Second-Partner Review: An Experimental Economics Investigation

Key Words: Second-partner review, Experimental economics, Game theory, Reporting, Sampling. Data Availability: Data used in this study are available from Robert R. Tucker upon request. In an effort to self-regulate, the accounting profession and its member firms have undergone structural changes and instituted mechanisms and procedures to insure audit quality and auditor independence. One such quality control technique--second-partner review (SPR)--is the focus of this study. Many firms instituted second-partner reviews over a decade before it was mandated by the SEC Practice Section in 1977; however, the nature and scope of the review varied considerably from firm to firm. As the nature of the review evolved with regulation, so too has its importance. Unlike peer reviews, which occur after the fact and involve only a sample of clients, SPR may represent a firm's last defense in preventing an audit failure. This preventative feature and the rising cost of litigation have refocused interest in this review and rekindled the controversy over its purpose and proper implementation. This investigation does not attempt to model typical audit behavior; rather, it models auditors who are economically rational and work only in their self interest. When economically advantageous, such partners will succumb to client pressure, ignore their professional duty, and embroil their fellow partners in financially devastating lawsuits (Wall Street Journal 1987). Though infrequent, litigation and media coverage of such unprofessional behavior can have devastating consequences to an audit firm and profound ramifications for the accounting profession, and thus such behavior warrants investigation. For example, the ESM Securities, Inc. case involves a biased engagement partner and an inadequate second-partner review (Knapp 1996, 15-28; Maggin 1989, 215; CCH 1987, AERR 118). Their actions led to a class action lawsuit that sought a damage award of one billion dollars from the firm. SPRs on all audits of publicly listed companies have been required since 1977. In 1985, the SEC Practice Section's revised standard clarified the qualifications of the reviewer, the scope and extent of the review, and the documentation to result from the review. The Treadway Commission (1987) reported considerable variance in the practice of SPR, and recommended that the SEC Practice Section further clarify the qualifications and scope requirements (Krogstad 1986). Few academic or professional articles exist on SPR. A behavioral study by Johnson et al. (1989) investigates the different lines of reasoning audit partners follow in arriving at a judgment. Luehlfing et al. (1995) obtain empirical evidence that interfirm differences are more important than risk factors in describing the extent of the SPR in practice. Myers and Davidson (1995) investigate the effect of second-partner reviews using a case method. Professional articles include Krogstad's (1986) staff summaries for the Treadway Commission, Mautz and Matusiak's (1988) discussion on the current practice of SPR and proposed changes intended to strengthen the review, and Lathan's (1987) survey of firms' review policies and procedures. The analytical model of Matsumura and Tucker (1995) provides an economic rationale for the value of second-partner reviews. The model examines the review's role in promoting accurate, unbiased decisions by an engagement partner who possesses imperfect information and is subject to economic pressures to bias judgment. The task modeled involves an engagement partner who decides how much costly information to acquire and what opinion to express, and a second partner who must also express an opinion. Based on the model of Matsumura and Tucker (1995), this paper uses experimental economic methods to test the effects of second-partner reviews and the availability of sampling information on the competence and independence reflected in the engagement partner's audit reports. …