Professional cornerstone

By Yves Gendron

What viewpoints Context-based research reveals regarding auditor independence

Auditor independence is commonly viewed as the cornerstone of the accounting profession. However, it is a complex notion. What do we know about the viewpoints of practicing auditorsregarding auditor independence, who have to articulate this complexnotion and apply it in concrete situations every day? How is auditor independence experienced in the field? A small but growing stream of context-based research, which fundamentally aims to develop a better understanding of the day-to-day realities of professional accountants, provides insights on the matter.

Context-based research differs significantly from quantitative, large-sample studies predicated on publicly available information. The latter studies typically examine relationships between a few variables, which researchers strive to measure as objectively as possible. In contrast, context-based research assumes that the phenomenon under study takes place in a complex system, and actors’ thoughts and viewpoints need to be investigated if one wants to grasp appropriately the complexities of real life. Context-based research is usually predicated on qualitative data (e.g., interviews); however, thistype of research can also rely on quantitative, proprietary data obtained from participating organizations. Authors have shown that context-based research can influence practitioners. For example, Mark Covaleski and his colleagues1 mention that partners who participated in a longitudinal context-based research program about control mechanisms in large accounting firms reported that the ensuing papers on the matter influenced the way in which they viewed their respective firms.

What does context-based research reveal about the experiences and viewpoints of practicing auditors regarding auditor independence?

Several studies provide meaningful insights (pre-Enron) about the influence of commercialistic pressures in large accounting firms, as well as doubts regarding the extent to which public accountants are able to act in ways that are highly consistent with the expectations of the public regarding auditor independence.

Through a series of interviews, Covaleski and his colleagues examine how professional accountants are controlled in large US accounting firms. Their analysis indicates that large-firm CPAs are subject to significant commercial pressures through the influence of control mechanisms. For example, according to a regional managing partner from a large accounting firm in the US:

“When we have monthly sales meetings with all the partners [in the region], each partner has sales goals and targets. And every month we have a report that comes out. It’s very fancy and it’s got a bar chart, it’s got it by partner’s name and it shows what we did last year in terms of total revenue, what he’s doing year to date this year, what he did year to date last year, and what his plan is for this year. Every month he sees the peer pressure because he’s got to get up, and there’s a flip chart up there and an overhead, and he’s got to explain [to fellow partners] why he is behind plan or ahead of plan.”

Covaleski and his colleagues further specify that the same interviewee proudly stated that he sent the entrepreneurial reports home to the partners’ spouses “to add a little more pressure” for achieving the individual’s, office’s and region’s objectives. Through such interview data the reader is provided with a deep-level indication of the magnitude of commercialistic forces deployed in large accounting firms through organizational practices and policies — forces typically seen as a threat to auditor independence. Although the impact of these organizational practices and policies is not quantified, one is left feeling they can have significant effects on firm partners. Importantly enough, although their research deals with a sensitive topic (i.e., auditor control within large accounting firms), Covaleski and his colleagues highlight that their interviewees proved interested in developing a better understanding of their experiences through the reading of the field reports and research working papers provided to them.

A context-based research project by Yves Gendron and Roy Suddaby2 provides interview data on the extent to which the notion of auditor independence was seen as problematic (pre-Enron), in large accounting firms as well as smaller ones. In November 2000, one Big Five partner commented on the controversial debate regarding auditor independence — in which the US Securities and Exchange Commission was deeply involved:

“I think that the inherent conflict around independence is not nonaudit services. The inherent conflict is the client pays your fees and as long as that is in place it doesn’t matter about all the rest of the stuff. ... That is a career-limiting move in any firm. And the big career-limiting move is losing a client, a big client. Even if you do no consulting work, that is the conflict. You can’t deal with that short of taking the responsibility for audit out of private sector and turning it to the government or onto the auspices of the SEC or the OSC or something. The SEC looked at that in the [1930s] and said no we don’t want to go there and I can’t see them ever changing. This is all smoke as far as I see. But it is life.”

This quote implies that audit partners are subject to significant pressures arising from the fear of losing audit engagements and comments on the effect that loss could have in undermining their career in the firm. The interviewee appears to be quite insecure regarding the extent to which the notion of auditor independence can be appropriately handled within accounting firms, under extant institutional arrangements.

Another context-based study carried out by Yves Gendron and Jean Bédard3 provides additional insights on the extent to which the notion of auditor independence was seen as problematic (pre-Enron) in the auditor community. Through interviews, the study investigates how participants in audit committee meetings make sense of the effectiveness of their audit committee. One of the external auditors interviewed in March 2000 is quite doubtful about the ability of audit committees in general to challenge management regarding auditor dismissals:

Interviewee: “I would speculate that ... the audit committee takes a recommendation from management regarding retention or the consideration for replacement of the audit firm. So if the CFO is unhappy because, and look we have lost clients like this, where you have to make some hard calls. And you [the external auditor] say, sorry, you can’t do this, this way of presenting your financial information isn’t right. So the CFO says, fine I will go along with you and then he is unhappy. So the CFO says, I am unhappy with the services for such and such a reason, and out goes the audit engagement for tender. The CFO administers it and selects who the new ones are going to be, comes up with the reasons why it is appropriate and puts it to the audit committee, the audit committee goes along with it. They are not involved with the selection process.”

Interviewer: “So that is the way it works?”

Interviewee: “Yes. Absolutely. Visibly if youlook at it, they are involved because they probably get the copies of the proposals and things like that, but it is management’s recommendation and they don’t go through theselection process. The other thing whenthere is a change in auditors, the securities commission requires you, and you probablyknow this, to put out a notice saying if there were any disagreements, qualified opinions or anything like that because they think that should be brought into bear. Now, howmany [audit] firms do you know put qualifications in a report because there are disagreements? You put that in there, you aren’tgoing to get any work. Nobody’s going to want you. They won’t hire you again.”

This excerpt provides a negative picture of the effectiveness of mandatory corporate governance disclosures that are supposed to strengthen auditor independence. The perceived functioning of market mechanisms would prevent auditors from bringing into the field of visibility disagreements with management and the underlying reasons.

The above studies allowed researchers to go beyond frontstage pronouncements about auditor independence and investigate the realities that take place backstage, from the perspective of interviewees. As summarized in the table on page 49, evidence indicative of problematic situations concerning auditor independence had therefore been gathered and, with regard to Covaleski et al., published a few years before the collapse of Enron. With the benefit of hindsight regarding the Enron scandal, one can only wish that more context-based studies had been produced about changes having occurred within large accounting firms and the impact of these changes on auditor behaviour. A stronger awareness of these changes might have led to timely changes in auditing standards and practices, thereby perhaps having made a difference in mitigating the ascendancy of commercialism in large accounting firms and preventing some unfortunate events from taking place. Although the relationship between the two is undeniably complex and ambiguous, a stronger support of context-based research in the accounting practitioner community might help strengthen long-term professional and organizational legitimacy.

A comparison of a large-sample study predicated on publicly available information carried out by Richard Frankel, Marilyn Johnson and Karen Nelson4 (2002) to the articles in the table provides a further indication of the power of context-based research. They analyzed the ratio of nonaudit to audit fees paid by a sample of approximately 3,000 US firms. Their hypothesis is that auditees paying a higher ratio of nonaudit to audit fees might be able to exert more influence over auditors. They measured management influence through the amount of income-increasing accruals (over which management has some discretion to report in financial statements). Their results indicate that auditees paying higher ratios of nonaudit to audit fees tend to have greater income-increasing accruals, thereby suggesting that auditors are less independent when auditees purchase a higher proportion of nonaudit services. In spite of its contribution to accounting literature, this study is inevitably subject to criticism regarding, for example, the use of income-increasing accruals as a proxy for management influence. On this basis, it can be argued that on a methodologicallevel the study is too far removed from the realities of practitioners. On a practical level,accounting practitioners also often complain about quantitative accounting research (predicated on publicly available information) being too far removed from the realities of practice (e.g., J.B. Sullivan5). This is unlikely to be the case for context-based research as evidence of a better understanding of real-life aspects of public accounting permeates the three context- based articles summarized above.

Context-based research can therefore be of interest to accounting practitioners and stakeholders through the development of better understanding, which can eventually have an impact on practice in diverse ways, for example, through the formulation of organizational and regulatory policies. Importantly, context-based research can also exert a key influence on would-be practitioners in university classrooms, through the development of teaching material and cases that aim to reflect real-life aspects of accounting practice. As a matter of fact, given the strong commitment of accountancy towards university education, practitioners should not rely exclusively on their firm’s interest when deciding to participate or not to participate in a given context-based research project; they should also take into account broader implications, notably educational ones.

On the surface, accounting practitioners and other stakeholders often appear to be quite open to the undertaking of context-based research. However, access to field data is sometimes problematic (Gendron6). Time pressure and client confidentiality are typically invoked by organizations when denying access to field data. Regarding the former, the time involvement for interviewees is often around one hour — which is not that significant. Regarding the latter, it should be noted that academic researchers in Canada have to abide by stringent ethical procedures (Kevin Haggerty7), which are controlled by their affiliated university and aim to protect participants from being harmed by research. In particular, research ethics boards at Canadian universities commonly require any identifiable information to be removed from published research. Consequently, client confidentiality in most cases is not, and should not be, a significant concern.

In conclusion, the practitioner literature abounds with statements pointing to the importance of knowledge development activities. Hopefully, a number of accounting practitioners and stakeholders will be more receptive to the undertaking of context-based research projects on real-life aspects of accounting practices. Consequences arguably ensue from context-based research being only fragilely sustained in the accounting domain.

Yves Gendron, PhD, CA, is with the Faculté des sciences de l’administration at Université Laval. He can be reached at yves.gendron@fsa.ulaval.ca

Technical editor: Michel Magnan, PhD, FCA, Lawrence Bloomberg Chair in accountancy, John Molson School of Business, Concordia University and Associate Raymond Chabot Grant Thornton

References
1. Covaleski, M.A., Dirsmith, M.W., Heian, J.B. and Samuel, S. 1998. “The calculated and the avowed: Techniques of discipline and struggles over identityin Big Six public accounting firms.” Administrative Science Quarterly, 43(2), 293-327.
2. Gendron, Y. and Suddaby, R. 2004. “Professional insecurity and the erosion of accountancy’s jurisdictional boundaries.” Canadian Accounting Perspectives, 3(1), 85-115.
3. Gendron, Y. and Bédard, J. 2006. “On the constitution of audit committee effectiveness.” Accounting, Organizations and Society, 31(3), 211-239.
4. Frankel, R., Johnson, M. and Nelson, K. 2002. “The relation between auditors’ fees for nonaudit services and earnings management.” The Accounting Review, 77(Supplement), 71-105.
5. Sullivan, J.B. 1993. “The impact of auditing research on auditing practice.”Auditing: A Journal of Practice & Theory, 12(Supplement), 1-2.
6. Gendron, Y. 2000. “Openness to context-based research: The gulf between the claims and actions of Big Six firms in the USA.” Accounting, Auditing & Accountability Journal, 13(2), 175-196.
7. Haggerty, K.D. 2004. “Ethics creep: Governing social science research in the name of ethics.” Qualitative Sociology, 27(4), 391-414.