THE EFFECT OF PARTNER COMPENSATION SCHEMES AND GENERALLY ACCEPTED ACCOUNTING PRINCIPLES ON AUDIT PARTNER JUDGMENT

This paper examines the impact of audit partner compensation schemes a nd GAAP on audit judgments involving auditor-client conflict. These fa ctors are important because of their potential impact on auditor objec tivity. For example, objectivity may be compromised if a partner's com pensation is closely tied to client retention. Alternatively, objectiv ity may be enhanced by GAAP which limits the acceptable range of audit or's judgments, thereby increasing consensus within the profession and reducing the credibility of clients' threats to switch auditors. Fift y-four audit partners participated in a study by completing hypothetic al audit cases designed to allow varying ranges of acceptable accounti ng alternatives (e.g., (1) a restrictive case in which the client want ed to report higher values for marketable securities in direct violati on of GAAP, vs. (2) a less restrictive case in which the client wanted to report a relatively small bad debt expense). For analysis purposes , respondents were categorized by the extent to which their firm empha sized local office profitability in determining partner compensation. This categorization scheme was derived from a preliminary investigatio n in which partners from six large public accounting firms identified important factors in determining partner compensation. This investigat ion revealed that the degree to which firms emphasized local office pe rformance in determining individual partner compensation was a discrim inating feature of compensation schemes. The validity of this categori zation was corroborated later by respondents' answers to a compensatio n questionnaire. Findings indicate that: (1) partners with compensatio n more closely tied to client retention were less likely to require do wnward adjustments to income, suggesting that the design of audit part ner compensation schemes may have an effect on auditor objectivity and (2) more specific GAAP increased the likelihood that partners would r equire downward adjustments to income, suggesting that GAAP may limit the client's ability to influence the auditors judgment. Results also suggest that internal monitoring mechanisms related to second partner reviews may vary systematically across firms. Thus, while differences in compensation schemes may affect auditor objectivity, between-firm d ifferences in internal monitoring may moderate these differences.