The Impact of Retention Incentives and Client Business Risks on Auditors' Decisions Involving Aggressive Reporting Practices

Abstract

This research examines the individual and interactive effects of client retention incentive and client business risks on auditors' decisions regarding whether to accept clients' aggressive reporting practices. Fifty-five audit seniors and managers from all of the Big 5 accounting firms participated in this experimental study. We find a significant main effect of client business risks and an interactive effect between client retention incentives and client business risks on auditors' decisions. Specifically, the results indicate that, when a client's business risks are high, auditors tend to scrutinize such risks and carefully evaluate a client's proposed accounting practices. However, when there is less concern over a client's business risks, auditors may be willing to accept the client's aggressive reporting proposal if retention incentives are high.

A Model and Literature Review of Professional Skepticism in Auditing

“…Some studies also provide evidence of more complex relationships among incentive factors, e.g., that concerns over client retention might sway auditor judgment more when litigation risk is low (Chang and Hwang [2003], but also see Asare et al [2005] for evidence of independent effects of litigation risk and potential for nonaudit services). Figure 1 depicts evidential input, pre-existing knowledge, traits and incentives all affecting audit judgment.…”

Can Auditors be Independent? Experimental Evidence on the Effects of Client Type

“…For example, auditors are more willing to accept the accounting method proposed by the management when the risk of losing the client is high (e.g., Blay, 2005), when the client is important (e.g., Chang and Hwang, 2003), when the auditor's compensation scheme rewards client retention (e.g., Trompeter, 1994), or when the client represents future business opportunities (e.g., Moreno and Bhattacharjee, 2003). The potential negative effects of client retention incentives on auditors' independence are especially likely to occur when the auditor is highly committed to retaining the client (Kadous et al, 2003).…”

Litigation environment and auditors’ decisions to accept clients’ aggressive reporting

“…Furthermore, Nelson et al (2002) report that auditors are more likely to accept earnings management attempts made by large clients than by smaller clients. In addition, Chang and Hwang (2003) significant interactive effect between client business risk and client retention pressure on auditors' decisions with respect to the client's aggressive accounting treatment.…”

“…As documented in the literature (Hackenbrack and Nelson, 1996;Chang and Hwang, 2003), client business risk may discourage auditors from accepting clients' preferred accounting methods. Client retention pressure, however, may provide incentives for auditors to go along with clients' preference to report more favorable earnings in their financial statements (Lord, 1992;Lee and Gu, 1998;Zhang, 1999;Myers et al, 2003;Shafer et al, 2004).…”

“…Similar to prior studies, a client's aggressive reporting is defined as a reporting method, adopted by the client and accepted by the auditor that portrays the client's financial conditions more favorably than the facts would support (Hackenbrack and Nelson, 1996;Phillips, 1999;Chang and Hwang, 2003;Kadous et al, 2003). Since significant professional judgment is involved in evaluating a client's accounting choices, auditors may find it difficult to reject a client's preferred reporting practice if that practice is not in direct violation of the Generally Accepted Accounting Principles (Trompeter, 1994;Kennedy et al, 1997;Nelson et al, 2002;Johnstone et al, 2002;Kadous et al, 2003).…”