September 25, 2000
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW.
Washington, DC 20549-0609
Re: File No. S7-13-00
Dear Mr. Katz:
The purpose of this letter is to provide my comments on the proposed Revision of the Commission's Auditor Independence Requirements. As you are aware, I provided testimony at the public hearings held on September 21, 2000. My intention is to use this letter to expand upon that testimony.
I am a Professor of Business Administration at the University of Illinois at Urbana-Champaign. My expertise is in the psychology of judgment and decision making in business organizations. I have a particular interest in the relationship between accounting and financial decision making. In addition, I have contributed to academic research on auditor judgment and decision making both as an author and an editor.[Note 1]
Let me start by disclosing three facts: First, I have been retained as a consultant by Arthur Andersen, Deloitte & Touche, and KPMG as well as the AICPA to provide insight and guidance on the issue of audit independence. Second, at different times a number of accounting firms, including all of the Big 5, have supported some of my research either directly or indirectly. Currently, I have a research project that is being supported by PricewaterhouseCoopers. Finally, I hold a substantial ownership interest in a privately held software firm that competes with the accounting firms for non-audit services.
My primary concern with the proposed revision relates to the issue of audit firms supplying non-audit services to audit clients and what psychological research is (or is not) able to conclude regarding how such arrangements influence auditor independence. In discussing the proposed restriction on the scope of non-audit services, the proposal notes the lack of empirical evidence directly supporting the hypothesis that providing non-audit services impairs the quality of financial reporting (section II.C.2.d). The proposal continues:
"It is common sense, however, and confirmed by studies, that a person's decision changes when he or she has a stake in the outcome of that decision. Furthermore, common sense dictates that the more someone - including an auditor - has at stake, the more likely his or her decision is to be affected. "
However, the "studies" described in the passage above is a reference to a single article published in the Sloan Management Review in 1997.[Note 2] The cited article does not report any actual empirical evidence on the behavior of auditors or audit firms. Rather, the article references research findings from other domains that document a well-known psychological phenomenon known as a "self-serving bias." The article asserts that auditors unknowingly process information in a way that leads them to favor the opinion that serves their own self-interest. The implicit presumption in this argument is that the auditor's self-interest is aligned with that of the audit client's management.
I am aware of no research that directly documents the presence of a self-serving bias in auditors. However, I do not disagree with either common sense or with the argument that auditors can unknowingly bias their opinions in a self-serving manner. Rather, I believe that in applying these notions, it is important to recognize two important and distinctive features of the audit environment that greatly limit their relevance to issues of audit independence. First, auditors face a more complex set of incentives, including self-interests that run counter to management's interests. Second, even if individual auditors are subject to a bias towards management-favored positions, given the presence of other intervening factors, such as established review protocols, it is not clear that this bias will ultimately affect the audit opinion.
What exactly constitutes the auditor's self-interest? The audit client pays the auditor, and this obviously creates a direct economic relationship. However, the fees for a current audit engagement are not at risk, since contingent fees are prohibited under AICPA rules. Of course, the auditor would like to obtain additional fees from the audit client. However, this is true whether the fees in question are for non-audit services or for audit services in subsequent years. In fact, the value of a stream of future audit fees can be quite high, and may, in many cases, overshadow the value of a single non-audit engagement. Limiting or restricting non-audit services will not remove the economic relationship between the client and the auditor, and thus, will not remove the possibility that an auditor would be tempted to change his or her opinion.
On the other hand, the audit firms, the accounting profession, and regulators have created powerful incentives that pull auditors in the opposite direction, making them accountable for their judgments. These sources of accountability are both internal and external to the firm. Internally, auditors (whether partners or other professional staff) are accountable to their colleagues and their superiors. Like many other business organizations, accounting firms have developed sophisticated performance measurement systems that do far more than simply tally the revenue generated from client engagements. Thus, engagement partners and other professional staff are going to be concerned with how they score on a whole range of performance metrics. All of the large accounting firms have divisions dedicated to firm-wide risk management, professional and regulatory matters, independence monitoring, and dissemination of targeted independence-related training. To the extent that the firms explicitly measure performance relative to professional quality standards, compliance with firm policy and guidelines, and compliance with risk management procedures, accounting firms reinforce rather than undermine independence.
There are also many external sources of accountability including, but not limited to peer review by the AICPA SEC Practice Section, reviews by the Quality Control Inquiry Committee and the AICPA Ethics Division, the threat of SEC enforcement investigations, and the very real possibility of litigation. A final and significant source of external accountability is the anticipated negative impact of adverse publicity on a firm's reputation, which directly impacts the firm's ability to attract and retain both clients and employees. These factors provide powerful incentives for the firms to enforce audit quality, including compliance with independence standards.
One could argue that the probability of review, enforcement action, or litigation in any specific audit engagement is statistically remote, and may be ignored by individual auditors. However, across a large firm's entire portfolio of audit clients, the aggregate risk exposure can be substantial, even when the individual exposures are miniscule. These external incentives are likely to be felt most keenly at the top of a firm's chain of command, where the focus is on the portfolio rather than any single engagement. Consider as a case in point the considerable costs associated with litigation that the firms pay year in and year out. The chance of any particular audit engagement ending up in litigation is usually quite small. However, the chance that a large accounting firm will end up with at least one case in expensive litigation approaches statistical certainty. Concern with managing this sort of risk exposure in turn provides the rationale for the implementation of systems to create internal accountability, which are likely to be quite salient further down the chain of command.
Another potential counter-argument is that despite the existence of alternative sources of accountability, the direct economic relationship with the client might simply be too tempting to an auditor. However, there is a growing body of psychological research that shows that sources of accountability can have a powerful influence on decision making.[Note 3] Notably, this research, which was originally developed in a variety of social and organizational contexts, has been explicitly documented in audit settings. An area that is particularly relevant is research that examines how auditors regard the requirement to justify their decisions, an important element of accountability. Auditors view the justifiability of their decisions as a critical aspect of professional judgment.[Note 4] Experiments show that the requirement to justify a decision can improve the quality of those decisions.[Note 5] Further, holding auditors accountable can influence their judgments and decisions, and auditors are going be swayed not just by the preferences of their clients, but also by the preferences of their superiors, reviewing partners, and other members of their profession.[Note 6]
I would like to draw particular attention to a study I published with Professors Jane Kennedy and Mark Peecher.[Note 7] We conducted an experiment where we asked experienced auditors to examine a scenario in which an auditor was confronted with a choice between permitting an aggressive accounting treatment favored by a client versus informing the client that his preferred treatment was not acceptable. The scenario was interesting for several reasons. In the first place, there was considerable ambiguity regarding the appropriate accounting treatment. In previous studies using this scenario, the majority of auditors typically selected the more conservative accounting treatment. However, in this scenario there was authoritative guidance available that supported the more aggressive (client-favored) treatment. We found that when auditors evaluated the quality of another auditor's decision, they were sensitive to much more than the potential financial losses associated with disappointing the clientthey were also strongly influenced by whether the auditor was able to support his position with authoritative guidance and whether he had sought out and followed the advice of a knowledgeable audit partner.
In this kind of situation, any reasonable person would naturally consider the expected financial consequences of their decision, including the expected cost of potential stakeholder lawsuits if the aggressive treatment is permitted and the expected cost of losing the client's business if the treatment is not allowed. Significantly, we found that auditors also attend to nonfinancial goals and objectives, as represented by their desire to conform to authoritative guidance and to receive the confirming opinion of knowledgeable partners. More generally, I believe that auditors also focus on such objectives as the desire to maintain a favorable long-term reputation, the desire to meet or exceed professional codes of ethical conduct, and the desire to fulfill their public responsibilities. Naturally, auditors, like all professionals, sometimes find themselves in situations where these various objectives conflict. While there is much that we do not yet understand about how auditors balance their conflicting objectives, it is inadvisable to regulate the profession based on a simplistic perspective that reduces the auditor's incentives to a single economic dimension.
To summarize my first point: An auditor's self-interest is more complicated than what is described in the rule proposal, and auditors are accountable in ways that counter the influence of their economic relationship with the audit client.
This brings me to my second point: Even if individual auditors do fall prey to a self-serving bias that favors the client, I do not believe that the outcome of an audit will necessarily be affected adversely. In order to understand this point, it is vital to understand some critical features of the environments in which psychologists typically study human judgment, in contrast to the environment in which auditors exercise their professional judgment.
Psychologists typically study judgment in static, one-shot experiments, in which they present information and ask study participants to review the information and arrive at an evaluation, prediction, or choice. Typically, the judgments involved can be completed in a short period of time (e.g., minutes rather than hours or days). As an example, consider the published studies of the self-serving bias in legal settings, which formed much of the empirical basis for the Sloan Management Review article referenced in the proposed rule.[Note 8] Experimental participants had either 30 minutes or a week to read 27 pages of testimony and other case materials. Pairs of subjects then engaged in a negotiation exercise that lasted exactly 30 minutes, at which point the experiment concluded. The financial stakes were typically less than $10. By the standards of psychological experiments, these were relatively complex procedures, with a contextually rich set of experimental stimuli.
However, contrast this environment with the typical external audit, where the stakes are much higher and the audit engagement goes on for weeks or months. An audit consists of an extended series of judgments, assessments of further evidence, and subsequent reviews, with plenty of opportunity for the auditor to uncover previous errors and take corrective action. Auditors, like many other professionals, make judgments that are embedded in a series of judgment-action-outcome feedback loops. An initial judgment need not be perfectly accurate, if there are plenty of opportunities to catch and correct subsequent errors.[Note 9] As long as early decisions do not irrevocably commit the auditor to a course of action, initial judgment errors need not produce undesirable outcomes.[Note 10]
Also in contrast to the general psychological research on self-serving and similar biases is the fact that teams of professionals perform audits, with other teams of professionals available to consult, review, and provide close supervision. Notably, some of the auditors involved are reviewers explicitly charged with catching errors and oversights. For SEC engagements, there are concurring partner reviews and, for members of the AICPA SEC Practice Section, firm level peer reviews. These extensive review and quality control processes, in combination with the accountability considerations mentioned above, enhance an audit firm's ability to catch and correct biased judgments before they affect audit quality.
Furthermore, psychological research on self-serving biases and similar biases typically involve settings where there is only a limited opportunity for interaction between participants. In contrast, auditors interact with both clients and other members of their profession over extended periods of time. They are very much aware both of the past history of their interactions as well as the anticipated effect of their decisions on their future interactions. We simply do not know very much about how factors like the desire to protect one's reputation affect the prevalence of biased decision making in long-term group or organizational interactions.[Note 11] However, it is quite clear that to professionals, including members of the accounting profession, reputation matters.
Given this analysis, I do not believe that restrictions on non-audit services are likely to contribute in any real way to auditor independence. On the other hand, I do believe that there are elements of the proposed rule that will enhance independence. Proxy disclosure of non-audit services may enhance accountability by giving investors and regulators the clearest possible picture of the auditor's incentives. Increased disclosure of the nature, quantity, and cost of non-audit services will make it possible to conduct statistical investigations of the relationship (if any) between the provision of non-audit services and the occurrence of audit failures. This will create another significant source of accountability, as well, since public disclosure will mean that investors will be able to take note of situations where potential impairments of independence exist and factor those concerns into their investment decisions.
I also welcome the recent move towards strengthening corporate governance by making audit committees who have management oversight responsibilities directly responsible for appointment and removal of the auditor, as well as communications with the auditor on financial reporting matters. Similarly, steps that encourage the enhancement of accounting firms' internal quality control mechanisms reinforce those firms' current efforts to create appropriate internal incentives and correct problems before they affect audit quality.
Don N. Kleinmuntz,
Professor of Business Administration
University of Illinois at Urbana-Champaign
208 Wohlers Hall, MC-706
1206 South Sixth Street
Champaign, IL 61820
See Ashton, R. H., Kleinmuntz, D. N., Sullivan, J. B., and Tomassini, L. A. (1988). Audit decision making. In A. R. Abdel-khalik & I. Solomon (Eds.), Research Opportunities in Auditing: The Second Decade (pp. 95-132), Sarasota, FL: American Accounting Association. As past chair of the Society for Judgment and Decision-Making's Publication Committee, I played a significant role in shaping the volume Judgment and Decision-Making Research in Accounting and Auditing, R. H. Ashton & A. H. Ashton (Eds.), (1995), Cambridge University Press.
Bazerman, M. H., Morgan, K. P., and Loewenstein, G. F. (1997). "The impossibility of auditor independence." Sloan Management Review, 38, 89-94.
Garud, R. and Shapira, Z. (1997). "Aligning the residuals: Risk, return, responsibility, and authority." In Z. Shapira (Ed.), Organizational decision making (pp. 238-256), Cambridge University Press; and Tetlock, P. (1985). "Accountability: The neglected social context of judgment and choice." Research in Organizational Behavior, 7, 297-332.
Emby, C. and Gibbins, M. (1988). "Good judgment in public accounting: Quality and justification." Contemporary Accounting Research, 287-313.
Ashton, R. H. (1990). "Pressure and performance in accounting decision settings: Paradoxical effects of incentives, feedback, and justification." Journal of Accounting Research (Supplement), 148-180; Johnson, V. E. and Kaplan, S. E. (1991). "Experimental evidence on the effects of accountability on auditor judgments." Auditing: A Journal of Practice and Theory (Supplement), 96-107; Kennedy, J. (1993). "Debiasing audit judgment with accountability: A framework and experimental results." Journal of Accounting Research, 231-245.
Peecher, M. E. (1996). "The influence of auditors' justification processes on their decisions: A cognitive model and experimental evidence." Journal of Accounting Research, 34, 125-140.
Kennedy, J., Kleinmuntz, D. N., and Peecher, M. E. (1997). "Determinants of the Justifiability of Performance in Ill-Structured Audit Tasks." Journal of Accounting Research, 35 (Supplement), 105-123.
Babcock, L., and Loewenstein, G. (1997). "Explaining bargaining impasse: the role of self-serving biases." Journal of Economic Perspectives, 11, 109-126.
Hogarth, R. M. (1981). "Beyond discrete biases: Functional and dysfunctional aspects of judgmental heuristics." Psychological Bulletin, 90, 197-217.
Kleinmuntz, D. N. (1985). Cognitive heuristics and feedback in a dynamic decision environment. Management Science, 31, 680-702.
Davis, J. H., Kameda, T., and Stasson, M. F. (1992). "Group risk taking: Selected topics." In J. F. Yates (Ed.), Risk-taking behavior (pp. 163-199), Chichester, England: John Wiley & Sons; Payne, J. W. (1997). "The scarecrow's search: A cognitive psychologist's perspective on organizational decision making." In Z. Shapira (Ed.), Organizational decision making (pp. 353-374), Cambridge University Press.