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The harsh criticism of the audit profession, which followed in the wake of the Enron collapse, had a major impact on regulators’ activities worldwide. One result of the Enron debacle was that regulators started to address auditor independence issues as never before, claiming auditors’ independence was impaired for the following reasons:

The purpose of this chapter is to lay the economical and theoretical explanations for auditor independence risk. Therefore, in section A I first defines the relevant terms related to this research and in section I then explain the economical changes which lead to auditor independence risk issues. In section I extend the theoretical framework by explaining the identified threats to auditor independence and the safeguards created to reduce threats.

Based on the suggestions of Mock et al. (2005), in this section I will synthesize and evaluate prior research on auditor independence by categorizing research with respect to the type of threat analyzed: incentive, opportunity or compromised integrity. This will also allow me to give an overview of previously investigated safeguards with respect to relevant threats. Section reviews the research on auditor independence with respect to incentives. Sections and D examine research on the effects of opportunities and integrity, respectively. In section E I discuss the problems inherent in integrating this body of research. I then conclude by identifying my main research questions.

The need for financial regulation is often justified by the potential for market failure that can result when managers’ posses inside information while investors do not, called “information asymmetry,” as well as from inappropriate behavior of auditors, called “moral hazard.” New laws that attempt to address these issues in the United States (Sarbanes-Oxley Act 2002) and in the European Union (Proposal for a 8 Directive of the European Commission 2004a) indicate that the predominant view among legislators is that we need more regulation, more severe penalties, and larger enforcement budgets to protect financial markets from fraud.

Task complexity can be defined as the amount of cognitive processing a task requires (Bonner 1994: 215) and thus has a major impact on decisions (Libby 1985: 664). Although characteristics of task complexity may seem minor, such as wording of instructions, the effects of these characteristics on decision making can be huge (Libby 1985). In the field of accounting, one area where task complexity is relevant is in decisions of how to apply auditor independence regulations. As such, task complexity deserves additional attention.

The purpose of this chapter is to study regulation approach as it affects the safeguarding quality of auditor independence regulation. Related to the model of auditor independence risk, this research will provide further information on whether the regulation approach itself may lead to its own risk of impairing auditor independence in fact instead of maintaining auditor independence as intended.

In this chapter I deduce consequences for European Union Regulation setting. Section A compares national requirements of Germany, France and the United Kingdom to investigate whether national regulation approaches and requirements differ significantly from what is being proposed by the European Union. This is, whether Member States use a rules- or principles-based national regulation approach and whether regulation differs in terms of the requirements’ content. I found differences in national regulation approaches and requirements, which may lead to audits of different quality throughout the European Union and therefore to differences in the risk of impaired auditor independence. I then describe possible effects of impaired auditor independence on the European capital market. Since one mechanisms to align information asymmetries concerning audits and thereby decreasing deficiencies in capital markets is greater transparency, the influence of transparency on impaired auditor independence risk as studied in a third experiment is presented in section B.

This research studied the effect of regulation approach on decisions that require applying the regulation. Subjects in the first and second experiment were asked to make a decision as to whether an audit firm should perform additional non-audit services for a financial statement audit client. Subjects’ decisions were compared to what was argued to be the regulations intended outcome and were interpreted as complying, as under-complying or as over-complying. Over-compliance can be inefficient, since an unintended prohibition of providing a certain service leads to unnecessary switching costs and perhaps lower quality services, because the prohibited service needs to be outsourced to a different provider. However, if a regulation is under-complied with, it does not provide an appropriate safeguard to auditor independence and therefore the risk of impaired auditor independence may be higher.