Independence, impartiality, and advocacy in client conflicts

Research in Accounting Regulation 22 (2010) 29–39

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Independence, impartiality, and advocacy in client conflicts Michael L. Roberts University of Colorado Denver, The Business School, Campus Box 165, POB 173364, Denver, CO 80217 3364, USA

a r t i c l e

i n f o

Keywords: Independence Earnings management Professional judgment Impartiality

a b s t r a c t Prior research indicates auditors’ financial reporting judgments are conservative when client preference is unknown, but auditors are less conservative (though not client-supportive) when clients’ preferred accounting methods for favorable financial reporting are explicitly communicated. This paper reports, for the first time, a situation in which experienced auditors exhibit client-supportive behavior. Professional judgments in an audit setting in which there is an explicit client preference for a material, income-increasing reporting classification and the relevant GAAP standard is principle-based are compared to a similar judgment in a tax setting. This research design contrasts the auditor’s ethical duty to exercise ‘‘judicial impartiality” toward the client with Certified Public Accountants’ ethical duty to be a client advocate in tax contexts. The results suggest experienced CPAs’ are as client-supportive in audit settings as they are in tax settings when exercising their professional judgment, and ethical standards mandating impartiality in auditing are not uniformly being followed. Ó 2009 Elsevier Ltd. All rights reserved.

Introduction The purpose of this research is to utilize the judgments of Certified Public Accountants [CPAs] in a tax decision context as a benchmark to assess the influence of audit clients’ preferences for favorable financial reporting on CPAs’ professional judgments in an audit decision context. In recent years, the integrity of accountants has been called into question by numerous high-profile corporate frauds and audit failures. One leading accountant has suggested (a) the problem is not an audit problem, it is a corporate governance problem and (b), if it is an audit problem, then it is limited to a very small percentage of bad auditors and/or clients, perhaps as little as one percent or less (DiPiazza, 2002); another has suggested the problem is auditors’ failure to understand business risk, not a lack of independence (Wyman, 2004). In 2002, as a direct result of concern over auditors’ independence and the failure of self-regulation, Congress established the Public Company Accounting Oversight Board [PCAOB] to independently regulate audit quality (US Congress, 2002a).

E-mail address: [email protected] 1052-0457/$ - see front matter Ó 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.racreg.2009.11.001

No prior accounting research study has found mean judgments of experienced auditors are client-supportive when a material item is in question (e.g., Libby & Kinney, 2000; Salterio & Koonce, 1997, Trompeter, 1994; also, see review by Kleinman, Palmon, & Anandarajan, 1998). However, no prior study has addressed the question directly. Instead, prior studies have examined the relative influences of factors such as economic risk (Farmer, Rittenberg, & Trompeter, 1987), pressure to conform to partners’ expectations (Lord, 1992), partner compensation schemes (Trompeter, 1994), in-house precedents and audit evidence (Salterio & Koonce, 1997), audit communications (Libby & Kenney, 2000), and materiality aggregation effects (Braun, 2001). This study examines CPAs’ independence by examining how CPAs apply the same accounting principle under two different ethical standards. The accounting principle application examined is the classification of a material expenditure as a current expense (i.e., a repair) versus capitalization as an asset (i.e., an improvement) with subsequent depreciation. Generally accepted accounting principles require expense treatment in this case unless: (1) the expenditure creates, enhances or improves an asset, in contrast to repair or maintenance, (2) the expenditure is

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expected to provide benefits beyond the current year, and (3) the amount is material (Kieso, Weygandt, & Warfield, 2010). The expected reporting incentives for profitable businesses are for income-increasing classifications for financial reporting (capitalization) and income-decreasing classifications for income tax reporting (expense) (Cloyd, Pratt, & Stock, 1996). This GAAP evaluation applies equally to classifications for financial reporting as for income tax reporting. In both decision contexts, professional ethical standards mandate the CPA exercise his or her judgment independently (in both appearance and fact) of client influence (AICPA, 1991a). However, in the audit decision context, there is a professional duty for CPAs to be impartial; in the tax decision context, there is a professional duty for CPAs to be a client advocate, i.e., partial. The tax decision context thus provides a benchmark for examining the extent to which CPAs’ GAAP judgments are client supportive in audit decision contexts. The results of this study suggest CPAs are as client-supportive in audit as they are in tax contexts when applying a principle-based GAAP standard. CPAs in this study are just as willing to acquiesce to client’s demands for incomeincreasing classification for financial reporting in the audit setting as they are to acquiesce to income-decreasing classification for tax reporting. The judgments of CPAs in both audits and tax settings are significantly on the client-supportive side of the response scale. These results extend prior research on accountants’ independence in two ways. First, this study demonstrates for the first time a situation in which mean judgments of experienced auditors indicate acquiescence to earnings management by audit clients: CPAs’ professional judgments for classifying a material, income-increasing audit adjustment in this study are significantly client-supportive, not neutral. Secondly, judgments in the audit context are just as influenced by clients’ preferences for specific accounting treatments as are CPAs’ professional judgments in an advocacy-mandated tax setting. Thus, there appears to be no difference between client-supportiveness in the audit setting where impartiality is mandated by professional ethics and in the tax setting where an attitude of client advocacy is mandated by professional ethics. The results of this study suggest Congress’ creation of the PCAOB to regulate auditor independence was justified, i.e., that auditors’ independence from their audit clients was not sufficiently guaranteed by the self-regulation of the profession. Congress acted in 2002 based on a handful of highly-publicized audit and corporate accounting failures and on longer-term concerns about auditor independence at the Securities and Exchange Commission (Schuetze, 1994) based on anecdotal evidence. This study provides experimental evidence confirming that previous anecdotal evidence. Whether Congress’ remedy—i.e., the new regulatory powers of the PCAOB—is sufficient for improving auditor independence or not, is a question for future research. The next section summarizes Certified Public Accountants’ professional responsibilities regarding independence and impartiality and prior research investigating professional judgments in client conflict situations in audit and

tax contexts. The following sections describe the methodology for the experiment, results, possible remedies, limitations, and suggestions for future research.

Theory and hypotheses development Cognitive Moral Development and Rational Choice Theory The Theory of Cognitive Moral Development [CMD] (Kohlberg, 1976; Rest, Narvaez, et al., 1999) has dominated the social sciences, other than economics, for the past 30 years (Watson & Sheikh, 2008). CMD assumes a morally well-developed individual evaluates ethical situations as though he or she is a disinterested third-party (Walker & Pitts, 1998). According to CMD, self-interest is an early stage of moral development individuals pass through on their way to adulthood and to becoming morally developed. Once an individual ‘‘arrives” at a mature stage of moral development, he or she adopts a mindset of altruism, that is, regard for others’ well-being that is greater than self-interest. Notably, this view has been adopted by the AICPA and by the US Supreme Court for professional ethical and legal standards for the auditing profession as discussed below. To test whether individuals’ behavior matches the altruism predicted by CMD, Batson et al. (2006, 1997) conducted a series of experiments involving assigning dull, repetitive tasks versus intrinsically interesting tasks to oneself or to others. Batson et al. found individuals exhibited self-interest, assigning the dull task to others, despite scoring highly on the Defining Issues Test, the measuring device for Cognitive Moral Development. Further, Batson et al. conclude most individuals want to appear to be moral without paying the price of self-sacrifice (Batson et al., 1997). Batson et al. refer to this situation as ‘‘moral hypocrisy.” In contrast to CMD, Rational Choice Theory [RCT] (also referred to variously as Neoclassical Economics, Expected Utility Theory, and Expectancy Theory) has long been the dominant paradigm in economics and has been applied to explain human behavior in sociology, political science, and anthropology (Green, 2002). RCT is primarily concerned with choice behavior in the allocation of scarce resources. The theory assumes individuals apply a selfinterest standard of rationality to make choices consistent with their objectives and that they use a cost-benefit analysis to do so. The theory also assumes certainty, consistency, and transitivity of choice alternatives. Green (2002) summarizes how the theory has been successfully applied to choices as diverse as predicting church attendance, suicide, effects of auto safety regulation, addiction to heroin, racial profiling, megafauna extinction, employee shirking, the development of language, and the outcomes of civil wars. RCT makes several simplifying assumptions, so application to real-world issues is not always straightforward. One problem with RCT is the definition of ‘‘rational.” According to RCT, rational simply means an individual’s choices reflect the most feasible alternative according to preferences that are complete and transitive, i.e., that a choice

M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

maximizes the individual’s utility. The larger problem, in terms of RCT as an ethical model, is the absence of considerations of moral values and psychological payoffs to individuals. Instead, RCT assumes individual utility is a function of self-interest limited to material well-being alone (Hausman & McPherson, 1996). If Rational Choice Theory is to have value to explain individuals’ behavior in ethical contexts, the theory needs to be expanded to include the achievement of personal values and psychological payoffs in addition to material payoffs. We know from prior research that individuals do derive utility from achieving values such as fairness (Kahneman, Knetsch, & Thaler, 1986), justice (Fehr & Gachter, 2000), and community (Watson & Sheikh, 2008), and that they sometimes choose to achieve these values even at the expense of nonrecoverable financial costs to themselves (Fehr & Gachter, 2000; Watson & Sheikh, 2008), results that are not predicted by traditional Rational Choice Theory. Research in psychology also has shown individuals are motivated to avoid cognitive dissonance, i.e., to behave in ways consistent with their sense of self and their espoused values (Plous, 1993). Therefore, a logical extension of Rational Choice Theory would include explicit consideration of an individual’s internalized societal-moral values and concomitant psychological benefits and costs. For example, for Certified Public Accountants, benefits of complying with official professional ethical standards might include enhanced moral values such as feelings of loyalty, community and respect for authority – which prior research has found to be universal (Pinker, 2008). Benefits could also include avoiding the potential costs of violating social norms (e.g., personal shame), and professional and financial sanctions for violating professional ethics. Consistent with this expanded view of Rational Choice, in any given ethical judgment, we might expect auditors will weigh the perceived costs and benefits of alternative actions—including both psychological payoffs as well as material costs and benefits—and their choices will reflect rational self-interest in this expanded sense. The CPA’s duties of independence, impartiality, and advocacy The accounting profession’s long-standing emphasis on auditor independence (Previts, 1998) is reflected in the AICPA’s revised code of ethics (now Code of Professional Conduct, 1991a, 6). Statement on Auditing Standards No. 1 (AICPA, 1988 sec. 220, par. 0.02) clarifies that independence implies ‘‘a judicial impartiality that recognizes an obligation for fairness not only to management and owners of a business but also to creditors and those who may otherwise rely (in part, at least) upon the independent auditor’s report” (emphasis added). The United States Supreme Court in US v. Arthur Young & Co. (465 US 805, 1984, pp. 817– 818) stated independent public accountants owe ‘‘ultimate allegiance to the corporation’s creditors and stockholders as well as to the investing public. This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times. . ..” Mautz and Sharaf (1961, p. 50) describe independence as a distinguishing feature of the accounting profession. Previts (1998) sum-

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marizes the history of auditor independence from 1900 to recent times. In contrast to the CPA’s duty of impartiality in auditing, CPAs have a professional duty to be a client advocate in tax matters (AICPA, 1991c). Statement No. 1 of Statements on Responsibilities in Tax Practice states: ‘‘A CPA has both the right and responsibility to be an advocate for the client...” (emphasis added) (5, par. 0.04). An IRS-commissioned survey of tax practitioners (IRS, 1987) revealed that 85% of CPAs reported their loyalties were partly or completely with clients when dealing with gray areas of the tax law.1 In tax situations, the Internal Revenue Code contains an explicit ‘‘realistic possibility” standard in favor of clientsupportiveness (§6694(a)) that permits resolving a controversial position on a tax return in favor of the client if there is merely a one in three possibility of success.2 The AICPA’s Code of Professional Conduct broadly requires the CPA to maintain independence from the client in all engagements. However, the attitude of impartiality is required only in auditing and other attest functions, and the attitude of advocacy is required only in tax functions. Fig. 1 shows the relationships of these three concepts of independence, impartiality, and advocacy as they relate to CPAs’ professional judgments in audit and tax activities. Prior findings concerning audit judgment in client conflicts Given the critical importance of auditor impartiality, it is surprising that relatively few experimental studies have directly examined auditors’ impartiality in making audit judgments.3 Only six prior studies have examined audit partners’ and managers’ judgments regarding material items. Data in Farmer et al. (1987) suggest that most partners and managers are independent in fact when it comes to accepting the client’s position. They report that only 12.5% of partners and managers would go along with the client’s preference. Similarly, Lord (1992) and Trompeter (1994) found all judgment means were on the non-client-supportive side of the response scale. Salterio and Koonce (1997) reported a mean response for the client preference group that is not significantly different from the midpoint of their scale (their third experiment involving mixed precedents). Braun (2001), in cases that presented single-item, material adjustments, found 90% of subjects made GAAS-correct decisions for income-decreasing adjustments and 70% made GAAS-correct decisions for income-increasing adjustments (the difference indicating greater conservatism when faced with a probably correct, but income increasing, adjustment). Jenkins and Haynes (2003) reported initial responses to a material liability disclosure that is significantly non-client-supportive. 1 Research on CPAs’ tax advice confirms the view that CPAs act as client advocates in tax matters and that tax judgments are affected by economic factors such as penalties (see Roberts, 1998 for a review). This is not to say that CPAs are acting inconsistently with the professional standards for independence, but that the orientation in tax matters differs from that in auditing and other attest functions. 2 In 2007, Congress revised the tax preparers’ standard to a ‘‘more likely than not” standard. 3 Corless and Parker (1987) point out there are few empirical studies involving the action or behavior of the auditor regarding independence.

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M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

Audit Settings

Tax Settings Independence | | | |

Impartiality | | | Weigh Client Interest

=?

Weigh Public Interest

Advocacy | | | Weigh Authority For Client

>1/3

Weigh Authority Against Client

Fig. 1. Independence-in-fact in audit and tax decision making.

Thus, across these six studies, one (Jenkins & Haynes, 2003) indicates audit partners and managers are independent in fact, two (Braun, 2001; Farmer et al., 1987) report 89–90% of partners and managers are non-client-supportive, and three (Lord, 1992; Trompeter, 1994; and Salterio & Koonce, 1997) indicate auditors’ and partners’ judgments are not significantly different from neutral when faced with client preferences for material adjustments. None of the prior studies indicate a majority of audit partners and managers would acquiesce to a client’s preference for classifying a material adjustment. These prior studies have demonstrated that client preference can make a slight impact on auditors’ judgments, but no prior study has demonstrated that the professional judgments of a majority of experienced auditors agree with their clients’ preferences for financial reporting of material items.4 However, none of these studies have directly compared audit partners’ and managers’ judgments to a clearly client-supportive benchmark. Prior findings concerning tax judgment in client conflicts In contrast to prior findings in audit contexts, prior research in tax settings has consistently found accountants’ reporting recommendations reflect clients’ preferences for aggressive tax return positions (see Roberts, 1998 for a review). The incentive to retain an important client, when retention is implicitly or explicitly conditioned upon the tax accountant’s acquiescence to a given reporting position, influences the tax accountant’s judgment for grayarea decisions, i.e., when the reporting position is not clearly wrong. This finding is consistent with the professional ethics of tax practice, i.e., that in gray areas the CPA has a duty to be a client advocate (AICPA, 1991c). In gray areas, it is expected that tax accountants will make more aggressive 4 Several studies have examined economic influences on decisions of lower rank auditors, e.g., audit seniors. A consistent pattern has emerged in these studies that indicate lower rank auditors’ judgments are influenced by economic incentives such as fee pressure and client retention to accept client-supportive reporting methods (e.g., Farmer et al., 1987; Hackenbrack & Nelson, 1996). Client conflicts are resolved by more experienced accountants, i.e., audit partners and managers, however, and it has been suggested that partners and managers may possess tacit knowledge that enables them to resist client pressures better than lower rank auditors (Farmer et al., 1987; Moreno & Bhattacharjee, 2003).

reporting recommendations when the expected economic benefits of continued client relations, and fees, are higher and economic risks are low (Roberts, 1998).

Hypotheses Because professional guidelines for tax practice require an attitude of client advocacy, and because the tax regulations permit adopting a client’s position with merely a one in three possibility of success on the merits (in effect until this past year) while, on the other hand, professional guidelines for auditing require an attitude of impartiality, CPAs should be more client-supportive in tax than in audit decision contexts, ceteris paribus. However, if CPAs’ professional judgments in audit contexts are inappropriately influenced by economic considerations tied to clients’ preferences then there may be no difference in the degree of client-supportiveness between audit and tax contexts. Prior audit judgment research has demonstrated auditors sometimes are less conservative when client preference is explicit and when standards, precedents, and evidence are ambiguous or mixed (Salterio & Koonce, 1997). However, prior research has not yet found any evidence that auditors’ judgments take the direction of clients’ preferred classifications nor have auditors’ judgments been tested against a benchmark context in which advocacy is mandated. The generally accepted accounting principle of conservatism historically has been interpreted by CPAs as preferring that possible errors in measurement be in the direction of understating rather than overstating income and net assets in financial reports (FASB, 1990, SFAC 2 par. 91). Prior research has demonstrated auditors’ judgments reflect conservatism in the absence of an explicit client preference (Salterio & Koonce, 1997). The Financial Accounting Standards Board has explained that conservatism should not bias financial reports, but should reflect ‘‘prudent reporting based on a healthy skepticism” (FASB, 1990, SFAC 2 par. 97). Therefore, one would expect, ceteris paribus, that CPAs’ professional judgments involving measurements and classifications for which there are no clear authoritative guidance would be conservative (i.e., ‘‘prudent reporting based on a healthy skepticism”) when the statements

M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

are to be relied upon by creditors and/or the investing public. If a client’s desired treatment would result in higher values for reported income or assets and such treatment cannot be justified on either facts or authoritative guidelines, then a priori the CPA would be expected to recommend a more conservative approach. This is especially so given the potential for biased reporting as a result of the inherent conflict of interest between financial statement preparers (i.e., client management) and external users that is ‘‘a primary condition creating the need for the audit function” (American Accounting Association, 1973). Salterio and Koonce (1997), Braun (2001), Jenkins and Haynes (2003), and other researchers have provided evidence that auditors are conservative with regard to income-increasing financial statement adjustments in prior experimental studies. Thus, I test the following null hypothesis: H1null. In a decision context in which the relevant accounting principles and facts permit the application of professional judgment in favor of or against the client’s preferred treatment, CPAs mean classification judgments of expense versus capitalization will not differ between tax and audit contexts. Rejection of H1null would lead to the conclusion CPAs are more client-supportive in tax contexts than in audit contexts, a result consistent with professional ethics for audit and tax practice: H1A. In a decision context in which the relevant accounting principles and facts permit the application of professional judgment in favor of or against the client’s preferred treatment, CPAs mean classification judgments of expense versus capitalization will be more client-supportive in tax than in audit contexts. Failure to reject H1null would lead to concluding either (1) client-supportiveness in auditing cannot be distinguished from the level of client advocacy in tax contexts and would appear to be inconsistent with professional standards for impartiality and independence-in-fact—if and only if mean judgments in both the audit as well as the tax contexts are in the direction of client-support would indicate; or (2) CPA participants’ mean judgments are conservative in both audit and tax contexts in this experiment. Since a plurality of prior studies (three of six) has reported auditors’ mean professional judgments are neutral in the presence of an explicit client preference, I also test a second null hypothesis: H2null. In a decision context in which the relevant accounting principles and facts permit the application of professional judgment in favor of or against the client’s preferred treatment, CPAs mean classification judgments of expense versus capitalization will not differ from neutral in audit contexts, i.e., they will be neither conservative nor clientsupportive.5

5 I do not state the parallel hypothesis for tax contexts because prior research has consistently demonstrated CPAs are client-supportive (Roberts, 1998).

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Methodology Experimental design and task The materials include a background case and seven subsequent cases (eight total) constructed from three risk variables with two levels each, a full 23 research design. The background case describes an expenditure classification problem—expense versus capitalization—in connection with the current year’s audit or tax return, for which specific authoritative guidance is lacking. The facts disclose that other CPAs in the respondent’s firm are working on the problem and have approached the respondent for an opinion. The facts also describe the client as contributing a relatively large percentage of the firm’s annual gross revenues and describe the expenditure amount in question as material. The three risk factors, previously shown to significantly affect auditors’ judgments (see for example Farmer et al., 1987 and Gramling, 1999), are varied at high and low levels: the client’s operating performance (strong or poor) over the last two years, the likelihood (high or low) of losing the client if the client’s desired classification (capitalization in the audit case, immediate expensing in the tax case) is not made, and the likelihood (reasonably possible or remote) of a third-party creditor questioning the CPA’s classification decision. These three risk factors are not intended to be exhaustive. Client size, materiality, and nature of the issue, for example, were controlled, rather than manipulated, in the experimental materials (Nelson, Elliott, & Tarpley, 2002). Respondents indicated their judgments for each case on a five-point Likert-type scale including Definitely Expense, Probably Expense, Neutral, Probably Capitalize, and Definitely Capitalize. Responses were coded from 1 to 5.6 For the audit context, the case states explicitly that ‘‘because expensing would adversely affect reported earnings, company management insists on capitalizing the expenditure.” Thus, a client supportive response (i.e., capitalize) would be to the higher end of the response scale, while a non-client-supportive response (i.e., a conservative response to expense the item) would be to the lower end of the scale. For financial reporting purposes, both a public supportive perspective and the principle of conservatism would result in expensing the expenditure if there was uncertainty about its beneficial effect on future periods. For the tax context, the case stated the engagement was only for tax return purposes, and not for audit, to avoid confounding. Further, participants were explicitly told that company management insisted on expensing the expenditure because it would lower the company’s taxes. The only other change in wording between the two sets of cases was in the identity of the third-party, represented by the IRS in the tax case instead of a client creditor. The tax case was expected to generate client-supportive responses represented by

6 Instructions indicated the respondent could mark anywhere along the line. Responses were divided into tenths for coding purposes. Fewer than 10 respondents in each of the audit/tax conditions marked a response between the labels. Likert-type scales are clearly at least ordinal measures and can usually be treated as interval measures as well (Reckase, 2000, p. 59). Accordingly, both nonparametric as well as parametric analyses of these data are presented in Results section.

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M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

responses on the left, or lower, end of the scale. To aid in comparing the results of the two contexts, responses for the tax cases have been reverse-scored so that higher numbers consistently represent more client supportive positions. Although tax practice and audit practice might seem to be mutually exclusive domains of professional judgment, both auditing and tax practice require the application of generally accepted accounting principles to many of the same transactions involving income and expense recognition and timing. The accounting principle participants in this study are asked to apply is identical in both contexts—whether a material expenditure should be classified as a current expense (i.e., a repair) or capitalized. Generally Accepted Accounting Principles require capitalization treatment if: (1) the expenditure creates, enhances or improves an asset, in contrast to repair or maintenance, (2) the expenditure is expected to provide benefits beyond the current year, and (3) the amount is material (Kieso et al., 2010). The first requirement is intentionally left open in both the audit and tax cases; the second and third requirements are explicitly met by describing the amount as material and having a future effect on reported earnings for the next five years. This GAAP evaluation applies equally to classifications for financial reporting as for income tax reporting. In both decision contexts, professional ethical standards mandate the CPA exercise his or her judgment independently (in both appearance and fact) of client influence (AICPA, 1991a). However, in the audit decision context, there is a professional duty for CPAs to be impartial; in the tax decision context, there is a professional duty for CPAs to be a client advocate, i.e., partial. The tax decision context thus provides a benchmark for examining the extent to which CPAs’ GAAP judgments are client supportive in audit decision contexts.7 Because multiple-item measures are considered to be more reliable than single-item measures (Nunnally, 1978), responses to each of the eight cases were summed to form a Professional Judgment Scale to measure the latent construct of interest in this research, auditors’ dispositions to recommend client-neutral or client-supportive professional judgments in gray-area decision contexts.8 Cronbach’s alpha was calculated to test the scale’s reliability

7 There are of course some notable reporting differences between GAAP and mandated tax accounting methods (e.g., MACRS depreciation, including advanced payments in income even for accrual method taxpayers), but there are many more similarities—particularly in the areas of applying accounting principles to issues of income and expense recognition, annualization principles, cutoff rules, accrual versus cash method, the matching principle, the continuity of ownership principle (like-kind exchanges), etc. The eight partners from eight different public accounting firms who advised me on the development of the materials agreed that applying the principle of expense recognition versus capitalization of improvement expenditures is one of the decision contexts in which GAAP and tax accounting methods overlap and, as a result, it provides a good vehicle for comparing how CPAs respond to client pressure in the two different professional ethical contexts. 8 The repeated measures aspect of the design permits analysis of interaction effects among the three manipulated risk factors; however that is not the purpose of this research and repeated measures analysis is not shown here. The manipulation of multiple risk factors would be expected to produce numerous significant higher-level interactions as well as main effects which, in fact, is the case. Interested readers are invited to contact the author directly if they desire further information about interactions among the manipulated risk factors across the eight cases.

for both the audit and tax contexts. For the audit Professional Judgment Scale, Cronbach’s alpha is 0.96. For the tax Professional Judgment Scale (after reverse-scoring), Cronbach’s alpha is 0.97. Since alpha scores above 0.80 are considered adequate, the Cronbach alpha scores indicate internal reliability of the Professional Judgment Scale is high. The cases were pretested among fellow faculty and eight partners from both local and international accounting firms. Feedback from these individuals was helpful in modifying the final case scenarios. In addition, the pretest revealed substantial variation in the responses, and the cases were judged by the partner panel to be sufficiently balanced that neither clearly client supportive nor clearly non-client-supportive responses would be expected due to the wording of the cases. Participants The eight-page booklets containing the experimental materials and demographic questions concerning the individual’s practice experience were mailed (along with postage paid return envelopes) to 1000 randomly selected members of the American Institute of Certified Public Accountants who practice in both auditing and income tax areas according to membership records. The audit versions were sent to 500 members of the sample; the tax versions were sent to the other 500 members.9 All procedures followed those suggested by Dillman’s Total Design Method (1978) to the extent possible to maximize the response rate. Usable booklets were received from 413 of the 1000 person sample, a 41.3% response rate. This response rate compares favorably with the 40% response rate obtained by the AICPA for its periodic practice analysis surveys (cf., AICPA, 1991b) and the 16% response rate for a field-based study of auditors’ earnings management experiences (Nelson et al., 2002). Slightly more than half of the AICPA membership consists of accountants who are not currently in public practice. Responses from these members were screened out. This resulted in a sample of 293. Eliminating replies with missing responses to one of the eight cases produced a useable sample of 278. Tests for differences in responses between early and late responders revealed no significant differences. Demographics are reported in Table 1. The average age of respondents is 41.92 years. They reported having spent an average of 12.71 years in public accounting auditing work and 12.53 years in public accounting tax work.10 9 Prior studies of auditor impartiality have been conducted almost exclusively with auditors from the Big 6, 5, or 4 international accounting firms (e.g., Lord, 1992; Salterio & Koonce, 1997; Trompeter, 1994). However, it is also important to study the professional judgments of auditors from smaller accounting firms whose clients represent small businesses and middle-market companies because these businesses have as much if not more impact on the economy as multinationals, producing about half the total economic output and employing about half of all private sector employees (Small Business Administration, 2004, p. 13). Thus, this study examines the decisions for a representative sample of AICPA members who practice in both auditing and tax. 10 Two-thirds of respondents (n = 209) apparently replied with total years spent in public accounting auditing, tax, etc., regardless of equivalent-years. For example, the means for this group are 15.3 years of audit, 14.8 years of tax, 6.5 in MAS, and 7.3 in Other. The other one-third of respondents (n = 99) responded with equivalent-years, adjusting for the fact that they may spend only 3–6 months of each year doing tax or audit work. Their means were: 5.8 years of audit, 6.2 tax, 0.5 MAS, and 0.9 Other.

M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39 Table 1 Descriptive statistics for participants n = 278.

Years of public accounting Audit experience: Years of public accounting Tax experience: Percentage of total Work experience in audit Percentage of total Work experience in tax Age Females Firm type (%) Local firm Sole practice National/international firm Regional firm Part-time practice

Mean

Std. dev.

12.71

10.51

12.53

11.19

36.41

28.82

39.84 41.92 1.12

27.04 11.00 0.33

50.17 23.21 13.65 8.19 2.05

50.09 42.29 34.39 27.47 14.19

Eighty-eight (88) percent of the respondents are male (18.6% of the CPAs on the AICPA-supplied mailing list were females). Seventy-three percent of the participants are in local or sole-proprietorships, compared to about 61% in the AICPA survey, and nearly 22% are members of national/international or regional firms. All the respondents are current members of the AICPA, and 91% reported having the CPA as their only professional license. Approximately 62% are partners in their firms. Between-group analyses were performed (t-tests) to check for potential differences between respondents to the audit versus tax instruments. No significant differences were found (p > 0.10) for age; type of practice (sole, local firm, regional firm, national firm, etc.); percentage of time currently spent in audit, tax, MAS, or other accounting practice; years spent in public accounting practice in tax or MAS work; certification; highest degree earned; or actual experience with a similar situation. Significant differences did exist for gender (92% male audit respondents versus 84% male tax respondents, t = 2.15, p = 0.03), years in public accounting audit work (14.8 years among audit respondents versus 10.3 years among tax respondents, t = 3.82, p = 0.0002), and number of actual similar experiences (6.5 occurrences for audit respondents versus 3.0 occurrences for tax respondents, t = 2.03, p = 0.04). Since respondents in both groups report considerable years of practice experience, none of these differences are expected to adversely affect the results.

Results H1null predicts no difference in CPAs client-supportiveness in tax versus audit decision contexts. Reported in Table 2, Panel A, a t-test for differences in mean responses on the Professional Judgment Scale for the audit cases (mean, 27.51) is not significantly different from the responses for the tax cases (mean, 28.60) (t = 1.12, p = 0.13, one-tailed). Because Likert-type response scales may only represent ordinal, rather than ratio, responses, I also conducted a Median (Daniel, 1978; Reckase, 2000) test. The Median test for differences between the Professional Judgment Scale

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for the audit and tax contexts, shown in Table 2, Panel B, also is not significant, with a one-sided p-value of 0.16. Thus, both the parametric t-test as well as the nonparametric Median test show convergent results, and both indicate no difference between judgments in the audit context (impartiality ethical standard) as compared to the tax context (advocacy ethical standard). Thus, I cannot reject H1null. Generally, when testing hypotheses it is not appropriate to conclude in favor of the null hypothesis without examining the possibility of a Type II error, i.e., the likelihood of accepting a false hypothesis. The appropriate method for examining this possibility is a power analysis (Howell, 1982). Power is a function of several variables, including (1) a, the probability of a Type I error, (2) the true alternative hypothesis, lA (3) the sample size, and (4) the particular test employed (e.g., independent versus matched samples). Setting a at a one-sided 0.05 level, and with the sample size of 278, and test-type as two independent samples, leaves only the true alternative hypothesis, lA, to be estimated. Estimating lA can be done in one of three ways: (1) a rough approximation from prior research, (2) personal assessment of what is an important difference, and (3) a fall-back convention using three arbitrary levels of effect size, c, where c = (lA l0)/r: Small, 0.20; Medium, 0.50, and Large, 0.80 (Howell, 1982, 155–156). For applying method (1), the only prior study that explicitly manipulated client preference (no stated preference versus a stated reporting preference) is Salterio and Koonce’s (1997) third experiment. They found a mean difference of 23.74% (on a 100 point, converted scale, the mean score was 56.08, not significantly different from neutral, with a stated preference; and 32.34, significantly conservative, with no stated preference). Applying this percentage difference in means to the possible range of 32 (from 8 to 40) on the Professional Judgment Scale developed for the present study suggests a true mean difference of 7.6 for method (1) (i.e., 23.74%  32). For method (2), if auditors are truly impartial, their mean responses should be near 3.0 on the response scale, resulting in a mean scale value of 24.0. If in the tax setting, judgments are client supportive, responses should be at least Probably Expense, or 4.0 on the reverse-scored response scale, resulting in a mean value of 32.0. This implies a true value for lA l0 of 8 (32–24). For method (3), applying the Small, Medium, and Large levels to the actual standard deviation of differences, 7.92 (Table 2, Panel B), yields approximations of the true value of: Small, 1.6; Medium, 4; and Large, 6. Thus, approaches (1–3) converge on a finding of 4–8 as a reasonable difference to expect on the Professional Judgment Scale for audit versus tax judgments. I performed the power analysis using the Proc Power procedure in SAS version 9.1 (SAS Institute, 2003). For mean differences of 4, 5, 6 and above, the power of the test is, respectively, 0.92, 0.99, and >0.999. Thus, I conclude power is acceptably high, and the probability of a Type II error, concluding in favor of a false hypothesis, is not significant. Therefore, I conclude CPAs are equally client-supportive in audit decision contexts as they are in tax decision contexts when the client’s preference for earnings

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M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

Table 2 Effects of client preferences on professional judgments in audit versus tax contexts: Professional Judgment Scale. N Panel A: audit versus tax decision context t-test Audit Judgment Scale 146 Tax Judgment Scale 132 Tax-audit difference 278

Mean

Std. dev.

t Value

Pr > |t|*

27.51 28.60 1.08

6.94 8.89 7.92

1.12

0.13

Panel B: audit versus tax context Median test Median scores (number of points above Median) for audit/tax judgment scale classified by audit/tax context Context

N

Sum of scores

Expected under H0

Std. dev. under H0

Mean score

Audit Tax

146 132

69.11 69.89

73.0 66.0

3.95 3.95

0.47 0.53

Median two-sample test Statistic Z One-sided Pr > Z Two-sided Pr > |Z| N Panel C: audit and tax decision contexts versus neutral t-tests Audit judgment context – neutral 146 Tax judgment context – neutral 132

Mean

Std. dev.

t Value

69.89 0.99 0.16 0.32 Pr > |t|*

3.51 4.59

6.94 8.89

6.12 5.93

<0.0001 <0.0001

Audit Judgment Scale is the sum of responses to the eight expense versus capitalization cases (1 = Definitely Expense, 5 = Definitely Capitalize) where client preference is to capitalize for financial reporting purposes. Tax Judgment Scale is the sum of reverse-scored responses to the eight expense versus capitalization cases (1 = Definitely Capitalize, 5 = Definitely Expense) where client preference is to expense for tax purposes. * One-tailed.

management is explicit and the relevant accounting principle is subject to the accountant’s professional judgment. H2null predicts CPAs’ audit judgments will not differ from neutral in client conflict situations. Some controversy exists whether a true neutral point exists for Likert-type scales (Guy & Norvell, 1977). Peabody (1962) examined the direction of responses to Likert-type scales and concluded that Likert scores strongly reflect direction. Therefore, to test H2null, I examined whether respondents’ audit judgments are significantly different from neutral. A neutral response on the five-point Likert-type scale for the eight cases would be a mean response of 24.0 (3.0 neutral response  8 cases = 24.0 Professional Judgment Scale response). As shown in Table 2, Panel C, results for audit mean difference from neutral (mean of 27.51– 24.0 = +3.51, t = 6.12, p < 0.0001) are significantly in the direction of the client’s explicit preference for an incomeincreasing classification decision. Therefore, I reject H2null and conclude CPAs in this study conform their professional judgments to acquiesce to the client’s intent to manage earnings. The tax mean difference from neutral (mean of 28.59– 24.0 = +4.59, t = 5.93, p < 0.0001) is also significantly in the client-supportive direction of an income-decreasing classification decision, as expected from prior research (Roberts, 1998). Both results add convergent validity to the earlier results for H1null and indicate CPAs tend to be not only client supportive, but just as client supportive (direction-oriented) in audit (income-increasing per the client’s preference in this study) as in tax decision contexts (income-decreasing per the client’s preference). CPAs’ gray area tax judgments are consistent with their professional duty and economic incentives to be client advocates. Surprisingly, CPAs appear to be equally client-

supportive in audit contexts for professional judgment as to the proper classification of a material item as an expense or an asset.11

Discussion and conclusions The results of this study indicate that auditors exhibit self-interest in reacting to clients’ reporting preferences. Auditors’ behavior is consistent with predictions of Rational Choice Theory but is inconsistent with predictions of Cognitive Moral Development Theory and with current professional ethical standards. The finding of auditors’ self-interest in this study is also consistent with psychology research that demonstrates decision makers’ exhibit bias consistently with incentives (Bazerman, Moore, & Loewenstein, 2002; Bazerman, Morgan, & Loewenstein, 1997; Kadous, Kennedy, & Peecher, 2003). People tend to focus on outcomes that are personally beneficial and to interpret 11 I also examined the possibility that participants’ responses might be influenced by the relative amount of time spent on attest (audit) versus advocacy (tax) work, i.e., whether more time performing auditing, or attestrelated work functions rather than advocacy-related work functions, influences the extent of client-supportiveness of accountants’ judgments. I regressed participants’ responses to the Professional Judgment Scale on four continuous variables, (1) percentage of total work time in audit, (2) percentage of current work time in audit, (3) percentage of total work time in tax, (4) percentage of current work time in tax in four separate regressions. None of the measures of percentage of work time in auditing or tax was significant (p = 0.32 and 0.37, respectively, for audit percentage and p = 0.54 and 0.81, respectively, for tax percentage). This suggests there is not a systematic pro-client bias attributable to spending more time in nonattest or in advocacy-related work engagements. This finding of no significant differences in client-supportive judgments attributable to work orientation adds further support to the hypotheses tests concerning about the impartiality of CPAs in gray-area audit decisions.

M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

information consistently with the outcome that reflects self-interest. This is especially the case when the available information is ambiguous (Einhorn & Hogarth, 1985; Nelson & Kinney, 1997). CPAs are required by professional standards to exercise professional judgment independently from their clients in all practice settings, tax practice as well as auditing. In audit situations, independence-in-fact requires an impartial weighing of client versus public interests. In tax situations, however, there is an explicit mandate for advocacy (AICPA, 1991c). From this difference, it is clear the duty owed by the CPA to creditors and to the general investing public in the auditing scenario is a higher standard than the duty owed to the government in the tax scenario. The results of this study, however, indicate that in gray area situations where professional guidance does not clearly mandate the correct reporting method, there tend to be no difference in the degree of client-supportiveness among a representative sample of CPAs in audit versus tax settings. This study contributes to prior research on accountants’ independence from clients in two ways. First, by comparing experienced auditors’ judgments to accountants’ judgments made under an advocacy standard, this study demonstrates a situation in which auditors conform their professional judgments to comply with a client’s demand for earnings management. This is the first study to report this result. Secondly, this study extends prior research on audit independence by comparing audit decisions to tax decisions, using the tax setting, in which an attitude of advocacy is mandated by professional ethics, as a benchmark. I find no difference in the degree of client-supportiveness of CPAs in the audit setting (impartiality standard) as compared to the tax setting (advocacy standard). These results reported in this study are surprising given what appears to be clear differences between the impartiality and advocacy standards described in the authoritative literatures for audit and tax judgments. Postexperiment debriefing discussions with audit managers revealed anecdotal evidence confirming the experimental results, i.e., an attitude that reflects a standard of decision making that may be summed up as ‘‘go along with the client unless there is a compelling reason not to.” Walter Schuetze, former Chief Accountant for the Securities and Exchange Commission, has cited numerous anecdotal examples and expressed concern over the extent to which auditors behave as client advocates in financial reporting decisions (Schuetze, 1994). This study adds experimental evidence to support those concerns. While an advocacy attitude in audit judgments may reflect the practical realities of public accounting, it reflects neither the spirit, nor the letter, of the impartiality standard. This suggests that the current impartiality standard should be revised by accounting regulators to better define the limits of impartiality. It must be possible for reasonably prudent accountants to distinguish partial from impartial judgments according to standards of independence; if not, such standards are useless. The results of this study indicate this may not be possible under the current standards. Further, my findings suggest that training programs using case studies should be developed to better hone

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auditors’ knowledge and skills at distinguishing partial from impartial judgments and the circumstances in which violations are most and least likely to occur. Auditing and auditing ethics teachers at colleges and universities should similarly develop new case studies or modify existing case studies to call attention to the impartiality standard and to help auditing students understand the dangers of unconsciously acquiescing to clients’ preferences for favorable audit adjustments and classifications. These results also suggest accountants should support financial reporting standards that provide ‘‘bright-line” tests for determining accounting and reporting treatments rather than principles-based standards whose interpretations are more ambiguous (MacDonald, 2002). Prior results and discussions with audit managers and partners indicate accountants are more comfortable confronting clients over self-serving reporting practices when the accountant has clear authoritative support than when the standards are vague. In short, ‘‘hard GAAP” is preferable to ‘‘soft GAAP” when the accountant is arguing in support of a position that is not favorable to the client. The conclusions of this study are limited to the expense/ capitalization decision context of the cases used and to the description of the client as private rather than public. Other results might be obtained with different gray-area decisions or in the context of publicly-held audit clients. Future research should test the robustness of the finding of a client-supportive bias in other gray-area audit decision contexts and in a publicly-held context. In addition, the participant pool of mostly small-firm CPAs differs from most prior research with auditors from international accounting firms. Although smaller accounting firms serve businesses that, in the aggregate, constitute a significant percentage of employment and economic activity, large firms serve almost all of the publicly traded audit clients, and it is possible different results would be obtained among large firm audit partners and managers. Future research should investigate this possibility. The experiment reported in this study was conducted prior to the Enron and subsequent accounting scandals and prior to passage of the Sarbanes–Oxley Act. Discussions with CPA partners since these events have suggested they have experienced a renewed respect from their clients’ boards of directors and that CPAs’ recommendations are receiving greater attention. Section 10 of the Exchange Act (US Congress, 2002b) currently requires public company auditors to report alternative treatments of financial information discussed with management to an independent audit committee of directors. A survey of accountants’ pre- and post-scandal attitudes reflects a shift towards conservatism (Lindberg & Beck, 2004). Do these changes suggest external auditors are no longer subject to an inherent conflict of interest with audit clients? This seems unlikely. What seems more likely is the heightened public and regulatory awareness from the numerous accounting scandals of 2001–2003 and the passage of Sarbanes–Oxley have created a temporary blip on the radar screen of auditor–client relations. Already there have been calls to repeal or scale back the provisions of the Act (Desmond, 2002). Prior research has shown temporary increases in compliant behavior in response to

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M.L. Roberts / Research in Accounting Regulation 22 (2010) 29–39

increased regulatory sanctions do not consistently lead to permanent changes in behavior when the fundamental incentives affecting compliance remain unchanged (Alm & McKee, 1990; Christian, Gupta, & Young, 2002). Additional research is needed to determine whether and to what extent auditors’ professional judgments in earnings management situations change over time as the regulatory climate changes, specifically whether or not the establishment of an independent regulatory body (PCAOB) in place of self-regulation, and increased personal sanctions for wrong-doing by auditors (PCAOB can impose fines of up to $750,000 on individuals for intentional misconduct), is sufficient to deter the inherent self-interest of auditors to retain clients. This study indicates client-supportiveness prior to the scandals was endemic to the profession; auditor self-interest is not attributable to ‘‘a few bad apples.” Even though the decision tasks involved situations that CPAs do encounter in practice (e.g., expense versus capitalization was the issue in the nine billion dollar WorldCom fraud per Sandberg, Solomon, & Blumenstein, 2002), they did not include an important criterion, i.e., the identity of the client. CPAs develop relationships with their clients based on mutual trust over long periods of time. They do not make such decisions in a vacuum. Nevertheless, I interpret the results as indicative of CPAs’ tendencies in client conflict situations. More research is needed to understand the conditions in which CPAs interpret accounting principles, standards, and data in favor of the client and rationalize their decisions and, perhaps more importantly, how best to realign auditors’ self-interests with audit quality instead of with clients’ reporting preferences. Such research is critical to the reputation and the very existence of the public accounting profession. References Alm, J., & McKee, M. (1990). Amazing grace: Tax amnesties and compliance. National Tax Journal, 43(March), 23–37. American Accounting Association (1973). A statement of basic auditing concepts. Sarasota, FL: AAA. American Institute of Certified Public Accountants (1988). Statement on auditing standards No. 1. NY: AICPA. American Institute of Certified Public Accountants (1991a). Code of professional conduct. NY: AICPA. American Institute of Certified Public Accountants (1991b). Practice analysis of certified public accountants in public accounting. NY: AICPA. American Institute of Certified Public Accountants (1991c). Statement on responsibilities in tax practice (Rev.). NY: AICPA Federal Tax Division. Batson, D., Collins, P., et al. (2006). Doing business after the fall: The virtue of moral hypocrisy? Journal of Business Ethics, 66(2), 321–335. Batson, D., Kobrynowicz, D., et al. (1997). In a very different voice: Unmasking moral hypocrisy. Journal of Personality and Social Psychology, 72(6), 1335–1348. Bazerman, M. H., Moore, D. A., & Loewenstein, G. (2002). Why good accountants do bad audits. Harvard Business Review, 80(November), 96–103. Bazerman, M. H., Morgan, K. P., & Loewenstein, G. (1997). The impossibility of auditor independence. Sloan Management Review, 38(Summer), 89–95. Braun, K. W. (2001). The disposition of audit-detected misstatements: An examination of risk and reward factors and aggregation effects. Contemporary Accounting Research, 18(Spring), 71–99. Christian, C. W., Gupta, S., & Young, J. C. (2002). Evidence of subsequent filing from the State of Michigan income tax amnesty. National Tax Journal, 55(December), 703–722. Cloyd, C. B., Pratt, J., & Stock, T. (1996). The use of financial accounting choice to support aggressive tax positions: Public and private firms. Journal of Accounting Research, 34(Spring), 23–43.

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