wang and tuttle - 2009 - the impact of auditor rotation on auditor–client negotiation

The impact of auditor rotation on auditor–client negotiation Karl J. Wang a, * , Brad M. Tuttle b,1 a The Patterson School of Accountancy, University of Mississippi, Oxford, MS 38677, United States b School of Accounting, Moore School of Business, University of South Carolina, Columbia, SC 29208, United States Abstract This paper reports the results of an experiment designed to investigate how mandatory audit firm rotation affects audi- tor–client negotiations. Drawing upon process theories of negotiation, we examine the strategies used by auditors and cli- ents as well as the outcomes of their negotiations in alternative settings in which mandatory rotation is imposed or is not imposed. We posit that mandatory rotation changes (1) the dynamics of the audit market by increasing the number of clients who are in the market for a new auditor, and (2) the political costs to a client who switches auditors. These changes, in turn, alter the willingness of the auditor and the client to cooperate during negotiation. The results suggest that with mandatory rotation auditors adopt less cooperative negotiation strategies, producing asset values that are more in line with the auditor’s preferences than with the client’s preferences and more negotiation impasses. Ó 2008 Elsevier Ltd. All rights reserved. ‘‘All of the technical aspects [of auditing] are important but they can’t substitute for the pri- mary skill, which is the art of negotiation.” –Michael Buxba um The CPA Jo urnal, 72(5), p. 80, May 2002 Introduction This paper reports the results of an experiment designed to investigate process differences in audi- tor–client negotiation under conditions with and without mandatory audit firm rotation (hereafter, mandatory rotation). Prior experimental research shows that client-preferred reporting by auditor s is less likely under mandatory rotation (Dopuch, King, & Schwartz, 2001). The present study builds on previous findings by adding negotiation to the auditor–client mix and then, using the negotiation protocols, explores the process that produces audited asset values. This research methodology enables us to look inside each negotiation script to determine the negotiation strategies used by both parties, and to relate these strategies to the negoti- ated outcomes. Negotiation applies to auditing (Gibbins, Salterio, & Webb, 2001; McNair, 1991; Nelson, Elliott, & Tarpley, 2002; Ng & Tan, 2003) because for many financial statement accounts (1) uncer- tainty exists about the true value to report, and (2) different incentives exist for managers and auditors (c.f., Murnighan & Bazerman, 1990). Uncertainty 0361-3682/$ - see front matter Ó 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.aos.2008.06.003 * Corresponding author. Tel.: +1 662 915 3980; fax: +1 662 915 7483. E-mail addresses: karlwang@olemiss.edu (K.J. Wang),tuttle@ sc.edu (B.M. Tuttle). 1 Tel.: +1 803 777 6639. Available online at www.sciencedirect.com Accounting, Organizations and Society 34 (2009) 222–243 www.elsevier.com/locate/aos implies that a range of possible and reasonable val- ues exist so that the selection of any one particular value is not necessarily right or necessarily wrong ex ante. In this context, differing incent ives can lead client managers and auditors to prefer different val- ues within the range of possibilities. Hence, negoti- ation in an auditor–client context is a natural process of reconciling differences in incentive- induced preferences within a range of possibilities and not necessarily about truthful versus deceitful reporting as has been explored in much of the exist- ing auditing literature. We draw upon process theories of negotiation to predict the nature and outcome of auditor–client negotiations. Negotiation theories developed in a social context suggest that concerns for self and for the other party in the relationship dominate the negotiation process (c.f., Bazerman, Curhan, Moore, & Valley, 2000). Extending these theories to an economic context, Savage, Blair, and Sorensen (1989) link concern for self to the substantive out- come of the immediate negotiation episode and con- cern for the other party to the economic benefits one expects from a continued relationship. Applying this model to an audit setting, the current period’s audit outcome equates to the substantive outcome of the immediate negotiation while the ability to retain a client over multiple audit periods provides continued economic benefits and motivates concern for the relationship. Mandatory rotation affects the auditor’s con- cern for the relationship. The possibility of retain- ing the same client indefinitely provides incentives for the auditor to prefer the same financial state- ment values as does the client in ord er to maintain a good relationship with the client even when these values conflict with those preferred by investors (c.f., Fisher, Frederickson, & Peffe r, 2006; Zhang, 1999). Mandatory rotation diminishes the expected future benefits to the individual auditor who is negotiating and thus alters the auditor’s concern for the relationship from a negoti ation perspec- tive. 2 In addition, the costs of en ding the relation- ship differ to both the auditor and the client with mandatory rotation than without mandatory rota- tion. Based on these theoretical considerations, we predict the negotiation strategies that each party is motivated to adopt. Specifically, we predict, and find, that mandatory rotation results in the auditor being more likely to adopt non-cooperative negoti- ation strategies and that the negotiation is more likely to end in impasse. This study contributes to the auditing literature by combining experimental economics methods with real-time negotiation/verbal protocol analysis methods developed in the negotiation communica- tion literature. This combination enables us to pro- vide a more complete image of the process that produces the experimental outcome, the process that is both issue and incentive driven. The adoption of this research methodology also co ntributes to the negotiation literature as it attempts to capture the unique aspects of negotiation activity. As Davis and Holt (1993, p. 244) point out, the rich mes- sage-space and the real-time nature of unstructured negotiation create a larger set of strategies than is typically considered in traditional economic research. Our results may stimulate negotiation research outside the context of auditing. In addi- tion, our study contributes to the negotiation litera- ture also in that we find support for the dual concern theory in a highly institutionalized setting in which rotation of the negotiation parties occurs. The remainder of this paper proceeds as follows: The next section provides the theoretical back- ground and develops the hypotheses. Section ‘‘Method” outlines our research method, Section ‘‘Results” presents the results, and ‘‘Discussion” section concludes the paper with a discussion of the results and limitations of the study. Literature and hypotheses Auditor–client negotiation A number of studies investigate issues pertinent to auditor–client negotiations (e.g., Antle & Nalebuff, 1991; Beattie, Brandt, & Fearnley, 2000; Demski & Frimor, 1999; Farmer, Rittenberg, & Trompeter, 1987; Goodwin, 2002; Nelson et al., 2002; Ng & Tan, 2003; Trotman, Wright, & Wright, 2005; Zhang, 1999). These studies generally suggest that auditor–client negotiations can materially affect financial statements while identifying a number of accounting and other contextual issues that impact auditor–client negotiations . Other studies, whi ch we will briefly review below, have looked specifically 2 We acknowledge that with only a limited number of large accounting firms, the loss of the audit engagement may result in an increase in other non-audit revenues. While this situation mitigates the audit incentives to the firm, the benefits of increased non-audit revenues may not specifically accrue to the individual auditor who is negotiating. K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 223 at the process of auditor–client negotiation with implications for how mandatory rotation may affect this process. Gibbins et al. (2001) develop a process model of auditor–client negotiation. They use this model to analyze a survey of 93 partners in large audit firms and draw several conclusions related to our study. They find that auditor–client negotiation is a nor- mal part of auditing and that audit partners view negotiation as a part of client service in which audi- tors help produce appropriate financial statements. They also find that at the start of the negotiation, the partners believe that a range of mutually accept- able outcomes exist and do not typically expect the final outcome to be the same as their initial position. Within this setting, both clients and auditors hold a mutual desire to reach agreement. Interestingly, their data suggest that retention risk affects the whole process of auditor–client negotiation. Contin- uing this line of research, Gibbins, McCracken, and Salterio (2005) provide responses from both audi- tors and clients and analyze the problem solving process used by eight matched audit partner–CFO dyads. These studies, however, reflect a presump- tion that the auditor–client relationship is on-going. Most studies of auditor–client negotiation share this assumption and so do not examine how incentives imbedded in an on-going relationship drive audi- tor–client negotiations or how changes in incentives as a result of a mandatory rotation policy impact such negotiations. Brown and Johnstone (2005) examine the influ- ence of engagement risk and auditor negotiation experience on negotiations. Using computer simu- lated clients, they infer the negotiation strategies of audit managers and partners based on their open- ing and final bids. Specifically, they infer a contend- ing strategy when the final bid is the same as the opening bid, a concessionary strategy when the final bid is closer to the client’s initial position than to the auditor’s opening bid, and an integrating strategy when final bids are closer to (but not the same as) the auditor’s opening bid. They find that auditors with less client negotiation experience use more con- cessionary negotiation strategies when engagement risk is high. While Brown and Johnstone investigate negotiation strategy, they only simulate the client therefore holding its negotiation strategy constant. Furthermore, they only infer the negotiation strat- egy based on the negotiated outcomes. In dynamic negotiations, i.e., those in which both sides actively participate, it is possible for more than one strategy to arrive at similar outcomes depending upon the strategy of the opponent (Pruitt & Carnevale, 1993; Pruitt & Rubin, 1986). Hence, negotiation strategy can be ascertained only by measuring the negotiation strategy direct ly from the negotiation itself. Several studies examining certain negotiation tac- tics of auditors and clients are also related to our study. Using decision case methodology, Hatfield, Agoglia, and Sanchez (2005), for example, find that auditors use reciprocity tactics when faced with a non-cooperative client. Sanchez, Agoglia, and Hatfield (2007) find that reciprocity tactics influence the client into accepting more proposed audit adjustments and feeling better about the process. Bame-Aldred and Kida (2007) investigate auditor and client initial negotiation positions and tactics, and find that auditors, compared to clients, are less willing to make concessions in negotiations. These studies, however, do not consider the economic con- ditions in which such negotiation tactics were used. The results of these studies may not hold when incentives that drive auditor–client negotiations are changed. Mandatory rotation Several recent studies specifically examine the possible effects of mandatory rotation. Using decision case methods, Hatfield, Jackson, and Vandervelde (2007) find that proposed audit adjust- ments are more conservative under the conditions of either audit partner rotation or audit firm rotation. However, Hatfield et al. only look at proposed adjustments and not at the final booked adjust- ments. Proposed adjustments are ‘‘pre-negotiation” whereas final booked adjustments are likely to be negotiated outcomes. Daniels and Booker (2006) find that the imposition of mandatory rotation alters loan officers’ perceptions about auditor inde- pendence but not about audit quality. Kaplan and Mauldin (2008) find that non-professional investors do not have the similar perception of the effect of mandatory rotation on auditor independence, co n- sistent with the GAO study (2003). In contrast, Kim, Min, and Yi (2004) find that discretionary accruals in the quasi-mandatory rotation environ- ment actually implemented in Korea tended to be low, suggesting a substantial impact of mandatory rotation on financial reporting. These studies, how- ever, do not examine the effect of mandatory rotation on auditor–client interactions. 224 K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 In a seminal study, Dopuch et al. (2001) experi- mentally test the effect of mandated auditor rotation and mandated auditor retention (in non-rotating periods) on auditors’ willingness to issue client- preferred reports. They find that mandatory rota- tion changes the interaction between the auditor’s reporting decisi on and the client’s investing deci- sion. Specifically, they find that mandatory rotation reduces the willingness of the auditor-subjects to issue client-preferred reports and the willingness of the client-subjects to invest (which would reduce the risk of auditor misreporting). Unlike the present study, Dopuch et al. do not examine the process of an auditor and a client directly negotiating a reporting choice. This limita- tion restricts the generalizability of Dopuch et al.’s findings with respect to two processes that are criti- cally important to auditing: client reporting decision and negotiation. While our study helps to extend the generalizability of Dopuch et al., its primary contri- bution is that it directly examines the process by which the auditor and the client reach a reporting decision. It provides new understanding about audi- tor–client negotiation strategies under the condition of mandatory rotation. Negotiation as a social process A primary theory of negotiation as a social pro- cess is dual concern theory (Pruitt & Carnevale, 1993). Accor ding to this theory, individuals mod- ify their negotiating strategy by taking into account their individual incentives and their rela- tionship to the other party. That is, the theory posits that concern for one’s self and concern for the other party influence the negotiation strategy. Savage et al. (1989) extend this theory to an eco- nomic context by both recognizing that the pri- mary motivators in a business setting are economic outcomes and defining ec onomic out- comes in terms of relationship. 3 They characterize two general types of negotiations. One type includes negotiations in which ‘‘negotiators are motivated to establish or maintain positive rela- tionships and willingly share the pie through mutually beneficial collaboration.” Hence, concern for the other party derives not so much out of concern for the other’s well-being but out of a desire to maintain a mutually beneficial economic relationship. The other type of negotiation involves ‘‘substantive outcomes that can benefit one negotiator only at the expense of the other” (p. 38). This latter concern for the substantive out- come motivates negotiators to ‘‘discount the rela- tionship and claim as much of the pie as possible.” From an auditor–client engagement point of view in which economic forces are domi- nant, concern for the substantive outcome of the negotiation equates to a focus on the current per- iod’s financial statements while concern for the other party results in a focus on maintaining the auditor–client relationship over continued engage- ments. Because audits can be characterized as a series of repeated negotiations from year to year, concern for the relationship implies that auditors and clients attempt to ensure the continuation of engagement even if it comes at the expense of the current year’s negotiation. Before we describe how mandatory rotation influences these concerns, first, we should note that both concerns for sub- stantive outcome and for the relationship can vary in degree, resulting in four basic combinations leading to four basic negotiation strategies as illu s- trated in Fig. 1. According to Savage et al. (1989), when negotia- tors are less concerned about the relationship, they are more likely to adopt a non-cooperative strategy. For instance, negotiators who have low concerns for both the substantive outcome and the relationship 3 See Bazerman et al. (2000) for a comprehensive review of negotiation research and Gelfand, Major, Raver, Nichii, and O’Brian (2006) for an outline of recent developments. Up until recently, academic work in negotiations had been ‘‘the province of mainly economists of game theory and its applications ” (Lewicki, 1997, p. 589). One limitation with this body of knowledge, according to Greenhalgh and Chapman (1995),is its failure to address relationships – the most common element in real-world negotiations and a particularly important element in auditor–client negotiations. Unilateral Negotiation Strategies Concern for Substantive Outcome Concern for Relationship High Low High A Integrating Strategy B Obliging Strategy Low C Contending Strategy D Inaction Strategy Fig. 1. Unilateral negotiation strategies. (Adapted from Savage et al. (1989).) K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 225 tend to adopt a strategy of inaction as shown in cell DofFig. 1. Inaction strategies are typically associ- ated with the goal to avoid a loss. Such strategies may exhibit wait-and-see behavior that results in agreement only if something viewed as a gain is offered. For example, the auditor may ignore the cli- ent’s request for negotiating a mutually agreeable asset value to report and stick to the most conserva- tive approach when client punishment is unlikely (Antle & Nalebuff, 1991). Likewise, negotiators who are unconcerned about the relationship but who are concerned about the substantive outcome are more likely to adopt a contending strategy as shown in cell C of Fig. 1. Negotiators who adopt a contend ing strategy actively argue for their own positions without considering the costs to the other party or parties. For example, the client may press the auditor to accept an aggres sive accounting treat- ment by using, explicitly or implicitly, a dismissal threat. Inaction and contending strategies do not rely on cooperation to achieve agreement. On the other hand, when negotiators are more concerned about the relationship, they will be more likely to adopt a cooperative strategy. For instance, as shown in cell A of Fig. 1, negotiators who have high concerns for both the substantive outcome and the relationship are more likely to adopt an integrat- ing strategy. Negotiators who adopt an integratin g strategy may seek a mutually compromising, ‘‘fair” agreement that is somewhere between the two oppos- ing initial positions. Alternatively, they may propose ‘‘win–win” solutions to the negotiation by introduc- ing a new issue and/or a new solution that neither party initially considered. For example, the auditor and the client may both agree to concessions within the current period or over a series of periods as sug- gested by Dopuch et al. (2001). In like manner, nego- tiators who have low concerns for the substantive outcome but high concern for the relationship tend to ad opt an obliging strategy. Negotiators who adopt an obliging strategy seek agreement to maintain the relationship with less regard to its cost to their current payoffs. Integrating and obliging strategies rely on cooperation to achieve agreement. To implement the dual concern model in an audi- tor–client negotiation setting, we identify the eco- nomic incentives associated with each party’s actions concerning financial reporting in the rota- tion and non-rotation regimes. That is, we define how the auditor’s and the client’s concerns change as a function of the economic conditions that varies with whether mandatory rotation is imposed. In absolute terms, auditor–client relationships and spe- cific audit outcomes are very important to both cli- ents and auditors. In relationship to the various negotiation contexts manipul ated in the present study, however, the two dimensions differ in relative importance. Hence, we frame the discussion in terms of one negotiation setting relative to other negotiation settings. We first outline the effect of mandatory rotation on the negotiation strategies of the auditor followed by a discussion of its effects on the client’s negotiation strategies. Auditor negotiati on strategies We first assume that whether or not mandatory rotation is imposed, the auditor is gu aranteed the audit fee for the current year and that the current fee amount is unaffected by any negotiation regard- ing the financial statements. We further assume a healthy client without risk of insolvency so that the risk of litigation is relatively low. While these assumptions do not describe every client, we believe that they represent the general audit environment. Together, these assumptions work to lower an audi- tor’s concern for the immediate substantive outcome. On the other hand, the current audit environ- ment contains incentives for auditors to be con- cerned about their long-term relationship with the client. The Government Accounting Office (GAO, 2003) reports that the average auditor tenure for Fortune 1000 companies is 22 years. Likewise, a study published by Fulcrum Financial Group (2003) reports that 10% of the companies in their sample have had the same auditor for 50 or more years, with the average tenure of this group being 75 years. Although the opportunity costs to a large audit firm from losing a single client may be mini- mal, individual partners and managers (who are doing the negotiation) face very high personal opportunity costs related to their reputations and to possible lost long-term profits for their offices if negotiations fail (Defond, Francis, & Carcello, 2005; Francis, Maydew, & Sparks, 1999; Reynolds & Francis, 2000). Under these economic incentives, auditors may be willing to concede some items in the short term in order to preserve the long-term relationship with their clients, as suggested by some proponents of mandatory rotation (Benson, 2002; Imhoff, 2003; Wolf, Tackett, & Claypool, 1999). Hence, we argue that the auditor’s concern for the substantive outcome is relatively low compared to 226 K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 their concern for the on-going relationship. 4 Given that the concern for this relationship is higher with- out mandatory rotation and lower with mandatory rotation, as we will explain below, we propose ‘‘Obliging” as the dominating strategy for auditors without mandatory rotat ion and ‘‘Inaction” as the dominating strategy for auditors with mandatory rotation, as displayed in Fig. 2. Mandatory rotation potentially affects an audi- tor’s incentives during a negotiation in three ways: First, in the final audit year before the rotation occurs, it removes much of the possible reputation effects to the auditor arising from an auditor switch. 5 This freedom from reputation effects accrues to the individual auditor both from inside and outside of the firms, reducing the auditor’s con- cern for the relationship with the client. Second, in non-final years, mandatory rotation reduces the prospect of long-term rents arising from subsequent audits beyond the limit. As a resul t, the auditor’s concern for the relationship is reduced, whi ch is the argument typic ally employed by mandatory rotation proponents (e.g., Gietzmann & Sen, 2002; Imhoff, 2003; SEC, 1994; US Senate, 1976, 1977). Third, mandatory rotation alters the market for cli- ents by increasing the number of clien ts looking for new auditors in any given year, thus dramatically reducing the auditor’s concern for the relationship. 6 In summary, we argue that without mandat ory rotation, auditors have relatively low concern for the substantive outcome and relatively high concern for the relationship compared to auditors with man- datory rotation. This in turn leads to the greater adoption of obliging strategies during negotiation. We also argue that, with mandatory rotation, audi- tors have relatively low concerns for both substan- tive outcome and the relationship, which leads to a greater use of inaction strategies. These arguments are formalized in the followin g hypotheses regard- ing auditor strategies in auditor–client negotiations: H1 : Mandatory rotation affects the negotiation strategies used by auditors. H1a : Auditors will use an obliging negotiation strategy more frequently without mandatory rotation than with mandatory rotation. H1b : Auditors will use an inaction negotiation strategy more frequently with mandatory rotation than without mandatory rotation. Client negotiation strategies When negotiating with the auditor, the client management (client) has strong reasons to be con- cerned with the substantive outcome. Unlike the auditor, who receives a guarant eed audit fee, cur- rent period financial statements can influence the client’s immediate compensation. Hence, the client has strong incentives to influence the outcome of the current negotiation as set forth in the earnings management literature (c.f., Defond & Jiambalvo, 1993). Imposing auditor term limits has no impact on these incentives as they are endogenous to the auditor–client relationship. We, therefore, assert that client concern for substance in the negotiated outcome is relatively high regardless of mandat ory rotation. In terms of concern for the relationship, without mandatory rotation the client generally benefits from a good relationship by avoiding switching costs associated with training a new auditor. These switching costs are thought to be substantial (GAO, 1996) thus leading to a high concern for the relationship. In addition, clients that switch auditors can incur political costs associated with market perceptions of opinion shopp ing. 7 We assert 4 If one alternatively assumes that the auditor’s concern about the substantive outcome of the current negotiation is high, the auditors’ specific negotiation strategy changes from contending to inaction. As pointed out by a reviewer, neither strategy involves cooperation and the gist of our predictions holds. 5 We implement our experiment in an anonymous setting, thus precluding reputation effects while allowing us to focus on the other effects of mandatory rotation. Analysis of the negotiation scripts revealed that no one ever made an effort to identify who their opponent was. 6 Mandatory rotation increasing the negotiating auditor’s ability to replace a lost client is a critical distinction between an audit environment with mandatory rotation and the current audit environment. Assuming that the average auditor tenure is 22 years or more, it follows that less than 5% of clients are in the market for new auditors in any given year. Hence, at the individual office level, a partner involved in the negotiation knows that the likelihood of replacing the client is very small. However, should the auditor term be limited to just four years as has been advocated by some (US Senate, 2002), one out of four clients every year will be looking for a new auditor. As a result, the prospects of replacing a lost client when mandatory rotation is imposed are improved. The fact that audit firm rotation dramatically alters the availability of replacement clients is a key difference between audit firm rotation and audit partner rotation that has not been considered in previous studies. 7 There may be, however, some limited circumstances, such as a switch from a non-Big-Four auditor to a Big-Four auditor, in which this may not be the case. K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 227 that market perceptions of opinion shopping by the client are more likely in the early years of an audi- tor–client relationship and are more likely for more frequent switches. These political costs are consid- ered to be substantial and to be present without mandatory rotation and in the non-final years with mandatory rotation. This suggests that in all these circumstances, the client’s concern for the relation- ship will be high. In the final year under mandatory rotation, a change in auditor after the current period is auto- matic so the client incurs the same switching costs (i.e., those related to efficiency) regardless of the outcome of negotiations. However, the automatic change in auditor prevents investors from attribut- ing this event to opinion shopping without addi- tional information. Hence, the client is unlikely to experience political costs in this year regardless of the reason for the change. This suggests that in the final year under mandatory rotation, the client’s concern for maintaining a long-term relationship with the auditor is lower than in non-final years, as illustrated in Fig. 2. As illustrated in Fig. 1, clients who have high concerns for the substantive outcome and high con- cerns for the relationship are more likely to adopt an integrating strategy of negotiation. This occurs when mandatory rotation is not imposed and in non-final years when it is imposed. On the other hand, in the final year under mandatory rotat ion, with high concern for the substantive outcome but low concern for the relationship, clients are more likely to adopt a contend ing strategy. These predic- tions are summarized in the following hypotheses: H2 : Mandatory rotation affects the negotiation strategies used by clients. H2a : Clients will use an integrating negotiation strategy more frequently without mandatory rotation thanwithmandatory rotation,particu- larly in the final yearbeforerotationtakesplace. H2b : Clients will use a contend ing negotiation strategy more frequently with mandatory rotation, particularly in the final year before rotation takes place, than without mandatory rotation. Relative Concern for Relationship and Substantive Outcome And the Tendency to Adopt Specific Negotiation Strategies a Mandatory Rotation No Mandatory Rotation Non-Final Periods Final Periods Auditor Client Auditor Client Auditor Client Panel A: Unilateral Strategies Concern for Relationship Higher Higher Lower Higher Lower Lower Concern for Substantive Outcome Lower Higher Lower Higher Lower Higher Unilateral Negotiation Strategy More Obliging More Integrating More Inaction More Integrating More Inaction More Contending Cooperation Higher Higher Lower Higher Lower Lower Panel B: Interactive Strategies Interactive Negotiation Strategy Trusting Collaboration Trusting Collaboration Principled Collaboration & Soft Competition Focused Subordination Responsive Avoidance & Firm Competition Principled Collaboration & Soft Competition Fig. 2. Relative concern for relationship and substantive outcome and the tendency to adopt specific negotiation strategies. (In absolute terms, auditor–client relationships and specific audit outcomes are very important to both clients and auditors. In relationship to the various negotiation contexts manipulated in the present study, however, the two dimensions differ in relative importance thus leading to the prediction that the use of the various negotiation strategies will differ across conditions.) 228 K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 Negotiation outcomes Particularly in the final year under mandatory rotation, the aud itor appears to wield complete power over the client. The economic prediction in this case is that no negotiation will take place and that auditors will simply dictate their positions to their clients. However, the literature on ultimatum and dictator games, in which one party has com- plete power over the other (c.f., Davis & Holt, 1993; Kagel & Roth, 1995), suggests that people do not strictly adhere to eco nomic predictions but often follow social norms related to fair play even when given complete power over another individ- ual. Hence, we make comparative predictions, rec- ognizing the relative economic power rather than the absolute economic power that dictates equilib- rium predictions without considering the impact of social factors. Notice from Fig. 2 that both auditors and clients tend to use cooperative strategies (oblig- ing and integrating) without mandatory rotation but tend to use non-cooperative strategies (inaction and contending) when mandatory rotation is imposed. To the extent that cooperation leads to successful negotiation, the following hypotheses are proposed: H3a : Mandatory rotation leads to less cooperation by auditors in negotiation. H3b : Mandatory rotation leads to less cooperation by clients in negotiation. H4 : More negotiations will end in impasse with mandatory rotation than without mandatory rotation. When an agreement is reached, the party that uses an obliging strategy is more likely to receive a lower payoff and the party that uses an inaction strategy is more likely to receive a higher payoff than the party that uses other strategies (Pruitt & Carnevale, 1993). This finding, when applied to Fig. 2, leads us to predict H5 : Negotiation outcomes will be closer to audi- tors’ preferences with mandatory rotation and closer to the clients’ preferences without man- datory rotation. Negotiation theory recognizes that individual negotiators may tend towards certain unilateral strategies but that these strategies can change over time after interacting with the opponent as shown in Panel B of Fig. 2. For instance, Savage et al. (1989, Exhibit 3) predict that when one negotiator unilaterally adopts an obliging stra tegy while the opponent adopts an integrating strategy, they both may possibly evolve into using a strategy of collab- oration based on trust. The key point from Fig. 2 is that the various interactive strategies that are perti- nent to this study retain their cooperative or non- cooperative nature from their root unilateral strate- gies (Greenhalgh & Chapman, 1995). For instance, all low cooperation unilateral strategies depicted in Fig. 2 may evolve into interacti ve strategies that emphasize competition. The high cooperation uni- lateral strategies shown in Fig. 2 may evolve into trusting collaboration or subordination. Because people evolve into using integ rative strategies that are either cooperative or non-cooperative in a man- ner that reflects their cooperation under their initial unilateral strategies, predictions about ne gotiated outcomes are likely to be the same. Furthermore, to design a study that investigates the use of integra- tive strategy requires complex negotiations over an extended time. For these reasons, we only examine unilateral strategies. Method Participants and experimental task Fifty-four graduate business students partici- pated in a laboratory negotiation experiment con- ducted over six sessions with nine participants in each session. The typic al participant was 26.2 years old with 3.7 years of work experience. About 44% of the participants were women. Within each session, four participants were ran- domly assigned the role of manager (i.e., client) and five participants were assigned the role of veri- fier (i.e., auditor). Together in pairs, one manager and one verifier negotiated a value to be reported for an asset. Hence, each session consisted of four pairs of negotiators with one verifier in each period sitting out and thus earning zero fees for that period. In all negotiations, managers and verifie rs shared the same set of information indicating the range and associated probabilities of the actual value of the asset, as shown in Fig. 3. The actual value of the asset for each negotiation period was pre-deter- mined using a computer-generated random process consistent with the probabilities shown in Fig. 3. The actual value of the asset was revealed to both K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 229 managers and v erifiers after each negotiation period was over. Experimental manipulations Negotiation, including auditor–clien t negotia- tion, is a proce ss by which two or more parties hav- ing different preferences arrive at a joint decision (Murnighan & Baz erman, 1990). Thus, understand- ing preferences is key to understanding negotiation. Preference differences can arise because of informa- tion asymmetry between the client and the auditor (Gibbins et al., 2001) or because the client and the auditor operate under different incentives (Zhang, 1999). Because our predictions are based on changes to client and auditor incentives as affected by mandatory rotation, we hold information to be symmetric and allow only incentives to affect the negotiators’ preferences. 8 The experiment manipulates mandatory rota- tion at two levels (mandatory rotation imposed, yes versus no) between subjects. Participants in the mandatory rotation (MR) condition were told that ‘‘Each manager–verifier pair continues to negotiate with each other for up to three periods as long as the verifier continues to accept the man- ager’s submitted values.” In this condition, when the same negotiating pair reached the third period together, the computer screen automatically showed a message reminding both that it was their final pe riod. Participants in the no mandatory rotation (NoMR) condition were told that ‘‘Each manager and verifier pair continues to negotiate with each other for an unlimited number of periods as long as the verifier continues to accept the man- ager’s submitted values.” The consequences of a negotiation impasse to the verifier are determined by the market for cli- ents. Recall that the negotiations took place in a laboratory and in groups of nine participants con- sisting of four manager s and five verifiers. The addition of one more verifier than manager cre- ated a competitive market such that if a negotia- tion fails and the relationship is terminated, the manager is guaranteed a new verifier but the ver- ifier may or may not be reassigned to a new man- ager as described below. 9 In the NoMR condition, if a negotiation fails, the verifier can only be reas- signed to a new manager if another manager–ver- ifier pair also fails to reach an agreement. The data suggest that after an impasse in the NoMR condition, the verifier often had to wait three or more periods before being reassigned to another manager. In the MR condition, if a negotiation fails, the verifier has the same chance to be reas- signed to a new manager as in the NoMR condi- tion plus the chance to be reassigned to any manager that had reached the three-period term limit. The data suggest that in the MR condition, after a failed negotiation the verifier was immedi- ately reassigned to another manager in two of three instances and was reassigned in the next fol- lowing period in the remaining instances. The consequence of an impasse to a manager is a 40% reduction in earnings for the period, represent- ing the political costs incurred by the manager. This cost is imposed in all periods in the NoMR condi- tion and the MR condition except in a third (final) consecutive period in the MR condition with the same verifier in which political costs do not apply. Procedures and negotiation rules After arriving in the computer lab and receiving their role assignments and a computer, the partici- pants began by reading written instructions. The instructions were pre-tested to clearly communicate 8 Some prior studies manipulate negotiator preferences by providing less information to auditors than to clients. Arguably, differences in opinion can occur with full information on both sides. The present study assumes that the auditor performs sufficient tests, etc. in order to arrive at the same probability distribution as the client thus controlling for information asymmetry. 9 The decision to have one out of five auditors without a client (i.e., 20%) is constrained by the availability of subjects and a desire not to make the auditor’s incentive to avoid an impasse too strong (such as two out of five). Asset Value Distribution Value ($) Probability of being true Probability of being too high 500 5% 95% 450 5% 90% 400 10% 80% 350 10% 70% 300 15% 55% 250 15% 40% 200 15% 25% 150 10% 15% 100 10% 5% 50 5% 0% Fig. 3. Asset value distribution. 230 K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 the incentives and mechanics of the experiment. The participants then completed two practice periods. Practice periods did not affect earnings and are excluded from hypotheses testing. Following other negotiation studies (Roth, 1995), we set each period to last two and a half minutes. After the two prac- tice periods, 18 negotiation periods were co nducted for each session. In order to prevent end of game antics, the participants were not told how many periods the experiment would last. At the conclu- sion, cash earnings were determined and the partic- ipants paid and excused. Each session lasted approximately 1 hour and 15 minutes. To begin each period of negotiation, a manager submitted an asset value on the computer screen depicted in Fig. 4. After receiving the manager’s proposal, the verifier could choose to accept the submitted asset value or to negotiate with the man- ager on the computer screen dep icted in Fig. 5. Negotiations proceeded by typing messages back and forth in a text box and by the manager propos- ing new asset values on the computer screen. The Fig. 4. Manager screen. Fig. 5. Verifier screen. K.J. Wang, B.M. Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 231 [...]... presents the count of messages coded to each of the four strategies in no mandatory rotation condition and mandatory rotation condition Both verifiers and managers submitted more messages in mandatory rotation condition than in no mandatory rotation condition Also, integrating messages 10 In the negotiation literature, the use of a negotiation strategy is typically measured by the frequency of verbal... test of H1 consists of a general comparison across mandatory and no mandatory rotation conditions of the percentage of messages coded to each of the four negotiation strategies Results of this analysis are K.J Wang, B.M Tuttle / Accounting, Organizations and Society 34 (2009) 222–243 235 Table 3 Strategy use as evidenced by negotiation scripts No mandatory rotation Mandatory rotation (MR) Non-final... client-preferred values with mandatory rotation than without mandatory rotation These findings are consistent with the intent of mandatory rotation The results of our supplemental analysis further suggest that asset values are lower under mandatory rotation because of changes to the incentives experienced by the auditor and the client and not because of the length of the audit–client relationship The. .. party in the negotiation? ” Responses were anchored at 1 = ‘‘never” and 7 = ‘‘very often” The mean on this question for verifiers in mandatory rotation condition (5.47) is marginally higher (t = 1.69, p = 0.10) than the mean in no mandatory rotation condition (4.57) These findings suggest that mandatory rotation may evoke greater concerns about fairness on the part of the auditors perhaps because of the greater... year of negotiation in mandatory rotation condition in which 23.1% of the verifiers employ a strategy of inaction Hypothesis 2 predicts that mandatory rotation will change client negotiation strategies, particularly in the final periods of negotiation before rotation takes place (i.e., the third consecutive period with the same auditor) Table 2 shows that in mandatory rotation condition, manager messages... form of non-cooperation, i.e., more contending and less inaction, when mandatory rotation is imposed A possible reason for these results may be that managers responded to verifiers’ increased use of integrating and inaction strategies under the same condition (mandatory rotation) If so, the results suggest that the changes in auditor behavior caused by mandatory rotation drives the changes in client negotiation. .. mandatory rotation may affect the process of auditor client negotiations that produce financial statements observed by the public To the extent that the economic conditions in our laboratory reflect the economic conditions in which auditors provide the attestation services (c.f., Smith, Schatzberg, & Waller, 1987), the results suggest that mandating audit firm rotation 239 may affect auditor negotiations... condition No mandatory rotation Difference 21 181 44.7 88.7 À44.0 26 23 55.3 11.3 44.0 47.17 . tests compare a mandatory rotation condition against the no mandatory condition. For example, the overall hypothesis of no association between mandatory rotation condition and the use of a negotiating. test of H1 consists of a general comparison across manda- tory and no mandatory rotation conditions of the percentage of messages coded to each of the four negotiation strategies. Results of this. provides continued economic benefits and motivates concern for the relationship. Mandatory rotation affects the auditor s con- cern for the relationship. The possibility of retain- ing the same