jennings et al - 2006 - strong corporate governance and audit firm rotation- effects on judges' independence perceptions and litigation judgments

253 Accounting Horizons Vol. 20, No. 3 September 2006 pp. 253–270 Strong Corporate Governance and Audit Firm Rotation: Effects on Judges’ Independence Perceptions and Litigation Judgments Marianne Moody Jennings, Kurt J. Pany, and Philip M. J. Reckers SYNOPSIS: The Sarbanes-Oxley (SOX) legislation mandated modest threshold levels of corporate board independence and expertise, as well as audit partner (not firm) rotation. One objective was to create an environment supportive of enhanced actual and perceived auditor independence. This study examines whether perceptions of au- ditor independence and auditor liability are incrementally influenced by further strength- ening corporate governance and by rotating audit firms. Our experimental study ad- dresses these questions by analyzing responses of 49 judges attending a continuing education course at the National Judicial College. The experiment manipulates cor- porate governance at two levels (minimally compliant with current corporate gover- nance requirements versus strong) and auditor rotation at two levels (partner rotation versus audit firm rotation). We find that strengthening corporate governance (beyond minimal SOX levels) and rotating audit firms (compared to partner rotation) lead to enhanced auditor independence perceptions. We also find that judges consider audi- tors less likely to be liable for fraudulently misstated financial statements when firm rotation is involved in a minimally compliant corporate governance environment. Keywords: auditor rotation; corporate governance; judges. Data Availability: Confidentiality agreements prevent the authors from distributing the data. INTRODUCTION T he Sarbanes-Oxley Act of 2002 (SOX, U.S. House of Representatives 2002) provides a variety of initiatives intended to enhance audit quality and restore investor confi- dence in capital markets. With respect to auditors, provisions of the Act seek to enhance independence both in fact and in appearance. First, SOX reforms the relationship between corporate boards of directors and external auditors. By elevating the degree of independence and expertise of corporate board members, legislators reasoned that they Marianne Moody Jennings, Kurt J. Pany, and Philip M. J. Reckers are all Professors at Arizona State University. Submitted: May 2005 Accepted: May 2006 Corresponding author: Philip M. J. Reckers Email: philip.reckers@asu.edu 254 Jennings, Pany, and Reckers Accounting Horizons, September 2006 could reduce the pressures brought to bear by corporate management on the auditor to compromise independence. Second, legislators considered mandatory audit partner and firm rotation. By limiting the duration of auditor (or audit firm) client relationships, legislators reasoned that economic incentives associated with compromised independence might be lessened. SOX ultimately mandated new minimal levels of corporate board independence and expertise (discussed below) as well as engagement and review partner rotation, but it did not require that CPA firms be rotated. 1 While corporations have shown some interest in adopting board governance standards beyond those required by SOX, they have resisted corporate policies mandating audit firm rotation. Indeed, 89 percent of corporate boards still do not have an independent chairman (Business Roundtable 2006), and nearly 99 percent of Fortune 1000 public companies and their audit committees had no policy of rotating audit firms as of November 2003. Only 4 percent were even considering rotating auditors a full year following passage of SOX (U.S. General Accounting Office [GAO] 2003, 15). Nevertheless, both regulators and the business press continue to consider the proposition that long-term relationships between companies and their auditors create a closeness between the auditor and management that reduces the public’s perception of auditor independence and audit quality. We report the results of an experimental study of the effects of enhanced levels of corporate board independence and expertise and of audit firm rotation on U.S. judges’ perceptions of auditor independence and auditor liability. Our research instrument first pre- sents judges with background information about a public company, including audited fi- nancial statements, and it asks whether they perceive the external auditors as independent under varied conditions of corporate governance (minimally compliant with regulatory cor- porate governance requirements versus strong) and audit rotation (partner versus firm). Subsequently, the instrument discloses that the earnings were discovered to be fraudulently misstated, and that a lawsuit was initiated. The discovery stage of the lawsuit reveals ad- ditional information regarding the fraudulent actions of management and the conduct of the audit. Judges are then asked to assess auditor liability. We find that both strong corporate governance and audit firm rotation result in increased judicial perceptions of auditor independence. We also find that firm rotation (compared to partner rotation) cause judges to consider auditors less liable for fraudulently misstated financial statements in an environment of minimally compliant corporate governance, a condition typical of many firms. The second section presents background information and develops hypotheses. The third section presents our research method. The fourth and fifth sections present and discuss our results, respectively. BACKGROUND AND DEVELOPMENT OF HYPOTHESES Background The importance of auditor independence, both actual and as perceived by others, has been widely accepted both in theory and by regulators. De Angelo (1981a, 1981b) defines audit quality as the market-assessed joint probability that auditors will discover a breach 1 Section 207 of SOX required the Comptroller General of the United States to conduct a study to review the potential effects of requiring mandatory rotation of registered public accounting firms. The subsequent study issued in November 2003 (U.S. General Accounting Office 2003), concludes that the benefits of mandatory firm rotation are not certain and that more experience with the effects of SOX’s other requirements is needed before any requirements relating to audit firm rotation can be considered further. Strong Corporate Governance and Audit Firm Rotation 255 Accounting Horizons, September 2006 in the accounting system and report that breach. She reasons that auditors who have an economic interest in their clients (i.e., lack financial independence) may be less apt to report a discovered breach or may apply less effort to discover one. She defines economic interest as a future ‘‘quasi-rent’’ stream in which quasi-rents represent the present value of future revenues (less costs) over the expected duration of an auditor-client relationship. The pos- sibility of potentially earning long-term quasi-rents can result in a situation in which the auditor’s professional independence is impaired and/or is perceived to be impaired. Most legal challenges faced by auditors are based on plaintiff arguments that an in- appropriate audit report was issued due to deficient standards of work performance and/or reporting linked to failed independence. A lack of actual independence is a lack of objec- tivity in weighing audit evidence or in reporting. 2 The lack of actual independence is ordinarily unobservable because audit working papers seldom, if ever, acknowledge a lack of objectivity. Accordingly, legal independence assessments must be based on judges’ (or juries’) perceptions of auditor independence, given circumstantial evidence and environ- mental conditions. The Securities and Exchange Commission (SEC) standard for auditor independence also uses a subjective determination based on perception, not necessarily through specific circumstances that compromise independence or through auditor acknowl- edgment of independence issues. 3 In 2000, the SEC expressed concern that the forces that hamper independence are insidious and difficult to document, but are nonetheless forces that impair judgment. The SEC reaffirmed the ‘‘appearance standard’’ that has been applied in both regulatory matters and litigation. 4 SOX’s list of prohibitions on auditor activities and conflicts of interests codified the appearance standard. 5 In our experiment we thus manipulate two factors related to auditor independence—corporate governance and auditor rotation. Judicial Decisions Judges, as a group, are highly experienced in the art of evaluating evidence. Further, given their role in society, judges normatively should decide cases strictly on their merits: the facts and the law. However, research suggests that judges’ objectivity can be compro- mised. In particular, Guthrie et al. (2001, 779) point out that legal scholars representing a variety of schools of thought have long argued that judges do not find facts or apply legal principles in a completely accurate and unbiased fashion. Judges’ views have been found to be subject to: 2 See Elliott and Jacobson (1998) for a discussion of independence concepts. 3 Rule 2.01(b) of Regulation S-X states that ‘‘[t]he Commission will not recognize any certified public accountant or public accountant as independent who is not in fact independent,’’ 17 C.F.R. § 210.2.01(b) (1985). In support of this rule, the SEC has a wide variety of releases (http://www.sec.gov/about/offices/oca/ocaprof.htmpresents a listing of various releases and reference materials). 4 For SEC statements, see Security and Exchange Commission. 2000. Exchange Act Release No. 33-7919: Auditor Independence Requirements. Federal Register 65 (Dec. 5) at 76,008, 76,017. U.S. Government: Washington, D.C. (also available at www.sec.gov Ͻhttp://www.sec.govϾ) For SEC judicial statements on independence, see United States Supreme Court. 1984. United States versus Arthur Young and Co. United States Supreme Court 465 at 805, 817–18: Washington, D.C. (also see supremecourtus.gov) and Second District of New York. 2001. Complete Management Inc. Securities Litigation. Federal Supplement 153 (2d) at 314, 334–35. U.S. Govern- ment: Washington, D.C. Shareholder actions include Second District of Texas. 2002. Enron Corporation Secu- rities, Derivative and ERISA Litigation. Federal Supplement 235 (2d) at 549. U.S. Government: Washington, D.C. and Security And Exchange Commission. 2001. Exchange Act Release No. 43862: Accounting and Au- diting Enforcement release No. AE-1360: Matter of KPMG Peat Marwick LLP. Administrative Proceeding File No. 3-9500 (Jan 19). U.S. Government: Washington, D.C. (also see S.E.C. Docket 74 (2001) 384 at www.sec.gov Ͻhttp://www.sec.govϾ). 5 SOX (ن 107-204). 256 Jennings, Pany, and Reckers Accounting Horizons, September 2006 ● many of the same heuristic biases that afflict others, ● direct exposure to issues in courtrooms over which they presided, ● matters gleaned from other court cases and the popular press, and ● beliefs and attitudes built up over a lifetime of experiences. 6 A significant body of research supports the conclusion that beliefs and attitudes are decision-influencing because individuals often ignore relevant information (or differentially weigh positive and negative information) to support their prior beliefs (e.g., Mahoney 1976, 1977; Lord et al. 1979; Wilson et al. 1993; Pham et al. 2001). Similar findings are likely to apply to judges. Historically, judges’ attitudes and their decisions are significantly correlated (e.g., Champagne et al. 1981; Danelski 1966; Robbennolt 2005). In accounting, laboratory ex- periments find that judges’ attitudes and their judgments relating to auditor liability are related directly and interactively with other environmental factors (Jennings et al. 1991a, 1991b, 1993; Anderson et al. 1997). For example, an extensive literature is developing within accounting pertaining to the outcome-bias phenomenon among judges (see Lowe and Reckers [2006] for a summary). Beliefs and attitudes arise through learning, whereby a person acquires a reaction to an action over a period of time. Once learned, the attitude is triggered automatically when one is exposed to the action or thinks about it (Bagozzi et al. 2003). Since attitudes are ‘‘learned’’ reactions acquired over time, they can also change over time, but they change only modestly in normal times (for reviews see, Ajzen 1996; Eagly and Chaiken 1993). Reckers et al. (2006) document a significant change in judges’ attitudes and beliefs regard- ing auditors over the last decade (similar to that found in other groups) and argue that Enron and related debacles precipitated a significant change in previously engrained atti- tudes and beliefs. Thus, a timely issue is whether SOX reforms produce a counter-effect in judges’ views and influence their judgments on auditor independence and shared liability. Corporate Governance Perceptions of an auditor’s independence and the magnitudes of liability judgments are likely to be affected by the strength of corporate governance. SOX reforms, among other things, target the relationship between corporate boards and external auditors. The extent of independence and expertise of corporate board members potentially alters pressures that might be brought to bear by corporate management on the auditor to compromise indepen- dence. Although SOX and the resulting changes in stock exchange listing requirements include increased corporate governance standards for registrants, significant flexibility still exists in the manner in which such reforms are implemented. To illustrate areas of contin- uing flexibility, consider the following: ● The chairperson of the board may be independent of management or be part of management, including the corporate CEO. ● The proportion of independent directors on the Board may vary. ● The level of financial expertise of members of the Board may vary. ● The level of financial expertise of members of the audit committee may vary. ● The diligence of the audit committee may vary (e.g., number of meetings per year, activities undertaken, etc.). 6 See Guthrie et al. (2001), Champagne et al. (1981), and Redding and Repucci (1999). Strong Corporate Governance and Audit Firm Rotation 257 Accounting Horizons, September 2006 Prior research has shown a direct correlation between financial reporting quality and each of the following: ● board and audit committee independence, ● financial expertise, and ● audit committee diligence. 7 We investigate the impact of enhancements of corporate governance beyond minimal SOX requirements on judicial perceptions of auditor independence and auditor liability. Audit Firm Rotation Numerous researchers have argued that audit firm rotation makes auditors appear to be more independent (e.g., Arel et al 2005; Brody and Moscove 1998; Kemp et al. 1983; Ramsey 2001; Winters 1978; Wolf et al. 1999). Threats to auditor independence are not new; more than 40 years ago, Mautz and Sharaf (1961, 208) warned auditors that: the greatest threat to his independence is a slow, gradual, almost casual erosion of this ‘‘honest disinterestedness’’ the auditor in charge must constantly remind his assistants of the importance and operational meaning of independence. Accordingly, a lengthy tenure is often perceived to limit an auditor’s ability to exercise objectivity and may lead to poor audit quality and audit failures. In this study, we consider the perceptions of judges relating to situations with and without audit firm rotation. Regulators have openly suggested the need for audit firm ro- tation. Lynn Turner (2002), former Chief Accountant of the Securities and Exchange Com- mission, speaking before the United States Senate Committee on Banking, Housing, and Urban Affairs, indicated that to truly protect the independence and integrity of the audit, Congress should require mandatory rotation of the audit firm. Turner’s remarks followed those of Ellen Seidman (2001), Director of the Office of Thrift Supervision, who opined that audit firm rotation every 3–4 years was desirable, in that it would allow a ‘‘fresh look’’ at the organization. Similarly, nonregulatory bodies such as the Conference Board (2003) have suggested the need for firm rotation. A recent GAO study (GAO 2003) observed that further analysis is needed to determine the benefits of mandatory rotation, because the benefits are harder to predict and quantify than the additional costs. However, the combi- nation of no regulatory requirement of audit firm rotation and few companies voluntarily establishing such a policy makes archival research directly addressing rotation virtually impossible. Still, independence in appearance can be examined. In this paper, we address an issue that has not been addressed—the likely effects of audit firm rotation on judges’ perceptions of auditor independence and auditor liability. We do so using an experiment that manipu- lates (1) minimally compliant versus strong corporate governance and (2) firm versus part- ner rotation across subjects. Hypotheses Perceptions of Independence This study addresses two hypotheses related to perceptions of auditor independence, and one hypothesis and one research question related to auditor liability. The first issue addressed is whether further strengthening of corporate board independence and expertise 7 See Arel et al. (2006) for a summary of this research. 258 Jennings, Pany, and Reckers Accounting Horizons, September 2006 will sufficiently alter the environment in which an auditor works to lead judges to perceive enhanced levels of auditor independence. The second issue is whether audit firm rotation (compared to partner rotation) will lead judges to perceive enhanced levels of auditor in- dependence. Our first two hypotheses (stated in the alternative form) thus are: H1: Judges will perceive the extent of auditor independence to be greater under a situation with incrementally stronger corporate governance. H2: Judges will perceive the extent of auditor independence to be greater under a situation with incrementally greater auditor rotation (i.e., firm rotation rather than partner rotation). If a synergy exists between the two manipulated enhancements, then an interaction hypothesis would also be in order. We did not see a basis, ex ante, to predict such a synergy, and no interaction was found. Auditor Liability After eliciting participants’ perceptions of auditor independence and financial statement credibility, 8 we informed participants that the financial statements are misstated. We then asked participants to assess auditor liability. An extensive literature exists within and outside of accounting regarding outcome (hindsight) bias. Knowledge of a misstatement can po- tentially restrict the ability of judges to objectively evaluate auditor performance retrospec- tively. Extant research offers a cognitive explanation of the phenomenon. Judges (and juries) process information in a temporally backward mode, from the given outcome to the ante- cedent conditions. That is, individuals focus their attention on the given outcome and try to explain its occurrence by creating causal links to predecessor events and actions. Once this causal framework is developed, individuals experience difficulty considering how al- ternative outcomes could have occurred (Schkade and Kilbourne 1991; Baron and Hershey 1988; Fischhoff 1975). Events surrounding the recent demise of Arthur Andersen and sim- ilar allegations of impropriety of other audit firms increased public skepticism as to the independence of the auditors. In the context of a failed audit, judges will more likely reconstruct a scenario of auditor guilt in an environment lacking controls, such as audit firm rotation. By way of analogy, Lowe et al. (2002) find that jurors considered auditors more responsible for a failed audit when they failed to use available quality control decision aids. With respect to auditor liability, culpability in the form of a lack of indepen- dence ordinarily can only be inferred from surrounding circumstances; a lack of inde- pendence cannot be proven. Our case materials do not provide explicit proof that the firm lacks independence. Yet, the audit firm rotation condition suggests greater independence safeguards. Partner rotation only, on the other hand, is the historic status quo and as such is a condition more consistent with auditor independence being compromised to achieve personal gain. Accordingly, we hypothesize that audit firm rotation will lead to lower as- sessments of auditor legal liability. 9 More specifically: 8 In addition to asking participants about perceived auditor independence, participants were asked the extent to which they perceived the environment to protect the public, and the perceived likelihood of unintentional errors and intentional misstatements. Findings were highly consistent across these four queries, and thus only the responses to the independence question are reported. 9 Bonner et al. (1998) report that although alleged independence violations are relatively infrequent, when such a violation exists, it has the highest likelihood of resulting litigation. Strong Corporate Governance and Audit Firm Rotation 259 Accounting Horizons, September 2006 H3: Subsequent to an audit that has failed to identify existing fraud, judges will per- ceive lower auditor liability under conditions of audit firm rotation. Predicting the effects of the strength of corporate governance on judges’ perceptions of auditor legal liability is more complex because no directly germane prior research exists. The strength of corporate governance speaks most directly to the culpability/liability of management and corporate board members and only indirectly to auditor liability. Two lines of argument can be advanced as to the potential effects of corporate governance on judges’ assessments of auditor liability. First, as discussed above, extant hindsight research (using judges as well as juries) supports the notion that individuals process information in a temporally backward mode, reconstructing events to make sense of the negative outcome (Lowe and Reckers 2006). In auditing, arguably the most sinister scenario is one of a conspiracy between a non-independent auditor and a corporate client lacking a culture of integrity. An attribution of a lack of independence and legal culpability can be most easily reached in an environment of otherwise relatively weak corporate governance (i.e., an en- vironment in which management pressure on the auditor is likely to be high) and rotation of partners but not firms (a condition in which the audit firm has the highest economic incentives to retain the client). This reasoning suggests that auditor liability would be greatest under the joint condition of partner rotation and minimal board strength resulting in a significant interaction between the experiment’s two manipulated factors. Alternatively, a less cynical possibility is that auditor liability could be greatest under the joint condition of partner rotation and strong corporate governance. That is, if the financial misstatements cannot be attributed at least in part to minimally compliant corporate governance, by default, then greater blame is laid at the feet of the auditor when corpo- rate governance is strong. This result is arguably consistent with attribution theory. A basic attribution theory tenet is that causal attributions are made either to the environment or to the individual—a zero sum game. Thus, if corporate governance seems strong, then the misstated financial statements must be the fault of the auditor. Added support for this second perspective may accrue from prevailing ‘‘comparative contribution’’ judicial philosophy. Under proportionate liability rules, judges’ allocations of damages for the plaintiff’s loss are made by using a percentage of total fault for each party (Raoke and Davidson 1996). Judges may determine that other parties (e.g., corporate board, lax corporate internal con- trols) are responsible in part for the damages and can assign blame through fault apportionment. Accordingly, this second line of thought suggests that the effects of auditor rotation (partner versus firm), once again, may be conditional on the strength of corporate board governance. But it is unclear whether the significance of the auditor rotation manipulation would be greatest in the weak or strong corporate governance condition, or equally signif- icant under each governance condition. That is, we are unsure if auditor rotation will be a main effect or interaction effect. Accordingly, we investigate the issue as a nondirectional research question: RQ1: Subsequent to an audit that has failed to identify existing financial reporting fraud, will judges’ perceptions of auditor liability be a joint product of the strength of corporate governance and the form of auditor rotation? And, if so, what will be the nature of the interaction? 260 Jennings, Pany, and Reckers Accounting Horizons, September 2006 TABLE 1 Profile of Subjects (n ϭ 49) Mean Age Gender (% Female) Years as a judge Owner of stock 48.3 25% 2.61 94% METHOD Participants The experiment was conducted during a continuing professional education training program at the National Judicial College. Table 1 provides a general demographic data profile. Participants under the various experimental conditions did not differ on any of the profiling items. Nine participants who failed manipulation checks were removed from our analyses. The findings are based on the responses of 49 judges. Research Task and Dependent Variables Judges were provided with experimental materials describing the scenario of a typical audit. The materials included background information on the corporate audit client that manufactured a variety of industrial products. Materials also addressed the relationship (fees and tenure) of the audit firm and audit client. 10 The CPA firm had issued unqualified opinions throughout its audit tenure. Manipulated variables included auditor rotation and the corporate governance structure. Additionally, the scenario included summarized income statement and balance sheet information for the current year. Finally, to add stress to the situation, we included the need for the company to restate earnings three years earlier due to inappropriate revenue recognition practices. The background information is presented in the Appendix. After receiving the common background information and the auditor rotation and cor- porate governance manipulations, judges were then asked to reply to the following question to permit an assessment of their perceptions of auditor independence: To what extent do you believe the external auditors, K&L, are independent? Not Independent 0 1 2 3 4 5 6 7 8 9 10 Completely at All Independent Subsequently, participants were informed that current-year net income was misstated. We then solicited the judges’ views on likely auditor liability. A disgruntled employee ‘‘blew the whistle’’ on a fraud involving overstated income effected by prematurely and inappro- priately recognizing revenues on sales that were subsequently cancelled or substantially reduced. A lawsuit was filed when the corporation’s stock price declined precipitously after the fraud disclosure. The experimental materials informed the judges that the discovery process revealed that weak internal controls had been overridden to effect the fraud. The 10 In addition to audit fees of $758,000, fees for nonaudit services performed by the CPA firm were $2,325,875, of which $2,072,374 was related to tax services. Strong Corporate Governance and Audit Firm Rotation 261 Accounting Horizons, September 2006 FIGURE 1 Details of Corporate Governance Manipulation Minimally Compliant Strong Board of Directors Size Number Independent of Management Chairman 15 8 Not Independent (Company Founder) 15 12 Independent Audit Committee Size Members all independent? Expertise (and literacy) Meetings in 2002 Summary Description 3 Yes Minimally Compliant Relatively Weak 5 26 Yes Strong Strong auditor had previously informed the audit committee of weak controls. Judges’ responses to the following question were then elicited. To what extent do you believe the external auditors are legally liable and plaintiff investors should be allowed to recover substantial damages? Not at All 0 1 2 3 4 5 6 7 8 9 10 To a Great Extent Independent Variables Corporate Governance Structure While any number of variables within corporate governance might be manipulated, we selected two levels that comply with current corporate governance requirements (SEC 2003), are realistic, 11 and are documented by prior research as affecting the financial re- porting process. The low level is minimally compliant with regulatory corporate governance requirements and the high level goes beyond regulatory requirements (‘‘strong’’). Specifi- cally, Figure 1 shows that, when compared to the ‘‘minimally compliant’’ condition, the ‘‘strong’’ condition has a chairman who is independent of management, a higher proportion of independent directors on the Board, a higher level of financial expertise of members of the audit committee, and more audit committee diligence. Auditor Rotation This variable has two levels: partner rotation and audit firm rotation. Because SOX requires periodic partner rotation (within the same CPA firm), we select this as the low-independence condition. In contrast, a policy of rotating audit firms is our high- independence condition. This manipulation allows us to directly test whether the level of rotation affects judges’ beliefs. In either type of rotation, partner versus firm, a study must 11 See Taub (2004) for a discussion of continuing differences in strength of corporate governance and audit committees. 262 Jennings, Pany, and Reckers Accounting Horizons, September 2006 TABLE 2 Effects of Auditor Rotation (Hypotheses 1) and Corporate Governance (Hypothesis 2) on Perceptions of Auditor Independence Analysis of Variance for Auditor Independence Source Mean Square F Significance a Governance b 24.964 3.895 .028 Rotation c 26.449 4.127 .024 Interaction d 3.686 .575 n.s. Error 6.471 a One-tailed tests for main effects, two-tailed for interaction. b Minimally compliant with SOX versus strong corporate governance as operationally defined in Figure 1. c Audit partner rotation versus audit firm rotation. d Joint or synergistic influence of governance and rotation experimental treatments on perceptions of independence. also address the current year within the rotation cycle. For example, if a company rotates every four years, then the CPA firm involved could be in any one of the first through the fourth years of the relationship. To provide a strong and realistic test, we tested the final year prior to rotation—regardless of whether it was partner rotation (same firm retained) or firm rotation. In the firm rotation condition, the firm will lose the client within the next year, regardless of how current accounting matters are handled. Thus, the CPA firm has the least to lose by resisting client pressure. Also, the CPA firm personnel are aware that the manner in which the accounting issue is resolved will be obvious to successor auditors (with another firm), who will be expected to review this year’s audit documentation. This scenario is in contrast to the partner rotation situation in which any such review will be performed by different partners within the same firm or, less probably, in conjunction with the peer review process. Manipulation Checks Manipulation checks for both manipulated variables were included at the end of the task. The percentage of subjects who failed either manipulation check was 15 percent (9 of 58). The results of our analyses are substantively the same if these subjects are included or excluded. Accordingly, the subjects who responded incorrectly to either manipulation check are dropped, resulting in a total usable sample of 49. Experimental Design Subjects were randomly assigned to one of four forms of the questionnaire in a 2 ϫ 2 between-subjects design that manipulates mandatory auditor rotation (partner versus firm rotation) and corporate governance (minimally compliant versus strong). We use a between- subjects design to make it difficult for subjects to identify the exact nature of the variables being manipulated (see Pany and Reckers 1987). One-tailed tests are applied to directional hypotheses; two-tailed tests are applied to the nondirectional research. RESULTS Hypotheses 1 and 2 Table 2 presents the analysis of variance results for the first two hypotheses. Hypothesis 1 is supported, given that the mean assessment of independence in the strong corporate [...]... Under the minimum governance condition, firm rotation leads to FIGURE 2 Cell Means for Auditor Independence 6 5.75 Strong Governance 5 Auditor Independence 3.77 4 3.73 Minimal Compliance 3 2.85 2 1 Partner Rotation Firm Rotation Partner Rotation – Firm Rotation Accounting Horizons, September 2006 264 Jennings, Pany, and Reckers TABLE 3 Effect of Auditor Rotation (Hypotheses 3) and Corporate Governance (Research... factors have on awards (Helland and Tabarrok 2000, 327) Implications Subject to the limitations, our study has implications for the auditing profession and U.S capital markets Specifically, judges’ perceptions of auditor independence can be improved by both stronger corporate boards (than currently mandated) and by audit firm Accounting Horizons, September 2006 266 Jennings, Pany, and Reckers rotation; these... 1988 Outcome bias in decision evaluation Journal of Personality and Social Psychology 54 (4): 569–579 Bertelsen, K L 1998 From specialized courts to specialized juries: Calling for professional juries in complex civil litigation Suffolk Journal of Trial and Appellate Advocate (3): 1–26 Bonner, S E., Z-V Palmrose, and S M Young 1998 Fraud type and auditor litigation: An analysis of SEC accounting enforcement...263 Strong Corporate Governance and Audit Firm Rotation governance condition is significantly higher than the mean in the minimally compliant condition The difference in means is significant at traditional levels (p ϭ 028; one-tailed directional test) This result can be seen in the graph in Figure 2, as the line for strong corporate governance is higher than the minimally compliant line Governance. .. 2006 Strong Corporate Governance and Audit Firm Rotation 265 firm rotation in a strong corporate governance setting compared to a weak governance setting While not an explicit part of our tests, finding that strong corporate governance can mitigate the reduction in liability assessments from using audit firm rotation has some interesting implications, which we discuss further in the next section DISCUSSION... Runaway judges? Selection effects and the jury Journal of Law and Economics 16 (2): 306–333 Jennings, M M., D Kneer, and P M J Reckers 1991a The auditor’s dilemma: The incongruous judicial notions of the audit profession and actual auditor practice American Business Law Journal 29 (Spring): 99–125 ———, ———, and ——— 1991b Selected auditor communications and perceptions of legal liability Contemporary Accounting... effects of prior theories on subsequently considered evidence Journal of Personality and Social Psychology 37 (11): 2098–2109 Lowe, D., and P M J Reckers 1994 The effects of hindsight bias on jurors’ evaluations of auditor decisions Decision Sciences 25 (3): 401–426 ———, ———, and S M Whitecotton 2002 The effects of decision-aid use and reliability on jurors’ evaluations of auditor liability The Accounting... the audit Under the strong corporate governance condition, the difference in means between partner and firm rotation is not statistically significant (means of 6.91 versus 6.67) This is why the interaction between our rotation and corporate governance manipulations is significant (p Ͻ 026; two-tailed nondirectional test) Interestingly, judges assess higher liability for Accounting Horizons, September 2006. .. Sarbanes-Oxley Act, management (1) certified the financial statements as presenting fairly Crowne’s financial position and results of operations, and (2) issued a statement indicating that the corporation maintained effective internal control over financial reporting K&L’s audit staff also issued an internal control evaluation opinion indicating that it agreed with management’s conclusion on internal control... Cognition and Motivation to Behavior, edited by P M Gollwitzer, and J A Bargh, 385–405 New York, NY: Guilford Press Anderson, J C., M M Jennings, D J Lowe, and P M J Reckers 1997 The mitigation of hindsight bias in judges’ evaluations of audit decisions Auditing: A Journal of Practice & Theory 18 (2): 20–39 Arel, B., R Brody, and K Pany 2005 Audit firm rotation and audit quality The CPA Journal (February): . Horizons Vol. 20, No. 3 September 2006 pp. 253–270 Strong Corporate Governance and Audit Firm Rotation: Effects on Judges’ Independence Perceptions and Litigation Judgments Marianne Moody Jennings, . (or juries’) perceptions of auditor independence, given circumstantial evidence and environ- mental conditions. The Securities and Exchange Commission (SEC) standard for auditor independence also uses. (e.g., Kadous 2000, 2001; Lowe et al. 2002; Brandon and Mueller 2006) or judges (e.g., Lowe and Reckers 1994; Jennings et al. 1998; Jennings et al. 1993; Anderson et al. 1997). What are the advantages