelines. We also highlight areas that, although considered important by the SEC, have not been addressed by researchers.

WHY IS THE ISSUE OF AUDITOR INDEPENDENCE IMPORTANT? Prior to the Sarbanes Oxley Act (2002), man-agement frequently sought to highlight their short-term successes because of incentive plans in place. (Scholarly literature has explained this behaviour using agency theory.) Auditors are supposed to act as safeguards to investors by preventing such self-seeking behaviour. Prentice 8 notes that there are several problems unique to the United States. First, auditors are paid by the fi rm s managers rather than by the stockholders. The second problem, according to Prentice, is that managers may attempt to



buy off their auditors by giving them short-term incentives (eg, increasing their total fees by providing them with consulting work unre-lated to their audit). 9,10 There is another theory that that audit partners would not want con-sulting work because of their concern over the perception of independence. Further, the Public Oversight Board (POB) required this matter to be addressed by the fi rm and audit committees on an annual basis. No research has attempted to reconcile these two views. This is another potential fi eld for research that would be illu-minating to both academics and practitioners alike.

WHAT IS AUDITOR INDEPENDENCE? What is auditor independence? The SEC in November 2001 defi ned independence from a conceptual viewpoint. (See site: http://sec.gov/rules/fi nal/33-7919.htm that has the November 2001 release.) The defi nition is primarily based on that provided by Mautz and Sharaf. 11 The latter defi ne independence as a characteristic of virtue of a good practitioner, who must be independent of any interest that might affect his / her judgment. Kleinman and Palmon 12 review different conceptions of auditor inde-pendence and conclude that the defi nition, and certainly achievement, of independence is profoundly problematic since the objectivity and integrity of judgment, for example, that the The American Institute of Certifi ed Public Accountants (AICPA) describes as being at the heart of independence is impossible of realisation. In Kleinman and Palmon s view, while true independence is extremely dif-fi cult given the wide range of contradictory, social, professional, fi nancial and legal pressures that face the auditor and the audit fi rm, there may be a range of deviations from true inde-pendence that the auditor may be affected by that is not large enough to lead the auditor to behave in a nonindependent manner. Thus, while thoughts and emotions may be engaged in a way that leads the auditor to cognise in a nonobjective manner, his / her behaviour may not be affected.

Conceptual confusion aside, independence is one of the central values upon which the auditing profession s legitimacy is predicated. 13 In other words, independence cannot be com-promised. Francis 14 argues that an auditor s ability to be independent has been eroded by changes in the environment that commenced in the 1970s. For example, the Federal Trade Commission s 1978 actions encouraging com-petition for clients among audit fi rms led to an erosion of standards of conduct regarding client solicitation. Increased competition, while nor-matively a good thing, may have led to increased pressure on incumbent audit fi rms to compro-mise their standards in the hope of retaining clients. Accordingly, we believe that the Federal Trade Commission s action in 1978 exacer-bated any previous problems regarding inde-pendence that may have affl icted the profession. For example, subsequent to the ruling, it was not unusual for accounting fi rms to low ball audit fees to get a client. We have heard anec-dotal evidence that some fi rms would offer to perform an (initial) audit for no fee, betting on future growth. 15 One fi rm was known for not charging an audit fee for start up tech compa-nies. This continued in the mid-1980s, when CPA fi rms began to view internal audit activi-ties as an expanding service area for both new and existing clients. Most fi rms were not that successful in providing outsourcing services to audit clients because of the resistance of the internal audit departments and the audit com-mittee s concern over independence. Enron was an anomaly.

Geiger et al . 16 noted that it was perceived that the provision of consulting services may improve audit quality by providing external auditors with considerable knowledge about the client, its operations and its industry. The greater the external auditor s insight into the client, the better their ability to understand business transactions and identify key audit risks. This was also the argument that the AICPA 17 made in its 1997 White Paper. The audit fi rms that did provide consulting services did so using the rationale that more detailed understanding of



the fi rm and its operations would also enhance the subsequent quality of the audit.

In November 2000, concerned in part by the increasing percentages of audit fi rm revenue that were earned by the audit fi rms from per-formance of nonaudit services for their clients, the SEC adopted a new rule. The latter pro-hibited accounting fi rms from providing cer-tain nonaudit consulting services to their audit clients. The rule also requires public companies to disclose in their proxy statements the fees paid to their independent auditors for audit and nonaudit services. The purpose of adopting the rule was to mitigate the threat to independence posed by auditors providing both auditing and con-sulting services to a client (eg, Schneider et al. 10 ).

This was not the fi rst time, however, that the SEC addressed this issue. After the Foreign Corrupt Practices Act (FCPA) of 1977, the SEC had registrants report these fee relationships. The AICPA POB required member fi rms to report the percentage of audit fees to nonaudit fees. This information was also required to be presented to registrants audit committees. The SEC s November 2000 independence-related action provided more clarity than had existed previously, and updated the requirements.

But was this update to audit to nonaudit fee reporting meaningful? Palmrose and Saul 18 noted that the lack of further SEC action on fees when the reporting requirement was origi-nally instituted (circa 1977 1980s) refl ected the failure of published research to demonstrate that nonaudit service provision compromises auditor independence (See also Kleinman, Palmon and Anandarajan 2 ). Palmrose and Saul 18 further note that even in the wake of the Enron affair, there was no clear evidence that the provision of nonaudit services led to an impaired audit. As Schneider et al . 10 state, only the auditor him / herself knows whether he / she retained his / her inde-pendence! In the extreme, that is certainly true. Also, Kleinman and Palmon 12 argue, based on a comprehensive analysis of the social psycho-logical, sociological and environmental webs that entangle the auditor, that the auditor may lose his / her independence without being aware

that it has been lost (see also Kleinman and Palmon 19 ). The implication of Palmrose and Saul s 18 argument was that researchers had not provided the SEC with conclusive evidence providing impetus for further action. The SEC, however, conducted its own research. In point of fact, one of the reasons that the SEC rescinded its audit and nonaudit fee disclosure requirement in 1980 was because its sponsored research revealed no conclusive evidence that independence had been impaired. Don Kirk, a member of the POB and former Chair of the FASB, also did an independence project in the late 1990s and found that independence had not been impaired by rendering nonaudit services (see Craig 20 ). While it may seem that the issue is the perception of impaired inde-pendence, rather than the fact of independence impairment, understanding what actually hap-pens between the auditor and client is diffi cult absent catastrophic client failure. Nevertheless, even if we grant that distinction, perception of lack of independence is a serious issue in itself given that the role of the auditor is to serve as a guarantor, of sorts, of the informational integrity of the fi rm s fi nancial statements.

Given the CPA fi rms vigorous efforts to derail the SEC s limited efforts at reining in audit fi rm consulting services in 2000 (eg, Norris 21 ), a great deal of supporting evidence would have been required to sustain the SEC effort. Does this situation pertain today? Have accounting researchers tackled the key issues that would provide fodder for the regulatory bodies deliberations as to whether to take fur-ther action to enhance auditor independence? And, if not, what remains to be done?

THE SOX AND ITS IMPACT ON AUDITOR INDEPENDENCE In the summer of 2002, as we now well know, there were several signifi cant accounting scan-dals in the United States. The business failures of Enron, WorldCom, Global Crossing and other large fi rms and the subsequent admission of key offi cials that they had deliberately misled



investors, led the public to question the role and integrity of these companies auditors. The auditor of Enron, Arthur Andersen, suffered a criminal indictment (later overturned) that forced the fi rm s dissolution. These events led the public to strongly question the independence of the auditor. The most far-reaching legislation resulting from the scandals is formally entitled An Act to Protect Investors by Improving the Accuracy and Reliability of Corporate Disclo-sures Made Pursuant to the Securities Laws, and for Other Purposes. Its short title is the SOX. The SOX also created the Public Com-pany Accounting Oversight Board (PCAOB) to set standards for, and to police the behaviour of, auditors. Further consequences included strengthened auditor independence rules and placing the audit committee, not management, in charge of the auditor s engagement.

The effect of SOX has been far reaching. Not only has it transformed corporate governance in the United States, but also it has had a pro-found infl uence abroad. SOX requires publicly traded companies to disclose the amount and nature of fees paid to their external auditors. These disclosures can be incorporated into a company s annual proxy statement or included in its annual 10K fi ling. The purpose of the fee disclosures is to allow investors to evaluate for themselves whether the proportion of fees for audit and nonaudit services causes them to question the auditor s independence. 10,22 (We note that prior to the SOX and subsequent to 1980 when the SEC rescinded ASR 250 and 264, public companies were disclosing the audit fees and nonaudit fees in proxy statements. SOX only formalised this requirement.) In January 2003, the SEC adopted rules to fulfi l the requirements of the SOX. In particular, the SEC took numerous actions. We present these under topic headings.

Nonaudit services The SEC revised the rules relating to the nonaudit services that, if provided to an audit client, would impair the accounting fi rm s inde-pendence. SEC rules also require disclosures to

investors of information related to audit and nonaudit services provided by and fees paid to, the auditor. (We, however, note that some public companies were voluntarily disclosing these data prior to SOX) Sections 201 and 202 of SOX require that an audit committee must approve all nonaudit services with the exception of non-audit services where the total fees amount to less than fi ve per cent of total revenues paid by the audit client to its auditor. (We note that SOX only formalised this requirement. POB required that nonaudit services be disclosed to audit committees. Most audit committees required that nonaudit services be approved prior to auditors performing the services. The reasoning was to address whether independ-ence of the auditors would be impaired.) In particular, Section 201 of the SOX lists nine nonaudit services that would potentially impair the fi rm s independence. (Most of this informa-tion was also addressed in the November 2000 SEC independence release.) The prohibited services (unless approved by the audit com-mittee) include:

Bookkeeping or other services related to the accounting records or fi nancial state-ments of the audit client. Financial systems design and implementa-tion. The new rules prohibit the accounting fi rm from providing any service related to the audit client s information system unless it can be proved that the results of these tests will not be subject to audit tests. Appraisal or valuation services including any process of valuing assets that could be subject to audit tests. Actuarial services involving the determina-tion of amounts recorded in the fi nancial statements and related accounts that could be audited. Internal auditing that relates to the audit client s internal accounting controls, fi nan-cial systems or fi nancial statements. Auditor acting, temporarily or permanently, as a director, offi cer or employee of an audit client, or performing any decision-making,



supervisory or ongoing monitoring func-tion for the audit client. Expert opinions or other expert services to an audit client for the purpose of advo-cating that audit client s interests in litiga-tion or in regulatory proceedings.

Section 202 of SOX requires public disclosure of nonaudit services approved by the audit committee and requires that all fees paid to the accountant be disclosed. (Again we note that SOX only formalised this process.)

Partner rotation It is also required that certain partners on an audit engagement team rotate after no more than fi ve to seven consecutive years, depending on the partner s involvement in the audit (cer-tain small accounting fi rms are exempt from this requirement). This had been a POB requirement since the 1980s until the POB s demise. SOX just adopted the POB rules. An audit partner is defi ned as a member of the audit engagement team who has responsibility for decision making on signifi cant auditing, accounting and reporting matters that affect the fi nancial statements.

Audit engagement team An accounting fi rm would not be considered independent from an audit client if certain members of the management of that issuer had been members of the accounting fi rm s audit engagement team within the one-year period preceding the commencement of audit proce-dures. (See SEC November 2000 release, which also had this rule.)

Additional auditor compensation An accountant would not be considered inde-pendent from an audit client if any audit partner received compensation based on the partner procuring engagements with that client for services other than audit, review and attest services. (This would be akin to a contingency fee, which is prohibited.)

Audit committee approval Require that the company s audit committee pre-approve all audit and nonaudit services pro-vided to the issuer by the auditor. The audit committee now also has a major role to play in the hiring and fi ring of auditors.

Additional provisions of SOX were put in place to establish code of ethics for manage-ment to ensure greater independence (Sec-tions 305 and 406). In addition management is required to test the controls over fi nancial reporting (Section 404). The confl uence of these provisions with the auditor client rela-tional aspects of SOX together provide further insulation between the auditor and its fi ndings and the power of management to displace or threaten the auditor. The confl uence of these provisions, as well as SOX s insistence on greater board independence in its own right, act to mitigate, if not remove, what Arthur Levitt called a fraternal culture on the boards of directors. Instead, Levitt went on to note that a culture of skepticism was developing on cor-porate boards. 23 The success of these efforts is noted by the number of CEOs who are being ousted by their now more assertive boards (see Barrionuevo 23 ). Our personal belief is that this fraternity still exists.

WHAT ARE THE FINDINGS OF CURRENT RESEARCH IN THE POST-SOX PERIOD? Initial research sought to examine investor perceptions of auditor independence in the post-SOX period. See Table 1 for a summary of research.

In a survey involving loan offi cers, Geiger et al . 16 found that respondents viewed the infl uence of SOX on auditor independence negatively. Respondents perceptions of auditor independence and fi nancial statement integrity were negative, thus reducing their willingness to grant a loan. Hodge 24 observed that the non-professional, individual investors in his sample perceived auditor independence to have declined over time, even in the post-SOX period. Given the recency and vividness of the Enron collapse, it is doubtful that auditors would be seen in



a positive light, especially with Andersen s dis-grace still gracing the newspapers front pages. Drawing conclusions about the adequacy of SOX so quickly after Enron, therefore, is very problematic. In a pre-SOX survey, Hussey and Lan 25 surveyed fi nance directors and concluded

that they, overall, agreed that prohibiting non-audit work by auditors would signifi cantly enhance perceptions of auditors independence, with the respondents still pessimistic. The addi-tional constraints placed on audit fi rms through SOX, however, and the heightened sense of

Table 1 : Selected post-SOX studies related to auditor client relationships

Authors Year Finding

Schneider et al . 2006 Examined NAS provision by the auditor and concluded that it impaired the perception of auditor independence, not the reality

Geiger 2002 Surveyed loan offi cers. Found that respondents viewed the infl uence of SOX on auditor independence negatively

Hodge 2003 Investors perceived auditor independence to have declined, even in post-SOX period Chung and Kallapur

2003 Post-SOX study. Found importance of client to auditors offi ce was negatively related to abnormal accruals

Marchesi and Emby

2005 Found that audit partners judgments about client credibility were positively associated with the partners tenure with the client fi rm

Frankel et al . 2002 Found a positive association between auditor fees and the closeness of client earnings to analyst forecasts

Ashbaugh et al . 2003 Found no association between auditor fees and the closeness of client earnings to analyst forecasts

Ruddock et al . 2006 Confi rmed Ashbaugh et al .s result using an Australian sample Whisenant et al . 2003 Did not fi nd a positive association between auditor provision of consulting

services to a client and achievement of economies of scale Mayhew and Pike

2004 Used a laboratory experiment to investigate whether having investors, not managers, hire the auditors increases auditor independence. Their fi ndings confi rmed this expectation

Lu 2006 Using post-SOX data, found that neither the predecessor nor successor auditors opinion was affected by client threats of dismissal

Gul et al . 2007 The results of this study indicate that non-audit fees may impair auditor independence when auditor tenure is short. However, nonaudit fees do not impair auditor independence when auditor tenure is long. The fi ndings about short tenure may refl ect auditor concern about losing the client and the potential revenues. However, this association does not hold as client tenure increases. (The authors used positive discretionary accruals to surrogate for auditor independence)

Kinney et al . 2004 The authors note that SOX assumes that nonaudit services infl uence independence and result in reduced quality of fi nancial reporting. They examined the association of certain elements of nonauditors independence. In particular, they examined whether the provision of services such as fi nancial information systems design and internal audit consulting services could impair independence. Their tests led to a conclusion that auditor independence was not impaired

DeFond et al . 2002 They fi nd no signifi cant association between nonaudit service fees and impaired auditor independence. The key difference here from the two studies cited immediately above is that auditor independence is surrogated for by the auditors propensity to issue going concern audit opinions



auditor legal liability that came with the fall of Andersen, however, may result in tempered pes-simism in some future replication of the Hussey and Lan study.

Legislators and lawmakers appear to believe that before SOX, auditor independence was widely compromised. 26 There are, however, no prior archival studies that provide robust evidence of auditors compromising their independence (eg, see Kleinman, Palmon and Anandarajan 2 ). The next area of research exam-ined different components of SEC legislation to improve auditor independence. In the post-SOX period, Chung and Kallupar 27 found a negative relation between absolute abnormal accruals and an offi ce level measure of client importance to the audit fi rm. This was a study that measured auditor independence indirectly by using abnormal accruals. An abnormal accrual is defi ned as the incremental accrual over and above the expected accrual under the circum-stances. Abnormal accrual was computed as the difference between the actual, total, accrual and the expected accrual. The theory was that higher abnormal accruals refl ected lower earn-ings quality. Lower earnings quality in turn can be attributed to impaired auditor independence. The researchers found a negative association. This implied that lower discretionary accruals were associated with bigger clients. The study s conclusions imply that auditors are more strin-gent with larger clients, not less stringent as theory espouses. Chung and Kallapur con-cluded, post-SOX, that existing incentives may be suffi cient to motivate auditors to be inde-pendent. This may refl ect heightened fear of auditor liability given Andersen s fall, as well as unclear guidance from the PCAOB and the SEC regarding AS-2. An alternate explanation for this fi nding, however, would be that the clients reined in their own impulses to book abnormal accruals given the high level of public attention that Enron brought to large fi rm accounting practices. Section 404 reviews of controls over fi nancial accounting and Sec-tion 302 certifi cation probably fostered this more cautious environment.

If so, then it is unclear whether the results stemmed from (a) audit fi rms becoming stricter; (b) clients being less willing to push the enve-lope with regard to corporate reporting; or (c) some combination of the above. This is clearly an issue that future research should address. It may be very diffi cult, however, to gain access to the intra-fi rm dialogues of auditors and of clients as well as their discussions with each other (see, 28 however, for an excellent study of this type).

While the Chung and Kallapur study adopted a macro view, other studies adopted a micro view by examining the infl uence of dif-ferent aspects of the recent SEC requirements. One SEC requirement was partner rotation. In an experimental study, Marchesi and Emby 29 examined whether duration of tenure with a client would infl uence a goodwill impairment decision. They placed actual audit partners in two groups. One group was told that they had a long-standing relationship with a client, while another group was told that they were new partners. They found that partners with longer association believed clients assertions and therefore concluded that purchased goodwill was not impaired. Newer partners, in contrast, were more likely to conclude that there was impairment. Marchesi and Emby concluded that within-fi rm rotation of partners should help improve auditor independence. Gul et al . 30 found that, in the presence of fees for nonaudit services, the short-term independence of the auditor seemed to be impaired, but not the long-term independence of the auditor. These results are consistent with the Kleinman and Palmon 12,19 theoretical framework for under-standing auditor client relationships.

The bulk of the research to date, however, has examined the impact of the provision of nonaudit services in the post-SOX period. Ashbaugh et al . 31 found no signifi cant associa-tion between fi rms meeting analyst forecasts and auditor fees. Hence, they concluded that there is no evidence to support the claim that auditors violate their independence as a result of their clients purchasing relatively more



nonaudit services. This is corroborated by Ruddock et al. 32 Using Australian fi rms, Ruddock et al. examined whether auditor inde-pendence was impaired by provision of nonaudit services. They postulated that if independence was impaired, then audit reports would show less conservatism. They did not fi nd this and concluded that the provision of nonaudit serv-ices did not impair the auditor s independence. These results were similar to those of Kinney et al . 33 and DeFond et al . 34 Finally, Whisenant et al . 35 concluded that economies of scale (and more effective audit due to a better under-standing of the client s affairs) were not fostered by auditor consulting service provision.

SOX also attempted to increase auditors independence from management by assigning authority to hire and fi re auditors to the audit committee. Prior to SOX, management exerted a signifi cant infl uence over auditor hiring and fi ring. Boards of directors were and still are dominated by management (but see Barrionuevo 23 ), even though audit committees are now made up of independent directors, not insiders. Hence, this situation enables manage-ment to have signifi cant infl uence over auditor hiring and fi ring decisions. Even though the Blue Ribbon Committee on Improving the effectiveness of Corporate Audit Committees (1999) argued that this impaired auditor inde-pendence and suggested that authority to hire and fi re auditors be transferred to the audit committee, this was not done till SOX s enact-ment. Mayhew and Pike 1 created a laboratory experimental situation in order to shed light on whether transferring the power to hire and fi re auditors from managers to investors sig-nifi cantly changes auditor independence. They used auditors and, hence, their study has external validity. They concluded that when managers have reduced power to hire and fi re auditors, based on reactions in an experimental situa-tion, the independence of auditors increased. Hence, they provide evidence to corroborate the stance of SOX that reducing the power of managers to hire auditors improves independ-ence. Clearly, other arrangements may exist, for

example, auditors being hired and fi red based upon relationships with board members and powerful shareholders.

The recent spate of corporate reporting scan-dals tied to backdating of options grants, how-ever, suggests that management still has many opportunities to manipulate corporate accounts in their favour. With these scandals many post-SOX the cry again arose Where were the auditors? The surfacing of these scandals is of too recent vintage to have generated aca-demic research. We note, however, that aca-demic research uncovered the current scandals and triggered the SEC s scrutiny of stock option dating practices. This is an example where man-agement withheld information from the auditor and provided an audit trail that supported man-agement s position. The SEC s enforcement has been against corporate legal counsel and CEO s not, as far as we are aware, audit fi rms. Management certainly has many other oppor-tunities to collude in hiding transactions from the auditor. Given that three key parties (the boards of directors, which at least nominally are required to approve management compen-sation and increasingly should be populated by independent directors; top management, the putative recipients of this corporate largess; and the auditors whose responsibility is to ensure that the options are booked appropriately and were granted pursuant to board action (but see Nocera 36 )) are all involved, this is an issue ripe for study. An interesting question for study is just how far back the practice of backdating options goes.

Lu 37 investigated how companies (a) threats to dismiss auditors and (b) their engagement in opinion shopping infl uenced auditor independ-ence. The results do not indicate loss of inde-pendence by either the predecessor nor successor auditor. This is consistent with older research cited by Kleinman, Palmon and Anandarajan. 2 While Lu found no impact of opinion shop-ping and threatened auditor dismissal on auditor independence, it is interesting to explore in detail the reasons for auditor changes since SOX. This is a subject for future researchers.



In earlier literature (see Kleinman, Palmon and Anandarajan 2 for a review), auditors were often said to lowball auditing bids because they expected to make up any losses on initial year audits in future years since subsequent years auditing costs would be lower, while the audit fee would be the same or higher. Since the low-balling took place when the audit fi rms had other services available to sell clients, this behav-iour no longer has a clear economic rationale. Further, audit costs in subsequent years may not be lower because of a change in scope, but the auditor was locked in on a fi xed fee for a certain period (eg, three years). With the spin-offs or outright sales of auditing fi rm consulting arms, the auditor has less of an economic rent to gain in future years. Instead, the client faces a severe penalty should they displace the auditor. While the successor auditor has the ability to review the prior auditor s working papers, these are very likely to be less informative than having had hands-on experience with the client previously.

SUMMARY AND FUTURE RESEARCH In this paper, we only examine published studies. What has the research found that could be useful to regulators? To date, there have been few published studies. Initial studies examined investors perceptions of the impact of auditor independence. Geiger et al . concluded that inves-tors were still pessimistic. That study, however, was published directly after the implementation of SOX. It is now fi ve years since that study has been published. Has investors initial pessi-mism been alleviated? This is an area for future research. Another viewpoint is that, judging by the great increase in the stock market since the 2000 reporting scandals, there is considerable uncertainty as to whether the auditor plays an important role in the capital market or whether investors are even concerned with auditor independence. Alternatively, investors may have been lulled into feeling comfortable about audit fi rm performance given the clear legal penalties that the audit fi rms face in the era of Sarbanes Oxley. This, too, is an area for future

research that has not been thoroughly exam-ined. It would be interesting to see whether SOX itself, and the impact of SOX on auditor independence, is now viewed more positively by the investing public. An empirical study by Chung and Kallapur demonstrates that auditors are more stringent with larger companies in the post-SOX period. This is just one study. It is four years old and used data gathered almost immediately after the implementation of SOX. Researchers now have access to four more years of data. A replication of this study could reveal whether the tough stance of the auditors has softened in the intervening years. Research on the provision of nonaudit services has been relatively more extensive. The results, however, are confl icting. Frankel et al . 38 conclude that the provision of nonaudit services (and increased fees therefrom) impairs the independence of auditors. Ashbaugh et al ., however, fi nd results to the contrary. Both studies used data imme-diately after the SOX enactment. Hence, this is another area deserving of further scrutiny. Finally, other results tend to support the idea that audit partner rotation, required by SOX, increases independence (Marchesi and Emny). The studies also fi nd that auditor rotation improves independence in the post-SOX period (Mayhew and Pike). Finally, dismissal threats do not appear to have a signifi cant impact on audi-tors decisions, implying an independent auditor stance in the post-SOX period.

The SEC requirement to enhance auditor independence has been far reaching. It involves providing guidelines on matters relating to the provision of nonaudit services, partner rotation, audit engagement teams, auditor compensation and the role of the audit committees. Overall, the paucity of current research on these issues has led the fi eld to fall short of providing detailed guidance to the SEC and other regu-lators on the effectiveness of their guidelines in enhancing auditors independence.

Now let us look at other research opportuni-ties in this area. An interesting research question posed by Kinney 39 is still valid today, namely, do other countries have a better system? Italy



has long proscribed management consulting services rendered by the audit fi rm to an audit client. Have the Italian rules been successful? Does Italy have more investor confi dence in the auditors independence, or in the effi ciency and integrity of the system of audited fi nan-cial reporting and disclosure? Kinney notes that comparative survey research across regulatory regimes could be instructive in determining whether the United State s might be improved, and how that might be accomplished. In Eng-land, the Cadbury Committee recommended the rotation of audit partners within fi rms with respect to audits. China is conducting an open market policy and Chinese fi rms are seeking independent audit services. China is charac-terised by government control and infl uence over CPA fi rms which, in turn, protects auditors from the threat of litigation. The government, in their desire to promote foreign investment, has, however, imposed penalties ranging from suspension of licenses for signing false reports to imprisonment for violation of criminal stat-utes and forced dissolution of fi rms. 40 Have the threats of these actions improved independence in China? What about the French system of having two audit fi rms act jointly as auditors for specifi c clients. 41 Under this system, two audit fi rms serve as auditors for large clients, allowing one of them to be dismissed without gravely damaging the ability of the client to achieve a timely audit in the future since one of the two prior auditors is still on the audit. According to Herbinet, 41 this system has led to markedly lower auditor concentration in France than elsewhere. Given US Treasury Secretary Paulson s concerns about auditor concentration, and the diffi culty second- or third-tier audi-tors have in auditing giant corporations, having audit fi rms team up provides alternatives to the continued dominance of the Big Four. In the alternate, of course, such a system gives compa-nies an ability to seek auditors beyond the Big Four, thus increasing the audit fi rm s perceived risk that they could be replaced by the client.

A further consequence of the French system, however, is that it will be more diffi cult for

any particular audit fi rm to lose its indepen -dence to the client since such an outcome becomes more quickly disoverable by its co-audit fi rm. We note that Canada has had a co-audit fi rm for its banking system for a number of years.

An additional framework for understanding auditor research internationally comes from using the insights of La Porta et al . 42 These researchers argued that legal systems in countries around the globe refl ect the legal system of the former colonial power that had once governed that country, pre-independence. According to La Porta et al ., 42 Anglo-Saxon countries offer the best investor protections. The Anglo-Saxon countries are characterised as having common law systems. Germanic code countries offer a middling level of investor protection, while the Civil Code, characteristic of the legal systems of former French colonies, provides relatively less protection. Research questions that stem from this include: are auditors more likely to toe the line on independence in common law coun-tries than in Germanic code countries since investor protections are better in the former, thereby raising the prospect of audit fi rm litiga-tion losses? Similarly, are auditors in Germanic code countries more likely to toe the line on independence than auditors in Civil Code countries? Given this background, it would be instructive to understand how the interplay between board members, managers and auditors plays out across countries that have adopted different legal codes. Are auditor client rela-tions clearly more constrained in common law countries than in Germanic countries, and so forth? We believe that it is important to under-stand these especially given strong trends toward globalisation of business and easing of cross-border stock exchange listing requirements. Understanding this, along with the interaction of national characteristics (see discussion of Italian, British and Chinese auditor regulatory regimes above) should be of great use in gaining a greater understanding of the determinants of auditor independence and behaviour across a variety of settings.



Finally, the AICPA suggests that independ-ence-related research should analyse issues related to confi dence in the independence of auditors, perceptions of fi nancial statement accuracy and reliability, and discretionary deci-sion making by fi nancial statement users. In this paper, we identify defi ciencies in existing research and provide guidelines on expanding the reach of auditor independence research by looking at developments in the international, as well as domestic, arena.

ACKNOWLEDGMENTS We acknowledge our gratitude to Don Warren for his comments and suggestions.

REFERENCES 1 Mayhew , B . W . and Pike , J . E . ( 2004 ) Does

investor selection of auditors enhance auditor independence? The Accounting Review , 79 (3) , 797 822 .

2 Kleinman , G . , Palmon , D . and Anandarajan , A . ( 1998 ) Auditor independence: A synthesis of theory and empirical research , Research in Accounting Regulation , 12 , 3 42 .

3 Sweeney , J . ( 2004 ) A Firm for All Reasons: Having Rejected the Popular Wisdom of Its Profession, Deloitte Advances With Integrated Services , Found at http://www.consulting-magazine.com/CMCoverFeat-Deloittesept04.html , visited on 5/5/2007 .

4 Norris , F . ( 2004 ) Big Auditing Firm Gets 6-Month Ban On New Business , Found at http://select.nytimes.com/search/restricted/article?res=F30D10FC385F0C748DDDAD0894DC404482 , visited on 5/5/2007 .

5 Abelson , J . ( 2002 ) Enrons many strands: boardroom reactions; Trying Not to Be the Next Enron, Companies Scrutinize Practices , Found at http://select.nytimes.com/search/restricted/article?res=FB0F16FC3F5E0C758EDDA80894DA404482 , on 5/5/2007 .

6 Levitt , A . ( 2000 ) Renewing the covenant with investors. Speech delivered at New York University Center for Law and Business. 28th September .

7 Securities and Exchange Commission ( 2000 ) Revision of the Commissioners Auditor Inde-pendence Requirements. File no. S7-13-00, effective 5th February, 2001 .

8 Prentice , D . ( 2006 ) A voice crying in the wil-derness for auditor independence: Abe Briloff and section 201 of the Sarbanes Oxley act of 2002 , Journal of American Academy of Business , 8 (2) , 190 195 .

9 See Schneider et al. 10 Kleinman , G . Palmon , D . and Anandarajan , A . ( 1998 ) Auditor inde-pendence: A synthesis of theory and empirical research , Research in Accounting Regulation , 12 , 3 42 .

10 Schneider , A . , Church , B . and Ely , K . M . ( 2006 ) Non-audit services and auditor independence: A review of the literature , Journal of Accounting Literature , 25 , 169 211 .

11 Mautz , R . K . and Sharaf , H . A . ( 1961 ) . The Philosophy of Auditing , American Accounting Association, Sarasota, FL .

12 Kleinman , G . and Palmon , D . ( 2001 ) . Under-standing Auditor Client Relationships: A Multi-Faceted Analysis , Markus Weiner Publications, Inc., Princeton .

13 Sikka , P . and Willmott , H . ( 1995 ) The power of independence: Defending and extending the jurisdiction of accounting in the United Kingdom , Accounting, Organizations and Society , 20 (6) , 547 581 .

14 Francis , J . ( 1994 ) Auditing, hermeneutics and subjectivity , Accounting, Organizations and Society , 19 (3) , 235 269 .

15 We are grateful to an anonymous reviewer for this information .

16 Geiger , M . A . , Lowe , D . J . and Pany , K . J . ( 2002 ) Outsourced internal audit services and the perception of auditor independence , The CPA Journal , 72 (April) , 4 20 .

17 AICPA ( 1997 ) Report of the Special Com-mittee on Assurance Services ( www.aicpa.org/assurance/scas/comstud/assind/index.htm ) on 30th August .

18 Palmrose , Z . V . and Saul , R . S . ( 2001 ) The push for auditor independence , Regulation , 24 (Winter) , 4 18 .

19 Kleinman , G . and Palmon , D . ( 2000 ) A nego-tiation-oriented model of auditor client rela-tionships , Group Decisions and Negotiations , 9 (Winter) , 2000, 17 45 .

20 Craig , J . L . ( 1995 ) Strengthening the profes-sionalism of the auditor: An interview with Donald Kirk , CPA Journal , February, found at http://www.nysscpa.org/cpajournal/old/16641850.htm , on 7th December, 2007 .



21 Norris , F . ( 2000 ) THE MARKETS: Market Place; A top accounting executive asks the S.E.C. to amend a new proposal on auditor independence , Found at http://select.nytimes.com/search/restricted/article?res=F20614FF345B0C758DDDA10894D8404482 , on 5/5/2007 .

22 Schneider et al. 10 surveyed the literature on NAS disclosures and concluded that such pro-vision impairs the perception of auditor inde-pendence but not the reality. The authors note that contextual effects (eg, user cognitive style and the presence of audit committees) may affect those perceptions .

23 Barrionuevo , A . ( 2005 ) Changing the guard: The boards; the rise of the boards , Found at http://select.nytimes.com/search/restricted/article?res=F00917FB39580C768DDDAA0894DD404482 , on 5/5/2007 .

24 Hodge , F . ( 2003 ) Investors perceptions of earnings quality, auditor independence, and the usefulness of audited fi nancial information , Accounting Horizons , 17 (Supplement) , 37 48 .

25 Hussey , R . and Lan , G . ( 2001 ) An examina-tion of auditor independence issues from the perspectives of U.K. fi nance directors , Journal of Business Ethics , 32 (July) , 169 178 .

26 Iyer , V . M . and Raghunandan , K . ( 2002 ) Audi-tors employment with clients and interaction with their former CPA fi rm , Journal of Mana-gerial Issues , 14 (Winter) , 486 499 .

27 Chung , H . and Kallupar , S . ( 2003 ) Client importance, non-audit services, and abnormal accruals , The Accounting Review , 78 , 931 955 .

28 Beattie , V . , Fearnley , S . and Brandt , R . ( 2001 ) Behind Closed Doors: What Company Audit is Really About , Palgrave Macmillan, Basingstoke, UK .

29 Marchesi , M . F . and Emby , C . E . N . ( 2005 ) The impact of continuity on concurring partner reviews: An exploratory study , Accounting Horizons , 19 (1) , 1 10 .

30 Gul , F . , Jaggi , B . L . and Krishnan , G . V . ( 2007 ) Auditor independence: Evidence on the joint effects of auditor tenure and non audit fees , Auditing: A Journal of Practice and Theory , 26 (2) , 117 142 .

31 Ashbaugh , H . , LaFond , R . and Mayhew , B . W . ( 2003 ) Do nonaudit services compromise

auditor independence? Further evidence , The Accounting Review , 78 (3) , 611 639 .

32 Ruddock , C . , Taylor , S . and Taylor , S . ( 2006 ) Non audit services and earnings conservatism: Is auditor independence impaired? , Contempo-rary Accounting Research , 23 (13) , 701 746 .

33 Kinney , W . R . Jr. , Palmrose , Z . V . and Scholz , S . ( 2004 ) Auditor independence, non audit services and restatements: Was the U.S. gov-ernment right? , Journal of Accounting Research , 42 (3) , 561 588 .

34 DeFond , M . L . , Raghunandan , K . and Subra-manyam , K . R . ( 2002 ) Do non audit service impair auditor independence? Evidence from going concern opinions , Journal of Accounting Research , 40 (4) , 1247 1274 .

35 Whisenant , S . , Sankaraguruswamy , S . and Raghunandan , K . ( 2003 ) Evidence on the joint determination of audit and non audit fees , Journal of Accounting Research , 41 (4) , 721 744 .

36 Nocera , J . ( 2007 ) Talking Business: Weighing Jobs role in a scandal , Found at http://select.nytimes.com/search/restricted/article?res=F6061FFB395A0C7B8EDDAD0894DF404482 , on 5/5/2007 .

37 Lu , T . ( 2006 ) Does opinion shopping impair auditor independence and audit quality? , Journal of Accounting Research , 44 (3) , 561 583 .

38 Frankel , R . M . , Johnson , M . F . and Nelson , K . F . ( 2002 ) The relation between auditors fees for non audit services and earnings manage-ment , The Accounting Review , 77 (Supplement) , 71 105 .

39 Kinney , W . R . Jr. ( 1999 ) Auditor independ-ence: A burdensome constraint or core value? , Accounting Horizons , 13 (1) , 69 75 .

40 Yang , L . , Dunk , A . , Kilgore , A . and Lin , Z . J . ( 2003 ) Auditor independence issues in China , Managerial Finance , 29 (12) , 57 64 .

41 Herbinet , D . ( 2007 ) Letter to the Editor: Competitive audit market would foster inno-vation , Financial Times , found at http://www.ft.com/comment/letters , on 5/23/2007 .

42 La Porta , R . , Lopez-de-Silanes , F . , Shleifer , A . and Vishny , R . W . ( 1997 ) Legal determinants of external fi nance , Journal of Finance , 52 (3) , 1131 1150 .

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

Auditor independence revisited The effects.pdf

Documents

Transcript of Auditor independence revisited The effects.pdf