Applying the General Partnership Contract:A Theoretical Explanation Challenging the

Concept of Independence

By

Khalid Al-Adeem

Presented at the AAA, Ohio Regional Meeting

Columbus, Ohio

Saturday 5/12/2007

Summary of the Argument• To be independent is a synonym to be perfect, and no person is

perfect.

• Rather describing the relationship between managers and the auditor as “a general partnership contract” provides an explanation to understand the behavior of the auditors.

• The application of “general partnership contract” offers an answer to why auditors lack independence, a concept that is never achieved.

• This paper supports such a claim by using the argument against the recent attempt represented by Sarbanes-Oxley Act to increase independence and by stating the problems that the act has brought to the client-auditor relationship.

The Notion of the “General Partnership Contract”

• A general partnership is a form of organizing efforts to achieve certain objectives and accomplish specific tasks.

• Bagley stresses, “A general partnership can be created with nothing more than a handshake” (2002, p.756).

• Not having a written contract does not mean there is no partnership (Mann and Roberts, 2000).

The Notion of the “General Partnership Contract”

• The law might consider individuals as partners, disregarding the way they characterize themselves, “if two or more individuals share the control and profits of business” (Mann and Roberts, 2000, p.619).

• A person would be a partner in a general partnership even if he did not intend it, as long as he is involved in carrying “on as business co-owner for profit” (Bagley, 2002, p.749).

Some Examples of What Others Have Said about the Phenomenon

• “As time passes the client and the [audit] firm are increasingly identified with one another in the public eye” (Cottell and Perlin,1990, p.34).

• Price of the services does not create dispute between the audit firm and the company as long as the services are demanded “once the two firms work together as partners in value added agenda” (Fogarty, 2002, p.33).

• “Now, in the eyes of many, ‘CPA’ is synonymous with ‘CEO’, and ‘CEO’ does not stand for anything good” (Cheney, 2002, p.30)

A Coalition between Managers and Auditors

• Kleinman and Palmon (2001) observe:

The agency model permits “coalitions” between any two of the three parties: owners i.e., shareholders, managers and auditors, in ways that may be unfavorable to the third.

• Accordingly, managers and auditors can create a coalition that is unfavorable to the shareholders (the owners).

Visualizing the Proposed Coalition

Managers

Auditors

Mutualbenefits

Giving the image thateverything is as it ought

to beShareholders

Figure (1): The Coalition between Managers and Auditors

Figure 2 will Explore this Box

Modeling the Proposed Coalition

Managers Auditors

Personal Ties

1- Trust.2- Each party views theother party as important.

Outcomes (Products)

1- Getting unqualifiedopinions.2- Reselecting theauditor.3- Enough fees thatwould please auditors.

Responsibilities

Sharing legal liabilities.

Figure (2): The Implementation of the Partnership ContractExploring the Box in figure 1

I. The contract is implicitly agreed upon• Managers do not establish explicit relationships with

their auditors unless they are confident enough that auditors would not default.

• Levinthal and Fichman (1988, p.366) stress that

“initiating a relationship” points toward some “optimism” about the “validity” of the auditor/client relationship.

• Levinthal and Fichman (1988, p.366) further describe this “initiated relationship” as an asset, and they believe that the existence of this asset would guard the relationship from “unfavorable outcomes.”

II. Benefits from the partnership

• The management wants to obtain the “external certification” in the form of an unqualified opinion from the current auditor who would save the management substantial cost, most importantly by avoiding any market reaction should a switch occur (Neu et al., 1991; Gibbin et al. 2001).

• The auditor wants to be reselected, to perform the non audit services (prior to Sarbanes-Oxley Act) and to have the managers refer their colleagues to him (Neu et al. 1991; Gibbin et al. 2001; Investor Business Relation 2002).

• The relationship becomes symbiotic in that each party takes and receives mutual benefits.

III. The agreed upon subject and duties

• The main goal of this partnership is to push the corporation forward and to continue the existence of it.

• The wealth of the corporation provides the main source to fund and finance the coalition.

• The loyalty is given to this partnership at the expense of the shareholders.

IV. How the contract is enforced• The parties perform their duties having faith that the

other party would do its part in this partnership, since it is a contract based on trust.

• Trust is a condition of developing the relations between

managers and the auditor (Levinthal and Fichman, 1988), and hence it is the condition that must exist prior to organizing the partnership--no trust, no partnership.

• While discussing the partnership contract, Mann and Roberts make it clear that “A fiduciary relationship exits…Based on high standards of trust and confidence they [partners] place on one another…Each partner owes…Loyalty to his partners” (2000, p.645).

V. Unlimited legal liability• The law holds the managers (particularly the

CEOs) legally liable for their actions if it is ever proven that actions and the decisions were made and taken with bad faith and not in the best interest of the shareholders.

• The law allows the shareholders to file a lawsuit against the auditors who issued clean opinions knowing well that the corporations were facing difficulties, since shareholders may have made decisions to buy stocks in the corporation based upon the auditor’s opinion.

Independence, But to What Extent!

• Impartiality is “probably impossible to attain” (Kleinman and Palmon, 2001, p.9).

• Auditors are the “only professionals who act independently from the client but depend financially on the client” (Xu and Wang, 2004, p.14).

Is Independence A Real Possibility? • “Auditing, unfortunately, does not have any

‘built-in’ characteristics that assure the skeptic of its integrity and independence” (Mauts and Sharaf,1982, p.210).

• “Auditor independence may be psychologically unrealistic because auditors’ self-serving bias typically enters unconsciously and unintentionally at the stage of making judgments” (Bazeman et al 1997 as cited in Xu and Wang, 2004, p.15).

Problems Associated with SOX’s Attempt to Increase Independence

• Auditors are “social animals and therefore depend heavily upon the information and social influences of others, including client and other audit firm personnel” (Kleinman and Palmon, 2001, p.10).

• Rotating the partner in charge every five years brings up two issues:

1. The new partner will be under the mercy of the auditors in the engagement that would increase the power of the lower participants.

2. The new partner will rely on the client to understand the client’s business, which will increase the power of managers who are already more powerful.

Problems Associated with SOX’s Attempt to Increase Independence

• Making CEOs and CFOs officially responsible about the financial statements increases the jointness that already exits.

• Now CEOs, CFOs and auditors are tied together.

• Providing MAS used to give auditors an

opportunity to understand the clients’ businesses, e.g. new financial instruments (derivatives) (GAO, July 2003, p.13).

A Possible Correlation between Public Companies and Audit Firms

• Forming multinational corporations has called for multinational audit firms that are able to meet the needs, of such giant corporations.

• Barriers for small firms to enter the audit market (GAO, July 2003, p.6 and p.45):

1. The lack of staff resources and expertise. 2. Their inability to raise capital to expand their operations.3. The inability to bear the insurance cost. 4. The public’s perception of the reputation of Big 4.

• GAO (July 2003, p.45) states, “Because the audit market has become more concentrated, the Big 4 have been increasing their focus on gaining contracts of larger public companies.”

Conclusion• Auditing has not yet been a successful profession due to the

impossibility of implementing independence, the core ideal that the profession takes as its “truth.”

• The auditors in the engagements that failed had failed to be

independent and accordingly could not act professionally in a responsible way.

• Therefore, a possible view is to treat the auditors as partners to managers.

• This new view is supported by what the market has experienced in example like Enron and Arthur Andersen: that some audit firms disappeared when some, or even one, of their clients collapsed for committing unethical actions.

• In the eye of Noland, “one audit failure is too many” (2003, p.5).

It Is Up to Your Judgment • If the idea of “the general partnership contract” were

considered an interesting theory, it would be a great payoff for the researcher.

• According to Davis (1971, p.309), “A theorist is considered

great, not because his theories are true, but because they are interesting.”

• Davis (1971) believes that “…All interesting social

theories….constitute an attack on the taken-for-granted world for the audience” (p.311).

• Independence is an old belief that accounting scholars have argued the necessity of for decades.

• I believe that the idea of the “general partnership contract” represents a new paradigm that has emerged because of the failure of the old paradigm (independence).

Acknowledgments• Dr. Fogarty, for the knowledge, guidance,

encouragements, support and many other things I have learned from him.

• Dr. Parker, for allowing me to talk about ethics in his class.

• Dr. Grant, for her valuable comment that has reshaped the presentation of this paper.

• Reed Roig, for supplying me with a related book that I used in this paper.

• Meredith Myers, for her valuable comments, encouragements and editing the paper and slides.

• The Government of Saudi Arabia for providing a scholarship through King Saud University.

• My Wife, for her patience, support and the sacrifices she has been making for her family.