THE IMPACT OF MANDATORY AUDIT FIRM ROTATION ON AUDITOR-CLIENT NEGOTIATIONS by Jianqiang Wang Bachelor of Arts Fudan University, 1982 Master of Arts Fudan University, 1986 Master of Accountancy University of South Carolina, 1996 Submitted in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy in Moore School of Business University of South Carolina 2003 Director of Dissertation Committee Member Committee Member fommittee Member Dean of The Graduate School Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3098716 UMI UMI Microform 3098716 Copyright 2003 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DEDICATION I dedicate this dissertation to my beautiful wife, Min, who has amazingly made a philosopher an accounting professor, and to our wonderful son, Diexia, who has easily made a lousy accountant a great piano teacher by being one of the best young pianists in America. Thank you for your support and making my life so enjoyable. ii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS I would like to offer my sincere thanks to my dissertation chair, Dr. Brad Tuttle, for being incredibly generous with his talent and time in helping me develop, conduct, and finish this study. Without his remarkable and tireless effort, this work would not have been possible. I also want to extend my special thanks to Dr. Maribeth Coller for giving me so much help in so many ways since I took my first accounting course from her, to Dr. Scott Jackson for always providing insightful and challenging feedback and comments on my work, and to Dr. Lisa Rutstrom for her expert advice on experimental economics and many other contributions to the completion of this dissertation. I was very fortunate to have these wonderful scholars on my dissertation committee and I am deeply grateful for their invaluable guidance and support throughout the whole process of writing this dissertation. I also would like to thank the School of Accounting faculty, especially Dr. Rich White, Dr. Adrian Harrell, Dr. Scott Vandervelde, Dr. Tim Doupnik, Dr. Gene Chewning, and Dr. A1 Leitch, for helping me in various stages of this work and in many years of my study in this great school. My gratitude and appreciation also go to Dr. Mark Taylor and Dr. Todd DeZoort for their advice and encouragement before and after they left this school. It is my great pleasure to acknowledge the friendship and support of my fellow Ph.D. students: Young-Won Her, Jennifer Kahle, George Tsakumis, and Danny Wadden. It has been four unforgettable years and we had so much fun. I also want to acknowledge financial support for this study from the Moore School of Business. iii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ABSTRACT Mandatory rotation of audit firms has become an increasingly attractive regulatory option to lawmakers in light of a series of recent disastrous corporate accounting scandals. The Sarbanes-Oxley Act of 2002 requires a study of potential effects of such a regulation. This study investigates how the mandatory rotation of audit firms will affect auditor-client negotiations when there is a disagreement on accounting values to report in financial statements. It is hypothesized that the imposition of mandatory rotation will reduce the auditor's incentive to compromise throughout the entire term of the audit engagement with a client and will also reduce the client's incentive to compromise in the final engagement year. As a result of such changes in the auditor’s and the client’s incentives to compromise, any regulation that requires mandatory rotation of audit firms may have unanticipated effects on the outcome of auditor-client negotiations, i.e., the financial statements issued to the public. The study was conducted through experiments in a laboratory setting in which participants assumed the role of a manager (client) or of a verifier (auditor). Using a computerized negotiation system, participants negotiated an asset value to report under one of two manipulated conditions—limited auditor term (i.e., mandatory audit firm rotation) or unlimited auditor term. The effects of mandatory rotation are measured by the rate of agreement between auditors and clients and the agreed-upon asset values. It is found that mandatory rotation results in a lower rate of agreement between auditors and clients and lower agreed-upon asset values. iv Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS Chapter 1: INTRODUCTION Chapter 2: THEORY AND HYPOTHESES 2.1 Auditor-Client Disagreements 2.2 Incentives Facing the Client 2.3 Incentives Facing the Auditor 2.4 Hypotheses Chapter 3: METHOD 3.1 Experimental Task 3.2 Experiment Design 3.3 Independent Variables 3.4 Dependent Variables 3.5 Negotiation Procedure and Rules 3.6 Payoffs 3.7 Participants Chapter 4: RESULTS 4.1 Randomization and Manipulation Check 4.2 Descriptive Statistics 4.3 Hypothesis Tests 4.4 Other Tests Chapter 5: CONCLUSION REFERENCES APPENDIX 1 6 6 8 11 14 19 19 22 22 24 24 27 31 33 33 34 41 52 54 59 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES Table 3.1: Participant Demographics 32 Table 4.1: Analysis of Variance of Continuous Demographic Data 34 Table 4.2: Descriptive Statistics: Mandatory Rotation Condition 35-36 Table 4.3: Descriptive Statistics: Mandatory Rotation Condition (Non-Final periods) 37-38 Table 4.4: Descriptive Statistics: Mandatory Rotation Condition (Final periods) 39-40 Table 4.5: Descriptive Statistics: No Mandatory Rotation Condition 41 Table 4.6: Rate of Agreement: Comparison between Mandatory Rotation Condition and No Mandatory Rotation Condition 42 Table 4.7: Rate of Agreement: Comparison between Mandatory Rotation Condition (Non-Final periods) and No Mandatory Rotation Condition 42 Table 4.8: Rate of Agreement: Comparison between Mandatory Rotation Condition (Final Periods) and No Mandatory Rotation Condition 43 Table 4.9: Rate of Agreement: Comparison between Non-Final Periods and Final Periods within Mandatory Rotation Condition 44 Table 4.10: Correlation between Auditor Tenure and Asset Values within No Mandatory Rotation Condition: All Negotiation Resulting in Agreement 45 Table 4.11: Correlation between Auditor Tenure and Asset Values within No Mandatory Rotation: Negotiations lasting Longer than Eight Periods 46 Table 4.12: Asset Values: Comparison between Earlier Periods and Later Periods within No Mandatory Rotation Condition 47 Table 4.13: Asset Values by Negotiating Pair: Comparison between Mandatory Rotation Condition and No Mandatory Rotation Condition 48 Table 4.14: Asset Values by Verifier or Manager: Comparisons between Mandatory Rotation and No Mandatory Rotation 49 vi Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 4.15: Asset Values by Negotiating Pair: Comparison between Mandatory Rotation Condition (Non-Final Periods) and N o Mandatory Rotation Condition 50 Table 4.16: Asset Values by Negotiating Pair: Comparison between Mandatory Rotation Condition (Final Periods) and No Mandatory Rotation Condition 50 Table 4.17: Asset Values by Negotiating Pair: Comparison between Non-Final Periods and Final Periods within Mandatory Rotation Condition 51 Table 4.18: Tests of Behavior Over Time: Rate of Agreement 52 Table 4.19: Tests of Behavior Over Time: Asset Values 53 vii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF FIGURES Figure 3.1: Asset Values Distribution 20 Figure 3.2: Experiment Design 22 Figure 3.3: Payoffs 28-29 viii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. “The Comptroller General of the United States shall conduct a study and review of the potential effects of requiring the mandatory rotation of registered public accounting firms.” —Sarbanes-Oxley Act o f2002, H. R. 3763-31 “All of the technical aspects [of auditing] are important but they can’t substitute for the primary skill, which is the art of negotiation.” —Michael Buxbaum The CPA journal, 72(5), p.80, May 2002 1. INTRODUCTION Auditors and clients may not always agree on accounting principles or practices, financial disclosure, or auditing scope or procedures. Auditor-client disagreements often occur because the auditor and client have different preferences representing legitimate but divergent beliefs regarding the appropriate application of the current accounting/auditing standards (Magee and Tseng 1990; Dye 1991; Antle and Nalebuff 1991; DeAngelo et al. 1994; Defond and Subramanyam 1998). In these circumstances, auditors and clients often attempt to resolve their disagreements through a process that resembles negotiation (Murnighan and Bazerman 1990; Antle and Nalebuff 1991; Dye 1991; Zhang 1999; Gibbins et al. 2001). Prior research suggests that costs associated with an auditor switch should influence auditor-client negotiations (Magee and Tseng 1990; Dye 1991; Antle and Nalebuff, 1991; Teoh 1992; Zhang 1999). From the auditor’s perspective, there are at least two types of switching costs: (1) inefficiencies arising from learning to audit a new client and (2) the loss of potential revenue before the lost client is replaced. The second 1 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. [...]... study It then discusses the differing incentives facing the client and the auditor that drive auditor-client negotiations and develops hypotheses comparing the outcomes of auditorclient negotiations in the presence and absence of mandatory rotation 2.1 Auditor-Client Disagreements The term auditor-client disagreement” as used in this study refers to any situation in which the auditor and the client... early engagement years The existing negotiation literature generally does not provide a satisfactory theory that can be used to predict agreed-upon asset values resulting from auditor-client negotiations Auditor-client negotiations are rather unstructured in nature and the information setting of auditor-client negotiations, such as the payoffs to the auditor and the client, are rather unique (Zhang 1999)... the auditor disagrees with the client’s position on a reporting issue, is credible only if auditors in the market disagree among themselves over the same issue They further argue that auditors in the market differ in their opinions on an accounting or auditing issue only if the current professional standards allow them to do so These arguments explain why auditor-client disagreements that arise in the. .. and protect investors.1 The Sarbanes-Oxley Act of 2002 that recently has been signed into law calls for a study and review of the potential effects of mandatory rotation, due July 2003, in contemplation of possible Congressional action on this measure (Sec 207 (a), H.R 376 3-3 1) Mandatory audit- firm rotation may accomplish some of its intended goals, but there may also be other consequences that have... irrelevant to the auditor’s decision during the negotiation with the client in the final engagement year since the client is no longer legally retainable regardless of the auditor’s actions Consequently, the auditor has even less incentive to compromise in the final engagement year relative to prior years under the condition of mandatory rotation Because the auditor’s incentive to compromise is further reduced... permission of the copyright owner Further reproduction prohibited without permission research method Chapter 4 presents proposed analyses Chapter 5 concludes the paper with a discussion of the implications and limitations of the study 5 Reproduced with permission of the copyright owner Further reproduction prohibited without permission 2 THEORY AND HYPOTHESES This chapter first defines the term auditor-client. .. Half of the negotiating pairs negotiated without restriction on auditor tenure whereas the other half had auditor term limits imposed The outcomes of the negotiations were measured by the rate of agreement and the agreed-upon asset values The remainder of this dissertation is organized as follows Chapter 2 provides a review of the related literature and develops the hypotheses Chapter 3 describes the. .. permission of the copyright owner Further reproduction prohibited without permission 1976, 1977; AICPA 1978; Berton 1991; SEC 1994a; Wolf et al 1999; Benson, 2002; Imhoff 2003) In response to the recent audit failures with some of the largest U.S corporations, several bills have been proposed in the House and Senate that contain provisions limiting the term of the auditor-client relationship as part of an... that the rate of agreement will be lower in the final engagement year than in prior years within the condition of mandatory rotation These arguments lead to H I: H I: Mandatory rotation will result in a lower rate of agreement between auditors and clients If an agreement is reached in the negotiation, the outcome of the agreement, i.e., whether the disagreement is resolved in the client’s or in the auditor’s... volume of calls for mandatory rotation One of the assumptions held by many proponents of mandatory rotation is that there is a tendency for auditors, over time, to gradually align with the wishes of their clients For example, the Metcalf Committee report (U.S Senate 1976, 21) asserts that: Long association between a corporation and an accounting firm may lead to such close identification of the accounting . costs. The purpose of this study is to investigate the potential effects of mandatory audit firm rotation (hereafter mandatory rotation) on auditor-client negotiations through its impact on the. review of the potential effects of mandatory rotation, due July 2003, in contemplation of possible Congressional action on this measure (Sec. 207 (a), H.R. 376 3-3 1). Mandatory audit- firm rotation. Statistics: Mandatory Rotation Condition 3 5-3 6 Table 4.3: Descriptive Statistics: Mandatory Rotation Condition (Non-Final periods) 3 7-3 8 Table 4.4: Descriptive Statistics: Mandatory Rotation Condition (Final