Auditor–Client Interactions in the Changed UK Regulatory Environment – A Revised Grounded Theory Model

• Published date: 01 March 2015
• DOI: http://doi.org/10.1111/ijau.12031
• Author: Tony Hines,Stella Fearnley,Vivien Beattie
• Date: 01 March 2015

Auditor–Client Interactions in the Changed UK Regulatory Environment –

A Revised Grounded Theory Model

Vivien Beattie,1Stella Fearnley2and Tony Hines3

1Lancaster University Management School,Lancaster University

2Bournemouth University

3University of Portsmouth

Audit and financial reporting quality are under intense scrutiny nationallyand globally. The outcome of high-level

auditor-auditee discussion and negotiation issues (auditor–client interactions) is central to this debate. Beattieet al.

developed a grounded theory model of these interactions in the 1997 UK setting. This paper reports on a field

study of 45 interactions in nine case companies in the radically changed post-SOX regulatory environment.

Crucially, interviewees in each case company extend the chief financial officer–audit partner dyad to include the

audit committee chair. Fundamental revisions to the model emerge. The strongest influence on interactions has

become the national enforcement regime, overlaid upon the international standard-setting regime. The outcome in

both the eyes of the participants and in our evaluation is full compliance (contrary to the findings from the 1997

setting), regardless of the perceived quality of the standards and the integrity of the outcome. Personal and

company characteristics, which were of most importance in 1997, have become peripheral. The audit committee

chair is shown to fulfil a gatekeeping role in relation to the full audit committee.

Key words: Auditor–client interaction, audit committee, audit committee chair, discussion, enforcement, financial

reporting quality, IFRS, ISAs, negotiation.

INTRODUCTION

The global financial crisis has served to heighten concern

regarding the performance of auditors and the quality of

financial reporting generally(e.g., European Commission,

2011; House of Lords, 2011, 2012). One key issue being

debated is the need to establish a principles-based

disclosure framework (EFRAG/ANC/FRC, 2012; IASB,

2013a; IIRC, 2013) to eliminate irrelevant disclosures and

better organise disclosure. Another key debate concerns

measures to enhance audit quality, including further

extending the role of the audit committee (Competition

Commission, 2013). Additionally, the inherent quality of

InternationalFinancial Reporting Standards (IFRS) as a set

of accounting standardsis now being questioned in public

discourse surrounding the banking crisis (Beattie,

Fearnley & Hines, 2008a; House of Lords/House of

Commons, 2013). (To aid the reader, a full list of

abbreviations used in the paperis provided in Appendix 1

and key terms are defined in Appendix 2.)

Behavioural models of auditor–client interactions,1

covering antecedents and consequences, have been

developed and tested using both inductive and deductive

approaches using a range of experimental, questionnaire

and interview methods in several settings (principallythe

US, Canada and the UK). For a recent review focusing on

deductive approaches, see Salterio (2012).2The seminal

qualitative study by Beattie, Fearnley and Brandt (2001)

(hereafter BFB) was reported in a research book titled

Behind Closed Doors: What Company Audit is Really About.3

A grounded theory model of the negotiation process was

developed and findings were summarised in a paper

in the International Journal of Auditing (Beattie, Fearnley

& Brandt, 2004). This study contributed towards

establishing audit negotiation and interaction as a clearly

identifiable research area (Salterio, 2012, p. 235).

In the decade following the collection of data for the

original study, several radical changes occurred in the UK

accounting, audit and governance environment. First, the

mandatory adoption of IFRS for the group accounts of

all EU listed companies from 2005 resulted in a more

technically complex accounting regime for listed

companies. Second, the Auditing Practices Board (APB)

was given responsibility for setting ethical standards for

auditors and adopted International Standards on

Auditing (ISAs) amended for use in the UK (APB, 2004a)

for 2005 year-ends. These are based on ISAs set by the

International Auditing and Assurance Standards Board

(IAASB) and include ISA 260 (APB, 2004b), which

requires the auditor to engage with the client’s audit

committee on audit and accounting related matters.

Third, changes to the UK Corporate Governance Code

(previously known as the Combined Code for Corporate

Governance)4required audit committees to engage with

the audit and financial reporting process in a more

formalised way. Under the comply or explain regime, if

this requirement was not complied with, the company

had to offer an explanation. Finally, in terms of

enforcement, the Financial Reporting Review Panel

(FRRP),5the UK’s financial reporting enforcement body,

was given a new proactive remit, and a new body, the

Audit Inspection Unit (AIU), was set up under the aegis

of an expanded and reformed Financial Reporting

Council (FRC), to inspect public interest audits and issue

public reports on their findings.6In summary, key

changes likely to influence financial reporting and audit

quality since Behind Closed Doors was published were

the move to a more rules-based and complex set of

accounting standards (relative to UK GAAP), the

enhanced engagement of the company’s auditcommittee

and stronger monitoring of both audit qualityand overall

financial reporting quality.

Correspondence to: Vivien Beattie, Lancaster University Management

School, Lancaster University, Lancaster LA1 4YX, UK. Email:

v.beattie@lancaster.ac.uk

International Journal of Auditing doi:10.1111/ijau.12031

Int. J. Audit. 19: 15–36 (2015)

© 2014 John Wiley & Sons Ltd ISSN 1090-6738

The impact of these changes on the behaviour of

preparers and auditors was investigated in a follow-up

field study by Beattie, Fearnley and Hines (2011). The

parties interviewed included, for the first time, the audit

committee chair (ACC) along with the audit engagement

partner (AP) and the chief financial officer (CFO). This

study therefore responded to Nelson and Tan’s(2005) call

for research that recognises that practice has changed ‘to

involve auditcommittees and various forms of regulatory

oversight to a greater extent’. The research question is

unchanged from the original field study and can be stated

as follows: How do companies and their auditors resolve

important financial reporting issues?

Matched interviews were conducted with the CFOs,

APs and ACCs of nine major UK listed companies who

had recently engaged in significant discussions and

negotiations. Interviewees were asked to ‘tell the story’ of

these interactions. The analytical procedures followed

enable concepts to be identified and grouped into

categories. Theinteraction itself is the core category of the

grounded theory analysis.It is a process involving events,

strategies, outcome and consequences. The findings were

published in a book titled Reaching Key Financial Reporting

Decisions: How UK Directors and Auditors Interact (Beattie,

Fearnley & Hines, 2011) (hereafter BFH). The purpose of

the present paper is to summarise the findings of that

study, thereby making it accessible through the scholarly

journal literature. Developments in the scholarly and

professional literatures that emerged subsequent to the

book’s publication are incorporated in the paper and

subsequent events and regulatory debates are discussed.

It is shown that the process for reaching agreement on

financial reporting outcomes has changed fundamentally

under the revised UK regulatory framework, requiring

substantial revision to the original grounded theory

model. Our findings indicate that regulatory changes,

especially the more stringent enforcement of both audit

and accounting standards which is a feature of the UK

context, have had a profound impact on the quality of

interaction outcomes, reducing variability. These changes

(enhanced scrutiny and stronger sanctions) apparently

created incentives for the key players (including the

firms’ technical departments) to comply with the

accounting standards, irrespective of the perceived

intrinsic quality of the accounting outcome. In evaluating

individual outcomes under the analytical framework, we

define ‘quality’ narrowly in terms of the applicable

regulatory framework, without making any evaluation of

that framework. In the case of compliance issues, quality

may be equated to compliance. Where an outcome is a

matter of judgement, it is not always possible to evaluate

the quality of the judgement, such as a discount rate, but

it is possible to consider an outcome in terms of

compliance with the process of reaching the judgement.

However, in our broader discussion of the quality of

outcomes in general, the broader intrinsic quality is

considered, i.e. whether the outcome shows a true and

fair view. This is an overriding provision in UK company

law to ensure the integrity of financial statements. The

application of the true and fair view under the changed

regime in the UK remains the subject of controversy

between investors and the FRC. In several interactions,

there was evidence of a divergence between quality in

terms of compliance and quality in terms of true and fair

view. One CFO described the outcome from a particular

interaction in the following terms, ‘It even got to what I

regard as a rather silly situation with the auditors where they

were agreeing that it didn’t make sense but that is what the

accounting standard said and therefore that is what you have to

do.’ Another CFO noted that investors are challenging the

sense of IFRS: ‘Most analysts use figures from . . . investor

presentations . . . what happens in the statutory accounts is a

side show.’ Recently, the Local Authority Pension Fund

Forum has confirmed the existence of substantial legal

problems with IFRS (LAPFF, 2013).

Findings from the UK setting will be of interest to an

international audience for a number of reasons. First,

the UK is a major capital market and many countries

historically adopted UK accounting standards before

moving to IFRS. Second, many aspects of the current UK

setting are common to other countries (the adoption of

international accounting and auditing standards and

aspects of the corporate governance regime), suggesting

that certain outcome consequences maybe found in other

settings. However each country offers a unique blend of

national and supranational regulation that influences the

particular field logic of the time and hence the behaviour

of individual actors. In considering reform, other

jurisdictions can be informed by the consequences

(desirable and undesirable) of particular regulatory

mixes. Finally, this study provides a methodology for

assessing the consequences of regulation and regulatory

change that could be replicated in other settings.

The remainder of this paper is structured as follows.

The next section first sets out the changes to the UK

regulatory environment since the first study was

undertaken, before reviewing the relevant literature on

audit interactions. The methods used in the study are

then discussed. The following section then presents the

revised grounded theory model and compares this with

the original model. A final section summarises and

concludes.

LITERATURE REVIEW

The UK regulatory environment

The key changes in the UK regulatory environment that

occurred between the two study periods, together with a

comparison with the international setting are described in

this sub-section. A summary is provided in Table 1. The

UK regulatory environment remains fundamentally

unchanged from 2007 to the present time, although

further changes are likely to take place.7

International context and national structures

Increasingly, national regulatory bodies are

interconnected with supranational private sector

regulatory bodies at the global level (i.e., the International

Accounting StandardsBoard (IASB) and the International

Audit and Assurance Standards Board (IAASB) which

functions under the aegis of the International Federation

of Accountants (IFAC)). There are also governmental

regulatory bodies at European Union (EU) level such as

the European Financial Reporting Advisory Group

(EFRAG) which endorses IFRS as suitable for use in the

EU (Cooper & Robson, 2006).

This creation of a new institutional field and attendant

shifts in regulatory logics are well documented by

Suddaby, Cooper and Greenwood (2007) and Suddaby,

Gendron and Lam (2009). In particular, supranational

regulators and the global accounting firms have gained

power at the expense of national regulators and the

professional accountancy bodies, although national

16 V. Beattie et al.

Int. J. Audit. 19: 15–36 (2015)© 2014 John Wiley & Sons Ltd