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Effects of Earnings Forecasts and Heightened Professional Skepticism on the Outcomes of Client–Auditor Negotiation

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Abstract

Ethics has been identified as an important factor that potentially affects auditors’ professional skepticism. For example, prior research finds that auditors who are more concerned with professional ethics exhibit greater professional skepticism. Further, the literature suggests that professional skepticism may lead the auditor to more vigilantly resist the client’s position in financial reporting disputes. These reporting disputes are generally resolved through negotiations between the auditor and client to arrive at the final reported amounts. To date, the role that professional skepticism potentially plays in the negotiation process has been relatively unexplored. The literature prior to the enactment of Sarbanes–Oxley (SOX) suggests that auditors are more likely to approve a client position when the matter in dispute is relatively ambiguous and when changing the client’s position will result in the client failing to meet analysts’ expectations. However, changes resulting from SOX have led auditors to be more vigilant and therefore results found in the pre-SOX environment may not hold in the current environment where auditors are held more accountable for their actions. Results from an experiment with experienced audit managers and partners suggest that in the post-SOX climate, auditors’ negotiations do not appear to be substantively influenced by management being able to meet or beat forecasts. Moreover, we find that when auditors exhibit heightened professional skepticism, they are more ethical by being conservative and they stand more resolute than when auditors do not exhibit heightened professional skepticism. Finally, although we do not find a main effect for the influence of earnings forecast, we do find a significant interaction between earnings forecast and heightened professional skepticism. Implications for practice and research are then presented.

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Notes

  1. In the post-SOX environment, archival research findings suggest a reduction in earnings management (Bartov and Cohen 2009; Cohen et al. 2008a, b; Davis et al. 2009; Bennie and Pflugrath 2009). However, on an individual basis, managers still have incentives to engage in earnings management to enhance stock prices, the value of options or the likelihood of earning a performance-based bonus (Beyer 2008). These incentives give rise to the potential that clients will pressure their auditors to permit earnings management.

  2. See Brown and Wright (2008) for a review of this literature.

  3. The SEC and PCAOB independence rules specifically state that auditors must approach audits with professional skepticism and must be willing to objectively and without bias decide issues regardless of management’s or the auditor’s incentives.

  4. Auditors came from two of the Big 4 firms. Inclusion of audit firm membership does not influence the results of our hypothesis tests (p ≥ 0.10).

  5. Forty-five participants took part in the study; however, seven participants were dropped from the statistical analyses because their final decision resulted in an indeterminable final EPS, resulting in a final sample of 38. For example, if participants indicated “other” as their option and did not specify which issue they would book or waive, or an alternative, we excluded these responses. We included “other” as an option in the event that participants wanted to propose a solution other than the four predefined solutions. For example, a participant may decide to allow the client to use the more aggressive reporting choice as long as the client agreed to disclose the method in the footnotes to the financial statements.

  6. One auditor did not provide rank, general, or negotiation task experience. Exclusion of this participant did not qualitatively affect the results of our hypothesis testing.

  7. Because prior research indicates that negotiation experience matters (Brown and Johnstone 2009), we controlled for task experience and years of experience and found no significance for these variables, nor did inclusion of these variables significantly affect our results. Therefore, we do not include them in our primary model. We also ran the model with experience as a covariate which did not qualitatively change the results. We also compared the means of negotiation and general experience across all conditions and there were no significant differences (p > 0.10).

  8. When facing a contentious client, auditors may be willing to make small concessions (Hatfield et al. 2008). For example, auditors may compromise in a negotiation by waiving a subjective issue to induce the client to book the less subjective issue. This reciprocity based approach (i.e., trading off issues) potentially provides an opportunity to reach an integrative outcome that results in a win–win outcome for both the auditor and the client.

  9. Other factors such as the impact on income and the nature of the adjustment (subjective versus objective) as well as the size of the client also are associated with the decision to waive adjustments (Wright and Wright 1997).

  10. We used the results of prior research internet-based negotiation studies (e.g., Brown and Johnstone 2009; Brown and Wright 2008) to determine the maximum number of rounds. Participants were not informed of the maximum number of rounds because auditors in practice do not know how long a client might continue to resist their preferences.

  11. In a contending strategy an individual maintains a favorable position by using persuasive agreements, threats, and/or commitments, ultimately with the intent of resulting in a “win-lose” outcome (Brown and Wright 2008).

  12. We decided to limit the CFO strategy to contending since this strategy is of the highest risk and difficulty for the auditor because it represents greater pressures on the auditor to acquiesce to the client’s preferred reporting outcome. Additionally, in this setting there is also a greater risk to investors, who rely on auditors to deter the client from engaging in inappropriate behavior. Further, manipulating the client strategy would have required doubling the sample size. Given the difficulty in obtaining audit participants at the partner and manager level, we decided to make the strategy constant across all conditions.

  13. It should be noted that approximately 89 % of participants mentioned materiality in their responses during the negotiation process. This suggests that the adjustments were perceived to be material to the client’s financial statements.

  14. For example, the following participant statement was considered to represent salience of risk factors; “We need to get on the same page as to the appropriateness of the accounting first. I could probably get comfortable with the CFO's position on the materiality issue but would want to understand more. Did the revenue amounts help them hit estimates, bonus targets etc. where they errors or intentional.…any fraud indicators”. However, a statement such as this, “The cutoff problem is basic and unsupportable” does not explicitly address salience of risk factors.

  15. We also conducted this analysis using a continuous variable for professional skepticism (i.e., the number of times the participant cited a client risk factor) and the results were not significantly different for the main effect but were different for the interaction term. We ran a regression and the results were significant for the continuous skepticism (β = −0.351, p < 0.05) variable but not the interaction (β = 0.243, p > 0.10).

  16. The results are also robust to a median split of skepticism where low skepticism was less than or equal to 1 and high skepticism was greater than 1 for both the main effect of skepticism (χ2 = 9.845, p = 0.007) and the interactive effect (t 32 = −2.2293, p = 0.028).

  17. We conducted a post hoc power analysis using G*Power, a power analysis program, to determine achieved power. Results indicate that for our sample size (N = 38) power approximated 0.80.

  18. The critical F-value (2.65) is significant as compared to the table for critical F values [F (0.05, 5, 33) = 2.46].

  19. We compared participants in the high vs. low skepticism groups across the earnings management incentives conditions (high vs. low) and the results were not significant. Therefore, we conclude that earnings management incentives do not differentially allocate participants to the skepticism condition.

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Acknowledgments

We appreciate the thoughtful comments provided by Arnie Wright, Karla Johnstone, Lori Holder-Webb, Luc Quadackers, workshop participants at Northeastern University, Rutgers University, Kennesaw State University, University of Virginia, the Midyear Auditing Section conference, Sally Gunz, anonymous reviewers and practicing professionals at a number of firms.

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  1. Rutgers University, New Brunswick, NJ, USA

    Helen L. Brown-Liburd

  2. Boston College, Chestnut Hill, MA, USA

    Jeffrey Cohen

  3. University of Central Florida, Orlando, FL, USA

    Greg Trompeter

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  1. Helen L. Brown-Liburd
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  2. Jeffrey Cohen
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Correspondence to Jeffrey Cohen.

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Brown-Liburd, H.L., Cohen, J. & Trompeter, G. Effects of Earnings Forecasts and Heightened Professional Skepticism on the Outcomes of Client–Auditor Negotiation. J Bus Ethics 116, 311–325 (2013). https://doi.org/10.1007/s10551-012-1473-5

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