Legal systems and auditor independence



This paper examines whether an appropriate legal system, which is a combination of a legal regime and a damage apportionment rule, effectively enhances auditor independence. Economic and psychological hypotheses derived from a one-period game model in which the auditor may commit either a technical audit failure (resulting from the auditor’s inability to detect true output given a lack of audit effort) or an independence audit failure (resulting from the auditor’s intentional misreporting on false output) are tested. Three major findings are documented. First, auditor independence affects firm investment, which in turn affects audit effort. Under this strategic dependence, no single legal system can provoke audit effort, improve auditor independence, and encourage firm investment simultaneously. To enhance auditor independence and motivate investment, a legal system consisting of both a strict regime and a proportionate rule is preferred. Second, the strict regime induces more auditor independence than the negligence regime, while the proportionate rule induces higher audit effort than the joint-and-several rule. Finally, auditors’ moral reasoning and penalty for misreporting are both positively associated with their independence. In addition, the effect of moral reasoning on auditor independence diminishes as the level of penalty increases. These two results hold only when the legal systems that auditors face are considered.


Audit failure Auditor independence Damage apportionment rule Experimental economics Legal regime Moral reasoning 

JEL Classification

C72 C91 K40 M42 


  1. American Institute of Certified Public Accountants. (1999). Auditing standards: Original pronouncements. New York: AICPA.Google Scholar
  2. Bloomfield, R. J. (1997). Strategic dependence and the assessment of fraud risk: A laboratory study. The Accounting Review, 72(October), 517–538.Google Scholar
  3. Bowie, N. E., & Duska, R. (1990). Business ethics (2nd ed.). Englewood Cliffs, NJ: Prentice Hall.Google Scholar
  4. Business Week. (2002). Accounting in crisis. Business Week, 28, 50–54.Google Scholar
  5. Cushing, B. E. (1990). Discussion of auditor independence judgments: A cognitive-developmental model and experimental evidence. Contemporary Accounting Research, 7(Spring), 252–260.CrossRefGoogle Scholar
  6. DeFond, M. L., & Francis, J. R. (2005). Audit research after Sarbanes—Oxley. Auditing: A Journal of Practice & Theory, 24(Supplement), 5–30.CrossRefGoogle Scholar
  7. Dopuch, N., Ingberman, D. E., & King, R. R. (1997). An experimental investigation of multi-defendant bargaining in ‘joint and several’ and proportionate liability regimes. Journal of Accounting and Economics, 23(3), 189–221.CrossRefGoogle Scholar
  8. Dopuch, N., & King, R. R. (1992). Negligence versus strict liability regimes in auditing: An experimental investigation. The Accounting Review, 67(January), 97–120.Google Scholar
  9. Dopuch, N., King, R. R., & Schatzberg, J. W. (1994). An experimental investigation of alternative damage-sharing liability regimes with an auditing perspective. Journal of Accounting Research, 32(Supplement), 103–139.CrossRefGoogle Scholar
  10. Dopuch, N., King, R. R., & Schwartz, R. (2003). Independence in appearance and in fact: An experimental investigation. Contemporary Accounting Research, 20(Spring), 79–119.CrossRefGoogle Scholar
  11. Efron, B., & Tibshirani, R. J. (1993). An introduction to the bootstrap. New York: Chapman & Hall.Google Scholar
  12. Falk, H., Lynn, B., Mestelman, S., & Shehata, M. (1999). Auditor independence, self-interested behavior and ethics: Some experimental evidence. Journal of Accounting and Public Policy, 18(Winter), 395–428.CrossRefGoogle Scholar
  13. Fehr, E., & Falk, A. (2002). Psychological foundations of incentives. European Economic Review, 46(May), 687–724.CrossRefGoogle Scholar
  14. Gaa, J. C. (1992). The philosophy and psychology of auditor independence and objectivity. In R. Srivastava (Ed.), The 1992 Deloitte & Touche University of Kansas symposium of auditing problems. Kansas: University of Kansas.Google Scholar
  15. General Accounting Office. (1996, September). The accounting professionmajor issues: Progress and concerns. Report to the Banking Minority Member, Committee on Commerce, House of Representatives. Washington, DC: US Government Printing Office.Google Scholar
  16. Hillegeist, S. A. (1999). Financial reporting and auditing under alternative damage apportionment rules. The Accounting Review, 74(July), 347–369.CrossRefGoogle Scholar
  17. Jones, S., & Ponemon, L. (1993). A comment on a multidimensional analysis of selected ethical issues in accounting. The Accounting Review, 68(April), 411–416.Google Scholar
  18. Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1986). Fairness as a constraint on profit-seeking: Entitlements in the market. American Economic Review, 76(September), 728–741.Google Scholar
  19. King, R. R. (2002). An experimental investigation of self-serving biases in an auditing trust game: The effect of group affiliation. The Accounting Review, 77(April), 265–284.CrossRefGoogle Scholar
  20. King, R. R., & Schwartz, R. (1999). Legal penalties and audit quality: An experimental investigation. Contemporary Accounting Research, 16(Winter), 685–710.CrossRefGoogle Scholar
  21. King, R. R., & Schwartz, R. (2000). An experimental investigation of auditors’ liability: Implications for social welfare and exploration of deviation from theoretical predictions. The Accounting Review, 75(October), 429–451.CrossRefGoogle Scholar
  22. Kofman, F., & Lawarrée, J. (1993). Collusion in hierarchical agency. Econometrica, 61(May), 629–656.CrossRefGoogle Scholar
  23. Kohlberg, L. (1958). The development of modes of moral thinking and choice in the years 10 to 16. Unpublished Ph.D. dissertation, University of Chicago.Google Scholar
  24. Kohlberg, L. (1984). The psychology of moral development: The nature and validity of moral stages essays on moral development (Vol. 2). San Francisco, CA: Harper & Row.Google Scholar
  25. Kreps, D. M. (1990). Game theory and economic modeling. Oxford: Oxford University Press.CrossRefGoogle Scholar
  26. Loewenstein, G. (1999). Experimental economics from the vantage point of behavioral economics. The Economic Journal, 109(February), F25–F43.CrossRefGoogle Scholar
  27. Magee, R. P., & Tseng, M. C. (1990). Audit pricing and independence. The Accounting Review, 65(April), 315–336.Google Scholar
  28. Mayhew, B. W., & Pike, J. E. (2004). Does investor selection of auditors enhance auditor independence? The Accounting Review, 79(July), 797–822.CrossRefGoogle Scholar
  29. Narayanan, V. G. (1994). An analysis of auditor liability rules. Journal of Accounting Research, 32(Supplement), 39–64.CrossRefGoogle Scholar
  30. Newman, D. P., Patterson, E., & Smith, R. (2001). The influence of potentially fraudulent reports on audit risk assessment and planning. The Accounting Review, 76(1), 59–80.CrossRefGoogle Scholar
  31. Ponemon, L. A., & Gabhart, D. R. L. (1990). Auditor independence judgments: A cognitive-developmental model and experimental evidence. Contemporary Accounting Research, 7(Winter), 227–251.CrossRefGoogle Scholar
  32. Ponemon, L. A. & Gabhart, D. R. L. (1994). Ethical reasoning research in the accounting and auditing professions. In J. R. Rest, & D. Narvaez (Eds.), Moral development in the professions: Psychology and applied ethics (pp. 101–119).Google Scholar
  33. Private Securities Litigation Reform Act of 1995. Public Law No. 104–167. Washington, DC: US Government Printing Office.Google Scholar
  34. Rest, J. R. (1979). Development in judging moral issues. Minneapolis, MN: University of Minnesota.Google Scholar
  35. Rest, J. R., Narvaez, D., Bebeau, M. J., & Thoma, S. J. (1999). Postconentional moral thinking: A Neo-Kohlbergian approach. New Jersey: Lawrence Erlbaum.Google Scholar
  36. Ryan, R. G. (2004). SEC enforcement of auditor independence violations: Recent cases and developments. Securities Regulation Law Journal, 32(1), 178–193.Google Scholar
  37. Sarbanes–Oxley Act of 2002. Public Law No. 107–204. Washington, DC: US Government Printing Office.Google Scholar
  38. Schatzberg, J. W., Sevcik, G. R., Shapiro, B. P., Thorne, L., & Wallace, R. S. O. W. (2005). A reexamination of behavior in experimental audit markets: The effects of moral reasoning and economic incentives on auditor reporting and fees. Contemporary Accounting Research, 22(Spring), 229–264.CrossRefGoogle Scholar
  39. Schwartz, R. (1997). Legal regimes, audit quality and investment. The Accounting Review, 72(July), 385–406.Google Scholar
  40. Securities and Exchange Commission. (2000). Revision of the requirements on auditor independence. Washington, DC: Government Printing Office.Google Scholar
  41. Securities and Exchange Commission. (2003). Strengthening the commission’s requirements regarding auditor independence. Washington, DC: Government Printing Office.Google Scholar
  42. Smith, V. L. (1976). Experimental economics: Induced value theory. American Economic Review, 66(May), 274–279.Google Scholar
  43. Spellmire, G., Baliga, W., & Winiarski, D. (1993). Accountants’ legal liability guide: Prevention and defense. New York: HBJ Publishers.Google Scholar
  44. Windsor, C. A., & Ashkanasy, N. M. (1995). The effect of client management bargaining power, moral reasoning development, and belief in a just world on auditor independence. Accounting, Organizations and Society, 20(7/8), 701–720.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2011

Authors and Affiliations

  1. 1.Department of Accounting, College of CommerceNational Chengchi UniversityTaipeiTaiwan, ROC

Personalised recommendations