The Effect of Accounting Uncertainty and Auditor Reputation on Auditor Independence

Abstract

This paper reports the results of experimental economic markets designed to examine whether an auditor's objectivity (independence) is impacted by uncertainty regarding the appropriate accounting treatment for a client. In particular, we are interested in whether the auditor exploits this uncertainty by agreeing with her client's preferred accounting treatment even when her evidence suggests an alternative treatment is more likely to be correct. We examine the effect of accounting uncertainty in a setting where the auditor not only wants to satisfy her client but also wants to maintain a reputation for audit objectivity in the market.

The results provide strong evidence that the level of accounting uncertainty impacts auditor independence. Specifically, when accounting uncertainty did not exist, auditors maintained their independence by truthfully reporting the observed value. Auditors appeared to remain independent due to concerns about their reputations with managers and investors. However, when accounting uncertainty existed, auditors impaired their independence by misreporting the observed value in favor of the manager. Our results specify some initial boundary conditions for the impact of auditor reputation and investor pricing on auditor independence, and suggest that regulators should focus on enhancing auditor incentives to maintain independence when faced with accounting uncertainty. It appears that regulators do not need to be as concerned about independence violations when accounting pronouncements provide unambiguous guidance. An auditor's concern about her reputation provides adequate incentive to prevent independence impairment when she is certain about the appropriate accounting treatment. Our results also suggest future research should assess the ability of other audit market forces to reduce the propensity of auditors to violate independence when faced with accounting uncertainty.

JEL Classification: M41, M49, D80, C91