This study investigates the decline of auditor independence coinciding with the rise of regulatory capitalism. A critical analysis supported by experimental evidence reveals regulatory capitalism's influence on auditor independence. Regulatory capitalism began in the United States during the 1970s when state enforced neo-liberal free-market doctrines of competition and deregulation commercialized the profession. Since then, regulatory capitalism's economic neo-liberal agenda has transformed the auditing profession and the employer firms into a transnational network of professional services firms that now promote and diffuse regulatory capitalism worldwide. Regulatory capitalism is further facilitated by the Sarbanes-Oxley Act and the PCAOB that provide interconnections of powerful non-democratic private regulators such as the IFAC and IAASB. An experiment reveals auditors’ ethical predisposition to provide consistently high quality independence judgments required by IFAC's code of ethics. The majority of this sample of 174 Danish auditors was not consistently independent in the context of client economic factors, indicating that the code of ethics’ appeal to auditors’ altruistic behavior has failed. Moreover the transformed profession has become the transformer but at a price, the loss of public confidence and the decline of auditor independence. Conflicts of interests still abound.
Fairness and justice are fundamental to society's need for auditor independence (Mautz and Sharaf, 1961) hence auditors must balance the interests of various stakeholders to ensure credible corporate transparency of corporate reporting in the public interest (Goldman and Barlev, 1974; International Federation of Accountants or IFAC, 2005). Auditors became crucial to regain confidence in the integrity and credibility of the capital markets shortly after the massive corporate collapses that triggered the 1929 Wall Street Crash. The Crash brought misery to millions of people who lost their savings, their jobs and their dignity. Enduring detrimental social, economic and psychological effects of the Crash were felt worldwide. Following the crash, the Great Depression damaged the financial systems of several countries, in turn fermenting social unrest and disillusionment that culminated in World War II (Berg-Schlosser, 1998). In the United States, President Franklin D. Roosevelt's administration was so concerned about society's financial security and political stability that the Securities and Exchange Acts, 1933 and 1934 were signed into law to rebuild public trust in the governance of the capital markets. These acts mandated listed companies’ financial reports to be independently audited in the public interest (Zeff, 2003b).
Influential accountants successfully opposed proposals for the U.S. government to oversee business directly or conduct audits of public companies. Instead accountants in private practice were given the monopoly franchise to perform company audits on the condition that they abide by a code of ethical conduct mandating auditor independence (see Zeff, 2003a for more discussion). This regulatory arrangement had an inherent critical flaw identified by Mautz and Sharaf (1961). They questioned the ability of professional auditors to maintain an independent mind to ‘present fairly’ in the judicial sense (Reiter and Williams, 2004) when they are economically dependent on the client management. This regulatory flaw predisposes conflicts of interests because auditors have to negotiate compensation and employment conditions with the regulated, the auditee company.
The profession's code of ethical conduct attempts to prevent obvious conflicts of interests that may occur between the auditor and auditee company. The code also legitimates and defends the self-regulation of auditor independence that essentially relies on the personal ‘virtues’ and altruism of its members (Limperg, 1985). The notion of personal independence is further enhanced by the inexorable objectivity and neutrality engendered in the measurement expertise of the accounting profession (Chua, 1986 and Hines, 1991). For several decades the profession dealt with minor scandals from time to time and audits were performed without much incident until the 1970s (Zeff, 2003a).
During the early 1970s regulatory capitalism emerged in the United States as neo-liberalism gathered the political strength to radicalize government policies. These policies changed social relationships and institutions, including the auditing profession. This study first critically examines the rise of regulatory capitalism and the decline of auditor independence. Specifically we argue that the commercialization of audit has exacerbated the inherent regulatory flaw of the auditor economically depending upon the auditee client company and its management. An experiment provides further empirical evidence about the affect of client economic considerations on practicing auditors’ independence judgments in an era of regulatory capitalism.
The results of this experiment reveal that personality factors have a significant effect on auditors’ independence, suggesting an ethical inconsistency in response to client management. Moreover, auditors’ ability to resist management economic considerations may not be largely influenced by the profession's decree to follow codes of ethical guidelines. In effect, the ability to maintain auditor independence (or not) is a human process, integral to the whole person's life experiences and personal predisposition, not a just “state of mind” that can be excised from the auditor's life experiences as described in the code of ethics.
Even though auditors in this experiment have had a similar education and training (all participants worked for the large international assurance and advisory services firms in one city) the findings suggest that auditors have varying ethical predispositions in response to the same hypothetical audit conflict. Six decision-making groups emerged demonstrating the influence of beliefs in a just world (BJW) on auditors’ moral reasoning to affect independence judgments: client financial condition and whether the audit is tendered are the factors that affected all decision-making groups. In particular, when client financial condition was good, the six groups of auditors were less independent (see Table 3 and Fig. 1).
An explanation for this response is that managements of client firms with good financial condition have more economic strength to bargain with. Auditors were more willing to be independent when the client is in poor financial shape, where there is a situational risk of corporate collapse and subsequent litigation (deep pockets theory). A corporate collapse could not only result in the auditor being sued but also in losing the client. The findings also show that auditors with mid moral reasoning and weak BJW were the most acquiescent when the client was in good financial condition and tendered audit work.
Tendering in conjunction with good financial condition of the client also affected auditors (Fig. 1). This gave client management more effective control over the working conditions of auditors as well as career success linked to client revenues (Goldman and Barlev, 1974 and Wyatt, 2004). Hence, when the audit was not tendered but the client was in good financial condition, auditors were less likely to acquiesce, suggesting tendering increased the client's economic influence.
Limitations of this experiment include, firstly, that the research methodology relies on auditors’ responses to hypothetical scenarios, which varied on client economic situational variables that can be used by management to control auditor independence. Given that the respondents in this study were practicing auditors expected to meet high professional and ethical standards (in the present instance: IFAC, 2001, IFAC, 2004 and IFAC, 2005), it would be surprising if they were to indicate high likelihood of acquiescence to management demands. In reality, auditors have been successfully sued for malpractice and are currently facing multi-billion dollar lawsuits. Nonetheless, the audit conflict situation was constructed with the active participation and close consultation of the senior audit partners, so that it constituted a realistic conflict between client management and the auditor.
The second limitation of the present investigation is that it was based on a repeated-measures design, and therefore possibly subject to problems of demand characteristics (see Gul and Windsor, 1994 and Knapp, 1987). Demand characteristics are ameliorated in this study by including the between-groups design with belief in a just world and moral reasoning development (Keppel, 1991). The third limitation concerns the construct validity of the psychological measures used in this research, and the extent to which they reflect respondents’ actual cognitions and belief (see Rest, 1986 and Rest et al., 1999). Collins’ (1974) belief in a just/unjust world scale, however, is justified in the present research on the basis that the scales are well validated in the literature (see Dalbert, 2001) and provide theoretically interpretable results
