HE value of auditing services depends upon the fundamental assumption that certified publicaccountants are independent of theirclients. Experience has shown, however,that independence in fact is insufficienttosupport the credibility of this assumption.Concern about a potential lack of independence in auditors exists withingovernment U.S. Senate, Metcalf StaffReport, 1976; U.S. SEC Report toCongress, 19791 and in the financialcommunity AICPA, Cohen Commission Report, 1978, p. 94. This concernthreatens the viability of the auditorsrole in society, for credibility dependsultimately on the perception rather thanon the fact of independence
Perceptions of Auditors' Independence: An Empirical Analysis Author(s): Randolph A Shockley Source: The Accounting Review, Vol 56, No (Oct., 1981), pp 785-800 Published by: American Accounting Association Stable URL: http://www.jstor.org/stable/247201 Accessed: 09/06/2014 18:57 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive We use information technology and tools to increase productivity and facilitate new forms of scholarship For more information about JSTOR, please contact support@jstor.org American Accounting Association is collaborating with JSTOR to digitize, preserve and extend access to The Accounting Review http://www.jstor.org This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions THE ACCOUNTING Vol LVI, No October 1981 REVIEW Perceptions An of Auditors' Empirical Independence: Analysis RandolphA Shockley ABSTRACT: Recent challenges of the audit independence assumption have impelled the accounting profession to consider ways of improving the credibility of audit reports This study examines the perceived effects of competition, MAS, audit-firm size, and tenure on the risk that audit independence may become impaired Factorial analysis of variance techniques are used to analyze judgments obtained in an experimental task from four subject groups: (a) Big Eight partners, (2) partners from local and regional CPA firms, (3) commercial loan officers, and (4) financial analysts Results indicate that audit firms operating in highly competitive environments, firms providing MAS, and smaller audit firms are perceived as having a higher risk of losing independence An audit firm's tenure with a given client is not significant Though perceptual differences exist between the groups, an overall analysis ranks competition as the most important factor, followed by audit-firm size and MAS value of auditing services depends upon the fundamental assumption that certified public accountants are independent of their clients Experience has shown, however, that independence in fact is insufficient to support the credibility of this assumption Concern about a potential lack of independence in auditors exists within government [U.S Senate, "Metcalf Staff Report," 1976; U.S SEC Report to Congress, 19791 and in the financial community [AICPA, "Cohen Commission Report," 1978, p 94] This concern threatens the viability of the auditor's role in society, for credibility depends ultimately on the perception rather than on the fact of independence.' The publication of the Metcalf Staff Report on "The Accounting Establishment" [U.S Senate, 1976] spurred increased interest in the possibility of nonindependence In its own report [19771, the subcommittee clearly stated its position on independence: T Because of the economic and social environment which now exists, the subcommittee believes it is timely for the public and the accounting profession to reassess the role which independent auditors should play in making the Nation's economic system function effectively Above all, the auditor's essential qualities of independence and professionalism must be strengthened and adapted to the present environment [p 5] HE ' The importance of the appearance of independence is well established in the AICPA Code of Professional Ethics, ET section 52 [1978] This paper is based on my dissertation at the University of North Carolina I would like to thank the following faculty members there for their comments and assistance: Howard Rockness, Lewis F Davidson, Edward J Blocher, William D Perreault, Jr., Dannie J Moffie, and Harold Q Langenderfer The comments of Carl S Warren are also gratefully acknowledged Randolph A Shockley is Assistant Professor of Accounting, University of Georgia Manuscript received January 1980 Revisions received August and November 1980 AacceptedJanuary 1981 785 This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions The Accounting Review, October 1981 786 As concern about independence has increased, the profession has come under increasing pressure to take positive steps to minimize any potential for nonindependence The current controversy over the advisability of restrictions on management advisory services (MAS) is one obvious example [Burton, 1980, p 48] However, empirical evidence useful in evaluating the potential impact of such steps is limited As a result, the accounting profession has been obliged to rely too heavily on conjecture and assertion in its efforts to establish effective policy The objective of this study is to provide additional empirical evidence relevant to perceptions of auditors' independence Specifically, the study examines the effects of four variables on the perceptions of four subject groups with respect to audit independence The four variables are (1) competition for audit clients, (2) whether management advisory services (MAS) are provided to audit clients, (3) the size of the audit firm, and (4) the tenure of an audit firm with a given client The four groups are (1) partners from Big Eight auditing firms, (2) partners from local or regional auditing firms, (3) bank commercial loan officers, and (4) financial analysts It is hypothesized that accountants and financial-statement users perceive a higher risk of a loss of independence for CPA firms which operate in high-competition environments, render MAS, are smaller in size, or have longer periods of tenure Interactions between certain of these factors are also hypothesized The hypotheses are examined by using factorial analysis of variance tech- acterizedby threeselectioncriteria.First, they arepresentin all auditengagements; i.e., they are characteristicsof the audit environment Second, their effects on independencehypotheticallymay be influencedby the institutionof appropriate policy Third, they may be associated with audit firms rather than with individuals Alternative hypotheses associated with each variableappearbelow: niques Two additional hypotheses specify interactionsbetween (1) size and MAS, and (2) size and competition H5: The perceivedrisk of an impairment of independencedue to the renderingof MAS is greaterfor EXPERIMENTALVARIABLESAND HYPOTHESES The independent variables were chosen from a larger set identified by a review of the accounting literature They are char- Hi: CPA firms operating in an environmentcharacterizedby a highlevelof competitionfor audit clients are perceivedas having a greaterrisk of losing their audit independencethan are CPAs operatingin a low-competitionenvironment H2: CPA firms rendering management advisory services to their audit clients are perceived as having a greater risk of losing theirauditindependencethan are CPAsnot renderingsuchservices H3: Large CPA firms (those which perform SEC audits) are perceived as having a smallerrisk of losing their audit independence than are smaller firms (those which not perform SEC audits) H4: CPA firmswhichhave performed a given client'saudit for a period exceeding five consecutive years are perceivedas having a greater risk of losing their audit independence than are firms which have performed the audit for five yearsor less This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions Shockley 787 small audit firms than for larger firms H6: The perceived risk of an impairment of independence due to competition for audit clients is greater for small audit firms than for larger firms of this argument by testing the effect of competition on perceptions of independence For experimental purposes, it implicitly defines the two levels of competition in a particular firm's geographic area as "high" or "low.'" The rationale for these six hypotheses is developed in the following discussion of the four exogenous variables MAS has been the most prevalent topic for independence-related research.2 Most empirical work on the issue has been survey research, the most widely known and quoted group being the studies of Schulte [1965], Briloff [1966], Titard [1971], and Hartley and Ross [1972] In general, these studies report conflicting results; their data can be used to support both sides of the MAS question For example, certain empirical results of Schulte [1965, p 590] and Hartley and Ross [1972, p 44] may be interpreted as support for the position that rendering MAS increases an audit firm's independence These results are consistent with an argument presented by Goldman and Barlev [1974, p 715] Goldman and Barlev's analysis suggests that the offering of nonroutine services makes the auditor more nearly unique to the client, thereby increasing the auditor's value to and relative power over the client Consequently, the audit firm is better able to resist client pressure and so is more likely to maintain its independence However, evidence and arguments opposing the provision of MAS to audit clients are more common Schulte [1965, p 593] lists four arguments which are representative First, CPAs providing consulting services may become advocates of the client making it difficult to Competition Two points of view exist with respect to the desirability of competition in the auditing profession For example, the Metcalf subcommittee's staff believed that too little competition exists, allowing the Big Eight accounting firms too much influence in the establishment of accounting principles and policy [U.S Senate, 1976, pp 35-46] On the other hand, the Cohen Commission states that "It is not lack of competition, however, but possible excessive competition that appears to present a problem to the public accounting profession today" [1978, p 109] The Cohen Commission's chief concern was competition's effect on the extent and quality of audit services provided However, an audit firm which allows competition, and implicitly its fee, to affect the nature of its audit may also be dangerously close to nonindependence As competition for audit clients increases, clients' opportunities and incentives to replace incumbent auditors also increase Reasons for the change may range from minimization of audit fees to a search for a more compliant auditor Regardless, auditors' dependence on their clients may increase if they believe that other auditing firms would be happy to accept the engagement should a client become displeased [Beams and Killough, 1970, p 17] Hypothesis examines the plausibility Management Advisory Services The MAS-independence controversy is now generally referred to as the "scope of services" issue For an excellent history and overview of the issue, see the Public Oversight Board's Scope of Services by CPA Firms 11979] This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions 788 The Accounting Review, October 1981 Consequently, it would be difficult to interpret results based on a comprehensive definition of MAS In this study, MAS are defined for the subjects as the "design and installation of financial and cost accounting systems, budget and inventory control systems, and other accounting-related information systems." While this definition prevents generalization to all consulting services provided by CPAs, it should include the majority of services typically provided dependent on a given client than is a smaller firm because the associated fees usually constitute a smaller proportion of the audit firm's total resources [Mautz and Sharaf, 1961, p 213 ] Second, certain characteristics inherent in small audit practices may increase the danger of impairment, e.g., the nature of the typical small firm client or the tendency toward a more personal mode of service and close relationships with the client Hypothesis is consistent with the direction of effect implicit in these arguments The operational definition of large and small firms is consistent with the two practice divisions of the AICPA: large firms are those which perform audits of SEC-registered corporations, while small firms not perform such audits Audit firm size may also modify the effects of other variables in this study Such an interaction with the MAS variable may occur in at least two ways First, the impact of losing a client and its MAS revenue would not be as great for a large firm as for a smaller firm [Hartley and Ross, 1972, p 48] Second, large CPA firms usually have separate MAS departments Separation of auditors and consultants would act to reduce any negative effect of MAS on audit independence In small firms, however, the auditor and the consultant are often the same person Empirical support for this hypothesis is also available [Schulte, 1965, p 587; Titard, 1971, pp 51-52; Hartley and Ross, 1972, p 48] These arguments are reflected in Hypothesis Audit-firm size may also interact with Size3 Larger audit firms are often considered less subject to a loss of independence than are smaller firms Arguments to this effect commonly follow one of two lines First, a large audit firm tends to be less Size of the audit firm may be interpreted as a surrogate for numerous other variables, possibly including the relative proportion of a CPA firm's total fees obtained from a given client, the size of the client, the presence or absence of specialization of the MAS function within the firm, or the proportion of total fees from a given client represented by MAS fees from that client remain truly independent Second, the audit firm may develop a stake in the client, for its prestige as a successful adviser depends upon the client's success Third, consultants may, in effect, become decision makers, thus placing the audit firm in the position of auditing its own decisions Finally, CPAs may develop too close a relationship with management during an MAS engagement In addition, Hartley and Ross suggest that an audit firm's financial dependence on a client may increase as the size of the MAS fee increases [1972, p 44] Research findings supporting such negative relations between MAS and independence have been reported by Schulte [1965, p 590], Briloff [1966, p 492], Titard [1971, p 51], and Hartley and Ross [1972, p 44] The empirical evidence against MAS appears more convincing than the evidence for it-hence the direction of hypothesis Note, however, that the MAS issue is often not considered in terms of such a simple dichotomy The question has often focused on the advisability of providing specific services This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions Shockley 789 the level of competition in the audit environment Because of its smaller revenue base, a small firm may not be able to withstand the effects of competition as well as a larger firm (Hypothesis 6) It is usually at a disadvantage because of (1) the prestige associated with larger firms, and (2) the superior financial resources available to larger firms [AICPA, Cohen Commission Report, 1978, p 1141 Tenure An audit firm's tenure, the length of time it has been filling the audit needs of a given client, has been cited as having an impact on the risk of a loss of independence: Long association between a corporation and an accounting firm may lead to such close identification of the accounting firm with the interests of its client's management that truly independent action by the accounting firm becomes difficult [U.S Senate, 1976, p 211 In a great many cases, however, the greatest threat to [the auditor's] independence is a slow, gradual, almost casual erosion of his "honest disinterestedness" [Mautz & Sharaf, 1961, p 208] Complacency, lack of innovation, less rigorous audit procedures, and a learned confidence in the client may arise after long association with a client The Metcalf subcommittee's staff considered this danger serious enough to recommend mandatory rotation of auditors as a possible remedy [U.S Senate, 1976, p 211 Hypothesis divides possible levels of tenure into two categories: (1) five or fewer years, and (2) more than five years This division is consistent with the membership requirements of the AICPA's SEC Practice Section, which provide that one partner may not remain in charge of an audit for more than five years It is doubtful that perceptions of an audit report's credibility are influenced by the tenure of an individual (unless he is a sole practitioner) In most cases, the financial statement user's knowledge of the auditor is limited to the name of the auditing firm on its report This study therefore adopts a similar fiveyear criterion While the direction of Hypothesis agrees with the preceding arguments, there is a potential for a causal effect in the opposite direction, i.e., that long association may increase independence Opponents of mandatory rotation point out that a CPA firm gains a deeper familiarity and insight into the client's operations through audit repetition, thus facilitating more efficient, less costly audit service than is possible for a "fresh" auditor Because the client is likely to consider the "tenured" auditor to be more valuable, the audit firm becomes less dependent on the client and better able to resist client pressure METHODOLOGY Essentially, this study analyzes the perceptions of four respondent groups with regard to the effects of the four independent variables on the risk that an audit firm's independence might become impaired The data are analyzed by factorial analysis of variance techniques Sample The study compares the perceptions of CPAs and two groups of financialstatement users Financial analysts were chosen as a surrogate group for investors Bank commercial loan officers were chosen to represent creditors The CPA category was divided into two groups: partners from large national (Big Eight) CPA firms and partners from local or regional firms This segregation was made because it seemed likely that the perceptual models of the two groups are This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions The AccountingReview,October1981 790 TABLE I MAILED, SAMPLINGRATE, AND RESPONSERATE SUMMARYOF QUESTIONNAIRES Group Questionnaires Mailed Sampling Rate Questionnaires Returned Response Rate Big Eightpartners OtherCPAs Loan officers Financialanalysts Overall 77 69 67 64 277 1.00 10 54 58 na 48 44 45 39 176 0.623 638 672 609 635 and response-ratecolumns Note: Questionnairesmailed exclude those undeliverable.Questionnaires-returned excludeunusableresponses significantly different [Briloff, 1966, p 492] All of the subjects were selected from relevant populations in North Carolina The survey instrument was mailed to all 77 partners of Big Eight firms residing in the state Local and regional CPAs were randomly selected from the Directory of Members of the North Carolina Association of Certified Public Accountants Loan officers were selected from the North Carolina membership of the Virginia-Carolina Chapter of Robert Morris Associates Finally, financial analysts were randomly selected from the roster of the North Carolina Society of Financial Analysts Table provides information on sampling and return rates Ten of the 287 questionnaires mailed were undeliverable and are not included in the table Of the questionnaires returned, another ten were unusable due to missing data or ambiguity in group classification Respondents failing to return the questionnaire in four weeks were mailed a second request along with a copy of the original questionnaire.4 Data and Instrumentation The instrument used to collect the data is illustrated in Appendix A Essentially, it presented the subjects with a scaling task Each subject was required to make a subjective estimate [Torgerson, 1958, pp 61-93] of the relative strengths of 16 scenarios along a numerical scale from one to seven The scale represented the risk that an audit firm's independence may become impaired, the dependent variable The scenario depicted a set of circumstances describing a hypothetical audit firm, each scenario representing one of 16 possible combinations of levels of the four experimental variables.5 Each subject was asked to rate each scenario entirely on the basis of the four pieces of information provided therein It is assumed that the data are measured at the interval level.6 The dependent variable scale is anchored at two points, defining the unit and origin of the scale judgments The number was defined as "very high risk," while number was defined as "very low risk." Re4 Approximately 74 percent of the subjects responding did so before the second mailing The independent variables were restricted to two levels for theoretical as well as pragmatic reasons Levels for MAS and size have counterparts in the auditing environment, i.e., the pro-con arguments for MAS and the usual distinction between Big Eight and "other" firms Additional levels for tenure or competition would greatly increase the size of the experimental task, potentially lowering the response rate and effort invested by the subjects, thereby lowering data quality In addition, it was uncertain whether the respondents could usefully distinguish between additional levels Analysis of the data suggests that this is a reasonable assumption Following the method suggested by Grove and Savich [1979, p 5311, correlational analysis was conducted using both interval and ordinal assumptions Little difference was found between the two This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions Shockley 791 spondents had all 16 scenarios available simultaneously and were encouraged to alter any response if they should change their minds while completing the questionnaire.7 To support the assumption of equal intervals, captions were omitted from the intermediate scale values to avoid bias due to differing interpretations of the captions Possible bias due to order and learning effects inherent in the instrument was anticipated To minimize the potential for bias, the order of scenarios and variables within scenarios was randomized and printed separately for each subject.8 Experimental Design Analysis of variance was chosen as the most appropriate methodology for the study because of ANOVA's unique ability to focus on the hypothesized interactions and its utility in dealing with categorical variables The experimental task called for repeated judgments by individual subjects across the 16 scenarios Hence, the experimental design was a repeated-measures block design with one grouping factor and four trial factors [Winer, 1971, pp 514-603] The four grouping factor levels corresponded to the four categories of subjects Each trial factor had two levels corresponding to the levels defined implicitly in hypotheses I through Analysis of the data was conducted at the overall level and within each subject group At the overall level, each of the four experimental factors, their interactions, and the grouping factor were tested for significance Because of the expected perceptual differences between groups, data for each group were also analyzed separately The formal hypotheses for each group would be similar to those presented for the overall analysis The separate analyses allowed computation of a more precise set of descriptive statistics for each group, yielding the relative weights ascribed to the factors by the different groups The w2 statistic was computed for significant effects in all of the analyses This statistic provided a measure of the weight ascribed to each effect by estimating the proportion of variance which it explained [Hays, 1973, pp 484 488] Analysis of variance often finds trivial effects to be significant because the F statistic is partly a function of sample size The wt2 statistic provides additional insight into an effect's significance For examples of its use in the accounting literature, see Ashton [1974], Joyce [1976], Hofstedt and Hughes [1977], and Schultz and Gustavson [1978] RESULTS Overall Analysis The overall analysis of variance is summarized in Table Tests of the main effects in the ANOVA model are equivalent to tests of Hypotheses through Tests of the first-order interactions (1) MAS and size of the audit firm, and (2) competition and size are equivalent to tests of Hypotheses and Interactions between the grouping factor and independent variables indicate differences between groups in the perceived significance of the independent variables Three of the four main effects were significant at the 01 level This result indicates that, overall, the subjects perceive (1) that higher levels of competition increase the risk that independence may be impaired, (2) that CPA firms which ' This technique, described as the "multiple stimulus procedure" by Torgerson [1958, p 66], helps to minimize bias due to modification of the psychological scale as a subject progresses through the stimulus series ' The printing of the randomized instruments was accomplished by a computerized randomization procedure in combination with a text editing program This content downloaded from 188.72.96.138 on Mon, Jun 2014 18:57:47 PM All use subject to JSTOR Terms and Conditions The AccountingReview,October1981 792 TABLE2 ANALYSISOF VARIANCEFORALL SUBJECTRESPONSES Main Effects C Competition M MAS S Size T Tenure G Groups Interactions CM CS CT CG MS MT MG ST SG TG SS df MS F p 647.9 234.7 544.4 8.6 454.9 i 1 647.9 234.7 544.4 8.6 151.6 134.2* 85.6* 132.2* 3.9 13.8* 000 000 000 050 000 6.6 13.6 1.9 45.4 181.2 4.1 1 1 3 6.6 4.5 1.9 15.1 60.4 1.4 1.1 11.3* 3.4 1.3 5.5* 14.7* 302 001 986 423 067 262 001 687 000 601 Note: Repeated-measures designs use the mean square associated with the specific treatment-subject interaction as the F ratio denominator Though not shown above, each error term has 172 degrees of freedom None of the second or higher order interactions are significant for a=.01 *p[...]... classic study of gastroenterologists' diagnoses of the benignancy or malignancy of gastric ulcers, Hoffman et al [1968] reported a level of consensus of 38 Joyce [1976, p 42], using CPAs as subjects, found a consensus level of 373 in a study of audit program planning Ashton [1974], in a study of internal control quality in payroll systems, reported a higher level of 70 [p 151] " For individuals, the variance... not The task facing the profession is to identify the causes of the differences The significance of competition to the judgments of all four groups (Table 4) supports the Cohen Commission's position that the problem facing the profes- sion is too much rather than too little competition From the standpoint of independence, the stance of the Metcalf subcommittee's staff in favor of increasing competition... undesirable However, the scope of this experiment did not allow identification of its causes Additional investigation is needed to establish these causes and to examine possible remedies for the problem The nonsignificance of the tenure factor implies that any policy action taken to reduce the average tenure of auditors may have little positive effect on perceptions of auditors' independence However, this... unacceptable? Research is needed to relate perceptions of the risk directly to third parties' reliance on financial statements SUMMARY This study examined the perceptions of certified public accountants and financial statement users with respect to the independence of public accounting firms The subjects considered the impact of four variables on the risk that the independence of an audit firm might become impaired:... imperative that the profession recognize these differences when responding to current pressures for policy and structural changes in the accounting profession Problems of credibility arise from outside the profession Therefore, the auditor as policy maker cannot afford a biased perspective; he must be constantly aware of the perceptions of those who depend on his service and how these perceptions differ... level of analysis Thus, the separation of the two functions is not likely to improve third parties' perceptions of indepen- dence Another significant implication of the findings is that third parties may view small CPA firms as less independent than larger firms This is a severe problem, for the majority of the nation's CPAs are, of course, "small" practitioners Certainly, this differential in perceptions. .. impaired: competition for audit clients, the provision of MAS, the size of the audit firm, and the audit firm's tenure Firms operating in highly competitive environments, firms providing MAS, and smaller audit firms were perceived as having a higher risk of impairment of independence Tenure was not found to have a significant impact on perceptions of independence For all respondents, the competition variable... the direction of impact can be predicted Future policy decisions designed to improve perceptions of independence should therefore take these effects into account APPENDIXA INSTRUMENT The instrument contained 16 scenarios of the form illustrated below Together, they represented all possible combina- tions of the four independentvariables The scale refersto the risk that the independenceof the CPA firmdepictedin... Competition among auditors is likely to increase now that constraints on advertising and solicitation have been removed The increased potential for damage to the profession's credibility justifies careful consideration of any policy designed to insulate the auditors from inappropriate influence by manment An existing example of this type of policy, long endorsed by the AICPA, is the use of an audit committee... were highly consistent in judging the direction of effect Therefore, individual differences would not be expected to seriously undermine the effectiveness of related policy actions Finally, in evaluating a study of perceptions, it is prudent to consider that financial-statement users may recognize the risk of nonindependence but accept it as a necessary part of the audit function If so, at what point does