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Volume 04

Auditor Changes and Information Suppression

Michael C. Knapp and Fara M. Elikai

The increasing rate of auditor turnover in recent years has spurred analytical and empirical research to identify the factors primarily responsible for this trend. One plausible explanation, the information suppression hypothesis, suggests that auditor changes are often motivated by client management's need or desire to suppress "sensitive" financial information. This study is designed to provide insight on the validity of that hypothesis as well as to yield more general insights on the nature of predecessor-successor auditor communications. Data for this study was collected from a sample of 94 audit partners drawn from the roster of Texas CPAs compiled annually by the Texas State Board of Public Accountancy. The results suggest that approximately one of every five auditor changes is motivated by an information suppression objective on the part of client management. Empirical data further imply that the present structure regulating auditor switching may not deter corporate managers from successfully concealing problematic information from financial statement users by changing auditors.

Public confidence in the integrity of corporate financial reports is shaken whenever cases of abusive financial reporting are publicized [National Commission on Fraudulent Financial Reporting (NCFFR), 1987; Cowherd, 1988]. These events, such as the recent scandals in the savings and loan industry, reduce, at least in perception, the integrity and credibility of all participants in the financial reporting process, including independent auditors. Congress and the Securities and Exchange Commission (SEC) monitor these events since they dampen public confidence in financial reports and may affect the costs of raising capital for public and private entities [Ingersoll, 1985; NCFFR, 1987].

One of the concerns expressed about the financial reporting system is the rapid increase in the rate of auditor dismissals by public firms over the past decade [Public Accounting Report, 1988]. The SEC is particularly sensitive to allegations that auditor switches are motivated by a desire on the part of corporate managers to suppress negative or problematic financial information [Schwartz and Menon, 1985; Knapp and Elikai, 1988]. Even in the absence of ulterior motives for auditor changes, a high rate of switching activity diminishes the overall credibility of audited financial data because of the higher degree of "information risk" associated with post-switch financial statements.

The principle purpose of this study is to provide insight on the validity of the "information suppression hypothesis" which posits that the disproportionate number of "auditor failures" following auditor changes [St. Pierre and Anderson, 1984] is a consequence of switching firms successfully concealing audit-relevant information from successor auditors [Mangold, 1984; Schwartz and Menon, 1985]. This problem is explored from the perspective of audit partners since these individuals are in a strategic position to observe and comment on the motives underlying auditor changes.

The objective of this research is to develop a base of information to evaluate existing and proposed policies intended to assist in ensuring that critical audit-relevant information will not be lost when auditor changes occur. By ensuring that "audit sensitive" information is communicated to successor auditors, such measures should assist in decreasing the risk of audit failures subsequent to auditor changes and promote the credibility of the corporate financial reporting system as well as the independent audit function. Volume 4, 1990, pgs. 3-20.

The Evolution of Inflation Accounting in France Since 1960

Denis Cormier, Helen McDonough,
and Bernard Raffournier

This paper describes how the French legislature affected the development of inflation accounting in France from 1960 to the present. The first part of the paper gives a brief historical overview of inflation in France. Next, this organization of the accounting profession is described, illustrating the influence of the State on the profession and on accounting thought. This is followed by a description of the legislation adopted by the French government to respond to inflation, including a discussion of optional and legal revaluation of financial statements. Finally, the latest Exposure Draft of public accountants concerning price-adjusted data is given. A brief discussion and critique conclude the paper. Volume 4, 1990, pgs. 21-42.

An Evaluation of the Reporting Standards for Litigation:
Some Empirical Evidence

James H. Thompson, L. Murphy Smith,
and John R. Williams

The frequency of litigation has increased substantially in recent years. Involvement in litigation often requires that a company present information in its financial statements regarding its exposure to loss. Some researchers and financial statement users have claimed that disclosure of information regarding litigation is not adequate. This paper analyzes the annual reports of a sample of companies as a basis for assessing the adequacy of reporting standards relating to litigation.

Disclosure of information relating to litigation may be inadequate for two reasons. This disclosure depends heavily on the judgment of management. Although many financial statement disclosures depend upon management's judgment, litigation disclosures depend more heavily on judgment than many other decisions. The usefulness of litigation disclosure may also be limited because a potential conflict of interest exists. On one hand, management has a responsibility to apply, in good faith, the accounting and reporting standards of SFAS 5. On the other hand, management is reluctant to provide information that is adverse to its interests, particularly if the information relates to events that are uncertain.

The results of this analysis indicate that litigation disclosure is often very general, vague, or incomplete. A financial statement user would probably have difficulty in drawing valid conclusions regarding a company's exposure to loss from litigation. This study highlights the difficult disclosure decisions faced by management. A more complete assessment of the adequacy of disclosure provisions related to litigation requires additional research regarding the information needs of users as well as the relationship between litigation disclosures and the ultimate outcome of a lawsuit. Volume 4, 1990, pgs. 43-57

An Examination of Auditor Independence:
Further Evidence on the Effect of System
Design Practice on Auditor Judgment

Van E. Johnson and Steven E. Kaplan

A longstanding controversy concerns whether auditor independence is adversely affected when an external auditor also performs non-audit services for the company. In 1979, the Public Oversight Board identified a special concern over system design work where the audit firm is placed in the position of reviewing its own work. The only study to examine the concern that an auditor may audit a system designed by the auditor's firm more favorably than one designed by another source was by Corless and Parker in 1987.

The present study extends the study by Corless and Parker and provides additional evidence to evaluate the concerns over audit firms evaluating systems designed by their firms. An experiment was conducted using practicing Big 8 auditors assigned an internal control evaluation task. Auditors evaluated internal control system strength and determined planned audit hours. The independent variable, system designer, was manipulated across subjects at four levels. The results indicated that auditors' judgments for a system designed by their own firm were no different than the judgments of auditors evaluating an identical system designed by another Big 8 firm. However, both auditors' internal control evaluations and planned audit hours were significantly more favorable for a system designed by their own firm than for an identical system designed by either the client personnel or a non-accounting consulting firm. Volume 4, 1990, pgs. 59-75

From the Contract to Tort:
The Evolution of Accountants' Legal Liability for Negligence

Orace Johnson and William D. Terando

The scope of legal liability of accountants to injured third parties for negligent misrepresentation has been gradually expanding for two decades. It is becoming more and more common to see accountants defending their actions against parties who have suffered financial losses from (allegedly) relying on faulty financial statements and reports prepared by accountants. This paper surveys the developments in case law and federal legislation that have driven the expansion process from privity under contract to reasonably foreseeable third-party users. This paper concludes with an analysis of the current scope of legal liability of accountants with respect to injured parties. Volume 4, 1990, pgs. 77-97.

The Simple Majority Vote Required for Passage
of a Statement of Financial Accounting Standards:
An Analysis of One Aspect of the Standards Overload Problem

Janet S. Omundson, Karl B. Putnam,
and Richard G. Schroeder

Accounting Standards overload is a complex, controversial topic. One aspect of the standards overload issue has been the change in 1977 by the Financial Accounting Standards Board (FASB) to allow passage of Statements of Financial Accounting Standards (SFASs) by a 4-3 vote of the members. The impact of this change and the subsequent release of several complex SFASs have been noted by financial statement preparers and users. The FASB is faced with conflicting arguments when deciding on the number of votes necessary for passage of an SFAS. A Special Advisory Group to the FASB summarized the arguments for and against returning to the 5-2 majority vote for passage procedure. Due to a diversity of opinion among its members, the Group did not make a recommendation on this issue. The study reported herein examined the impact of the change to the 4-3 majority vote for passage procedure on: (1) the number of statements issued, and (2) the relationship of the original majority votes for passage of a Statement of Financial Accounting Standards with the frequency with which those statements were later amended. Both the number of statements issued and the number of statements requiring amendment increased following the decision to allow a Statement of Financial Accounting Standards to be passed by a simple majority vote of the Board. It was concluded that the question of whether the number of votes for passage of a proposed SFAS should be 4-3 or 5-2 turns on the perceived relative importance of: (1) the standards overload issue, and (2) the need to react to a changing environment. Volume 4, 1990, pgs. 99-109

Trust or Antitrust for the Profession of Accountancy?

Billie M. Cunningham, Rasoul Tondkar,
and Edward N. Coffman

Early in 1986, the American Institute of Certified Public Accountants retained Louis Harris and Associates to conduct a public opinion poll on CPA qualifications and services, and on regulation of the profession. While the overall result of the poll was positive, there was concern over the few CPAs who behave less than professionally. The poll supported more regulation of the profession and a stronger system of enforcement of professional standards, and reflected very high expectations for the future performance of accountants.

Actually, the response to this poll should not be surprising, for the public has always had a healthy skepticism about the effectiveness of professional self-regulation and about the real motives of professionals. In the last two and a half decades, the broad area of competition or restraint of trade in the professions, or antitrust, has been one focus of public skepticism. The purpose of this paper is to provide a general historical overview of legislation, litigation, and investigation involving antitrust issues relating to the professions in general, and the accounting profession in particular. It traces the interpretation of antitrust laws from the points of view of legislators, regulators, and the general public, as well as from the viewpoint of professional accountants. Volume 4, 1990, pgs. 111-128

Auditor/Client Joint Investments and Independence

John M. Lacey

This study examines the effect of investments by CPA partners and client principals on the perception of auditor independence. Specifically examined are the effect of (1) a joint investment by a CPA partner and a client's Chief Financial Officer (CFO) in a limited partnership unrelated to the audit client, and (2) a direct investment by a CPA in a client company. Auditors, preparers, and users of financial statements returned a total of 630 completed questionnaires.

The results show an inconsistency between the respondents' perception of risk of loss of independence and the AICPA independence rules. Specifically, respondents are more concerned about certain joint investments, which are acceptable under AICPA rules, than they are about small percentage, financially immaterial direct investments which are unacceptable under AICPA rules. CPAs perceive that the risk of loss of independence when there is direct ownership of stock by the CPA is greater than any other group perceives the risk to be. Volume 4, 1990, pgs. 129-149.

Reflections on the FASB Conceptual Framework

Eugene H. Flegm

  In 1976, the FASB published a Discussion Memorandum titled "Objectives of Financial Reporting and Elements of Financial Statements of Business Enterprises," which proposed significant changes in the conceptual basis of accounting as it had been applied since the debates of the 1930s had settled upon an income statement orientation, for example, the matching of related costs with revenues being produced.

The proposed change was to shift the emphasis of accounting from an income statement orientation and the attest function to a balance sheet orientation intended to give prospective investors a more value-based view of an enterprise.

The Discussion Memorandum and subsequent public hearings resulted in considerable debate which is unresolved today. (The unprecedented two-year delay of the required implementation of Statement No. 96, Accounting for Income Taxes, in December 1989 by the Financial Accounting Standards Board is a direct outgrowth of that debate.)

The Committee on Corporate Reporting of the Financial Executives Institute, as well as several corporations (including General Motors Corporation) filed position papers and testified at the public hearings protesting the shift proposed in the Discussion Memorandum. Robert K. Mautz and Albert Koch, partners with Ernst & Ernst at that time, even went so far as to give a series of presentations to the Committee on Corporate Reporting, various chapters of the FEI, and other interested groups pointing out the major shift being proposed.

As noted, the debate continues to this day. Much has been made of the disaffection the business community has with the source of this disaffection is businesses "own ox being gored" syndrome. In fact, the now acknowledged shift (see "What Today's Balance Sheet Tilt Means," Ray Groves, Financial Executive, Sept./Oct. 1989, FEI, Morristown, NJ? of the FASB to the balance sheet, investor view as proposed in the 1976 Discussion Memorandum, is the cause of the basic disagreement.

Following the 1977 and 1978 public hearings, the FASB decided to meet with selected representatives of their constituencies (this was before they had adopted the "sunshine" rules) to attempt to thrash out the disagreement concerning the Discussion Memorandum. Thomas A. Murphy, who was Chairman of the Board for General Motors at that time and a former trustee of the Financial Accounting Foundation, was invited as one who held a representative view of business. Mr. Murphy was not able to attend and requested that I attend in his place. Attached is a memorandum of this meeting that I prepared for Mr. Murphy after one meeting. 

As I re-read the memorandum today, I find that the issues are unchanged and unresolved.

    -E.H. Flegm (December 12, 1989) Volume 4, 1990, pgs. 153-168.

Hopkins v. Price Waterhouse:
Personnel Policy Implications of a Supreme Court Ruling

Ross Quarles and Michael J. Tucker

This paper examines the details of the recent Supreme Court ruling which specifically applied standards of Title VII of the Civil Rights Act of 1964 to promotion practices in a public accounting firm. The case involved an allegation of sexual discrimination in the partner selection process of a national accounting firm. The ruling recognizes the legal relevance of sex stereotyping in the promotion process and clearly identifies such a practice as prohibited by the legal burden of proof in Title VII actions from the employee to the employer with regard to the legal defensibility of the final employment decision. The ruling also establishes the preponderance of the evidence test in Title VII cases as the required defense for promotion decisions. This article discussed the implications for both accounting firms and the accounting profession, resulting from the judicially created standards set by this case. Volume 4, 1990, pgs. 169-179.

The Emerging Issues Task Force:
An Examination of Activities and Implications for Practice

Paul R. Bahnson and Andrew J. Rosman

Although the Emerging Issues Task Force (EITF) was established in 1984 to advise the FASB on emerging issues, the EITF has evolved into a "de facto" standard setting body for publicly held companies since its conclusions on accounting practice enjoy the full support of the SEC. Without similar support to follow EITF guidance. The opportunity, therefore, exists for inconsistent accounting recognition practices to develop between public and nonpublic companies, which may seriously impair the EITF's credibility in the long run. In turn, the FASB could be forced to reassume the direct burden of providing practice with comprehensive timely guidance. This paper proposes two steps to eliminate the opportunity for nonpublic companies to ignore EITF conclusions. First, the EITF should be recognized by the profession as a standard-setting body subject to FASB oversight. Second, a new hierarchy establishing the sources of authoritative guidance should be established to raise the present "official" status of the EITF as a GAAP source of last resort to an equivalent level of authority with FASB Statements and Technical Bulletins. In addition, the paper raises other issues concerning the EITF that should be addressed by the profession to make the standard-setting process more efficient and effective. Volume 4, 1990, pgs. 181-193

The Controversy over the Receipt of Commissions and Contingent Fees

Alan T. Lord and David G. Jaeger

The recent agreement between the Federal Trade Commission (FTC) and the American Institute of Certified Public Accountants (AICPA) (subject to the final FTC approval) would cause substantive changes in the restrictions that the AICPA places on its members regarding the receipt of commissions and contingent fees. The impact of the changes contained in the agreement is questioned in light of the state action doctrine, which provides an exemption from federal antitrust law. We argue that the result of the FTC's actions may be an increase in regulatory diversity for the profession of accountancy. Volume 4, 1990, pgs. 195-204.