An accountability framework for financial statement auditors and related research question

Description
We address the following overarching questions: What kind of accountability framework
could regulators use to (a) motivate auditors to improve audit quality, and (b) evaluate
how well auditors have carried out their duties? We draw on research in accounting,
economics, psychology, and neuroscience to critique the accountabilities, incentives, and
learning opportunities embedded in auditors’ extant regulatory environment. We first
establish that forward-looking estimates are the basis for most financial statement
information and that some of these estimates are highly uncertain, which increases the
challenges faced by auditors. We propose an accountability framework with two dimensions:
rewards versus penalties and processes versus outcomes. We show that auditors’
current regulatory accountabilities generally are in the form of penalties rather than
rewards and primarily depend on audit outcomes rather than attributes of auditors’ judgment
processes. We provide evidence from a range of disciplines that questions the suitability
of the present system for improving the quality of auditors’ judgments and the
quality of evaluations of those judgments made by inspectors. We identify four potential
changes for improvement in audit quality based on our framework

An accountability framework for ?nancial statement auditors
and related research questions
Mark E. Peecher
a,?
, Ira Solomon
b,1
, Ken T. Trotman
c,2
a
Department of Accountancy, College of Business, University of Illinois at Urbana-Champaign, 1206 South Sixth Street, Champaign, IL 61820, United States
b
A.B. Freeman School of Business, Tulane University, 7 McAlister Drive, New Orleans, LA 70118, United States
c
School of Accounting, Australian School of Business, University of New South Wales, Sydney 2052, Australia
a b s t r a c t
We address the following overarching questions: What kind of accountability framework
could regulators use to (a) motivate auditors to improve audit quality, and (b) evaluate
how well auditors have carried out their duties? We draw on research in accounting,
economics, psychology, and neuroscience to critique the accountabilities, incentives, and
learning opportunities embedded in auditors’ extant regulatory environment. We ?rst
establish that forward-looking estimates are the basis for most ?nancial statement
information and that some of these estimates are highly uncertain, which increases the
challenges faced by auditors. We propose an accountability framework with two dimen-
sions: rewards versus penalties and processes versus outcomes. We show that auditors’
current regulatory accountabilities generally are in the form of penalties rather than
rewards and primarily depend on audit outcomes rather than attributes of auditors’ judg-
ment processes. We provide evidence from a range of disciplines that questions the suit-
ability of the present system for improving the quality of auditors’ judgments and the
quality of evaluations of those judgments made by inspectors. We identify four potential
changes for improvement in audit quality based on our framework. Each of these identi?ed
changes has an impact on one or both of the two dimensions in our framework. For each of
these changes, we outline JDM research questions that could be addressed to inform our
overarching questions and to provide empirical evidence to help re?ne our accountability
framework and improve audit quality.
Ó 2013 Elsevier Ltd. All rights reserved.
Introduction
Until relatively recently, public company auditing in
many countries was self-regulated, but this era ended fol-
lowing some major corporate collapses and subsequent
worldwide changes in legislation (for example, the
Sarbanes–Oxley Act of 2002 (SOX) in the USA). New stan-
dard setters and regulators for audits of public companies
also emerged across the globe including the Public Com-
pany Accounting Oversight Board (PCAOB), the Financial
Reporting Council in the UK, and the Australian Securities
and Investments Commission.
3
These audit standard setters and regulators attempt to
ensure audit quality by promotion of informative, fair,
and independent ?nancial audits, using periodic
0361-3682/$ - see front matter Ó 2013 Elsevier Ltd. All rights reserved.http://dx.doi.org/10.1016/j.aos.2013.07.002
?
Corresponding author. Tel.: +1 217 333 4542; fax: +1 217 244 0902.
E-mail addresses: [email protected] (M.E. Peecher), isolomon@tu-
lane.edu (I. Solomon), [email protected] (K.T. Trotman).
1
Tel.: +1 504 865 5407.
2
Tel.: +61 2 9385 5831; fax: +61 2 662 4491.
3
In addition, the European Group of Auditors’ Oversight Bodies was
established in 2005, comprising representatives from the public oversight
authorities of EU Member States. Further, in 2006, the International Forum
of Independent Audit Regulators formed with 18 countries as inaugural
members, and since then it has expanded to include 46 countries as
members.
Accounting, Organizations and Society 38 (2013) 596–620
Contents lists available at ScienceDirect
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j our nal homepage: www. el sevi er. com/ l ocat e/ aos
inspections of auditors’ compliance with applicable audit-
ing standards and laws in their jurisdictions as a key tool
to achieve this objective.
4
Following these new regulatory
inspections, there have been reports of audit de?ciencies
and calls for improved audit quality (e.g., European Commis-
sion, 2010; IFAC, 2011; Palmrose, 2006).
In this paper, we begin by characterizing the ?nancial
statement audit context as one in which the auditor regu-
larly must apply professional judgment to assess the rea-
sonableness of many complex ?nancial statement
estimates that are future orientated. We also characterize
it as one where there is uncertainty about what is expected
of the auditor because it is dif?cult to conclude on the
appropriateness of judgments made. We propose a two-
dimensional accountability framework with one dimen-
sion being rewards versus penalties and the other being
processes versus outcomes (which together form four
quadrants). We categorize existing sources of auditor
accountability and ?nd that presently most accountabili-
ties are in the penalties-outcomes quadrant and that
accountabilities in the rewards-processes quadrant are
noticeably missing. We then discuss research from
accounting, economics, psychology, and neuroscience to
describe currently forgone advantages of accountabilities
that would hinge predominantly on auditors’ judgment
processes and/or that would reward higher audit quality.
Research from the above disciplines suggests that audi-
tors’ current accountabilities are unlikely to motivate them
to target high quality ?nancial statement audits or to
invest in research and development activities that would
improve longer-term audit quality. Instead, these accoun-
tabilities likely motivate shorter-term, compliance-focused
behaviors, with auditors operating at or slightly above the
threshold of noncompliance to avoid sanctions. Yet, as
Palmrose (2006) observes, ‘‘Importantly, audit ?rms
should have incentives to go beyond the ?oor and compete
on the basis of quality. This occurs . . . when, for example,
audit quality carries a premium and clients are willing to
pay more for higher quality services.’’
5
We address two overarching questions: What kind of
accountability framework could regulators use to motivate
auditors to improve audit quality? What accountability
framework could regulators use to evaluate how well audi-
tors have carried out their duties? We then identify four
potential changes to auditor accountabilities based on
our framework. For each potential change, we outline
relevant literature from a range of disciplines along with
an accompanying set of more speci?c research questions.
The research questions address possible effects of the po-
tential changes on the judgments of auditors, inspectors
and potential users of audit reports. Future research
addressing these research questions will allow re?nement
of our accountability framework and provide evidence
aimed at improving audit quality.
The context of ?nancial statement auditing
In recognition of uncertainty surrounding estimates, the
SEC for decades required that only factual information ap-
pear in registrants’ proxy statements, annual reports, and
prospectuses (Romajas, 1993). The SEC (1969, p. 12) ex-
pressed its traditional argument in a document called
The Wheat Report:
Although company projections of sales and earnings are
of great interest to investors, serious problems are asso-
ciated with requiring, or permitting, such projections to
be included in ’33 Act prospectuses. Because of their
conjectural and rapidly changing character, projections
would—if included in prospectuses—raise dif?cult ques-
tions of civil liability. Moreover, projections in ?led doc-
uments might become traps for the unsophisticated
who would be prone to attach more signi?cance to such
projections than they deserve.
Even during this era, however, ?nancial statements con-
tained some future-orientated estimates, including bad
debt estimates, the useful lives of ?xed assets, and war-
ranty expenses. In fact, McSweeney (1997, 2000) demon-
strates that even ?nancial statement amounts pertaining
to the past require assumptions about hypothetical future
events. However, the degree to which ?nancial statement
estimates depend on complex, forward-looking judgments
has grown in recent decades.
6
Exhibit 1 provides examples
of ?nancial statement estimates that rest on such judg-
ments, including estimates of fair value and of deferred
taxes assets and liabilities.
When auditing ?nancial statement estimates, ‘‘reason-
ableness’’ is the construct that auditors must use in assess-
ing whether or not a misstatement exists (e.g., ISA 540 in
IFAC, 2010), and auditors’ conclusions pertaining to an
estimate’s reasonableness are matters of professional judg-
ment.
7
In addition, similar kinds of estimates that appear in
4
Regulatory agencies have many common elements across jurisdictions.
For example, they typically encompass both audits directly (e.g., risk
assessments and audit procedures) and quality controls over audits (e.g.,
supervision and review policies and determinants of partners’ compensa-
tion). There are some differences, however. For example, while most
jurisdictions use separate organizations to set standards and to conduct
oversight, the USA PCAOB combines these two functions (Simnett & Smith,
2005).
5
While cost/bene?t tradeoffs likely prevent most stakeholders from
desiring the absolutely highest-possible quality in ?nancial statement
auditing (or ?nancial reporting, for that matter), we assume most stake-
holders do desire improved audit quality (more effective and/or more
ef?cient) that, in turn, holds promise for improved ?nancial reporting.
6
There has been associated debate on whether or not ?nancial
statement assertions refer to truth that ultimately can be measured and
fairly re?ected in ?nancial statements (e.g., Shapiro, 1997). Bayou,
Reinstein, and Williams (2011, p. 116), for example, present problems
with predicating asset values on beliefs about the future. A related
perspective is that ?nancial statements should re?ect objective, historical
facts, and judges sometimes support this perspective via rulings. For
example, In re: Employee Solutions Sec. Lit., 1998 WL 1031506 (District
Court of Arizona, 1998) the court ruled that insurance company reserves
are statements of present fact and not forward-looking.
7
ISA 200 now de?nes professional judgment as ‘‘. . . the application of
relevant training, knowledge, and experience, within the context provided
by auditing, accounting and ethical standards, in making informed
decisions about courses of action that are appropriate in the circumstances
of the audit engagement’’ (IFAC, 2010, p. 77).
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 597
Management’s Discussion and Analyses (MD&A) instead of
in the ?nancial statements receive further, safe harbor pro-
tection as a result of being legislatively construed as for-
ward-looking.
8
Both the reasonableness construct for
?nancial statement estimates and the safe harbor protection
for MD&A estimates recognize how dif?cult it is to acquire
persuasive evidence about the veracity of complex, future-
orientated estimates, even for expert auditors (Grif?th,
Hammersley, & Kadous, 2013; Peecher, Schwartz, & Solo-
mon, 2007).
9
A related issue is whether auditors’ professional judg-
ments are accorded similar latitude as is accorded to man-
agement in preparing and reporting complex estimates in
?nancial statements. Further, even when auditors’ judg-
Exhibit 1. Illustrative forward-looking auditor judgments (FASB, 2008; Sands & Tseng, 2009; Thorsen, 2009; Weil, 2008).
8
Safe harbor protection in the USA comes from the Private Securities
Litigation Reform Act of 1995 (PSLRA). It de?nes forward-looking informa-
tion as a subset of soft information, which is ‘‘statements of subjective
analysis or extrapolation, such as opinion, motive, and intentions, or
forward-looking statements, such as projections, estimates, and forecasts.’’
The PSLRA’s safe harbor excludes statements for which the actual and
known intent was to mislead investors (Horwich, 2009).
9
Kinney (2000, p. 215) observes that ‘‘the term reasonable in many
contexts means a 60–70% con?dence interval.’’ Earlier he notes, ‘‘Because
no single estimate can be de?nitively defended, GAAS directs the auditor to
determine a ‘reasonable’ range for an accounting estimate. The question of
‘reasonableness’ is an important one since GAAS states that ‘likely’
misstatement for an accounting estimate is zero if book value is within
the range’’ (Kinney, 2000, p. 215). It is also notable that the size of
management’s uncertainty or of auditors’ reasonable ranges can be
multiples of materiality (Christensen, Glover, & Wood, 2012).
598 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
ments are reasonable at the time of the audit, evaluators
may be overly harsh when assessing the quality of their
performance in hindsight after adverse outcomes (Fischhoff,
1982). It is possible that new regulatory inspections only
increase the likelihood that auditors will face penalties de-
spite reaching conclusions that were reasonable at the
time of the audit. To the degree auditors’ judgments are
held to a higher standard than reasonable judgment at
the that time their judgments were made, there appears
to be an anomaly in ?nancial statement auditors’ accountabilities
compared to preparers’ accountabilities.
Auditor accountability framework
With the auditing context in mind, we provide a two-
dimensional accountability framework. One dimension is
the degree to which auditors are accountable for their con-
clusions, or even for subsequent ?nancial statement out-
comes, versus accountable for their professional
judgment processes. The second dimension is the degree
to which auditors’ accountabilities manifest in the form
of penalties versus rewards. We discuss each dimension
more extensively below but, for now, we locate auditors’
current accountabilities on these dimensions via Exhibit 2.
The lower left quadrant in Exhibit 2 is heavily popu-
lated and only two sources of accountability cross into
the lower right quadrant (e.g., regulator inspection re-
ports). The predominance of the lower left quadrant re-
?ects how auditors’ current regulatory accountabilities
typically manifest in the form of penalties and are trig-
gered primarily by auditor conclusions together with sub-
sequent adverse ?nancial statement outcomes. The
absence of accountability sources in the two upper quad-
rants re?ects the present lack of regulatory rewards pred-
icated on the quality of auditors’ judgment processes.
However, our discussion of the psychology and economics
literatures below suggests that there are conditions under
which rewards (alone or in concert with penalties) better
Exhibit 2. Accountability framework.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 599
accomplish positive frames of mind and better motivate
desired performance levels compared to penalties alone.
A related point is that, ordinarily, qualitatively different
performance thresholds come to mind when considering
rewards versus penalties. Penalties exact negative utility
on persons who fail to meet a minimum expected perfor-
mance threshold (de?cient performance), whereas re-
wards give positive utility to persons who perform at a
strong level (meritorious performance).
The lack of accountabilities in the right quadrants of Ex-
hibit 2 indicates the absence of mechanisms that hold
auditors accountable directly for their judgment processes.
Our review of the relevant psychology, economics, neuro-
science and accounting literatures, however, suggests po-
tential to improve audit quality with more emphasis on
auditors being accountable for their judgment processes.
The next two sections of the paper outline these literatures
related to rewards versus penalties and processes versus
outcomes.
The rewards versus penalties dimension
Historic and current spectrum of auditors’ rewards versus
penalties accountabilities
Auditors’ accountabilities predominantly have been in
the form of penalties. In litigation contexts, the best out-
come is avoidance of damages and settlements. Auditors’
new regulators have generated a range of new penalties,
but so far no new rewards. While there is some anecdotal
evidence, there is limited empirical evidence that auditors
are rewarded for particularly good judgment processes or
innovative audit procedures.
10
The limited empirical evi-
dence comes from studies on auditor expertise and audit
markets. The expertise studies indicate that, as auditors gain
industry experience, their technical knowledge of account-
ing and auditing, procedural knowledge about how to gather
and interpret audit evidence, and their tacit knowledge
about how to manage interpersonal relationships all tend
to improve (Solomon, Shields, & Whittington, 1999; Tan &
Libby, 1997). Tan and Libby (1997) provide evidence that
relatively more knowledgeable auditors at various ranks
also tend to have higher performance ratings, which may in-
crease their compensation or chances for promotion.
Research also shows that elements of audit ?rms’ qual-
ity control processes, including their audit review and
informal consultation processes, can reward individual
auditors who perform their task at relatively high-quality
levels (e.g., Gibbins & Trotman, 2002; Rich, Solomon, &
Trotman, 1997a). At the audit ?rm level, during certain
market conditions, larger and/or specialist audit ?rms are
rewarded with reputational capital and audit fee premi-
ums (Carson, 2009; Craswell, Francis, & Taylor, 1995).
Nevertheless, we do not know the degree to which
these rewards motivate auditors to improve audit quality
(e.g., adjust audit programs or staff audit teams differently
to address unusual risk factors). It also is unclear whether
these rewards are intended to motivate auditors to supply
audits that just meet a statutory minimal-quality thresh-
old, or superior audits that easily exceed such thresholds.
Interestingly, nearly all archival and experimental studies
examining auditor judgments either presume that espe-
cially good auditor performance is suf?ciently rewarded
or, more commonly, are silent about the degree to which
better performance by auditors is rewarded.
11
Regulatory inspections also are penalties-orientated.
They focus on locating audit ?rm quality-control defects
as well as audit-speci?c de?ciencies. In the USA, the public
version of PCAOB inspectors’ reports enumerate audit de?-
ciencies the inspectors have located and deemed to be so
signi?cant that the audit ?rm did not have suf?cient, com-
petent evidence to support its audit opinion. This approach
penalizes audit ?rms reputationally, but it does not reward
exceptional or best practices, nor does it provide incentives
for audit ?rms to undertake research and development
activities aimed at improving auditing over the longer
term. Similarly, while inspection summaries in Australia,
Canada, Singapore and the United Kingdom indicate satis-
faction across many of the inspected audit engagements,
they still commonly highlight detected de?ciencies.
To summarize, little empirical evidence exists that
auditors receive tangible rewards for attempting to excel
in ful?lling their professional responsibilities. There may
be intrinsic or extrinsic rewards within the audit ?rms,
but little about these rewards is presently known.
Research pertinent to the rewards versus penalties dimension
Here we brie?y outline some key ?ndings from research
on experimental economics, psychology, and accounting
related to rewards versus penalties. Experimental econom-
ics research provides theory and empirical evidence show-
ing that it is helpful to provide carrots (rewards) and not
just sticks (penalties) when motivating performance. Indi-
viduals often ?ght back when threatened with sanctions
(Fehr & Rockenbach, 2003; Houser, Xiao, McCabe, & Smith,
2008). Houser et al. (2008, p. 510) note, ‘‘. . .threats are not
necessarily effective. Under threats employees might shirk
. . . more than they had previously.’’ Consistently, research
using proposer-responder games ?nd that combinations
of rewards and punishments are superior to either alone
10
In one anecdote, Dennis Nally, PwC, referred to a new initiative of the
?rm called ‘Standing Firm on Quality’ where weekly awards were given to
‘‘those staff members who stood their ground and demonstrated courage
even when doing so may have cost the ?rm a client’’ (Nally, 2004).
11
Auditors may well receive such rewards, but little empirical evidence
has been reported. The archival literature examines large-sample associ-
ations among audit-?rm attributes, ?nancial-reporting attributes, and
market behaviors (e.g., Khurana & Raman, 2004). Data limitations, however,
prevent this line of research from identifying speci?c cases in which audit
?rms received market rewards (for discussion see, Dechow & Skinner,
2000). PCAOB inspectors reportedly have observed ‘‘situations in which
audit quality did not appear to be a signi?cant factor in the partner
evaluation process or its role in that process was unclear’’ (2008, p. 21).
PCAOB (2008, p. 26) provides anecdotes regarding steps that some ?rms
have taken to redress quality control concerns: ‘‘. . . revisions to the partner
evaluation process to place greater, or more explicit, emphasis on audit
quality and technical skills,’’ and ‘‘changes to provide greater separation
between the audit quality function and the audit business operations.’’
PCAOB (2010) reminds USA public company auditors of their supervisory
responsibilities and that failure to properly discharge them will result in
sanctions and penalties.
600 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
(Andreoni, Harbaugh, & Vesterlund, 2003). Thus, the current
regime of penalties attributable to audit litigation and regu-
latory inspections, likely can be improved by adding in a mix
of meaningful rewards for high quality auditing.
Luft (1994) highlights how individuals respond to eco-
nomically identical contractual payoffs that are framed as
either bonuses or penalties. This framing difference alters
how employees mentally account for their incentives,
and mental accounting affects a wide range of consump-
tion and savings behaviors (e.g., Pralec & Loewenstein,
1998; Thaler, 1999). Luft ?nds that, all else being equal,
managers must pay more to hire employees subject to pen-
alties compared to those eligible for bonuses, suggesting
that employees have a stronger preference for rewards
than for economically equivalent penalties.
Frederickson and Waller (2005) extend Luft (1994) by
demonstrating that bonus-frame employees outperform
penalty-frame employees. Better performance is achieved
by more accurate interpretation of informative signals,
which, together with participant’s effort, determined ?nal
payoffs. Penalty-frame employees tended to persistently
underweight informative signals. Thus, the framing of
incentives that are economically identical as rewards ver-
sus as penalties alters how favorably or unfavorably per-
sons interpret their incentives.
A related line of research examines whether there are
conditions under which rewards motivate greater effort
than penalties in incomplete contracting settings. Such set-
tings feature contingencies that are not explicitly con-
tracted upon, usually due to the setting’s complexity or
prohibitive costs of specifying, monitoring and/or enforc-
ing complete contracts. Incomplete contracts can heighten
agency problems (Hart, 1988), and auditing is a prime
example of an incomplete contracting setting.
12
Theory
and ?ndings in Christ, Sedatole, and Towry (2012) show that
penalties, relative to rewards, communicate to agents that
their work is not to be trusted or respected, due to expected
incompetence or dishonesty (Christ et al., 2012, p. 8). When
not trusted or respected by their principals, agents expend
less effort on an important second task that is not explicitly
covered by their contract. Christ et al. (2012) has potentially
major implications for audit researchers and practitioners.
The threats of large regulatory or legal penalties on auditors
who fail to perform up to an ill-de?ned minimum standard,
especially when coupled with the absence of signi?cant re-
wards for performing above this minimum standard, may
well implicitly convey to auditors that their work and pro-
fessional judgment is neither respected nor trusted. An open
question is whether auditors reciprocate as participants do
in Christ et al. (2012), i.e., by reducing their effort in audit
areas less likely to be inspected. These threats may also re-
sult in audit ?rms forgoing research and development activ-
ities that could improve fraud detection and/or enhance
audit effectiveness or ef?ciency over the longer term.
There are also questions about the bene?ts of extrinsic
(versus intrinsic) rewards in both economics and psychol-
ogy literatures (e.g., Bénabou & Tirole, 2003; Deci, Ryan, &
Koestner, 1999; Lepper & Greene, 1978). Deci et al. (1999)
reviewed 128 experiments covering two decades of re-
search and concluded ‘‘tangible rewards tend to have a sub-
stantially negative effect on intrinsic motivation’’. Kunz and
Pfaff (2002), however, conclude that while extrinsic re-
wards may undermine intrinsic motivation, the conditions
necessary for this to occur seldomprevail in business situa-
tions and when they do, they can be relatively easily
avoided. Nevertheless, the relationbetweenextrinsic incen-
tives and agent performance on tasks requiring creativity is
complex and not always positive (Amabile, 1983; Amabile,
1998). In Kachelmeier, Reichert, and Williamson (2008),
for example, participants given incentives to be creative
did tend to develop solutions rated as being more creative,
but the quantity of their output declined, despite partici-
pants also having a quantity incentive. This research is rele-
vant because auditor creativity is indispensable in the
design of diagnostic and ef?cient analytical procedures, in
fraud brainstorming sessions, and in being responsive to
strategic management behaviors (Bell, Peecher, & Solomon,
2005; Trotman & Wright, 2012). There is no extant research
in auditing of which we are aware, and little research in
accounting (Libby & Lipe, 1992), that offers insights into
the determinants of auditors’ extrinsic andintrinsic motiva-
tion to perform well on ill-structured audit tasks.
In moral domains, penalties can be more effective than
rewards (Mulder, 2008). For example, in a whistleblowing
situation, participants treat a penalty as an indicator that
whistleblowing is a social norm, but they treat a reward as
an indicator that whistleblowing is going above and beyond
one’s social responsibility (Chen, Nichol, & Zhou, 2012).
Whether or not this study’s ?ndings would hold for auditing
settings, in whichthere are authoritative standards that for-
mally describe one’s professional obligations, is unclear.
Finally, there is a rich literature on the importance of
the shape of the incentive-performance function
(Merchant & Van der Stede, 2011). A key feature of incen-
tive-performance functions are lower thresholds below
which penalties are possible and/or at which bonuses be-
gin to accumulate as well as upper thresholds above which
no further bonuses accumulate (Merchant & Manzoni,
1989). Auditors’ incentive-performance function differs in
that they feature regulatory penalties but no regulatory re-
wards of signi?cance. That is, auditors can be heavily
penalized if audits entail gross negligence or recklessness
and they can be less severely penalized for audits that en-
tail simple negligence or audit de?ciencies. Inspectors doc-
ument when auditors’ work does not achieve a minimum
threshold, such as insuf?cient professional skepticism.
However, once auditors meet the minimum threshold,
their reward function shape is ?at, giving them little incen-
tive to substantially improve audit quality. In this respect,
auditors’ incentive-performance function is nearly the
opposite of what one sees in ?rm pro?t centers in which
managers are eligible for rewards, but only when they
meet some lower threshold.
12
Auditing is a prime example of an incomplete contracting setting in
part because the objective of gathering suf?ciently persuasive evidence to
provide reasonable assurance that ?nancial statements are not materially
misstated includes many professional judgments (cf., Tirole, 1999). Nota-
bly, in simpler and complete contracting settings there is evidence that
penalties fare better than rewards in motivating agent effort (Church, Libby,
& Zhang, 2008; Hannan, Hoffman, & Moser, 2005).
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 601
The above research indicates that it likely would be
bene?cial to identify new ways to reward ?nancial state-
ment auditors, and in some circumstances to reframe audi-
tors’ current incentives in reward terms. The current
system, dominated by penalties, is likely sub-optimal with
the resulting need to consider using new rewards to ensure
auditors are accountable for a broad range of performance
levels, especially levels beyond a minimal performance
threshold.
The processes versus outcome dimension
Historic and current spectrum of processes versus outcome
accountabilities
Historically, auditors have been held accountable when
adverse ?nancial statement outcomes (e.g., client bankrupt-
cies, material misstatements due to fraud, or large decreases
in market capitalization) follow after particular audit con-
clusions (e.g., an unquali?ed opinion or the absence of a
going-concern modi?cation). These two in combination
trigger attempts by regulators and third parties to extract
penalties from auditors through ?nes, compensatory or
punitive damages, and removal of license (e.g., Beasley, Car-
cello, Hermanson, & Neal, 2010; Carcello & Palmrose, 1994;
Heninger, 2001). Outcome-triggered accountabilities usu-
ally entail retrospective assessments of auditors’ judgment
processes, and both the salience of and uncertainty sur-
rounding various risk factors can widely change during ver-
sus after the audit, especially in volatile economic times.
In the last decade, audit regulators began conducting
inspections of audits and audit ?rms’ quality control poli-
cies. These inspectors have a complex task—one of assess-
ing the quality of an auditor’s judgments about
management’s ?nancial statement judgments (Kinney,
2008). Regulators use a risk-based approach, based on an
undisclosed set of cues, to select audits for inspection. Still,
there ordinarily is some time lag between auditors’ risk
assessments and audit testing versus regulators’ inspec-
tions and reports. Regulators who retrospectively believe
a different approach to audit testing would have been bet-
ter may well be drawing reasonable conclusions, but audi-
tors also may have used a different approach to audit
testing, if they had knowledge of changing conditions. Con-
sequently, regulators’ assessment of auditors’ judgment
processes may be biased (perhaps unconsciously) by inter-
vening outcomes (e.g., changed economic conditions or
large decreases in stock price).
Alleged examples of regulator bias are present in the
following anecdotes which suggest that regulators inter-
pret disagreement with auditors’ judgments as evidence
that an audit de?ciency exists:
[F]or many of the ?ndings we respectfully disagree with
the conclusion that ‘the Firm had not, at the time it
issued its audit report, obtained suf?cient competent
evidential matter . . .. [w]e believe: The work performed
was adequate in the context of the audit as a whole and
therefore such ?ndings represent good faith differences
of opinion on the application of professional judgment.
(Pricewaterhousecoopers (PwC)., 2005).
The issues raised in the report . . . require signi?cant pro-
fessional judgment. This is particularly true as it relates
to the testing, assessing the proper application of
accounting principles and determining what constitutes
suf?cient documentation. We . . . disagree with certain
views of the PCAOB. We base our views onsigni?cant dis-
cussion and consultation between the engagement
teams and specialists within Grant Thornton. We believe
these judgments were appropriately supported and
well-reasoned. While we believe that the PCAOB should
continue to challenge judgments and documentation
during the inspection process, we do not believe that,
in the end, reasonable judgments should be criticized
and second-guessed. (Grant Thorton., 2009).
Research pertinent to the processes versus outcome dimension
Psychologists emphasize that because evaluators rarely
obtain perfect knowledge about the judgment processes
decision makers use to reach conclusions (e.g., clean audit
opinion), outcomes following these conclusions (e.g., mis-
statements later are revealed) ordinarily are useful in
assessing judgment-process quality (e.g., Einhorn,
1980).
13
However, they also emphasize that outcome-in-
formed assessments of judgment process quality are fraught
with risk of bias (e.g., Hershey & Baron, 1992, 1995; Smith &
Kida, 1991). Concern about judgment bias has motivated re-
search in accounting and psychology as to whether evalua-
tors’ belief revision following adverse outcomes causes
them to be too harsh on evaluatees, including auditors
(e.g., Brown & Solomon, 1987; Kadous, 2001; Kennedy,
1995; Kinney & Nelson, 1996; Tan & Lipe, 1997).
When belief revision following adverse outcomes is
normatively too large, outcome bias is said to occur (Her-
shey & Baron, 1992, 1995). Outcome bias could occur in
auditing, for example, if the revelation of a material mis-
statement or of a material weakness in internal controls
causes jurors or regulators to overestimate the degree to
which high- versus low-quality audit judgment processes
actually alter the likelihood of that a material misstate-
ment later will be revealed. Hindsight evaluators similarly
may overestimate outcome controllability or even misre-
member their own prior beliefs (e.g., Fischhoff, 1982; Ken-
nedy, 1995).
14
13
Economists come to a similar conclusion. Relying on perfect knowledge
about the quality of an agent’s judgment process (i.e., effort) dominates
relying on outcomes for contracting purposes. First-best (optimal risk-
sharing) arrangements with an agent are possible only when principals can
perfectly observe an agent’s judgment process. When an agent’s judgment
processes are unobservable, second-best solutions must be devised (e.g.,
Holström, 1979). In these situations, principals rely on combinations of
outcome information and imperfect monitoring of an agent’s judgment
processes.
14
The Advisory Committee onImproving Financial Reporting (ACIFR, 2008)
in the USAasserts that when evaluating preparer and auditor judgments, it is
appropriate to use information that was obtainable at the time the judgment
was made but inappropriate touse informationnot obtainable at the time the
judgment was made. The latter seems inconsistent with Bayes’ Rule. In
particular, if unable to determine what information was obtainable at the
time of judgment, Bayesians would purposely use information not obtain-
able at the time the judgment if they believed it to be correlated with
obtainable information at the time of judgment.
602 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
Despite concern about outcome bias, however, recent
evidence shows that, under some conditions, outcome ef-
fects can be normatively too small in audit settings. Apply-
ing the probability weighting function from Cumulative
Prospect Theory (e.g., Tversky & Kahneman, 1992), Peecher
and Piercey (2008) predict and ?nd an inverse-S pattern of
judgment bias that starts with outcome bias for relatively
low Bayesian probabilities of auditor negligence, but later
?ips—in the vicinity of a 40% Bayesian probability of audi-
tor negligence—to reverse outcome bias (e.g., over-le-
niency) for relatively high Bayesian probabilities.
Outcome bias for lower Bayesian probabilities of auditor
negligence could lead to frivolous lawsuits against audi-
tors, but reverse outcome bias for higher Bayesian proba-
bilities could result in auditors being exonerated even
when plaintiffs objectively have strong cases against them.
There also is an extensive literature on the bene?ts and
risks of holding decision-makers accountable for outcomes
as opposed to for their judgment processes. While account-
ability for outcomes can help improve judgment perfor-
mance under some circumstances, and while outcomes
often are easier to observe than judgment processes, re-
search to date indicates that process accountability holds
as much or more promise than outcome accountability
for improving judgments. In addition, such research pro-
vides reason to conjecture that adding process account-
ability to a setting dominated by outcome accountability
will enhance judgment quality.
An early study showing that process accountability can
outperform outcome accountability on some aspects of
judgment accuracy is Siegel-Jacobs and Yates (1996).
Therein, students role-played either trial lawyers trying
to pick favorable jurors or political advisors trying to pre-
dict how their constituents felt about abortion.
15
Later, in
an employment interview setting, Brtek and Motowidlo
(2002) show that process accountability can improve judg-
ment accuracy by increasing decision makers’ attentiveness
but that outcome accountability can impair judgment accu-
racy. Based on their evidence they conjecture that organiza-
tions, ‘‘should not require interviewers to defend their hiring
decisions according to outcome . . .. they should require
interviewers to defend the way in which they conducted
the interview’’ (p. 189).
More recently, Chang, Cheng, and Trotman (2013) ?nd
that, in a customer–supplier negotiation setting, process
accountability better enabled participants to reduce
?xed-pie biases and to achieve lower costs compared to
outcome accountability. In addition, in three ?nancial
investment settings featuring moral hazard, Pitesa and
Thau (2013) ?nd that process accountability both de-
creased the incidence of self-serving decisions by agents
and curtailed the negative consequences of heightened
agent power. Outcome accountability, by contrast, was lar-
gely ineffectual in both respects. These studies, overall, are
consistent with process accountability improving judg-
ment quality by causing people to increase effort and be-
come pre-emptively self-critical (Tetlock & Lerner, 1999).
Preemptive self-criticism in audit contexts could mani-
fest at different stages of auditors’ judgment processes,
including evidence search. One possibility is that they
would be more apt to engage in what Gibbins and Newton
(1994) call self-discovery and external-discovery. Self-dis-
covery is introspection about what evidence would be pru-
dent to gather and about how to obtain it. External-
discovery entails balanced, thorough information search
for evidence in media or in advice from colleagues (Gibbins
& Newton, 1994). While these strategies may help auditors
who are outcome accountable, they likely hold greater di-
rect promise for auditors who are process accountable. The
relation is more direct for process accountable auditors be-
cause evidence of a more thorough, balanced reasoning
process can increase the justi?ability of their conclusions,
independent of conclusions ultimately reached (Kadous,
Leiby, & Peecher, 2013; Kennedy, Kleinmuntz, & Peecher,
1997).
Outcome accountability, by contrast, tends to be associ-
ated with greater stress levels and frustration (Siegel-Ja-
cobs & Yates, 1996) as well as with defensive bolstering
(Lerner & Tetlock, 1999). While outcome accountability
can impair the validity of reasoning even if implemented
before judgments have been reached (Brtek & Motowidlo,
2002), it can be especially deleterious when implemented
afterwards, as in litigation or regulatory inspections. In-
stead of objectively rethinking the basis for their conclu-
sions, evaluatees rationalize their conclusions. They
become less cooperative (Adelberg & Baston, 1978), more
polarized (Tetlock, Skikta, & Boettger, 1989) and more
committed to suboptimal actions (Simonson & Staw,
1992).
One way that auditors could be held accountable for ad-
verse audit outcomes is strict liability for third-party dam-
ages (Dopuch & King, 1992). An analytical model of strict
auditor liability, however, indicates it could cause an eco-
nomic loss in social welfare (Schwartz, 1997). In the Sch-
wartz model, this loss occurs due to third-party
overinvestment in risky assets because less diligence is
needed given potential compensation from auditors ex
post. Further, the model suggests that strict liability could
cause auditors to over-audit and/or to drive up audit fees
to the point that the endogenous market for audits shrinks
(Dopuch & King, 1992).
Despite such concerns about outcome accountability,
however, there is no reason to think that all forms of pro-
cess accountability will work the same way or always pro-
duce better results than all forms of outcome
accountability (Lerner & Tetlock, 1999). As one example,
de Langhe, van Osselaer, and Wierenga (2011) ?nd that
outcome accountable participants outperform process
accountable participants when process accountability
causes them to more diligently use ineffective judgment
processes. In de Langhe et al. (2011), process accountabil-
ity for performing a task requiring con?gural processing
15
In Siegel-Jacobs and Yates (1996), different aspects of judgment
accuracy improve given process accountability versus outcome account-
ability across experiments that differ according to whether both diagnostic
and non-diagnostic information or just diagnostic information is available.
Further, Lerner and Tetlock (1999) argue that the outcome accountability,
as operationalized in Siegel-Jacobs and Yates (1996), was at a disadvantage.
In particular, it rewarded only top-performers and so average performers
may have believed they had no chance. Lerner and Tetlock (1999)
recommend that outcome accountability reward improved, and not just
top, performance.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 603
intensi?ed how diligently participants engaged in linear
processing. Had the participants been more familiar with
con?gural processing required for the task, as experienced
auditors have been shown to be for some tasks (Brown &
Solomon, 1991), process accountability likely would have
resulted in better performance.
Finally, the potential bene?ts of both outcome account-
ability and process accountability can be undermined if
auditors simply try to appease regulatory inspectors. That
is, rather than motivating an evenhanded (and perhaps
complex) judgment process, some forms of process
accountability could cause auditors to use an acceptability
heuristic (Tetlock & Lerner, 1999). This heuristic entails
strategically adjusting one’s judgment process or judg-
ments to align with the preferences of those to whom
one is accountable. Along these lines, auditors have been
shown to adjust their judgment processes and judgments
to align with audit supervisors’ preferences, even those
that favor credulity as opposed to skepticism in evaluating
management assertions (e.g., Peecher, 1996). Similarly,
auditors who learn regulators’ preferences about facets of
audits may ?nd it riskier to try to be a mindful, objective
professionals than to mimic or appease regulators, so that
their judgments will appear acceptable to them.
Linking judgment processes and outcomes: learning,
impoverished feedback and OILS
Psychology research on learning shows that individuals
come to most deeply understand how to perform tasks and
how well they have performed tasks when provided with
timely, accurate process feedback (Einhorn & Hogarth,
1978). Outcome feedback alone, whether or not a perfor-
mance failure has occurred, tends to be insuf?cient for
knowledge acquisition (e.g., Bonner & Walker, 1994). Out-
come feedback coupled with upfront, explanatory instruc-
tion can help, as can mechanisms that encourage self-
explanatory thinking during task performance (Earley,
2001). Delayed feedback impairs individuals’ ability to
map from different actions into various consequences,
and, during the interim, they can become overcon?dent
(e.g., Sterman, 2002).
Auditors seldom receive timely high-quality outcome
feedback, in the sense of ascertaining when and whether
audit values approach true values (e.g., Anderson & Kraus-
haar, 1986). Additionally, the quality and timeliness of
auditors’ judgment-process feedback varies considerably
and depends heavily on the effectiveness of their supervi-
sors in mentoring them and in executing the audit review
process (e.g., Libby & Trotman, 1993; Peecher, Piercey,
Rich, & Tubbs, 2010; Rich et al., 1997a).
Sometimes auditors’ own actions limit their feedback
opportunities, further impoverishing their understanding
of the quality of their judgment processes, as a result of
an Outcome Irrelevant Learning Structures (OILS) problem
(Einhorn, 1980). Suppose, for example, that audit partners
promote subordinate auditors because they think these
subordinates are more likely than others to develop sound
professional judgment processes. If partners later review
promoted subordinates’ work and conclude that it is of
acceptable quality, they may conclude that they are skilled
at selecting which subordinates to promote above others.
16
It could be, however, that selected subordinates are not any
better than unselected subordinates, and it is possible that
even stronger subordinates were overlooked because they
were erroneously judged to be less promising (Waller & Fe-
lix, 1984a, 1984b).
Similar concerns about the quality of feedback, in part
due to the OILS problem, can apply to regulators evaluating
auditors’ judgment-process quality. If inspectors happen to
observe audit de?ciencies in audit working papers that
they initially subjected to their inspections because they
thought the audit would be of marginal quality, they might
too hastily conclude that they are experts in identifying
indicators of poor auditing. However, there may have been
as many or more de?ciencies in working papers not se-
lected for inspection. In addition, because regulators pre-
dominantly examine audits thought to be of marginal
quality while audit ?rms conduct and review a broad spec-
trum of audits, the two parties may have substantially dif-
ferent perspectives of factors that determine high- versus
marginal-quality audits.
What does a lack of consensus indicate about judgment
process quality?
As noted earlier, it has been suggested that regulators
treat the absence of inspector-auditor consensus on what
audit procedures should have been performed or what evi-
dence should have been collected as if they were diagnos-
tic of an audit de?ciency. However, there has been
considerable research on the extent to which experienced
auditors disagree with one another’s conclusions on a vari-
ety of audit tasks. Solomon and Shields (1995) report that,
in 22 studies of auditor judgment on a range of tasks (e.g.,
internal control strength assessment, audit test planning,
evaluating test results, and opinion issuance), the mean
consensus as measured by correlation in judgments be-
tween pairs of auditors is relatively modest, i.e., +0.59 (ran-
ged from +0.28 to +0.93). These correlation numbers drop
considerably when the analysis is redone without the more
extreme (and often easier to evaluate) cases (Trotman,
1990).
17
While these studies show that consensus between
auditors can be modest, related research shows that consen-
sus is an imperfect proxy for accuracy, especially in some
industries and among auditors with less industry experience
(Davis, Kennedy, & Maines, 2000).
All of these studies suggest that experts sometimes
disagree. Mumpower and Stewart (1996) identify several
reasons why expert disagreement is common: different
information sets, different mental models, different ways
of combining information, different weight of information,
different thresholds for reaching various conclusions,
16
Supervisors also likely are overly optimistic for non-OILS reasons.
Auditors tend to be overcon?dent in their subordinates’ technical knowl-
edge (Kennedy & Peecher, 1997), and they can be susceptible to halo effects
17
The average correlation of +0.59 is modest in the sense that a similar
level led Einhorn (1974) to question the competence of medical doctors,
but it is higher than consensus levels that Shanteau (2002) reports as being
commonly found in studies of experienced stockbrokers (+0.32), polygra-
phers (+0.33), and clinical psychologists (+0.40).
604 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
different propensity to be biased and differential variance
in judgment. Recent research from a related paradigm—
neuroscience—suggests that humans reason using idiosyn-
cratic perspectives, based on their speci?c biological make-
up and life experiences. One neurobiologist argues that,
‘‘The presumption that each of us, if presented with the
same evidence, should draw the same conclusions, isn’t
consistent with modern neuroscience’s view of brain func-
tion’’ (Burton, 2010). He elsewhere points out that a strong
‘‘feeling of knowing’’ can be misleading and that when ex-
perts do reach the same conclusions it does not mean they
used the same thought processes, as agreement sometimes
occurs despite substantially different genetic compositions
and ways of thinking (Burton, 2008).
Thus, both psychology research on expertise and neuro-
science indicate that, while there are situations in which
different experts given the same information will reach
the same judgment, their disagreement is more likely as
uncertainty, task complexity, and the number of alterna-
tive conclusions increase. In addition, divergence across
experts on either conclusions reached or judgment pro-
cesses used is more likely when there are differences in
judges’ genetic compositions, thinking dispositions, knowl-
edge structures, incentives, and information sets.
In medicine the expectation that experts commonly dis-
agree on appropriate procedures has led to the respectable
minority defence to malpractice lawsuits. Thereunder, if it
can be shown that a respectable minority of physicians ap-
prove of a course of action, the malpractice case should be
dropped (Hudson & Moore, 2011). Hudson and Moore refer
to court ?ndings noting that as long as the physician
chooses a ‘‘mode or form of treatment which a reasonable
and prudent member of the medical profession would
undertake under the same or similar circumstances [they]
shall not be subject to liability for harm caused thereby to
the patient’’.
18
While auditors could try to apply a similar
type of defence, arguing there are multiple or even ill-de-
?ned schools of thought with respect to facets of audits,
there is not, to our knowledge, the same established tradi-
tion of a respectable minority defence in alleged auditor
negligence cases. In addition, when regulators inspect audi-
tors, it is unclear whether and how a respectable minority
argument would moderate their propensity to characterize
conclusions with which they disagree as something other
than an audit de?ciency.
To summarize, research suggests that audit quality
would likely increase if auditors were more accountable
for their judgment-process quality. Holding auditors
accountable for conclusions that happen to differ from reg-
ulators’ conclusions or that happen to precede adverse
?nancial statement outcomes likely increase the chance
that hindsight bias and other biases will impair regulators’
and other evaluators’ ability to fairly assess auditor perfor-
mance. This literature also suggests that, even if auditors
were more accountable for their judgment processes, con-
siderable care needs to be taken in assessing the quality of
these processes. In particular, audit, psychology, and neu-
roscience research all provide reasons for regulators and
other evaluators to avoid interpreting a lack of consensus
between auditors and themselves as strong evidence of
auditor judgment error.
Potential changes and related research questions
We now describe four changes that have the potential
to improve audit quality and/or the quality of regulators’
evaluations of auditors’ performance. As a package, these
changes are aimed at providing greater balance in terms
of the reward-penalty and outcome-process dimensions
of our accountability framework. We provide Exhibit 3 to
illustrate how the changes likely would alter auditors’
accountabilities in terms of our two-dimensional frame-
work. Speci?cally, the ?rst three changes relate to moving
auditor accountabilities into the judgment process quad-
rants of Exhibit 3, while two ways to implement the fourth
potential change moves accountabilities into the reward
quadrants. We provide these changes as a means of
prompting discussion and research on the impact of intro-
ducing these changes. We set out speci?c research ques-
tions as illustrations of the types of research that could
be conducted. While these potential changes have wide
ranging research implications, we concentrate on those
questions that can be addressed by JDM research. Some
RQs will be easier to implement than others and some will
create challenges in both design and choice of appropriate
participants. As many of our suggestions do not presently
exist in practice, experiments are an appropriate method
to examine the likely impact of new developments under
different circumstances and in combination with different
environmental factors (see Libby & Luft, 1993). Some of the
advantages of experiments are that researchers have the
opportunity to test proposed alternatives rather than wait-
ing until after implementation, disentangle variables that
may be confounded in natural settings, and determine
how, when and why different changes in?uence behavior
(Libby, Bloom?eld, & Nelson, 2002).
Proposal 1: Introduce an auditor judgment rule
One potential change is that auditors’ professional judg-
ments could be evaluated within the context of an auditor
judgment rule, fashioned after the business judgment rule
that applies to USA corporate directors.
19
Under the busi-
ness judgment rule, directors who make judgments that
are within their authority and for which there is a rational
basis generally cannot have their judgments second-guessed
by the courts or be held responsible for subsequent
third-party losses (O’Connell and Boutros, 2002). The only
exceptions are when directors do not act in good faith or
intentionally do not act in the best interest of the company.
18
Henderson v. Heyer-Schulte Corp. Court of Civil Appeals of Texas, 1980.
600 S.W.2d 844. Peters (2002) elaborates, suggesting that because there can
be different opinions among competent physicians, the respectable
minority defence re?ects a ‘‘judicial unwillingness to choose among
con?icting schools of thought when physicians themselves cannot reach
a consensus’’.
19
Johnson (1992) reviews case law and concludes that while corporate
directors are explicitly protected by a business judgment rule, auditors are
only implicitly and problematically protected by an audit judgment rule.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 605
As such, subject to meeting some standard of process
accountability, courts generally do not second-guess corpo-
rate directors’ business judgments.
20
In the USA, courts have
extended a variant of the business judgment rule to certain
psychiatrists, in effect creating a medical judgment rule. This
occurred in a landmark appellate court case, Currie v. United
States (1987):
In the business judgment rule, courts defer to the deci-
sions of disinterested directors absent their bad faith or
self-interest. Many of the considerations cited as justi?-
cations for the business judgment rule are applicable to
the present case. For example, as with business deci-
sions, the court is not particularly quali?ed to review
commitment decisions involving mental health and
dangerousness.. .. and ‘after the fact litigation is a most
imperfect device to evaluate’ those decisions, as in the
corporate setting. .. .Finally, policy considerations favor
giving psychotherapists, as well as corporate directors,
signi?cant discretion to use the best judgment, recog-
nizing that ‘a rule which penalizes the choice of seem-
ingly riskier alternatives may not be in the interest’ of
parties or society.
21
In contrast to the above discussion of a business judg-
ment rule, auditors’ judgments, even if made in good faith,
can be second-guessed as courts can rule that alternative
judgments should have been reached. In addition, irrespec-
tive of how reasonable the auditors’ judgment process was,
Exhibit 3. Illustrative enhanced accountability framework.
20
A business judgment rule differs from a safe harbor, which would
provide incentives to reduce judgment quality, due to reduced threat of
litigation or sanctions (see Treasury, 2008, fn 120 and 121, VII, p. 31 for full
references).
21
While psychiatrists and psychotherapists are evaluated within the
framework of a medical judgment rule, many medical practitioners are not.
There is ongoing debate as to whether a more general medical judgment
rule should be crafted. Interested readers should refer to both Arkes and
Schipani (1994), who outline various rationales for why a medical
judgment rule should not generally apply to all physicians, and O’Connell
and Boutros (2002) who analyze each of these rationales and conclude that
they are insuf?cient to justify withholding a medical judgment rule from all
physicians.
606 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
regulatory inspectors currently have wide authority to
determine that the judgments of auditors are inappropri-
ate and this information is documented in their inspection
reports.
In Exhibit 4, we summarize dimensions that O’Connell
and Boutros (2002) used to compare and contrast judg-
ment rules for directors and certain medical practitioners
and extend these rationales to auditors. There are ?ve
dimensions: (1) the role of risk taking, (2) fear of liability,
(3) lack of accepted methodologies, (4) proliferation of
complex judgments and (5) reliance on market effective-
ness
22
(see Arkes & Schipani, 1994; O’Connell and Boutros,
2002). The comments in Table 4 on directors and physicians
Exhibit 4: Potential Actions of Directors, Physicians and Auditors Without Judgment Rules
Directors Physicians Auditors
1. Role of Risk Taking More risk adverse in
decisions and
opportunities for new
ventures.
Less inclined to
perform difficult and
high-risk procedures.
Use of defensive
medicine; declining to
perform difficult or
experimental
procedures.
Less inclined to take on
clients with high
business risk.
Use of defensive
auditing; declining to
move to new
techniques.
For all professions it appears that risk taking is reduced without a business
judgment rule.
Insights from Treasury (2008):
“The combination of catastrophic litigation risk and difficulty obtaining
insurance exacerbates concentration in the profession. Smaller firms are
reluctant to pursue public company clients to increase their market share
given the disproportionate threat of liability.”
“The threat of disproportionate liability can harm audit quality by …
impeding the evolution of more useful audit reports and causing overly
cautious audits or ‘defensive’ auditing.”
2. Fear of Liability Well-qualified
individuals rejecting
corporate positions
(e.g., Board of
Directors).
Physicians leaving high
risk geographical areas,
moving to less litigious
fields of medicine,
early retirement, gifted
students seeking
alternate professions.
Treasury (2008)
suggests that the
brightest students are
discouraged from
entering the profession.
This is supported by
our own discussions
with audit partners,
who indicate intense
competition from
consulting and
banking.
While it has been suggested that introducing a business judgment rule could
negatively impact quality in all professions there is no evidence it would
impact quality differentially across professions.
Insights from Treasury (2008):
“The threat of disproportionate liability can harm audit quality by
discouraging the best and brightest from entering and remaining in public
company auditing, inhibiting the use of professional judgment, impeding the
evolution of more useful audit reports and causing overly cautious audits or
‘defensive’ auditing.” (VII: 28)
Exhibit 4. Potential actions of directors, physicians and auditors without judgment rules.
22
O’Connell and Boutros (2004, p. 410) refer to various market mecha-
nisms that serve as checks on the behavior of directors and of?cers with the
aim of achieving congruency between the interests of management and
shareholders. These market mechanisms provide checks on the three
groups by rewarding satisfactory performance (continued employment,
promotion, compensation) but penalizing unsatisfactory performance.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 607
are based on conclusions in O’Connell and Boutros (2002),
and we examined the USA Treasury’s ACAP Committee
(Treasury, 2008) for similar insights on auditors. We con-
clude that practitioner risk taking, along with practitioner
research and development on ways to improve existing best
practices, are reduced without a judgment rule; that fear of
liability makes it dif?cult to attract and retain the most tal-
ented individuals; that considerable and complex judgment
Directors Physicians Auditors
3. Lack of Accepted
Methodologies
Differences of opinion
on whether commonly
accepted
methodologies exist for
officers and directors;
likely to vary
considerably with the
task.
Practice of medicine
relies on combination
of principles and
patient-specific
symptoms; importance
of clinical judgment
and reasoning skills;
detailed knowledge of
individual patients
needed and
complicated
information search and
combining of cues
involving interactions.
Practice of auditing
relies on combination
of principles and client-
specific contexts;
importance of
professional judgment,
reasoning skills, and
knowledge of the
auditee and the
environment;
complicated
information search and
combining of cues
involving interactions.
None of the professions can have a ‘cookbook’ approach and considerable
judgment is required in all professions.
Insights from Treasury (2008):
“The Committee notes that the increasing complexity of global business
operations are compelling a growing use of judgments and estimates.” (VII:
17)
4. Does Judgment
Entail Prediction of
Complex
Trajectories and
Pattern
Yes, how will markets
react to new products,
changes in interest and
exchange rates, etc.
Yes, how will a person
react to certain drugs
and treatments; how
will the drugs and
treatments interact;
what are long-term
effects; what are effects
if other diseases are
contracted.
Yes, extent of
prediction orientated
tasks are increasing;
deferred tax example
given in the text; cash
flow projections
involved in many audit
procedures particularly
related to fair value.
Answer is ‘yes’ for all professions and the extent of future orientated
judgments of auditors is increasing.
Insights from Treasury (2008):
“The Committee notes that the increasing complexity of global business
operations are compelling a growing use of judgments and estimates.” (VII:
17)
5. Reliance on Market
Effectiveness (i.e.,
will judgment quality
decline without a
business judgment
rule)
Market mechanisms
check officers’ and
directors’ behaviors to
align management and
shareholders’ interests.
Hospitals use
performance reports
and physicians face
dismissal and difficulty
in getting new
positions if poor
performance.
Many external and
internal reviews of
auditors (internal
quality reviews,
PCAOB, SEC, etc.).
In all cases, market mechanisms will impact as all three professions are
evaluated and rewarded on performance.
Insights from Treasury (2008):
“The threat of disproportionate, catastrophic liability is not necessary to
preserve or enhance audit quality. Auditors have many incentives to perform
audits to the best of their ability, without the added threat of catastrophic
liability. Professional standards, PCAOB inspections and SEC enforcement
activities, internal firm evaluations, ordinary civil liability based on actual
misconduct, and reputational concerns, are all more than sufficient to ensure
professional behavior.” (VII: 27)
Fig. 4 (continued)
608 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
is required across all three professions, and that market
mechanisms would penalize nonperformance even if a judg-
ment rule was introduced. While the above factors would
suggest that a judgment rule is unlikely to impact quality
differently across these three professions, we note that there
are differences in institutional structures and incentives.
Thus, prior to examining the potential impact of an auditor
judgment rule it is suggested that consideration be given
to what are the differences in the types of judgments made
by directors, physicians, and auditors that would suggest
differences in the application of judgment rules and whether
investors and other external parties perceive conceptual dif-
ferences between directors, physicians, and auditors in the
?ve dimensions noted by Treasury (2008).
Questions arise as to how the adoption of an auditor
judgment rule would in?uence the ?nancial statement
preparation and auditing process, including management’s
accounting choices, auditors’ judgments, audit committee
members’ execution of their ?duciary duties, and regula-
tory inspectors’ assessments of auditors’ professional judg-
ments. In this paper, however, we concentrate on auditor
judgments and inspector judgments.
With respect to auditor judgment, research questions
could be addressed by applying the methods in earlier pol-
icy capturing research that evaluated auditor performance
using such criteria as consensus, self-insight, cue usage,
and consistency over time (see Solomon & Shields, 1995
for a review). A second approach would use the expertise
paradigm research, which models auditor performance as
a function of ability, experience, knowledge, motivation
and environment (see Libby & Luft, 1993). Another ap-
proach would be to apply a framework of task, person,
and interpersonal interactions (Nelson & Tan, 2005).
To illustrate, there is substantial literature on the re-
view process (e.g., Nelson & Tan, 2005; Rich, Solomon, &
Trotman, 1997b), and it may be that the issues a reviewer
draws attention to will be different under an auditor judg-
ment rule. The role of the reviewer is likely to move from
one of looking for inconsistent information (Libby & Trot-
man, 1993) to one of assessing the implications of incon-
sistent information on judgment reasonableness. Related,
there may be a change in the mix of relative time reviewers
spend on conclusions and documentation errors (Bamber &
Ramsay, 1997; Tan & Trotman, 2003), as better documen-
tation could enhance perceived reasonableness. An auditor
judgment rule also may alter auditors’ information search
(e.g., Asare & Wright, 2003; Kida, 1984) and evaluations
of evidence (Peecher et al., 2007).
Extant models of professional skepticism(Nelson, 2009)
also may need to be embellished given a reasonableness
guideline. For example, Nelson operationalizes professional
skepticismas judgments and decisions that re?ect a height-
ened assessment of risk that an assertion is incorrect based
on evidence available to the auditor. Will the use of a
reasonableness criterion result in the need for more or less
convincing evidence before concluding on an assertion?
The adoption of a reasonableness criterion may require
adjustments to models of auditor–client negotiations
(Bame-Aldred & Kida, 2007; Gibbins, Salterio, & Webb,
2001; Hat?eld, Agoglia, & Sanchez, 2008) and to models of
auditor brainstorming sessions (Hammersley, 2011).
RQ 1.1 If inspectors apply an auditor judgment rule,
what will be the impact on auditors’
judgments? Will the impact differ depending
on whether auditors are penalized for using
unreasonable judgment processes or
rewarded for using superior judgment
processes? Speci?c issues related to auditor
judgments include
– amount and type of information search
and evidence collected
– con?gural processing
– review process, including the mix of time
spent on conclusion errors and
documentation
– nature and level of professional skepticism
– approach used in audit–client negotiations
including tactics used
– the form of the fraud brainstorming
session
To operationalize an auditor judgment rule, inspectors
could apply a reasonableness test to assess auditors’ judg-
ment processes. A reasonableness test resonates with the
professional judgment framework in Treasury (2008),
which stresses ‘‘reasoned evaluation made in good faith
and in a rigorous, thoughtful and deliberate manner’’
(Treasury, 2008, p. 94, italics added). Using a reasonable-
ness test to implement an auditor judgment rule also
would create greater consistency with how PCAOB and
IAASB auditing standards currently require auditors to
evaluate the judgment processes used by management to
develop accounting estimates. Under a reasonableness test,
auditors’ inspectors would give auditors the same leeway
that auditors must give management when assessing their
estimates (e.g., AU Section 342; ISA 540). Even if an auditor
develops an estimate that differs from management’s esti-
mate, uses a different method to reach an estimate than
used by management, or believes that his/her own estima-
tion process is superior to management’s process, the audi-
tor still can conclude that the preparer’s estimate is not
unreasonable. Unless an estimate is unreasonable it cannot
be a misstatement, much less materially misstated.
23
At
the same time, however, the reasonableness test does not
mean management can develop any estimate it desires; in
fact the auditor is required to exercise professional
skepticism when assessing the reasonableness of
management’s estimates.
23
It is noteworthy that although audit committee members are a critical
part of the ?nancial-reporting supply chain, their work generally is not
subject to the kinds of sanctions or penalties that auditors face. Black,
Chef?ns, and Klausner (2006) note that ‘‘. . .directors with state-of-the-art
insurance policies face little out-of-pocket liability risk, and even in a
perfect storm they may not face out-of-pocket liability. The principle
threats to outside directors who perform poorly are the time, aggravation,
and potential harm to reputation that a lawsuit can entail, not direct
?nancial loss’’. As such, although audit committee members’ accountability
is beyond the scope of this paper, the question arises as to whether
regulators and other evaluators should hold audit committee members to a
reasonableness judgment standard, creating consistency throughout the
?nancial-reporting supply chain.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 609
Adoption of an auditor judgment rule also would take
better account of the neuroscience and psychology ?nd-
ings that, especially for ill-structured tasks, disagreement
is common amongst experts, even when they are pre-
sented with the same evidence, and so when disagree-
ments occur, they reveal little about whether a de?ciency
exists (Burton, 2010; Mumpower & Stewart, 1996). Simi-
larly, conclusions may differ frequently between auditors
and their inspectors (or other evaluators), but such differ-
ences do not, in themselves, indicate that one judgment
is unreasonable and that others are reasonable. Consistent
with this conclusion, Treasury Recommendation 3.5 reads
(2008, p. 93):
The SEC should issue a statement of policy articulating
how it evaluates the reasonableness of accounting judg-
ments and include factors that it considers when mak-
ing this evaluation. The PCAOB should also adopt a
similar approach with respect to auditing judgments.
One potential line of research is to examine how the
introduction of an auditor judgment rule would in?uence
the judgments of inspectors, focusing them more on ele-
ments of the auditors’ judgment process. Although there
has been considerable discourse on the activities of the
PCAOB and other international inspection agencies, there
has been no research to our knowledge that has examined
the judgments of their inspectors. While we recognize the
dif?culties of obtaining inspectors as participants for
experiments to address the research questions discussed
below, it may be possible for researchers in some environ-
ments to carry out this research. Further, it likely is the
case that, for theory-testing purposes, one would not need
nor necessarily prefer to use real-world experienced regu-
latory inspectors. As an example, simply randomly assign-
ing suf?ciently knowledgeable participants (e.g., retired
partners) to different roles within an experimental setting
could provide a suf?ciently rich test of research questions
related to the judgments of inspectors.
RQ 1.2: Does an understanding that experts can
disagree, even when both have well
reasoned conclusions, increase
inspectors’ willingness to recognize the
validity of an auditor’s approach? Does
such an understanding cause them to
search for signals other than their own
(dis)agreement with the auditor’s
approach?
RQ 1.3: Does the introduction of an auditor
judgment rule decrease the likelihood of
outcome bias in inspectors’ evaluations of
auditors’ judgments?
Developing signals of reasonable versus unreasonable
audit approaches could be a signi?cant challenge for regu-
latory inspectors, as it often is for auditors as they attest to
management’s estimates (SAS No. 57; IAS 540; Grif?th
et al., 2013). Consideration needs to be given to what
guidelines or attributes of audit procedures (or of audit
team staf?ng, etc.) collectively make an audit approach
reasonable. Indicators of reasonableness would evolve
but initially could include: Did the auditor reach profes-
sional judgments in good faith and consider relevant
authoritative guidance (Ng & Tan, 2003)? Did the auditor
consider relevant con?gurations of evidence in reaching
conclusions (Solomon & Shields, 1995)? Did the auditor
informally or formally consult in their ?rm or with exter-
nal specialists (Kadous et al., 2013)? Did the auditor exhi-
bit a suf?cient level of professional skepticism (Hurtt,
2010; Nelson, 2009)? Did the auditor choose to get inde-
pendent estimates, either by in-house or third-party ex-
perts (Grif?th et al., 2013)? Other potential attributes
include whether any con?ict of interest existed, whether
conventional factors in assessing materiality were ignored
(Messier, Martinov-Bennie, & Eilifsen, 2005) or there were
indicators of a lack of professional skepticism (Nelson,
2009). Related research questions include:
RQ 1.5: What factors affect how signi?cant the
differences between auditors’ and
inspectors’ judgments need to be before
inspectors conclude that auditors’
judgments are unreasonable? Does the
presence versus absence of an auditor
judgment rule alter these factors?
RQ 1.6: What factors affect the extent to which
auditors and inspectors use similar cues
or combinations thereof in determining
the reasonableness of auditor
approaches?
RQ 1.7: How do changes in audit methodology
affect inspectors’ judgments of
reasonableness? How would a lack of
familiarity with the methodology affect
their judgments of reasonableness?
RQ 1.8: How would the respectable minority
defence impact inspector and auditor
judgments? Would adoption of an
auditor judgment rule moderate how
inspectors react to auditors’ use of a
respectable minority defence of their
audit approach?
An interesting research question is how reasonableness
differs from other evaluative criteria for ill-structured
tasks, such as justi?ability (Kennedy, Kleinmuntz, & Pee-
cher, 1997; Koonce, Anderson, & Marchant, 1995). Consis-
tent with accountability research on the acceptability
heuristic (e.g., Lerner & Tetlock, 1999), auditors attempt
to anticipate and tend to implement the judgment pro-
cesses or outcomes their justi?ees prefer (Peecher, 1996).
Preferred judgment processes or outcomes, however, need
not coincide with those that an auditor judges to be the
most cost-effective or useful at revealing misstatements.
As such, a focus on justi?ability may tempt auditors to go
against their better judgment under some conditions and
is likely to vary with task structure and complexity.
Recently both regulators (IAASB, 2011) and researchers
(e.g., Smith, 2012) have noted the importance of percep-
tions of audit quality and how they may vary among differ-
610 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
ent stakeholders, including investors, courts, and jurors. A
considerable body of research on factors impacting jury
decisions in audit cases (e.g., Kadous, 2000) could be ap-
plied in this setting.
RQ 1.9: As the level of task structure and
complexity change, how do different
evaluation criteria, such as
reasonableness and justi?ability,
differently impact auditor and inspector
judgments as well as the judgments of
investors, courts, and jurors?
Proposal 2: Add a concurrent element to regulators’
inspections
One way regulators could credibly communicate to
auditors that they are primarily accountable for the quality
of their judgment processes is to add some concurrent
inspections. Inspectors are charged with assessing the
competence and judgment processes used by auditors as-
signed to a task, and simply asking auditors to concur-
rently explain their judgment processes to them has
potential bene?ts.
Psychology researchers interested in capturing partici-
pants’ judgment processes have found that using retro-
spective verbal or written accounts of participants’
judgment processes often entail stylization, intentional or
unintentional bias (preference-consistent changes in
memory can occur), and omissions due to memory decays
(e.g., Ericsson, 2006). Similarly, research suggests that
audit working papers are stylized to reduce ambiguity, cre-
ate a desired portrayal of the judgment process, and give a
persuasive account of the auditor’s conclusions (Rich et al.,
1997a).
Compared to retrospective inspections, concurrent ap-
proaches would provide inspectors with unique, ?rst-hand
evidence for assessing auditor judgment processes. Inspec-
tors’ use of concurrent inspections has potential to lead to
more accurate assessments of auditor compliance with
documentation requirements. That is, to what degree are
auditors’ documented justi?cations of conclusions as per
their working papers faithful representations of the uncer-
tainties, circumstances, and alternative courses of action
they actually considered at the time of the audit (e.g.,
Auditing Standard No. 3, PCAOB., 2004)? In addition, audit
research suggests that training and quality-control bene?ts
arise from including some concurrent reviews of subordi-
nate auditors’ work instead of relying exclusively on retro-
spective reviews (e.g., Rich et al., 1997b). These bene?ts
include better diagnoses of subordinates’ shortcomings
and prevention of subordinate errors. The above differ-
ences suggest potential differences between retrospective
and concurrent approaches but these differences are likely
to vary with task, environment and the experience of the
auditors and inspectors.
It has been suggested that auditors react to increased
regulation and litigation risks by structuring their audit
procedures so as to better withstand scrutiny by courts
(Power, 2003). A similar phenomenon could occur to
withstand scrutiny of inspectors who conduct retrospec-
tive examinations. If audit approaches become increasingly
standardized to the point that a ‘check the box’ mentality
develops, the resulting homogeneity in auditing ap-
proaches could make it easier for management to commit
and conceal frauds (Bell et al., 2005).
Some potential research questions include:
RQ 2.1: What factors change the extent to which
concurrent versus retrospective
inspections lead to different evaluations
of auditors’ judgment processes or
judgments?
RQ 2.2: What factors in?uence the degree to
which concurrent versus retrospective
inspections lead auditors to collect or
document different sets of evidence?
RQ 2.3 What factors in?uence the degree to
which concurrent versus retrospective
regulatory inspections make auditors
more comfortable with exercising
judgment to deviate from a standard
audit program?
RQ 2.4: What factors affect the degree to which
concurrent versus retrospective
inspections increase the standardization
of audit approaches and does this
standardization make it easier for
management to commit and conceal
fraud?
RQ 2.5 What factors make inspectors more likely
to penalize auditors given a concurrent
versus retrospective inspection?
RQ 2.6 What factors moderate the learning
effects for both auditors and inspectors
associated with concurrent or
retrospective inspections?
In any move to a concurrent inspection, consideration
would need to be given to whether to start the inspection
before, during, or after the audit work paper review pro-
cess. Concurrent inspections prior to the audit review pro-
cess would create a challenge of howto discern whether an
audit de?ciency ultimately would occur, as the audit pro-
cess is still incomplete. Carrying out the inspection at this
earlier stage, however, would give inspectors more insights
into the audit ?rm’s supervision and review of work ini-
tially performed by audit staff, e.g., do staff auditors effec-
tively identify and communicate audit risks to senior audit
team members (Bennett & Hat?eld, 2013)?
Given potential operational dif?culties of carrying out
concurrent inspections face-to-face, there is the possibility
of online concurrent inspections, much like audit ?rms
now use an online process to review subordinates’ working
papers. Insights on potential effects may be informed by
previous research on online versus face-to-face review
(Brazel, Agoglia, & Hat?eld, 2004) and electronic brain-
storming (Chen, Trotman, & Zhou, 2013). We emphasize
that we see this potential change for only part of the
inspection process, not the whole inspection process.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 611
Concurrent inspections also may have some disadvan-
tages due to biases such as predecisional distortion of the
interpretation of evidence towards the beliefs held by an
authority ?gure (Russo, Medvec, & Wilks, 2000). Here the
authority ?gure would be auditors’ inspectors. Wilks
(2002) found that subordinate auditors who learn their
partner’s view before evaluating evidence interpreted evi-
dence as being more supportive of the partner’s view than
auditors who learn the same partner’s view after evaluat-
ing evidence. In the case of inspections of audit ?rms,
knowing the views of individual inspectors (as compared
to the overall inspection agencies) may lead to similar
biases.
RQ 2.7 How does the timing of the concurrent
inspection (pre, during, or post audit
work paper review) impact the presence
of bias (e.g., due to predecisional
distortion) in the judgments of auditors
and inspectors?
Proposal 3: Encourage auditors to be skeptical of their own
judgment processes
This proposal aims to improve auditors’ judgments by
encouraging auditors to be skeptical of judgment pro-
cesses that they have used so far. As noted earlier, when
people sense that they are certain, neuroscience research,
building on prior psychology research (e.g., Einhorn &
Hogarth, 1978), shows that people are still rather fre-
quently wrong (Burton, 2008). Even judgment processes
that auditors and other professionals are con?dent about
could still be biased as a result of common heuristics
(e.g., anchoring) (Smith & Kida, 1991; Tversky & Kahn-
eman, 1974) and both conscious and subconscious biases
(e.g., motivated reasoning) (Kadous, Kennedy, & Peecher,
2003; Kunda, 1990).
The historic culture in auditing is described by Church
(1991, pp. 516–517) who argues that audit seniors think
they would be less favorably evaluated if they were to go
back and forth between different conclusions than if they
were to stick with one conclusion. Yet, it is also likely
that auditors who are encouraged to be circumspect
about their own judgments will more frequently change
their minds as more evidence becomes available. To the
degree that Church (1991) captures the culture of audit
practice today, auditors may face organizational disin-
centives to actively question their own judgments. As
such, identifying effective antecedents for encouraging
auditors’ skepticism of their own judgments requires
considerable thought.
While auditing standards have encouraged auditors to
be skeptical of management and of audit evidence, Bell
et al. (2005) propose augmenting this outward orientation
with an inward orientation in which auditors’ focus is di-
rected towards questioning their own or their colleagues’
judgments. While still in its infancy, research in this area
has examined new approaches to inward-directed skepti-
cism. Grenier (2013), in a planning-stage analytical proce-
dures setting, prompts some auditors to be skeptical of
their own judgments, others to be skeptical of manage-
ment and evidence, and assigns still others to a no prompt,
control condition. He reports that only industry specialist
auditors prompted to be self-critical generate a signi?-
cantly higher number of fraud explanations for manage-
ment’s asserted ?nancial results and became signi?cantly
more concerned that an unknown misstatement could be
distorting management’s results. Interestingly, nonspecial-
ists were no more skeptical given either prompt compared
to the control condition.
Harding and Trotman (2013) also examine the in?u-
ence of outward versus inward prompts on nonspecialist
auditors’ skepticism. Speci?cally, auditors were prompted
either to be mindful of management’s capacity to conceal
fraud and in?uence the nature of evidence, or that others
may question their professional judgments. Consistent
with the nonspecialist ?ndings in Grenier (2013), they
report no evidence that inward prompts led to higher
fraud likelihood judgments. However, they found that in-
ward prompts helped more than outward prompts in
terms of the evidence auditors selected to test manage-
ment’s assertions. These two studies suggest it would
be valuable for future research to consider the effects
of different implementations of inward-directed skepti-
cism under varying conditions, including when there
are better matches between audit tasks and an auditor’s
specialization.
RQ 3.1: Under what circumstances will outward
versus inward skeptical orientation be
more effective? Are combinations of
inward and outward skeptical
orientations more helpful under some
circumstances?
RQ 3.2 What are the impacts on the level of
professional skepticism and
documentation of alternative methods of
prompting auditors to question their own
or their colleagues’ judgments? What
factors moderate the level of impact?
Future research could identify alternative or comple-
mentary approaches to auditors becoming more skeptical
of their own approaches. For example, a recent stream of
research in psychology has begun investigating how an
individual can leverage the ‘‘wisdom of crowds’’ even with-
in their own mind (e.g., Herzog & Hertwig, 2009). Much
like different individuals within a crowd, even the same
individual will tend to access different subsets of their
knowledge and preferences when they repeatedly make
the same judgment (Hourihan & Benjamin, 2010; Vul &
Pashler, 2008). A related way to potentially extract signif-
icant bene?ts from this approach is to have an individual
address a judgment problem both intuitively (e.g., more
automatic and experiential) and analytically (e.g., more
deliberatively and propositionally), as discussed by
Denes-Raj and Epstein (1994). The idea is that ‘‘averaging’’
these two judgments can decrease judgment bias since
612 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
they rely on different parts of the human brain (Herzog &
Hertwig, 2009) which likely are subject to different kinds
of biases, some of which may be countervailing.
24
Another way to encourage auditors to be more skeptical
of their own judgments is to ask them to take the perspec-
tive of another individual, such as a reasonable investor.
Auditors are familiar with the concept of reasonable per-
son/reasonable investor via a range of references through-
out the accounting/auditing regulations and standards.
25
In an experiment with senior ?nance managers, Mayorga
and Trotman (2012) examined whether putting a manager
‘‘in the shoes of a reasonable investor’’ as suggested in Trea-
sury (2008), affects disclosure recommendations. They ?nd
that managers prompted to take a reasonable investor per-
spective are more likely to recommend disclosure of a proba-
ble negative change in expected earnings. Altiero, Kang, and
Peecher (2013) similarly ?nd that audit seniors who are
explicitly prompted to take an investor’s perspective more
readily differentiate between misstatements that are qualita-
tively less material versus qualitatively more material. There
is potential to build on the above studies by examining differ-
ent methods of auditors questioning their own judgments.
RQ 3.3 Under what circumstances is there an
impact on professional skepticism of
approaches designed to elicit more than
one judgment from a single member of
an audit team?
RQ 3.4 Under what circumstances does eliciting
auditor intuitive risk judgments and their
deliberative risk judgments signi?cantly
improve their judgments?
RQ 3.5 Under what circumstances are auditors
more willing to question their own
judgments after receiving perspective-
taking prompts, such as reminders for the
auditor to consider future judgments of a
‘reasonable investor’?
RQ 3.6 Under what circumstances is there an
impact on inspectors’ judgments of an
auditor’s judgment process if the auditor
has been more skeptical of their own
judgment process?
In the naturalistic decision-making research literature,
Klein (1999) describes a related ‘pre-mortem’ strategy that
?re?ghters can use to make better decisions under ex-
treme time pressure. These ?re?ghters mentally simulate
how ?res will spread, and how that spread will change if
they implement particular ?re-?ghting tactics. The ‘pre-
mortem strategy’ involves the use of mental simulation
to ?nd ?aws in a plan. Klein hypothesizes that people tend
to be overcon?dent after arriving at a plan, especially when
less experienced.
Trotman, Simnett, and Khalifa (2009) found auditors in
a pre-mortem treatment outperform those who completed
a traditional brainstorming treatment, that is, the approach
typically used to ful?ll brainstorming requirements in SAS
99 and ISA 240. Another way to think about the pre-mor-
tem treatment is that it promotes thinking backward. For-
ward and backward thinking are different cognitive
processes (Einhorn & Hogarth, 1987; Rollier & Turner,
1994). Forward thinking involves selecting data, evaluating
variables and then predicting an outcome. Backward think-
ing requires looking for patterns, making links between
seemingly unconnected events and testing possible chains
of causation to explain the event. Forward and backward
thinking have potential to differentially affect auditors’
professional skepticism.
RQ 3.7: Under what circumstances does mental
simulation improve auditors’ judgments?
RQ 3.8: Under what circumstances do forward
and backward thinking enable auditors to
perform more effectively in error and
fraud detection?
Auditors’ emphasis on the fallibility of their own judg-
ments also has the potential to discourage the historic
practice of stylizing working papers (Rich et al., 1997a).
Auditors more likely would seek and document alternative
viewpoints regarding matters such as the possibility of
fraud, instead of only viewpoints consistent with their
own or management’s preferences (Bell et al., 2005; Gre-
nier, 2013). They also more likely would document inte-
grative rationales for trade-offs they made in reaching
their conclusions (Suedfeld, Tetlock, & Streufert, 1992).
There are some challenges to making progress on audi-
tors’ propensity to become more self critical of their own
judgments. In many jurisdictions, litigation concerns may
make auditors reluctant to transparently document rea-
sons why their judgments could be wrong. In fact, Kadous
et al. (2003) show that attempts by standard setters to re-
duce bias by asking auditors to assess whether or not man-
agement’s accounting is the most appropriate can make
auditors more likely to ?nd management’s preferred
accounting method to be of acceptable quality. It also
may be dif?cult for specialists to be open to the possibility
that their judgment can be readily improved (Grenier,
2013; Kadous et al., 2013). As such, it may require a culture
shift before auditors embrace the fallibility of their own
judgments.
This culture shift already may have started. KPMG.
(2011), for example, sets out a professional judgment
framework to mitigate common judgment biases, such as
availability and con?rmation bias. The second step of this
framework is to consider alternative explanations.
24
Denes-Raj and Epstein (1994) show that people who rely on their
intuitive, automatic judgment make decisions that sometimes goes against
what the logical, deliberative side of their mind would have them do. In
some conditions, however, a single person may be able to ‘‘average’’ the
judgments that emerge from these two modes of reasoning. Depending on
whether biases that occur in each mode are positively or negatively
25
For example, FASB (1980) de?nes an item as material ‘‘if, in the light of
surrounding circumstances, the magnitude of the item is such that it is
probable that the judgment of a reasonable person relying upon the report
would have been changed or in?uenced by the inclusion or correction of
the item’’ and SEC (2001) states ‘‘. . . an auditor is not independent if a
reasonable investor . . . would conclude that the auditor is not comfortable
of exercising objective and impartial judgment’’.
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 613
Speci?cally, KPMG (2011) notes ‘‘making the opposing case
is perhaps the most universal of the mitigation techniques.
We can improve our professional skepticism and the qual-
ity of audit evidence by taking a few moments to consider
whether there may be alternative explanations for ob-
served relationships’’ (KPMG, 2011, p. 33). Research
addressing the impact of the above alternatives on various
parts of the audit process is warranted.
RQ 3.9 What are the impacts on the level and
type of stylization in audit workpapers of
alternative methods of questioning one’s
own judgment? What factors affect the
extent of stylization?
RQ 3.10 Under what circumstances are different
interventions (e.g., training, performance
evaluation changes) more likely to lead
specialist auditors to be more likely to
consult or more readily follow advice?
RQ 3.11 Under what circumstances are there
impacts of different implementations of
making the opposing case on professional
skepticism and the quality of audit
evidence?
RQ 3.12 What are the cognitive processes
involved in reducing the availability and
con?rmation biases by considering
alternative explanations? What factors
affect the extent of reduction?
RQ 3.13 What culture changes would enable
specialist auditors to increase their level
of skepticism of their own judgments?
What factors affect the increase in
skepticism?
Proposal 4: Reward auditors who take stands on ?nancial
reporting quality
Earlier, in our review of research on rewards versus
penalties, we observed that while auditors are penalized
for failure to meet some minimum threshold of audit qual-
ity, the shape of their incentive-performance function is
such that they receive no signi?cant rewards for exceeding
this minimum level. In addition, we noted that there were
potential psychological and performance bene?ts of
rewarding rather than just penalizing auditors. Here, we
consider two potential areas where it would be possible
to potentially change the shape of auditors’ incentive-per-
formance function by rewarding them for particularly good
performance: (1) When they resign from a public company
audit out of concern over the quality of the ?nancial state-
ments; and (2) When they report that they have detected
material ?nancial statement fraud (qui tam lawsuits).
26
Presently, when audit ?rms resign from an engagement,
they generally provide very limited information to the
public about their reasons. Further, audit ?rms who incur
the immediate and substantial cost of resigning receive
no incremental extrinsic reward for being transparent
about any disputes over accounting policies or practices
that prompted the resignation.
27
The SEC encourages, but
does nothing to reward, forthcoming disclosure of the rea-
sons for the change.
Consistent with this cost-bene?t analysis, evidence in
Hackenbrack and Hogan (2002) shows that language in
auditor-change ?lings contain commentary about account-
ing disputes only about 12% of the time. However, they also
?nd that when commentary about accounting disputes ex-
ists, it in?uences investors’ resource allocation decisions.
Hence while investors may bene?t from such language,
auditors appear to receive no reward for producing it.
We propose that consideration be given to how one
might reward auditors who resign from public company
audits when they have concerns about management’s
accounting principles and practices. One possibility is that
audit ?rms receive a substantial payout (perhaps a multi-
ple, 5Â, of the most recent audit fee) if, within a speci?ed
window after the resignation, the public company’s ?nan-
cial statements are subsequently restated. The speci?cs of
the reward could evolve over time (e.g., Does the auditor
need to mention their concern about management’s
accounting publicly or would it be suf?cient to notify reg-
ulators?) and experiments testing the impact of these re-
wards would be bene?cial. However, we note that
conducting research on questions related to rewards or
penalties in an audit environment will involve design
choices regarding the size and nature of these (dis)incen-
tives. In addition, careful attention is warranted concern-
ing institutional and organizational characteristics that
may moderate auditors’ responses to these (dis)incentives.
Given these challenges, it likely would be helpful to em-
ploy experimental markets research to test the relevant
theories (see Kachelmeier & King, 2002).
RQ 4.1: Considering that auditor rewards can affect
both auditor and management behavior,
what are the impacts of rewards on the
likelihood of auditor resignations? How
would the impact change with the nature
(e.g., ?nancial or positive publicity) and
level of the rewards?
RQ 4.2: What would be the impact of rewards
related to auditor resignations on ?nancial
statement quality (e.g., information
content of auditor resignations)? Would
the credible threat established by such
rewards improve management’s ?nancial
reporting quality?
26
Another potential fruitful area to examine would be modi?cations to a
standard audit report, especially given potential changes in the auditors’
reporting model concerning the auditors’ responsibility to report on
qualitative aspects of the entity’s accounting practices (see, e.g., Financial
Reporting Council, 2013).
27
In many countries including the USA, management must provide the
reasons for the change in auditor, and auditors append a letter indicating
that they agree or disagree with management’s stated reasons.
614 M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620
Another fruitful area of research is to examine how
auditor reporting of fraud in a public company’s ?nancial
statements can be rewarded, especially if such claims are
later validated. Such rewards would augment any reputa-
tional gains auditors derive from discovering and reporting
?nancial statement fraud, and they may provide incentives
for audit ?rms to undertake research and development to
improve their fraud detection capabilities.
Based on 216 reported fraud cases in the USA between
1996 and 2004, Dyck, Morse, and Zingales (2010) conclude
that most whistle-blowers, including auditors, have weak
incentives for reporting fraud. The implications of these
weak incentives might be tolerable if fraud incidence rates
or costs were low. Dyck, Morse, and Zingales (2011), how-
ever, estimate an ongoing fraud rate of 11.2% to 13.2% of
USA public companies and a loss for each ?rm at which a
fraud is later detected of 40.7% of enterprise value.
Still, audit ?rms are unlikely tofully deploy their capabil-
ities to reveal fraud on speci?c audit engagements if they
stand to gain no rewards from reporting fraud. Rewards re-
ceived by auditors who report frauds would help offset the
costs of ?nding fraud on a continuing client (e.g., forgone
audit fees, litigation about why the auditor did not ?nd the
fraud earlier, and strained discussions with audit commit-
tees). Other parties such as analysts and short sellers may
have greater incentives to discover fraud. These parties, un-
like auditors, stand to directly bene?t or lose as public com-
panies’ stock prices increase or decrease.
28
One study shows how auditors can impair or add value
to investors by failing to be or by being the ?rst reporter of
fraud. Guler, Heron, and Zur (2010) report that when the
auditor is not the initial whistleblower, the stock price
for other public companies that operate in the same indus-
try and are audited by the same audit ?rm suffer a negative
abnormal stock return during the 5-day window around
the ?rst disclosure date of the fraud compared to other
public companies in the same industry but audited by dif-
ferent audit ?rms. When the auditor is the initial whistle-
blower, however, the analogous abnormal stock return is
positive, consistent with investors bene?ting from an en-
hanced auditor reputation for fraud detection. Unlike
investors, however, auditors cannot earn these abnormal
stock returns. Further, it is unclear whether auditors can
convert such investor returns into more market share or
larger audit fees.
Recent experimental research provides an additional
reason to be concerned about auditors’ current net incen-
tives for designing their audits to try to ?nd any extant
fraud compared to just using a standardized set of audit
procedures. In particular, jurors are more likely to penalize
auditors and more likely to hold them culpable when audi-
tors come closer to ?nding fraud (Reffett, 2010). Speci?-
cally, auditors who identify an incremental fraud risk
and/or perform extra audit tests designed to determine
whether any related fraud exists, but still fail to ?nd the
fraud, are judged to be more liable for damages than audi-
tors who do not identify the fraud risk and/or do not
undertake these extra audit tests. If auditors face a disin-
centive to undertake incremental procedures to detect
fraud because of the nature of jurors’ decision processes,
an offsetting extrinsic reward for fraud detection has all
the more potential merit.
RQ 4.3: What are the comparative effects of rewards
of different nature and levels on auditor
propensity to report fraud and
management’s propensity to commit fraud?
RQ 4.4: What impact would introducing rewards for
the detection of ?nancial statement fraud
have on auditor search for evidence,
evaluation of evidence, review of audit
workpapers and quality control reviews?
RQ 4.5: How do the circumstances of the detection
of fraud (e.g., nature of fraud, work done by
the auditor, ?rst year audit, level of
management deceit, etc.) impact auditor
reputation among users of accounting
reports and impact on jury/court decisions?
One avenue by which auditors could be provided with
greater direct incentives to detect fraud and/or to invest
more in research and development to improve their fraud
detection techniques would be to model new auditor
incentives after qui tam lawsuits. Qui Tam comes from a La-
tin phrase meaning on behalf of ‘‘the king,’’ and qui tam
provisions enable private individuals to bring legal actions
on behalf of their sovereign (Lovitt, 1996, pp. 852–3). Soci-
ety may ?nd it bene?cial to apply qui tam or a similar the-
ory of law because, as Treasury (2008, p. 8) notes, ‘‘auditing
of public companies is fundamentally a matter of national
interest and concern.’’
Under qui tam, when a lawsuit involves a fraud against
the USA federal government, individuals are entitled to be-
tween 15% and 30% of the money recovered (Dyck et al.,
2010). They note that qui tam is available for only a few
industries where the government is a signi?cant buyer of
services. In their sample of 216 corporate frauds, individu-
als on three qui tam cases already had won substantial set-
tlements of $35 million, $35 million and $70 million. More
damages may manifest as cases are litigated. Further, Dyck
et al. (2011) report that availability of qui tam is associated
with a signi?cantly higher chance that an employee of the
organization committing fraud is the ?rst to report the
fraud (beating analysts, auditors, client/competitors, inves-
tors, regulators, law ?rms, and the media).
In the USA, other administrative or judicial actions
adopt a qui tam approach for information that results in
monetary sanctions/?nes being collected by the SEC. Spe-
ci?cally, Section 922 Whistleblower Protection in the
sweeping Dodd-Frank Wall Street Reform and Consumer
Protection Act (111th Congress, 2010) stipulates that whis-
tleblowers will earn 10–30% of monetary sanctions col-
lected, at the SEC’s discretion. The rewards will come
from a new, self-?nanced Investor Protection Fund. While
28
Dyck et al. (2010) report that, pre-SOX, auditors were the ?rst reporters
of fraud in only 6% of the time. Post-SOX, auditors were substantially more
likely to be ?rst reporters (up to 24% of cases), but the authors do not report
on extent to which this increase is attributable to ?nancial-statement
frauds versus other types of fraud (e.g., disclosure of misleading forward-
looking information).
M.E. Peecher et al. / Accounting, Organizations and Society 38 (2013) 596–620 615
a broad range of whistleblowers are eligible to receive re-
wards, Section 922 expressly excludes ?nancial statement
auditors from eligibility for rewards.
29
In fact, auditors are
one of the few parties ineligible for these rewards.
The above research and new legislation suggest the po-
tential for improved and more timely fraud detection and/
or reporting on the auditors’ part. Providing incremental,
signi?cant, and direct rewards for auditors who uncover
fraud has the potential to motivate helpful innovation by
auditors to develop novel procedures that are more likely
than current approaches to detect concealed fraud. The
size of the reward under qui tam is also likely to be impor-
tant given research showing that relatively small rewards
can be ineffective or even detrimental, contrary to the
standard assumption that effort is monotonically increas-
ing in incentives (Gneezy & Rustichini, 2000).
RQ 4.6: Relative to other approaches to rewards,
how would a qui tam approach impact
auditor behavior (e.g., evidence collection
and evaluation, skepticism, etc.)?
RQ 4.7: Relative to other approaches to rewards,
what effect would a qui tam approach have
on inspectors’ and other ?nancial statement
users’ perceptions of audit quality?
Concluding remarks
We have addressed two overarching questions in this
paper: What kind of accountability framework could regu-
lators use to motivate auditors to improve audit quality?
What accountability framework could regulators use to
evaluate how well auditors have carried out their duties?
We address these questions via a two-dimensional (re-
wards versus penalties and processes versus outcomes)
accountability framework. This framework leads to a con-
sideration of what the research in psychology, neurosci-
ence, economics and accounting would suggest for extant
and reformed accountability mechanisms. Based on these
analyses, we discuss four potential changes and, for each
potential change, a related series of speci?c research ques-
tions. The potential changes are: (1) implementing an
auditor judgment rule for inspectors’ use in evaluating
auditors’ judgment processes; (2) including a concurrent
element in regulators’ inspections; (3) extending the pro-
fessional skepticism construct to incorporate auditors’ ac-
tive questioning of their own judgment processes; and
(4) rewarding auditors who detect fraud or otherwise take
strong stands for ?nancial reporting quality.
It is potentially useful to compare auditors’ extant
accountabilities (Exhibit 2) and their revised accountabilities
inlight of thesepotential changes (Exihibit 3). Webelievethat
each of these potential changes would move auditors’
accountabilities towards being more process-focused and/
or towards being more reward-focused. Collectively,
however, they would provide new rewards for auditors who
use well-justi?ed judgment processes, exceed the minimum
quality threshold for compliance, and improve their fraud
detection procedures.
Researchers can begin to examine intended and possi-
ble unintended consequences of the research questions
we identify even before these (or other) potential changes
are made to auditors’ accountabilities. Analytical theory,
audit simulations, and experimental research methods
are well suited to providing ex ante theoretical insights
and empirical evidence about potential auditing and
accounting changes (Libby & Luft, 1993; Libby et al.,
2002; McDaniel & Hand, 2006).
Similarly, audit scholars can propose additional poten-
tial changes and position them within the dimensions of
rewards versus penalties and processes versus outcomes
within our accountability framework. As an example, com-
mentators and regulators have long debated a variety of
potential changes to the auditor’s reporting model (e.g.,
Church, Davis, & McCracken, 2008; European Commission,
2010; PCAOB, 2011), and audit scholars have started to
empirically explore how potential modi?cations to the
auditor’s reporting model would in?uence the behavior
of auditors, audit committee members, and investors
(e.g., Kang, 2013). In terms of our framework, one recurring
idea is that audit reports could have more discrete catego-
ries, e.g., letter grades (Clikeman, 2001). A related idea,
however, would be that audit regulators would move away
from itemizing alleged audit de?ciencies and towards
summary statistics, such as letter grades or some other
set of categorical evaluations of audit quality, so as to pub-
licly reward auditors who undertake especially high qual-
ity judgment processes instead of processes that appear
to just meet or exceed some minimally acceptable ?oor.
These and other important research questions can bene?t
from being addressed from within our proposed account-
ability framework.
Acknowledgements
We thank Dorsey Baskin, Tim Bauer, Chris Chapman,
Clara Chen, Jere Francis, Anna Huggins, Jessen Hobson,
Yoon Ju Kang, Richard Kaplan, Justin Leiby, William Mess-
ier, Jenny Nichol, Bradley Pomeroy, Elizabeth Poziemski,
Peter Roebuck, Scott Showalter, Roger Simnett, Hun-Tong
Tan, Anne Thompson, Andrew Trotman, Raghu Venugopa-
lan, Flora Zhou, Aaron Zimbelman as well as workshop par-
ticipants at the University of Texas at San Antonio,
Nanyang Business School, and the 3rd Workshop on Audit
Quality (Bellagio, Italy) for their helpful comments.
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