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    The Effect of Magnitude of Audit Difference and Prior Client...
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, tagged 09.0 Auditor Judgment, 09.10 Prior Dispositions/Biases/Auditor state of mind, 10.0 Engagement Management, 10.04 Interactions with Client Management 
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    Title:
    The Effect of Magnitude of Audit Difference and Prior Client Concessions on Negotiations of Proposed Adjustments
    Practical Implications:

    The results of this study are important for auditors to consider because, ceteris paribus, the auditor’s proposed adjustment should not be affected by either the magnitude of the audit difference or prior concessions. The study demonstrates that even when auditors plan and execute quality audits, financial statement quality may suffer when high initial audit differences (client’s unaudited balance - auditor’s independent estimate) and/or prior client concessions exist due to unintentional bias in auditors’ proposed adjustments. Audit firms may want to consider providing formal training opportunities to address this bias and improve negotiation outcomes. Though further research is needed in this area, the authors suggest that the order in which misstatements are negotiated or resolved should be considered.

    Citation:

    Hatfield, R.C., R.W. Houston, C.M. Stefaniak, and S. Usrey. 2010. The Effect of Magnitude of Audit Difference and Prior Client Concessions on Negotiations of Proposed Adjustments. The Accounting Review 85 (5): 1647-1668.

    Keywords:
    Auditor negotiation, audit adjustments, accounting estimates, audit differences, client concessions
    Purpose of the Study:

    Auditors are required to remain skeptical of management’s estimates and form independent expectations in evaluating their reasonableness. When differences between the auditor’s expectations and management’s estimates exist, auditors must treat them as likely misstatements (SAS No. 107). Treatment as likely misstatements implies that the auditor must both propose and negotiate an adjustment with management. Auditors may not realize that their negotiation goals, limits, and initial position are likely affected by the magnitude of the difference between the client’s account balance and their own independent estimate. Additionally, the negotiation literature suggests that the existence of previously resolved misstatements may cause auditors to adopt an unintentionally biased position in subsequent negotiations. This paper examines whether auditor negotiations are negatively influenced by: 

    • The magnitude of the initial audit difference. Specifically, the authors test whether a large initial audit difference causes an unintentional downward bias in auditors’ negotiation goals, limits, and initial position.
    • The existence of a previously resolved misstatement (client concession). Specifically, the authors test whether the existence of a previously resolved objective misstatement causes an unintentional downward bias in auditors’ negotiation goals, limits, and initial position for a subsequent inventory valuation issue. 

    The authors’ expectations are derived from the negotiation literature pertaining to opening moves and reciprocity. In the audit environment, a client’s opening move may be considered the unaudited financial statements. Research demonstrates that when a counterpart’s initial demands are high, negotiators tend to lower their own expectations regarding the outcome of the negotiation, and thus adopt a negotiation position closer to their counterparts.  Similarly, due to the social norm of reciprocity, auditors might feel pressure to reduce the magnitude of their initial position when prior client concessions exist.

    Design/Method/ Approach:

    The research evidence was collected in the mid to late-2000s. Audit partners and managers from regional and Big-4 firms participated in the experiment. Participants electronically completed a simulated negotiation involving the existence of two audit issues: a subjective inventory valuation issue (obsolescence) and an objective accrual issue (quantitatively immaterial, but significant). Participants provided their negotiation goal, their negotiation limit (lowest acceptable balance), and their initial negotiation position. The final negotiation outcome was used as a dependent variable as well.

    Findings:
    • The authors find that auditors’ negotiation goal, negotiation limits, and initial negotiation position were significantly less when the magnitude of the initial audit difference was high, compared to when the magnitude was low.
    • The authors find that auditors’ negotiation goal, negotiation limits, and initial negotiation position were lower when a prior client concession existed, compared to when it did not. 
    • The authors find that both the magnitude of audit difference and prior concession affect the negotiation outcome through their influence on the auditor’s initial negotiation position.
    • The authors find that differences in confidence or perception of client’s strength in negotiation do not drive the above results.
    Category:
    Auditor Judgment, Engagement Management
    Sub-category:
    Prior Dispositions/Biases/Auditor state of mind, Interactions with Client Management
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