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  1. list(list(content = c("Critical Perspectives on Accounting", "", "(1991)", "", "2,201--2X", "", "THE RATIONALITY", "OF DOING “NOTHING”:", "AUDITORS’ RESPONSES TO LEGAL LIABILITY", "IN AN INSTITUTIONALIZED", "ENVIRONMENT", "TIMOTHY J. FOGARTY, JAMES B. HEIAN” AND DENNIS L. KNUTSON~", "Case Western", "", "Reserve University,", "*Pennsylvania", "State University", "f University of Wisconsin, Eau Claire", "", "and", "", "The auditing", "profession", "has come under increasing", "pressure in the past 30",
  2. "years to respond to allegations", "that it has failed in its prime mission--that", "of notifying", "investors", "and others", "when", "financial", "statements", "of client", "companies", "are not to be relied upon. Faced with a legal liability", "whose", "actual consequences", "pale only in comparison", "to its future potential", "losses", "due to this failure,", "public accounting", "has mounted", "a multi-faceted", "campaign to address the situation.", "This paper explores", "the public accounting",
  3. "profession’s", "responses", "to their malpractice", "situation", "against the suggestion", "that the crisis is institutional", "in its nature, and therefore", "not remediable", "within", "current", "social arrangements.", "Institutional", "theory", "is outlined", "and", "applied to auditing", "as a preface for a detailed", "examination", "of the many", "aspects of this public debate. This argument", "spans not only what public", "accounting", "has done in the face of its legal situation,", "but also what it has",
  4. "not done.", "", "Introduction", "The last two decades have occasioned", "what could be interpreted", "as a", "perpetual", "state of crisis for public accounting.", "Two major Congressional", "investigations", "have questioned", "the integrity and independence", "of the profession. An increasingly hostile press has seized upon the accounting", "profession", "as a corrupt accomplice", "in a series of financial scandals. A steady stream of", "plaintiffs,", "many who were previously", "without", "standing,",
  5. "have succeeded in", "claiming the resources of public accountants", "as compensation", "for business", "losses. Together these trends might indicate that the profession has failed in", "its purpose.", "The profession", "has been anything", "but quiet in the face of these disturbances. Committees", "have been formed,", "lobbying", "has been intensified", "and", "procedures", "have been reviewed. The profession", "has taken pains to let its", "position be known and, as a result, its current status is much more visible to",
  6. "the public. However, very little analysis of these positions have been made. If", "anything, they have been accepted at face value.", "This paper critically examines the response of public accounting to the most", "consequential", "of these occurrences,", "legal liability. The basic point made by", "this paper is that the liability crisis is institutional", "in nature and that, within", "current arrangements,", "there are no direct and obvious solutions. Given this,", "accounting", "firms have acted rationally in “doing nothing”",
  7. "to directly mitigate", "their legal losses. Instead, they have pursued", "a variety of more subtle", "Address", "", "for", "", "correspondence:", "", "ment of Accounting,", "Received", "", "1 IJune", "", "Cleveland,", "1990;", "", "revised", "", "Professor T. Fogatty, Case Western", "Ohio 44106, U.S.A.", "30 Au&X", "", "1990,", "", "22 December", "", "7990;", "", "Reserve University,", "accepted", "", "4 March", "", "Depart-", "", "1991.", "", "201", "104%2354/91/030201", "", "+ 26 $03.00/O", "",
  8. "Q 1991 Academic", "", "Press Limited", "", "\f202", "", "T. J. Fogarty et", "", "al.", "", "strategies", "designed", "to benefit the profession.", "To explain these apparent", "contradictions,", "institutional", "theory", "needs to be appreciated", "as a general", "perspective.", "The paper is organized into four sections. In the first section, institutional", "theory is introduced", "and applied to the provision of auditing services. In the", "next section, an examination", "of public accountant",
  9. "responses to the liability", "crisis is conducted.", "This section will reveal that these responses, as predicted", "by the theory, are exaggerated,", "inconsistent", "and largely illusory. The next", "section examines actions that public accounting", "have not taken. For the most", "part, elements", "of this section relate to central dilemmas", "of auditing", "as a", "profession", "and as a business. The final section summarizes", "the institutional", "perspective", "of the problem and future scenarios presaged by the argument.",
  10. "An Institutional", "", "Perspective", "", "on Auditing", "", "Institutional", "theory purports to explain outcomes", "developed", "in institutionalized environments.", "An institutionalized", "environment", "is a setting which does", "not provide an organization", "with tangible and obvious goals (Selznick, 1949;", "Tolbert,", "1988). The objectives", "for an organization", "in an institutionalized", "environment", "are instead symbolic intangibles", "whose achievement", "is subject", "to interpretation",
  11. "(DiMaggio", "& Powell, 1983). The state and its agencies are", "classic examples", "of organizations", "in institutionalized", "environments", "since", "progress toward their goals (such as citizens’ well-being,", "consumer", "protection, justice and even national", "defense)", "tend to be unquantifiable", "and", "symbolically", "mediated", "(Meyer, 1986). Non-governmental", "yet regulated", "entities (such as education", "and utilities) also tend to have environments", "with", "institutionalized",
  12. "aspects (see Weick, 1976; Kamens, 1977; Ritti & Silver, 1986).", "Partly because of their important", "roles and partly due to the unobservability", "of", "their performance,", "organizations", "in institutionalized", "environments", "have external constituents", "that they are obliged", "to satisfy (Meyer & Rowan,", "1977).", "Politicians have voters, bureaucrats", "have politicians,", "and industry has regulatory boards to whom they are accountable.", "Institutional", "theory", "suggests", "that in such environments,",
  13. "organizations", "develop", "structures", "and practices that serve as symbols", "to demonstrate", "appropriate", "performance", "(Scott, 1987). Specifically,", "organizations", "document", "rationality", "and efficiency consistent", "with their mission through", "displays that", "would not exist but for the need to satisfy external groups.", "In this way,", "organizations", "retain the support", "of important", "constituents,", "ensure", "their", "continued", "access to necessary resources and mitigate the need for more",
  14. "rigorous examinations", "of the organizations", "by outsiders.", "Meyer and Rowan", "(1977) propose that the displays are, in essence, deeply ingrained rationalizing", "myths that create technical purposes out of social ones and minimize the role", "of unilateral discretion over the process.", "However,", "the central element", "of institutional", "theory is the paradox", "that", "these displays create when contrasted", "with the real work of organizations.", "Whereas symbols are simplistic and geared for the consumption",
  15. "of external", "parties", "rather unfamiliar", "with the organization,", "the actual work of the", "organization", "tends to be highly complex, if not indeterminable", "(Meyer, 1986).", "", "\fRationality", "", "of doing nothing", "", "203", "", "The latter tends to be the case because the domain", "of organizations", "in", "institutionalized", "environments", "tends to be poorly understood", "and intertwined", "with the social.", "To escape the paradox and to avoid massive dysfunction,", "organizations",
  16. "tend to “decouple”", "their external image systems from their internal operating", "processes (Salancik, 1975; Meyer & Rowan, 1977). This process essentially", "buffers the core of organizational", "action from environmental", "threat and", "observability,", "thus allowing the organization", "to function", "according to whatever logic pertains to the subject matter it processes (Powell, 1985). This", "however, can only be accomplished", "in an atmosphere", "where good faith is a", "viable assumption.",
  17. "The “logic of confidence”", "allows the organization", "to", "proceed without", "strict accountability,", "wherein its symbolic displays are not", "taken literally and seriously by constituents", "(Zucker, 1988).", "Public accounting", "exists within", "an institutionalized", "environment", "to the", "extent of its mandate to provide the marketplace", "with information", "about the", "economic", "realities underlying", "financial", "reporting.", "Investors", "and creditors", "serve as the very salient external constituencies",
  18. "for this effort. For the most", "part, the audit opinion serves as the only visible product for these parties.", "Encapsulated", "in standardized", "language and impervious to definition, the audit", "report seems only loosely related to the entirety of the audit process.", "However,", "apart from this ideal is the commonplace", "recognition", "that", "auditing is purchased", "by corporate", "clients who bring their own interests to", "bear. For these parties, auditing’s", "institutionalized",
  19. "environment", "is secondary", "to the more conventional", "acquisition", "of services. Although", "the audit being", "purchased is still mostly intangible,", "as a signal to the investing and lending", "publics, the client is in a position to observe its conduct and to temper its", "parameters.", "Therefore,", "the audit exists in an only partially institutionalized", "environment.", "At the heart of the accountant", "malpractice", "dilemma", "lies the structural", "ambiguity", "of requiring", "public service duties from a group solidly part of the",
  20. "private sector. When audits were made mandatory", "for publicly held firms,", "society sanctioned", "the appropriateness", "of the selection and compensation", "of", "the auditor by the auditee. While this choice avoided governmental", "intrusion", "and made unnecessary", "a supervising", "bureaucracy,", "it insured that truly", "adversarial, arms-length", "relationships", "could never emerge. The public’s hope", "for a watchdog", "in defense against corporate mismanagement", "is fuelled by the",
  21. "literal meaning", "of the symbol they observe, the inability to appreciate", "the", "uncertainties", "of the audit and their unawareness", "of the very important", "non-institutionalized", "portions of the auditor’s environment.", "The crux of the matter is that the audit, when paid for by private parties, is", "naturally compromised", "and tailored to the interests of those that pay the fare.", "This prevents the audit from realizing the safe harbour of a fully institutionalized environment",
  22. "wherein prevention", "of the citadel through the imposition", "of", "legal liability would", "be essentially", "precluded.", "However,", "retaining", "its noninstitutionalized", "facet enables public accounting", "to profit from the sale of", "unrelated services and to freely price the audit.", "The public accounting", "community", "has not exerted much effort to escape or", "publicize this paradox.", "The duality of public guardian", "and client confidant", "", "\f204", "", "T. 9. Fogarty et al.",
  23. "", "brings benefits", "that make any movement", "less than desirable.", "As client", "advocate, public accounting", "firms are able to charge whatever the traffic will", "bear for an ever widening", "panoply of services that ties the audit to other more", "desired engagements.", "As a public servant, accounting", "firms (in addition to", "having a monopoly)", "lay claim to the privileges", "and immunities", "associated", "with the professions", "(see Goode, 1957). The righteousness", "of the attest",
  24. "function is without parallel in the consulting", "community.", "The existence of two", "roles rather than one allows a built-in defense against any critic that suggests", "that performance", "in one role or the other is less than optimal. The current", "state of legal liability can be then characterized", "as the price for this", "institutionalized", "ambiguity.", "Viewed accordingly,", "the legal liability of auditors", "escapes the otherwise", "narrow interpretation", "of the unfair prosecution",
  25. "of an", "honourable", "profession.", "Institutional", "theory focuses on the actions of organizations", "as they encounter their environment.", "This approach however, is not inconsistent", "with a focus", "upon the audit as a public good that must be purchased by private parties and", "be provided", "by public accounting", "firms on a profitable", "basis. In this view,", "there are systematic advantages", "for these two parties to privatize the nature", "of the audit and attempt to de-emphasize",
  26. "the interests of “free-riding”", "publics.", "Lawsuits however,", "invoke the public duties of the auditor and thereby are", "inconsistent", "with efforts to treat the audit as having the characteristics", "of", "private goods. Once again, legal liability can be seen as a consequence", "of the", "audit not truly being a public good.", "Actions", "Assumption", "", "of Fraud Detection", "", "Taken by Public Accountants", "Responsibility", "", "After a long history of resistance, auditors have accepted expanded",
  27. "responsibility for the detection of fraud. The recently adopted SAS 53 (AICPA, 1988)", "requires audits to be designed to provide reasonable", "assurance that these", "irregularities", "will be discovered. This would appear to be a positive response", "of the profession", "to contract", "the “expectations", "gap” that became", "most", "apparent through", "lawsuits that held auditors accountable", "to such a standard,", "despite the much less demanding", "pronouncements", "that were in effect at the",
  28. "time. Auditor", "liability has been related to incidences", "of management", "fraud", "(Saint Pierre & Anderson,", "1982) and fraud magnitude", "(Palmrose,", "1987).", "Embracement", "of wider responsibility", "had been widely recommended", "and has", "since been generally applauded.", "While this change in professional", "standards", "moves the work of public", "accounting", "more in line with societal expectations,", "little else of substance has", "been accomplished.", "Increased social value and a reduction",
  29. "in accountants’", "legal liability will only occur if the embracement", "of heightened", "responsibility", "for fraud results in more fraud detection.", "Despite extensive work by criminologists,", "psychologists", "and others, very", "little insight exists about the genesis of fraud and other forms of deceit", "motivated", "by the desire for ill-gotten gain. In a society predicated", "upon good", "faith but inundated", "with temptation,", "fraud may be something", "that will always", "", "\fRationality",
  30. "", "of doing nothing", "", "205", "", "be present,", "yet beyond", "the understanding", "of most. Advances", "in data", "processing technology", "and information", "system sophistication", "contribute", "as", "much to frauds’ disguise as to its detection.", "Management", "fraud, despite its disproportionate", "publicity, is a low incidence", "phenomena.", "The number", "of audit engagements", "where material", "fraud is", "present has been estimated at less than 1 percent of all engagements",
  31. "(Psaros,", "1987). While this greatly lessens the magnitude", "of the problem", "it greatly", "increases the difficulty of detection. The test basis of most audit procedures", "contradicts", "the likelihood", "of finding", "this “needle", "in a haystack”", "among", "countless transactions.", "The many arguments", "made by auditors to justify their", "previous “only if observed”", "standard continue to have considerable", "merit. An", "extraordinary", "increase in the magnitude", "and scope of the audit will be",
  32. "necessary to create a realistic probability", "of detecting", "infrequent", "events that,", "in many cases, would not be found even if all transactions", "were examined.", "Even when detection", "is plausible with aggressive auditing, those contemplating management", "fraud may not be deterred", "(Uecker et al., 1981). Finally,", "collusion among", "management", "personnel", "and non-recording", "of fraudulent", "entries in the books may effectively defeat even the most inquisitive auditors.", "No clear guidelines",
  33. "have been issued to delineate", "how auditing", "must", "change to meet the new fraud responsibility.", "Auditors, for the most part, have", "no specific training", "to enable them to unravel the subterfuges", "of fraud.", "Furthermore,", "educational", "institutions", "appear", "unprepared", "to revise significantly the education", "of new generations", "of auditors. While there is some", "debate over alternative", "methods of detection (see Eliiott & Willingham,", "1980)", "recent scholarship suggests that if high levels of detection accuracy cannot be",
  34. "attained, the debate over methods is moot (Murphy,", "1987). Insiders, able to", "collude and intimately", "familiar with the business, can be expected to prevail", "over outsiders.", "The alteration", "of fraud responsibilities", "for auditors may not be as straightforward", "a response", "to legal liability as it appears.", "Acceptance", "of fraud", "detection responsibility", "may increase the “demand”", "for auditing services, and", "therefore may be seen as a means to increase audit fees. While some suggest",
  35. "that this may not be costly or that it is worth the price (i.e. Kaplan, 1987),", "sizeable reduction", "in materiality", "levels and related changes are not easily", "accomplished", "nor should they be attempted", "without the realistic expectation", "of corresponding", "social benefits. Alternatively,", "the profession", "also gains if no", "additional audit work is done or charged to clients. By accepting responsibility", "for fraud, public accounting", "has changed the dialogue", "of liability from the",
  36. "need to rely upon an unsupported", "abdication", "of responsibility", "to one that", "centres upon due professional", "care and professional", "judgment.", "Since auditors", "were losing many lawsuits involving management", "fraud, they have nothing to", "lose and everything", "to gain if juries must focus on whether", "the audit was", "properly designed to detect fraud. A more sympathetic", "response might be", "available to those that tried and failed as opposed to those that plead that the",
  37. "public is mistaken about the need to even try. Even if auditors continue to lose", "cases involving", "fraud, their professional", "status may be elevated", "by the", "positive approach in SAS 53 (AICPA, 1988). This prospect might even tolerate", "a difference", "between", "promised", "conduct and actual conduct", "if audit fees", "", "\f206", "", "T. J. Fogarty", "", "et al.", "", "cannot be commensurately", "increased, given the relatively rare incidence of", "litigation and fraud.", "Accepting responsibility",
  38. "for fraud in the absence of any realistic prospect of", "detection forms a classic instance of decoupling", "under institutional", "theory.", "SAS 53 is a symbolic", "display designed", "for the consumption", "of external", "constitutents.", "Underlying", "that structure however,", "lies at best a murky grasp", "of cause and effect.", "Reactions to the Competitive", "", "Environment", "", "Increased competition", "in the auditing market, noted by many observers, has", "often been implicated as the culprit in the increased legal liability of auditors",
  39. "(see Kunitake & White, 1986). Several factors contribute", "to this conclusion,", "most notably the merger-induced", "reduction", "in the number", "of companies", "requiring audits (Green, 1987) and the increased awareness among auditees", "that putting audits up for competitive", "bidding could reduce audit costs by as", "much as 50 percent (Zeff, 1987). In this setting of lower client loyalty,", "accounting", "firms have been unable to maintain fee levels. As if involved in a", "high stakes game of Prisoner Dilemma, the immediate",
  40. "advantage of obtaining", "new clients by offering lower fees tends to outweight", "the more delayed and", "diffuse gain of maintaining", "fee structures.", "Competition", "seems to have changed the character", "of public accounting.", "Joseph Connor, former Senior Partner of Price Waterhouse,", "admits “There", "may be a lessening of professionalism", "that comes about through unrelenting", "commercialism”", "(Green, 1987). Zeff (1987) notes how the spirit of commercialism has altered the language, self-image",
  41. "and priorities of the major firms.", "Most prominent", "in this transition", "is the heightened", "reluctance of firms to lose", "clients and the increase in efforts to attract new clients. In this brave new", "world, the reward for standing on principle, when such might entail the loss of", "a client, goes to zero (Kaplan, 1987). In marginal cases, the failure to stand up", "for more rigorous", "accounting", "methods", "may be linked to increased", "legal", "liability. Experimental", "results show that auditors tend to take client-oriented",
  42. "positions when potential client loss is involved (Farmer et a/., 1987). It is not", "only accounting", "principles which are given short shrift. High risk firms are", "accepted or retained as clients, sometimes", "with only cursory inquiries into", "management", "integrity. Only recently, when pushed by new SEC documentation demands,", "have public accounting", "firms demonstrated", "any skepticism", "about their clients. Rather than assuming", "that CPA firms are irrational", "in", "failing to erect quality control filters in the selection and retention of clients, it",
  43. "is more likely they believe that a client maximization", "strategy also maximizes", "firm income. In other words, the increased revenue from more clients more", "than offsets greater lawsuit costs related to clients with managements", "of", "doubtful", "integrity. Perhaps this only appears to be true because the costs are", "of a lower probability than are the revenues.", "In large accounting", "firms, an emphasis", "on growth", "to compensate", "for", "liability costs seems to command", "much more effort than any prophylactic",
  44. "effort to directly limit liability losses. The managing", "partner of an office must", "turn outward", "in the attempt", "to maintain", "and cultivate", "relationships.", "The", "", "\fRationality", "", "of doing", "", "nothing", "", "207", "", "marketing", "of the firm and its services often entails more subtle and social", "engagements", "and involvements,", "perhaps in part due to the lack of visible", "quality criteria in the audit service. The marketing effort must also be borne by", "staff below the partner rank. Compensation",
  45. "and promotion", "decisions reflected", "the growing", "importance", "of “rain-making”", "for individuals", "within both the", "partner and staff pyramids.", "Ceteris paribus, the reward for the conservative", "provision of high quality services diminishes.", "While there may be personal", "satisfaction", "derived by many for the quality of their work, this tends to erode", "over time when not explicitly rewarded and recognized.", "This emphasis tends", "to preclude the success of a “quality",
  46. "control”", "effort to directly limit legal", "losses. Goldman", "and Barlev (1974) demonstrate", "that auditors", "have no", "countervailing", "power to clients’ ability to select and discharge with whom", "they do business with.", "The focus upon growth", "in revenues,", "though", "designed", "in part to offset", "increased", "legal costs, may itself serve to magnify", "legal costs through", "decreased audit quality. The impact of competition", "upon audit quality may", "occur in a variety of ways. The increased ability of corporations",
  47. "to “opinion", "shop” in such a market has been suspected", "(Kripke, 1989) and empirically", "supported", "(Knapp, 1985; Serlin, 1985). Although", "the profession would like to", "characterize this abuse as the fault of auditees (see Big-7, 1986), it would not", "be possible without very cooperative", "accounting", "firms in hot pursuit of new", "clients. The Commission", "on Audit Responsibility", "(AICPA, 1978) pinpointed", "budget pressures as a contributor", "to audit failures. This attribution",
  48. "is relevant", "only if one reasons that growth puts greater emphasis", "on quantity to the", "detriment of quality of production.", "However, an auditor’s marketing promises", "could outstrip the actual ability to deliver. This combined", "with the inability to", "fully pass litigation", "losses on to clients could create additional", "incentives to", "skimp on audit work.", "Although a return to the non-competitive", "era is very unlikely, a case can be", "made that the audit industry is excessively competitive.",
  49. "Shockley (1981) found", "competition,", "defined as the extent of efforts to please clients and avoid their", "defection, to be inversely related to perceptions", "of independence.", "Formichella", "(1987) details several practices that represent the most far-reaching", "attempts", "to extract client revenue. Prohibiting", "those practices that widely depart from", "the ideal type of professional", "service would impose short run costs on the", "firms in constraining", "their action choices. This might purchase",
  50. "“healthy", "competition”", "and greater credibility that might lessen legal exposure.", "However, the CPA firms have not strenuously", "supported", "these suggestions.", "These", "organizations", "seem to prefer their chances in a no-holds-barred", "world to", "outrun their losses. Malpractice", "losses are, after ail, infrequent", "in occurrence", "and potentially", "diminished", "in other ways.", "Consideration", "of the competitive", "environment", "of auditing focuses attention", "upon the audit fee literature.",
  51. "If audits among the national firms are qualitatively indistinguishable", "(Kaplan, 1987), fees become", "an especially salient", "characteristic.", "Evidence of price cutting and the expectation", "of subsequent", "recoupment", "exists (Turpen, 1990; Simon & Francis, 1988; Simunic, 1980).", "Recoupment", "that is jeopardized", "by threatened", "client departures", "poses a grave", "independence", "problem.", "Collectively, the larger firms may enjoy a reputation", "", "\f208", "", "T. J. Fogarty",
  52. "", "et al.", "", "for higher quality but no individual", "firm can be said to surpass the others", "within this group (Palmrose,", "1986). This would suggest that competition", "among accounting", "firms will continue to centre upon fees. However, research", "following", "the Saint Pierre and Anderson", "(1982) speculation", "that audit fee", "structure may be critical to audit failure has been mixed (see Palmrose, 1989).", "Research defining", "audit effort as equal to audit hours is limited",
  53. "by the", "systematic", "under-reporting", "of actual hours by staff (Lightner", "et a/., 1983).", "Therefore,", "it cannot", "be confidently", "asserted", "that the focus upon price", "competition", "will necessarily lead to more audit failures. However, that audit", "prices seem not to be risk-adjusted", "(Wallace, 1985) suggests that insufficient", "consideration", "to troublesome", "elements", "of exposure", "may be routinely", "occurring.", "Ludwigsen", "(1987) suggested", "a different", "perspective",
  54. "on audit fees and", "competition", "in the auditing market. In his review of the literature pertaining to", "why clients switch auditors,", "he unearthed", "the possibility", "that the true", "importance", "of competition", "might be that practitioners", "believe that clients", "make decisions", "upon audit fees alone. In other words,", "a self-fulfilling", "prophecy", "has superceded", "the importance", "of the reality of the competitive", "situation.", "In sum, the large CPA firms have embraced their newly competitive",
  55. "market", "in an all-out effort to outrun their legal liability losses. However, these efforts", "remain a backstage operation.", "To remain effective they must remain mostly", "invisible", "behind their institutionalized", "allegiance", "to the production", "of a", "valuable public service and to the quality of the product that service brings", "into being.", "Diversification", "Closely related to the emergence", "of a competitive", "market is the development", "of management", "advisory services (MAS) as a major component",
  56. "of public", "accounting", "firms. Unlike auditing,", "MAS promises non-zero sum growth and,", "therefore,", "has captured the imagination", "of the accounting", "profession.", "CPA", "firms consider consulting", "a traditional", "service (Chatov,", "1985) and aim to", "transcend even its limitations", "through", "unrelated", "acquisition", "towards the aim", "of being a full service conglomerate", "in the eyes of potential", "clients. A very", "recent high watermark", "was established", "by one of the larger firms that",
  57. "“rented”", "a staff member to a corporation", "to serve as its CFO (Cowan, 1990).", "This trend seems to serve as an indirect solution to the liability problem.", "It", "may instead act to exacerbate these losses,", "The revenue potential", "of management", "advisory services, even narrowly", "defined, is breathtaking.", "In a few short years, MAS has begun to rival auditing", "as the primary income generator", "for most firms. MAS does not yet pose the", "malpractice", "dilemma", "that lurks behind",
  58. "every unexamined", "document", "in", "auditing. While immunity", "from MAS suits does not exist, the exposure seems", "to be limited to conventional", "negligence", "doctrines asserted by client plaintiffs.", "The social role of the accountant", "qua consultant", "is clearly one of client", "advocate,", "uncluttered", "by the burden of being the public’s watchdog.", "The", "approach is unabashed", "in its sales orientation", "and unfettered", "with images of", "", "\fRationaMy of doing nothing",
  59. "", "209", "", "professional", "restraint. Diversification", "with MAS serves not only to maximize", "revenue growth but also to escape what Cardozo described as a “liability in an", "indeterminate", "amount for an indeterminate", "time to an indeterminate", "class”", "(Ultramares", "vs. Touche, 1931). In this way, the public accounting", "firms have", "acted similar to the cigarette manufacturers.", "Offering a product that cannot be", "perfected, quiet diversification", "combined", "with strong denials form a serviceable and non-contradictory",
  60. "strategy.", "The audit-MAS", "combination", "has not been unproblematic", "for CPA firms.", "Users of financial", "statements", "are skeptical", "of the independence", "that is", "possible when the firm is asked to attest to the results of their own", "suggestions", "and when the firm is more heavily dependent", "upon the two", "service fees (Lea, 1981; Audits and Surveys, 1986). Evidence exists to suggest", "that this situation increases the client’s power over the auditor (Knapp, 1985).", "More subtle is the shift in self-perceptions",
  61. "by auditors", "towards", "client", "advocacy and service that could compromise", "the reasoned skepticism", "endorsed by Mautz and Sharaf (1961).", "A rigorous", "defense", "of consulting", "has been put forth by the public", "accounting establishment.", "Often suggested", "is the contribution", "to audit quality", "made possible by familiarity", "gained through", "MAS employment.", "If this is the", "case, it is not reflected in cost savings that are passed on to clients. Simunic", "(1984) showed that economic rents accrue to CPA firms that are able to sell",
  62. "both these services to clients. Other business and professional", "leaders also", "disagree with this defense (Audits and Surveys, 1986; Pany & Rechers, 1984).", "The AICPA has asserted", "that the potential", "for abuse is mitigated", "by", "professional", "judgment", "and self-restraint", "(AICPA, 1978). But as Zeff (1987)", "indicates, the mind set of consulting treats restraint as anathema.", "It is difficult", "to conceive that the rapid growth of MAS within CPA firms demonstrates", "any \\",
  63. "sort of hesitancy. The firms also take solace in the absence of any demonstrated instance of an actual compromise", "of standards or a clear conflict of", "interest. They have advocated", "continuation", "of the MAS-audit", "combination", "barring", "a strong", "showing", "of detriment", "(Public Oversight", "Board, 1979).", "However, the opposite burden of proof might be more appropriate,", "given the", "sub rosa nature of these abuses. Apparently,", "the requirement", "to avoid even", "the appearance",
  64. "of non-independence", "has been compromised", "by a service", "with such an income potential.", "Research showing", "the overwhelming", "client", "preference", "to purchase", "consulting", "services from their auditor", "(Palmrose,", "1988b) indicates that the market is not only large, but also mostly captive.", "In sum, consulting", "operations", "that have become more important", "(from a", "profit and non-profit", "perspective)", "than auditing", "invite the notion that the", "entire auditing",
  65. "process may be an institutionalized", "front for the sale of", "miscellaneous", "services. MAS as a purely private exchange", "is tied in the", "delivery, but decoupled", "in its essence, from the semi-public", "audit exchange.", "For some firms, the audit has lost its centrality and is just a loss-leader for the", "sale of MAS.", "Demands for Legal Reform", "One of the more concerted strategies for any group facing adverse financial", "consequence", "is to pursue", "legal reform.", "Public accounting",
  66. "has severely", "", "\f210", "", "T. 3. Fogarty", "", "et al.", "", "criticized the operations", "of the legal system. These include the claim that", "public accounting", "is a convenient", "scapegoat with deep pockets and insurance", "to spread losses, that the joint and several nature of liability is unfair, and that", "the application", "of the Racketeer Influence Corrupt Organization", "(RICO) statute", "is miscast. Using auditors’", "insurance", "as societal insurance for investment", "losses is assailed by the accounting",
  67. "profession", "as a departure", "from fault", "principles (Mednick, 1987). The recent prohibitive", "cost of such insurance", "is", "also used to indicate that the mechanism", "of sharing these losses might have", "been ill-conceived.", "Joint and several liability threatens", "accountants", "with", "liability that exceeds their proportionate", "share of responsibility", "for the injury", "when they remain the sole solvent defendant.", "RICO, although", "intended", "to", "assail organized", "crime, can impose treble damages",
  68. "in audit failure cases.", "Furthermore,", "the citadel of privity which protected", "accountants", "from all", "except their own clients has eroded. An estimated", "75 percent of all suits are", "launched", "by investors (Muczajk et a/., 1986). A restoration", "of strict privity", "along the lines established", "by Ultramares", "vs. Touche is sought.", "In sum,", "lobbying", "for legal reform has been a multi-dimensional", "effort to alter the", "structural rules of litigation on grounds other than the merits.",
  69. "The revision of the entire tort system is the broader context that the legal", "reform demands", "of the accounting", "profession", "deserves. However,", "this is", "beyond", "the scope of the paper. The societal", "policy and the equitable", "consequence", "of expanded", "third party tort protection", "is often less conclusive", "than assumed", "(see Siliciano, 1988) and potentially", "counterproductive", "(see", "Priest, 1987). If nothing else, this context suggests that the auditing situation",
  70. "is just one of many that requires a potential", "reformulation", "that cuts to the", "heart of the relationship", "between the individual and the collective.", "Legal reform must also be appreciated", "relative to the proper and practical", "functions", "of insurance", "in this market. As a public good, audits cannot be", "insured in the conventional", "sense without allowing financial statement", "users", "to be free-riders.", "However,", "insurance", "is not necessarily the best vehicle to", "socialize the costs of a problem.",
  71. "A fuller treatment", "of the prospects for, and", "consequences", "of, insurance are beyond the limits of this paper.", "Thus far, the cries for reform have not met with much success. The inability", "of public accounting firms to purchase insurance as cheaply and as readily as", "before has not been seen as a reason to relieve them from liability. No liability", "cap has been installed. RICO has not been tailored to exclude accountants", "from", "its definition", "of possible perpetrators", "of securities fraud. At least three interpretations of privity coexist without",
  72. "any apparent movement", "towards reinstitution of the time honoured", "protection", "of accountants", "in all jurisdictions.", "Several reasons can be offered for the past and likely future failure of", "legislators to accede to auditors’ pleas for reforms. The current state of the", "law, contrary to the profession’s", "protestation,", "is not an aberration", "but a", "societal judgment", "about responsibility.", "“Reform”", "envisions the correction", "of", "erroneous", "direction.", "However,",
  73. "such should not be advocated", "without", "consideration", "of the logic behind the evolution", "of the law to the present. The", "standards set by the 1933 Securities Act may have been a generalized encapsulation of emergent societal expectations", "(Davies, 1979). Furthermore,", "current", "privity rules, as well as the joint and several structure,", "are not unusual tort", "", "\fRationality of doing nothing", "", "214", "", "rules that single accountants", "out for punishment", "(Kraakman,",
  74. "1988; Prosser,", "1971). Departures", "from these conditions", "would have to be based on strong", "public policy considerations", "if they are to be anything other than subsidies for", "the public accounting", "profession.", "Those portions of legal opinions that cite", "the availability", "of insurance and the analogy of the audit to product liability", "are merely dicta. In other words, even if these suggestions", "are patently", "erroneous,", "it does not follow that public accountants", "need special privilege.",
  75. "Specific reforms such as the narrowing", "of the RICO statute will not lessen", "current malpractice", "losses. Despite its threatening", "nature, most firms (large", "and small) have yet to lose anything under RICO’s provisions.", "In fact, in an", "area where liability is as nebulous", "as this, plaintiffs that persist with this", "confiscatory", "and misapplied", "claim may risk tipping the balance of equity back", "to the accountant’s", "favour. Support", "for a statutory", "ceiling on accountant",
  76. "liability is undercut by its inherently arbitrary nature. This would also tend to", "compromise", "the due care basis of professional", "service. While such an", "approach may reflect the balancing of interests between", "users and auditors", "(Murray, 1978), it also serves as a radical departure", "from fault precepts. The", "current state of accountants’", "malpractice", "liability is comparable", "with the", "liability of other professionals", "and reflects a matured sense of the scope of",
  77. "wrongs that can be redressed by the judicial system. Davies (1979) suggests", "many of the supports for the public policy expressed in the Ultramares case in", "1931 no longer exist. To expect an unchanged", "liability may be tantamount", "to a", "demand for the restoration", "of an anachronism.", "The tort reform demands", "of the accounting", "profession", "may also have its", "symbolic", "dimensions.", "Hubbard", "(1989) argues that similar demands", "by", "physicians", "cannot", "be understood",
  78. "in economic", "terms", "but instead have", "implications", "for the societal approval connoted", "by legal reform. Likewise, the", "problematic", "professional", "status of accountants", "would tend to be resolved by", "specific legal relief afforded", "to auditing", "activities.", "Reforms of this nature", "would affirm the societal importance", "of public accountants", "and would tend to", "be the start of further deference to their monopoly", "claims.", "The demands for legal reform are predicated",
  79. "upon the audit’s institutionalized public good sense. However, to the extent that the structures in support", "of this vantage are incomplete", "and contradicted", "by the decoupled", "processes", "that support the actual delivery of services, demands for reform are not likely", "to be fruitful. Nonetheless,", "they have to be made to bolster the image of the", "public accountant", "tirelessly serving the public interest.", "Cost Containment", "All industries", "attempt", "to control", "costs. The elimination",
  80. "of unnecessary", "expenditures", "is not inconsistent", "with the provision of a professional", "service.", "However, public accounting firm actions to contain costs can also be seen as a", "planned,", "rational", "response", "to legal liability", "losses that may have counterproductive", "tendencies.", "The incentive to reduce audit costs has been exacerbated", "by the squeeze", "that malpractice", "losses have put on partner income. In the recently competitive audit market, these losses cannot be wholly passed on to clients in the",
  81. "", "\f212", "", "T. J. Fogarty", "", "et al.", "", "form of higher audit fees. Lacking a more direct approach to the financial", "problems caused by these losses, public accounting", "firms have compensated", "with more control over the better understood", "audit costs.", "Many methods of reducing costs have been called upon for this purpose. In", "a regime approaching", "strict legal liability, a reduction in audit work for clients", "perceived to possess low risk can be expected (Nelson et a/., 1988). Ceteris",
  82. "paribus, reductions", "in the time budgeted", "to accomplish", "the audit translates", "into work reductions.", "Lowering", "the amount", "of audit work on engagements", "can be done in indirect ways by increasing", "reliance upon client representations,", "upon internal controls and upon the previous year’s audit work.", "Furthermore,", "additional", "work can be delegated", "to client personnel", "and", "resources. By the fuller utilization", "of lower level staff to do the audit work,", "great savings can be realized. This can be done by reducing",
  83. "partner", "involvement,", "increasing", "the use of para-professionals", "and promoting", "high", "turnover", "rates. Maintenance", "of the “up or out” structure ensures that there", "will always be a large cadre of low-cost", "recruits to perform", "audit work.", "Pushing down more responsibility", "earlier in the recruit’s career also conserves", "the use of high-cost", "personnel.", "CPA firms also have contained", "costs by", "resisting pressures to improve the compensation", "package for staff. Starting",
  84. "salaries have risen in the last few years but not at a level commensurate", "with", "other professions or sufficient to compensate", "for inflation (CPC Salary Survey,", "1961-1989).", "Fringe benefits remain poor relative to the standards of industry", "(CPA Personnel", "Report,", "1987). The result has been the persistence", "of", "dissatisfaction", "with compensation", "throughout", "staff ranks (see Ferris, 1981).", "Intangibles", "such as the prospect of partnership", "and the diversity", "of work",
  85. "experience", "have replaced compensation", "on the forefront", "of the recruiting", "effort.", "Cost containment", "is especially attractive", "if legal liability is not related to", "audit effort. Findings by Saint Pierre and Anderson", "(1982) and Palmrose", "(1988a) would tend to support such a conclusion.", "However, the failure to find", "this relationship", "might not be replicated at lower levels of audit effort. Budget", "pressures may become more salient as a force behind audit failures when",
  86. "their total effect is to reduce the extent of independent", "investigations", "conducted.", "Promotion", "of the notion that overauditing", "was conducted", "in the", "past flies in the face of public expectations.", "Muczyk et al. (1986) call for more", "partner involvement", "‘rather than less to redress the problem", "of managerial", "fraud. Using staff with limited industry specific experience is inconsistent", "with", "the spirit of the new detection", "responsibility", "of SAS 54 (AICPA, 1988).",
  87. "Facilitating the departure", "of competent", "senior staff to mitigate the dilution of", "partner income shares also demonstrates", "less than a total commitment", "to", "audit quality. Finally, inadequate", "starting salaries and benefits", "may be an", "indication that firms are not sincerely interested in competing", "for those with", "the potential to add to the stature of the profession over the long term.", "Cost containment", "seeks to buffer CPA equity owners from the financial", "consequences",
  88. "of legal liability in the short run. The consequences", "that result", "from pervasive cost containment", "are invisible due to the institutionalized", "environment", "in which the audit exists. “Audit quality”", "only matters to the", "", "\fRationality of doing nothing", "extent it can be observed by a party inclined to complain", "have a close causal relationship", "with legal liability.", "Expestatiola", "", "213", "since", "", "it does not", "", "Gap “Projects”", "", "The “expectations",
  89. "gap” and the accounting", "profession’s", "reaction towards it", "reveals much about its position", "on legal liability. The recognition", "of a", "discrepancy", "between perceptions", "of the public and the profession", "regarding", "the audit has come from many quarters.", "The general explanation", "for the", "development", "of this gap is the failure of the public to appreciate", "the nature", "and limitations", "of the audit. The cornerstone", "of what the public should realize", "is the limited responsibility",
  90. "of auditors for the financial statement", "assertions.", "Very little has been said of the time honoured", "contribution", "to the gap by the", "profession", "itself. In constructing", "a reputation", "for exactitude", "and a goal of", "protecting the public, accounting", "has made a good portion of their own bed", "(see Amhowitz,", "1987; Abraham,", "1978; Liggio, 1975). The consequences", "of", "being held to such standards", "were unforeseen.", "However,", "like the legal", "doctrine of promissory",
  91. "estoppel,", "the course of past conduct", "has its own", "logical conclusion.", "The expectations", "gap is a multi-faceted", "problem that subsumes basic issues", "of social responsibility,", "financial viability and integrity", "(AICPA, 1986). However, the profession’s", "responses have coalesced around the revision of the", "audit opinion. Campbell and Michenzi (1987) voiced the popular belief that the", "wording of the opinion is the critical issue facing the profession. After lengthy", "debate, a revision was recently adopted and most declared that the expectation gap was narrowed.",
  92. "However, this fails to understand", "that the audit report", "is in essence a symbol that an audit was conducted.", "Small changes in", "wording are irrelevant if the audit opinion is either not read, as suggested by", "Pound and Courtis (1980) or truly understood", "only via association", "(Seider,", "1976). Even if the audit opinion were a substantive", "communication,", "it falls", "well short of being a clear statement", "of role and responsibilities.", "The recent", "audit opinion revision has preserved the status quo that includes an expectation gap and sizeable malpractice",
  93. "liability. The favourable", "publicity generated", "was just about all that could be accomplished", "without", "an effort that would", "need to go much beyond the visible three-paragraphed", "end product of audit", "work.", "Responses Expected", "New Audit", "", "Procedures", "", "But Not Observed", "", "Developed", "", "Many courts have reasoned", "that legal liability", "will serve as additional", "encouragement", "for the performance", "of quality audits. If the source of liability", "is defective",
  94. "procedures,", "improvements", "to those procedures", "should reduce", "liability. Over time, benchmarks", "of minimal conduct will create public benefit", "that would otherwise", "not be forthcoming", "(Sommer,", "1974). We argue that", "concern over legal liability has not translated", "into better auditing procedures", "for several reasons. In general, such enhancements", "are not cost effective.", "", "\fIt is tortuous to reduce the audit process to a definite set of procedures.", "At", "best, the audit comprises",
  95. "usual procedures", "whose specific application", "and", "intensity is a function of particular", "client, industry and temporal", "considerations. The salience of a large set of factors wax and wane not only between", "audits but also within audits (Gibbins & Wolf, 1982). Even the strongest", "proponents", "of structured audit approaches", "(i.e. Mullarkey, 1984) admit a large", "role for professional judgment", "in the use of specific procedures. Therefore the", "issue is more often the selection of procedures rather than their refinement.",
  96. "Consistently,", "the courts have recognized that audits are more than the sum", "of their parts. The Continental", "Vending", "Case (US vs. Simon, 1969) broke", "ground by interpreting", "“fairly present”", "in an aggregate", "sense that could not", "necessarily be met by the individual", "acceptability", "of all accounting", "standards", "employed.", "If auditors are to escape liability, financial statements", "are expected", "to communicate", "economic truth reflected through a coherent set of appropriate accounting",
  97. "principles.", "This mandate", "tends to minimize", "the value of", "investments", "in highly circumscribed", "audit procedures.", "The nature of audit error, especially", "in its nexus with legal liability,", "minimizes the value of audit improvements.", "The true incidence of audit error", "is pure guesswork", "since it is a function", "of how one defines standards", "of", "accomplishment.", "Estimates", "have ranged from rampant", "(Collins, 1986) to", "miniscule (Public Oversight Board, 1984). Avoiding this useless debate seems",
  98. "judicious given the post hoc definition", "of error in court determinations", "and the", "fact that absent", "such determinations,", "audit error goes undetected", "and", "unpunished.", "Audit procedures", "by their nature are very selective, both in the", "scope of their design or frequency", "of their application.", "These basic characteristics point towards the unflappable", "nature of audit “error” and undermine", "costly methods of battling them.", "Even if cost effective means of reducing audit error existed, such would not",
  99. "guarantee the reduction in legal liability. Palmrose (1987) indicates that audit", "errors related to accounting", "errors,", "herein contrasted", "to managerial", "irregularities,", "tend to result in dismissed", "cases against auditors. The linkage", "between error and liability is weak enough to make efforts to reduce error a", "cost without obvious payoffs. This has been shown analytically", "by Nelson et", "al. (1988) who concluded", "that increased", "liability will more likely affect the",
  100. "distribution", "of audit effort than its absolute level.", "Legal liability is likely to increase effort in a manner", "which does not", "necessarily contribute", "to the value of the audit. Highly idiosyncratic", "procedures pinpointed", "as lacking by a court may become de rigueurfor", "subsequent", "audits, whether or not they are necessary or helpful to forming an opinion on", "the statements.", "Moreover,", "a comprehensive", "“defensive”", "audit approach", "has", "been recommended", "that would greatly increase the documentation",
  101. "of effort", "(Nobes, 1985; Murray, 1985). Akin to over-testing", "in the medical community,", "defensive", "auditing is expected to increase audit costs. Kothari et al. (1988)", "suggest that such wasteful and redundant", "disclosure will actually reduce the", "information", "value of audit work. Defensive auditing will do for auditing what", "the Foreign Corrupt Practices Act did for internal control (see Maher, 1981),", "that is, allow form to win over substance.", "The prospects of legal liability should encourage",
  102. "audit firms to engage in", "", "\fRationality", "", "of doing nothing", "", "215", "", "more extensive pre-audit review of the client‘s business environment.", "If this", "consideration", "can be translated", "into more intensive", "auditing", "around the", "“pressure", "points” of this interface then a positive alteration", "of procedures", "may occur. However, uncertain business environments", "may call for a flexible", "audit approach (Dirsmith & McAllister, 1982; Hershey, 1976). This may not be",
  103. "fully possible in a defensive auditing regime that favours full documentation", "over tailored practices.", "Consistent with institutional", "theory, the legal liability of accountants", "is a war", "waged at the institutional", "level. Very little substantive", "change at the operational level is necessary or for that matter relevant. However, the pretense that", "a procedural", "response has occurred becomes a potentially", "important", "symbol", "for future courts to observe.", "Substantive Self-disciplinary",
  104. "", "Actions", "", "Within their repertoire of actions open to a profession", "in the wake of a crisis in", "public confidence", "is the demonstration", "of serious self-discipline", "among", "members. Enforcement", "of standards reveals how the substandard", "work of a", "few is a threat to all and proffers to the public that the profession shares the", "seriousness of the quality issue. However, despite numerous", "prods, the public", "accounting", "profession", "remains disinclined", "towards self-discipline",
  105. "(Abraham,", "1978).", "Over the last 20 years the number of bodies charged with responsibility", "for", "audit quality have grown. Peer review is a very visible activity of the SEC", "Practice Section of the AICPA. Members of this organization", "are also required", "to conduct concurring", "partner reviews within their firms. The Public Oversight", "Board provides a review of these reviews and contains independent", "investigatory units. Overlaid upon these structures, the SEC has broad enforcement",
  106. "powers under the Securities Acts. It would seem from the proliferation", "of", "these bodies and their activity level that there has been a distinct selfregulation initiative of the accounting", "profession.", "All of this effort however", "is predicated", "upon a rather flimsy and rarely", "assessed assumption", "that post hoc review can influence", "audit quality. It", "would seem only a remote possibility that once the audit is done, enough", "could be reconstructed", "from the traces that have been created by it, to",
  107. "produce any additional value. Reviews are invariably removed from the reality", "of the process by temporal", "and spatial distance. As such, they usually can", "only assess the system", "of quality", "control", "rather than the work itself.", "Consistently,", "the problem most often observed", "by these bodies, inadequate", "documentation", "(Daly, 1987), is only a derivative", "of the audit work itself. To", "return to implications", "for the actual audit, the logic of confidence", "is often",
  108. "necessary.", "Since this is often only a leap of faith, the use of the word", "“regulation”", "is appropriate", "in only a generic sense.", "The self-regulatory", "efforts of accountants", "are, almost without", "exception,", "corrective", "rather than disciplinary", "(Daly, 1987). As such, they carry less", "consequence", "for firms found to be deficient in their practices and serve as less", "of a deterrent", "for future transgressions", "(Berton, 1986). Costs of compliance", "are usually minimal since they often require only that policy be established.",
  109. "", "\f216", "", "T. 1. Fogarty", "", "et al.", "", "To compound", "this situation,", "the secrecy that surrounds", "these reviews", "mitigates", "the concern", "that firms would", "normally", "have for reputational", "consequences.", "Several observers", "have recommended", "new structures", "that", "would bring more proactive practice monitoring", "and post hoc enforcement.", "At", "a minimum,", "these might be responsive to charges that bodies are currently", "disengaged,", "unprotected", "and non-independent",
  110. "(Ansari & McDonough,", "1980).", "Thus far, however, the accounting", "community", "has chosen not to establish", "more substantive", "approaches", "that would", "increase the credibility", "of selfregulation.", "Several possible reasons can be offered in explanation", "of this non-response.", "At the heart of the matter lies the great difficulty accounting", "has in discerning", "audit quality. While there is no shortage", "of techniques", "and procedures", "typically", "employed", "by auditors,",
  111. "most are heavily influenced", "by a poorly", "understood", "judgment", "process. Even if these practices more closely resembled", "a science, the loose coupling", "between", "them and the attestation", "objective", "undercuts", "the substantive", "meaning", "of audit quality. Enforcement", "has not", "insured adequate audit performance", "(AICPA, 1986). Furthermore,", "even if audit", "quality could be improved through the enforcement", "of standards there would", "not necessarily", "be an immediate",
  112. "reduction", "in malpractice", "losses. The", "accounting", "establishment", "has apparently", "chosen not to make this investment", "in the possible long run gains of heightened", "professionalism.", "The present reality of committees", "that do not truly assess audits, do not", "dispense sanctions and do not operate in sunshine is the ideal solution for", "entities that are interested in creating the appearance", "that something", "is being", "done without enduring", "the costs associated", "with actually doing something.",
  113. "The self-serving nature of these processes (see also Bet-ton & Ingersoll, 1985)", "has apparently been subtle enough to satisfy the SEC that all is well. Although", "it has pushed for mandatory", "peer review and more punitive", "sanctions", "(Wallace, 19891, the SEC has accepted these efforts as a major part of its", "charge to oversee the profession.", "In sum, the “reforms”", "that have been instituted have left in place the duality", "between institutional", "and client-centered", "environments.",
  114. "These changes have", "promoted", "an enhanced", "impression", "of public accountants", "as professionals", "in", "service of the public welfare. To do this, structures whereby the exclusivity of", "the performer’s", "responsibility", "is eroded by review by others exist. Institutional", "theory", "suggests that these are meant to be displays for the benefit", "of", "outsiders", "but without", "any serious", "implications", "for how audit work is", "performed.", "Pursuit of More Certain Accounting",
  115. "", "Standards", "", "An often overlooked", "but necessary aspect of accountant", "legal liability is the", "uncertain and incomplete", "nature of Generally Accepted Accounting", "Principles", "(GAAP). GAAP legitimizes a set of accrual accounting", "techniques", "that are not", "definitive", "and somewhat", "at odds with economic", "realities. As such, GAAP", "facilitates purposeful", "and strategic managerial", "selections that can distort the", "reporting", "of operating", "results and signal a different",
  116. "projection", "of future", "profitability", "and solvency. Even without", "such attempts,", "investors that limit", "", "\fRationality", "", "of doing nothing", "", "217", "", "their information", "to accounting", "reports are likely to mis-specify estimates of", "future", "returns.", "With an appreciation", "of the difference", "between", "accrual", "accounting", "and economic", "reality, a business failure following", "an unqualified", "opinion becomes something", "that might not be due to a lack of audit quality.",
  117. "To the extent that accountant", "liability is a product of the shortcomings", "of", "GAAP, accountants", "should have an interest to clarify and extend the content", "of those principles. Saint Pierre and Anderson", "(1982) documented", "that a high", "percentage", "of cases against auditors involve the misinterpretation", "of professional standards. Ceteris paribus, accounting", "firms should favour authoritative", "pronouncements", "that reduce choice in accounting", "methods,", "(see Chaffee,",
  118. "1988) as well as those that create the larger information", "sets that investors", "want. Mednick (1986) illustrates the desire among users for more quantitative,", "economically", "relevant", "information.", "Giving users such information", "might", "reduce the need to pursue accountants", "in court. Both Knapp (1985) and", "Nichols and Price (1976) show that non-definitive", "standards", "give managers", "extra leverage over auditors in disputes about accounting", "methods. Reducing", "choice might reduce the need to concede to client demands",
  119. "and thereby", "lessen legal liability.", "Public accounting", "has not systematically", "used its influence", "on standard", "setting", "bodies to accomplish", "the objectives", "that would", "minimize", "their", "GAAP-induced", "legal exposure.", "If anything,", "the profession", "has opposed the", "narrowing", "of choice and indeterminacy", "within GAAP. Such a strategy could", "be interpreted", "as advocacy", "of the interests", "of their clients to maintain", "“flexibility”", "within reporting.",
  120. "Except in isolated instances,", "pronouncements", "that would increase the usefulness of financial statements", "as “early warning", "systems” have been opposed. Auditing organizations,", "for example, have been", "adamant in their opposition", "to standards that would mandate", "management", "forecasts.", "Sorter et al. (1988) show that legal liability systematically", "encourages the underproduction", "of decision-useful", "information.", "However, Sack", "(1988) suggests that the failure of public accounting",
  121. "to champion", "innovation", "reflects the power of clients who oppose the loss of control that might result if", "anything other than the traditionally", "required information", "is disclosed. The", "marketing", "interests of the firms seems to have not only outweighted", "their", "legal interests, but also this aspect of their social responsibility.", "Despite the failure to approach closure, there has been an unprecedented", "proliferation", "in the total number of pronouncements.", "“Standards",
  122. "overload”", "has been bemoaned", "but no serious opposition", "has been launched. Zeff (1987)", "argues that when professional", "judgment", "gives way to an ever expanding", "set", "of rules, the search for loopholes", "in those rules becomes a profitable", "new", "endeavour", "for accounting", "firms. Richardson", "(1988) provides cross-cultural", "evidence that rewards to the accounting", "profession", "are positively related to", "codification", "of accounting", "procedures.", "On the other hand, increasing specificity in standards",
  123. "creates additional", "non-compliance", "assertions", "by plaintiffs", "(Abraham,", "1978). CPA firms apparently", "have chosen to lobby for standards", "that facilitate their product diversification", "and marketing strategies.", "Standard setting, itself operating", "in a highly institutionalized", "environment", "(Fogarty, 1990), provides public accounting", "with an opportunity", "to clarify their", "responsibilities", "and the parameters", "for the exercise of their professional", "", "\f218",
  124. "", "T.", "", "J. Fogarty", "", "et", "", "al.", "", "judgment.", "If public accounting", "existed within", "a purely", "institutionalized", "context, standard setting would provide an excellent vehicle for the production of their external", "image. However,", "in that standards", "matter also to", "preparers and that standards", "delimit the sale of auditing", "services to those", "preparers, public accounting’s", "standard setting involvement", "must incorporate", "elements of client servicing. The interpenetration",
  125. "of the operational", "level into", "the rarified world of standard setting explains why public accounting", "has not", "taken a unified stance in the predicted direction.", "Issuing Qualified", "", "Opinions", "", "Another", "expected", "response", "of accounting", "firms would", "be to issue more", "non-standard", "or qualified", "opinions.", "Non-standard", "opinions", "should insulate", "the auditor from liability because conformity", "with GAAP is specifically", "not", "asserted. Although adverse opinions are not an option for the SEC client, this",
  126. "and other opinion options are to be considered when malpractice", "claims are", "examined.", "Malpractice", "is by no means limited to publicly-held", "companies.", "Whether the qualification", "of the audit report results as a direct consequence", "of increased prospects of lawsuit is impossible to determine", "since economic", "fortunes", "and professional", "standards", "are simultaneously", "changing.", "Berton", "(1985) reported a sharp increase in the total number of qualified", "opinions",
  127. "during the early 1980s. Furthermore,", "Kothari et al. (1988) correlated", "the", "volume of lawsuits with lagged qualified opinions over a longer time frame.", "This suggests", "the expected", "direction", "of causality", "from the incidence", "of", "lawsuits to the rendering of qualified opinions. In sum, research supports the", "intuition", "that, at the margin,", "qualification", "has been a reaction", "to the", "worsening", "malpractice exposure of accountants.", "The expected response to qualification,",
  128. "or its threat, is the suspension of the", "audit relationship", "by the client. Knapp (1985) suggests that qualification", "is", "insufficient power in the face of the clients control over the auditor’s ability to", "earn fees. The fear of client opinion shopping and the belief that standing on", "principle might jeopardize the audit fee annuity are serious matters for audit", "partners.", "Results by Smith", "(1986) that show dispute-motivated", "auditor", "switches to be infrequent", "do not go far in allaying suspicions. Gynther (1967)",
  129. "reported that client pressure of this nature in the face of qualification", "is not", "unusual. One dark yet possible interpretation", "of these two studies is that client", "pressure is successful, making auditor switches unnecessary.", "Kalbers (1990)", "reviewed the audit committee", "literature", "but found no evidence that these", "buffers between management", "and external auditors made any difference.", "Additional", "stipulations", "about", "the qualification", "decision", "are necessary.",
  130. "Nelson et al. (1988) portray the qualification", "action as the only possible action", "for clients at the high end of the risk continuum.", "They demonstrate", "analytically that the incentives to qualify may differ for large and small audit firms", "given different", "magnitudes", "of possible", "losses and marginal", "audit costs.", "Schwartz and Menon (1985) show that failing firms tend to switch auditors", "more frequently", "than viable enterprises.", "However, audit qualification", "actions",
  131. "are not related to audit displacement", "for failing firms. Again however, the sub", "rosa nature of these negotiations", "gainsay the ability to conclusively", "interpret", "", "\fRationality", "", "of doing nothing", "", "219", "", "these studies. However, it appears as if the prospect of lost fees has assumed", "a rather disproportionate", "importance", "with auditors and, therefore, has blunted", "qualification", "as a response to legal liability.", "~~~s~~ae~ Management", "", "Designed to Improve",
  132. "", "Audit", "", "Qlaality", "", "Malpractice", "losses should trigger a reform of personnel", "practices that might", "improve audit quality. Such a review should include recruitment,", "training,", "supervision", "and socialization.", "It should also address the problem of dysfunctional turnover.", "Recruiting is the life blood of the accounting", "firm. The process is expensive", "and time consuming", "but valuable if the “best and brightest”", "can be secured.", "In several forums, accounting",
  133. "firms have suggested", "that recruiting is hampered by the cloud of personal legal liability that exists for auditors. The", "reality of this claim can be contested. Fogarty et al. (1990) found that, despite", "high levels of awareness of the prospect of personal liability, undergraduates", "are not deterred from public accounting", "career aspirations.", "Potential legal", "liability is no doubt dwarfed by other aspects of the competitive", "disadvantage", "CPA firms face in the recruiting wars, such as starting salary and improbable",
  134. "promotion", "to partner", "(Green, 1987). Furthermore,", "Formichella", "(1987) perceives the erosion of professionalism", "and independence", "to be more salient in", "public accounting’s", "recruiting difficulties.", "Following recruitment,", "training is the central personnel agenda. The lack of", "professional", "training in auditing", "among recruits is directly tied to the firms’", "practice of recruiting", "primarily", "among those with only bachelors", "degrees.", "Although the firms solidly support externalizing",
  135. "the costs of training through", "“fifth years” and professional", "schools of accountancy,", "they continue to extend", "job offers to those that might otherwise", "continue", "their education.", "The", "in-house educational", "programs", "of these firms are at first quite impressive.", "However, training", "has been ineffective", "in improving", "audit quality, at least", "insofar as it would significantly", "lessen losses from legal liability. Muczyk et al.", "(1986) make a strong case that audit failures will persist until industry and",
  136. "client-specific", "expertise", "is more commonplace", "among those that actually", "perform audit work. This suggestion", "cuts to the very heart of how audits and", "auditing organizations", "are organized.", "Quick fixes, such as peer review and", "better communication", "of new developments", "are unable to undo poorly", "performed work. However, there appears to be insufficient", "incentives to justify", "investments", "in greater “on-line”", "audit expertise.", "Legal liability induced",
  137. "financial", "pressures,", "encourage", "reductions", "in the", "extent and effectiveness", "of audit supervision.", "Increasing leverage translates", "into spreading supervision", "thinner and pushing such responsibilities", "down to", "lower levels quicker and more extensively", "(Abraham,", "1978). The short-run", "advantages", "of these actions are immediately", "realized, whereas", "long-run", "consequences", "are probabilistic", "and debatable.", "An undeniable", "element in the socialization",
  138. "of staff is instilling a marketing", "focus. Early in the career of staff members,", "encouragement", "is provided to", "form relationships", "with individuals that can subsequently", "be cultivated into a", "subtle form of client solicitation.", "Perfecting this web of relationships", "often", "", "\f220", "", "T. J. Fogarty et al.", "", "requires polished social skills that the firms are selectively willing to facilitate.", "Technical competence,", "no longer sufficient, experiences", "relative decline as a",
  139. "criteria to ascertain partner potential.", "If deepening", "technical", "auditing", "talent were the route to meeting", "public", "expectations,", "accounting firms would not tolerate dysfunctional", "staff turnover,", "especially at senior levels. The development", "of permanent", "staff at higher", "levels would retain skills within the firm. However, this could not be done", "without paying a wage commensurate", "with this expertise. Such alterations to", "firm structure would lessen leverage and apparently",
  140. "have not been seriously", "considered", "by the firms. Although", "high turnover is officially lamented by the", "leaders of public accounting", "in a variety of forums, other steps to reduce it", "are equally unlikely since they conflict with short-run profitability.", "Widespread", "beliefs among staff auditors that time budgets are “virtually", "unattainable”", "(Kelley & Seiler. 1982) and that the stress induced", "by audit time budget", "pressures is related to turnover", "(Alderman", "& Deitrick, 1981) point out that",
  141. "solutions to the turnover", "“problem”", "exist but are not presently palatable to", "the firms.", "In sum, legal liability does not seem to have permeated", "the personnel", "decisions of CPA firms. These decisions in total, reflect a desire to maximize *", "short-run", "profitability.", "Once again, this may be at odds with a strategy", "designed to substantively", "address the malpractice", "situation.", "These actions", "make sense only if public accounting", "believes that infusing the audit with",
  142. "greater human capital values is a poor investment", "in terms of lessening legal", "liability. As an institutionalized", "phenomena", "legal liability relates more to the", "fact of the audit rather than the quality of its performance.", "Once again there is", "a decoupling", "of the operational", "level (where personnel", "decisions are made)", "and the institutional", "level (where legal liability is determined", "as a policy", "decision).", "Conclusion", "Public accounting", "is a profession",
  143. "under siege. Malpractice", "losses from audit", "engagements", "constitute", "the most consequential", "aspect of current problems.", "This paper does not endeavour", "to explain the genesis of this situation", "nor", "does it take a normative", "position on its appropriateness.", "Instead this paper", "uses the actuality of audit malpractice", "to enhance the understanding", "of public", "accounting", "organizations.", "To do this, the responses of public accounting", "to", "their legal crises have been analyzed within the framework",
  144. "provided", "by", "institutional", "theory.", "Positions taken by public accounting", "pertaining to their legal situation must", "be understood", "not in isolation but only together with their actions on a wide", "range of affairs related to their operation.", "Doing this suggests the existence of", "two loosely related planes. On what can be called the institutional", "environment,", "public accounting", "produces symbolic displays pertaining", "to diligent public service in an area of vital societal concern. However,",
  145. "there also", "exists an operational", "level ruled more closely by short-run", "profit maximization. Only through the simultaneous", "considerations", "of both levels can sense", "be made of the apparent inconsistencies", "that exist within public accounting’s", "legal liability responses.", "", "\fRationality", "", "of doing nothing", "", "221", "", "institutional", "theory provides a perspective", "that essentially", "precludes “resense. The lack of close coupling between levels", "form”, in the conventional",
  146. "allows positive change to appear to happen,", "only to be contradicted", "by", "operational", "realities that for the most part escape attention. To the extent that", "two planes moving in non-parallel", "directions", "allow public accounting", "their", "cake and its consumption", "means there will be no internal incentive towards", "more substantive", "reform.", "Legal losses notwithstanding,", "the privileges", "of", "professional", "monopoly", "and the lack of constraints", "on profit-making,",
  147. "construct", "a powerful", "combination", "that can be conceived of as the direct fruit of the", "successful bifurcation", "of their salient environment.", "The malpractice", "exposure of public accounting", "has reached unprecedented", "levels which could escalate to ruinous levels. Even so, legal losses can be", "characterized", "as an immediate", "consequence", "of the contraditions", "implicit in", "acting at two levels. This analysis reveals great flaws in the institutional", "armament", "of public accounting",
  148. "which facilitate successful legal actions. For", "the most part public accounting", "does not have unilateral control over how its", "central symbols are understood", "by the public. Legal liability appears to have", "its origins at this level thereby giving some credence to the notion that public", "accounting", "is treated as if they are insurers of financial statements,", "or that", "they are liable primarily due to their “deep pockets”. This situation however,", "has to be evaluated", "against the benefits",
  149. "derived", "by public accounting", "from the existence of, and incremental", "manipulation", "of, their institutionalized", "selves.", "If public accountants", "could act to reduce their malpractice", "exposure they", "would do so to the extent that the alterations", "necessary did not, contradict the", "economic rationality", "that defines the operational", "level. However, the reform", "that would be necessary to even approach consequential", "change would have", "to be so far-reaching", "and extensive",
  150. "that it would", "greatly reduce profit", "margins. Even that cost would not guarantee", "success, given the vicissitudes", "of the legal system. When audit quality is, or for that matter, what audit", "quality should be, is so poorly understood", "that the concept has no place", "within", "the operational", "level. That very little is done, however,", "is not", "disasterous", "because the economic", "rationality", "of public accounting", "is such a", "well-oiled", "machine that there is reason to believe that legal losses can be",
  151. "outdistanced", "by new and improved", "profitability", "elsewhere.", "Legal losses in", "that context also appear quite different than they do in isolation.", "The maintenance", "of the present arrangements", "impose some social consequences beyond the embedded", "hypocrisy of a flexible reality. External parties", "continue to be deluded about, and by, accountants", "when they grapple with the", "profession", "on one level or the other, but not both. Accountants", "are forever", "unsure about their professional",
  152. "status. While all professions", "in a capitalistic", "society are also businesses, the straddle remains even more problematic", "and", "uncomfortable", "for accountants.", "Continued", "confusion", "about the audit makes", "uncertain", "future allocations", "of the consequence", "of unexpected", "business", "failure.", "Two basic future scenarios exist. One requires the recognition", "that institutional problems", "can only be addressed with institutional", "solutions.", "“Public”", "accounting",
  153. "can be made public in a truer sense by moving it into the public", "sector. This would be the expression", "of a value judgement", "that favours the", "", "\f222", "", "T. J. Fsgaaty et al.", "", "need for certainty in information", "over the usual belief that private enterprise", "governmental", "left alone will produce", "superior", "results. In this scenario,", "immunity would make the liability crisis moot. Auditing can also be privatized.", "Movements", "in this direction", "that have been advocated",
  154. "include allowing", "non-CPAs to become partners and to allow firm incorporation", "(see Ellyson,", "1990; Cowan, 1989). This would entail stripping away the public service ideal", "through", "the recognition", "that auditing", "is just another", "product about which", "consumers", "are entitled to certain finite expectations.", "This would lead to an", "exacerbated", "malpractice situation, whose magnitude", "would ultimately", "be left", "to the vicissitudes", "of legal interest balancing.", "Devoid of ambiguities",
  155. "associated with its shorn public servant role, accounting’s", "legal situation should", "become more certain. However, moving public accounting", "in either of these", "directions", "would involve significant", "costs for current equity owners of the", "firms. To characterize this scenario as a “solution”", "does not contemplate", "the", "perspective taken by most in public accounting.", "The other scenario however, is even less a solution. Public accounting,", "left", "just as it is, has demonstrated",
  156. "an ability to survive, if not prosper. Doing so", "requires an ever increasing decoupling", "between espousals and actions. Only", "through", "a systematic", "manipulation", "of a concept of an idealistic audit can", "auditing, as practised, exist. With enough imagery, proofs of compliance", "and", "loud protestations,", "the ambiguities", "are not always apparent", "to those who", "consume auditing services or to those who would regulate their provision. A", "pivotal part of this is to claim that auditing is on the verge of collapse due to",
  157. "an obsession with legal liability, whereas the reality of the situation", "is that", "very few resources have been expended", "on efforts to make things change.", "Another part is played by the willingness", "of CPA firms to settle lawsuits, even", "at great expense, in furtherance", "of protecting", "reputation and preventing", "close", "inspection by outsiders of the audit process. This strategy may sow the seeds", "for an even larger crisis of confidence", "in the future if the inherent contradictions are slowly unravelled.",
  158. "A future cataclysm of exploding", "legal liability", "would no doubt inspire the now familiar governmental", "bailout. By socializing", "the cost, subsidies to public accounting", "would become less visible, if not more", "palatable. But if public accounting", "persists in the belief that the operational", "level is the only decision", "relevant", "plane, “doing", "nothing”", "represents", "an", "optimal course. As this paper has shown however, “doing nothing”", "requires", "“Doing nothing”",
  159. "requires the organizaextraordinary", "effort by the profession.", "tional schizophrenia", "implicit within a partially institutionalized", "environment.", "Underlying", "the analysis of auditor legal liability as an institutional", "matter is", "the more fundamental", "question of the allocation of financial responsibility", "for", "business risk. Imposing", "a substantial", "portion of the consequences", "off risk", "upon auditors", "may not be optimally", "efficient (see Jurinski, 1987). Just as",
  160. "expanded", "tort liability may not result in enhanced", "accident prevention", "(see", "Priest, 1987), holding auditors liable for business failures may not reduce the", "likelihood", "of business failure. Making public accountants", "liable for investor", "losses may reflect a societal unwillingness", "to confront an issue no one wishes", "to deal with.", "The institutional", "perspective", "also provides a basis to resist arguments", "that", "the current crisis facing the accounting", "profession",
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  204.     id = "1991_The rationality of doing “nothing”.pdf", language = "en", origin = "Acrobat 4.05 Capture Plug-in for Windows")))
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