jennings et al - 2006 - strong corporate governance and audit firm rotation- effects on judges' independence perceptions and litigation judgments

253
Accounting Horizons
Vol. 20, No. 3
September 2006
pp. 253–270
Strong Corporate Governance and
Audit Firm Rotation: Effects
on Judges’ Independence Perceptions
and Litigation Judgments
Marianne Moody Jennings, Kurt J. Pany,
and Philip M. J. Reckers
SYNOPSIS: The Sarbanes-Oxley (SOX) legislation mandated modest threshold levels
of corporate board independence and expertise, as well as audit partner (not firm)
rotation. One objective was to create an environment supportive of enhanced actual
and perceived auditor independence. This study examines whether perceptions of au-
ditor independence and auditor liability are incrementally influenced by further strength-
ening corporate governance and by rotating audit firms. Our experimental study ad-
dresses these questions by analyzing responses of 49 judges attending a continuing
education course at the National Judicial College. The experiment manipulates cor-
porate governance at two levels (minimally compliant with current corporate gover-
nance requirements versus strong) and auditor rotation at two levels (partner rotation
versus audit firm rotation). We find that strengthening corporate governance (beyond
minimal SOX levels) and rotating audit firms (compared to partner rotation) lead to
enhanced auditor independence perceptions. We also find that judges consider audi-
tors less likely to be liable for fraudulently misstated financial statements when firm
rotation is involved in a minimally compliant corporate governance environment.
Keywords: auditor rotation; corporate governance; judges.
Data Availability: Confidentiality agreements prevent the authors from distributing the
data.
INTRODUCTION
T

he Sarbanes-Oxley Act of 2002 (SOX, U.S. House of Representatives 2002) provides
a variety of initiatives intended to enhance audit quality and restore investor confi-
dence in capital markets. With respect to auditors, provisions of the Act seek to
enhance independence both in fact and in appearance. First, SOX reforms the relationship
between corporate boards of directors and external auditors. By elevating the degree of
independence and expertise of corporate board members, legislators reasoned that they
Marianne Moody Jennings, Kurt J. Pany, and Philip M. J. Reckers are all Professors at
Arizona State University.
Submitted: May 2005
Accepted: May 2006
Corresponding author: Philip M. J. Reckers
Email:
254 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
could reduce the pressures brought to bear by corporate management on the auditor to
compromise independence. Second, legislators considered mandatory audit partner and firm
rotation. By limiting the duration of auditor (or audit firm) client relationships, legislators
reasoned that economic incentives associated with compromised independence might be
lessened.
SOX ultimately mandated new minimal levels of corporate board independence and
expertise (discussed below) as well as engagement and review partner rotation, but it did
not require that CPA firms be rotated.
1
While corporations have shown some interest in
adopting board governance standards beyond those required by SOX, they have resisted
corporate policies mandating audit firm rotation. Indeed, 89 percent of corporate boards
still do not have an independent chairman (Business Roundtable 2006), and nearly 99
percent of Fortune 1000 public companies and their audit committees had no policy of
rotating audit firms as of November 2003. Only 4 percent were even considering rotating
auditors a full year following passage of SOX (U.S. General Accounting Office [GAO]

2003, 15). Nevertheless, both regulators and the business press continue to consider the
proposition that long-term relationships between companies and their auditors create a
closeness between the auditor and management that reduces the public’s perception of
auditor independence and audit quality.
We report the results of an experimental study of the effects of enhanced levels of
corporate board independence and expertise and of audit firm rotation on U.S. judges’
perceptions of auditor independence and auditor liability. Our research instrument first pre-
sents judges with background information about a public company, including audited fi-
nancial statements, and it asks whether they perceive the external auditors as independent
under varied conditions of corporate governance (minimally compliant with regulatory cor-
porate governance requirements versus strong) and audit rotation (partner versus firm).
Subsequently, the instrument discloses that the earnings were discovered to be fraudulently
misstated, and that a lawsuit was initiated. The discovery stage of the lawsuit reveals ad-
ditional information regarding the fraudulent actions of management and the conduct of
the audit. Judges are then asked to assess auditor liability.
We find that both strong corporate governance and audit firm rotation result in increased
judicial perceptions of auditor independence. We also find that firm rotation (compared to
partner rotation) cause judges to consider auditors less liable for fraudulently misstated
financial statements in an environment of minimally compliant corporate governance, a
condition typical of many firms. The second section presents background information and
develops hypotheses. The third section presents our research method. The fourth and fifth
sections present and discuss our results, respectively.
BACKGROUND AND DEVELOPMENT OF HYPOTHESES
Background
The importance of auditor independence, both actual and as perceived by others, has
been widely accepted both in theory and by regulators. De Angelo (1981a, 1981b) defines
audit quality as the market-assessed joint probability that auditors will discover a breach
1
Section 207 of SOX required the Comptroller General of the United States to conduct a study to review the
potential effects of requiring mandatory rotation of registered public accounting firms. The subsequent study

issued in November 2003 (U.S. General Accounting Office 2003), concludes that the benefits of mandatory firm
rotation are not certain and that more experience with the effects of SOX’s other requirements is needed before
any requirements relating to audit firm rotation can be considered further.
Strong Corporate Governance and Audit Firm Rotation 255
Accounting Horizons, September 2006
in the accounting system and report that breach. She reasons that auditors who have an
economic interest in their clients (i.e., lack financial independence) may be less apt to report
a discovered breach or may apply less effort to discover one. She defines economic interest
as a future ‘‘quasi-rent’’ stream in which quasi-rents represent the present value of future
revenues (less costs) over the expected duration of an auditor-client relationship. The pos-
sibility of potentially earning long-term quasi-rents can result in a situation in which the
auditor’s professional independence is impaired and/or is perceived to be impaired.
Most legal challenges faced by auditors are based on plaintiff arguments that an in-
appropriate audit report was issued due to deficient standards of work performance and/or
reporting linked to failed independence. A lack of actual independence is a lack of objec-
tivity in weighing audit evidence or in reporting.
2
The lack of actual independence is
ordinarily unobservable because audit working papers seldom, if ever, acknowledge a lack
of objectivity. Accordingly, legal independence assessments must be based on judges’ (or
juries’) perceptions of auditor independence, given circumstantial evidence and environ-
mental conditions. The Securities and Exchange Commission (SEC) standard for auditor
independence also uses a subjective determination based on perception, not necessarily
through specific circumstances that compromise independence or through auditor acknowl-
edgment of independence issues.
3
In 2000, the SEC expressed concern that the forces that
hamper independence are insidious and difficult to document, but are nonetheless forces
that impair judgment. The SEC reaffirmed the ‘‘appearance standard’’ that has been applied
in both regulatory matters and litigation.

4
SOX’s list of prohibitions on auditor activities
and conflicts of interests codified the appearance standard.
5
In our experiment we thus
manipulate two factors related to auditor independence—corporate governance and auditor
rotation.
Judicial Decisions
Judges, as a group, are highly experienced in the art of evaluating evidence. Further,
given their role in society, judges normatively should decide cases strictly on their merits:
the facts and the law. However, research suggests that judges’ objectivity can be compro-
mised. In particular, Guthrie et al. (2001, 779) point out that legal scholars representing a
variety of schools of thought have long argued that judges do not find facts or apply legal
principles in a completely accurate and unbiased fashion. Judges’ views have been found
to be subject to:
2
See Elliott and Jacobson (1998) for a discussion of independence concepts.
3
Rule 2.01(b) of Regulation S-X states that ‘‘[t]he Commission will not recognize any certified public accountant
or public accountant as independent who is not in fact independent,’’ 17 C.F.R. § 210.2.01(b) (1985). In support
of this rule, the SEC has a wide variety of releases ( />a listing of various releases and reference materials).
4
For SEC statements, see Security and Exchange Commission. 2000. Exchange Act Release No. 33-7919: Auditor
Independence Requirements. Federal Register 65 (Dec. 5) at 76,008, 76,017. U.S. Government: Washington,
D.C. (also available at www.sec.gov
ϽϾ) For SEC judicial statements on independence, see
United States Supreme Court. 1984. United States versus Arthur Young and Co. United States Supreme Court
465 at 805, 817–18: Washington, D.C. (also see supremecourtus.gov) and Second District of New York. 2001.
Complete Management Inc. Securities Litigation. Federal Supplement 153 (2d) at 314, 334–35. U.S. Govern-
ment: Washington, D.C. Shareholder actions include Second District of Texas. 2002. Enron Corporation Secu-

rities, Derivative and ERISA Litigation. Federal Supplement 235 (2d) at 549. U.S. Government: Washington,
D.C. and Security And Exchange Commission. 2001. Exchange Act Release No. 43862: Accounting and Au-
diting Enforcement release No. AE-1360: Matter of KPMG Peat Marwick LLP. Administrative Proceeding File
No. 3-9500 (Jan 19). U.S. Government: Washington, D.C. (also see S.E.C. Docket 74 (2001) 384 at www.sec.gov
ϽϾ).
5
SOX (ن 107-204).
256 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
●
many of the same heuristic biases that afflict others,
●
direct exposure to issues in courtrooms over which they presided,
●
matters gleaned from other court cases and the popular press, and
●
beliefs and attitudes built up over a lifetime of experiences.
6
A significant body of research supports the conclusion that beliefs and attitudes are
decision-influencing because individuals often ignore relevant information (or differentially
weigh positive and negative information) to support their prior beliefs (e.g., Mahoney 1976,
1977; Lord et al. 1979; Wilson et al. 1993; Pham et al. 2001). Similar findings are likely
to apply to judges.
Historically, judges’ attitudes and their decisions are significantly correlated (e.g.,
Champagne et al. 1981; Danelski 1966; Robbennolt 2005). In accounting, laboratory ex-
periments find that judges’ attitudes and their judgments relating to auditor liability are
related directly and interactively with other environmental factors (Jennings et al. 1991a,
1991b, 1993; Anderson et al. 1997). For example, an extensive literature is developing
within accounting pertaining to the outcome-bias phenomenon among judges (see Lowe
and Reckers [2006] for a summary).

Beliefs and attitudes arise through learning, whereby a person acquires a reaction to
an action over a period of time. Once learned, the attitude is triggered automatically when
one is exposed to the action or thinks about it (Bagozzi et al. 2003). Since attitudes are
‘‘learned’’ reactions acquired over time, they can also change over time, but they change
only modestly in normal times (for reviews see, Ajzen 1996; Eagly and Chaiken 1993).
Reckers et al. (2006) document a significant change in judges’ attitudes and beliefs regard-
ing auditors over the last decade (similar to that found in other groups) and argue that
Enron and related debacles precipitated a significant change in previously engrained atti-
tudes and beliefs. Thus, a timely issue is whether SOX reforms produce a counter-effect in
judges’ views and influence their judgments on auditor independence and shared liability.
Corporate Governance
Perceptions of an auditor’s independence and the magnitudes of liability judgments are
likely to be affected by the strength of corporate governance. SOX reforms, among other
things, target the relationship between corporate boards and external auditors. The extent
of independence and expertise of corporate board members potentially alters pressures that
might be brought to bear by corporate management on the auditor to compromise indepen-
dence. Although SOX and the resulting changes in stock exchange listing requirements
include increased corporate governance standards for registrants, significant flexibility still
exists in the manner in which such reforms are implemented. To illustrate areas of contin-
uing flexibility, consider the following:
●
The chairperson of the board may be independent of management or be part of
management, including the corporate CEO.
●
The proportion of independent directors on the Board may vary.
●
The level of financial expertise of members of the Board may vary.
●
The level of financial expertise of members of the audit committee may vary.
●

The diligence of the audit committee may vary (e.g., number of meetings per year,
activities undertaken, etc.).
6
See Guthrie et al. (2001), Champagne et al. (1981), and Redding and Repucci (1999).
Strong Corporate Governance and Audit Firm Rotation 257
Accounting Horizons, September 2006
Prior research has shown a direct correlation between financial reporting quality and
each of the following:
●
board and audit committee independence,
●
financial expertise, and
●
audit committee diligence.
7
We investigate the impact of enhancements of corporate governance beyond minimal SOX
requirements on judicial perceptions of auditor independence and auditor liability.
Audit Firm Rotation
Numerous researchers have argued that audit firm rotation makes auditors appear to be
more independent (e.g., Arel et al 2005; Brody and Moscove 1998; Kemp et al. 1983;
Ramsey 2001; Winters 1978; Wolf et al. 1999). Threats to auditor independence are not
new; more than 40 years ago, Mautz and Sharaf (1961, 208) warned auditors that:
the greatest threat to his independence is a slow, gradual, almost casual erosion of this ‘‘honest
disinterestedness’’ the auditor in charge must constantly remind his assistants of the importance
and operational meaning of independence.
Accordingly, a lengthy tenure is often perceived to limit an auditor’s ability to exercise
objectivity and may lead to poor audit quality and audit failures.
In this study, we consider the perceptions of judges relating to situations with and
without audit firm rotation. Regulators have openly suggested the need for audit firm ro-
tation. Lynn Turner (2002), former Chief Accountant of the Securities and Exchange Com-

mission, speaking before the United States Senate Committee on Banking, Housing, and
Urban Affairs, indicated that to truly protect the independence and integrity of the audit,
Congress should require mandatory rotation of the audit firm. Turner’s remarks followed
those of Ellen Seidman (2001), Director of the Office of Thrift Supervision, who opined
that audit firm rotation every 3–4 years was desirable, in that it would allow a ‘‘fresh look’’
at the organization. Similarly, nonregulatory bodies such as the Conference Board (2003)
have suggested the need for firm rotation. A recent GAO study (GAO 2003) observed that
further analysis is needed to determine the benefits of mandatory rotation, because the
benefits are harder to predict and quantify than the additional costs. However, the combi-
nation of no regulatory requirement of audit firm rotation and few companies voluntarily
establishing such a policy makes archival research directly addressing rotation virtually
impossible.
Still, independence in appearance can be examined. In this paper, we address an issue
that has not been addressed—the likely effects of audit firm rotation on judges’ perceptions
of auditor independence and auditor liability. We do so using an experiment that manipu-
lates (1) minimally compliant versus strong corporate governance and (2) firm versus part-
ner rotation across subjects.
Hypotheses
Perceptions of Independence
This study addresses two hypotheses related to perceptions of auditor independence,
and one hypothesis and one research question related to auditor liability. The first issue
addressed is whether further strengthening of corporate board independence and expertise
7
See Arel et al. (2006) for a summary of this research.
258 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
will sufficiently alter the environment in which an auditor works to lead judges to perceive
enhanced levels of auditor independence. The second issue is whether audit firm rotation
(compared to partner rotation) will lead judges to perceive enhanced levels of auditor in-
dependence. Our first two hypotheses (stated in the alternative form) thus are:

H1: Judges will perceive the extent of auditor independence to be greater under a
situation with incrementally stronger corporate governance.
H2: Judges will perceive the extent of auditor independence to be greater under a
situation with incrementally greater auditor rotation (i.e., firm rotation rather than
partner rotation).
If a synergy exists between the two manipulated enhancements, then an interaction
hypothesis would also be in order. We did not see a basis, ex ante, to predict such a synergy,
and no interaction was found.
Auditor Liability
After eliciting participants’ perceptions of auditor independence and financial statement
credibility,
8
we informed participants that the financial statements are misstated. We then
asked participants to assess auditor liability. An extensive literature exists within and outside
of accounting regarding outcome (hindsight) bias. Knowledge of a misstatement can po-
tentially restrict the ability of judges to objectively evaluate auditor performance retrospec-
tively. Extant research offers a cognitive explanation of the phenomenon. Judges (and juries)
process information in a temporally backward mode, from the given outcome to the ante-
cedent conditions. That is, individuals focus their attention on the given outcome and try
to explain its occurrence by creating causal links to predecessor events and actions. Once
this causal framework is developed, individuals experience difficulty considering how al-
ternative outcomes could have occurred (Schkade and Kilbourne 1991; Baron and Hershey
1988; Fischhoff 1975). Events surrounding the recent demise of Arthur Andersen and sim-
ilar allegations of impropriety of other audit firms increased public skepticism as to the
independence of the auditors. In the context of a failed audit, judges will more likely
reconstruct a scenario of auditor guilt in an environment lacking controls, such as audit
firm rotation. By way of analogy, Lowe et al. (2002) find that jurors considered auditors
more responsible for a failed audit when they failed to use available quality control decision
aids.
With respect to auditor liability, culpability in the form of a lack of indepen-

dence ordinarily can only be inferred from surrounding circumstances; a lack of inde-
pendence cannot be proven. Our case materials do not provide explicit proof that the firm
lacks independence. Yet, the audit firm rotation condition suggests greater independence
safeguards. Partner rotation only, on the other hand, is the historic status quo and as such
is a condition more consistent with auditor independence being compromised to achieve
personal gain. Accordingly, we hypothesize that audit firm rotation will lead to lower as-
sessments of auditor legal liability.
9
More specifically:
8
In addition to asking participants about perceived auditor independence, participants were asked the extent to
which they perceived the environment to protect the public, and the perceived likelihood of unintentional errors
and intentional misstatements. Findings were highly consistent across these four queries, and thus only the
responses to the independence question are reported.
9
Bonner et al. (1998) report that although alleged independence violations are relatively infrequent, when such
a violation exists, it has the highest likelihood of resulting litigation.
Strong Corporate Governance and Audit Firm Rotation 259
Accounting Horizons, September 2006
H3: Subsequent to an audit that has failed to identify existing fraud, judges will per-
ceive lower auditor liability under conditions of audit firm rotation.
Predicting the effects of the strength of corporate governance on judges’ perceptions
of auditor legal liability is more complex because no directly germane prior research exists.
The strength of corporate governance speaks most directly to the culpability/liability of
management and corporate board members and only indirectly to auditor liability. Two
lines of argument can be advanced as to the potential effects of corporate governance on
judges’ assessments of auditor liability. First, as discussed above, extant hindsight research
(using judges as well as juries) supports the notion that individuals process information in
a temporally backward mode, reconstructing events to make sense of the negative outcome
(Lowe and Reckers 2006). In auditing, arguably the most sinister scenario is one of a

conspiracy between a non-independent auditor and a corporate client lacking a culture of
integrity. An attribution of a lack of independence and legal culpability can be most easily
reached in an environment of otherwise relatively weak corporate governance (i.e., an en-
vironment in which management pressure on the auditor is likely to be high) and rotation
of partners but not firms (a condition in which the audit firm has the highest economic
incentives to retain the client). This reasoning suggests that auditor liability would be
greatest under the joint condition of partner rotation and minimal board strength resulting
in a significant interaction between the experiment’s two manipulated factors.
Alternatively, a less cynical possibility is that auditor liability could be greatest under
the joint condition of partner rotation and strong corporate governance. That is, if the
financial misstatements cannot be attributed at least in part to minimally compliant corporate
governance, by default, then greater blame is laid at the feet of the auditor when corpo-
rate governance is strong. This result is arguably consistent with attribution theory. A basic
attribution theory tenet is that causal attributions are made either to the environment or to
the individual—a zero sum game. Thus, if corporate governance seems strong, then the
misstated financial statements must be the fault of the auditor. Added support for this second
perspective may accrue from prevailing ‘‘comparative contribution’’ judicial philosophy.
Under proportionate liability rules, judges’ allocations of damages for the plaintiff’s loss
are made by using a percentage of total fault for each party (Raoke and Davidson 1996).
Judges may determine that other parties (e.g., corporate board, lax corporate internal con-
trols) are responsible in part for the damages and can assign blame through fault
apportionment.
Accordingly, this second line of thought suggests that the effects of auditor rotation
(partner versus firm), once again, may be conditional on the strength of corporate board
governance. But it is unclear whether the significance of the auditor rotation manipulation
would be greatest in the weak or strong corporate governance condition, or equally signif-
icant under each governance condition. That is, we are unsure if auditor rotation will be a
main effect or interaction effect. Accordingly, we investigate the issue as a nondirectional
research question:
RQ1: Subsequent to an audit that has failed to identify existing financial reporting

fraud, will judges’ perceptions of auditor liability be a joint product of the
strength of corporate governance and the form of auditor rotation? And, if so,
what will be the nature of the interaction?
260 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
TABLE 1
Profile of Subjects
(n
ϭ 49)
Mean
Age
Gender (% Female)
Years as a judge
Owner of stock
48.3
25%
2.61
94%
METHOD
Participants
The experiment was conducted during a continuing professional education training
program at the National Judicial College. Table 1 provides a general demographic data
profile. Participants under the various experimental conditions did not differ on any of the
profiling items. Nine participants who failed manipulation checks were removed from our
analyses. The findings are based on the responses of 49 judges.
Research Task and Dependent Variables
Judges were provided with experimental materials describing the scenario of a typical
audit. The materials included background information on the corporate audit client that
manufactured a variety of industrial products. Materials also addressed the relationship (fees
and tenure) of the audit firm and audit client.

10
The CPA firm had issued unqualified
opinions throughout its audit tenure. Manipulated variables included auditor rotation and
the corporate governance structure. Additionally, the scenario included summarized income
statement and balance sheet information for the current year. Finally, to add stress to the
situation, we included the need for the company to restate earnings three years earlier due
to inappropriate revenue recognition practices. The background information is presented in
the Appendix.
After receiving the common background information and the auditor rotation and cor-
porate governance manipulations, judges were then asked to reply to the following question
to permit an assessment of their perceptions of auditor independence:
To what extent do you believe the external auditors, K&L, are independent?
Not Independent 0 1 2 3 4 5 6 7 8 9 10 Completely
at All Independent
Subsequently, participants were informed that current-year net income was misstated.
We then solicited the judges’ views on likely auditor liability. A disgruntled employee ‘‘blew
the whistle’’ on a fraud involving overstated income effected by prematurely and inappro-
priately recognizing revenues on sales that were subsequently cancelled or substantially
reduced. A lawsuit was filed when the corporation’s stock price declined precipitously after
the fraud disclosure. The experimental materials informed the judges that the discovery
process revealed that weak internal controls had been overridden to effect the fraud. The
10
In addition to audit fees of $758,000, fees for nonaudit services performed by the CPA firm were $2,325,875,
of which $2,072,374 was related to tax services.
Strong Corporate Governance and Audit Firm Rotation 261
Accounting Horizons, September 2006
FIGURE 1
Details of Corporate Governance Manipulation
Minimally
Compliant

Strong
Board of Directors
Size
Number Independent of Management
Chairman

15
8
Not Independent
(Company Founder)

15
12
Independent
Audit Committee
Size
Members all independent?
Expertise (and literacy)
Meetings in 2002
Summary Description

3
Yes
Minimally Compliant

Relatively Weak

5
26

Yes
Strong

Strong
auditor had previously informed the audit committee of weak controls. Judges’ responses
to the following question were then elicited.
To what extent do you believe the external auditors are legally liable and plaintiff
investors should be allowed to recover substantial damages?
Not at All 0 1 2 3 4 5 6 7 8 9 10 To a Great Extent
Independent Variables
Corporate Governance Structure
While any number of variables within corporate governance might be manipulated, we
selected two levels that comply with current corporate governance requirements (SEC
2003), are realistic,
11
and are documented by prior research as affecting the financial re-
porting process. The low level is minimally compliant with regulatory corporate governance
requirements and the high level goes beyond regulatory requirements (‘‘strong’’). Specifi-
cally, Figure 1 shows that, when compared to the ‘‘minimally compliant’’ condition, the
‘‘strong’’ condition has a chairman who is independent of management, a higher proportion
of independent directors on the Board, a higher level of financial expertise of members of
the audit committee, and more audit committee diligence.
Auditor Rotation
This variable has two levels: partner rotation and audit firm rotation. Because SOX
requires periodic partner rotation (within the same CPA firm), we select this as the
low-independence condition. In contrast, a policy of rotating audit firms is our high-
independence condition. This manipulation allows us to directly test whether the level of
rotation affects judges’ beliefs. In either type of rotation, partner versus firm, a study must
11
See Taub (2004) for a discussion of continuing differences in strength of corporate governance and audit

committees.
262 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
TABLE 2
Effects of Auditor Rotation (Hypotheses 1) and Corporate
Governance (Hypothesis 2) on Perceptions of Auditor Independence
Analysis of Variance for Auditor Independence
Source
Mean Square F Significance
a
Governance
b
24.964 3.895 .028
Rotation
c
26.449 4.127 .024
Interaction
d
3.686 .575 n.s.
Error 6.471
a
One-tailed tests for main effects, two-tailed for interaction.
b
Minimally compliant with SOX versus strong corporate governance as operationally defined in Figure 1.
c
Audit partner rotation versus audit firm rotation.
d
Joint or synergistic influence of governance and rotation experimental treatments on perceptions of
independence.
also address the current year within the rotation cycle. For example, if a company rotates

every four years, then the CPA firm involved could be in any one of the first through the
fourth years of the relationship. To provide a strong and realistic test, we tested the final
year prior to rotation—regardless of whether it was partner rotation (same firm retained)
or firm rotation. In the firm rotation condition, the firm will lose the client within the next
year, regardless of how current accounting matters are handled. Thus, the CPA firm has the
least to lose by resisting client pressure. Also, the CPA firm personnel are aware that
the manner in which the accounting issue is resolved will be obvious to successor auditors
(with another firm), who will be expected to review this year’s audit documentation. This
scenario is in contrast to the partner rotation situation in which any such review will be
performed by different partners within the same firm or, less probably, in conjunction with
the peer review process.
Manipulation Checks
Manipulation checks for both manipulated variables were included at the end of the
task. The percentage of subjects who failed either manipulation check was 15 percent (9
of 58). The results of our analyses are substantively the same if these subjects are included
or excluded. Accordingly, the subjects who responded incorrectly to either manipulation
check are dropped, resulting in a total usable sample of 49.
Experimental Design
Subjects were randomly assigned to one of four forms of the questionnaire in a 2
ϫ 2
between-subjects design that manipulates mandatory auditor rotation (partner versus firm
rotation) and corporate governance (minimally compliant versus strong). We use a between-
subjects design to make it difficult for subjects to identify the exact nature of the variables
being manipulated (see Pany and Reckers 1987). One-tailed tests are applied to directional
hypotheses; two-tailed tests are applied to the nondirectional research.
RESULTS
Hypotheses 1 and 2
Table 2 presents the analysis of variance results for the first two hypotheses. Hypothesis
1 is supported, given that the mean assessment of independence in the strong corporate
Strong Corporate Governance and Audit Firm Rotation 263

Accounting Horizons, September 2006
FIGURE 2
Cell Means for Auditor Independence
3.73
5.75
2.85
3.77
1
2
3
4
5
6
Partner Rotation Firm Rotation
Partner Rotation – Firm Rotation
Auditor Independence
Strong Governance
Minimal Compliance
governance condition is significantly higher than the mean in the minimally compliant
condition. The difference in means is significant at traditional levels (p
ϭ .028; one-tailed
directional test). This result can be seen in the graph in Figure 2, as the line for strong
corporate governance is higher than the minimally compliant line. Governance structures
that exceed the minimum requirements of SOX (and the revised NYSE and NASDAQ rules
as relating to boards of directors) can potentially enhance judges’ perceptions of the audi-
tors’ ability to conduct their audits independently.
Hypothesis 2 posits firm rotation also increases perceptions of independence. The anal-
ysis of variance in Table 2 shows support for this hypothesis as well (p
ϭ .024; one-tailed
directional test). In terms of the graph (Figure 2), both lines are upward sloping, which

implies that participating judges perceive CPA firms to be significantly more independent
when audit firms instead of partners are about to be rotated. Finally, note that the lines in
the graph are almost parallel. This implies no interaction between the strength of corporate
governance and the type of rotation, as confirmed by the insignificant interaction term in
the ANOVA. In other words, the improved perceptions due to governance seem to occur
regardless of rotation, and vice versa.
Hypothesis 3 and Research Question 1
Table 3 presents the results for H3 and RQ1. In the firm rotation condition, judges
perceive auditors to be significantly less liable (p
Ͻ .01; one-tailed directional test) than in
the partner rotation condition. This finding lends support to H3. But as can be seen in the
graph in Figure 3, the effect of rotation differs depending on the level of corporate gov-
ernance, and vice versa. Under the minimum governance condition, firm rotation leads to
264 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
TABLE 3
Effect of Auditor Rotation (Hypotheses 3) and Corporate
Governance (Research Question 1) on Perceptions of Auditor Liability
Analysis of Variance for Auditor Liability
Source
Mean Square F Significance
a
Governance
b
.223 .043 n.s.
Rotation
c
36.768 7.145 .005
Interaction
d

27.219 5.28 .026
Error 5.146
a
One-tailed tests for main effect of auditor rotation, two-tailed for interaction.
b
See Table 2.
c
See Table 2.
d
Joint or synergistic influence of governance and rotation experimental treatments on perceptions of liability.
FIGURE 3
Cell Means for Auditor Liability
6.91
6.67
8.54
5.31
5
6
7
8
9
Partner

Rotation
Firm Rotation
Partner Rotation – Firm Rotation
Strong
Governance
Minimal Compliance
Liability Perception

significantly lower liability judgments than partner rotation (means of 5.31 versus 8.54).
That is, under the minimum governance condition, judges consider auditors to be much
less liable for errors that occur in the year when the firm is about to rotate off of the audit.
Under the strong corporate governance condition, the difference in means between partner
and firm rotation is not statistically significant (means of 6.91 versus 6.67). This is why
the interaction between our rotation and corporate governance manipulations is significant
(p
Ͻ .026; two-tailed nondirectional test). Interestingly, judges assess higher liability for
Strong Corporate Governance and Audit Firm Rotation 265
Accounting Horizons, September 2006
firm rotation in a strong corporate governance setting compared to a weak governance
setting. While not an explicit part of our tests, finding that strong corporate governance can
mitigate the reduction in liability assessments from using audit firm rotation has some
interesting implications, which we discuss further in the next section.
DISCUSSION
Before discussing implications of our study, we acknowledge several limitations and
discuss the use of judges as subjects. First, due to limited subject availability, we restrict
our inquiries to only two levels of two variables (i.e., corporate governance and auditor
rotation). As such, our results cannot assess other variables or other levels of these variables.
Second, we limit our inquiries to one stakeholder group: judges. Even within the legal
arena, many cases are either resolved out of court or by a jury. This raises an issue pertinent
to future research. What is the advantage, if any, of using judges instead of jurors? Getting
potential jurors to participate is decidedly easier.
Judges versus Jurists as Subjects
A number of studies in accounting use either potential jury members (e.g., Kadous
2000, 2001; Lowe et al. 2002; Brandon and Mueller 2006) or judges (e.g., Lowe and
Reckers 1994; Jennings et al. 1998; Jennings et al. 1993; Anderson et al. 1997). What are
the advantages of using each type of subjects? One advantage of using jurors or potential
jurors is greater availability. However, the use of jurors also introduces a number of limi-

tations. First, experimental ‘‘jurors’’ may never actually be selected as jury members, much
less as jury members in an accounting or even a business-related trial. Second, jury deci-
sions are group decisions, not individual decisions. Group decisions are not necessarily the
same as decisions made by individuals. At least two studies (Kaplan and Miller 1978; Kerr
et al. 1999) find that juries are influenced differently than individual members when pre-
sented with extralegal information that is not supposed to be considered in the final decision.
Studies involving judges are less frequent, because obtaining judges as subjects is more
difficult. Judges are more familiar with the law than are individuals who act as ‘‘jurors.’’
Some judges also may have direct experience with the sort of case involved in the study.
Some cases are adjudicated initially by judges. Virtually all appeals are handled by judges.
Various researchers have attempted to identify circumstances in which juries rule differently
than judges. Many authors argue (while others dispute) that judges are better than juries,
especially in professional malpractice suits (e.g., Bertelsen 1998; see also Palmrose [2005]
as related to the liability of auditors). Helland and Tabarrok (2000) document that juries
grant systematically larger awards to injured plaintiffs than judges grant, and they are more
receptive to arguments from economically disadvantaged plaintiffs. Win rates in product
liability and malpractice cases also are higher among juries than with judges, especially
when the jury pool reflects lower income strata members. Helland and Tabarrok (2000)
examine data from 59,000 trials and 27,000 settled cases. They conclude that 25–33 percent
of the differences in mean awards may be due to differences in ‘‘attitudes and decision
processes across judges and juries’’ (Helland and Tabarrok 2000, 307) and statistically
significant differences exist between judges and juries in the impact that various factors
have on awards (Helland and Tabarrok 2000, 327).
Implications
Subject to the limitations, our study has implications for the auditing profession and
U.S. capital markets. Specifically, judges’ perceptions of auditor independence can be im-
proved by both stronger corporate boards (than currently mandated) and by audit firm
266 Jennings, Pany, and Reckers
Accounting Horizons, September 2006
rotation; these two effects are independent of each other. Also, audit firm rotation, compared

to audit partner rotation, leads judges in our study to perceive auditors as less liable for
fraudulently misstated financial statements, but only in a minimally compliant corporate
governance environment. In brief, judges assign significant value to audit firm rotation in
most cases and to stronger boards in some cases.
For the public accounting profession, our results suggest audit firms at the end of their
rotation are perceived as being more independent than when the impending rotation only
affects the partner, and the difference occurs in both our strong and minimally compliant
control environments. If the public accounting profession values its appearance of indepen-
dence, then rotation of audit firms offers a possible benefit. In addition, our findings suggest
that external auditor rotation might somewhat mitigate legal liability in circumstances in
which a client’s corporate governance is minimally compliant with SOX. Minimally com-
pliant corporate governance dominates today. However, if the strength of corporate gover-
nance gets sufficiently high across the spectrum of firms, then liability reduction from
rotating auditing firms may be minimal.
The GAO decided against requiring firm rotation in part due to a question concerning
whether other provisions of SOX (such as mandating minimal thresholds for corporate
board independence and expertise) may have made such a requirement unnecessary. In
essence, the question is whether the legislated threshold levels of audit committee indepen-
dence and expertise were sufficient to allay fears of lack of auditor independence Our
results indicate that the judges in our sample believe that stronger corporate boards and
audit firm rotation add to perceptions of auditor independence.
The credibility of financial markets has been badly impaired by recent and continuing
corporate scandals. The outcry for reform is the loudest it has been in our lifetime; perhaps
the most recent parallel is that of the 1930s. Issues of reform deserve serious and unbiased
study. No one study can guide costly legislation, but we hope that these findings challenge
the current thinking of corporate insiders, lobbyists, and legislators, as well as encourage
further research on these issues.
APPENDIX
Crowne Products Case Background Information
Crowne Products Corporation (Crowne) is a 30-year-old firm traded on NASDAQ that

manufactures a variety of industrial products. In the late-1990s Crowne’s earnings and
market share diminished. New management was appointed in 1999 with the purpose of
reversing trends. Summarized financial data for 2002 follow:
Income Statement Balance Sheet
Sales
Cost of Sales
Net Income
$980,215,000
744,979,000
74,746,000
Accounts Receivable
Inventory
Plant & Equipment
$209,721,000
160,805,000
519,071,000
Background Information
●
In 2000, the Securities and Exchange Commission (SEC) required Crowne to issue
restated 1999 financial statements. The restatement corrected what the SEC deemed
to be aggressive and inappropriate revenue recognition practices that materially over-
stated income. Weak corporate internal control was identified as contributing to the
need for restatement: members of the new management had been allowed to override
routine accounting controls and impose inappropriate revenue recognition practices.
Strong Corporate Governance and Audit Firm Rotation 267
Accounting Horizons, September 2006
After the restatement, members of the Audit Committee (a committee of the Board
of Directors) were quoted in the business press as having informed management of
the need to tighten controls and that the Audit Committee would oversee the process.
●

[Corporate Governance Manipulation, described in Figure 1]
●
Early in 1999, Crowne hired K&L CPAs, a large international CPA firm with offices
in most major cities in the world. K&L conducted the external audit of Crowne and
issued ‘‘clean’’ audit opinions for each year—1999, 2000, 2001, and this year, 2002.
A ‘‘clean’’ audit opinion provides reasonable assurance to the public, based on
various audit tests and samples, that the annual financial statements released to the
public are free of material misstatements and omissions and are in compliance with
generally accepted accounting principles.
●
In 2002, in accordance with the Sarbanes-Oxley Act, management (1) certified the
financial statements as presenting fairly Crowne’s financial position and results of
operations, and (2) issued a statement indicating that the corporation maintained
effective internal control over financial reporting. K&L’s audit staff also issued an
internal control evaluation opinion indicating that it agreed with management’s con-
clusion on internal control.
●
[Auditor Rotation Manipulation, described in ‘‘Auditor Rotation’’ subsection]
●
In 2002, Crowne reported a profit increase of 8%, despite a recession.
●
In 2002, Fees for Non-Audit Services performed by K&L amounted to $2,325,875
of which $2,072,374 was related to tax services. Audit fees in 2002 were $758,000.
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