How Does Price Competition Affect Auditor Reporting? Experimental Evidence Christopher Koch* Assistant Professor University of Mannheim, Germany [email protected]Joost van Buuren Associate Professor of Accounting, Auditing & Assurance Nyenrode Business University, the Netherlands [email protected]Arnold Wright Joseph M. Golemme Research Professor Northeastern University, U.S. [email protected]This Version: August 30, 2011 Comments welcome *Corresponding author: Dr. Christopher Koch, University of Mannheim, Schloss Ostflügel, 68131 Mannheim, Tel. +49 (621) 181 2359, Fax: +49 (621) 181 1694, Email: [email protected]. We thank all audit practitioners who supported us by providing feedback on the case material, participating in the pretests or taking part in the final study. The comments of Jörg Baetge, Jochen Bigus, Janne Chung (Discussant), Ulfert Gronewold, Christopher Humphrey, Yuping Jia, Niels van Nieuw Amerongen, Steven Salterio, Hans Verkruijsse, and Jens Wüstemann are greatly appreciated, and those from participants at the 2010 Workshop of the Annual Conference of the Accounting Section of the German Academic Association for Business Research in Aachen, Germany, the 2010 International Symposium on Auditing Research in Singapore, the 2011 Annual Congress of the European Accounting Association in Rome, Italy, and at the research seminars at the Queen’s School of Business, Canada, and the University of Trier, Germany.
Transcript
How Does Price Competition Affect Auditor Reporting?
effort restricts the opportunities to collect audit evidence, leading to higher levels of reporting
uncertainty, defined as the degree of auditors’ uncertainty about the appropriate accounting value.
Third, a high reporting uncertainty hinders auditors to take a firm stand and to require audit
adjustments, because clients are generally well informed about the financial affairs of their firm
and have the bargaining power to successfully protest audit adjustments that are not sufficiently
substantiated (Antle and Nalebuff, 1991).
We emphasize a potential moderating role of internal control strength in affecting the
links between price competition and reporting. If a client has strong as opposed to weak internal
controls, the audit risk model provides a strong justification for the reduction of audit effort; the
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auditor achieves higher assurance from additional testing by having the ability to rely on internal
audit evidence in further testing; and the lower risk of material misstatement makes lenient
reporting less risky for the auditor. These potential interactive effects between internal control
strength and each of these factors show that the conventional wisdom of more lenient reporting
with stronger price competition needs to be qualified.
Prior behavioral studies on the effects of price competition find that fee pressure can lead
to lower audit effort. However, these studies provide some mixed findings on how the reaction to
fee pressure interacts with client risk and they do not provide a definite answer to the question
whether the reduction in effort is an efficient response to fee pressure or whether it constitutes a
threat to audit effectiveness. For example, Houston (1999) finds that fee pressure makes auditors
less sensitive to client’s risk. But Gramling (1999) argues that fee pressure increases auditors’
reliance on the work of the internal audit department, suggesting a higher sensitivity of auditors
to client’s risk. We show that both positions can be reconciled. More importantly, we extend
Gramling (1999) by explicitly manipulating the important factor of internal control strength. This
manipulation constitutes an important test to Gramling’s theory. It also informs the debate on the
efficiency and effectiveness of effort reduction in response to fee pressure by testing whether
auditors also reduce effort for clients with weak internal controls for which this reduction is less
justifiable due to their high risk.
Prior studies often assume that low effort inevitable leads to lenient reporting. This
assumption is common in experimental economics studies (e.g., Fischbacher and Stefani, 2007;
Bowlin et al., 2009). It is also implicit in the definition of acts of reduced audit quality that
regularly comprise both low effort and lenient reporting (e.g., accepting doubtful audit evidence,
truncating a sample) {e.g., Coram, 2008 #2114}. However, analytical literature shows that it can
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be rational for auditors to use a strategy of both low effort and conservative reporting if litigation
risk is high (Fellingham and Newman, 1985). Therefore, we design an experiment that captures
both effort and subsequent reporting as two distinct decisions of auditors. This design makes it
possible to investigate all links between price competition and reporting individually.
We conduct an experiment to investigate how auditors respond to price competition. Both
price competition (high or low) and internal control strength (weak or strength) are manipulated
in a 2x2 between-subjects factorial design with 164 audit professionals of Big 4 and non-Big 4
audit firms as participants. The client is described as having a high inventory position. The
participants acting as audit seniors decide whether they wish to extend audit work of inventory
after having spent the initial budget on audit procedures that indicated an inventory obsolescence
issue. The audit seniors are told that their audit partner agrees to their suggestion to do additional
audit work to the extent they wished for. Then, the audit seniors state their expectations about the
audit adjustments they will recommend to the audit partner after having completed the additional
audit testing. The recommendation covers both the audit adjustment that should be proposed and
the minimum audit adjustment that should be persisted on by the audit partner. The experimental
design is unique as it captures how price competition affects auditor reporting (proposed and
minimum audit adjustments) via audit effort (audit hours) and reporting uncertainty (range of
audit adjustments). Only a few experimental studies capture both audit effort and auditor
reporting (e.g., Kadous et al., 2008), and we are not aware of any study employing such a design
for investigating the effects of price competition.
The findings support the presence of the predicted links between price competition and
reporting, but also highlight the moderating role of internal control strength. First of all, auditors
reduce audit effort in response to price competition more if internal controls are strong. Second,
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additional audit effort reduces reporting uncertainty more if internal controls are strong. Third, a
reduction in reporting uncertainty leads to less lenient reporting especially if internal controls are
strong. This means that auditors reduce testing effort which, in turn, increases reporting
uncertainty and finally leads to more lenient reporting only if internal controls are strong. If the
internal controls of the clients are weak, the results suggest that auditors consider it less
justifiable to reduce testing effort, achieve a smaller reduction in uncertainty with additional
effort, and are less likely to report leniently in response to higher reporting uncertainty.
The paper proceeds as follows. Section 2 develops the hypotheses. Section 3 describes
the experimental design and section 4 presents the results. Section 5 discusses the results and
their implications for practice and future research.
II. HYPOTHESIS DEVELOPMENT
1. Internal Control Strength and the Effects of Price Competition on Audit Effort
Economic theory predicts that intense price competition constitutes an incentive to increase
efficiency (e.g., Hay and Liu, 1997).2 The audit risk model suggests the consideration of the risk
of material misstatements as a means to achieve audit efficiency. If the client has strong internal
controls and an effective internal audit department, the auditor can reduce substantive audit
2 Archival evidence on the effects of price competition on audit effort is limited. The studies often focus on the relationship between competition and audit fees, a surrogate measure for audit effort. Jensen and Payne (2005) observe for the municipal audit market that allowing audit firms to disclose their audit fees in the initial stages of auditor selection is associated with reduced audit fees. Hay and Knechel (2010) show with data from New Zealand that audit fees decrease after audit firms are given permission to solicit public firms, but that audit fees increase after the removal of the ban on audit firm advertisements. Further, Johnstone et al. (2004) report that audit firms submit lower bids for competitive engagements. However, it is not obvious whether fee pressure causes a reduction in audit effort, since auditors could alternatively accept a lower margin for more competitive engagements. In line with this reasoning, Johnstone et al. (2004) do not observe that auditors decrease their planned audit hours in response to competition.
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testing and still achieve sufficient audit assurance (ISA 200.32; ISA 330.5). However, the
research on the descriptive validity of the audit risk model provides mixed evidence on the
relationship between internal control strength and audit hours. Earlier archival studies based on
audit working papers find no or only limited evidence that auditors risk-adjust their audit plan
(Mock and Wright, 1993; O'Keefe et al., 1994; Quadeckers et al., 1996; Mock and Wright, 1999),
while a more recent study does (Bell et al., 2008). We predict that fee pressure motivates
auditors to be more responsive to the risk of material misstatement and, accordingly, to lower
effort for clients with strong internal controls.
Our prediction relates most closely to the study of Gramling (1999) who finds that fee
pressure increases auditors’ reliance on the internal audit function. Gramling interprets the
finding as potentially worrying, because her experimental setting portrays the internal audit
department to be of low-to-moderate quality. But she admits that the lack of a benchmark makes
it difficult to evaluate whether auditors in her study rely too strongly on the work of the internal
audit department. Our additional manipulation of internal control risk provides such a benchmark,
because it tests whether auditors increase their reliance on internal controls in response to price
competition if internal controls are weak. We expect that auditors will be more reluctant to
reduce testing (i.e., increase detection risk) for clients with weak internal controls, since overall
audit risk will be unacceptably high in that scenario.
Houston (1999) suggests that fee pressure can actually reduce auditors’ sensitivity to
clients’ risk of material misstatement, an effect that would go against our prediction. Based on
accountability theory (Gibbins and Newton, 1994), he argues that auditors under fee pressure
will evaluate client risk in a biased manner and will disregard increases in the risk of material
misstatement. He finds evidence for such a behavior and shows that it can have the effect that
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auditors under fee pressure do not adjust their time budget to client’s risk. However, an
interpretation of the results needs to consider that Houston (1999) does not manipulate client risk
by varying internal control strength, but by changing accounting ratios across experimental
conditions. Gramling (1999) emphasizes that auditors’ reaction to fee pressure happens through a
higher reliance on the work of the internal audit department, an effect that the experimental
design of Houston (1999) does not capture. As our study manipulates internal control strength,
we expect to observe that fee pressure enhances auditors’ sensitivity to the risk of material
misstatement. We do not expect that the biased evaluation of client’s risk will affect our results,
because our experimental scenario focuses on auditor behavior during the audit after an
assessment of client’s risk has already taken place.
In summary, we expect that auditors are more likely to reduce effort in response to strong
internal controls if price competition is intense versus weak based on competition theory and the
audit risk model (see also Figure 1, Panel A).
H1: Auditors reduce effort in response to strong internal controls to a
greater degree if price competition is strong versus weak.
2. Internal Control Strength and the Indirect Effects of Price Competition on Auditor
Reporting Through Audit Effort
Analytical auditing research suggests that effort influences reporting via its effect on the level of
uncertainty that auditors have in their judgment (Fellingham and Newman, 1985). Larger audit
effort decreases auditors’ uncertainty about the underlying economic reality and about the
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appropriate accounting method. The lower uncertainty enables auditors to make better informed
reporting decisions. Similarly, the audit risk model that predicts that more extensive auditing
reduces audit risk which should also reduce the reporting uncertainty.
Therefore, we investigate in a first step how effort affects reporting uncertainty. We
expect that the relationship between audit effort and the level of uncertainty to be stronger the
more efficient the collection of audit evidence is. We argue that evidence collection is more
effective and efficient for a client with strong internal controls, because the evidence gathered is
more reliable. Therefore, we expect that audit effort has a stronger impact on auditors’ reduction
of reporting uncertainty if internal controls are strong versus weak.
H2: Auditors’ reporting uncertainty decreases to a greater degree with
additional effort if internal controls are strong versus weak.
Following the concept that effort and reporting are linked through reporting uncertainty,
Fellingham and Newman (1985) group combinations of effort and reporting decisions into
strategies, and identify three strategies as dominant. In their model, auditors decide on whether
or not to extend the audit after having conducted regular planned audit testing. If auditors decide
not to extend the audit, they have to make their reporting decision under higher uncertainty about
the true states underlying the financial statements than if they have the opportunity to extend the
audit. In this case, the auditors may either accept the preliminary valuations and disclosures in
the financial statements (lenient strategy) or require audit adjustments (conservative strategy). If
auditors decide to extend the audit, they can gather additional audit evidence which allows them
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to report contingent on the further findings (extensive strategy). Each of these strategies has its
own advantages: the lenient strategy reduces the risk of losing the client due to disagreements,
the conservative strategy reduces litigation risk, and the extensive strategy is more costly, but
reduces both the risk of litigation and of failing to detect a material misstatement that may be
present by enabling the auditor to make a more precise reporting decision. Thus, consideration of
which of the three strategies to select entails in essence a consideration of costs (litigation and/or
client loss) and benefits (reporting precision).
Applying the cost-benefit considerations to our experimental setting suggests that high
reporting uncertainty leads to lenient reporting only if clients’ internal controls are strong. The
reasoning is as follows. Strong internal controls imply that the risk of material misstatement is
low. Therefore, the expected costs of accepting the clients’ preferred accounting method (e.g.,
litigation risk, reputation risk) are relatively low compared to the expected costs of rejecting it
(e.g., client retention risk) as long as reporting uncertainty is high. Only if auditors have gained
sufficient certainty about the presence of errors or irregularities might the costs of demanding
adjustments be relatively high compared to the benefits from accepting the statements. This
suggests a strong relation between a reduction in reporting uncertainty and the amount of
required audit adjustments for clients with strong internal controls. Our expectations differ for
clients with weak internal controls. In this scenario, the relative costs of accepting clients’
financial statements are relatively high compared to the expected costs of demanding
adjustments. Therefore, auditors are likely to require audit adjustments in an attempt to reduce
litigation risk even when facing high reporting uncertainty. This willingness to require
adjustments already under high reporting uncertainty means that the relation between the level of
uncertainty and required audit adjustments is weak for clients with weak internal controls.
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Therefore, we expect that a reduction in uncertainty increases audit adjustments more for
clients with strong as opposed to weak internal controls (see also Figure 3, Panel A).
H3: The amount of required audit adjustments increases to a greater degree
with lower reporting uncertainty resulting from additional testing if
internal controls are strong versus weak.
In summary, we expect that price competition only leads to lenient reporting through lower effort
and higher reporting uncertainty if internal controls are strong. This prediction is consistent with
the prediction of the reduced audit quality acts literature that auditors are more willing to accept
doubtful audit evidence or to truncate a sample in response to time pressure if the risk of material
misstatement is low (Coram et al., 2004). However, we note that our experimental design differs
substantially compared to the design used by that literature. The main difference is that auditors
in our study make both an effort and a reporting decision, while the reduced audit quality acts
literature let auditors judge the likelihood to engage in predefined strategies involving low effort
and lenient reporting. Our approach adds to the literature in several ways. Most importantly, it
enables an explicit testing of all links between price competition and auditor reporting.
Furthermore, it involves auditors’ decisions instead of auditors’ evaluation of other auditors’
behavior and it uses a neutral and general framing of the effort and reporting decision. These
differences make it possible to re-evaluate the mixed findings of the reduced audit quality
literature on the effects of time pressure and risk of material misstatement (Coram et al., 2004)
from a new perspective.
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IV. EXPERIMENTAL DESIGN
1. Participants and Procedure
We conduct a controlled experiment in which audit practitioners assumed the role of the in-
charge senior responsible for auditing inventory. The case material was developed and pre-tested
in collaboration with 12 audit practitioners at all levels of experience. The structure of the
experiment is as follows. First, practitioners received background information on the audit
engagement and the audited client. This description included the between-subject manipulation
of price competition and internal control strength at two levels (2x2 factorial design), with
participants being randomly assigned to one of the four experimental conditions. The
experimental case also introduced an inventory obsolescence issue as a material auditing
problem. Second, the materials described the audit procedures conducted so far in order to
evaluate the appropriateness of the measurement of inventory, and informed the practitioners
about the outcome of these procedures. The description portrayed the evidence gathered as
sufficient but also highlighted additional audit procedures that could be taken to further reduce
the remaining uncertainty. Third, participants were informed that the initial time budget for
evaluating the appropriateness of inventory valuation has been fully spent. Then, participants
were asked whether they would like to request the manager-in-charge for additional audit hours
on this audit issue. Fourth, they were told that the audit manager approved the additional audit
hours and they were asked to assume that they conducted the additional procedures as planned.
Fifth, they recommended the amount of audit adjustment which the audit managers should
propose and the adjustment on which the audit manager should persist. Thus, participants
provided the write-down that should initially be proposed in auditor-client negotiation and the
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write-down limit, which essentially reflects the bargaining range and reporting uncertainty
(Gibbins et al., 2010; Hatfield et al., 2010).
Table 1 presents descriptive statistics on the sample. One hundred and sixty four (164) 3
audit practitioners from Big 4 (n = 92) and non-Big 4 (n = 65) audit firms participated in the
experiment and were predominately at the rank of senior (41 staff; 96 seniors, 16 managers, and
11 other ranks). Their average number of years of experience in auditing was 5.79 years (SD =
2.95), and they are experienced as an in-charge auditor (median: 6-20 times). This level of
participants’ experience fits the demands of the experimental task. First, seniors regularly have a
substantial influence on the detailed planning of the audit (Bierstaker et al., 2006, p. 3), and prior
studies regularly recruit staff and senior auditors in experiments examining audit effort (e.g.,
Gramling, 1999; Houston, 1999). Second, the task of assessing the appropriateness of inventory
valuation is usually assigned to seniors (Abdolmohammadi, 1999). Participants report they have
been involved in inventory write-down decisions several times (median: 2-5 times) and, thus,
have the requisite task knowledge for the experiment. Further, while the final decision to ask the
audit client for audit adjustments is with audit managers and audit partners, they often base their
decision on the findings and suggestions of the senior-in-charge (e.g., Dezoort et al., 2001).
Moreover, we expect audit seniors to be aware of the pressure arising from price competition,
because prior studies show that fee pressure is passed on to the audit team members in the form
of time budget pressure (Kelley and Margheim, 1990; Otley and Pierce, 1996; Sweeney and
Pierce, 2006). Achieving time budgets is an important goal for auditors at all levels, because
career advancement and performance evaluations often depend on it (Wright, 1982; Kaplan and
Reckers, 1985; Pierce and Sweeney, 2004). 3 This number excludes seven participants not actively involved in auditing, and five subjects with missing values on the dependent variables. The reported numbers of auditors in subsamples do not always add up to the total number of 164 participants due to further missing values on the demographic factors.
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The participants were recruited from two Executive Master and one Executive Post-
Master Course at a university in the Netherlands. 4 The experiment was conducted under
controlled conditions with at least one of the researchers present. First, the general instructions
were read aloud before participants received the instructions, the background description on the
audit engagement, and the case study. After completing the case study, participants were asked
to fill out a questionnaire including demographical questions and manipulation checks. Most
participants self-reported they spent between 20 and 30 minutes on the study. Participants rated
the study to be realistic (mean (SD) = 5.09 (1.14)), self-reported to be highly motivated to
answer all questions appropriately (mean (SD) = 6.06 (0.83)) and to take the study very seriously
(mean (SD) = 6.24 (0.70)) based on a 7-point-Likert scale ranging from 1 (= not realistic/not
motivated/not serious at all) to 7 (= very realistic/very motivated/very serious).
2. Setting
The background description portrayed the client to be a large company active in the development
and manufacturing of telecommunication devices that has grown steadily over the last couple of
years. The management of that firm receives a compensation package that is half fixed (salary)
and half variable (compensation tied to earnings), and the audit committee is fully independent
from the management and is supportive of the auditor. The description of the audit committee is
reflective of the prescribed role of the audit committee in Europe (European Union, 2006) and
the U.S. (DeZoort et al., 2008; Cohen et al., 2010b). The litigation and reputation risk for the
client were set at high levels by explaining that the largest shareholder of the company is an
4 There were two sessions where the data were gathered. No significant differences were found between the different experimental administrations.
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investment fund that has a history of actively pursuing their interest through lawsuits and press
campaigns. Such a setting is especially interesting to consider, because “(p)ublic scrutiny of the
audit profession, coupled with intense competitive pressures, appears to shape the context in
which public accounting firms exist” (McNair, 1991, p. 635). It is also realistic scenario for the
Netherlands where auditor liability is not limited (Meuwissen and Wallage, 2007). In addition,
participants received an abbreviated financial statement and income statement, together with the
information that the audit partner has set the tolerable error level for the specific account at 10
Million €.
3. Independent Variables
Price competition and internal control strength were manipulated between-subject at two levels.
The level of price competition was set at strong (weak) by stating that the firm audited will
probably (not) have a public call for tender, because it has a regular procedure (has no history) of
putting audits out for tender. This manipulates the level of competition, because the incumbent
auditor is regularly sought to submit tenders, but faces a high risk of being replaced if other
auditors submit more competitive bids especially with regard to pricing (Beattie and Fearnley,
1998). We further emphasized that competition will affect the pricing of the audit by stating that
it is very likely that other audit firms will submit price competitive bids. In the strong (weak)
price competition setting auditor tenure was also set at 3 years (12 years), since shorter tenure is
associated with a higher likelihood of auditor dismissal (Landsman et al., 2009).
The description of a strong (weak) internal control system stated that the internal audit
department is fairly large (small), centralized (decentralized) and with a sufficient (limited)
budget for ensuring that controls are effective, resulting in all (not all) necessary internal controls
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being implemented and effective. The description of the internal audit department is based on
findings that the size (in terms of personnel) and budget are important determinants for internal
audit effectiveness (Prawitt et al., 2009).
4. Task and Dependent Variables
The task involved a case study on an inventory obsolescence issue. First, participants were
informed that 40 audit hours have been budgeted for evaluating the appropriateness of the
measurement of inventory, and that this is a key issue in the audit. Further, they were provided
with the reporting standard that the measurement of inventory is based on the lower of cost or net
realizable value (IAS 2.9), that the accounting guidelines of the audit client implement this rule
by writing down inventory that is unlikely to be sold within the next six months, and that this
accounting guideline is in line with audit firm policies. This guideline is based on an example in
the auditing textbook by Knechel et al. (2007, p. 552).
The audit procedures conducted were then described. The audit senior interviewed the
contact person of the accounting department and learned that the estimate of future sales was
based on last year sales figures with a slight upward adjustment reflecting the general positive
sales trend experienced in the past. The auditor looked into several directions for evaluating the
appropriateness of this estimate and collected evidence on recent sale figures, technological
developments and competitors’ behavior. Together, the findings suggest an undue build-up of
inventory indicating that probably 15% (60 Mio. €) to 17.5% (70 Mio. €) of total inventory is
obsolete. These audit procedures used up the scheduled budget of 40 hours.
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Second, attention was directed towards the decision of whether to extend the audit. It was
emphasized that the evidence collected so far could be considered sufficient for a normal audit,
but that it would also be possible to gather additional evidence for further reducing uncertainty.
This was illustrated by describing how the audit procedures could be extended and by pointing
out possible areas to look at, e.g., searching for additional information about future orders of
large costumers. After having received this information, participants were asked how many
additional audit hours they would schedule for auditing inventory if any. The response to this
question constitutes the dependent variable for measuring audit effort.
Third, the case study then focused on the reporting decision. If participants chose to
conduct additional procedures, they were told that the audit manager agrees to the amount of
additional audit testing.5 Then, they were asked to imagine conducting the additional procedures
as planned and to recommend to the audit manager the audit adjustment they would propose and
the minimum audit adjustment they would persist. The mean value of the proposed and
minimum adjustments is our dependent variable for expected write-downs, because negotiation
literature finds that both the initially proposed and the minimum amount of audit adjustments
determine the expected outcome (Hatfield et al., 2008; Trotman et al., 2009). The range between
initially proposed and minimum audit adjustments is the negotiation range (Hatfield et al., 2010).
The negotiation range scaled by expected write-downs is our proxy for reporting uncertainty.
5 In the first round of experiments, we also included a within-subject manipulation on audit effort. This was implemented by constructing a second scenario in which participants were told that their audit manager asks them to restrict their audit testing to an absolute minimum due to budget constraints and were asked about their write-down decision under that circumstance. The first round of experiments found no effect of this manipulation which is why this was excluded in the second round of experiments.
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We deliberately asked auditors to imagine that the audit proceeds as expected instead of
providing additional audit evidence in order to capture the effects of extending effort on
reporting and in order to avoid confounding effects of auditors’ interpretation of additional
evidence. In other words, we assume that auditors follow an ex ante strategy of reducing
reporting uncertainty through gathering additional evidence. For example, we expect that an
auditor choosing to extend the audit will assess lower reporting uncertainty when making the
audit adjustment decision. Providing audit test results would confound the effects of the strategy
decision with the interpretation of the audit evidence. We note that negotiation literature in
auditing regularly uses expectations about outcomes as dependent variables (e.g., Ng and Tan,
2003; Trotman et al., 2009)
V. RESULTS
1. Manipulation Checks and Covariates
After completing the case study, participants received a questionnaire on five relevant factors of
the audit engagement in order to verify that they encoded the main characteristics of the scenario
correctly.6 The first two factors are the level of price competition and the strength of internal
controls. First, we asked participants to assess the degree of price competition on a scale ranging
from 1 (= very weak) to 7 (=very strong). Mean (SD) risk ratings are 2.78 (1.07) and 5.49 (0.67)
for the weak and high price competition condition respectively, which is a highly significant
difference (two-tailed t-test: p < 0.01) and in the direction expected. Second, we asked
6 In addition, participants were asked about the relevant factors of the audit engagement directly after the information on the background of the audit engagement was presented and before the case study started in order to ensure that participants carefully read and were familiar with the description of the audit engagement. The responses to this question and to the questions asked in the follow-up questionnaire differ insignificantly.
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participants to assess the strength of internal controls on a scale ranging from 1 (=very weak) to
7 (=very strong). Mean (SD) risk ratings were 3.39 (0.99) and 5.06 (0.97) for the weak and
strong internal control system condition respectively, which is again a highly significant
difference (two-tailed t-test: p < 0.01) and in the direction expected. The results indicate the
manipulations were successful.
Houston (1999) predicts that auditors under fee pressure are more likely to disregard high
client risk. He finds evidence for the prediction for client risk arising from high sales growth and
high accounts receivable position. We observe that auditors in the weak internal control
condition evaluate internal controls significantly stronger if price competition is strong versus
weak (mean (SD) = 3.71 (1.04) vs. 3.05 (0.81), p < 0.01). But auditors in the strong internal
control condition do not differ significantly in their internal control judgment across price
competition conditions (mean (SD) = 5.10 (1.03) vs. 5.02 (0.92), p = 0.73). This confirms
Houston’s predictions in a new context. We note that the difference in the perception of client
risk still differs highly significantly across internal control conditions for both auditors in the
weak and strong price competition condition (p < 0.01)
In the three following questions, we were interested in whether participants understood
and remembered relevant factors of the audit environment from the description. Consistent with
our intention, participants rated the client to be important (mean (SD) = 5.98 (0.60)), the audit
committee to be cooperative towards the auditor (mean (SD) = 5.61 (0.83)), and the litigation
risk to be high (mean (SD) = 5.25 (0.99)). These ratings were elicited by using a scale from 1
(=very unimportant/very uncooperative/very low) to 7 (=very important/very cooperative/very
high). All mean values are significantly greater than the middle point of the response scale (p <
0.01).
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Participants’ demographic characteristics measured in post-experimental questionnaire
are not significant covariates in any of the primary analyses, i.e., gender, auditor experience
(number of years of auditing experience, prior experience as senior-in-charge and prior
experience in inventory auditing), and auditor attitude (risk attitude, trust, professional
skepticism)7.
2. Descriptive Statistics
Table 2 shows descriptive statistics for the dependent variables: audit hours, write-down range
and write-downs.8 Auditors ask the manager to extend the audit of inventory valuation by an
average of additional 20.88 hours (SD = 9.87 hours). The lowest amount of additional audit
hours is requested by auditors facing strong price competition and auditing a client with strong
internal controls (mean = 18.38 hours; SD = 9.42 hours). The expected write-down is the mean
of the proposed write-down (Mean (SD) = 76.95 Mio. € (36.46 Mio. €)) and the minimum write-
down (Mean (SD) = 56.51 Mio. € (29.35 Mio. €)). It is on average 66.43 Mio. € (SD = 30.50
Mio. €). The write-down range between the proposed and minimum write-down scaled by the
expected write-down is on average 32.43 % (SD = 25.93 %).
--- Insert Table 2 here ---
7 Auditor employer has a significant main effect on audit effort as Big 4 auditors are associated with fewer additional audit hours. Meanwhile, this factor has no significant main effect on the other dependent variables and no significant interaction effects with the treatment variables. Including a Big 4 dummy into the reported analyses does not affect the interpretation of the results. 8 All dependent variables have a natural lower bound of 0. As we do not restrict the upper bound, we need to control for outliers. We do so by winsorizing all dependent variables at the upper bound at the 99th percentile. This moves two observations with audit hours of 60 hours and 100 hours to the upper bound of 40 audit hours, one observation with a 200% write-down range observation to the upper bound of 100% write-down range, and one observation with a 200 Mio. € write-down to the upper range of a 150 Mio. € write-down.
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3. Internal Controls and the Effects of Price Competition on Audit Hours (H1)
Hypothesis 1 states that auditors reduce effort in response to strong internal controls to a greater
degree if price competition is strong versus weak (see Figure 1, Panel A). The results show the
expected interactive effect of internal controls and price competition on audit hours (p-value
(one-tailed) = 0.032; see Table 3, Panel A; Figure 1, Panel B). If price competition is strong,
auditors adjust significantly the extent of additional audit hours to the strength of internal
= 0.046). In comparison, if price competition is weak, auditors do not change their audit effort
significantly in response to internal control strength (weak IC: 20.45 (10.28); strong IC: Mean
(SD) = 22.45 (9.27); p-value (two-tailed t-test) = 0.358). This suggests that competitive pressure,
as predicted in H1, motivates auditors to enhance audit efficiency through reliance on internal
controls.
4. Internal Controls and the Effects of Effort on Reporting Uncertainty (H2)
We hypothesize that audit effort affects reporting via its impact on reporting uncertainty. We
expect to observe such a reduction in uncertainty especially in a scenario where internal controls
are strong (H2, Figure 2, Panel A). In line with our expectation, we observe a highly significant
interaction between audit hours and internal control strength on the write-down range (p-value
(one-tailed) = 0.001, Table 3, Panel B; Figure 2, Panel B). If internal controls are strong,
additional audit hours help auditors to reduce the range of potential write-downs as a significant
negative correlation between both variables shows (corr. (pearson) = -0.272, p-value = 0.013). If
20
internal controls are weak, the relationship becomes insignificant (corr. (pearson) = 0.122, p-
value = 0.276). One further observation is that price competition is another highly significant
factor in the analysis (p-value = 0.002), indicating that intense price competition is associated
with lower reporting ranges reflecting a desire to reach agreement.
5. Internal Controls and the Effects of Reporting Uncertainty on Reporting (H3)
Finally, we test whether reporting uncertainty affects reporting contingent on internal control
strength (H3; Figure 3, Panel A). As anticipated, write-down range as a proxy for reporting
uncertainty and internal control strength have a significant interactive effect on the expected
write-down (p-value (one-tailed) = 0.034; Table 3, Panel C, Figure 3 Panel B). A reduction in
reporting uncertainty is associated with a larger expected write-down if internal controls are
strong (corr (pearson) = -0.505; p-value = 0.003), but does not significantly affect the expected
write-down if internal controls are weak (corr (pearson) = -0.064; p-value = 0.571). The negative
correlation between reporting uncertainty and the expected write-down for clients with strong
internal controls suggest that auditors reduce reporting uncertainty in order to be in a position to
demand a write-down in that scenario. In contrast, the insignificant correlation for clients with
weak internal controls suggests that auditors demand a write-down from clients even if reporting
uncertainty is high given higher risks of an undetected misstatement.
Competition has no a significant main effect on expected write-down (p-value = 0.976).
This suggests that competition has no direct effect on reporting, but only the indirect effect via
audit effort and reporting uncertainty.
21
6. Empirical Structural Equation-based Path Model
The use of structural equations-based path analysis offers the advantage of simultaneously
testing all hypothesized links together with additional potential links. Further, the method
considers and adjusts for potential measurement errors in the observed variables. We test for the
potential moderating role of internal control strength by using a nested model comparison
(Rigdon et al., 1998). This approach compares the goodness of fit of two models. The first model
assumes no interaction effects, constructed by constraining the coefficient parameters to be equal
across both internal control conditions. The second model releases the constraint of one
parameter. The parameter that has the highest absolute standardized residual covariance in the
constrained first model should be unconstrained first. An interaction effect is demonstrated if the
goodness of fit of the less constrained second model is statistically significantly higher than that
of the first model. If an interaction effect is present, the respective parameter should remain
unconstrained. The procedure is continued until the fit of the model cannot be further improved.
We include in the model all hypothesized links and add a potential link between price
competition and write-down range, since this link was significant in the prior analysis reported
(see Table 3, Panel B). Further, we allow for errors in the observed variables audit hours, write-
down range and expected write-down with a potential correlation in the errors of the write-down
range and write-down variable, since both variables rely on the same underlying factors
(proposed and minimum write-down). Applying the nested model approach reveals that internal
control strength has a moderating effect which is significant for Link 1 and Link 2 and with
marginally significant effects for Link 3 and for the link between price competition and write-
down range. This provides further support for the interactive effects predicted in hypotheses 1-3.
The fit of the model is excellent as indicated by a Tucker-Lewis index value of 1.349 (cutoff <
22
0.96) and a standardized root-mean-square residual of 0.004 (cutoff > 0.08) (Hu and Bentler,
1997, 1999). Consistently, the root mean square error of approximation (RMSEA) clearly rejects
that the model is incorrectly specified (p < 0.01). Further, an insignificant chi-square statistics of
the model of 1.127 (6 df, p = 0.980) suggests that the model fit cannot be significantly improved.
VI. CONCLUSION
In this study, we investigate how auditors respond to price competition. We capture both auditors’
effort and reporting decision which makes it possible to test all links through which price
competition can affect reporting. Our results show that price competition can affect reporting via
its impact on audit effort and reporting uncertainty. We also identify internal control strength as
an important moderating variable.
We find that auditors select less additional audit testing in response to intense price
competition if they can rely on strong internal controls. Gramling (1999) observed that price
competition reduces effort even if internal controls are only moderate. Our findings suggest that
this tendency is mitigated in the critical scenario where clients have weak internal controls.
We further observe that lower audit effort leads to a higher reporting uncertainty and,
thus, to lower audit adjustments if internal controls are strong. This observation supports
conventional wisdom that lower effort can lead to lenient reporting, and it demonstrates that
reporting uncertainty is an important mediating variable in this relation. But it also shows that
weak internal controls are a boundary condition for the conventional wisdom. This adds to the
literature on reduced quality acts that identifies the risk of material misstatement as a mitigating
factor for auditors’ tendency to prematurely sign-off accounts under time pressure (e.g., Coram
23
et al., 2004). Our study offers further support for this finding by using a new approach that
captures audit effort and auditor reporting in two subsequent decisions and that measures
additionally reporting uncertainty. This enables a more detailed and comprehensive investigation
of auditors’ strategy choice.
The interpretation of the results should consider the specific characteristics of the
experimental setting. Note that the highly judgmental nature of the audit task does not provide a
normative benchmark for evaluating the quality of the decision auditors make. Accordingly,
different auditor effort and reporting choices should not be interpreted as indicating different
levels of audit quality. Further, the experimental setting emphasized the presence of high
litigation risk. In environments of low litigation risk, it is more likely that low effort is associated
with lenient reporting (Caramanis and Lennox, 2008). The experimental setting portrayed the
audit committee to be highly supportive of the auditor. This fosters the viability of the
conservative strategy by increasing the bargaining power of the auditor (Cohen et al., 2010a).
We believe that this setting interesting, since recent regulatory initiatives emphasize the role of
independent audit committees (DeZoort et al., 2008). However, future research that examines the
auditor’s strategies under high price competition where the audit committee is less effective
would be useful. Another characteristic to consider is that auditor reporting is measured by the
recommended audit adjustments of audit seniors to the audit manager and not by the final
negotiated resolution of the matter and resulting audit opinion. This focus does not capture the
negotiation strategies and decision-making of the audit manager or audit partner under price
competitive conditions in considering audit adjustments (e.g., Gibbins et al., 2001), an additional
promising avenue for future research.
24
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27
TABLE 1 Participants’ Characteristics
mean (SD) / n (%)
Auditing experience [years] 5.79 (2.95)
Hierarchy level
Staff 41 (25.0%)
Senior 96 (58.5%)
Manager 16 (9.7%)
Other 11 (6.7%)
Experience as auditor on-site in charge
Never 17 (10.4%)
Once 4 (2.4%)
2-5 times 42 (25.6%)
6-20 times 50 (30.5 %)
> 20 times 51 (31.1 %)
Experience in inventory write-down decisions
Never 16 (9.8%)
Once 17 (10.4%)
2-5 times 65 (39.9%)
6-20 times 50 (30.7%)
> 20 times 15 (9.2%)
Employer
Big 4 audit firm 92 (56.1%)
Non-Big 4 audit firm 65 (39.6%)
Gender
Female 47 (28.7%)
Male 116 (70.7%)
n = 164 (numbers do not always add up due to missing values on demographics).
28
TABLE 2 Descriptive Statistics
Weak Competition Strong Competition Total
Internal Controls Internal Controls
Weak (n = 40)
Strong (n = 42)
Weak (n = 42)
Strong (n = 40)
Audit Hours 20.45 (10.28)
22.45 (9.27)
22.09 (10.32)
18.38 (9.42)
20.88 (9.87)
Proposed Write-down
80.80 (39.40)
74.19 (29.95)
79.69 (38.91)
73.13 (37.70)
76.95 (36.46)
Minimum Write-down
52.33 (25.74)
55.21 (30.14)
62.26 (27.90)
56.03 (33.30)
56.51 (29.35)
Expected Write-down
66.56 (31.19)
64.70 (29.26)
70.98 (31.89)
63.33 (30.18)
66.43 (30.50)
Write-down Range [in %]
43.29 (27.02)
34.36 (23.16)
23.94 (24.30)
28.45 (26.02)
32.43 (25.93)
Table 2 shows the means (SD) of dependent variables by experimental condition. Audit Hours: Requested additional audit hours for extending substantive audit testing [in hours]. Proposed Write-down: Audit senior’s recommendation of the amount of write-downs the audit manager should initially propose in auditor-client negotiation [in Mio. €] Minimum Write-down: Audit senior’s recommendation of the amount of write-downs the audit manager should definitely persist on in auditor-client negotiation [in Mio. €] Expected Write-down: Mean value of Proposed Write-down and Minimum Write-down [in Mio. €]. Write-down Range: Difference between Write Proposed Write-down and Minimum Write-down scaled by Expected Write-down [in %].
29
TABLE 3 ANOVA/ANCOVA Results Panel A: The Effects of Competition and Internal Control Strength on Audit Hours
Source df SS F p-value
Competition 1 61 0.63 0.430
Internal Control Strength 1 30 0.31 0.577
Internal Control Strength * Competition
1 335 3.47 0.032+
Error 160 15469
Panel B: The Effects of Competition, Internal Control Strength and Audit Hours on Write-down Range
Source df SS F p-value
Competition 1 8515 14.14 0.002
Internal Control Strength 1 240 0.40 0.529
Internal Control Strength * Competition 1 1163 1.93 0.167
Audit Hours 1 635 1.06 0.306
Internal Control Strength * Audit Hours
1 5627 9.34 0.001+
Error 158 95140
Panel C: The Effects of Competition, Internal Control Strength and Write-down Range on Expected Write-down
Source df SS F p-value
Competition 1 1 <0.01 0.976
Internal Control Strength 1 1115 1.24 0.268
Internal Control Strength * Competition 1 487 0.54 0.464
Write-down Range 1 5066 5.62 0.019
Internal Control Strength * Write-down Range
1 3037 3.37 0.034+
Error 158 142474 n = 164 Audit Hours: Requested additional audit hours for extending substantive audit testing [in hours]. Write-down Range: Difference between Write Proposed Write-down and Minimum Write-down scaled by Expected Write-down [in %]. Expected Write-down: Mean value of Proposed Write-down and Minimum Write-down [in Mio. €]. +one-tailed p-value (all other p-values are two-tailed)
30
FIGURE 1 (H1) The Effects of Competition and Internal Control Strength on Audit Hours Panel A: Predicted Effect
14
Weak Strong
Audit Hours
Internal Controls
WeakCompetition
StrongCompetition
Panel B: Observed Effect
Audit Hours: Requested additional audit hours for extending substantive audit testing [in hours]. See Table 3, Panel A for ANOVA underlying the interaction effect.
16
18
20
22
24
Weak Strong
Audit Hours
Internal Controls
WeakCompetition
StrongCompetition
31
FIGURE 2 (H2) The Effects of Internal Control Strength and Audit Hours on Write-down Range Panel A: Predicted Effect
Panel B: Observed Effect
Audit Hours: Requested additional audit hours for extending substantive audit testing [in hours]. Write-down Range: Difference between Write Proposed Write-down and Minimum Write-down scaled by Expected Write-down [in %]. See Table 3, Panel B for ANCOVA underlying the interaction effect.
0
0 40
Write-down Range
Audit Hours
WeakInternal Controls
StrongInternal Controls
0
10
20
30
40
50
60
0 40
Write-down Range
Audit Hours
WeakInternal Controls
StrongInternal Controls
32
FIGURE 3 (H3) The Effects of Internal Control Strength and Write-down Range on Expected Write-down Panel A: Predicted Effect
50
0 100
ExpectedWrite-down
Write-down Range
Panel B: Observed Effect
50
60
70
80
90
0 100
ExpectedWrite-down
Write-down Range
Write-down Range: Difference between Write Proposed Write-down and Minimum Write-down scaled by Expected Write-down [in %]. Expected Write-down: Mean value of Proposed Write-down and Minimum Write-down [in Mio. €]. See Table 3, Panel C for ANCOVA underlying the interaction effect.
33
FIGURE 4 Path Model of the Effects of Price Competition and Internal Control Strength Panel A: Hypothesized Path Model Panel B: Observed Path Model ___________ Panel A illustrates how price competition is expected to influence audit adjustments via its impact on audit effort and reporting uncertainty. The parenthetical comment next to each link represents the expected coefficient sign. The star (*) indicates that the strength of Link 1, Link 2 and Link 3 is expected to be moderated by the strength of the internal controls. Panel B shows the results of the path analysis. The unstandardized path coefficient is shown next to each link. Overall goodness of fit of the model is very good (Chi-square = 1.127; df = 6; p = 0.980, n = 164). Audit Hours: Requested additional audit hours for extending substantive audit testing [in hours]. Write-down Range: Difference between Write Proposed Write-down and Minimum Write-down scaled by Expected Write-down [in %]. Expected Write-down: Mean value of Proposed Write-down and Minimum Write-down [in Mio. €]. *, **, *** p <0.10, p < 0.05, p < 0.01 (two-tailed), respectively
Price competition Write-down Range IC strong: - 8.15 *** IC weak: - 19.98***
