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  • Jennifer M Mueller-Phillips
    Nonaudit Services and Independence in Appearance: Decision...
    research summary posted October 19, 2015 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.03 Non-Audit Services, 06.0 Risk and Risk Management, Including Fraud Risk, 06.09 Litigation Risk in Auditing Section Research Summaries Space public
    Title:
    Nonaudit Services and Independence in Appearance: Decision Context Matters.
    Practical Implications:

    An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.

    Citation:

    Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.

    Keywords:
    auditor independence, auditor litigation, decision context, nonaudit services
    Purpose of the Study:

    Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.

    The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.

    Design/Method/ Approach:

    The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.

    Findings:
    • The results of the experiments indicate that users’ perceptions of NAS differ across decision contexts.
    • In the first experiment, participants initially perceive that NAS are associated with auditor faultin the face of a bad outcome (loss in value), NAS are perceived negatively.
    • In the second experiment, participants initially provide a higher assessment of asset value when the auditor supplies NASthat is, the net effect of NAS on asset value is beneficial.
    • In both experiments participants eventually decipher the experimental relationsthat NAS are not associated with auditor fault or asset value.
    • The findings indicate that decision context dramatically alters users’ perceptions of NAS and auditor independence.
    • Undoubtedly accounting scandals, which create significant losses for owners and creditors, can lead users to question auditor independence.
    • The findings suggest that users react in this manner for strategic reasons.
    • In responding to public outcry, regulators may overreact, for political purposes, and enact laws/rules that are excessive, potentially sacrificing social welfare.
    Category:
    Independence & Ethics, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Litigation Risk, Non-audit Services