Effects of Authoritative Guidance

Availability and Audit Committee

Effectiveness on Auditors' Judgments in
an Auditor-Client Negotiation Context
Terence Bu-Peow Ng
Hun-Tong Tan
Nanyang Technological University
ABSTRACT: In this paper, we present the results of an experiment that investigates
the effects of two contextual featuresthe availability of authoritative guidance and
the effectiveness of the client's audit committeeon auditors' perceived outcome of
auditor-client negotiations concerning an audit adjustment that affects the client's abil-
ity to meet analysts' forecasts. Results show that auditors' perceived negotiation out-
come is jointly influenced by authoritative guidance availability and audit committee
effectiveness. Specifically, authoritative guidance availability has a greater effect on
auditors' perceived negotiation outcome in the absence of an effective audit committee
than in its presence. We also find that concessionary moves by the client increase
auditors' propensity to concede to the client's preferred position.
Keywords: authoritative guidance; audit committee; audit adjustments; negotiation.

Data Availability: Contact the authors.

 802 Ng and Tan

interact, we identify boundary conditions under which prior research findings hold. Spe-
cifically, our study suggests that the influence of authoritative guidance on auditor judgment
and financial reporting quality (e.g., Salterio and Koonce 1997; Nelson et al. 2002) is
contingent on audit committee effectiveness, and that the influence of audit committee
strength on auditor effectiveness and financial reporting quality (e.g., Carcello and Neal
2000) depends on the availability of authoritative guidance.
We conduct an experiment in which auditors provide judgments relating to a proposed
audit adjustment that is quantitatively immaterial but that will affect the client's ability to
meet or beat the analysts' consensus forecast. We manipulate availability of precise au-
thoritative guidance and audit committee effectiveness as between-subject variables. This
setting allows us to gain some insights into issues related to audit adjustments and audit
committee communication that are the subject matter of authoritative pronouncements (SAS
No. 89 and SAS No. 90). In addition, we use an audit adjustment context that relates to
the potential inappropriate choice of revenue-recognition method because this is a major
avenue for earnings management attempts (Committee of Sponsoring Organizations
[COS0] 1999; Nelson et al. 2002) that has prompted recent issuance of authoritative guid-
ance on revenue recognition by the AICPA (Anonymous 1999) and the SEC (Staff Ac-
counting Bulletin No. 101; SEC 1999a). More generally, in a post-SAS No. 90 environment,
auditors and audit committee members are likely to be concerned about audit adjustments
pertaining to accounting method choice that affect financial reporting quality.
We find that authoritative guidance availability has a greater effect on auditors' per-
ceived negotiation outcome when the client's audit committee is ineffective than when it is
effective. Similarly, audit committee effectiveness has a greater effect on auditors' perceived
negotiation outcome in the absence of authoritative guidance than in its presence. In ad-
ditional analyses, we provide some evidence that auditors' propensity to concede to the
client's preferred position is also influenced by these two factors, and by concessionary
moves made by the client. Our results suggest that precise standards and effective audit
committees are potential substitutes /compensating mechanisms for enhancing auditor ef-
fectiveness and financial reporting quality. Specifically, our results suggest that corporate
governance mechanisms such as effective audit committees may mitigate the potential ad-
verse effects of imprecise accounting rules by bolstering auditors' positions during nego-
tiations with the client, and provide support for continual efforts to enhance the effectiveness
of audit committees (e.g., Blue Ribbon Committee 1999; National Association of Corporate
Directors 1999).
The following section develops our research hypotheses. This is followed by a descrip-
tion of the research methods used and presentation of the results. The paper concludes with
a discussion of the study's main findings, limitations, and opportunities for future research.
II. BACKGROUND AND HYPOTHESIS DEVELOPMENT
Pronouncements issued by standard setters and regulatory bodies (such as the FASB,
ASB, and SEC) provide authoritative guidance on the treatment and resolution of potentially
ambiguous accounting issues. The availability of precise authoritative guidance that indi-
cates the (more) appropriate accounting treatment among available alternatives provides
justification for auditors' choice of accounting methods and treatment of accounting issues
(Kennedy et al. 1997). Prior literature has documented that auditors respond to incentives
to permit aggressive reporting by interpreting imprecise standards or precedents as allowing
such reporting (Hackenbrack and Nelson 1996; Salterio and Koonce 1997; Nelson et al.
2002). Thus, besides serving a technical justification role, precise authoritative guidance

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 Effects of Guidance Availability and Audit Committee Effectiveness 803

can also be viewed as part of the repertoire of bargaining "ammunition" available to au -

ditors in their negotiations with clients on aggressive accounting choices. Such authoritative
guidance generally recommends or mandates how accounting issues are to be treated, and
therefore limits accounting choices available to the client (e.g., see Libby et al. [20021 for
a review of this literature).
Like authoritative guidance availability, audit committees form part of the institutional
environment that auditors and clients face, and are an important corporate governance
mechanism with a direct role in the oversight of the financial reporting process (Nichols
and Price 1976; Johnstone et al. 2001). Unlike authoritative guidance availability, audit
committees do not play a technical justification role. The effectiveness of an audit com -
mittee has little direct bearing on the technical justifiability of an accounting choice. How-
ever, similar to authoritative guidance, effective audit committees also help to bolster au-
ditors' bargaining power in their negotiations with clients, because they signal that auditors'
judgments with respect to appropriate accounting will be considered carefully, even if they
could reflect unfavorably on management. Recently issued standards requiring communi-
cation between auditors and audit committees on unrecorded misstatements (SAS N o. 89)
and on the quality of accounting principles/estimates (SAS No. 90) enhance the importance
of the audit committee as a party that influences the outcome of accounting negotiations
with the client.
Despite the influence that both authoritative guidance and effective audit committees
likely have on auditor effectiveness and financial reporting quality, evidence on their inter-
active effects is lacking. For example, Trompeter (1994) finds that auditors make more
aggressive recommendations when GAAP has fewer limits on the range of acceptable ac-
counting alternatives. Other studies show that auditors have a tendency to interpret vague
standards as indicating support for management's aggressive or conservative financial re-
porting, depending on their incentives (Hackenbrack and Nelson 1996). However, these
studies do not examine the influence of clients' corporate governance mechanisms, so it is
unclear whether the findings hold even when the client has an effective corporate gover -
nance structure (e.g., an effective audit committee)) Another stream of research investigates
the effect of audit committee existence/effectiveness on financial reporting quality (DeFond
and Jiambalvo 1991; Dechow et al. 1996; McMullen 1996; Beasley et al. 2000), and on
auditor effectiveness (Carcello and Neal 2000; Cohen and Hanno 2000). However, these
studies do not examine how the impact of audit committee effectiveness on auditors' judg-
ments may vary depending on the level of authoritative guidance available.
Consider a situation where auditors are told that management is reluctant, even after
several rounds of discussions and negotiations, to record an audit adjustment relating to a
revenue-recognition issue that will result in their inability to meet the analysts' consensus
forecast. Suppose auditors are asked to indicate the amount of the audit adjustment that
will ultimately be recorded in the audited financial statements. As discussed earlier, auditors'
judgments are likely influenced by the availability of authoritative guidance on the under-
lying technical issue (here, revenue recognition). Furthermore, given the background infor-
mation, it should be apparent to the auditors that the amount ultimately recorded is the
An earlier study by Knapp (1987) finds that audit committee members are more likely to support auditors'
stance in an auditor-client conflict where objective technical standards also support the auditors' stance (i.e.,
when the issue relates to disclosure of subsequent events), but not otherwise (i.e., when the issue relates to the
materiality of an audit adjustment). Knapp's (1987) study focuses on the judgments of audit committee members,
not auditors, and is conducted before the introduction of several regulatory measures that enhance the audit
committee's role in the financial reporting process (e.g.. SAS No. 89, SAS No. 90).

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 804 Ng and Tan

result of a negotiation process with the client's management, and consideration of bargain-
ing power should factor into the auditors' assessments of the ultimate negotiated outcome.
In particular, besides authoritative guidance availability, auditors are also likely to consider
the effectiveness of the client's audit committee because the ultimate negotiated audit ad-
justment likely occurs after meetings with the audit committee to discuss audit findings
(see SAS No. 89 and SAS No. 90).
The availability (or the lack) of authoritative guidance can be viewed as an external
(technical) constraint on the eventual audit adjustment ultimately recorded, but the effect
of this constraint may be moderated by the effectiveness of the audit committee (a source
of bargaining power). Negotiation research using buyer-seller contexts suggests that bar-
gaining power can moderate the effect of external constraints on negotiation outcomes (see
McAlister et al. [1986], which investigates the context of an externally set profitability
constraint). Authoritative guidance availability and audit committee effectiveness can also
be viewed as alternative sources of bargaining power for auditors in their negotiations with
clients (e.g., Nichols and Price 1976; Gibbins et al. 2001), or as compensating control
mechanisms over financial reporting quality (Johnstone et al. 2001; see also Brown and
Solomon [1990] on auditors' configural processing of internal controls). For these reasons,
authoritative guidance availability and audit committee effectiveness likely interact to in-
fluence auditors' perceived negotiation outcome. Specifically, we predict that in the absence
(presence) of an effective audit committee, auditors are less (more) likely to perceive that
they are able to negotiate successfully with client's management for a more conceptually
sound accounting method that will cause the client to miss the analysts' consensus forecast.
Thus, the availability of authoritative guidance (which serves as a technical constraint on
auditors' decisions, as well as an alternative source of bargaining power) is likely to exert
a greater influence on auditors' perceived negotiation outcome (as proxied by whether the
negotiated adjustment perceived by auditors to be ultimately recorded will cause the client
to miss the analysts' forecasts) in the absence of an effective audit committee than in its
presence. Our hypothesis on the interactive effect of authoritative guidance availability and
audit committee effectiveness on auditors' perceived negotiation outcome is formally stated
below:
Hla: The proportion of auditors who believe that the amount of the audit adjustment
ultimately recorded will result in the client's failure to meet the analysts' consen-
sus forecast is more positively affected by the availability of authoritative guid-
ance when the audit committee is ineffective than when the audit committee is
effective.
An alternative perspective on the interaction effect of authoritative guidance availability
and audit committee effectiveness is that audit committee effectiveness is more likely to
affect auditors' perceived negotiation outcome when authoritative guidance is absent than
when it is present. The absence of authoritative guidance increases the level of ambiguity,
which could increase the role and impact of bargaining power arising from differential audit
committee effectiveness. The joint effect of authoritative guidance availability and audit com-
mittee effectiveness on auditors' perceived negotiation outcome is restated as follows:
Hlb: The proportion of auditors who believe that the amount of the audit adjustment
ultimately recorded will result in the client's failure to meet the analysts' con-
sensus forecast is more positively affected by audit committee effectiveness when
authoritative guidance is absent than when authoritative guidance is present.
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 Effects of Guidance Availability and Audit Committee Effectiveness 805
HI. METHOD
Design
We employ a 2 x 2 between-subject factorial design, with Guidance Availability (ab-
sent, present) and Audit Committee Effectiveness (low, high) as the independent variables.
Case information provided to participants contained a brief description of the hypothetical
company, Libra Inc., selected financial information, and the accounting issue involving an
audit adjustment proposed by the audit staff. The audit adjustment represents the difference
in the revenue recognized from a new sales contract between the method used by the client
and that proposed by the audit staff. It amounts to 3 cents per share, which is quantitatively
immaterial (i.e., less than 1 percent of sales, earnings, and total assets). However, since the
EPS before the audit adjustment is $3.68 and the analysts' consensus forecast is $3.66,
booking the full amount of the audit adjustment will result in a failure by the client to meet
the analysts' consensus forecast by 1 cent per share, a qualitative factor considered to be
relevant for materiality considerations under Staff Accounting Bulletin No. 99 (SEC 1999b).
Given that it has been argued that missing analysts' consensus forecasts by even 1 cent per
share is material to financial statement users (e.g., Fox 1997; Levitt 1998; Brown 2001),
we use 1 cent per share as the amount of the analysts' consensus forecast missed to
provide a boundary condition for testing the hypothesized effects.
The case information indicates that the amount of the audit adjustment represents about
0.08 percent of sales, 0.8 percent of earnings, and 0.09 percent of total assets, and that
booking the full amount of the audit adjustment will cause the company's adjusted EPS to
fall short of the analysts' consensus forecast by 1 cent per share. We instructed all partic-
ipants, before they made their recommendations on the audit adjustment, that the client's
management had strong reservations about the proposed audit adjustment and were not
willing to record any amount of the audit adjustment that would reduce the revenue
recognized.
The first independent variable manipulates the availability of authoritative guidance on
the accounting issue. We provided general descriptions of the accounting issue (without
reference to specific revenue-recognition methods) to ensure that auditors made judgments
based on their average experience of similar auditor-client negotiation situations, which
better controls for differential technical knowledge about the accounting issue among au-
ditors (e.g., see Libby and Kinney 2000). In all conditions, we informed participants that
"there are some reasons to believe that the method proposed by the audit staff may be
more conceptually sound (relative to the method used by the client)." This ensures that
there are grounds to believe that the auditors' proposed method is the more appropriate
method regardless of authoritative guidance availability, and provides a basis for the audit
adjustment to be proposed and supported in the first place. In particular, SAB No. 101
notes that "in the absence of authoritative literature...the existing authoritative accounting
standards as well as the broad revenue-recognition criteria specified in the FASB's concep-
tual framework that contain basic guidelines for revenue recognition" should be considered.
Thus, according to SAB No. 101, the presence of authoritative guidance is not a necessary
condition for the determination of the appropriate accounting treatment applicable for spe-
cific transactions and situations, as existing conceptual frameworks are to be used in its
absence. We informed participants in the No Guidance condition that "there is no author-
itative guidance indicating which of the two methods is the more appropriate method under
GAAP," and those in the Guidance condition that "there is also authoritative guidance
indicating that the method proposed by the audit staff is the more appropriate method under
GAAP."
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 806 Ng and Tan

The second independent variable manipulates the effectiveness of the client's audit
committee (in terms of its independence from management). We informed participants in
the Ineffective Audit Committee condition that "in your past dealings with the audit com-
mittee, you have found that it has a tendency to be sympathetic toward the management's
position," and those in the Effective Audit Committee condition that "in your past dealings
with the audit committee, you have found that it consistently exercises independent judg-
ment without a tendency to be sympathetic toward the management's position."
After reading the case information, participants provided two judgments: their recom-
mendations on the amount of the audit adjustment to be booked, and assessments of the
perceived negotiation outcome. At the first stage of the experiment, participants were posed
the following question: "Suppose that you are about to meet Libra's management to discuss
the audit adjustment. What is the amount of the proposed audit adjustment that you would
recommend to be booked?" We asked participants to indicate an amount from $0 (i.e.,
completely waive the audit adjustment) to $300,000 (i.e., completely book the audit ad-
justment), and to indicate the rationale for their responses. After answering the above
questions, they proceeded to the second stage of the experiment where we provided them
the following information: "Suppose that after a few rounds of discussions and negotiations,
Libra's management has reiterated its strong reservations about the proposed audit adjust-
ment, but has indicated that it is now willing to record up to $100,000 of the proposed
audit adjustment (i.e., up to 1 cent per share), but no more than that." Management's
willingness to record up to $100,000 is held constant across all experimental conditions.'-
Following the approach used in Libby and Kinney (2000), we elicited auditors' estimates
of the auditor-client negotiation outcome (which form our main dependent variable) by
asking this question: "In light of the client's stand above, what is the amount of the pro-
posed audit adjustment that you believe will ultimately be recorded in Libra's audited
financial statementsr
Upon providing the above judgments relating to the audit adjustment, the participants
responded to debriefing questions.

Participants and Administration

Participants were audit managers from various U.S. offices of a Big 4 firm.' The ex-
periment was administered online with the help of a contact person from the firm's Assur-
ance Services Division. Through the contact person, participants were randomly assigned
and emailed the different versions of the instrument corresponding to the four cells of our
2 x 2 design. The email was accompanied by a cover message from the Assurance Services
Director requesting participation in the study and assuring participants of the confidentiality

2 Prior research suggests that auditors are open to booking partial amou nts of audit adjustments (e.g., Libby and
Kinney 2000; Braun 2001). In the context of our study, it is possible that changes in parameters and estimates
within the accounting methods may be used to justify partial audit adjustments.

Libby and Kinney (2000, 387) argue that auditors "provide relatively informed and unbiased estimates of
reported (audited) earnings" resulting from auditor-client negotiations (relative to management) given that they
"are in the best position to estimate their own behavior" and "are likely to have experience negotiating corrections
across several client contexts."

4 Managers are appropriate participants for our study because they likely provide inputs to partners in the latter's
negotiations with clients' management, and should also be aware of negotiation outcomes. They also may directly
engage in negotiations with clients' management on some audit adjustments. Supporting the usefulness of audit
managers' data. Nelson et al. (2002) find no differences in audit managers' and part ners' responses describing
audit outcomes with respect to clients' earnings management attempts.

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 Effects of Guidance Availability and Audit Committee Effectiveness 807
of their responses. In our instructions, we reminded participants to perform the judgment
tasks independently and to provide their email address.'
The data-collection program used allows participants to proceed from one stage to
another only after they have responded to questions in the preceding stages. The program
has features that limit respondents from scrolling back to earlier screens to change their
responses. As an added control, we designed the program to immediately email completed
6

responses at each stage to the researchers. We pilot-tested the instrument with five faculty
members who had between four to eight years of audit experience, and modified it based
on the feedback received from the Assurance Services Director and two field managers
from the participating firm. We obtained responses from 113 out of 224 audit man -
agers contacted via email, yielding a response rate of 50 percent. We eliminated responses
from 12 participating auditors with incomplete or non-interpretable answers. The remaining
101 auditors had an average of 8.3 years of audit experience (standard deviation = 3.1
years), 38 percent of which was spent with SEC-listed clients.

IV. RESULTS
Manipulation and Other Checks
We ask several questions to assess whether auditors correctly interpret our task and
manipulations. A large majority do so, with the following exceptions: three auditors who
indicate that they are not aware that booking the full amount of the audit adjustment would
cause a failure to meet the analysts' consensus forecast; two auditors who indicate that
authoritative guidance is available when it is not, and vice versa; and seven auditors in the
effective (ineffective) audit committee condition who rate the audit committee below
(above) the mid-point of the audit committee effectiveness scale (0 = not effective at all;
10 = extremely effective).' We eliminate the responses of these auditors from further anal-
yses. Of the remaining 89 auditors, 50 respond to the versions corresponding to the four
experimental treatments related to our main experiment, while 39 respond to additional
treatments used for further analysis (see discussion under "Additional Analyses" in this
section).
We also ask auditors additional questions, related to the task, on 11-point scales with
the appropriate verbal anchors (e.g., 0 = not likely at all; 10 = extremely likely). Auditors
express a strong belief that management's reservations about the proposed audit adjustment
are likely due to their desire to meet the analysts' consensus forecast (mean = 8.61, standard
By asking participants for their email addresses, we intend that participants become aware that, even though
their responses are confidential, the researchers may potentially contact them. This should induce greater ac-
countability than if their responses were anonymous. Only three participants did not provide an email address.
Eliminating these participants from the analyses does not alter the results of the hypothesis tests.
Participants who double-click on the "back" button in quick succession can return to the earlier screen (a feature
inherent in the program). However, the program is designed such that we are alerted if they change their
responses. Only two participants changed their earlier responses. These responses are treated as uninterpretable,
and have been eliminated from the analyses.
7 The average ratings in the Effective Audit Committee and Ineffective Audit Committee conditions are 6.82 and
2.93, respectively (p = 0.000). Unless otherwise stated, two-tailed p-values are reported. One-tailed p-values
are reported for directional tests.
s These questions screen out auditors who may not have carefully read the contents of our Internet-administered
research instrument. Auditors who misinterpret the experimental manipulations add noise to the analyses and
weaken the power of the tests. The manipulation check failures occur evenly across the four main experimental
and three additional conditions. Including these responses in the analyses yield similar results for HI a (where
the effect of authoritative guidance availability is only statistically significant when the audit committee is
ineffective; p = 0.028. one-tailed) but not for H1 b (where the effect of audit committee effectiveness is not
significant for both guidance conditions: p > 0.271).

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 808 Ng and Tan

deviation = 1.63), suggesting that they are aware of management's incentive to avoid
recording the audit adjustment. On average, auditors rate the materiality of the audit ad-
justment to be moderate and not low (mean = 6.07; standard deviation = 3.16), suggesting
that they do consider the analysts' forecast factor in their materiality assessments. They rate
the client's engagement risk (defined as the likelihood that the audit firm will suffer a loss
as a result of its association with the client) to be moderate (mean = 4.96; standard deviation
= 2.21). Auditors' materiality and engagement risk assessments do not vary systematically
across experimental conditions (p > 0.741). Across experimental conditions, auditors rate
9

the client's management to be of moderate integrity (mean = 5.19, standard deviation

= 1.85). We also ask the auditors to rate separately the importance of authoritative guidance
and audit committee effectiveness in mitigating biased financial reporting by clients in
general. The mean rating for the importance of authoritative guidance is significantly higher
than that for audit committee effectiveness (means = 8.61 and 7.85, respectively; p
= 0.004), suggesting that auditors across conditions believe that authoritative guidance has
a major influence on financial reporting quality.

Tests of Hypotheses
The dependent variable we use in the hypothesis tests is a dichotomous variable coded
based on whether the amounts judged by the auditors to be ultimately booked after nego-
tiations with the client are above $200,000, an amount that will result in a failure by the
client to meet the analysts' consensus forecast (coded as 1), or otherwise (coded as 0). This
is because what matters to the client and users of audited financial statements (in the context
of this study) is not the magnitude of the audit adjustment booked, per se (given that the
amount of the audit adjustment is quantitatively immaterial), but whether the amount
booked will enable the client to meet or beat the analysts' consensus forecast. Booking an
amount of $200,000 (i.e., 2 cents per share) reduces the adjusted EPS to $3.66, which
would enable the client to just meet the analysts' consensus forecast. Thus, the dichotomous
variable distinguishes between judgments that are consistent with the client's preference
and those that are not.'"
Table 1, Panel A presents the descriptive statistics on the proportion of auditors who
believe that the audit adjustment ultimately booked after auditor-client negotiation will
result in the client's failure to meet the analysts' consensus forecast. The mean and standard
deviation of the actual amounts of the adjustment perceived to be ultimately booked by
auditors are also presented in Panel A. On average, across all experimental conditions, only
an average of 26 percent believe that the amount ultimately booked after negotiations will
result in the client's failure to meet the analysts' consensus forecast.
Panel B of Table 1 reports the categorical analysis results (using the likelihood ratio
tests of partial associations of the log-linear model) relating to auditors' perceived negoti-
ation outcome. The main effect of Guidance Availability is statistically significant (p
= 0.031), but not that of Audit Committee Effectiveness (p = 0.309). Of relevance to the
tests of H 1 a and H 1 b is the statistically significant interaction effect between Guidance
Availability and Audit Committee Effectiveness (p = 0.030, one-tailed). Hla predicts that

9 Including auditors' materiality or engagement risk assessments as an independent variable (coded as a dichot-
omous variable based on median splits) in the hypothesis tests yield similar results. While the main effects of
materiality and engagement risk assessments are statistically significant (p < 0.021), these assessments do not
interact significantly with the key independent variables of interest.
m Coding the dichotomous variable based on whether the amounts are above $250,000 yields similar results for
the tests of hypotheses. We also obtain similar results when the hypotheses are tested based on the amounts
reported by auditors instead of the dichotomous variables.

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 Effects of Guidance Availability and Audit Committee Effectiveness 809

TABLE 1
Effects of Authoritative Guidance Availability and Audit Committee Effectiveness on Auditors'
Perceived Negotiation Outcome
Panel A: Descriptive Statistics
Audit Committee Effectiveness
Ineffective Effective Average
Authoritative Proportion' 0.00 0.25 0.13
Guidance
Absent Mean (s.d.) Adjustment" 50 (52) 117 (127) 83 (101)
Sample size 12 12 24
Proportion' 0.38 0.38 0.38
Present Mean (s.d.) Adjustment" 162 (126) 154 (127) 158 (124)
Sample size 13 13 26
Panel B: Tests of Partial Associations of the Log-Linear Model:0.20
Proportion' Effects on Auditors'
0.32 Perceived
0.26
Negotiation Outcome
Average Mean (s.d.) Adjustment" 108 (112) 136 (125) 122 (118)
E f f e c t df Likelihood Ratio Chi-Square p-value
Guidance Availability Sample size1 25
4.666 25 50
0.031
Audit Committee Effectiveness 1 1.033 0.309
Guidance Availability x, Audit 1 3.556 0.030*
Committee Effectiveness
* Denotes one-tailed p-value.
Proportion = proportion of auditors who believe that the amount of the audit adjustment ultimately recorded will
result in the client's failure to meet the analysts' consensus forecast.

" Mean (s.d.) Adjustment = mean (standard deviation of) audit adjustment (in $000) that auditors believe will
ultimately be recorded in the client's audited financial statements.

the effect of authoritative guidance on auditors' perceived negotiation outcome is moderated

by the effectiveness of the audit committee. Tests of simple main effects indicate that, when
the audit committee is ineffective, a significantly higher proportion of auditors believe that
the amount ultimately booked will result in the client's failure to meet the analysts' con -
sensus forecast when authoritative guidance is present than when it is absent (proportions
= 0.38 and 0.00, respectively; x = 7.70, p = 0.003, one-tailed). In contrast, when the
2

audit committee is effective, the difference in proportions between the two guidance con-
ditions is not statistically significant (proportions = 0.38 and 0.25, respectively; x = 0.52, 2

p = 0.469). These results are consistent with H1 a.

Hypothesis lb predicts that the effect of audit committee effectiveness on auditors'
perceived negotiation outcome is moderated by the availability of authoritative guidance.
Tests of simple main effects indicate that, when authoritative guidance is absent, a signif-
icantly higher proportion of auditors believe that the amount ultimately booked will result
in the client's failure to meet the analysts' consensus forecast when the client's audit com-
mittee is effective than when it is ineffective (proportions = 0.25 and 0.00, respectively;
x = 4.57, p = 0.016. one-tailed). In contrast, when authoritative guidance is present, there
2

is no difference in the proportions between the two audit committee effectiveness conditions
(proportions = 0.38 and 0.38, respectively; x = 0.00, p = 1.00). These results are con-
2

sistent with H lb.

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 810 Ng and Tan

Additional Analyses
Auditors' Propensity to Concede to Client's Preferred Position
In this subsection, we assess whether auditors' perceived negotiation outcome deviates
from their initial recommendations in a manner that suggests a concession toward the
client's preferred position. To the extent that auditors' initial recommendations approximate
their assessments of the most appropriate audit adjustment, a move away from their initial
recommendations toward the client's preferred position indicates a shift in the auditors'
(apparent) objectivity.
In the context of our study, auditors' initial recommendations likely approximate their
true beliefs of the most appropriate audit adjustment. Although these initial recommenda-
tions can be viewed as opening moves that may be strategically "inflated" to incorporate
consideration of bargaining power (e.g., Yukl 1974; Pruitt and Carnevale 1993), institutional
constraints in the audit environment limit this possibility. In particular, auditors' initial
recommendation likely is recorded as a proposed adjusting entry, and auditors may avoid
making extreme recommendations if they consider it inappropriate or unprofessional to
propose an incorrect amount under existing accounting or auditing standards and guidelines.
We asked a subset of the auditors participating in additional experimental conditions (re-
ported later; n = 12) to indicate on 11-point scales (0 = not at all; 10 = to a large extent)
the degree to which their initial recommendations (a) are based on their assessments of the
most appropriate amount that they think should be recorded in the client's financial state-
ments, and (b) are higher than the most appropriate amounts that they think should be
recorded (to incorporate an expectation of potential bargaining down by the client during
subsequent negotiations). The mean responses for these two questions are 9.33 and 0.67,
respectively, with the difference being highly significant (p = 0.000). These results, from
a subset of the participants, indicate that auditors strongly believe that their initial recom-
mendations are based on their assessments of the most appropriate amounts that should be
recorded, and are not strategically biased upward to factor in anticipated adjustments likely
to occur in subsequent negotiations."
As in our main hypothesis, we anticipate that authoritative guidance availability and
audit committee effectiveness will interact such that auditors' propensity to concede to the
client's position is more significantly affected by the availability of authoritative guidance
when the audit committee is ineffective than when the client's audit committee is effective.' 2

We define propensity to concede as referring to a situation where auditors initially rec -

ommend booking an amount that will result in the client's failure to meet the analysts'
consensus forecast, but perceive that such an amount will not be ultimately recorded after
negotiations with the client. Thus, our analyses involve only the 34 auditors who initially

" We conduct a categorical analysis with authoritative guidance availability and audit committee effectiveness as
independent variables and, as dependent variable, a dichotomous variable coded based on whether auditors
recommend, at the initial stage, booking an amount that will result in the client's failure to meet the analysts'
consensus forecast. Consistent with the idea that auditors base their initial recommendations predominantly on
the technical justifiability of the audit adjustment, we find a statistically significant main effect of guidance
availability (mean proportions = 0.81 and 0.54 for the Guidance and No Guidance conditions, respectively;
p = 0.042). and neither the main effect of audit committee effectiveness nor the interaction effect is statisti -
cally significant (p > 0.527).

" Gibbins and Salterio's (2002) model suggests that the absence (presence) of authoritative guidance, which affects
auditors' issue assessments, increases the likelihood of overlap (non-overlap) between auditor- and client-desired
outcomes, and consequently the tendency of auditors to concede (not concede) toward the client -preferred
adjustment. Similarly, auditors' perceived bargaining power, which in creases with audit committee effectiveness
and authoritative guidance availability, decreases the tendency of auditors to concede toward the client -preferred
adjustment. In the context of Gibbins and Salterio's (2002) model, we assume that, within limits, auditors'
motivations are generally not adversarial to reaching client-desired outcomes.

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 Effects of Guidance Availability and Audit Committee Effectiveness 811
recommend booking an amount that will result in the client's failure to meet the analysts'
consensus forecast. Results are presented in Table 2. As an overall test, we conduct a
categorical analysis with Guidance Availability and Audit Committee Effectiveness as in-
dependent variables and, as dependent variable, a dichotomous variable based on whether
the audit adjustment perceived to be ultimately recorded in the audited financial statements
results in the client's failure to meet the analysts' consensus forecast. Table 2, Panel B
shows that, as expected, the two-way interaction is statistically significant (p = 0.025, one-
tailed).' 3

TABLE 2
Effects of Authoritative Guidance Availability and Audit Committee Effectiveness on Auditors'
Propensity to Concede

Panel A: Descriptive Statistics

Audit Committee Effectiveness

Ineffective Effective Average

Authoritative Proportion' 1.00 0.57 0.77
Guidance
Absent Mean (s.d.) Adjustment' 233 (52) 114 (121) 169 (111)
Sample size 6 7 13
Proportion' 0.50 0.55 0.52
Present Mean (s.d.) Adjustment' 100 (115) 127 (127) 114 (120)
Sample size 10 11 21
Panel B: Tests of Partial Associations of the Log-Linear Model: Effects on Auditors'
Propensity to Concede Proportion' 0.69 0.56 0.62

E f f e c Average
t Mean (s.d.)
dfAdjustment" 150 (115)
Likelihood 122 (122)
Ratio Chi-Square 135 (118)
p-value
Guidance Availability Sample size 1 16 2.200 18 0.138
34
Audit Committee Effectiveness 1 0.705 0.401
Guidance Availability x Audit 1 3.823 0.025*
Committee Effectiveness
The results presented in this table involve only the 34 (out of 50) auditors who initially recommend booking an
amount that will result in the client's failure to meet the analysts' consensus forecast.
* Denotes one-tailed p-value.
Proportion = proportion of auditors who believe that the amount of the audit adjustment ultimately recorded will
not result in the client's failure to meet the analysts' consensus forecast.
b Mean (s.d.) Adjustment = mean (standard deviation) of the difference (in $000) between the amount of the audit
adjustment that auditors initially recommend to be booked and the amount the they believe will ultimately be
recorded in the client's audited financial statements.

13 We also analyze the difference in auditors' judgments between the two stages (initial recommendation and
perceived ultimate outcome), without consideration of whether they do or do not accede to the client's position
in their initial recommendations. To do this, we conduct a mixed categorical analysis, with Stage (initial rec-
ommendation, perceived ultimate outcome) as a within-subject variable and Guidance Availability and Audit
Committee Effectiveness as between-subject variables. Contrary to the main findings, we detect no statistically
significant three-way interaction (p = 0.379). This result is likely obtained because the analysis includes auditors
who do not initially recommend booking an amount that will result in the client's failure to meet the analysts'
consensus forecast and, therefore, are not considered to have conceded to the client at the second stage. Including
these auditors in the analysis weakens the power of the test on the joint effects of guidance availability and
audit committee effectiveness on auditors' propensity to concede to the client.

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 812 Ng and Tan

Results of McNemar tests (Siegel and CasteIlan 1988) within each treatment group
indicate that the change in auditors' position among those who initially recommend booking
an amount that will result in the client's failure to meet the analysts' consensus forecast is
at least marginally significant for each of the treatment groups, with the proportion of
auditors having the propensity to concede ( ,P concede) ranging from 0.50 to 1.00 (p < 0.063,
one-tailed), as summarized in Table 2, Panel A. Tests of differences between treatment
groups indicate that when the audit committee is ineffective, Pconeede is significantly higher when
authoritative guidance is absent than when it is present (proportions = 1.00 and 0.50,
respectively; x2 = 6.01, p = 0.007, one-tailed). In contrast, when the audit committee is
effective, the difference in P conc ede between the two guidance conditions is not statistically
significant (proportions = 0.57 and 0.55, respectively; x 2 = 0.01, p = 0.914). Similarly,
when authoritative guidance is absent, P cuncede is significantly higher when the client's audit
committee is ineffective than when it is effective (proportions = 1.00 and 0.57,
respectively; x 4.49, p = 0.017, one-tailed). In contrast, when authoritative guidance is
'

present, there is no difference in P,,, between the two audit committee effectiveness
conditions (proportions = 0.50 and 0.55, respectively; x2 = 0.43, p = 0.835). These results
suggest that authoritative guidance availability and audit committee effectiveness jointly
influence auditors' propensity to concede toward the client's position.
Effects of Client's Concessionary Moves during Negotiations

Prior research suggests that negotiation strategies can influence negotiated outcomes
(e.g., Antle and Nalebuff 1991; Neale and Northcraft 1991). To examine the effects of
concessionary moves by the client during negotiations on auditors' judgments, we include
three additional treatments. Two-thirds of the data for these treatments are randomly dis-
tributed and were collected at the same time as those for the four main experimental
treatments; the remaining one-third of the data was collected after the main data collection,
and participants were directed to cells with the fewest observations.
We expect that auditors will have a greater propensity to concede to the client's pre-
ferred position in the presence of concessionary moves by the client (e.g., see Yukl 1974;
Esser and Komorita 1975). We first test this expectation by creating two additional treatment
conditions, using a context where there is no guidance available on the accounting issue,
but where the audit committee is effective. We choose this context because negotiation
strategies likely matter here (given no authoritative guidance and presence of bargaining
power by the auditor).
Both new treatments are variations of the No Guidance/Effective Audit Committee
condition in the main experiment (henceforth referred to as the C , condition), where
( AG

the client relents somewhat during the negotiations by being willing to record up to 1 cent
per share (i.e., offering some concession). The first additional treatment is the NC AG

condition, which varies the initial position of the client (i.e., willing to record up to 1 cent
per share) while holding constant its final position during negotiations (i.e., still willing to
record only up to 1 cent per share). In the NC condition, therefore, the client is essen-
AG

tially not backing off from its initial position (i.e., no concession is offered during nego-
tiations). The second additional treatment condition is the Co, condition, which holds
/n AG

constant the client's initial position (i.e., not willing to record any amount), but varies its
final position (i.e., willing to make relevant footnote disclosures on the method used along
with the financial impact of using the alternative method proposed by the auditor, without
recording any amount of the audit adjustment), thus offering some concession. Our predic-
tions follow from prior research, which shows that "hard" or extreme initial offers followed
by relatively small concessions result in better negotiation outcomes for the negotiator
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 Effects of Guidance Availability and Audit Committee Effectiveness 813
(Chertkoff and Conley 1967; Yukl 1974), and that extreme offers held onto without con-
cessions are least effective (Benton et al. 1972). Hence, we expect that P
- concede will be lower
in the NC condition than in the C C , A conditions. However, we do not have a
o AG o AG hu G

basis to predict any difference in auditors' responses between the C,, C

conditions 0 AG and frino AG

because they differ only in the form of the concession.

Panel A of Table 3 presents the descriptive statistics. Tests of differences between
treatment groups indicate no significant differences in auditors' initial recommendations
(p > 0.201). However, in terms of auditors' perceived negotiation outcome, the proportion
of auditors who believe that the amount ultimately booked will result in the client's failure
TABLE 3
Effects of Alternative Treatments on Auditors' Judgments on the Audit Adjustment
Panel A: Descriptive Statistics (in the Context Where There Is No Available Authoritative
Guidance, but There is an Effective Audit Committee)
Client's Initial Perceived Final
Client's Final Recommended Adjustment after
Position Adjustment Negotiations
Initial after Mean Mean
Treatment Position Negotiations n Proportion' (s.d.)b Proportion` (s.d.)d
C A G Not willing Willing to 12 0.58 188 0.25 117
to record record up to (145) (127)
any amount 1 cent
NC, AG Willing to Willing to 13 0.62 192 0.46 146
record up record up to (144) (151)
to 1 cent 1 cent
C / no AG Not willing Willing to 11 0.82 245 0.18 55
to record make (121) (121)
any amount
footnote
disclosures
Panel B:Descriptive Statistics (in the Context Where There Is Authoritative Guidance and the
Client's Audit Committee is Effective)
Client's Initial Perceived Final
Client's Final Recommended Adjustment after
Initial Position Adjustment Negotiations
Position Mean Mean
after
Treatment Negotiations n Proportion' (s.d.)" Proportion' (s.d.)d
Willing to 13 0.85 254 0.38 154
CAG
Not willing
record up to (112) (127)
to record
NC, any amount
1 cent
0.80 253 0.47 143
Not willing (106) (147)
to record Not willing to 15
any amount record any
amount
3Refers to the proportion of auditors who recommend booking an amount of the audit adjustment that will
result in the client's failure to meet the analysts' consensus forecast.
Refers to the mean (standard deviation of) audit adjustment (in $000) that auditors recommend to be booked.
Refers to the proportion of auditors who believe that the amount of the audit adjustment ultimately recorded will
result in the client's failure to meet the analysts' consensus forecast.
dRefers to the mean (standard deviation of) audit adjustment (in $000) that auditors believe will ultimately be
recorded in the client's audited financial statements.

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The Accounting Review, July 2003
 814 Ng and Tan

to meet the analysts' consensus forecast is marginally higher in the NC AG than

in the C, and C ,,, conditions combined (proportions = 0.46 and 0.22, respectively;
f 0

p = 0.065, one-tailed). Also, as predicted, Pc concede is significantly lower in the NC

condition than in the combined C ,,,, and C conditions (proportions = 0.25 and 0.69,
fr Ac

respectively; p = 0.013, one-tailed).' We find no statistically significant difference between

the C no and C ,,
Ac in terms of auditors' perceived negotiation outcome
f AG

(proportions = 0.25 and 0.18, respectively; p = 0.690) or P concede (proportions = 0.57 and
0.78, respectively; p = 0.375). These results support our expectation that auditors have a
higher propensity to concede to the client's position in the presence of concessionary moves
by the client.
We also examine a third additional treatment, NC, where authoritative guidance is
available and the audit committee is effective. This treatment is identical to the Guidance/
Audit Committee Effective condition in the main experiment (henceforth, the C G condition) A

in all aspects except for one major feature: the client does not provide any concessionary
move at all during negotiation. As summarized in Panel B of Table 3, in the NC condition, AG

the client is not willing to record any amount of the audit adjustment at both stages of the
negotiation (i.e., no concession is offered); in contrast, in the C G condition, the client is A

unwilling to record any amount at first, but relents to record up to 1 cent per share later
(i.e., offering some concession during negotiations). As in the above discussion, we expect
P, , to be higher in the C condition than in the NC condition.'
AG

Tests of differences between the CAG and NC conditions indicate no significant dif-
ferences in either the initial recommendations (proportions = 0.85 and 0.80, respectively;
p = 0.748), perceived negotiation outcome (proportions = 0.38 and 0.47, respectively;
p = 0.330, one-tailed), or (proportions = 0.55 and 0.42, respectively; p = 0.267,
one-tailed). These results indicate no effects of concession in the presence of authoritative
guidance, and are in contrast to our earlier findings of an effect of concession when au-
thoritative guidance is absent. As an overall test to determine whether the presence of
client's concessions interacts with authoritative guidance availability, we perform a cate-
gorical analysis with Client Concessions (yes, involving treatments AG, C, and C hu

AG; no, involving treatments NC and NC) and Guidance Availability (yes, involving
AG

treatments C and NC ; no, involving treatments C , NC and C ,,, ) as independent

AG AG 0 4G, f 0 AG

variables, and either auditors' perceived negotiation outcome or P

concede as the

dependent variable. Results indicate that the main effect of client concessions is marginally
significant for auditors' perceived negotiation outcome (p = 0.094, one-tailed) and statis-
tically significant for P,, , (p = 0.022, one-tailed), but neither the main effect of guidance
e k

'A Further analyses indicate that the proportion of auditors who believe that the amount ultimately booked will
result in the client's failure to meet the analysts' consensus forecast in the NC,,, , condition is marginally higher
A

than that in the condition (proportions = 0.46 and 0.18, respectively; p = 0.061) but not significantly
Ct,,,,

higher than that in the C condition (proportions = 0.46 and 0.25, respectively; p = 0.128). In contrast,
AG

in the NC, , condition is significantly lower than that in the C , , condition (proportions = 0.25
4 f A

and 0.78, respectively; p = 0.005), and marginally lower than that in the C',, condition (proportions = 0.25
Ac

and 0.57, respectively; p = 0.092, all p-values are one-tailed).

We ask auditors to rate the client's persistence in insisting on their initial position. Persistence ratings are higher
in the NC condition than in the C , condition (means = 9.33 and 6.85, respectively; p = 0.002, one-tailed).
AG A

Ratings in the NC,, AG condition are marginally higher than those in the C condition (means = 8.69 and
AG

7.83, respectively; p = 0.062, one-tailed), but ratings do not differ between the C , AG and C AG conditions
f

(means = 8.09 and 7.83, respectively; p = 0.715).

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 Effects of Guidance Availability and Audit Committee Effectiveness 815
availability nor the interaction effect is statistically significant (p > 0.274).' Taken together,
the additional analyses presented here provide some evidence that the client's negotiation
strategies could exert an influence on auditors' propensity to concede to the client's position.
The results do not provide strong evidence that this influence is moderated by the availa-
bility of authoritative guidance.

V. DISCUSSION AND CONCLUSION

Using an auditor-client negotiation context, we conduct an experiment involving a quan-
titatively immaterial audit adjustment that affects the client's ability to meet the analysts'
consensus forecast. We find that the availability of authoritative guidance and the effect-
iveness of the client's audit committee jointly influence auditors' judgments of whether the
amount of the audit adjustment ultimately recorded after negotiations with the client will
result in the client's failure to meet the analysts' consensus forecast. Our finding suggests
that current FASB endeavors that consider the nature of promulgated accounting standards
(principles-based versus rules-based guidance) can significantly impact auditor-client ne-
gotiations of accounting issues, but that these effects on financial reporting quality are
contingent on the effectiveness of the client's audit committee.
Additionally, the results indicate that the availability of authoritative guidance and the
effectiveness of the audit committee interact to jointly affect auditors' propensity to concede
to the client's preferred position. Results from additional treatment conditions suggest that
auditors' propensity to concede to the client's position may be attributed, in part, to the
presence of concessionary moves by the client. To the extent that auditors are more likely
to objectively assess the merits of the issue before entering into the negotiation process, a
requirement to document auditors' (presumably objective) assessments of the issue before
the negotiation process, along with close scrutiny and justification of any significant shifts
in position from their initial assessments subsequent to negotiations, can serve as a useful
control mechanism to mitigate any negative impact of strategic influences that could un-
dermine auditors' effectiveness. Further, the finding that an effective audit committee mod-
erates the impact of authoritative guidance availability (and vice versa) on auditors' per-
ceived negotiation outcome has potential implications for practice in terms of allocation of
effort by firms and regulators to compensating mechanisms that serve to jointly promote
financial reporting quality.
A limitation of the paper is that it uses a setting where auditors are given general but
not specific information about the revenue-recognition issue and the guidance available.
Although this allows us to control for context and knowledge differences, it is unclear if
the findings generalize to richer settings, an area for future investigation. A good illustration
of how this can be successfully done is the study by Hackenbrack and Nelson (1996),
which finds that, at least in the context of vague accounting standards, there is convergence
in the findings obtained in both sterile and rich settings. One way of extending the current
study to a richer context is to use two different revenue-recognition issues that either have
or do not have authoritative guidance (because the guidance available for a specific revenue-
recognition problem is likely fixed at a given point in time). A trade-off of this approach

16 As a further analysis, we also conduct a mixed categorical analysis with Stage (initial recommendations, per-
ceived negotiation outcome) as a within-subject variable, and Client Concessions and Guidance Availability as
between-subject variables. The results indicate that only the main effect of Stage (p = 0.000) and the interaction
between Stage and Client Concessions (p = 0.027, one-tailed) are statistically significant, while the three-way
interaction between Stage. Guidance Availability, and Client Concessions is not statistically significant (p
= 0.402).

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816 Ng and Tan

is that while comparisons can he made on auditors' responses within a specific revenue-
recognition issue, caution would have to be exercised with respect to comparisons between
revenue-recognition issues, unless differences in ambiguity and complexity of issues are
controlled for.
Another limitation is that our participants are audit managers. As we have indicated
(footnote 4), audit managers are routinely involved in aspects of client negotiations. They
should be aware of what gets documented prior to negotiations, along with negotiated
outcomes (see Nelson et al. 2002), which are elements we measure in this study. Still, audit
partners are more intimately involved with the client negotiation process, and their re-
sponses may not mirror those of managers. In addition, our participants are from one Big
4 firm, and results may not extend to auditors from other audit firms. Also, the study is
administered online via the Internet to unobserved participants who perform the experi-
mental task in their normal work environments. As such, it lacks the control typically found
in laboratory experiments. Finally, this study examines a situation where recording the full
amount of a quantitatively immaterial audit adjustment will result in the client's failure to
meet the analysts' consensus forecast by 1 cent per share. Although this provides a boundary
condition for testing the effects of authoritative guidance availability and audit committee
effectiveness on auditors' judgments, the results may not extend to situations where the
analysts' consensus forecast is missed by greater than 1 cent per share.
In addition to the factors examined in this study, future research can further examine
the effects of other contextual features (e.g., negotiation expertise) on auditors' judgments
and negotiation outcomes. Future research can also delineate the specific mechanisms that
influence the strategies (or lack thereof) that auditors employ in their negotiations with
clients. Our present design precludes us from doing so. Like Libby and Kinney (2000), we
capture auditors' perceived negotiation outcome to provide evidence on how it is jointly
influenced by contextual features of auditor-client negotiations. We also measure auditors'
initial recommendations, and illustrate the use of a method that provides evidence (in our
additional analyses) on how these contextual factors interact to influence auditors' propen-
sity to concede to the client's position. A limitation of our approach is that, while there is
greater experimental control, there is no actual interactive negotiation, and the method
cannot speak directly on the process that goes on during negotiation. Thus, another useful
avenue to extend this line of research is to incorporate actual, interactive dyadic auditor-
client negotiations. Although contextually richer, this approach involves trade-offs in terms
of the potential noise in the dynamic (and unpredictable) nature of negotiations across
dyads, and the cost of assembling participants comprising clients and auditors.
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