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An experimental market analysis of auditor work-level reduction decisions
AN EXPERIMENTAL MARKET ANALYSIS OF AUDITOR WORK-LEVEL REDUCTION DECISIONS Maribeth Coller, Julia L . Higgs and Stephen Wheeler
ABSTRACT In this paper, we use an experimental market to test the link between competitive fee pressure and its alleged downstream consequences : time pressure and audit quality reduction . To induce fee pressure, transaction (auditor switching) costs, which have been found to be associated with fee lowballing in prior research, are manipulated in a competitive bidding environment. Our results show that (after controlling for subject skill level) the presence of transactions costs induces lower audit fees in first year engagements which result in significantly lower time budget levels selected and then, in turn, significantly higher levels of audit work-level reductions . Also, confirming prior survey results on the causes of audit quality reduction acts, we find that subjects encountering lower perceived misstatement rates select significantly lower time budgets and then, in turn, evidence significantly higher audit work-level reductions. These findings lend support to regulators' assertions about the link between fee competition and the potential for reductions in audit quality.
Advances in Accounting, Volume 19, pages 53-70 . Copyright © 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved . ISBN : 0-7623-0871-0 53
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
INTRODUCTION Factors that affect audit quality have long been of significant interest to practitioners, academicians, regulators and investors . For example, the Commission on Auditors' Responsibilities (Cohen Commission, 1978, pp. 110-115) asserted that excessive competition creates pressure to set "unrealistic and unnecessary deadlines for completion of audits" possibly leading to substandard auditing . Excessive time pressure, the Commission concluded, is one of the most pervasive causes of audit failures . Similarly, the National Commission on Fraudulent Financial Reporting (Treadway Commission, 1987) cited institutional and individual pressures as having the potential to compromise CPAs' professional skepticism and integrity . Along with fee and budget pressures, tight reporting deadlines were presumed to encourage auditors to reduce audit quality . Audit quality reduction acts take several forms, including premature sign-off on an audit program step, reducing the amount of work performed on an audit step below a reasonable level, failing to research an accounting principle, making superficial reviews of client records, and accepting weak client explanations (Kelley & Margheim, 1987, 1990) . Under-reporting of time may also contribute to reduced audit quality because current year audit budgets often are based on prior year amounts . When current budgets are unrealistic, auditors on these jobs may have an incentive to engage in other audit quality reduction acts (Kelley & Margheim, 1990) . In another line of audit research, DeAngelo (1981) develops a model of audit fee "lowballing" (offering services below cost) as a rational competitive response to obtain new clients . In this model, the presence of "transactions costs" associated with new audits makes lowballing possible . That is, auditors incur a fixed start-up cost (e .g . initial internal control evaluation, designing a new audit plan, etc .) and clients incur a fixed switching cost (e.g . bidding costs, retraining personnel) . The model holds that auditors attract clients by charging a fee that is less than their total cost in the initial period and then recoup the loss in future periods by charging a higher fee that is just less than their ongoing audit costs plus the client switching cost. Our experiments build on these prior lines of research in an attempt to link them. First, we include transaction costs as a way to induce lowballing . Second, we provide a rich experimental setting to measure potential audit quality reduction in the form of work-level reduction decisions . Our analysis then looks at the empirical relationships among these and other hypothesized variables to ultimately examine the logical link between fee pressure and audit quality reduction .
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THEORETICAL BACKGROUND Audit Quality
Given the institutional features that have arisen to encourage auditors to report breaches in manager/owner contracts and avoid them in auditor/client contracts, one might expect audit quality reduction acts to be rare . While the extent of breaches cannot be measured directly, some indirect evidence exists . For instance, the Big-6 CPA firms disclose in a letter to the AICPA membership that they spent $477 million on legal matters in 1991, and in 1990, the seventh largest firm (Laventhol & Co .) declared bankruptcy (Cook et al ., 1992) . Although much of this expense may be due to other causes, the magnitude of the legal expense suggests that audit firms find it necessary to defend themselves against accusations of breaches (St . Pierre & Anderson, 1982, 1984 ; Graham, 1985 ; Palmrose, 1991) . More directly, several surveys have established that premature sign-offs do occur . For example, Rhode (1978), in a survey sponsored by the Cohen Commission, reports that 47% of the respondents admitted signing-off on an audit step without completing the work or noting the omission . Other surveys (Alderman & Deitrick, 1982 ; Raghunathan, 1991) confirm the Rhode results . Two additional studies, (Buchman & Tracy, 1982 ; Reckers, Wheeler & Wong-on-Wing, 1997) use techniques designed to provide more anonymity for sensitive questions and find even higher rates . Reckers et al . (1997) report that 79% of the auditors in their sample admitted to signing-off prematurely at least once in the year preceding their study . Premature sign-off also has been found to extend to government auditors (Berry et al ., 1987) and to internal auditors (Buchman, 1983) . Hypothesized Causes of Reduced Audit Quality
Time pressure and low risk assessment are commonly cited precursors to audit quality reduction acts in several prior studies . In the Rhode report (1978), the primary motivation cited for omitting a required audit step is time budget pressure (p. 180) . Similarly, Lightner et al . (1982) and Lightner et al . (1983) conduct surveys establishing the extent and causes of under-reporting behavior and find that pressure to meet infeasible budgets is cited as the primary cause . A variety of other studies have examined specific ways in which time pressure can affect audit quality . See for example, Margheim and Pany (1986) ; Kermis and Mahapatra (1985) ; Kelley and Margheim (1990, 1987) ; McDaniel (1990) ; Ashton (1990) ; Marxen (1990) ; Waggoner and Cashell (1991) ; and Margheim and Kelly (1992) .
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MARIBETH COLLER, JULIA L. HIGGS AND STEPHEN WHEELER
In a different survey designed to determine the reasons for premature signoffs in particular, Raghunathan (1991) finds low risk to be the most cited reason . The experiments conducted here are designed to address the empirical question of how low risk assessments and time constraints affect audit quality . The evidence from prior research indicates that each of these factors may affect audit quality directly . Alternatively, perceptions of risk may affect audit quality through its effect on time budgets . In suggesting these alternatives, we note that auditors must assess client inherent and control risks before determining the extent of substantive testing to be done . As such, reducing testing due to a low risk assessment is completely proper and does not necessarily reduce audit quality . However, the behavior we are interested in occurs when audit procedures are represented as having been done when in fact they have not . The question is thus whether a low risk assessment leads to setting a time budget that is relatively tighter for a given audit procedure (and thereby leads to audit quality reduction), or whether a low risk assessment has some direct effect on audit quality other than through inducing time pressure . The Cohen and the Treadway Commissions also cite excessive audit competition as a potential cause of reduced audit quality . Although firms compete on several dimensions, price is one of the most important . Since DeAngelo's (1981) original model of lowballing, several studies have been conducted to determine if firms reduce audit fees in response to competition . On a macro scale, Maher et al . (1992) demonstrate that audit fees decreased for sample firms during the period 1977 to 1981, a period cited as having an increased level of competition . Simon and Francis (1988) compare the fee structure of companies depending on whether or not an auditor change has occurred . They find that fees for firms that change auditors are 24% below fees reported for ongoing engagements . Similarly, Rubin (1988) finds that auditor tenure is a significant (positively related) factor in determining fees for municipal audits . These findings are consistent with the DeAngelo (1981) lowballing model . Related Experimental Studies Schatzberg (1990) tests DeAngelo's (1981) model using a laboratory market methodology. He hypothesizes that in the presence of positive start-up and switching costs, the fee negotiated in the first period will be equal to the cost of conducting the audit less the client switching costs . The fee negotiated in the second period is hypothesized to be equal to the audit cost plus auditor start-up costs and client switching costs . The results indicate that the presence of transaction costs generally results in lowballing, while, in the absence of transaction costs, lowballing does not occur .
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Schatzberg (1994) extends this literature by developing a model that allows for differences in audit opinions (i .e . there are instances where auditors may differ in their judgments about the appropriate audit report for a given client) . Experimental market tests of the model thus include outcomes where different auditor types vary in their opinion on the resolution . The results are consistent with the concept of "opinion shopping" in the audit market and demonstrate that such heterogeneity in auditor reporting behavior can also result in lowballing, even without positive transactions costs . Schatzberg (1994) does not investigate the possibility of related reductions in audit quality . Calegari et al . (1998) do investigate reductions in audit quality in an experimental setting, but such reductions take the form of misrepresenting the audit results . In these markets, the auditor observes one of two possible outcomes and then reports (either honestly or dishonestly) . Although these experiments are a more complete test of the price-independence relationship, the opportunity to reduce audit quality is not present . Dopuch and King (1996) conduct experiments where reductions in audit quality take the form of shirking on the amount of investigation performed in the audit . Their setting is somewhat similar to ours in that they include transactions costs in a market where all auditors have common costs and audit-quality choices . As opposed to the other studies discussed, Dopuch and King (1996) do not treat audit costs as fixed. Instead, the auditors may choose between a costly high-quality audit (which reveals the value of the client's asset) or a costless low-quality audit (which does not reveal the value of the asset) . The audit decision is thus dichotomous and can be depicted as the choice between a complete investigation and no investigation . In the event that the costless (no investigation) audit is chosen, the auditor reports the asset value as he chooses (either high or low) and thereby misrepresents the extent of his audit . Dopuch and King (1996) find that lowballing occurs in their markets, but find little evidence of reductions in audit quality . They were able to induce some reductions in quality, but only in markets where a high degree of lowballing was imposed in the absence of competition .
HYPOTHESES This study addresses whether a competitive market environment contributes to reduced audit quality as suggested by the Cohen and Treadway Commissions . This involves linking several intervening variables suggested in prior research . The hypothesized linkage is pictured in Fig . 1 . DeAngelo's (1981) model of audit competition asserts that lowballing is a rational strategy to obtain new clients . Schatzberg's (1990) empirical results
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MARIBETH COLLER, JULIA L. HIGGS AND STEPHEN WHEELER
TRANSACTION COSTS
FEE PRESSURE
TIME BUDGET
ERROR RATE PERCEPTIONS
AUDIT WORK-LEVEL REDUCTIONS
Fig. 1 .
Hypothesized Relationships .
show lowballing to be contingent upon the presence of transactions costs. Thus, the first hypothesis addresses whether lowballing will occur when it is costly to switch auditors . As such, this hypothesis is tested to ensure that we have induced downward pressure on audit fees for this experiment . HI : In the presence of transactions costs, audit fee lowballing will occur . To then test the linkage between lowballing and time pressure, the selected time budgets in markets with positive transactions costs are compared with those in markets without transactions costs . The results provide insight into the supposition by the Cohen Commission that the competitive environment leads to increased time pressure . Accordingly, the second hypothesis is : H2 : In the presence of transactions costs, tighter total budgets will be selected . The third hypothesis addresses the link between time pressure and audit quality reduction as follows : H3 : Higher audit work level reductions will be positively associated with tighter total budgets . We next address the suggestions from the Raghunathan (1991) survey regarding risk levels and attempt to determine if the perceived risk level causes a higher degree of time pressure or if the risk level directly affects work level decisions in addition to its effect on time pressure . The fourth and fifth hypotheses are as follows : H4 : Tighter total budgets will be selected when the expected error rate is low .
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H5 : Higher audit work-level reductions will occur when the expected error rate is low, after controlling for time budget selected .
EXPERIMENTAL TASK The laboratory market experiments conducted here involve the selling of services and the performance of an attest-type task . The basic design includes seven rounds, with each round consisting of two attest periods . In the first period of each round, each subject submits a private offer for the performance of an attestation task to each computer-simulated client . Each market includes six auditors and five clients . Engagements are awarded based upon the "best" offer and no auditor can be awarded more than one job in any period . All auditors who are awarded jobs then select a time budget, perform the audit task, and finally render an opinion on the accuracy of thirty calculations . The contracting and attest process is then repeated in the second round. Experimental manipulations incorporate the presence/absence of transaction costs (where transaction costs are used to induce lowballing) and differential perceptions of audit risk (set at two levels) . Both are manipulated between audit markets, resulting in four treatments . Each treatment is conducted twice, resulting in a total of eight experiments . In each experiment, subjects are first provided with written instructions .' After everyone finishes reading these, the experimenter summarizes the sequence of events and answers any questions . A one-period practice session is then conducted during which the experimenter explains the computer screens and talks the subjects through the mechanics of the task . Subjects are next provided with an initial endowment of $5 .00, and the experiment begins . The first two complete rounds are treated as practice rounds . This is done in order to allow subjects to practice the entire sequence of events without financial risk . During these rounds, subjects have ample opportunity to ask questions between each period. At the end of the second round, earnings are reset to zero, and the initial endowment of $5 .00 is restored . In hypothesis testing, only data from rounds three through seven are used . Subjects are informed that the maximum value of the job to the client is $2 .00 . Providing the value of the audit gives an indication of an upper bound for offer starting points that should encourage convergence of audit prices . The bidding process begins with each subject submitting offers to conduct an audit to each client . In the two treatments where transactions costs are present, all subjects who are awarded jobs are charged a $0 .30 start-up cost in period one . In period two, only those subjects who contract with a different client than in
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
period one (i .e . an auditor switch) are charged the start-up cost . The computersimulated client faces a switching cost of $0 .25 in the second period only if the auditor used in period one is not retained for period two . The remaining two treatments are conducted in the same way, with the exception that there are no start-up or switching costs present . Jobs are awarded based on the highest non-negative value to the client . This is not always the lowest offer since, when the client faces transactions costs related to auditor switching, the lowest offer may not result in the highest value to the client . In the event of a tie, the winner is decided based on the first subject to submit the tying offer . Because there are more auditors (six) than clients (five), at least one auditor will not be awarded a job in each period . This is done in order to provide a competitive environment and encourage convergence of audit prices to equilibrium . Any subject who is not awarded a job is allowed the option of conducting a "practice" audit, involving only the attest task, where no costs are assessed and no fee is earned . This procedure ensures that everyone has the same number of periods to conduct an audit . To the extent that task-related skills may develop with repetition, this is a necessary control . In addition, this procedure ensures that no one might feel embarrassed by having to sit idle while the other subjects conduct audits . After the contracts are awarded, subjects also are given information about the winning prices for each job . Subjects are then asked to choose a time budget . Five budget levels (2, 2 .5, 3, 3 .5, and 4 minutes) are available . These times were determined through pre-tests to represent options ranging from a virtually impossible time budget to a very easy one . At this point, the cost of time is $0 .25 for the first two minutes with each additional one-half minute costing an additional $0 .25 . Once the budget is selected, the subject/auditor is asked to verify 30 multiplication problems. Two levels of errors are seeded in the problems . Half of the experiments have an error rate of 5% (the probability of an error in at least one of the 30 problems is 5%, and the probability that there are no errors is 95%) . The remaining experiments use a 40% error rate (i .e . there is a 60% probability that all 30 problems are correct) . In general terms, subjects are told what the error rate is . The known error rates are somewhat analogous to an auditor assessing client inherent and control risk and having expectations about the degree of error . While not completely analogous, for the experiment's purposes, it is simply the perception of high or low error rates that is necessary to accomplish the treatment effect . Each of the thirty multiplication problems consists of two three-digit numbers . Subjects are asked to enter the equation in blanks on a computer worksheet . The computer multiplies the typed numbers, and the subject compares the product to the previously provided answer . If the subject finds an error, he/she marks a
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decision box to indicate which equation is incorrect . Otherwise, no mark is made other than the typed equation . An on-screen clock, ticking down in ten second increments, displays the time remaining based on the budget selected . At the end of the budget period, the subject is asked if he/she wishes to opine on the correctness of the equations or to buy more time to work on the task . If the subject buys additional time, the cost is $0 .40 for each additional one-half minute . Because additional time can only be purchased at premium rates (analogous to overtime pay and opportunity costs to audit firms) at this point, the auditor has an incentive to select an initial time budget that is considered realistic . When the additional time (if any) expires, the subject is again given the opine/additional time option, continuing until the subject issues an opinion (either "no errors present" or "one or more errors present") . The computer then checks the errors in the equations against the decision boxes marked . If the subject does not identify an equation that is in error, a penalty of $1 .50 is assessed (a flat penalty, regardless of how many errors the subject fails to identify) . Conversely, if the subject incorrectly identifies an equation as being in error, a penalty of $0 .50 is assessed for each equation incorrectly marked, up to a maximum of three . These penalties are included to parallel the type I/type II errors possible in an audit and the differential severity of the errors to the auditor (type II errors, missing a material error, are considered more severe due to litigation possibilities) . Subjects must correctly identify all errors in the thirty multiplications to avoid the $1 .50 penalty . Therefore, the option to quit checking after one error is found and issue an opinion of "one or more errors present" could still result in a penalty . For analysis purposes, the computer also keeps track of how many equations the subject checks . This information is not used to determine subject earnings, only to measure the audit work-level selected . At the completion of the period, subjects are provided with their results and credited with the contract amount, reduced by costs for time, additional time, start-up costs, and penalties . The process is identical for the second period of each round, except for the additional possibility of switching auditors (and hence start-up and switching costs) . To measure and control for differences in subjects' typing skills, the experiment concludes by asking the subjects to perform a verification task containing 100 equations with three minutes to verify as many equations as possible . For each equation typed correctly, the subject earns an additional $0 .10 ; incorrectly entered equations reduce earnings by $0 .25, but not below the amount earned before the verification task begins . This measure, number of equations correct, is used as a covariate in the subsequent analysis . Finally, subjects are informed of their total earnings and paid accordingly . Figure 2 depicts the entire experimental process .
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER Computer server is connected to all subject terminals
Instructions given to participants
overs recorded
Subjects make offers to complete jobs
comrswssm on«srecomea
Computer Server awards contracts
Time
l` trod aed
Subjects I of 3 budgets
/
30 equations appear on screen
Subject has time based on budget selected to verify equations
Accuracy is recoded
Accuracy of opinion is chec ed
Subject receives offer reduced by costs & penalty
Subject receives pay based on offer . Costs of audit reduce earnings
Fig . 2. Overall, forty-eight student subjects participated in eight separate markets . All subjects had taken at least one computer course . They ranged in age from 20 to 43 (an average of 24), and in class level from junior standing to graduate level . Because students were required to have a sophomore level computer class, basic computer literacy was assumed . Beyond this, no special skills were required . Pre-tests (including group discussion with pre-test subjects) indicated that this task was seen as non-trivial, requiring some amount of effort, but was not so difficult that subjects did not want to participate .
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The average time to implement one market was just under two hours . Earnings ranged from $11 .25 to $25 .75, with an average of $19 .19 . Open-ended debriefing responses indicated that subjects understood the task, and casual analysis of the data showed little evidence of unusual heuristical approaches . Specifically, subjects demonstrated differing strategies in deciding which calculations to check or not to check. Most applied a sequential approach, but some employed an apparently random selection strategy . Beyond speculation, no reasons could be determined as to the selection of such strategies . To address possible end-of-game strategies, the data analyses were also run excluding round seven data. No substantial differences in results occurred . Also, results were substantially consistent between the different administrations of the experiments .
RESULTS To test the first hypothesis regarding lowballing, we make several analyses . First we compare the average fees in period one to fees in period two across rounds three through seven . In markets where transactions costs are present, the average fee in period one is $1 .35, while the average fee in period two is $1 .40 . The p-value for a paired comparison t-test of the difference is 0 .02 . By comparison, in comparable markets without transactions costs, the first period fees average $1 .47 compared to a $1 .46 average across all second periods (p = 0.54 for the t-test) . Second, we compare first period fees in markets with transactions costs to first period fees in markets without transactions costs . The first period fees in the presence of transactions costs ($1 .35) are significantly lower than first period fees ($1 .47) where no transactions costs are present (t = 2 .56, p <_ 0 .01) . These combined comparisons provide evidence of fee pressures in the experiment and indicate that subjects did lowball in the presence of transactions costs . To address Hypotheses 2 and 4, regarding time pressure, an ANCOVA analysis is conducted using the time budget selected as the dependent variable, with transactions costs and expected error rate as independent variables . Keyboarding skill (as measured by the results of subjects' post-experiment verification task) is included as a covariate . Because the design of the experiment includes as many as ten sequential observations from each of six subjects (fewer if the subject is not awarded a job in all periods), round number is also included as a blocking factor . Table 1 presents cell means for the budgeted time selected by treatment in Panel A, and ANCOVA results in Panel B . Both treatment variables are highly significant and are in the directions predicted by H2 and H4. Specifically, we find that : (1) in the presence of transactions costs, subjects choose tighter time
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
budgets, and (2) subjects choose tighter time budgets when the expected error rate is lower . The interaction term Error Rate x Transaction Costs was significant (F = 9 .42, p < 0 .0023) . Multiple comparison (Scheffe) tests and examination of cell means in Panel A reveal that the significance of these two treatments was driven by the low error rate/ transaction costs present cell . Thus the effect of the transaction costs variable (on time budget selected) manifested itself more when perceived error rates were low . Similarly, the effects of error rate perceptions (on time budget selected) were more pronounced when transaction costs were present. The significance of the round number attests to a learning effect across time . That is, as subjects' task familiarity increased, they tended to perceive a need for less time to accomplish the task . Hypotheses 3 and 5 predict that work-level reductions will be higher when tighter time budgets are selected and when error rate perceptions are low . To Table 1.
Analysis of Time Budget Selected .
Panel A : Cell Means by Treatment Transactions Costs Error Rate
Absent
Present
Total
High (0.40) Low (0 .05) Total
2 .57 2 .40 2 .49
2 .40 2 .08 2.24
2.49 2.24
Panel B: ANCOVA Results ; dependent variable = total time budget selected Variable
df
F
p-value
Transactions Costs Error Rate Subject Skill Level Round Number
1 1 1 4
132.25 125.44 90.75 38.43
0.0001 0.0001 0.0001 0.0001
Model RI = 76.9 Model F = 22 .61 (p :5 0.0001) Variable Definitions : Time Budget Selected: Total time purchased for audit task . Transactions Costs : Presence of start-up and switching costs, Yes/No . Error Rate: High (the probability of at least one error in the thirty problems is 60%) or Low (the probability of at least one error in the thirty problems is 5%) . Subject Skill Level : Number of calculations typed correctly during final verification task . Round Number : Round Number, 3-7 .
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test these hypotheses, we conduct a second analysis of variance with the number of calculations not verified as the dependent variable and time budget selected, transaction costs and error rates as independent variables . As previously discussed, keyboarding skill is included as a covariate and round number is also included . The results, presented in Table 2, indicate support for Hypothesis 3 . The selected time budget is highly significant in the ANCOVA and is negatively related to the number of calculations not verified (the correlation is -0 .49 and is significant at a level of less than 0 .0001) . Again, the significance of the round number variable apparently indicates that subjects required more evidence to opine as task familiarity increased . Interestingly, the two treatment variables, transactions costs and error rate, are not significant in directly explaining audit work-level reduction . Thus, these results do not support Hypothesis 5 ; instead they suggest that any effect of low Table 2.
Analysis of Number of Calculations Not Verified .
Panel A : Cell Means by Treatment Transactions Costs Error Rate
Absent
Present
Total
High (0 .40) Low (0 .05) Total
3 .85 3 .52 3 .68
4 .24 9 .67 6.95
4 .05 6 .59
Panel B : ANCOVA Results ; dependent variable = number of calculations not verified Variable
df
Time Budget Selected Transactions Costs Error Rate Subject Skill Level Round Number
1 1 1 1 4
F 429.94 1 .85 0 .41 498 .20 9 .45
p-value 0.0001 0.1744 0.5209 0.0001 0.0001
Model R'= 84 .9 Model F = 37 .51 (p :- 0 .0001) Variable Definitions : Time Budget Selected : Total time purchased for audit task . Transactions Costs : Presence of start-up and switching costs, Yes/No. Error Rate : High (the probability of at least one error in the thirty problems is 60%) or Low (the probability of at least one error in the thirty problems is 5%) . Subject Skill Level : Number of calculations typed correctly during final verification task . Round Number: Round Number, 3-7 .
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
risk on audit work-level choice is likely to be manifested through the intervening time budget selection variable . As an overall check on the causal relationships implied by the individual ANCOVA analyses, we conduct a path analysis . This analysis is performed using the SAS System's CALLS procedure which uses maximum likelihood estimated coefficients that produce an estimated covariance matrix that is as close as possible to the sample covariance structure . The relationships analyzed appear in Figure 3 . As in the previous analyses, typing skill and round number are included to provide the best specification of the overall model . The specified model appears to fit the data quite well . The chi-square statistic is 0.7343, indicating an inability (p = 0 .69) to reject the null hypothesis that the reproduced covariance matrix has the specified model structure . The model explains 41 .9% of the variation in the number of calculations verified and 33 .0% of the variation in the time budget selected . Individual coefficient results and significance levels, also reported in Fig. 3, are consistent with the ANCOVA results . All coefficients are significant (at less than the 0 .01 level) and in the predicted direction . The path analysis tests reveal that the presence of transaction costs has a significant negative effect on the time budget selected, while perceived error rate has a significant positive effect on the time budget selected. In turn, the lower the time budget selected, the greater the number of equations not checked .
Skill Level
Fig . 3 .
Path Analysis Results Standardized Coefficients .
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A path analysis of an alternative model indicates that significant causal relationships are present neither from transactions costs directly to the number of equations not checked nor directly from error rate to number of equations not verified (Neither estimated coefficient is significant at conventional levels (p > 0 .10)) . The significance of the paths directly from skill level and round number to number not checked provides further assurance about the treatment effects, even after partitioning subject skills and learning effects . Taken together, our path analysis results suggest that fee pressure is present in the markets with transaction costs . In these markets, and also in markets where low levels of risk are present, subjects select lower time budgets . The reduced time budget then leads to greater levels of work-level reduction . No direct relationship is found between fee pressure or risk level and the extent of audit work-level reduction .
DISCUSSION In this paper we examine the potential causes of premature sign-off in an experimental market setting . Regulators have long asserted that competition in the market for audit services, which causes downward pressure on audit fees, induces time pressures and may be responsible for decreased audit quality . Surveys have cited time pressure and perception of low risk as primary causes of quality reduction acts . The contribution of this study lies in extending the linkage of the prior literature on lowballing with survey results citing time pressure as a cause of audit quality reduction . While prior laboratory research has demonstrated the competition-lowballing link, prior experimental research has found little evidence of the audit quality reduction acts that may occur . In this study, we provide an experimental setting with a much richer time budget selection and attest-type task than prior research has used, and find evidence of subsequent audit work-level reduction. A second contribution lies in clarifying how perceptions of low audit risk affect audit quality reduction acts . We find that, after controlling for time pressure, risk assessment does not significantly explain audit work-level reduction as suggested in prior survey research . That is, holding time pressure constant, our subjects were not any more likely to reduce work loads on a low risk task than on a high risk task . Instead, the effect of risk assessment is manifested through its effect on time budget selection . Therefore, absent time budget constraints, the tendency to reduce audit quality is not necessarily inherent . Further, our results are consistent with the Cohen Commission's original take on the issue : fee pressures create budgeting constraints, which then potentially affect audit quality .
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Our findings are limited by certain factors . First, the use of student subjects, although appropriate for this generic attest-type task, makes generalization of the results to auditor behavior more difficult . Second, subjects were told in advance about the actual error rates in the populations . While successful in achieving the desired risk-perception-treatment effects, the correspondence with actual audit procedures (where auditors have only perceptions about what error rates might be) is less than perfect. Third, while our results show significant reductions in audit work levels, the question of whether such reductions constitute premature sign-off acts cannot be answered without a defined minimum level . This question is left for future research .
NOTE 1 . Copies of the instructions and computer screen examples are available from the authors upon request .
ACKNOWLEDGMENTS We gratefully acknowledge the helpful comments of Rob Bloomfield, Gene Chewning, Al Leitch, Barbara Pierce, Brad Ruffle, Jeff Schatzberg, Vernon Smith, John Wermert, and participants at workshops at the Economics Science Association Conference, the American Accounting Association National meeting, and the Western Decision Sciences meeting . Bonnie Glasberg and Alex Maitland provided invaluable programming assistance .
REFERENCES American Institute of Certified Public Accountants (1978) . The commission on auditors' responsibilities : report, conclusions, and recommendations . The Commission on Auditor's Responsibilities, M . F. Cohen (Chair) . Alderman, C . W ., & Deitrick, J . W . (1982) . Auditors' perceptions of time budget pressures and premature sign-offs : a replication and extension . Auditing: A Journal of Practice and Theory, 1(2), 54-68 . Ashton, R . H. (1990) . Pressure and performance in accounting decision settings : paradoxical effects of incentives, feedback and justification . Journal of Accounting Research, 28(Suppl .), 148-180. Berry, L . E ., Harwood, G . B ., & Katz, J . L . (1987) . Performance of auditing procedures by governmental auditors : some preliminary evidence . The Accounting Review, 62(January), 14-28 . Buchman, T. A (1983) . The reliability of internal auditors' working papers . Auditing : A Journal of Practice and Theory, 3(1), 92-103 . Buchman, T . A ., & Tracy, J. A . (1982) . Obtaining responses to sensitive questions : conventional questionnaire versus randomized response technique . Journal of Accounting Research, 20(1), 263-271 .
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Calegari, M . J ., Schatzberg, J . W., & Sevcik, G . R. (1998) . Experimental evidence of differential auditor pricing and reporting strategies . The Accounting Review, 73(2), 255-275 . Cook, J . M ., Freedman, E. M., Groves, R . J ., Madonna, J . C ., O'Malley, S . F ., & Weinbach, L. A . (1992) . The liability crisis in the United States : impact on the accounting profession . Journal of Accountancy, 174(November), 18-23 . DeAngelo, L . E . (1981) . Auditor independence, 'lowballing', and disclosure regulation . Journal of Accounting and Economics, 3(2), 113-127 . Dopuch, N ., & King, R . (1996) . The effects of lowballing on audit quality : An experimental markets study . Journal of Accounting, Auditing, and Finance, 11(1), 45-68 . Graham, L. E. (1985) . Audit risk - part V . CPA Journal, 55(12), 26-35 . Kelley, T ., & Margheim, L. (1987) . The effect of audit billing arrangement on under-reporting of time and audit quality reduction acts . Advances in Accounting, 5, 221-233 . Kelley, T ., & Margheim, L . (1990). The impact of time budget pressure, personality, and leadership variables on dysfunctional auditor behavior . Auditing: A Journal of Practice and Theory, 9(2), 21-42 . Kermis, G . F ., & Mahapatra, S . (1985) . An empirical study of the effects of time pressure on audit time allocations . Advances in Accounting, 2, 261-274 . Lightner, S . M., Leisenring, J. J ., & Winters, A . J . (1983). Under-reporting chargeable time . Journal • Accountancy, 155(1), 52-57 . Lightner, S . M ., Adams, S . J ., & Lightner, K . M . (1982) . The influence of situational, ethical, and expectancy theory variables on accountants' under-reporting behavior . Auditing : A Journal • Practice and Theory, 2(1), 1-12. Maher, M . W., Tiessen, P., Colson, R ., & Broman, A . J . (1992) . Competition and audit fees . The Accounting Review, 67(1), 199-211 . Margheim, L ., & Pany, K . (1986) . Quality control, premature sign-off, and under-reporting of time : some empirical findings . Auditing: A Journal of Practice and Theory, 5(2), 50-63. Margheim, L., & Kelley, T . (1992) . The perceived effects of fixed fee audit billing arrangements . Accounting Horizons, 6(4), 62-75 . Marxen, D . E . (1990). A behavioral investigation of time budget preparation in a competitive audit environment. Accounting Horizons, 4(2), 47-57 . McDaniel, L . S . (1990). The effects of time pressure and audit program structure on audit performance. Journal of Accounting Research, 28(2), 267-285 . National Commission on Fraudulent Financial Reporting (1987) . Report of the national commission on fraudulent financial reporting . J . C . Treadway, Jr . (Chair) . Palmrose, Z. (1991) . An analysis of auditor litigation disclosures . Auditing : A Journal of Practice and Theory, 1O(Suppl .), 54-71 . Raghunathan, B . (1991) . Premature signing-off of audit procedures : an analysis . Accounting Horizons, 5(2), 71-79 . Reckers, P., Wheeler, S ., & Wong-On-Wing, B . (1997) . An examination of the reliability of response elicitation techniques used in investigating auditor premature sign-off . Auditing : A Journal • Practice and Theory, 16(Spring), 69-78 . Rhode, J . G. (1978) . The independent auditor's work environment : a survey, commission on auditors' responsibilities research study no . 4 (New York : AICPA) . Rubin, M . A. (1988) . Municipal audit fee determinants . The Accounting Review, 63(2), 219-236 . Schatzberg, J . W . (1990) . A laboratory market investigation of low balling in audit pricing . The Accounting Review, 65(2), 337-362 . Schatzberg, J . W. (1994) . A new examination of auditor Alow ball@ pricing : theoretical model and experimental evidence . Auditing: A Journal of Practice and Theory, 13(Suppl.), 33-55 .
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Simon, D . T ., & Francis, J. R . (1988) . The effects of auditor change on audit fees : tests of price cutting and price recovery . The Accounting Review, 63(2), 255-269 . St . Pierre, K ., & Anderson, J. (1982) . An analysis of audit failures based on documented legal cases . Journal of Accounting, Auditing, and Finance, 1981-1982, 5(3), 229-247. St. Pierre, K ., & Anderson, J. (1984) . An analysis of the factors associated with lawsuits against public accountants . The Accounting Review, 59(2), 242-262 . Waggoner, J., & Cashell, J . D . (1991) . The impact of time pressure on auditors' performance . The Ohio CPA Journal, (Jan .-Feb./Mar.-Apr .), 27-32.
ABSTRACT In this paper, we use an experimental market to test the link between competitive fee pressure and its alleged downstream consequences : time pressure and audit quality reduction . To induce fee pressure, transaction (auditor switching) costs, which have been found to be associated with fee lowballing in prior research, are manipulated in a competitive bidding environment. Our results show that (after controlling for subject skill level) the presence of transactions costs induces lower audit fees in first year engagements which result in significantly lower time budget levels selected and then, in turn, significantly higher levels of audit work-level reductions . Also, confirming prior survey results on the causes of audit quality reduction acts, we find that subjects encountering lower perceived misstatement rates select significantly lower time budgets and then, in turn, evidence significantly higher audit work-level reductions. These findings lend support to regulators' assertions about the link between fee competition and the potential for reductions in audit quality.
Advances in Accounting, Volume 19, pages 53-70 . Copyright © 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved . ISBN : 0-7623-0871-0 53
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
INTRODUCTION Factors that affect audit quality have long been of significant interest to practitioners, academicians, regulators and investors . For example, the Commission on Auditors' Responsibilities (Cohen Commission, 1978, pp. 110-115) asserted that excessive competition creates pressure to set "unrealistic and unnecessary deadlines for completion of audits" possibly leading to substandard auditing . Excessive time pressure, the Commission concluded, is one of the most pervasive causes of audit failures . Similarly, the National Commission on Fraudulent Financial Reporting (Treadway Commission, 1987) cited institutional and individual pressures as having the potential to compromise CPAs' professional skepticism and integrity . Along with fee and budget pressures, tight reporting deadlines were presumed to encourage auditors to reduce audit quality . Audit quality reduction acts take several forms, including premature sign-off on an audit program step, reducing the amount of work performed on an audit step below a reasonable level, failing to research an accounting principle, making superficial reviews of client records, and accepting weak client explanations (Kelley & Margheim, 1987, 1990) . Under-reporting of time may also contribute to reduced audit quality because current year audit budgets often are based on prior year amounts . When current budgets are unrealistic, auditors on these jobs may have an incentive to engage in other audit quality reduction acts (Kelley & Margheim, 1990) . In another line of audit research, DeAngelo (1981) develops a model of audit fee "lowballing" (offering services below cost) as a rational competitive response to obtain new clients . In this model, the presence of "transactions costs" associated with new audits makes lowballing possible . That is, auditors incur a fixed start-up cost (e .g . initial internal control evaluation, designing a new audit plan, etc .) and clients incur a fixed switching cost (e.g . bidding costs, retraining personnel) . The model holds that auditors attract clients by charging a fee that is less than their total cost in the initial period and then recoup the loss in future periods by charging a higher fee that is just less than their ongoing audit costs plus the client switching cost. Our experiments build on these prior lines of research in an attempt to link them. First, we include transaction costs as a way to induce lowballing . Second, we provide a rich experimental setting to measure potential audit quality reduction in the form of work-level reduction decisions . Our analysis then looks at the empirical relationships among these and other hypothesized variables to ultimately examine the logical link between fee pressure and audit quality reduction .
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THEORETICAL BACKGROUND Audit Quality
Given the institutional features that have arisen to encourage auditors to report breaches in manager/owner contracts and avoid them in auditor/client contracts, one might expect audit quality reduction acts to be rare . While the extent of breaches cannot be measured directly, some indirect evidence exists . For instance, the Big-6 CPA firms disclose in a letter to the AICPA membership that they spent $477 million on legal matters in 1991, and in 1990, the seventh largest firm (Laventhol & Co .) declared bankruptcy (Cook et al ., 1992) . Although much of this expense may be due to other causes, the magnitude of the legal expense suggests that audit firms find it necessary to defend themselves against accusations of breaches (St . Pierre & Anderson, 1982, 1984 ; Graham, 1985 ; Palmrose, 1991) . More directly, several surveys have established that premature sign-offs do occur . For example, Rhode (1978), in a survey sponsored by the Cohen Commission, reports that 47% of the respondents admitted signing-off on an audit step without completing the work or noting the omission . Other surveys (Alderman & Deitrick, 1982 ; Raghunathan, 1991) confirm the Rhode results . Two additional studies, (Buchman & Tracy, 1982 ; Reckers, Wheeler & Wong-on-Wing, 1997) use techniques designed to provide more anonymity for sensitive questions and find even higher rates . Reckers et al . (1997) report that 79% of the auditors in their sample admitted to signing-off prematurely at least once in the year preceding their study . Premature sign-off also has been found to extend to government auditors (Berry et al ., 1987) and to internal auditors (Buchman, 1983) . Hypothesized Causes of Reduced Audit Quality
Time pressure and low risk assessment are commonly cited precursors to audit quality reduction acts in several prior studies . In the Rhode report (1978), the primary motivation cited for omitting a required audit step is time budget pressure (p. 180) . Similarly, Lightner et al . (1982) and Lightner et al . (1983) conduct surveys establishing the extent and causes of under-reporting behavior and find that pressure to meet infeasible budgets is cited as the primary cause . A variety of other studies have examined specific ways in which time pressure can affect audit quality . See for example, Margheim and Pany (1986) ; Kermis and Mahapatra (1985) ; Kelley and Margheim (1990, 1987) ; McDaniel (1990) ; Ashton (1990) ; Marxen (1990) ; Waggoner and Cashell (1991) ; and Margheim and Kelly (1992) .
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MARIBETH COLLER, JULIA L. HIGGS AND STEPHEN WHEELER
In a different survey designed to determine the reasons for premature signoffs in particular, Raghunathan (1991) finds low risk to be the most cited reason . The experiments conducted here are designed to address the empirical question of how low risk assessments and time constraints affect audit quality . The evidence from prior research indicates that each of these factors may affect audit quality directly . Alternatively, perceptions of risk may affect audit quality through its effect on time budgets . In suggesting these alternatives, we note that auditors must assess client inherent and control risks before determining the extent of substantive testing to be done . As such, reducing testing due to a low risk assessment is completely proper and does not necessarily reduce audit quality . However, the behavior we are interested in occurs when audit procedures are represented as having been done when in fact they have not . The question is thus whether a low risk assessment leads to setting a time budget that is relatively tighter for a given audit procedure (and thereby leads to audit quality reduction), or whether a low risk assessment has some direct effect on audit quality other than through inducing time pressure . The Cohen and the Treadway Commissions also cite excessive audit competition as a potential cause of reduced audit quality . Although firms compete on several dimensions, price is one of the most important . Since DeAngelo's (1981) original model of lowballing, several studies have been conducted to determine if firms reduce audit fees in response to competition . On a macro scale, Maher et al . (1992) demonstrate that audit fees decreased for sample firms during the period 1977 to 1981, a period cited as having an increased level of competition . Simon and Francis (1988) compare the fee structure of companies depending on whether or not an auditor change has occurred . They find that fees for firms that change auditors are 24% below fees reported for ongoing engagements . Similarly, Rubin (1988) finds that auditor tenure is a significant (positively related) factor in determining fees for municipal audits . These findings are consistent with the DeAngelo (1981) lowballing model . Related Experimental Studies Schatzberg (1990) tests DeAngelo's (1981) model using a laboratory market methodology. He hypothesizes that in the presence of positive start-up and switching costs, the fee negotiated in the first period will be equal to the cost of conducting the audit less the client switching costs . The fee negotiated in the second period is hypothesized to be equal to the audit cost plus auditor start-up costs and client switching costs . The results indicate that the presence of transaction costs generally results in lowballing, while, in the absence of transaction costs, lowballing does not occur .
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Schatzberg (1994) extends this literature by developing a model that allows for differences in audit opinions (i .e . there are instances where auditors may differ in their judgments about the appropriate audit report for a given client) . Experimental market tests of the model thus include outcomes where different auditor types vary in their opinion on the resolution . The results are consistent with the concept of "opinion shopping" in the audit market and demonstrate that such heterogeneity in auditor reporting behavior can also result in lowballing, even without positive transactions costs . Schatzberg (1994) does not investigate the possibility of related reductions in audit quality . Calegari et al . (1998) do investigate reductions in audit quality in an experimental setting, but such reductions take the form of misrepresenting the audit results . In these markets, the auditor observes one of two possible outcomes and then reports (either honestly or dishonestly) . Although these experiments are a more complete test of the price-independence relationship, the opportunity to reduce audit quality is not present . Dopuch and King (1996) conduct experiments where reductions in audit quality take the form of shirking on the amount of investigation performed in the audit . Their setting is somewhat similar to ours in that they include transactions costs in a market where all auditors have common costs and audit-quality choices . As opposed to the other studies discussed, Dopuch and King (1996) do not treat audit costs as fixed. Instead, the auditors may choose between a costly high-quality audit (which reveals the value of the client's asset) or a costless low-quality audit (which does not reveal the value of the asset) . The audit decision is thus dichotomous and can be depicted as the choice between a complete investigation and no investigation . In the event that the costless (no investigation) audit is chosen, the auditor reports the asset value as he chooses (either high or low) and thereby misrepresents the extent of his audit . Dopuch and King (1996) find that lowballing occurs in their markets, but find little evidence of reductions in audit quality . They were able to induce some reductions in quality, but only in markets where a high degree of lowballing was imposed in the absence of competition .
HYPOTHESES This study addresses whether a competitive market environment contributes to reduced audit quality as suggested by the Cohen and Treadway Commissions . This involves linking several intervening variables suggested in prior research . The hypothesized linkage is pictured in Fig . 1 . DeAngelo's (1981) model of audit competition asserts that lowballing is a rational strategy to obtain new clients . Schatzberg's (1990) empirical results
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MARIBETH COLLER, JULIA L. HIGGS AND STEPHEN WHEELER
TRANSACTION COSTS
FEE PRESSURE
TIME BUDGET
ERROR RATE PERCEPTIONS
AUDIT WORK-LEVEL REDUCTIONS
Fig. 1 .
Hypothesized Relationships .
show lowballing to be contingent upon the presence of transactions costs. Thus, the first hypothesis addresses whether lowballing will occur when it is costly to switch auditors . As such, this hypothesis is tested to ensure that we have induced downward pressure on audit fees for this experiment . HI : In the presence of transactions costs, audit fee lowballing will occur . To then test the linkage between lowballing and time pressure, the selected time budgets in markets with positive transactions costs are compared with those in markets without transactions costs . The results provide insight into the supposition by the Cohen Commission that the competitive environment leads to increased time pressure . Accordingly, the second hypothesis is : H2 : In the presence of transactions costs, tighter total budgets will be selected . The third hypothesis addresses the link between time pressure and audit quality reduction as follows : H3 : Higher audit work level reductions will be positively associated with tighter total budgets . We next address the suggestions from the Raghunathan (1991) survey regarding risk levels and attempt to determine if the perceived risk level causes a higher degree of time pressure or if the risk level directly affects work level decisions in addition to its effect on time pressure . The fourth and fifth hypotheses are as follows : H4 : Tighter total budgets will be selected when the expected error rate is low .
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H5 : Higher audit work-level reductions will occur when the expected error rate is low, after controlling for time budget selected .
EXPERIMENTAL TASK The laboratory market experiments conducted here involve the selling of services and the performance of an attest-type task . The basic design includes seven rounds, with each round consisting of two attest periods . In the first period of each round, each subject submits a private offer for the performance of an attestation task to each computer-simulated client . Each market includes six auditors and five clients . Engagements are awarded based upon the "best" offer and no auditor can be awarded more than one job in any period . All auditors who are awarded jobs then select a time budget, perform the audit task, and finally render an opinion on the accuracy of thirty calculations . The contracting and attest process is then repeated in the second round. Experimental manipulations incorporate the presence/absence of transaction costs (where transaction costs are used to induce lowballing) and differential perceptions of audit risk (set at two levels) . Both are manipulated between audit markets, resulting in four treatments . Each treatment is conducted twice, resulting in a total of eight experiments . In each experiment, subjects are first provided with written instructions .' After everyone finishes reading these, the experimenter summarizes the sequence of events and answers any questions . A one-period practice session is then conducted during which the experimenter explains the computer screens and talks the subjects through the mechanics of the task . Subjects are next provided with an initial endowment of $5 .00, and the experiment begins . The first two complete rounds are treated as practice rounds . This is done in order to allow subjects to practice the entire sequence of events without financial risk . During these rounds, subjects have ample opportunity to ask questions between each period. At the end of the second round, earnings are reset to zero, and the initial endowment of $5 .00 is restored . In hypothesis testing, only data from rounds three through seven are used . Subjects are informed that the maximum value of the job to the client is $2 .00 . Providing the value of the audit gives an indication of an upper bound for offer starting points that should encourage convergence of audit prices . The bidding process begins with each subject submitting offers to conduct an audit to each client . In the two treatments where transactions costs are present, all subjects who are awarded jobs are charged a $0 .30 start-up cost in period one . In period two, only those subjects who contract with a different client than in
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
period one (i .e . an auditor switch) are charged the start-up cost . The computersimulated client faces a switching cost of $0 .25 in the second period only if the auditor used in period one is not retained for period two . The remaining two treatments are conducted in the same way, with the exception that there are no start-up or switching costs present . Jobs are awarded based on the highest non-negative value to the client . This is not always the lowest offer since, when the client faces transactions costs related to auditor switching, the lowest offer may not result in the highest value to the client . In the event of a tie, the winner is decided based on the first subject to submit the tying offer . Because there are more auditors (six) than clients (five), at least one auditor will not be awarded a job in each period . This is done in order to provide a competitive environment and encourage convergence of audit prices to equilibrium . Any subject who is not awarded a job is allowed the option of conducting a "practice" audit, involving only the attest task, where no costs are assessed and no fee is earned . This procedure ensures that everyone has the same number of periods to conduct an audit . To the extent that task-related skills may develop with repetition, this is a necessary control . In addition, this procedure ensures that no one might feel embarrassed by having to sit idle while the other subjects conduct audits . After the contracts are awarded, subjects also are given information about the winning prices for each job . Subjects are then asked to choose a time budget . Five budget levels (2, 2 .5, 3, 3 .5, and 4 minutes) are available . These times were determined through pre-tests to represent options ranging from a virtually impossible time budget to a very easy one . At this point, the cost of time is $0 .25 for the first two minutes with each additional one-half minute costing an additional $0 .25 . Once the budget is selected, the subject/auditor is asked to verify 30 multiplication problems. Two levels of errors are seeded in the problems . Half of the experiments have an error rate of 5% (the probability of an error in at least one of the 30 problems is 5%, and the probability that there are no errors is 95%) . The remaining experiments use a 40% error rate (i .e . there is a 60% probability that all 30 problems are correct) . In general terms, subjects are told what the error rate is . The known error rates are somewhat analogous to an auditor assessing client inherent and control risk and having expectations about the degree of error . While not completely analogous, for the experiment's purposes, it is simply the perception of high or low error rates that is necessary to accomplish the treatment effect . Each of the thirty multiplication problems consists of two three-digit numbers . Subjects are asked to enter the equation in blanks on a computer worksheet . The computer multiplies the typed numbers, and the subject compares the product to the previously provided answer . If the subject finds an error, he/she marks a
Market Analyis of Auditor Work-Level Reduction Decisions
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decision box to indicate which equation is incorrect . Otherwise, no mark is made other than the typed equation . An on-screen clock, ticking down in ten second increments, displays the time remaining based on the budget selected . At the end of the budget period, the subject is asked if he/she wishes to opine on the correctness of the equations or to buy more time to work on the task . If the subject buys additional time, the cost is $0 .40 for each additional one-half minute . Because additional time can only be purchased at premium rates (analogous to overtime pay and opportunity costs to audit firms) at this point, the auditor has an incentive to select an initial time budget that is considered realistic . When the additional time (if any) expires, the subject is again given the opine/additional time option, continuing until the subject issues an opinion (either "no errors present" or "one or more errors present") . The computer then checks the errors in the equations against the decision boxes marked . If the subject does not identify an equation that is in error, a penalty of $1 .50 is assessed (a flat penalty, regardless of how many errors the subject fails to identify) . Conversely, if the subject incorrectly identifies an equation as being in error, a penalty of $0 .50 is assessed for each equation incorrectly marked, up to a maximum of three . These penalties are included to parallel the type I/type II errors possible in an audit and the differential severity of the errors to the auditor (type II errors, missing a material error, are considered more severe due to litigation possibilities) . Subjects must correctly identify all errors in the thirty multiplications to avoid the $1 .50 penalty . Therefore, the option to quit checking after one error is found and issue an opinion of "one or more errors present" could still result in a penalty . For analysis purposes, the computer also keeps track of how many equations the subject checks . This information is not used to determine subject earnings, only to measure the audit work-level selected . At the completion of the period, subjects are provided with their results and credited with the contract amount, reduced by costs for time, additional time, start-up costs, and penalties . The process is identical for the second period of each round, except for the additional possibility of switching auditors (and hence start-up and switching costs) . To measure and control for differences in subjects' typing skills, the experiment concludes by asking the subjects to perform a verification task containing 100 equations with three minutes to verify as many equations as possible . For each equation typed correctly, the subject earns an additional $0 .10 ; incorrectly entered equations reduce earnings by $0 .25, but not below the amount earned before the verification task begins . This measure, number of equations correct, is used as a covariate in the subsequent analysis . Finally, subjects are informed of their total earnings and paid accordingly . Figure 2 depicts the entire experimental process .
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER Computer server is connected to all subject terminals
Instructions given to participants
overs recorded
Subjects make offers to complete jobs
comrswssm on«srecomea
Computer Server awards contracts
Time
l` trod aed
Subjects I of 3 budgets
/
30 equations appear on screen
Subject has time based on budget selected to verify equations
Accuracy is recoded
Accuracy of opinion is chec ed
Subject receives offer reduced by costs & penalty
Subject receives pay based on offer . Costs of audit reduce earnings
Fig . 2. Overall, forty-eight student subjects participated in eight separate markets . All subjects had taken at least one computer course . They ranged in age from 20 to 43 (an average of 24), and in class level from junior standing to graduate level . Because students were required to have a sophomore level computer class, basic computer literacy was assumed . Beyond this, no special skills were required . Pre-tests (including group discussion with pre-test subjects) indicated that this task was seen as non-trivial, requiring some amount of effort, but was not so difficult that subjects did not want to participate .
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The average time to implement one market was just under two hours . Earnings ranged from $11 .25 to $25 .75, with an average of $19 .19 . Open-ended debriefing responses indicated that subjects understood the task, and casual analysis of the data showed little evidence of unusual heuristical approaches . Specifically, subjects demonstrated differing strategies in deciding which calculations to check or not to check. Most applied a sequential approach, but some employed an apparently random selection strategy . Beyond speculation, no reasons could be determined as to the selection of such strategies . To address possible end-of-game strategies, the data analyses were also run excluding round seven data. No substantial differences in results occurred . Also, results were substantially consistent between the different administrations of the experiments .
RESULTS To test the first hypothesis regarding lowballing, we make several analyses . First we compare the average fees in period one to fees in period two across rounds three through seven . In markets where transactions costs are present, the average fee in period one is $1 .35, while the average fee in period two is $1 .40 . The p-value for a paired comparison t-test of the difference is 0 .02 . By comparison, in comparable markets without transactions costs, the first period fees average $1 .47 compared to a $1 .46 average across all second periods (p = 0.54 for the t-test) . Second, we compare first period fees in markets with transactions costs to first period fees in markets without transactions costs . The first period fees in the presence of transactions costs ($1 .35) are significantly lower than first period fees ($1 .47) where no transactions costs are present (t = 2 .56, p <_ 0 .01) . These combined comparisons provide evidence of fee pressures in the experiment and indicate that subjects did lowball in the presence of transactions costs . To address Hypotheses 2 and 4, regarding time pressure, an ANCOVA analysis is conducted using the time budget selected as the dependent variable, with transactions costs and expected error rate as independent variables . Keyboarding skill (as measured by the results of subjects' post-experiment verification task) is included as a covariate . Because the design of the experiment includes as many as ten sequential observations from each of six subjects (fewer if the subject is not awarded a job in all periods), round number is also included as a blocking factor . Table 1 presents cell means for the budgeted time selected by treatment in Panel A, and ANCOVA results in Panel B . Both treatment variables are highly significant and are in the directions predicted by H2 and H4. Specifically, we find that : (1) in the presence of transactions costs, subjects choose tighter time
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
budgets, and (2) subjects choose tighter time budgets when the expected error rate is lower . The interaction term Error Rate x Transaction Costs was significant (F = 9 .42, p < 0 .0023) . Multiple comparison (Scheffe) tests and examination of cell means in Panel A reveal that the significance of these two treatments was driven by the low error rate/ transaction costs present cell . Thus the effect of the transaction costs variable (on time budget selected) manifested itself more when perceived error rates were low . Similarly, the effects of error rate perceptions (on time budget selected) were more pronounced when transaction costs were present. The significance of the round number attests to a learning effect across time . That is, as subjects' task familiarity increased, they tended to perceive a need for less time to accomplish the task . Hypotheses 3 and 5 predict that work-level reductions will be higher when tighter time budgets are selected and when error rate perceptions are low . To Table 1.
Analysis of Time Budget Selected .
Panel A : Cell Means by Treatment Transactions Costs Error Rate
Absent
Present
Total
High (0.40) Low (0 .05) Total
2 .57 2 .40 2 .49
2 .40 2 .08 2.24
2.49 2.24
Panel B: ANCOVA Results ; dependent variable = total time budget selected Variable
df
F
p-value
Transactions Costs Error Rate Subject Skill Level Round Number
1 1 1 4
132.25 125.44 90.75 38.43
0.0001 0.0001 0.0001 0.0001
Model RI = 76.9 Model F = 22 .61 (p :5 0.0001) Variable Definitions : Time Budget Selected: Total time purchased for audit task . Transactions Costs : Presence of start-up and switching costs, Yes/No . Error Rate: High (the probability of at least one error in the thirty problems is 60%) or Low (the probability of at least one error in the thirty problems is 5%) . Subject Skill Level : Number of calculations typed correctly during final verification task . Round Number : Round Number, 3-7 .
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test these hypotheses, we conduct a second analysis of variance with the number of calculations not verified as the dependent variable and time budget selected, transaction costs and error rates as independent variables . As previously discussed, keyboarding skill is included as a covariate and round number is also included . The results, presented in Table 2, indicate support for Hypothesis 3 . The selected time budget is highly significant in the ANCOVA and is negatively related to the number of calculations not verified (the correlation is -0 .49 and is significant at a level of less than 0 .0001) . Again, the significance of the round number variable apparently indicates that subjects required more evidence to opine as task familiarity increased . Interestingly, the two treatment variables, transactions costs and error rate, are not significant in directly explaining audit work-level reduction . Thus, these results do not support Hypothesis 5 ; instead they suggest that any effect of low Table 2.
Analysis of Number of Calculations Not Verified .
Panel A : Cell Means by Treatment Transactions Costs Error Rate
Absent
Present
Total
High (0 .40) Low (0 .05) Total
3 .85 3 .52 3 .68
4 .24 9 .67 6.95
4 .05 6 .59
Panel B : ANCOVA Results ; dependent variable = number of calculations not verified Variable
df
Time Budget Selected Transactions Costs Error Rate Subject Skill Level Round Number
1 1 1 1 4
F 429.94 1 .85 0 .41 498 .20 9 .45
p-value 0.0001 0.1744 0.5209 0.0001 0.0001
Model R'= 84 .9 Model F = 37 .51 (p :- 0 .0001) Variable Definitions : Time Budget Selected : Total time purchased for audit task . Transactions Costs : Presence of start-up and switching costs, Yes/No. Error Rate : High (the probability of at least one error in the thirty problems is 60%) or Low (the probability of at least one error in the thirty problems is 5%) . Subject Skill Level : Number of calculations typed correctly during final verification task . Round Number: Round Number, 3-7 .
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MARIBETH COLLER, JULIA L . HIGGS AND STEPHEN WHEELER
risk on audit work-level choice is likely to be manifested through the intervening time budget selection variable . As an overall check on the causal relationships implied by the individual ANCOVA analyses, we conduct a path analysis . This analysis is performed using the SAS System's CALLS procedure which uses maximum likelihood estimated coefficients that produce an estimated covariance matrix that is as close as possible to the sample covariance structure . The relationships analyzed appear in Figure 3 . As in the previous analyses, typing skill and round number are included to provide the best specification of the overall model . The specified model appears to fit the data quite well . The chi-square statistic is 0.7343, indicating an inability (p = 0 .69) to reject the null hypothesis that the reproduced covariance matrix has the specified model structure . The model explains 41 .9% of the variation in the number of calculations verified and 33 .0% of the variation in the time budget selected . Individual coefficient results and significance levels, also reported in Fig. 3, are consistent with the ANCOVA results . All coefficients are significant (at less than the 0 .01 level) and in the predicted direction . The path analysis tests reveal that the presence of transaction costs has a significant negative effect on the time budget selected, while perceived error rate has a significant positive effect on the time budget selected. In turn, the lower the time budget selected, the greater the number of equations not checked .
Skill Level
Fig . 3 .
Path Analysis Results Standardized Coefficients .
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A path analysis of an alternative model indicates that significant causal relationships are present neither from transactions costs directly to the number of equations not checked nor directly from error rate to number of equations not verified (Neither estimated coefficient is significant at conventional levels (p > 0 .10)) . The significance of the paths directly from skill level and round number to number not checked provides further assurance about the treatment effects, even after partitioning subject skills and learning effects . Taken together, our path analysis results suggest that fee pressure is present in the markets with transaction costs . In these markets, and also in markets where low levels of risk are present, subjects select lower time budgets . The reduced time budget then leads to greater levels of work-level reduction . No direct relationship is found between fee pressure or risk level and the extent of audit work-level reduction .
DISCUSSION In this paper we examine the potential causes of premature sign-off in an experimental market setting . Regulators have long asserted that competition in the market for audit services, which causes downward pressure on audit fees, induces time pressures and may be responsible for decreased audit quality . Surveys have cited time pressure and perception of low risk as primary causes of quality reduction acts . The contribution of this study lies in extending the linkage of the prior literature on lowballing with survey results citing time pressure as a cause of audit quality reduction . While prior laboratory research has demonstrated the competition-lowballing link, prior experimental research has found little evidence of the audit quality reduction acts that may occur . In this study, we provide an experimental setting with a much richer time budget selection and attest-type task than prior research has used, and find evidence of subsequent audit work-level reduction. A second contribution lies in clarifying how perceptions of low audit risk affect audit quality reduction acts . We find that, after controlling for time pressure, risk assessment does not significantly explain audit work-level reduction as suggested in prior survey research . That is, holding time pressure constant, our subjects were not any more likely to reduce work loads on a low risk task than on a high risk task . Instead, the effect of risk assessment is manifested through its effect on time budget selection . Therefore, absent time budget constraints, the tendency to reduce audit quality is not necessarily inherent . Further, our results are consistent with the Cohen Commission's original take on the issue : fee pressures create budgeting constraints, which then potentially affect audit quality .
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Our findings are limited by certain factors . First, the use of student subjects, although appropriate for this generic attest-type task, makes generalization of the results to auditor behavior more difficult . Second, subjects were told in advance about the actual error rates in the populations . While successful in achieving the desired risk-perception-treatment effects, the correspondence with actual audit procedures (where auditors have only perceptions about what error rates might be) is less than perfect. Third, while our results show significant reductions in audit work levels, the question of whether such reductions constitute premature sign-off acts cannot be answered without a defined minimum level . This question is left for future research .
NOTE 1 . Copies of the instructions and computer screen examples are available from the authors upon request .
ACKNOWLEDGMENTS We gratefully acknowledge the helpful comments of Rob Bloomfield, Gene Chewning, Al Leitch, Barbara Pierce, Brad Ruffle, Jeff Schatzberg, Vernon Smith, John Wermert, and participants at workshops at the Economics Science Association Conference, the American Accounting Association National meeting, and the Western Decision Sciences meeting . Bonnie Glasberg and Alex Maitland provided invaluable programming assistance .
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