Auditor Independence Revisited The Effects PDF

Auditor independence revisited: The effects
of SOX on auditor independence

Asokan Anandarajan, Gary Kleinman and Dan Palmon*
Received (in revised form): 25th January, 2008
*Rutgers Business School, Rutgers University, 180 University Avenue, Newark, NJ 07102, USA; Tel: + 1
973 353 5472; Fax: + 1 201 586 0218; E-mail: dan@palmon.com
Asokan Anandarajan is a professor of accounting
at the School of Management, New Jersey Institute
of Technology. He is a British-qualied Chartered
Management Accountant. He has a Masters degree
in Business Administration and a Masters degree in
Philosophy from Craneld University in the UK. He
obtained a PhD in accounting from Drexel University, Philadelphia. His research interests are in the
area of earnings management and developing
models to detect earnings overstatement fraud by
corporations.
Gary Kleinman earned his PhD in Management
from Rutgers University. He has co-authored articles
in the areas of international accounting, pensions,
tax forecasting, audit group decision-making,
accounting education and auditor independence.
He co-authored a very well-received book entitled Understanding Auditor-Client Relationships:
A Multi-faceted Analysis in 2001 (Markus Weiner
Publications, Inc.). He is currently a full professor at
the Touro Graduate School of Business, located in
New York City, NY.
Dan Palmon received his PhD from New York
University. He is the Chair of the Accounting, Business
Ethics, and Information Systems Department at the
Rutgers Business School. His publications appear
in The Accounting Review, Journal of Accounting
Research, Journal of Business, Journal of Banking
and Finance, among other journals. He has served
as a Director and Chair of the Audit Committee for
several corporations.
EXECUTIVE SUMMARY
KEYWORDS: SarbanesOxley Act, auditor
independence, corporate governance
112
Following a wave of accounting scandals, the Sarbanes

Oxley Act (SOX) was enacted on 30th July, 2002. The
objective of the Act was to provide investors with better
protection by establishing a new oversight board, improving
corporate governance and internal controls, enhancing
financial disclosure, and strengthening auditor independence.In this paper, we question the extent to which SOX
actually improved auditor independence. We seek to shed
some light on auditor independence-related issues by
asking: What has the academy learned about SOXs
impact on auditor independence in the five years since its
enactment? Have researchers even examined key ramifications of SOXs requirements? If not, what areas need
scrutiny? These are the issues considered here. In essence,
we examine whether there is a gap between what regulators want to see addressed and what researchers have actually looked at with regard to auditor independence in the
post-SarbanesOxley period. The Securities and Exchange
Commission (SEC) requirement to enhance auditor independence has been far reaching. It involves providing
guidelines on matters relating to the provision of nonaudit
services, partner rotation, audit engagement teams, auditor
compensation and the role of the audit committees. Therefore, we expected to find a large number of academic research
papers on this topic. Surprisingly, the number of such papers
is very small, with the results inconclusive. Overall, the
academy falls short of providing detailed guidance to the
SEC and other regulators on the effectiveness of their guidelines in enhancing auditors independence. We hope that,
after reading our paper, regulators and academicians will
agree with us that much more research is needed before
assessing the impact of SOX. A recent FEI survey shows
that 78 per cent of financial executives agree that the cost
of implementing SOX exceed its benefits. We hope financial executives, whether they hold this view or not, may
International Journal of Disclosure and Governance Vol. 5, 2, 112125
www.palgrave-journals.com/jdg
2008 Palgrave Macmillan Ltd. 1741-3591 $30.00
Anandarajan, Kleinman and Palmon
also find an interest in reading our paper.Given strong

trends toward globalisation of business and the concomitant
easing of cross-border stock exchange listing requirements,
we also suggest to regulators that insights into the structure
of US auditing may be gleaned by examining apparently
successful auditing innovations overseas.
International Journal of Disclosure and Governance

(2008) 5, 112125. doi:10.1057/jdg.2008.3;
published online 28 February 2008
INTRODUCTION
The issue of auditor independence is not new.

Mayhew and Pike1 state that the problem stems
from a lack of clarity about one issue; namely
for whom does the audit firm really work? They
pose the question, does the auditor work for
the investing public as intended by the securities acts of 1933 and 1934, or alternatively, does
the auditor work for the client firm? According
to the authors, this lack of clarity has resulted
in auditors independence being impaired. It
is difficult, however, to point to tangible evidence supporting this view. For example, there
are no Securities and Exchange Commission
(SEC) enforcement cases addressing independence as an issue in the recent financial reporting
failures including WorldCom. There remains,
however, a general perception that impaired
auditor independence is partially responsible for
recent financial reporting failures and investor
losses. Concerns have long been expressed that
auditor provision of consulting services to clients results in actual, as well as perceived, loss
of independence (eg, see Kleinman, Palmon
and Anandarajan2). Arthur Andersen, the
eponymous founder of the Arthur Andersen
accounting firm, pithily summarised the concerns raised about auditor provision of consulting services in 1934. He said,
Some regard [this] movement as wholly
unsound, the opening of a territory into
which the accountant could not venture
except at great risk of loss of professional
standing. Others saw in the movement an
opportunity for greater and more constructive service to business. (cited by Sweeney3).
Whether from the auditors or societys vantage point, the fundamental problem remains
the same, that is, what is the trade-off between
service to the society as reflected by highquality audits and the real or perceived threat
to that independence arising from, or being
exacerbated by, auditor provision of nonauditing services. Such threats are in addition to
those stemming from long auditorclient association, incentive structures within CPA firms
that reward client retention, and the like (eg,
Kleinman, Palmon and Anandarajan2). It has
also been argued that the fundamental problem
of auditor independence arises from the fact
that, in the United States at least, the client
hires, pays and can displace the auditor. While
this freedom is somewhat restricted by potentially negative publicity owing to SEC-required
auditor change reporting requirements and suspicions as to why the auditor may have been
displaced, the fact that the auditor serves at the
pleasure of the client remains, despite recent
reforms regarding the much greater empowerment and restructuring of audit committees.
As Norris4 documents, alleged breaches of
independence due to profitable business relationships with clients can be costly to the CPA
firm (Ernst and Young, in this case). As the
Enron and WorldCom episodes further document, independence loss may be catastrophic for
client employees, shareholders, creditors, and the
markets and society generally. The collapse of
these two huge firms further sensitised the audit
world (see Sweeney3), the corporate world,5 and
the SEC to the risks to auditor independence
that are posed by consulting practices. In 2000,
then SEC chairman Arthur Levitt instigated a
renewed evaluation of auditor independence.6
This led to the SECs issuance of new independence rules and disclosures in November
2000.7 After the collapse of Enron, and the fury
over the level and nature of the involvement
between Arthur Andersen and Enron, as well
as revelations about the internal processes at
Andersen with regard to retaining Enron as a
client, this issue was revisited in both houses of
the US Congress. The subsequent accounting
Vol. 5, 2, 112125
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Auditor independence revisited
scandals involving WorldCom became the

trigger for adoption of the allegedly draconian,
but important, SarbanesOxley Act (SOX).
Much has been written about Section 404
of the SOX, especially the great expense that
it inflicts upon SEC registrants preparing their
annual reports. We note that it is not the preparation of the reports, however, that increases the
expenses, rather it is the requirement to document the controls over financial reporting and
the concomitant certification that has impacted
the corporate bottom line. Had the management been carefully monitoring its control
systems previous to the enactment of Sarbanes
Oxley, the expense incurred to improve the
impacted systems would not have resulted. Less
remarked on, though, is whether the restrictions
that SOX imposes on the auditing profession in
its relationship to its clients have significantly
improved auditor independence. It is difficult
for researchers to address this question because
researchers require empirical evidence rather
than intelligent surmise to support a position.
The real question then is whether the
firms acted to shore up independence, and
if so, what actions were taken. Useful studies
here could involve researchers examining (by
means of case studies) the steps audit firms
took to enhance independence. A major criticism by practitioners is that the independence
discussed in the academic literature relates to
perceived independence. Clearly, a perception
of impaired independence may not mean actual
independence impairment. Also, clearly, studies
documenting the behaviours of CPA firms with
regard to independence maintenance should
shed useful light on this issue. Currently, no
research to date has attempted this, perhaps due
to the politically charged nature of the issue.
We seek to shed some light on auditor independence-related issues by asking: What has
the academy learned about SOXs impact on
auditor independence in the five years since
its enactment? Have researchers even examined key ramifications of SOXs requirements?
If not, what areas need scrutiny? These are the
issues considered here. In essence, we examine
114
whether there is a gap between what regulators

want to see addressed and what researchers have
actually looked at with regard to auditor independence in the post-SarbanesOxley period.
We also suggest that insights into the structure
of US auditing may be gleaned by examining
apparently successful auditing innovations overseas. We reserve this for the end because the
focus of our paper is on the domestic audit
market, its opportunities and constraints. In
terms of future research however, developments
overseas offer a rich source of potential alternative structures that may be worth investigating
for application here.
We first define and discuss the importance of
auditor independence. The SEC defined independence in a November 2000 release that
provided general guidelines with respect to
tasks auditors could undertake for their clients.
These guidelines were designed to eliminate
practices and service lines of business that constrain auditor independence. SOX then focused
on and addressed what auditors could do with
respect to nonaudit services. The time between
passage of SOX and this writing is brief. It
remains important, however, to examine the
extent to which accounting researchers have
provided insight into the SEC and other regulators on the efficacy of these guidelines. We
also highlight areas that, although considered
important by the SEC, have not been addressed
by researchers.
WHY IS THE ISSUE OF AUDITOR
INDEPENDENCE IMPORTANT?
Prior to the Sarbanes Oxley Act (2002), management frequently sought to highlight their
short-term successes because of incentive plans
in place. (Scholarly literature has explained
this behaviour using agency theory.) Auditors
are supposed to act as safeguards to investors
by preventing such self-seeking behaviour.
Prentice8 notes that there are several problems
unique to the United States. First, auditors are
paid by the firms managers rather than by the
stockholders. The second problem, according
to Prentice, is that managers may attempt to
buy off their auditors by giving them shortterm incentives (eg, increasing their total fees
by providing them with consulting work unrelated to their audit).9,10 There is another theory
that that audit partners would not want consulting work because of their concern over the
perception of independence. Further, the Public
Oversight Board (POB) required this matter to
be addressed by the firm and audit committees
on an annual basis. No research has attempted
to reconcile these two views. This is another
potential field for research that would be illuminating to both academics and practitioners
alike.
WHAT IS AUDITOR INDEPENDENCE?
What is auditor independence? The SEC in

November 2001 defined independence from a
conceptual viewpoint. (See site: http://sec.gov/
rules/final/33-7919.htm that has the November
2001 release.) The definition is primarily based
on that provided by Mautz and Sharaf.11 The
latter define independence as a characteristic
of virtue of a good practitioner, who must be
independent of any interest that might affect
his/her judgment. Kleinman and Palmon12
review different conceptions of auditor independence and conclude that the definition,
and certainly achievement, of independence is
profoundly problematic since the objectivity
and integrity of judgment, for example, that
the The American Institute of Certified Public
Accountants (AICPA) describes as being at
the heart of independence is impossible of
realisation. In Kleinman and Palmons view,
while true independence is extremely difficult given the wide range of contradictory,
social, professional, financial and legal pressures
that face the auditor and the audit firm, there
may be a range of deviations from true independence that the auditor may be affected by
that is not large enough to lead the auditor
to behave in a nonindependent manner. Thus,
while thoughts and emotions may be engaged
in a way that leads the auditor to cognise in a
nonobjective manner, his/her behaviour may
not be affected.
Conceptual confusion aside, independence

is one of the central values upon which the
auditing professions legitimacy is predicated.13
In other words, independence cannot be compromised. Francis14 argues that an auditors
ability to be independent has been eroded by
changes in the environment that commenced
in the 1970s. For example, the Federal Trade
Commissions 1978 actions encouraging competition for clients among audit firms led to an
erosion of standards of conduct regarding client
solicitation. Increased competition, while normatively a good thing, may have led to increased
pressure on incumbent audit firms to compromise their standards in the hope of retaining
clients. Accordingly, we believe that the Federal
Trade Commissions action in 1978 exacerbated any previous problems regarding independence that may have afflicted the profession.
For example, subsequent to the ruling, it was
not unusual for accounting firms to low ball
audit fees to get a client. We have heard anecdotal evidence that some firms would offer to
perform an (initial) audit for no fee, betting on
future growth.15 One firm was known for not
charging an audit fee for start up tech companies. This continued in the mid-1980s, when
CPA firms began to view internal audit activities as an expanding service area for both new
and existing clients. Most firms were not that
successful in providing outsourcing services to
audit clients because of the resistance of the
internal audit departments and the audit committees concern over independence. Enron was
an anomaly.
Geiger et al.16 noted that it was perceived
that the provision of consulting services may
improve audit quality by providing external
auditors with considerable knowledge about the
client, its operations and its industry. The greater
the external auditors insight into the client,
the better their ability to understand business
transactions and identify key audit risks. This
was also the argument that the AICPA17 made
in its 1997 White Paper. The audit firms that
did provide consulting services did so using the
rationale that more detailed understanding of
Vol. 5, 2, 112125
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the firm and its operations would also enhance

the subsequent quality of the audit.
In November 2000, concerned in part by
the increasing percentages of audit firm revenue
that were earned by the audit firms from performance of nonaudit services for their clients,
the SEC adopted a new rule. The latter prohibited accounting firms from providing certain nonaudit consulting services to their audit
clients. The rule also requires public companies
to disclose in their proxy statements the fees
paid to their independent auditors for audit and
nonaudit services. The purpose of adopting the
rule was to mitigate the threat to independence
posed by auditors providing both auditing and consulting services to a client (eg, Schneider et al.10).
This was not the first time, however, that
the SEC addressed this issue. After the Foreign
Corrupt Practices Act (FCPA) of 1977, the SEC
had registrants report these fee relationships.
The AICPA POB required member firms to
report the percentage of audit fees to nonaudit
fees. This information was also required to be
presented to registrants audit committees. The
SECs November 2000 independence-related
action provided more clarity than had existed
previously, and updated the requirements.
But was this update to audit to nonaudit
fee reporting meaningful? Palmrose and Saul18
noted that the lack of further SEC action on
fees when the reporting requirement was originally instituted (circa 19771980s) reflected the
failure of published research to demonstrate that
nonaudit service provision compromises auditor
independence (See also Kleinman, Palmon and
Anandarajan2). Palmrose and Saul18 further note
that even in the wake of the Enron affair, there
was no clear evidence that the provision of
nonaudit services led to an impaired audit. As
Schneider et al.10 state, only the auditor him/herself
knows whether he/she retained his/her independence! In the extreme, that is certainly true.
Also, Kleinman and Palmon12 argue, based on
a comprehensive analysis of the social psychological, sociological and environmental webs
that entangle the auditor, that the auditor may
lose his/her independence without being aware
116
that it has been lost (see also Kleinman and

Palmon19). The implication of Palmrose and
Sauls18 argument was that researchers had not
provided the SEC with conclusive evidence
providing impetus for further action. The
SEC, however, conducted its own research. In
point of fact, one of the reasons that the SEC
rescinded its audit and nonaudit fee disclosure
requirement in 1980 was because its sponsored
research revealed no conclusive evidence that
independence had been impaired. Don Kirk,
a member of the POB and former Chair of
the FASB, also did an independence project in
the late 1990s and found that independence
had not been impaired by rendering nonaudit
services (see Craig20). While it may seem that
the issue is the perception of impaired independence, rather than the fact of independence
impairment, understanding what actually happens between the auditor and client is difficult
absent catastrophic client failure. Nevertheless,
even if we grant that distinction, perception of
lack of independence is a serious issue in itself
given that the role of the auditor is to serve
as a guarantor, of sorts, of the informational
integrity of the firms financial statements.
Given the CPA firms vigorous efforts to
derail the SECs limited efforts at reining in
audit firm consulting services in 2000 (eg,
Norris21), a great deal of supporting evidence
would have been required to sustain the SEC
effort. Does this situation pertain today? Have
accounting researchers tackled the key issues
that would provide fodder for the regulatory
bodies deliberations as to whether to take further action to enhance auditor independence?
And, if not, what remains to be done?
THE SOX AND ITS IMPACT ON AUDITOR

INDEPENDENCE
In the summer of 2002, as we now well know,

there were several significant accounting scandals in the United States.The business failures of
Enron, WorldCom, Global Crossing and other
large firms and the subsequent admission of
key officials that they had deliberately misled
investors, led the public to question the role

and integrity of these companies auditors. The
auditor of Enron, Arthur Andersen, suffered
a criminal indictment (later overturned) that
forced the firms dissolution. These events led
the public to strongly question the independence
of the auditor.The most far-reaching legislation
resulting from the scandals is formally entitled
An Act to Protect Investors by Improving the
Accuracy and Reliability of Corporate Disclosures Made Pursuant to the Securities Laws,
and for Other Purposes. Its short title is the
SOX. The SOX also created the Public Company Accounting Oversight Board (PCAOB) to
set standards for, and to police the behaviour
of, auditors. Further consequences included
strengthened auditor independence rules and
placing the audit committee, not management,
in charge of the auditors engagement.
The effect of SOX has been far reaching. Not
only has it transformed corporate governance
in the United States, but also it has had a profound influence abroad. SOX requires publicly
traded companies to disclose the amount and
nature of fees paid to their external auditors.
These disclosures can be incorporated into a
companys annual proxy statement or included
in its annual 10K filing. The purpose of the
fee disclosures is to allow investors to evaluate
for themselves whether the proportion of fees
for audit and nonaudit services causes them to
question the auditors independence.10,22 (We
note that prior to the SOX and subsequent
to 1980 when the SEC rescinded ASR 250
and 264, public companies were disclosing the
audit fees and nonaudit fees in proxy statements.
SOX only formalised this requirement.) In
January 2003, the SEC adopted rules to fulfil
the requirements of the SOX. In particular, the
SEC took numerous actions. We present these
under topic headings.
investors of information related to audit and

nonaudit services provided by and fees paid to,
the auditor. (We, however, note that some public
companies were voluntarily disclosing these data
prior to SOX) Sections 201 and 202 of SOX
require that an audit committee must approve
all nonaudit services with the exception of nonaudit services where the total fees amount to
less than five per cent of total revenues paid
by the audit client to its auditor. (We note that
SOX only formalised this requirement. POB
required that nonaudit services be disclosed
to audit committees. Most audit committees
required that nonaudit services be approved
prior to auditors performing the services. The
reasoning was to address whether independence of the auditors would be impaired.) In
particular, Section 201 of the SOX lists nine
nonaudit services that would potentially impair
the firms independence. (Most of this information was also addressed in the November 2000
SEC independence release.) The prohibited
services (unless approved by the audit committee) include:
Nonaudit services
The SEC revised the rules relating to the

nonaudit services that, if provided to an audit
client, would impair the accounting firms independence. SEC rules also require disclosures to
Bookkeeping or other services related to

the accounting records or financial statements of the audit client.
Financial systems design and implementation. The new rules prohibit the accounting
firm from providing any service related to
the audit clients information system unless
it can be proved that the results of these tests
will not be subject to audit tests.
Appraisal or valuation services including
any process of valuing assets that could be
subject to audit tests.
Actuarial services involving the determination of amounts recorded in the financial
statements and related accounts that could
be audited.
Internal auditing that relates to the audit
clients internal accounting controls, financial systems or financial statements.
Auditor acting, temporarily or permanently,
as a director, officer or employee of an audit
client, or performing any decision-making,
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117
supervisory or ongoing monitoring function for the audit client.

Expert opinions or other expert services
to an audit client for the purpose of advocating that audit clients interests in litigation or in regulatory proceedings.
Section 202 of SOX requires public disclosure

of nonaudit services approved by the audit
committee and requires that all fees paid to
the accountant be disclosed. (Again we note
that SOX only formalised this process.)
Partner rotation
It is also required that certain partners on an

audit engagement team rotate after no more
than five to seven consecutive years, depending
on the partners involvement in the audit (certain small accounting firms are exempt from
this requirement). This had been a POB
requirement since the 1980s until the POBs
demise. SOX just adopted the POB rules. An
audit partner is defined as a member of the
audit engagement team who has responsibility
for decision making on significant auditing,
accounting and reporting matters that affect
the financial statements.
Audit engagement team
An accounting firm would not be considered

independent from an audit client if certain
members of the management of that issuer had
been members of the accounting firms audit
engagement team within the one-year period
preceding the commencement of audit procedures. (See SEC November 2000 release, which
also had this rule.)
Additional auditor compensation
An accountant would not be considered independent from an audit client if any audit partner
received compensation based on the partner
procuring engagements with that client for
services other than audit, review and attest
services. (This would be akin to a contingency
fee, which is prohibited.)
118
Audit committee approval
Require that the companys audit committee

pre-approve all audit and nonaudit services provided to the issuer by the auditor. The audit
committee now also has a major role to play
in the hiring and firing of auditors.
Additional provisions of SOX were put in
place to establish code of ethics for management to ensure greater independence (Sections 305 and 406). In addition management
is required to test the controls over financial
reporting (Section 404). The confluence of
these provisions with the auditorclient relational aspects of SOX together provide further
insulation between the auditor and its findings
and the power of management to displace or
threaten the auditor. The confluence of these
provisions, as well as SOXs insistence on greater
board independence in its own right, act to
mitigate, if not remove, what Arthur Levitt
called a fraternal culture on the boards of
directors. Instead, Levitt went on to note that
a culture of skepticism was developing on corporate boards.23 The success of these efforts is
noted by the number of CEOs who are being
ousted by their now more assertive boards (see
Barrionuevo23). Our personal belief is that this
fraternity still exists.
WHAT ARE THE FINDINGS OF CURRENT
RESEARCH IN THE POST-SOX PERIOD?
Initial research sought to examine investor

perceptions of auditor independence in the
post-SOX period. See Table 1 for a summary
of research.
In a survey involving loan officers, Geiger
et al.16 found that respondents viewed the
influence of SOX on auditor independence
negatively. Respondents perceptions of auditor
independence and financial statement integrity
were negative, thus reducing their willingness to
grant a loan. Hodge24 observed that the nonprofessional, individual investors in his sample
perceived auditor independence to have declined
over time, even in the post-SOX period. Given
the recency and vividness of the Enron collapse,
it is doubtful that auditors would be seen in
Table 1: Selected post-SOX studies related to auditorclient relationships

Authors
Year
Finding
Schneider et al.
2006
Geiger
2002
Hodge
Chung and
Kallapur
Marchesi and
Emby
Frankel et al.
2003
2003
Examined NAS provision by the auditor and concluded that it impaired the
perception of auditor independence, not the reality
Surveyed loan officers. Found that respondents viewed the influence of SOX
on auditor independence negatively
Investors perceived auditor independence to have declined, even in post-SOX period
Post-SOX study. Found importance of client to auditors office was negatively
related to abnormal accruals
Found that audit partners judgments about client credibility were positively
associated with the partners tenure with the client firm
Found a positive association between auditor fees and the closeness of client
earnings to analyst forecasts
Found no association between auditor fees and the closeness of client earnings
to analyst forecasts
Confirmed Ashbaugh et al.s result using an Australian sample
Did not find a positive association between auditor provision of consulting
services to a client and achievement of economies of scale
Used a laboratory experiment to investigate whether having investors, not
managers, hire the auditors increases auditor independence. Their findings
confirmed this expectation
Using post-SOX data, found that neither the predecessor nor successor auditors
opinion was affected by client threats of dismissal
The results of this study indicate that non-audit fees may impair auditor
independence when auditor tenure is short. However, nonaudit fees do not
impair auditor independence when auditor tenure is long. The findings about
short tenure may reflect auditor concern about losing the client and the
potential revenues. However, this association does not hold as client tenure
increases. (The authors used positive discretionary accruals to surrogate for
auditor independence)
The authors note that SOX assumes that nonaudit services influence
independence and result in reduced quality of financial reporting. They
examined the association of certain elements of nonauditors independence. In
particular, they examined whether the provision of services such as financial
information systems design and internal audit consulting services could impair
independence. Their tests led to a conclusion that auditor independence
was not impaired
They find no significant association between nonaudit service fees and impaired
auditor independence. The key difference here from the two studies cited
immediately above is that auditor independence is surrogated for by the
auditors propensity to issue going concern audit opinions
2005
2002
Ashbaugh et al.
2003
Ruddock et al.
Whisenant et al.
2006
2003
Mayhew and
Pike
2004
Lu
2006
Gul et al.
2007
Kinney et al.
2004
DeFond et al.
2002
a positive light, especially with Andersens disgrace still gracing the newspapers front pages.
Drawing conclusions about the adequacy of
SOX so quickly after Enron, therefore, is very
problematic. In a pre-SOX survey, Hussey and
Lan25 surveyed finance directors and concluded
that they, overall, agreed that prohibiting nonaudit work by auditors would significantly
enhance perceptions of auditors independence,
with the respondents still pessimistic. The additional constraints placed on audit firms through
SOX, however, and the heightened sense of
Vol. 5, 2, 112125
119
auditor legal liability that came with the fall of

Andersen, however, may result in tempered pessimism in some future replication of the Hussey
and Lan study.
Legislators and lawmakers appear to believe
that before SOX, auditor independence was
widely compromised.26 There are, however,
no prior archival studies that provide robust
evidence of auditors compromising their
independence (eg, see Kleinman, Palmon and
Anandarajan2). The next area of research examined different components of SEC legislation
to improve auditor independence. In the postSOX period, Chung and Kallupar27 found a
negative relation between absolute abnormal
accruals and an office level measure of client
importance to the audit firm. This was a study
that measured auditor independence indirectly
by using abnormal accruals. An abnormal accrual
is defined as the incremental accrual over and
above the expected accrual under the circumstances. Abnormal accrual was computed as
the difference between the actual, total, accrual
and the expected accrual. The theory was that
higher abnormal accruals reflected lower earnings quality. Lower earnings quality in turn can
be attributed to impaired auditor independence.
The researchers found a negative association.
This implied that lower discretionary accruals
were associated with bigger clients. The studys
conclusions imply that auditors are more stringent with larger clients, not less stringent as
theory espouses. Chung and Kallapur concluded, post-SOX, that existing incentives may
be sufficient to motivate auditors to be independent. This may reflect heightened fear of
auditor liability given Andersens fall, as well
as unclear guidance from the PCAOB and the
SEC regarding AS-2. An alternate explanation
for this finding, however, would be that the
clients reined in their own impulses to book
abnormal accruals given the high level of
public attention that Enron brought to large
firm accounting practices. Section 404 reviews
of controls over financial accounting and Section 302 certification probably fostered this
more cautious environment.
120
If so, then it is unclear whether the results

stemmed from (a) audit firms becoming stricter;
(b) clients being less willing to push the envelope with regard to corporate reporting; or (c)
some combination of the above. This is clearly
an issue that future research should address. It
may be very difficult, however, to gain access
to the intra-firm dialogues of auditors and of
clients as well as their discussions with each
other (see,28 however, for an excellent study
of this type).
While the Chung and Kallapur study
adopted a macro view, other studies adopted a
micro view by examining the influence of different aspects of the recent SEC requirements.
One SEC requirement was partner rotation. In
an experimental study, Marchesi and Emby29
examined whether duration of tenure with a
client would influence a goodwill impairment
decision. They placed actual audit partners in
two groups. One group was told that they
had a long-standing relationship with a client,
while another group was told that they were
new partners. They found that partners with
longer association believed clients assertions and
therefore concluded that purchased goodwill
was not impaired. Newer partners, in contrast,
were more likely to conclude that there was
impairment. Marchesi and Emby concluded
that within-firm rotation of partners should
help improve auditor independence. Gul et al.30
found that, in the presence of fees for nonaudit
services, the short-term independence of the
auditor seemed to be impaired, but not the
long-term independence of the auditor. These
results are consistent with the Kleinman and
Palmon12,19 theoretical framework for understanding auditorclient relationships.
The bulk of the research to date, however,
has examined the impact of the provision of
nonaudit services in the post-SOX period.
Ashbaugh et al.31 found no significant association between firms meeting analyst forecasts
and auditor fees. Hence, they concluded that
there is no evidence to support the claim that
auditors violate their independence as a result
of their clients purchasing relatively more
nonaudit services. This is corroborated by

Ruddock et al.32 Using Australian firms,
Ruddock et al. examined whether auditor independence was impaired by provision of nonaudit
services. They postulated that if independence
was impaired, then audit reports would show
less conservatism. They did not find this and
concluded that the provision of nonaudit services did not impair the auditors independence.
These results were similar to those of Kinney
et al.33 and DeFond et al.34 Finally, Whisenant
et al.35 concluded that economies of scale (and
more effective audit due to a better understanding of the clients affairs) were not fostered
by auditor consulting service provision.
SOX also attempted to increase auditors
independence from management by assigning
authority to hire and fire auditors to the
audit committee. Prior to SOX, management
exerted a significant influence over auditor
hiring and firing. Boards of directors were and
still are dominated by management (but see
Barrionuevo23), even though audit committees
are now made up of independent directors, not
insiders. Hence, this situation enables management to have significant influence over auditor
hiring and firing decisions. Even though the
Blue Ribbon Committee on Improving the
effectiveness of Corporate Audit Committees
(1999) argued that this impaired auditor independence and suggested that authority to hire
and fire auditors be transferred to the audit
committee, this was not done till SOXs enactment. Mayhew and Pike1 created a laboratory
experimental situation in order to shed light
on whether transferring the power to hire and
fire auditors from managers to investors significantly changes auditor independence. They
used auditors and, hence, their study has external
validity. They concluded that when managers
have reduced power to hire and fire auditors,
based on reactions in an experimental situation, the independence of auditors increased.
Hence, they provide evidence to corroborate
the stance of SOX that reducing the power of
managers to hire auditors improves independence. Clearly, other arrangements may exist, for
example, auditors being hired and fired based

upon relationships with board members and
powerful shareholders.
The recent spate of corporate reporting scandals tied to backdating of options grants, however, suggests that management still has many
opportunities to manipulate corporate accounts
in their favour. With these scandals many
post-SOX the cry again arose Where were
the auditors? The surfacing of these scandals is
of too recent vintage to have generated academic research. We note, however, that academic research uncovered the current scandals
and triggered the SECs scrutiny of stock option
dating practices.This is an example where management withheld information from the auditor
and provided an audit trail that supported managements position. The SECs enforcement
has been against corporate legal counsel and
CEOs not, as far as we are aware, audit firms.
Management certainly has many other opportunities to collude in hiding transactions from
the auditor. Given that three key parties (the
boards of directors, which at least nominally
are required to approve management compensation and increasingly should be populated by
independent directors; top management, the
putative recipients of this corporate largess; and
the auditors whose responsibility is to ensure
that the options are booked appropriately and
were granted pursuant to board action (but see
Nocera36)) are all involved, this is an issue ripe
for study. An interesting question for study is
just how far back the practice of backdating
options goes.
Lu37 investigated how companies (a) threats
to dismiss auditors and (b) their engagement in
opinion shopping influenced auditor independence. The results do not indicate loss of independence by either the predecessor nor successor
auditor. This is consistent with older research
cited by Kleinman, Palmon and Anandarajan.2
While Lu found no impact of opinion shopping and threatened auditor dismissal on auditor
independence, it is interesting to explore in detail
the reasons for auditor changes since SOX. This
is a subject for future researchers.
Vol. 5, 2, 112125
121
In earlier literature (see Kleinman, Palmon

and Anandarajan2 for a review), auditors were
often said to lowball auditing bids because they
expected to make up any losses on initial year
audits in future years since subsequent years
auditing costs would be lower, while the audit
fee would be the same or higher. Since the lowballing took place when the audit firms had
other services available to sell clients, this behaviour no longer has a clear economic rationale.
Further, audit costs in subsequent years may
not be lower because of a change in scope, but
the auditor was locked in on a fixed fee for a
certain period (eg, three years). With the spinoffs or outright sales of auditing firm consulting
arms, the auditor has less of an economic rent
to gain in future years. Instead, the client faces a
severe penalty should they displace the auditor.
While the successor auditor has the ability
to review the prior auditors working papers,
these are very likely to be less informative than
having had hands-on experience with the client
previously.
SUMMARY AND FUTURE RESEARCH
In this paper, we only examine published

studies. What has the research found that could
be useful to regulators? To date, there have been
few published studies. Initial studies examined
investors perceptions of the impact of auditor
independence. Geiger et al. concluded that investors were still pessimistic. That study, however,
was published directly after the implementation
of SOX. It is now five years since that study
has been published. Has investors initial pessimism been alleviated? This is an area for future
research. Another viewpoint is that, judging by
the great increase in the stock market since the
2000 reporting scandals, there is considerable
uncertainty as to whether the auditor plays an
important role in the capital market or whether
investors are even concerned with auditor
independence. Alternatively, investors may have
been lulled into feeling comfortable about
audit firm performance given the clear legal
penalties that the audit firms face in the era of
SarbanesOxley. This, too, is an area for future
122
research that has not been thoroughly examined. It would be interesting to see whether
SOX itself, and the impact of SOX on auditor
independence, is now viewed more positively
by the investing public. An empirical study by
Chung and Kallapur demonstrates that auditors
are more stringent with larger companies in
the post-SOX period. This is just one study. It
is four years old and used data gathered almost
immediately after the implementation of SOX.
Researchers now have access to four more years
of data. A replication of this study could reveal
whether the tough stance of the auditors has
softened in the intervening years. Research on
the provision of nonaudit services has been
relatively more extensive. The results, however,
are conflicting. Frankel et al.38 conclude that the
provision of nonaudit services (and increased
fees therefrom) impairs the independence of
auditors. Ashbaugh et al., however, find results
to the contrary. Both studies used data immediately after the SOX enactment. Hence, this
is another area deserving of further scrutiny.
Finally, other results tend to support the idea
that audit partner rotation, required by SOX,
increases independence (Marchesi and Emny).
The studies also find that auditor rotation
improves independence in the post-SOX period
(Mayhew and Pike). Finally, dismissal threats do
not appear to have a significant impact on auditors decisions, implying an independent auditor
stance in the post-SOX period.
The SEC requirement to enhance auditor
independence has been far reaching. It involves
providing guidelines on matters relating to the
provision of nonaudit services, partner rotation,
audit engagement teams, auditor compensation
and the role of the audit committees. Overall,
the paucity of current research on these issues
has led the field to fall short of providing
detailed guidance to the SEC and other regulators on the effectiveness of their guidelines in
enhancing auditors independence.
Now let us look at other research opportunities in this area. An interesting research question
posed by Kinney39 is still valid today, namely,
do other countries have a better system? Italy
has long proscribed management consulting

services rendered by the audit firm to an audit
client. Have the Italian rules been successful?
Does Italy have more investor confidence in
the auditors independence, or in the efficiency
and integrity of the system of audited financial reporting and disclosure? Kinney notes that
comparative survey research across regulatory
regimes could be instructive in determining
whether the United States might be improved,
and how that might be accomplished. In England, the Cadbury Committee recommended
the rotation of audit partners within firms with
respect to audits. China is conducting an open
market policy and Chinese firms are seeking
independent audit services. China is characterised by government control and influence
over CPA firms which, in turn, protects auditors
from the threat of litigation. The government,
in their desire to promote foreign investment,
has, however, imposed penalties ranging from
suspension of licenses for signing false reports
to imprisonment for violation of criminal statutes and forced dissolution of firms.40 Have the
threats of these actions improved independence
in China? What about the French system of
having two audit firms act jointly as auditors
for specific clients.41 Under this system, two
audit firms serve as auditors for large clients,
allowing one of them to be dismissed without
gravely damaging the ability of the client to
achieve a timely audit in the future since one
of the two prior auditors is still on the audit.
According to Herbinet,41 this system has led to
markedly lower auditor concentration in France
than elsewhere. Given US Treasury Secretary
Paulsons concerns about auditor concentration,
and the difficulty second- or third-tier auditors have in auditing giant corporations, having
audit firms team up provides alternatives to the
continued dominance of the Big Four. In the
alternate, of course, such a system gives companies an ability to seek auditors beyond the Big
Four, thus increasing the audit firms perceived
risk that they could be replaced by the client.
A further consequence of the French system,
however, is that it will be more difficult for
any particular audit firm to lose its independence to the client since such an outcome
becomes more quickly disoverable by its
co-audit firm. We note that Canada has had
a co-audit firm for its banking system for a
number of years.
An additional framework for understanding
auditor research internationally comes from
using the insights of La Porta et al.42 These
researchers argued that legal systems in countries
around the globe reflect the legal system of the
former colonial power that had once governed
that country, pre-independence. According to
La Porta et al.,42 Anglo-Saxon countries offer
the best investor protections. The Anglo-Saxon
countries are characterised as having common
law systems. Germanic code countries offer a
middling level of investor protection, while the
Civil Code, characteristic of the legal systems of
former French colonies, provides relatively less
protection. Research questions that stem from
this include: are auditors more likely to toe the
line on independence in common law countries than in Germanic code countries since
investor protections are better in the former,
thereby raising the prospect of audit firm litigation losses? Similarly, are auditors in Germanic
code countries more likely to toe the line on
independence than auditors in Civil Code
countries? Given this background, it would
be instructive to understand how the interplay
between board members, managers and auditors
plays out across countries that have adopted
different legal codes. Are auditorclient relations clearly more constrained in common law
countries than in Germanic countries, and so
forth? We believe that it is important to understand these especially given strong trends toward
globalisation of business and easing of crossborder stock exchange listing requirements.
Understanding this, along with the interaction
of national characteristics (see discussion of
Italian, British and Chinese auditor regulatory
regimes above) should be of great use in gaining
a greater understanding of the determinants of
auditor independence and behaviour across a
variety of settings.
Vol. 5, 2, 112125
123
Finally, the AICPA suggests that independence-related research should analyse issues
related to confidence in the independence
of auditors, perceptions of financial statement
accuracy and reliability, and discretionary decision making by financial statement users. In
this paper, we identify deficiencies in existing
research and provide guidelines on expanding
the reach of auditor independence research by
looking at developments in the international, as
well as domestic, arena.
10
ACKNOWLEDGMENTS
124
We acknowledge our gratitude to Don Warren

for his comments and suggestions.
11
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Auditor independence revisited: The effects

of SOX on auditor independence

Following a wave of accounting scandals, the Sarbanes

International Journal of Disclosure and Governance Vol. 5, 2, 112125

2008 Palgrave Macmillan Ltd. 1741-3591 $30.00

Anandarajan, Kleinman and Palmon

also find an interest in reading our paper.Given strong

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International Journal of Disclosure and Governance