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    Independence Threats, Litigation Risk, and the Auditor’s D...
    research summary posted May 4, 2012 by The Auditing Section, last edited May 25, 2012, tagged 04.0 Independence and Ethics, 04.02 Impact of Fees on Decisions by Auditors & Management, 09.0 Auditor Judgment, 09.04 Going Concern Decisions, 12.0 Accountants’ Reports and Reporting, 12.01 Going Concern Decisions 
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    Title:
    Independence Threats, Litigation Risk, and the Auditor’s Decision Process
    Practical Implications:

    This study is important for audit firms and audit regulators, as it provides a more complete picture of how threats to auditor independence and litigation risk affect auditor performance. Rather than just focusing on the auditor’s final decision, this study demonstrates that the above incentives affect auditors through their evaluation of information during the decision process. Therefore, firms and regulators may be interested in research that specifically addresses processing biases. This research advocates using decision aids, such as artificial neural networks, to attenuate processing bias. Accountability-inducing controls, like those promoted by audit documentation standards, are unlikely to achieve this goal. Further, reviews conducted by individuals within the same firm are less likely to detect process bias. Review by independent parties, such as an audit committee, would likely be more effective.

    Citation:

    Blay, A.D. 2005. Independence Threats, Litigation Risk, and the Auditor’s Decision Process. Contemporary Accounting Research 22 (4): 759-789.

    Keywords:
    Auditor independence, auditor reporting, decision process, going concern, motivated reasoning
    Purpose of the Study:

    The preservation of auditor independence is a concern of audit regulators. The Sarbanes-Oxley Act of 2002 attempts to minimize the economic bond between the auditor and the client, but cannot completely eliminate it. Litigation risk is often proposed as a safeguard to mitigate independence threats. Prior studies about auditor independence focus solely on auditors’ final reporting choices, but this paper addresses auditors’ judgment and decision-making process as well. Particularly, this paper investigates whether independence threats (high versus low) and litigation risk (high versus low) influence auditors’ evaluation of information and their subsequent reporting choices. 

    The author expects that when high threats to auditor independence are present, auditors will be more supportive of the client-preferred position (unqualified opinion) both during the decision process and in the final reporting decision.  However, when high litigation risk is present, the author expects auditors will be less supportive of the client-preferred position. 

    These expectations are derived from the psychology literature on directional goals and motivated reasoning. Directional goals arise when an individual is dependent on a particular decision outcome. Though accurate judgment should be the auditor’s ultimate goal, the literature on motivated reasoning suggests that, as long as the conclusion is justifiable, individuals will evaluate information consistent with a desired conclusion. Thus, economic incentives associated with independence threats and litigation risk are likely to affect not just the auditor’s final decision, but also his/her evaluation of information during the decision process.

    Design/Method/ Approach:

    The research evidence was collected in the early-2000s (pre-SOX). Audit managers from three Big-4 firms participated in the experiment.  Participants completed a simulated task involving a hypothetical manufacturing client where they assessed the initial likelihood of going-concern, searched for informational cues, and reassessed the likelihood of going-concern. As informational cues were obtained, auditors also assessed whether the cues provided positive or negative support for the client’s going concern.

    Findings:
    • The author finds that auditors facing greater threats to independence will be more supportive of an unqualified opinion (client-preferred) when:
      • Assessing initial information,
      • Evaluating additional information cues,
      • Making a final report choice.  
    • The author finds that auditors facing higher litigation risk will be less supportive of an unqualified opinion (client-preferred) only when:
      • Evaluating additional information cues,
      • Making a final reporting choice  
    • The author finds that both threats to independence and litigation risk affect final report choice completely through their influence on the auditor’s evaluation of additional information cues. Thus, it appears that independence threats and litigation risk lead to information processing bias, as opposed to an up-front choice bias. 
    • The author finds that when both threats to independence and litigation risk are high, auditors gather additional information cues and spend more time evaluating evidence.  Further, there is no significant difference in final reporting choice when independence threats and litigation risk are low, supporting regulators’ claim that litigation risk offsets independence threats.
    Category:
    Independence & Ethics, Auditor Judgment, Accountants' Reporting
    Sub-category:
    Impact of Fees on Decisions by Auditors & Managmeent, Going Concern Decisions, Going Concern Decisions
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