Managerial Auditing Journal

Tax services, consequence severity, and jurors' assessment of auditor liability

John M. Thornton Michael K. Shaub
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John M. Thornton Michael K. Shaub , (2013),"Tax services, consequence severity, and jurors' assessment
of auditor liability", Managerial Auditing Journal, Vol. 29 Iss 1 pp. 50 - 75
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MAJ
29,1 Tax services, consequence
severity, and jurors’ assessment
of auditor liability
50
John M. Thornton
Department of Accounting, Azusa Pacific University,
Azusa, California, USA, and
Michael K. Shaub
Department of Accounting, Texas A&M University,
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College Station, Texas, USA

Abstract
Purpose – The purpose of this research is to determine whether the type of tax services provided by
a public accounting firm to its audit client and the consequence severity of an audit failure impact
jurors’ assessment of audit quality and auditor liability.
Design/methodology/approach – The authors administer a court case to 168 jurors manipulating
three levels of tax services provided to an audit client (none, tax preparation, and aggressive tax
planning services); two levels of consequence severity of the alleged audit failure, observing the impact
on jurors’ assessment of audit quality, auditor responsibility for audit failure; and damages awarded
the plaintiff.
Findings – Consistent with recent US regulations, jurors perceive the quality of the audit to be lower
when auditors provide aggressive tax planning services, but not for tax preparation services. Damages
are greater when auditors provide aggressive tax planning services across both levels of consequence
severity.
Research limitations/implications – The results indicate that the type of tax services provided
may impact jurors’ views of audit quality and damage assessments against auditors. The
questionnaire uses previously validated measures, but the results may not be generalizable to jurors in
all jurisdictions.
Practical implications – Though empirical evidence is mixed at best about the impact of auditors
providing non-audit services on auditor independence in fact, auditor independence in appearance, and
thus audit quality, such impacts may affect the way jurors perceive the situation.
Originality/value – The study directly tests the implications for auditor liability of new restrictions
on tax services and more accurately measures the impact of consequence severity, using actual jurors.
Keywords Audit failure, Consequence severity, Jurors, Non-audit services, Tax planning, Tax services
Paper type Research paper

Managerial Auditing Journal
Vol. 29 No. 1, 2014
pp. 50-75
q Emerald Group Publishing Limited
0268-6902
DOI 10.1108/MAJ-03-2013-0834
The authors would like to thank Jordan Lowe for his significant help in the early part of this
project, particularly in the instrument design. The authors are also indebted to the participating
jurors and to Paula Perkins, the attorney who assisted with access to the court. The authors
thank Graeme Harrison, Nonna Martinov-Bennie, Alan Kilgore, Philip Sinnadurai, and workshop
participants at Macquarie University, Washington State University, and Georgia Southern
University for their helpful comments. The authors also recognize the research support of the
Washington State University College of Business, Texas A&M University’s Mays Business
School, and St Mary’s University’s Bill Greehey School of Business.
 Introduction Tax services and
Recent Securities and Exchange Commission (SEC) and Public Company Accounting consequence
Oversight Board (PCAOB) regulations ban public accounting firms from marketing
aggressive tax positions[1] to their audit clients, ostensibly to enhance audit quality severity
through increased auditor independence. Yet the regulations continue to allow firms to
provide tax compliance services such as preparing corporate returns. These
regulations were enacted without empirical evidence that public accounting firms’ 51
provision of these tax services negatively impact people’s perceptions of either auditor
independence or audit quality. Do jurors perceive these services to be a problem?
In the US legal system, claims of auditor negligence are ultimately decided by
jurors. Theoretically, auditors are liable for audit failure when their performance does
not meet the standard of care required of the average prudent auditor. However,
Kadous (2000) finds that severe consequences of an alleged audit failure create a
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hindsight bias, causing jurors to evaluate auditors ex post in a manner that makes it
difficult for an auditor to ever perform a high enough quality audit. The purpose of this
study is to investigate whether the type of tax service provided by a public accounting
firm impacts jurors’ perception of audit quality, the extent to which they hold auditors
responsible for plaintiff’s losses, and the damages they award. We also test whether the
severity of consequences in the case affect the standards of care to which jurors’ hold
auditors and their perception of the quality of the audit performed.
We investigate these issues by conducting an experiment where actual jurors waiting
to be selected for a trial evaluate a case where an audit firm is involved in an alleged audit
failure. Using a between-subjects experimental design, we manipulate the type of tax
services provided by the public accounting firm to its audit client, which we posit to
impact jurors’ assessment of the audit quality, auditor responsibility for audit failure,
and amount of damages they award the plaintiff. We also manipulate the severity of
the consequences of the audit failure, based on Kadous’s (2000, p. 327) finding that
higher quality audits may not protect auditors from legal liability when the
consequences of audit failure are severe.
We find that jurors’ perception of audit quality is significantly lower in the
aggressive tax planning services scenario when compared to the no tax service
scenario, but find no significant difference between the tax compliance service scenario
and the no tax service scenario. Also, jurors assess higher punitive damages in the
aggressive tax planning scenario. However, we found no significant difference in
jurors’ assessment of auditor responsibility for plaintiff losses or the compensatory
damages they award across the three scenarios. These findings provide limited
support for the PCAOB’s decision to ban aggressive tax planning services while
allowing tax compliance services.
Our results support Kadous’s (2000) finding that jurors appear to compare their
perceptions of audit quality to their perceptions of a standard of care in determining
auditors’ responsibility for failure. However, we find that consequence severity does not
significantly influence jurors’ assessment of standards of care or audit quality. Our results
do not replicate Kadous’s finding that consequence severity swamps this comparison,
thereby making it impossible for jurors to view auditors as having performed an adequate
audit when consequences are severe. Jurors’ assessments of auditor responsibility for
failure are linked to their assessment of damages to be awarded. In addition, more
educated jurors are less likely to award compensatory and punitive damages.
 MAJ Differences in the level of tax-related non-audit services (NAS) provided do not
29,1 impact jurors’ assessment of auditors’ responsibility for the audit failure. However,
damages assessed are greater for auditors who provide aggressive tax planning
services. This finding implies that while jurors are consistent in their judgments about
auditors’ responsibility for audit failure in the presence of NAS, the penalties they
assess may be more severe when the accounting firm is seen as profiting from a
52 morally questionable service. Thus, there may be protections to audit firms provided
by the PCAOB’s ban on providing these services.
The rest of the paper is organized as follows. First, we develop hypotheses by
exploring the history and recent developments of standards regarding auditors’
provision of NAS to audit clients and the resulting impact on auditor independence.
This section also examines the research regarding jurors’ ability to establish auditor
responsibility for audit failure, including the impact of consequence severity. Second,
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we describe the experimental design and method applied in this study. Finally, we
describe the empirical results, as well as offering a summary and conclusions.

Development of hypotheses
Tax services, audit quality and the role of the juror
The PCAOB (2005) and SEC (2006) have adopted rules that treat registered public
accounting firms as not independent of a public company audit client if the firm
provides assistance in planning, or provides tax advice on, certain types of potentially
abusive tax transactions[2]. Concurrently, “[. . .] the SEC made it clear that it did not
consider conventional tax compliance and planning to be a threat to auditor
independence” (PCAOB, 2004, p. 7)[3]. Determining the types of tax services that
potentially impair auditor independence is important because auditor independence is
an essential element of audit quality.
Audit quality is the probability that a financial misstatement is both detected and
reported (DeAngelo, 1981), and it is inversely related to audit failure. “Audit failure
occurs when the auditor issues an incorrect audit opinion because it failed to comply
with the requirements of auditing standards” (Arens et al., 2008, p. 113)[4]. Auditors
have a “common law” duty to perform with the care, skill, reasonable experience, and
faithfulness of an ordinary, prudent member of the auditing profession (Epstein and
Spalding, 1993, pp. 16-18), or they risk being liable for negligence.
In the US legal system, claims of auditor negligence are ultimately decided by
jurors. Palmrose (1991) finds that only about 10 percent of legal disputes involving
auditors are tried to verdict, but the possibility of a jury trial influences key legal
decisions (e.g. early settlement). Brandon and Mueller (2006) note that ultimately, it is
the jurors’ perceptions – not reality – that will determine an auditor’s fate in court.
Accordingly, jurors are a necessary link in the litigation process. This centrality of
jurors and juries to the US justice system has led many accounting researchers to
solicit jurors’ opinions when assessing the public’s perception of the accounting
profession’s performance (Buckless and Peace, 1993; Kadous, 2000, 2001; Lowe et al.,
2002; Brandon and Mueller, 2006). While there is concern about juror vs jury
differences, first ballot votes by individual jurors predict jury verdicts at a high level
(Kalven and Zeisel, 1966; Sandys and Dillehay, 1995). Moreover, the majority verdict
prior to jury deliberation usually prevails (MacCoun, 1993).
 Auditor independence, audit quality, and NAS Tax services and
Regulators and the accounting profession agree that auditor independence is an consequence
essential element of audit quality and require external auditors to be independent in
fact and in appearance in performing audits of public companies (AICPA, 1997, 2012; severity
SEC, 2000b; PCAOB, 2004)[5]. The requirement for auditors to be independent serves
two related, but distinct, public policy goals:
One goal is to foster high quality audits by minimizing the possibility that any external 53
factors will influence an auditor’s judgment. [. . .] the other related goal is to promote investor
confidence in the financial statements of public companies (PCAOB, 2004, p. 3).
The AAA Financial Accounting Standards Committee (2001, p. 382) states that audit
quality is “a joint product of auditor independence and auditor expertise”. Likewise, the
AICPA’s (2012) Code of Professional Conduct principles require that auditors perform
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audits with both objectivity and independence and also with due care.
Concern about the possibility of NAS negatively impacting audit quality by
decreasing auditor independence dates back to at least the mid-1950s, when public
accounting firms began offering management advisory services to their audit clients
(see Previts (1985) for a history of the development of these services), and this concern
attracted the attention of accounting researchers as early as the mid-1960s (Schulte,
1965, 1966; Briloff, 1966). The search for evidence of the effects of NAS on auditor
independence has generally focused on either independence in fact, or independence in
appearance.

Evidence regarding independence in appearance

The present study is concerned primarily with independence in appearance and uses
jurors as surrogates for public perception. The SEC has taken the position that the
perception (i.e. appearance) of independence is as important as the fact of
independence. In the SEC’s (2000a, Section III.A) Final Rule on Independence, they
argue, “public faith in the reliability of a corporation’s financial statements depends
upon the public perception of the outside auditor as an independent professional”.
Early research on the effects of NAS on perceived auditor independence (Schulte, 1965,
1966; Briloff, 1966; Titard, 1971; Hartley and Ross, 1972; Lavin, 1976; Pany and
Reckers, 1980, 1983, 1984, 1988; Firth, 1980, 1981; Shockley, 1981) found that a
significant proportion of users and preparers perceive that NAS tend to impair
independence, and that users generally perceive a greater problem with the provision
of NAS than do preparers[6].
McKinley et al. (1985) and Pany and Reckers (1987) warn of potential demand effects
in prior perception studies, and emphasize the importance of using a between-subjects
design to mitigate this risk. Despite the criticisms of early perception studies’
methodologies, several recent studies not subject to within-subjects design criticisms
find perception problems when NAS are performed by auditors for their audit clients
(Lowe et al., 1999, p. 7; Raghunandan, 2003; Brandon et al., 2004; Krishnan et al., 2005;
Francis and Ke, 2006; Eilifsen and Knivsfla, 2012). Attorneys appear to pay careful
attention to the level of NAS when shaping their arguments in the courtroom or
seeking settlements. For example, Schmidt (2012) finds that NAS-induced
independence impairment arguments drive plaintiffs’ attorneys’ claims for damages.
Also, when NAS fees are higher, restatement-related audit litigation is higher.
 MAJ Tax services
29,1 Recent regulations by the SEC and PCAOB banning certain tax services that public
accounting firms provide their audit clients, mark the first time that regulators have
included tax services proscriptions, an area of NAS that has been long associated with
accountants. The new regulations appear to be driven, at least in part, by recent scandals
involving the tax practices of large accounting firms (Sloan, 2005) rather than empirical
54 evidence that these services impair auditors’ independence. To distinguish between the
types of tax services that potentially do or do not impair auditor independence, the
PCAOB relies on the SEC’s (2000b) proposed rule on auditor independence, which lists
four “overarching” (PCAOB, 2004, p. 4) independence principles to determine whether a
particular service or client relationship impairs the auditor’s independence[7].
The recent regulations continue to allow accounting firms to provide certain tax
services (e.g. tax preparation services), but ban the firms from performing other tax
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services (e.g. marketing potentially abusive tax shelters). Like prior NAS scope
restrictions, there is limited empirical evidence linking these proscribed tax services to
impaired auditor independence or audit quality, though Mishra et al.’s (2005)
examination of shareholders’ auditor ratification voting indicates that the tax fee ratio
is positively associated with the proportion of votes against auditor ratification.
In the context of an alleged audit failure, the present study investigates whether the
type of tax services provided by the auditor to the audit client affects jurors’
perceptions of audit quality. The PCAOB’s (2005) recent decision to ban public
accounting firms from marketing aggressive tax planning products to their audit
clients is predicated on the assumption that the provider of these services will be
perceived to perform a lower quality audit than auditors providing no tax services to
their audit clients. Furthermore, consistent with Mishra et al. (2005), we expect the
receipt of tax fees of any kind by the public accounting firm to negatively impact
jurors’ perceptions of audit quality. Our hypothesis, stated in alternate form, is:
H1. Jurors’ assessment of audit quality will decrease with the level of tax NAS
provided.
This prediction is important because the PCAOB’s (2005) new regulations appear to be
decreasing demand for tax services that are potentially valuable to clients. Tax services
comprise 22-27 percent of total firm revenue for the Big Four firms, which in turn audit
nearly all of the largest companies both in the USA and worldwide (Arens et al., 2008,
p. 26). Uncertainty about the effects of tax services on auditor independence has reduced
audit client demand for tax services in recent years. Omer et al. (2006, p. 1095) find
evidence that some companies paying high audit fees reduced or terminated
auditor-provided tax services in 2002 due to separate disclosure requirements for
NAS, even though separate tax service fee disclosure was voluntary. Moreover,
auditor-provided tax services were reduced among new and short-tenure clients.
We also investigate whether tax services provided by the public accounting firm to
its audit clients will carry through to a measurable increase in jurors’ judgments of
auditor responsibility for audit failure. The accounting profession has expressed
concern that jurors’ judgments are a reflection of jurors’ attitudes and predispositions
(e.g. redistribute the wealth arguments), rather than being based on the merits of the
case regarding audit quality (Palmrose, 1997, 1991). Our second hypothesis, stated in
alternate form, is:
 H2. Jurors’ assessment of auditor responsibility for plaintiff losses will increase Tax services and
with the level of tax NAS provided. consequence
Once jurors have determined an auditor is responsible for a plaintiff’s loss, they may use a severity
second set of factors to determine the amount of damages they award (Kadous, 2000,
p. 340; Lowe et al., 2002, p. 190). Factors include the dollar value of plaintiff losses, the
auditor’s ability to pay and the number of additional defendants. Lowe et al. (2002, p. 198)
find that the relationship between jurors’ evaluations of auditor responsibility for audit 55
failure and jurors’ damage assessments is significantly positive. Kadous (2000) finds that
when consequences are moderate, guilt ratings are lower and verdicts are less frequent
against auditors when quality is higher. Since audit quality is, in part, a function of
perceived auditor independence, we predict jurors will award greater damage awards to
plaintiffs when accounting firms provide aggressive tax planning services to their audit
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clients. Our third hypothesis, stated in alternate form, is:

H3. Jurors’ assessment of damage awards will increase with the level of tax NAS
provided.
This prediction is important because damages awarded by jurors should reflect jurors’
assessment of the quality of the audit performed. Performing higher quality audits
should protect public accounting firms against liability for audit failures.

Consequence severity and jurors’ judgments

An auditor’s duty is to observe the standard of care that would be observed by an ordinary
prudent member of the auditing profession. In theory, performance of an audit that
conforms to a reasonable standard of care should relieve the auditor of liability for
subsequent audit failure (Causey and Causey, 1991). However, Kadous (2000) finds that
when the consequences of an audit failure are severe, jurors may hold auditors responsible
for the audit failure regardless of the quality of the audit. This may occur because the
auditor’s standards of care are inherently vague, as is the level of audit quality sufficient for
auditors to avoid legal liability for audit failure (Kadous, 2000, pp. 328-329).
While the law contemplates that standards of care are set ex ante, jurors evaluate audit
quality ex post. Jurors’ contemporaneous assessment of standards of care and audit
quality leaves their evaluative judgments open to the influence of hindsight bias
(Fischhoff, 1975) and outcome effects (Clarkson et al., 2002). “Hindsight bias is said to
exist when individuals overestimate the extent to which an outcome could have been
anticipated prior to its occurrence” (Lowe and Reckers, 1994, p. 401); courts “cite concerns
with hindsight in nearly one-third of all published opinions in securities class action
cases” (Gulati et al., 2004, p. 775). Hindsight bias has been shown to affect jurors’ (Lowe
and Reckers, 1994) and judges’ (Anderson et al., 1997) decisions in an audit context:
The outcome effect occurs where knowledge of the occurrence of an event outcome negatively
influences individuals’ evaluations of the skill and/or competence of a judge who did not
foresee that outcome prior to its occurrence, even where it is not clear that the event outcome
was foreseeable (Clarkson et al., 2002, p. 7)[8].
When evaluative judgments are made, knowledge of the outcome may hinder
the objectivity of the individual. Specifically, decision makers tend to attribute
responsibility to the evaluated person for negative outcomes proportional to the
perception that he or she should have or could have anticipated the outcome.
 MAJ In a case involving alleged audit failure, Kadous (2000) finds that when
29,1 consequences of an audit failure are severe, jurors hold auditors to a higher standard of
care than when consequences are moderate. In a worst case scenario, severe
consequences of an audit failure could potentially increase jurors’ perceived standards
of care so high that no level of audit quality would be sufficient to protect auditors
against claims of negligence. We investigate whether severe consequences increase
56 standards of care in the present case. Our fourth hypothesis, stated in alternate form, is:
H4. Jurors’ assessment of standards of care will be higher when consequences of
audit failure are severe than when consequences of audit failure are moderate.
Kadous (2000, p. 339) did not measure perceived audit quality specifically in her study,
so she was unable to disentangle the effects of jurors’ perceived standards of care and
perceived audit quality on jurors’ judgments of auditor responsibility for alleged audit
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failure. Since we measure perceived audit quality in our study rather than imbedding it
in the case as did Kadous (2000), we investigate whether severe consequences decrease
jurors’ assessment of audit quality, as her findings imply. Our fifth hypothesis, stated
in alternate form, is:
H5. Jurors’ assessment of audit quality will be lower when consequences of audit
failure are severe than when consequences of audit failure are moderate.
These hypotheses are important because the law contemplates that standards of care are
set ex ante, affording auditors the opportunity to perform an audit of sufficient quality to
protect themselves against claims of negligence. If hindsight bias or outcome effects
sufficiently bias jurors’ judgments in cases where ex post consequences are severe, then
auditors face a “no-win” situation that potentially renders audit quality irrelevant.
The overall theoretical model within which the hypotheses fit is shown in Figure 1.

Experimental design and method

Participants
We tested our hypotheses using an experimental court case administered to 168 jurors
who were waiting to serve on jury duty at a state’s Court of Appeals (second highest
state court, under the State Supreme Court). As discussed above, we chose jurors as
subjects because most audit litigation cases that come to trial are decided by jurors
rather than judges, and jurors are more likely to find for the plaintiff than are judges
(Palmrose, 1991). Also, past research shows that jurors can handle complex and
technical legal issues (Guinther, 1988, p. 100), and jury verdicts match individual
first-ballot juror decisions at least 90 percent of the time in real criminal trials (Kalven
and Zeisel, 1966; Sandys and Dillehay, 1995). Jurors completed the case instrument and
received $10 compensation. Demographics on participants, including age, gender,
income, education levels, and political orientation are provided in Table I.

Task
Participants read a case summarizing the written transcripts of a negligence lawsuit
that a client company’s creditor (plaintiff) had filed against the auditor (defendant). The
plaintiff alleges that the auditor should have uncovered material misstatements in the
client company’s inventory brought about by management fraud and sues to recover
damages incurred due to the misstatement[9]. The defendant audit firm argues that its
 Tax services and
Consequence
Severity consequence
severity
H4 Standards
H5 (+) of Care*
(-)
57
Auditor’s Juror’s
Responsibility Damage
for Plaintiff Award**
Losses*
Audit
Quality* H3
H2 (+)
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(+)
H1
(-)
Level of
Tax
Service

Notes: H1: AQ = f(-LTS); H2: ARL = f(LTS); H3: DA = f(LTS);

H4: SC = f(CS); H5: AQ = f (-CS); where: LTS – level of tax service (three
levels: none, tax compliance, tax planning); AQ – audit quality, assessed by
jurors; ARL – audit responsibility for plaintiff losses, assessed by jurors;
DA – damage awards, assessed by jurors; SC – standards of care, assessed by jurors;
CS – consequence severity (two levels: moderate, severe)
Sources: aAdapted from Kadous’ (2000) description of the juror task model; Figure 1.
bLowe et al.’s (2002) addition to Kadous’s juror task model Model and hypotheses

auditors performed the appropriate audit procedures, meeting the appropriate

standards of professional care. The case follows the flow of a real trial, including the
plaintiff’s complaint, the auditor-defendant’s response, attorneys’ opening and closing
statements, expert witness testimonies and cross-examinations for both parties, and
the judge’s instructions to the jury.
The case is adapted from Kadous’s (2000) investigation of audit quality and
consequence severity, and Lowe et al.’s (2002) study of decision aid use and reliability
on jurors’ evaluation of auditor responsibility for audit failure. Important trial features
enhance the external validity of the instrument, including the order of information
presented and the use of attorneys, expert witnesses and cross-examinations.
An attorney familiar with this type of litigation pilot tested the adapted case for
realism and ranked it high. Sixteen undergraduate business students and 14 MBA
students also pilot tested the case and found it to be easy to understand.

Design
We use a 3 £ 2 full-factorial between-subjects design that manipulates three levels of
tax services (independent variable) across two levels of consequence severity. The
three levels of tax services the public accounting firm provides to the audit client,
predicted to have a successively diminishing effect on jurors’ assessment of audit
quality and related dependent variables, are:
 MAJ
Ratings on demographics
29,1 Age
Mean 44.2 years
SD 12.0 years
Range 20-72 years
Gender
58 Male 93
Female 74
No report 1
Income
Mean $58,414
SD $37,267
Range $0-$250,000
Education level
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Mean 14.2 years (12 – high school graduate)

SD 2.4 years
Range 9-20 years
Political orientation
Mean 6.5 (0 – very liberal; 10 – very conservative)
SD 2.2
Range 0-10
Key variables
Standards of care
Mean 7.4
SD 1.3 (0 – completely disagree (that auditors should do £ ), 10 – completely agree)
Perceived audit quality
Mean 5.0
SD 2.5 (0 – completely disagree (that auditors did £ ), 10 – completely agree)
Table I. Auditor responsibility for plaintiff’s losses
Demographics and Mean 4.8
key variables SD 2.1 (0 – not at all; 10 – to a great extent)

.
no tax services;
. tax return preparation services; and
.
marketing a potentially abusive tax shelter/aggressive tax planning strategy
(PCAOB, 2005).

The no tax services scenario serves as a control group, and we expect that jurors will
perceive the public accounting firm in this scenario to have performed the highest
quality audit.
Even the newest regulations assume tax compliance services provided by a public
accounting firm to its audit client do not adversely affect the public’s perception of
audit quality and auditor independence. However, the fees from these services
potentially create a financial bond between the auditor and client, so we predict that
jurors’ assessment of audit quality will be lower than that for the no tax service
scenario. Finally, the PCAOB’s and SEC’s rules now ban public accounting firms’
marketing of potentially abusive tax shelters (or aggressive tax planning strategies) to
their audit clients, and we predict these services will have the most detrimental effect
on jurors’ assessment of audit quality, auditor responsibility for plaintiff losses, and
damage awards against auditors. However, when this instrument was administered,
 these services had not been officially banned[10], even for public companies, and there Tax services and
was clearly no ban in 2002, the year covered by the case. consequence
In the case, an expert witness for the defendant argues that the respective tax
services were appropriately approved by the client’s audit committee, and that there severity
was separation of duties within the public accounting firm between those who
performed the audit and those who provided the tax services. These are important
safeguards that the accounting profession has implemented in its standards apart from 59
outside regulation, and there is empirical evidence that these safeguards significantly
improve the quality of the audit (Lowe et al., 1999; Brandon, 2010). These services
were also allowed services in the year of the audit failure under consideration by
the jury.

Consequence severity and jurors’ judgments

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Kadous (2000) finds that when the consequences of audit failure are moderate, jurors
consider audit quality in their judgments of auditor responsibility for audit failure, but
when consequences of audit failure are severe, jurors’ judgments against auditors
remain high, regardless of audit quality. Accordingly, we test our hypotheses across
moderate and severe consequences of audit failure to determine if our results remain
consistent using actual jurors waiting to be assigned to a trial.
Similar to Kadous’s (2000) study, we manipulate the severity of the consequences by
varying the scope of those harmed by the audit failure and by varying the percentage
of the plaintiff-creditor loss. Specifically, in the moderate-consequences scenario, only
the plaintiff-creditor was harmed by the misstated financial statements. In the
severe-consequences scenario, investors, employees, and the company were harmed in
addition to the creditor-plaintiff. Also, in the moderate-consequences scenario, the
plaintiff-creditor lost $10,000,000 when only $15,000,000 of a $25,000,000 loan was
recoverable from the audit client (a 40 percent loss of the original loan value). In the
severe-consequences scenario, the plaintiff-creditor lost 100 percent of a $10,000,000
loan. While the magnitude of the loan loss ($10,000,000) is held constant across
scenarios, the percentage of loss increases, similar to Kadous (2000).

Dependent variables
Kadous (2000, p. 339) models the juror’s task as consisting of three components:
(1) assess standards of care;
(2) assess audit quality; and
(3) compare the two to determine auditor responsibility for alleged audit failure.

Lowe et al. (2002, p. 188) add that the jurors may then use another set of criteria to
award damages. Additional factors considered include the dollar amount of plaintiff
losses, the auditor’s ability to pay, and the number of additional defendants. We use
this model to test if jurors’ judgments follow this model and determine if their final
judgments are based on the merits of the case. We test to determine if jurors’
judgments of auditor responsibility for audit failure are based on their assessments of
standards of care and audit quality (including auditor independence), or whether other
factors such as the severity of the consequences dominate their final judgments.
To assess standard of care, Kadous (2000) requires participants to assess the type of
work and the extent of work auditors should perform to exercise due care in the
 MAJ performance of the audit, and to assess the degree of professional skepticism that
29,1 auditors must maintain in the course of the audit (Appendix 1). We adapt ten standard
of care measures from Kadous’s (2000) instrument that she finds to be significant in
measuring standards of care, to solicit feedback from subjects to determine what
standards of care they believed auditors should exercise in an audit. Subjects respond
using 11 point Likert-type scales (0 – completely disagree to 10 – completely agree) for
60 each measure within the three areas (type, extent, skepticism).
To measure jurors’ assessment of audit quality (and perceived auditor independence),
we ask participants to assess the type of work, extent of work, and professional
skepticism the auditors did maintain in the audit case being litigated, measured by one
item each consistent with Lowe et al. (2002) (Appendix 2). Accordingly, the perceived
audit quality dependent variable consists of descriptive and case-specific measures,
rather than the prescriptive and general measures used for standards of care. That is, as
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measures of standards of care, we ask participants what they believe an auditor should
do in their role as auditor. As measures of perceived audit quality, we ask participants
what they believe the auditor did in the specific case. Paralleling the standard of care
measure, we include one item each measuring type of work, extent of work, and
professional skepticism.
The third dependent variable measures jurors’ beliefs about the extent to which
auditors should be held responsible for plaintiff losses that resulted from the audit
failure (Appendix 3). We combine participants’ reverse scored responses to three
questions into an overall measure of jurors’ assessment of the auditor’s responsibility
for the plaintiff’s losses. These questions are adapted from Lowe et al. (2002, p. 193),
with one question revised to focus on auditor objectivity rather than auditor
independence.
The fourth dependent variable, also adapted from Lowe et al. (2002), measures
jurors’ assessment of the damages the audit firm is responsible for to the plaintiff
(Appendix 4), ranging from “some amount of damages” to “punitive (punishment)
damages”[11]. We also include several manipulation checks to assure that participants
read the case carefully and accurately identified the facts of the case that related to the
variables of interest.

Empirical results
Validation of the juror’s task model
To test whether jurors are responding rationally, we compare jurors’ assessed standards
of care and assessed audit quality to their assessment of auditor responsibility for audit
failure (Table II). Results of our regression (adjusted R 2 ¼ 0.526) indicate that assessed
audit quality is highly significant and negative (t-value ¼ 2 11.298, p-value , 0.0001),
so that as jurors’ assessment of audit quality decreases, they are increasingly likely to
make judgments against the auditor. This strong relationship is true in both the high
(t ¼ 2 8.187, p , 0.0001) and low (t ¼ 2 7.636, p , 0.0001) consequence severity
conditions. Likewise, as jurors’ assessment of standard of care increases, they are
significantly more likely (t-value ¼ 2.714, p-value ¼ 0.0074) to make judgments against
the auditor. These findings provide strong support that the jurors in our study rationally
compare their assessments of standard of care and audit quality to evaluate the auditor’s
responsibility for an audit failure.
 Tax services and
Regression summary
ARF vs two independents consequence
Count 160 severity
Number missing 8
R 0.730
R2 0.532
Adjusted R 2 0.526 61
RMS residual 1.422
ANOVA table
ARF vs two independents
DF Sum of squares Mean square F-value p-value
Regression 2 361.102 180.551 89.313 , 0.0001
Residual 157 317.385 2.022
Total 159 678.486
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Regression coefficients
ARF vs two independents Table II.
Coefficient SE Std. coeff. t-value p-value Regression of auditor
Intercept 5.613 0.824 5.613 6.812 , 0.0001 responsibility for failure
Std. of care 0.257 0.095 0.158 2.714 0.0074 on standard of care and
Audit quality 20.541 0.048 20.659 2 11.298 , 0.0001 audit quality

Tests of H1: tax services on audit quality

H1 predicts that jurors’ assessment of audit quality will decrease when accounting
firms perform aggressive tax planning services for their audit clients, and to a lesser
extent when they provide any tax service, because of the fees associated with the
service. Using our dependent measure constructed using three questions on audit
quality (type of work, extent of work, and professional skepticism), we find that jurors’
assessment of audit quality is significantly associated with the type of tax services
provided by the public accounting firm (t ¼ 2 2.117, p ¼ 0.0358), so that assessed
audit quality decreases with the performance of NAS. Table III illustrates this
relationship.
Specifically, Fisher’s protected least significant difference (PLSD) test in Table IV
indicates that perceived audit quality differs significantly between no tax services
(mean ¼ 5.595, SD ¼ 2.415) and aggressive tax planning services (mean ¼ 4.577,
SD ¼ 2.477, p ¼ 0.0352) but not significantly for differences between no tax services
and tax compliance services (mean ¼ 4.978, SD ¼ 2.523, p ¼ 0.1924). This evidence
supports regulators’ decision to ban public accounting firms’ marketing aggressive tax
strategies but to allow firms to continue to provide tax compliance services.

Tests of H2: tax services on auditor responsibility for failure

H2 predicts that jurors’ assessment of auditor responsibility for plaintiff losses will
increase when accounting firms perform aggressive tax planning services for their
audit clients. We find no support for this hypothesis (F-value ¼ 0.036, p ¼ 0.9647,
Table V)[12]. We interpret this to mean that the audit quality effect demonstrated
above did not persist to influence jurors’ attribution of auditor responsibility for audit
failure. This is consistent with Grenier et al. (2012), who find that for students acting as
jurors, client importance, which, like NAS services, potentially threatens auditor
objectivity, does not increase auditor negligence assessments.
 MAJ
Regression summary
29,1 Audit quality vs two independents
Count 167
Number missing 1
R 0.163
R2 0.027
62 Adjusted R 2 0.015
RMS residual 2.476
ANOVA table
Audit quality vs two independents
DF Sum of squares Mean square F-value p-value
Regression 2 27.487 13.744 2.243 0.1094
Residual 164 1,005.009 6.128
Total 166 1,032.496
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Regression coefficients
Table III. Audit quality vs two independents
H1 and H5: audit Coefficient SE Std. coeff. t-value p-value
quality Regressed Intercept 5.540 0.360 5.540 15.392 , 0.0001
on consequence NAS 20.508 0.240 2 0.163 22.117 0.0358
severity and NAS Consequence severity 0.029 0.384 0.006 0.076 0.9396

ANOVA table for audit quality

DF Sum of squares Mean square F-value p-value l Power
Non-audit serv. 2 27.903 13.951 2.278 0.1058 4.555 0.445
Residual 164 1,004.594 6.126
Means table for audit quality
Effect: level of tax service
Count Mean SD SE
NO 51 5.595 2.415 0.338
TC 60 4.978 2.523 0.326
TP 56 4.577 2.477 0.331
Fisher’s PLSD for audit
quality
Effect: level of tax service
Significance level: 5 percent
p-value
NO, TC 0.1924
Table IV. NO, TP 0.0352
H1: differences in TC, TP 0.3852
audit quality across
levels of NAS Notes: NO – no tax services; TC – tax compliance services; TP – tax planning services

Tests of H3: tax services on damage awards

H3 predicts that jurors’ assessment of damage awards will increase when accounting
firms perform aggressive tax planning services for their audit clients. We use three
measures of jurors’ damage awards (what is the likelihood that you would support the
plaintiff’s call for some amount of the damages (total amount of the damages)
(punitive damages} by the auditor?), and found that only punitive damages were
significantly different across NAS. As Table VI demonstrates, punitive damages are
significantly higher for those auditors providing aggressive tax planning services than
 Tax services and
ANOVA table for ARF
DF Sum of squares Mean square F-value p-value l Power consequence
Non-audit serv. 2 0.313 0.157 0.036 0.9647 0.072 0.055 severity
Residual 162 706.019 4.358
Means table for ARF
Effect: level of tax service
Count Mean SD SE 63
NO 49 4.810 1.939 0.277
TC 60 4.722 2.047 0.264
TP 56 4.815 2.250 0.301
Fisher’s PLSD for ARF
Effect: level of tax service
Significance level: 5 percent
p-value
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NO, TC 0.8283
NO, TP 0.9884 Table V.
TC, TP 0.8103 H2: differences in auditor
responsibility for failure
Notes: NO – no tax services; TC – tax compliance services; TP – tax planning services across levels of NAS

they are for those providing no tax services (diff. ¼ 1.218, p ¼ 0.0448) or for those
providing tax compliance services (diff. ¼ 1.190, p ¼ 0.0394).

Tests of H4: consequence severity and standards of care

We also predict that jurors’ assessment of standards of care will be higher when
consequences of audit failure are severe than when consequences of audit failure are
moderate. To test for an ex post increase in standards of care associated with higher
consequence severity, we use factor analysis to combine our measures of standard of
care into three primary factors: type of work, extent of work, and professional
skepticism (Table VII). Similar to Kadous (2000), we find that three eigenvalues greater

ANOVA table for punitive damages

DF Sum of squares Mean square F-value p-value l Power
Non-audit serv. 2 53.848 26.924 2.809 0.0632 5.618 0.536
Residual 164 1,571.925 9.585
Means table for punitive damages
Effect: level of tax service
Count Mean SD SE
NO 50 3.300 2.801 0.396
TC 61 3.328 3.395 0.435
TP 56 4.518 3.003 0.401
Fisher’s PLSD for punitive
damages
Effect: level of tax service
Significance level: 5 percent
p-value
NO, TC 0.9624
NO, TP 0.0448 Table VI.
TC, TP 0.0394 H3: differences in
punitive damages across
Notes: NO – no tax services; TC – tax compliance services; TP – tax planning service levels of NAS
 MAJ
Kadousa Current study
29,1
Type-of-work items
1. Auditors should always create and perform special tests ** *
designed to discover fraud, even if the company’s owners
and managers seem to be honest
***
64 2. Auditors should always perform a complete review of the n.s.
client’s accounting system and of the controls over the
system, even if they can verify the numbers on the financial
statements without doing so
3. Auditors must examine all aspects of a company’s financial * n.s.
health in order to properly do their jobs
Extent-of-work items
4. Auditors can tell a lot about a company’s financial records n.s. n.s.
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by inspecting only a few documents if those few documents

are selected carefully (R)
5. If auditors always required only the strongest type of * n.s.
evidence, audits would be too expensive (R)
6. Auditors cannot be expected to discover small n.s. n.s.
misstatements in financial statements, because the level of
detail of their tests has to be limited (R)
Professional-skepticism items
7. Auditors should be completely independent of their clients, ** n.s.
so they should not accommodate their clients’ wishes in
designing their tests
8. Auditors should be completely objective (that is, unbiased) ** n.s.
and unaffected by their clients’ wishes
9. Auditors work for the companies whose financial *** n.s.
statements they audit, so they have to allow their clients
some latitude in what they report (R)
10. Even though auditors are hired by and paid by their clients, n.s. n.s.
their responsibility is to the public; they should try to put
the public’s interest before the client’s in designing their
audits
Notes: A higher standard of care for the severe- vs moderate-consequence condition (one-tailed test)
at: *0.10, * *0.05, and * * *0.01 levels; asource of Kadous significance ratings (Kadous, 2000, p. 334); n.s.
Table VII. – non-significance; subjects responded from 0 (completely disagree) to 10 (completely agree); (R) –
Standards of care reverse scored
survey items Source: Adapted from Kadous (2000)

than 1 emerge, suggesting factor loadings, in order of significance, representing type of

work (standard of care measures 1-3, eigenvalue ¼ 2.727), professional skepticism
(standard of care measures 7-10, eigenvalue ¼ 1.965) and extent of work (standard of
care measures 4-6, eigenvalue ¼ 1.285). However, our ANOVA results indicate that
consequence severity does not significantly influence these standard of care factors
(F-value ¼ 0.025, p-value ¼ 0.8741). In unpaired t-tests of consequence severity on
individual standard of care measures, only one measure (type of work item 1) was
marginally significant ( p-value ¼ 0.0851). This finding is surprising, because Kadous
(2000) found that the severe- vs moderate-consequences conditions significantly
affected most of the standard of care items we use in the current study. Table VII
 compares our findings to Kadous’s findings of the effects of consequence severity on Tax services and
standards of care. consequence
Tests of H5: consequence severity and audit quality severity
Similarly, we predict that jurors’ assessment of audit quality will be lower when the
consequences of audit failure are severe than when the consequences of audit failure
are moderate. Again, the ANOVA results do not support this prediction 65
(F-value ¼ 0.004, p-value ¼ 0.9484). In fact, we find no significant correlations
between consequence severity and any of the measures of jurors’ assessment of
audit quality, indicating that ex post consequence severity does not negatively impact
jurors’ assessment of audit quality in the present study. Thus, our results do not
replicate Kadous’s finding that consequence severity swamps the comparison
between standards of care and audit quality, making it impossible for jurors to view
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auditors as having performed an adequate audit when consequences are severe[13].

The post-test questionnaire asked jurors to identify the consequences of the audit
failure as a manipulation check. Jurors correctly identified the severity of outcomes
consistent with the case they read (x21 ¼ 104.13, p , 0.0001), indicating the
manipulation was effective.

Damages regressions including demographics as control variables

While the focus of this paper is on the effects of consequence severity and NAS on
jurors’ judgments, we provide three final regressions that include the three primary
independent variables in Figure 1 and control for various demographics. We do not
hypothesize demographic effects, but we expect a link between the auditor’s
responsibility for failure and the damages awarded, even in the presence of control
variables. In these regressions, the jurors’ assessment of their likelihood of awarding
damages serves as the dependent variable: some damages in Table VIII, total damages
in Table IX, and punitive damages in Table X.
As expected, the auditor’s responsibility for failure is significant in predicting some
damages (Table VIII) and total damages (Table IX); however, this is not true for
punitive damages (Table X). We include five demographics as control variables: age,
education, annual income, accounting knowledge, and political liberalism/
conservatism. None of the demographics is significant in predicting damages
awarded by jurors except for education. More educated jurors are less likely to agree to
awarding the total damages sought by the plaintiffs and to awarding punitive
damages. This implies that more educated jurors attend to arguments that limit the
accountability of auditors in the case of audit failures.

Summary and conclusions

This study investigates whether certain tax services public accounting firms provide
their audit clients affect jurors’ assessment of audit quality, and whether jurors base
their judgments and damage awards about an alleged audit failure on their
assessments of audit quality and standards of care. Consistent with the PCAOB’s
(2005) proscription of certain tax services, we find that auditors’ marketing of
aggressive tax strategies negatively impacts jurors’ assessment of audit quality.
Providing aggressive tax planning services does not impact jurors’ assessment of
auditor responsibility for plaintiff losses, but it does increase jurors’ assessment of
 MAJ
Regression summary
29,1 Some damages vs eight
independents
Count 141
Number missing 27
R 0.564
66 R2 0.318
Adjusted R 2 0.276
RMS residual 2.762
ANOVA table
Some damages vs eight independents
DF Sum of squares Mean square F-value p-value
Regression 8 468.994 58.624 7.683 , 0.0001
Residual 132 1,007.275 7.631
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Total 140 1,476.270

Regression coefficients
Some damages vs eight independents
Coefficient SE Std. coeff. t-value p-value
Intercept 3.898 2.474 3.898 1.576 0.1175
ARF 0.331 0.170 0.215 1.944 0.0540
Standard of care 0.382 0.202 0.150 1.888 0.0612
Audit quality 20.335 0.136 20.262 22.459 0.0152
Age 0.017 0.021 0.064 0.827 0.4099
Education 20.073 0.090 20.062 20.806 0.4215
Annual income 20.001 0.007 20.015 20.194 0.8464
Table VIII. Acct knowledge 0.023 0.109 0.016 0.211 0.8331
Overall regression for Politically lib cons 20.114 0.117 20.076 20.976 0.3309
some damages with
control variables Note: ARF – auditor responsibility for failure

punitive damages. However, normal compensatory damages are not significantly

reduced by banning auditors from providing aggressive tax planning services to their
audit clients.
We also find that jurors’ judgments against the auditor depend on their assessments
of standards of care and audit quality. Specifically, as jurors’ assessment of standards
of care increases, jurors are more likely to hold auditors responsible for alleged audit
failures. As audit quality increases, jurors are less likely to hold auditors responsible.
Moreover, results indicate that jurors’ compensatory damage awards depend on their
assessment of auditor responsibility for audit failure.
Interestingly, we find that jurors’ assessments of standards of care and audit quality
do not depend on ex post consequences of the audit failure. These results are consistent
with Schwartz’s (1997) model holding that an increase in audit quality can reduce the
auditor’s legal liability, but differ from Kadous’s (2000) finding that standards of care
depend on ex post consequence severity. However, as described above, we do find a
consequence severity effect in the provision of aggressive tax planning services. This
result is important, because in order for auditors to forego revenues to achieve a high
quality audit, there should be an incentive (i.e. reduction in auditor responsibility and
damages assessed) associated with that cost.
This study is subject to the limitations common to research of this nature. Though
our study is enriched by the use of actual jurors instead of surrogates, they are the
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Regression summary
Total damages vs eight independents
Count 141
Number missing 27
R 0.505
R2 0.255
2
Adjusted R 0.209
RMS residual 2.736
ANOVA table
Total damages vs eight independents
DF Sum of squares Mean square F-value p-value
Regression 8 337.391 42.174 5.635 , 0.0001
Residual 132 987.900 7.484
Total 140 1,325.291
Regression coefficients
Total damages vs eight independents
Coefficient SE Std. coeff. t-value p-value
Intercept 4.969 2.450 4.969 2.028 0.0446
ARF 0.380 0.169 0.260 2.251 0.0260
Standard of care 2 0.013 0.200 20.005 2 0.063 0.9496
Audit quality 2 0.274 0.135 20.227 2 2.034 0.0439
Age 0.023 0.021 0.089 1.111 0.2687
Education 2 0.188 0.089 20.168 2 2.103 0.0374
Annual income 2.157 £ 102 4 0.007 0.003 0.032 0.9744
Acct knowledge 0.099 0.107 0.071 0.924 0.3572
Politically lib cons 2 0.037 0.116 20.026 2 0.322 0.7476
Note: ARF – auditor responsibility for failure
consequence
severity

control variables
Table IX.
Tax services and

total damages with

Overall regression for
67
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68
29,1
MAJ

Table X.

control variables
Overall regression for
punitive damages with
Regression summary
Punitive damages vs eight independents
Count 141
Number missing 27
R 0.479
R2 0.229
Adjusted R 2 0.182
RMS residual 2.738
ANOVA table
Punitive damages vs eight independents
DF Sum of squares Mean square F-value p-value
Regression 8 239.880 36.735 4.901 , 0.0001
Residual 132 989.354 7.495
Total 140 1,283.234
Regression coefficients
Punitive damages vs eight independents
Coefficient SE Std. Coeff. t-value p-value
Intercept 7.908 2.452 7.908 3.225 0.0016
ARF 0.198 0.169 0.138 1.175 0.2421
Standard of care 0.098 0.201 0.041 0.487 0.6271
Audit quality 20.310 0.135 20.260 2 2.297 0.0232
Age 20.013 0.021 20.053 2 0.645 0.5198
Education 20.224 0.089 20.204 2 2.514 0.0132
Annual income 20.002 0.007 20.028 2 0.332 0.7404
Acct knowledge 0.051 0.108 0.037 0.473 0.6372
Politically lib cons 20.129 0.116 20.093 2 1.115 0.2670
Note: ARF – auditor responsibility for failure
 jurors for one court in one US state. And though our adapted case is strongly tied to Tax services and
prior research, it omits details of a realistic court setting, simply because it is a written consequence
transcript and not a courtroom experience.
Perceived audit quality in this study is manipulated by a change in the level of tax severity
services consistent with recent PCAOB tax rules, and it sheds light on the implications
of those rules. Future research could examine the impact of these rules on jurors’
judgments now that the rules have been in place for several years to see if the ban 69
has subsequently influenced jurors’ responses to auditors. For example, these services
are not banned for auditors of private companies. It would be interesting to see if
jurors’ responses to a case involving a private company would be similar to our
findings here.
Future research could also extend this study by manipulating audit quality through
other factors associated with auditor independence, including audit committee
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independence, auditor rotation, and mandatory cooling off periods for auditors who go
to work for their clients. Future research is also needed to understand the differences in
jurors’ responses to ex post consequence severity between our study and Kadous’s
(2000) study. Finally, research is needed to better understand the factors that influence
jurors’ damage awards, especially with respect to differences between compensatory
and punitive damages.

Notes
1. The PCAOB defines aggressive tax positions as “those that are initially recommended,
directly or indirectly, by the auditor and a significant purpose of which is tax avoidance,
unless the proposed tax treatment is at least more likely than not to be allowable under the
applicable tax laws” (SEC, 2006, p. 4).
2. The PCAOB also banned CPA firms from providing any service or product to an audit client
for a contingent fee or commission, or providing any tax service to certain persons employed
by an audit client.
3. The PCAOB’s rules require firms to provide certain information to audit committees in
connection with seeking pre-approval to provide non-prohibited tax services.
4. Kadous (2000, p. 327) states, “audit failure occurs when an auditor issues an unqualified
opinion on financial statements that are subsequently found to have been materially
misstated”. Note that this definition is similar to the textbook definition of audit failure used
in our study, but it omits the causal attribution on the part of the auditor (i.e. the failure to
comply with GAAS component). In Kadous’ definition, the audit is a failure if it fails to give
the appropriate opinion. In the Arens et al. definition, the audit is a failure if it fails to give the
appropriate opinion due to a lack of performance on the part of the auditor. While our
definition technically includes both types I and II errors, our case only tests for a type II error
because the auditor issues an unqualified opinion.
5. Previts (1985) notes that the use of the term “independent in fact” has differed between
regulators and the accounting profession. The SEC’s historical use of the term generally
meant that there were no financial, familial, or friendly ties between the auditor and client,
whereas the profession generally used the same term to mean that the auditor had not, in
fact, subordinated his or her judgment to the auditee. The SEC’s focus was on observability,
whereas the profession’s focus was on actuality. The AICPA’s “Conceptual Framework for
AICPA Independence Standards”, in ET Section 100-1 defines independence as
independence of mind (“the state of mind that permits the performance of an attest
service without being affected by influences that compromise professional judgment,
 MAJ thereby allowing an individual to act with integrity and exercise objectivity and professional
skepticism”) (AICPA, 2012, ET 100.06) and independence in appearance (“the avoidance of
29,1 circumstances that would cause a reasonable and informed third party, having knowledge of
all relevant information, including safeguards applied, to reasonably conclude that the
integrity, objectivity, or professional skepticism of a firm or a member of the attest
engagement team had been compromised”) (AICPA, 2012, ET 100.06). The authors note that
in this definition, independence in mind reflects the profession’s independence “in fact”
70 stance. Use of the new terminology “independence in mind” may prove useful in separating
the AICPA’s and the SEC’s disparate use of the term “independence in fact”.
6. In an exception to this general finding, Lavin (1976) find CPAs perceive more independence
problems more frequently (in seven of 12 scenarios) than users (loan officers and financial
analysts).
7. The SEC’s (2000a) Proposed Rule on auditor independence lists four principles for
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determining whether a certain NAS might impair independence. “Rule 2-01(b) sets forth the
general standard of auditor independence. [. . .] in considering this standard, the commission
looks in the first instance to whether a relationship or the provision of a service: (a) creates a
mutual or conflicting interest between the accountant and the audit client; (b) places the
accountant in the position of auditing his or her own work; (c) results in the accountant
acting as management or an employee of the audit client; or (d) places the accountant in a
position of being an advocate for the audit client”.
8. See Hawkins and Hastie (1990) for a review of outcome effects literature.
9. Palmrose (1987) found management fraud to be present in nearly 50 percent of lawsuits
against auditors.
10. Our data were gathered in late June 2005. The PCAOB proposed rules banning aggressive
tax planning services on 26 July 2005. Technical amendments were adopted by the PCAOB
on 22 November 2005 and submitted to the SEC the next day, and the proposed rules were
published in the federal register on 7 March 2006. The rules were approved by the SEC on 19
April 2006 and took effect on 18 June 2006, about a year after our data gathering.
11. We included another item in our instrument asking whether the auditor should reimburse
the plaintiff in order to be consistent with Lowe et al. (2002), but we did not derive
incremental information from the item, since the question is effectively answered by the
three damages questions. We added the punitive damages question to the “some” and “total”
damages questions from Lowe et al. (2002).
12. Though there is no direct relationship, there is evidence of perceived audit quality serving as
a mediating variable between level of tax service and the auditor’s responsibility for plaintiff
losses. In other words, the impact of the level of tax service on perceived audit quality
explains the relationship between level of tax service and auditor’s responsibility for plaintiff
losses. Similar analyses do not support the same type of relationship among level of tax
service, perceived audit quality, and the three damages measures. We thank a reviewer for
suggesting this additional analysis.
13. However, when consequences are severe, the standard of care is higher ( p ¼ 0.0301) for
auditors providing aggressive tax planning services than for those providing no tax services.

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Appendix 1. Standards of care survey

(1) Auditors should always create and perform special tests designed to discover fraud, even
if the company’s owners and managers seem to be honest.
(2) Auditors should always perform a complete review of the client’s accounting system and
of the controls over the system, even if they can verify the numbers on the financial
statements without doing so.
(3) Auditors must examine all aspects of a company’s financial health in order to properly
do their jobs.
(4) Auditors can tell a lot about a company’s financial records by inspecting only a few
documents if those few documents are selected carefully (R).
 MAJ (5) If auditors always required only the strongest type of evidence, audits would be too
expensive (R).
29,1 (6) Auditors cannot be expected to discover small misstatements in financial statements,
because the level of detail of their tests has to be limited (R).
(7) Auditors should be completely independent of their clients, so they should not
accommodate their clients’ wishes in designing their tests.
74 (8) Auditors should be completely objective (that is, unbiased) and unaffected by their
clients’ wishes.
(9) Auditors work for the companies whose financial statements they audit, so they have to
allow their clients some latitude in what they report (R).
(10) Even though auditors are hired by and paid by their clients, their responsibility is to the
public; they should try to put the public’s interest before the client’s in designing their audits.
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Completely disagree 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 completely agree.
Source: Kadous (2000, p. 334).
(R) – reverse scored item.

Appendix 2. Audit quality survey

(1) Smith and Adams, CPAs gathered all the evidence they were required to get before they
drew any conclusions about Western’s financial statements.
Completely disagree 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 completely agree.
(2) The number of inventory sites that Smith and Adams, CPAs inspected was reasonable,
since auditors cannot and do not need to observe every inventory site.
Completely disagree 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 completely agree.
(3) The auditors of Smith and Adams, CPA firm were independent from Western’s
management in making their audit decisions.
Completely disagree 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 completely agree.

Appendix 3. Auditor responsibility for failure

(1) Do you feel that the audit firm Smith and Adams, CPAs made the right decision in
concluding that fraud was not present and that there was no need to perform additional
procedures?
Not at all 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 to a great extent.
(2) How objective (that is, unbiased) did you perceive audit firm Smith and Adams, CPAs to
be in performing its duties in the 2002 audit of Western Rock and Gravel, Inc.?
Very unobjective 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 very objective.
(3) To what extent do you believe that the plaintiff ( Johnson, Ltd) must assume normal
investment risks when loaning Western money, and therefore Johnson, Ltd is largely
responsible for their own loss?
Not at all responsible 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 responsible to a
great extent.

Appendix 4. Assessment of damages

(1) What is the likelihood that you would support the plaintiff’s ( Johnson, Ltd) call for some
amount of damages by the auditor?
Very unlikely 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 very likely.
 (2) What is the likelihood that you would support the plaintiff’s ( Johnson, Ltd) call for the Tax services and
total amount of damages by the auditor?
Very unlikely 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 very likely.
consequence
(3) What is the likelihood that you would support the plaintiff’s ( Johnson, Ltd) call for
severity
punitive (punishment) damages by the auditor (that is, damages above and beyond the
plaintiff’s loss)?
Very unlikely 0. . .1. . .2. . .3. . .4. . .5. . .6. . .7. . .8. . .9. . .10 very likely. 75
About the authors
John M. Thornton is Leung Chair of Accounting Ethics and Professor of accounting at
Azusa Pacific University.
Michael K. Shaub is Clinical Professor of accounting at Texas A&M University.
Michael K. Shaub is the corresponding author and can be contacted at: mshaub@mays.tamu.edu
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