Bierstaker, Wright - 2001 - The Effects of Fee Pressure and Partner Pressure on Audit Planning Decisions-Annotated

THE EFFECTS OF FEE PRESSUREAND PARTNER PRESSURE ON AUDITPLANNING DECISIONS

James L. Bierstaker and Arnold Wright

ABSTRACT

Significant concerns have been voiced about the negative impact ofcompetition on audit quality . Recent research suggests that auditors mayreduce budgeted hours in response to fee pressure despite an increase inclient risk (Houston, 1999). However, only one prior study (Gramling,1999) has considered the role of the auditor's superiors, who mayencourage subordinates to increase audit efficiency, particularly in caseswhere audit revenues have been reduced (McNair, 1991). Gramlingfocused on reliance on internal auditors rather than a generic programplanning decision. Further, there is little empirical evidence on theprogram planning strategies pursued by auditors with respect to the natureof tests, and no prior evidence regarding staffing assignments in responseto these pressures. In developing program plans auditors are accountableto multiple sources such as an immediate superior (e .g. a manager), thepartner, the firm and, in a broader sense, to the public . Often these sourcesprovide conflicting forces, which have been referred to by Gibbins andNewton (1994) as "complex accountability" .

Advances in Accounting, Volume 18, pages 25-46 .Copyright m 2001 by Elsevier Science Ltd.AB rights of reproduction in any form reserved .ISBN: 0-7623-0719-6

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JAMES L. BIERSTAKER AND ARNOLD WRIGHT

To investigate these issues, eighty-three auditors completed a case based onan actual audit client in which they were asked to perform programplanning for the revenue cycle. Fee pressure and partner pressure weremanipulated (present or absent) in a between-subjects design . There werethree main findings . First, corroborating prior studies, auditors reducedtotal budgeted hours in response to fee pressure . Second, auditors reducedplanned tests in response to partner pressure to improve audit efficiency .Third, there is evidence to suggest that in response to multiple competitivepressures auditors are more likely to reduce budgeted hours of moreexperienced staff. Specifically, auditors subject to both fee pressure andpartner pressure may focus on reducing second year staff hours becausegreater efficiency gains (i.e. cost reductions) come from eliminating hoursassigned to this more experienced personnel than first year staff. Theseresults suggest that both fee pressure and partner pressure motivateauditors to improve audit efficiency. Moreover, fee pressure may beperceived by auditors, based on previous experience, as an implicitsuggestion to improve audit efficiency. These findings suggest firms must becautious in communicating audit fees to staff, and that the audit partnerplays a key role in communicating ways to manage competitive pressures .

INTRODUCTION

In today's competitive audit environment, auditors face significant pressure toreduce costs . Competition has increased among auditing firms as a result ofbidding, advertising, and direct solicitation, as well as from merger activity inthe corporate sector, which reduces the number of available audit clients (Adamset al., 1987) . A concern is that competitive pressures may lead to audit hoursor tests that are reduced too extensively, and sufficient evidence may not begathered. Thus, audit effectiveness may be impaired, exposing the audit firmto potential litigation and loss of reputation . This study examines the impact ofan explicit suggestion from a partner to improve efficiency on auditors' programplanning decisions in the presence or absence of a reduction in audit fees .'While prior research has investigated the impact of these pressures on the extentof testing, there is little evidence of their affect on the nature of tests and thisis the first study to explore their impact on staffing decisions, two additionalevidence planning strategies available to the auditor . Detailed exploratoryanalyses are also provided on the planning and staffing of detailed audit tests .Therefore, the findings of this study are expected to provide a more completeunderstanding of how auditors adapt to competitive pressures .

The Effects of Fee and Partner Pressure on Audit Planning Decisions

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In investigating the potential impact of competitive pressures on programplanning decisions, the organizational context is an important consideration .Initial program planning decisions are normally made by an audit senior(Abdolmohammadi, 1999), who faces a complex web of accountabilities tohis/her immediate supervisor, to the partner, to the firm, to the client, and tothe public (Gibbins & Newton, 1994) . The senior must weigh these forces,which often provide competing pressures to achieve effectiveness and efficiency(McNair, 1991). The partner, in particular, is expected to set the tone for anengagement and, thus, have considerable impact on how seniors weigh andreconcile competing pressures . Gramling (1999) conducted the only prior auditplanning study to consider the influence of partner preferences in light of clientfee pressures. Information order regarding the quality of internal audit was alsomanipulated (positive evidence followed by negative evidence and vice versa) .A significant interaction between partner preferences and information order wasfound. Specifically, there was a difference in reduction of planned hours acrossorder conditions when the partner preference focused on efficiency but not whenthe focus was on effectiveness . Further, Gramling acknowledges that the focusof her study was on the decision to rely on internal auditors and that researchis needed to investigate other task settings, such as the more generic programplanning context of the current investigation .

In addition, Houston (1999) provides disturbing findings indicating that feepressure leads to fewer budgeted hours and less effort for particular tests despitean increase in client risk. This reduction in extent may negatively impact auditeffectiveness . Houston calls for future research related to audit staffing (i .e . themix of experienced and inexperienced auditors assigned) . The current studygoes beyond the earlier findings to examine how fee pressures impact both thenature and extent of tests, as well as budgeted hours of inexperienced and expe-rienced staff .

To investigate these issues, 83 auditors participated in an experiment in whichthey were asked to perform audit program planning for the revenue cycle . Feepressure and partner pressure were manipulated (present or absent) in a 2 x 2between-subjects design . The results indicate that auditors reduced budgetedhours in response to fee pressure . Further, the number of planned tests wasreduced and the staffing of tests altered by reducing the hours of second yearstaff. As will be discussed later in the paper, the findings could have impor-tant implications for the manner in which partners set the tone on an engagementwith respect to managing competitive pressures, as well as whether fees shouldbe communicated to seniors .

The remainder of the paper is divided into four sections . The next sectionprovides an overview of prior research and identifies the research hypotheses .

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The methods are then described, followed by presentation of the results . Thefinal section is devoted to a discussion of the major findings and their impli-cations for practice and future research.

LITERATURE REVIEW AND HYPOTHESISDEVELOPMENT

In a recent experimental study, Gramling (1999) found that client fee pressureinfluenced managers' decisions regarding the extent of reliance on the client'sinternal auditors . She also reports that reliance was greater in reducing plannedhours for control tests than substantive tests . In addition, Houston (1999) reportsthat in response to fee pressure audit seniors reduced the total number ofbudgeted hours despite an increase in client risk. Houston suggests that seniors,who initially plan the audit program, tend to focus on minimizing the currentcosts of conducting the audit and are less cognizant of future costs (i .e . litiga-tion costs and loss of reputation) that may occur if an effective audit is notperformed.

In considering auditors' responses to fee pressure it is important to consider

the organizational context . When fees are reduced seniors may anticipate theirsuperiors will favor greater efficiencies to respond to the economic pressurespresent. The research literature on justification indicates that when audienceviews are known in advance, individuals may adopt positions that conform withthose views to curry the favor of those to whom they are held accountable(Lerner & Tetlock, 1999; Rich et al., 1997 ; Peecher, 1996; Ashton, 1990) .Complying with such preferences may be expected to result in improved perfor-mance evaluations, which impact salary increases, promotions, and future workassignments (Wright, 1986) . For example, Tan et al . (1997) found that supe-rior's risk assessments influenced the risk assessments of subordinate auditors,and subordinate auditors exerted less cognitive effort when the views of thesuperior were known than when the superior's views were unknown . Gibbinsand Newton (1994) also report that actions taken to deal with accountabilitypressures vary considerably as a result of a number of factors, such as theimportance of the party to which one is accountable (e.g. one's superior), levelof knowledge of the party's desired action, and the strength of the auditor'sbelief in his/her desired action .

As noted earlier, in performing program planning the audit senior facesmultiple accountable parties . The senior is accountable to his (her) immediatesuperior, a manager . However, (s)he also is accountable to the partner, whowields greater power and influence in the firm than the manager. In addition,the manager is likely to convey the wishes of the partner to the senior, since


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the partner is the manager's immediate superior .2 Competitive pressures provideincentives for partners to enhance efficiency (Maher, Tiessen, Colson & Broman,1992). As the leader of the engagement, if the partner chooses to communicatethe need for efficiency to the audit team it is likely that efforts will be madeto comply. Moreover, a variety of factors may influence how the partner"manages" competitive pressures . Partner preferences for efficiency or effec-tiveness may vary depending on a variety of factors including : the profitabilityof the client, percentage of partner and firm revenues represented by the client,the partner's risk preferences, and the partner's concerns about litigation(Marxen, 1990 ; Farmer et al., 1987).

However, subordinates may place less weight on a superior's view when itis expressed as a preference rather than a certain outcome (Tan et al ., 1997) .For example, a clear directive to reduce hours by 20% is expected to have astronger influence on an auditor's program planning than a general recom-mendation to try to improve audit efficiency . In addition, subordinate auditorsare also professionals with considerable accounting and auditing knowledge,and a professional and moral perspective on the auditor's role in society (Jamal,1997; Aranya et al ., 1981 ; Sorensen & Sorensen, 1974). The firm's organiza-tional climate may not, however, serve to reinforce professional and firm policy,since superiors' informal communications with subordinates may not be whollyconsistent with the formal communications of the firm (Dirsmith & Covaleski,1985). Therefore, a subordinate auditor's compliance with a superior's viewsis not automatic . Auditors may chose to adopt a defensive non-compliancestrategy, involving the development of arguments in support of their own posi-tion, when they are not in agreement with the preferences of their superiors(Gibbins & Newton, 1994) .

As noted earlier, the only prior study to examine the impact of partner pref-erences on auditor planning judgments was performed by Gramling (1999) . Thisresearch entailed an experiment investigating auditors' judgments to reduce bud-geted hours by relying on internal auditors . Importantly, the internal auditors inthe case scenario were of questionable quality . Both client and partner prefer-ences were manipulated to reflect either a focus on audit efficiency or effective-ness. As discussed, a significant interaction between partner preferences andinformation order was found. Planned hours were reduced across order condi-tions when the partner preference focused on efficiency but not when the focuswas on quality. Further, a significant main effect was found for client prefer-ences, corroborating the findings of Houston (1999) . The current study examinesa different, more generic program planning task than that employed by Gramling .

In addition to reducing the extent of audit testing, another reasonable strategyto enhance efficiency may be to reduce the number of tests . Usoff (1997), for

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example, indicates that auditors have a variety of strategies available to themfor improving efficiency, including modifying planned tests . Whether or notauditors reduce planned tests in response to fee pressure is an important issuesince Graham (1985) indicates that the omission of audit steps is a leadingcause of audit failure . Auditors may also attempt to improve efficiency by modi-fying the level of audit personnel assigned to certain tasks . For example, auditorsmay hold budgeted hours constant, but reduce the rank of the auditor performingthe tests in order to lower audit costs . However, staffing decisions may also becontingent upon other factors such as the minimum perceived level of compe-tency needed to perform the task, and the level of inherent or control riskspresent . For instance, in a high-risk setting, assigning a less experienced auditorto do a task may be considered inappropriate . There has been relatively littleresearch examining staffing decisions (Bedard et al ., 1999) . A noteworthy excep-tion is a study by Prawitt (1995), who examined the effects of audit firmstructure and environmental complexity of the client on staff assignments. Hereported that invariant to complexity auditors from a structured firm assignedless experienced personnel to some audit activities such as preparing auditprograms. However, Prawitt's study does not investigate the impact of compet-itive pressures on audit staffing.

A final issue is the extent to which there may be an interaction between feepressure and partner pressure in affecting auditors' program planning decisions .Certainly a reduction in fees creates a situation where there are incentives for thepartner to communicate downward pressure on the audit staff to reduce costs(Margheim & Kelly, 1992) Without an explicit request by the partner to reduceaudit costs, informing a senior that fees have been reduced may be perceived bythe senior as an implicit suggestion to improve audit efficiency . Thus, partnerpressure may be redundant in light of client fee pressure . On the other hand, ifthere is a fee reduction, it is at the partner's discretion whether or not to encour-age staff to reduce audit effort . A general directive of this nature offers the riskthat efforts may be reduced by staff without proper consideration of the neededbalance between effectiveness and efficiency . In addition, partner pressure mayoccur with or without fee pressure . For instance, Houston (1999), Bedard andWright (1994), and Mock and Wright (1993) found that auditors generallyreduced budgeted hours from the previous year's audit, even when fees had notchanged, presumably due to general firm wide competitive pressures to enhanceefficiency . Thus, there are no clear expectations regarding interactive effectsgiven the conflicting theoretical arguments as to the incremental affect of partnerpressure beyond that of fee pressure on auditors' program planning judgments .

The discussion above leads to the following hypotheses regarding the affect ofcompetitive pressures on evidential planning decisions . HI serves to corroborate


3 1

the findings of prior research, while H2 examines the impact of competitivepressures on the number of planned tests . In addition, exploratory analyses willbe conducted to examine the affect of competitive pressures on auditors' staffingdecisions and selection of specific tests .

H1 : Budgeted hours will decrease as client fee pressure and partner pressureincreases .

H2: The number of planned audit tests will decrease as client fee pressureand partner pressure increases .

METHODS

Participants

Eighty-three auditors with an average of 25 .4 months of experience (standarddeviation of 8 .8 months) participated in the study . 3 Auditors with between 2and 3 years of experience were sought because they are normally the individ-uals assigned to perform audit program planning (Houston, 1999) .4 To controlfor potential confounding effects as a result of differences in audit approach,all participants came from a single Big 5 firm and were obtained undercontrolled conditions during staff training sessions . One of the researchers waspresent at each of the training sessions .

Experimental Design

As previously mentioned, an important feature of the audit environment is thatauditors are accountable to their superiors (Koonce et al ., 1995) . Furthermore,an auditor's response to fee pressure or partner pressure is contingent on theexistence of accountability, requiring the auditor to weigh pressures to improveefficiency from fee reductions and from the partner against those to preserveeffectiveness . Thus, all participants were held accountable . Based on priorresearch (Peecher, 1996 ; Cohen & Trompeter, 1998), two principal mechanismswere used to induce accountability : (1) auditors were informed that accountingfaculty would review their responses and a sample of individual responses,along with a summary of the results, would to be forwarded to an audit partnerat their home office ; and (2) auditors were directed to indicate their name, busi-ness address, and business telephone number . 5

Auditors were randomly assigned to one of two fee pressure conditions .Auditors in the no fee pressure condition were informed that the client feeswere the same as the previous year . In contrast, auditors in the fee pressure

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condition were told that as a result of competition client fees were reducedfrom $70,000 to $60,000, or about 12.5%. The magnitude of this decrease infees is substantial but representative of fee changes in practice (Houston, 1999 ;Simon & Francis, 1988) .

Auditors were also randomly assigned to one of two partner pressure condi-tions (present or absent) . Auditors in the partner pressure condition wereinformed that : "The partner in charge of the audit believes it should be possibleto conduct this year's audit more efficiently than last year ." This manipulationwas developed based on discussions with firm personnel to reflect a realistic,moderate form of pressure . 6 Auditors in the no partner pressure condition didnot receive input about the partner's expectations for improvements in auditefficiency. The information pertaining to the treatment conditions was providedto subjects prior to completing the tasks described below . To mitigate poten-tial demand effects, a between subjects design was employed.

Tasks

An experienced manager was consulted extensively during development of theaudit case. The manager was from the same firm as the auditors participatingin this study . The experimental case focuses on a single cycle to minimize thetime needed to complete the case.' The case was based on an actual client andincluded background information on the client (New England Company) in itsthird year under audit by the participants' accounting firm, a narrative descrip-tion of the client's accounting procedures for the revenue cycle, selected accountbalances and financial ratios, and the previous year's time budget for the revenuecycle. The case was designed to have a moderate level of risk . Consistent withthe intended risk level, auditors' mean rating for combined inherent and controlrisk was approximately 40% . 8

Auditors were asked to prepare a time budget and develop an audit programfor the current year's substantive audit tests of the revenue cycle . To preventinferences of reliance on other potential ways to enhance efficiency, auditorswere told to assume that: (1) assistance from the client will not increase overthe previous year, (2) further efficiency improvements are not possible throughthe use of computer audit technology, and (3) staff competence is consistentwith prior years . The time budget was based on an actual engagement andincluded a list of 19 substantive tests to choose from, as well as space whereadditional tests could be added if so desired . The number of budgeted hours inthe previous year for first year staff, second year staff, and the senior were alsoprovided based on the standard program of the participating firm . Auditors weregiven information about the previous year's audit because the participating firm

The Effects ofFee and Partner Pressure on Audit Planning Decisions

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develops preliminary audit programs based on prior year information . Inaddition, Hirst and Koonce (1996) report that this method of audit planning iscommonly used in practice . Auditors were also asked to complete a question-naire designed to gather information on their program planning experience.

Dependent Variables

The main dependent variables are the percentage change in budgeted hours(HOURS) and planned tests from the prior year (TESTS) . There were a totalof 128 hours and 19 tests in the audit program for the prior year . In addition,exploratory data are also presented on changes in the number of hours andplanned tests by staff level and for specific test categories . Based on the stan-dard audit program of the participating firm, the five test categories for therevenue cycle are as follows : accounts receivable circularization, accountsreceivable collections, accounts receivable summary, cash and revenues .

RESULTS

Manipulation checks

Fee pressureTo examine whether the audit fee pressure manipulation was successful, partic-ipants were asked in the debriefing questionnaire to respond on a seven pointLikert scale (1 indicated disagree and 7 agree) to the following statement : "Inthe situation presented in the New England Company case, I felt pressure toreduce the number of budgeted audit hours because of the audit fee." The meanfor the no fee pressure group is significantly lower than the mean for fee pressuregroup (3.51 vs. 4.69, t = 2 .72, p = 0.004), indicating the fee pressuremanipulation was successful.'

Hypothesis Tests

Hl: Percentage Change in Budgeted Hours From the Prior YearThe means for total budgeted hours and percentage change in hours from theprior year are shown on Panel A of Table 1 . As expected, auditors who didnot receive fee pressure reduced budgeted hours less (mean 2 .3 percent) thanthose subject to fee pressure (9.9%) . Also, as expected, auditors who did notreceive partner pressure reduced budgeted hours less (4 .7%) than auditorssubject to partner pressure (7 .6%). As shown on Panel B of Table 1, a regressionanalysis reveals the main effect of fee pressure is significant, supporting the

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Table 1 . Total Budgeted Hours and Percentage ChangeFrom the Prior Year.

Panel A : Mean Total Budgeted Hours (Standard Deviation] (Percentage Change) [sample size]

Partner Pressure

Panel B: Regression Analysis

REGRESSION MODEL: HOURS = f(FEE, PARTNER, FEE*PARTNER)

Key :HOURS = percentage change in budgeted hours from the prior yearFEE = fee pressure (0 = no pressure, 1 = pressure)PARTNER = partner pressure (0 = no pressure, 1 = pressure)

* p-values are one-tailed when there are directional expectations . Otherwise, two-tailed tests areemployed .

first hypothesis (H1) . Although, as noted above, the means for partner pressureare in a direction consistent with H1, the main effect of partner pressure is notstatistically significant at conventional levels . 10 Further, the interaction betweenfee pressure and partner pressure is also not significant .

Additional Analysis: Audit Staffing

Table 2 provides the mean budgeted hours for first and second year staff audi-tors by test category .' 1,12 A one-way ANOVA was performed for each test cate-gory to examine if significant differences existed between groups . Although therewere no significant differences within any of the test categories for first year staff,

Fee Pressure Absent Present Total

Absent 128 .7 (17.1) (0 .5) [19] 121 .8 (17.9) (-4 .8) [22] 125 .0 (17 .6) (-2.3) [41]Present 116 .0 (18.9) (-9 .4) [21] 114 .6 (20.5) (-10 .5) [21] 115 .3 (19.5) (-9.9) [42]Total 122 .0 (18 .9) (-4 .7) [40] 118 .3 (19.3) (-7 .6) [43] 120.1 (19.1) (-6.2) [83]

F VALUE : 2 .34 P-VALUE: 0.04

VARIABLE

EXPECTEDDIRECTION

R-SQ : 0 .082

BETA T-VALUE

ADJ. R-SQ: 0.047

P-VALUE*

FEE -0.334 -2.145 0.02PARTNER -0.180 -1 .174 0.12FEE*PARTNER 0.125 0 .668 0.50


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Table 2 . Mean (Standard Deviation) Budgeted Hours by Staff Level andTest Category and One-Way ANOVA Results .

Panel A : First Year Staff

Panel B: Second Year Staff

*P-values are one-tailed when there are directional expectations . Otherwise, two-tailed tests areemployed .

significant differences between groups were found for second year staff hourswithin accounts receivable summary, cash, and revenues . Post hoc tests (Duncanmultiple range) were performed to further analyze these differences . For accountsreceivable summary (see Table 4 for specific tests), the fee pressure groupbudgeted marginally significantly fewer hours for second year staff than the no

Test CategoryPriorYear

NoPressure

FeePressure

PartnerPressure

BothPressures

F-Value(P-Value)*

A/R Collections 0 1 .3 (4 .0) 1 .7 (2 .9) 0 .91 (4 .31 0 .23 {1 .1) 0 .71(0 .27)

A/R Circularization 0 9 .9 (15 .2) 7 .4 (12.1) 7 .9 (13 .21 8 .4 (13 .5) 0 .13(0 .47)

A/R Summary 0 2 .1 (4 .0) 4 .2 (5 .81 2 .2 14 .8) 3 .4 15 .2) 0 .88(0 .27)

Cash 12 9 .6 (3 .81 9 .7 (1 .6) 10.4 11 .8) 10 .0 12 .0) 0 .42(0 .37)

Revenues 5 4.9 12 .4) 6 .0 (4.9) 5 .4 13 .4) 6.4 {4 .1) 0 .60(0 .31)

PriorTest Category

YearNo

PressureFee

PressurePartnerPressure

BothPressures

F-Value(P-Value)*

A/R Collections 25 23 .4 (6 .7) 22 .0 {6.6) 22.6 (7 .5) 22 .3 {4 .7) 0 .17(0.45)

A/R Circularization 45 30 .9 (13 .7) 31 .1 [15 .91 30.1 (13.5) 26.9 (14 .4) 0.39(0.38)

A/R Summary 15 12 .1 (5 .5) 8 .0 15 .5) 11 .5 (5 .4) 9.8 (5 .8) 2 .3(0.04)

Cash 0 1 .2 (3 .51 0 .3 (1 .2) 0.0 10 .0) 0.0 (0 .0) 2 .27(0.04)

Revenues 10 8 .5 12 .01 7 .3 (4.4) 6.7 (4 .0) 4.3 (3 .8) 4 .76(0.002)

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pressure group (p < 0.05) . For cash, the partner pressure group and the groupthat received both forms of pressure budgeted significantly fewer hours forsecond year staff than the no pressure group (p < 0 .05) . For revenues, the groupthat received both forms of pressure budgeted significantly fewer second yearstaff hours than the other three groups (p < 0.05).

Overall these results provide detailed information on the effects of competitivepressures on program planning . Specifically, while the budgeted hours of firstyear staff were not significantly different between groups within test categories,the budgeted hours of second year staff were reduced in response to fee pressurewithin accounts receivable, partner pressure within cash, and both forms ofpressure within cash and revenues . These results suggest that auditors adaptedtheir audit program plans based on both staff level and test category in responseto competitive pressures. Moreover, hours of more experienced staff were oftenreduced for these areas in response to either or both form of pressure, potentiallyjeopardizing audit effectiveness .

H2: Percentage Change in the Planned Number of Tests from the Prior YearThe means for the total number of planned tests and the percentage change fromthe prior year are shown on Panel A of Table 3 . Auditors who did not receivefee pressure reduced the number of tests by 1% on average, compared to areduction of 4 .8% for auditors who were subject to fee pressure . Auditors whodid not receive partner pressure reduced the number of tests by 0 .8% on average,compared to a 4 .9% reduction for auditors subject to partner pressure . The regres-sion analysis on Panel B of Table 3 a shows a significant main effect for feepressure and partner pressure, supporting H2 .

There is also a significant (p = 0 .03) interaction between fee pressure andpartner pressure. However, post-hoc tests (Duncan) indicate that auditors subjectto both forms of pressure did not decrease tests significantly lower than thoseauditors subject to only one form of pressure . These findings suggest both formsof pressure appear to be viewed as substitutable in terms of their affect onauditors' program planning decisions .

Additional Analysis: Planned Tests

To examine auditor responses to competitive pressures at a more disaggregatedlevel further exploratory analyses were conducted on planned tests within eachtest category . The percentage of auditors in each treatment group that selecteda particular test listed on the standard audit program is shown in Table 4 . Theresults of chi-square tests indicate that significant differences among groups(p < 0.05) existed for three tests: accounts receivable circularization, accounts


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Table 3 . Total Planned Number of Tests and Percentage Change From thePrior Year .

Panel A : Mean Total Planned Number of Tests (Standard Deviation) (Percentage Change)[sample size]

Panel B: Regression Analysis

REGRESSION MODEL: TESTS = f(FEE, PARTNER, FEE*PARTNER)

Key :TESTS = percentage change in planned number of tests from the prior yearFEE = fee pressure (0 = no pressure, 1 = pressure)REVIEW = partner pressure (0 = no pressure, 1 = pressure)

* p-values are one-tailed when there are directional expectations . Otherwise, two-tailed tests areemployed .

receivable aging (see below), and review of bank reconciliations . Specifically,the results of Duncan multiple range tests indicate that auditors under both feepressure and partner pressure were less likely to perform the confirmation testsof accounts receivable stipulated in the standard audit program than the otherconditions (p < 0 .05). However, many of these auditors included confirmationsin the "other" confirmation category. In addition, auditors under partner pres-sure were less likely to plan other accounts receivable summary tests (generallytests of accounts receivable aging either by recalculation or comparison withthe prior year) than auditors under neither form of pressure (p < 0 .05) . Finally,auditors under fee pressure or both forms of pressure were less likely to review

Partner PressureFee Pressure Absent Present Total

Absent 19 .9 (3 .3) (5 .0) [19] 17.8 (2.7) (-6 .2) [22] 18 .8 (3 .1) (-1 .0) [41]Present 17 .9 (2 .5) (-6 .0) [211 18.3 (2.4) (-3 .5) [21] 18 .1 (2 .4) (-4 .8) [42]Total 18 .9 (3 .1) (-0 .8) [401 18 .1 (2.5) (-4 .9) [43] 18.4 (2 .8) (-2 .9) [83]

F VALUE : 2.67 P-VALUE : 0 .03

EXPECTEDVARIABLE DIRECTION

R-SQ: 0 .092

BETA

ADJ. R-SQ : 0.057

T-VALUE P-VALUE*

FEE

- -0.376 -2.43 0 .01PARTNER

- -0.382 -2.50 0 .01FEE*PARTNER

? 0.407 2 .18 0 .03

1 . Circularize all accounts receivable balances inexcess of $50,000 such that we obtain at least 60%of the outstanding balance at year end and randomlyselect 10 other balances to test .

2 . Upon receipt of returned confirmations, investigateany discrepancies in excess of $10,000 .

3 . For confirmations not received, examine subsequentcash receipts and to the extent cash receipts have notbeen returned, examine shipping documents .

4 . Other

Accounts Receivable : Collections

1 . Obtain a rollforward of the allowance for doubtfulaccounts for the year .

2 . Compare the allowance for doubtful accounts atyear end to writeoffs for the year for reasonablenessof the allowance .

3 . Compare the following ratios to the prior year andcomment: A/R turnover, Days sales outstanding,Year to year sales, Year to year A/R, Monthly salesto cash receipts .

4 . Obtain an explanation for all items in excess of90 days in excess of $50,000 not collected throughthe completion of fieldwork .

5 . Determine whether the reserve for credit memosis adequate by the following: Credits issued duringyear divided by 12 times the average lag time(usually completes in 3 months) . This amount shouldbe adjusted to the extent credit memos are issued forsimple return of goods that can be resold .

6 . Obtain all credit memos issued after year end thatrelate to prior period.

7 . Other

0 .89

0.95

0.82

0.57

11.3(0 .01)

0 .84

1.0

0.77

0.86

5.1(0.08)

1 .0

1 .0

0.86

0.95

5.8(0.06)

0.42 0 .33

0.45

0.38 0.73(0.43)

10.95 0 .95

0.91

0.95

0.50(0.46)

0.84

1 .0

0.86

0.95

4.4(0.11)

0.89 0.90 0 .95

0.90 0.60(0.45)

0.95

0.95

0.95

0.95

0.01(0.50)

0.47

0.29

0.32

0.48 2.65(0.22)

0 .79

0.71

0.77

0.86

1.28(0.36)

0 .53

0.33

0.45

0.38

1.77(0.31)

Key: NP = No pressures FP = Fee pressure PP = Partner pressure BP = Both pressures*P-values are one-tailed when there are directional expectations .

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Table 4. Percentage of Auditors Selecting Individual Tests byTreatment Group.

Chi-sq*Test NP FP PP BP (p-val .)

Accounts Receivable: Circularization


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Table 4. Continued .

Test

NP

Accounts Receivable : Summary1 . Agree aged trial balance to ledger and investigate

0.89items in excess of $250,000 .

2. Randomly select 5 invoices, obtain shipping

0.89documents and determine if amounts are aged properly .

3 . Document change in sales and accounts receivable

0.84from prior year and determine if movement makessense in light of current year business activity .

4 . Other

0.42

Cash1 . Obtain bank reconciliations at year end and agree

1.0to general ledger, to bank confirmation and investigateall reconciling items in excess of $200,000 .

2 . Obtain confirmations of all bank accounts at year end . 0 .95

3 . Test a transfer schedule of all transfers within the

0.89first and last five days of year end in excess of $25,000 .

4 . Review all bank reconciliations for the year and

0.95investigate any unusual items .

5 . Review a cash proof for the entire year .

0.26

6. Other

0.21

Revenues1 . Review a schedule of sales and gross margin by

1.0product line for the year and compare to the prioryear noting any unusual fluctuations .

2 . Agree the first and last invoices from the sales

0.84registers in excess of $50,000 before and after year endto shipping documents to determine if a proper cutoff was made .

3 . Other

0.26

Key: NP = No pressures FP = Fee pressure PP = Partner pressure BP = Both pressures*P-values are one-tailed when there are directional expectations .

FP PPChi-sq*

BP (p-val.)

0.86 0 .86 0.90 0 .32(0 .48)

0 .81 1 .0 0.86 4 .4(0.11)

0 .81 0 .82 0 .76 0.44(0 .46)

0 .24 0 .05 0 .43 10 .4(0.01)

1 .0 1 .0 1 .0 N/A

0 .95 0.91 0 .95 0.50(0.46)

1 .0 0 .91 0 .81 4 .4(0.11)

0 .57 0.68 0 .62 7 .86(0.02)

0 .19 0 .14 0 .14 1 .38(0.36)

0 .24 0.14 0 .29 1 .48(0.34)

0 .95 0 .95 0 .95 0.93(0.41)

0 .90 0.95 0 .86 1 .68(0 .32)

0 .29 0 .18 0 .10 2.86(0.21)

40


bank reconciliations for the year and investigate any unusual items than audi-tors under neither form of pressure (p < 0.05) .

Overall, these results suggest that auditors were more likely to eliminatecertain tests in the presence of competitive pressures. However, as shown onTable 4, most of the tests listed in the standard audit program (17 out of 19)were selected by a majority of the auditors . In addition, it is interesting to notethat there was one test (obtain bank reconciliations at year end and agree togeneral ledger, to bank confirmation and investigate all reconciling items inexcess of $200,000) that was selected by 100% of the auditors . Only two testsin the standard audit program (review a cash proof for the entire year and deter-mination of whether the reserve for credit memos is adequate) were generallynot selected by auditors. Therefore, in contrast to the findings for budgetedhours where auditors were sometimes willing to aggressively cut the hours ofexperienced staff in response to competitive pressures, auditors generallyappeared reluctant to eliminate tests from the standard audit program, consis-tent with the findings of Mock and Wright (1999, 1993) .

CONCLUSIONS

This study investigated the effects of fee pressure and pressure from a partnerto improve audit efficiency on auditors' evidential planning decisions. Therewere several important findings . First, auditors significantly reduced budgetedhours (mean of 13 hours or 10%) and planned tests (mean of 1 test) in responseto fee pressure. Second, auditors reduced planned tests (mean of 1 test) inresponse to partner pressure. Moreover, an interaction indicated that either pres-sure in isolation or combined had the same impact in reducing planned tests .Finally, auditors reduced experienced staff hours in certain test categories andeliminated certain tests from the standard audit program in response to compet-itive pressures .

These findings have both theoretical and practical implications . From a theo-retical standpoint, while previous research has suggested that accountability toone's superiors may impose pressure to improve audit effectiveness (Kennedy,1993; Ashton, 1992), the findings of this study suggest that this source ofaccountability may also provide pressures to enhance audit efficiency. Moreover,the results suggest that fee pressure and partner pressure may often have similareffects, perhaps because the senior may anticipate a partner preference forimprovements in audit efficiency when there is a reduction in fees. From apractical standpoint, both fee and partner pressure may result in fewer budgetedhours and planned audit tests as well as a shift in the allocation of hours bystaff level .


41

Auditors may attempt to enhance audit efficiency, while maintaining auditeffectiveness, by decreasing effort to less effective audit procedures and lowrisk audit areas (Houston, 1999) . Therefore, a reduction in budgeted hours andplanned tests may reduce audit costs and improve audit efficiency by possiblyeliminating over-auditing and budgetary slack . However, when hours and testsare reduced or less experienced staff are employed, there is also the potentialto jeopardize audit effectiveness, increasing the risk of audit failure, damage tothe firm's reputation, and future litigation.

Based on these findings, audit partners and managers should carefully weighthe formal and informal communications they have with seniors regarding auditefficiency . Consideration should be given as to whether or not it is prudent todisclose the audit fee to seniors, since the results of this study and Houston(1999) suggest that reduced fees may affect seniors' audit planning decisions .The findings indicating that partner pressure and fee pressure have analogousaffects suggest that communicating fees have been reduced to the senior maybe viewed as an implicit suggestion to enhance efficiency . Partners must becareful to ensure the desired level of audit effectiveness is maintained, thus,there is a danger in revealing a reduction in fees without a careful delineationof specific strategies (e .g. low risk accounts or elimination of less effectivetests) to enhance desired improvements in efficiency . If audit programs becometoo constrained in response to competitive pressures, auditors may be morelikely to engage in behaviors that interfere with the proper conduct of the audit,such as premature signoff and underreporting of time (Margheim & Pany, 1986) .In addition, to the extent that reported time is used as a basis to determinesubsequent audit fees, under-reporting of time could lead to further reductionsin audit fees .

While difficult to assess and measure, additional research is needed to inves-tigate the impact of competitive pressures on audit effectiveness . Further, whilethis study focused on pressure from a superior to reduce audit costs, futureresearch is also needed on whether firm guidance or directives from partnersto maintain audit effectiveness (e .g. Gramling, 1999) may mitigate the effectsof fee pressure on subordinates' program planning . In addition, superiors gener-ally assist in reviewing and revising the initial audit program. Marxen (1990),for example, suggests concerns about an excessive focus on efficiency, and thepotentially more salient threat of future lawsuits, may lead more experiencedauditors to revise the audit plans of their subordinates in the planning or reviewphases to improve audit effectiveness .

However, information asymmetry between preparers and superiors mayprevent managers or partners from appropriately revising the preliminary auditprogram (Rich et al ., 1997) . Moreover, competitive pressures and the need to

42


maintain good client relations may also influence superiors to revise budgetedhours and planned tests downward to further enhance efficiency . Thus, futureresearch is needed to investigate the impact of competitive pressures onmanagers' revisions to seniors' audit programs. A limitation of this study isthat seniors were not able to interact with their superiors regarding specificareas where audit efficiency could be improved . To examine this issue, futureresearch involving groups of seniors, managers and partners would be valuable .A limitation in the scope of this study is that all participants came from a singleBig 5 firm. Future research involving other accounting firms is needed .

Finally, while this study found a significant effect of fee pressure and partnerpressure at a moderate risk level, future research is needed to further examinehow/whether changes in client risk affect the impact of fee and partner pres-sures on audit program planning . For instance, in a high-risk setting auditorsmay continue to reduce budgeted hours but be less inclined to reduce plannedtests for several interrelated reasons . First, auditors may be more reluctant tosacrifice breadth of testing because they feel it is necessary to gather at leastsome evidence to address significant financial statement assertions (Asare et al .,2000). Second, auditors may view a reduction in budgeted hours as a moredefensible strategy rather than a reduction in planned tests because they couldpoint to the fact that a broad set of tests were conducted. Evidence gathered in

this study suggests that auditors are generally reluctant to eliminate tests listedon the standard audit program.

NOTES

1 . The partner preference for greater efficiency is termed "partner pressure" in thisstudy .

2. The preferences of the manager may not always be aligned with the preferencesof the partner . However, for the purposes of this study, we assume that as the leaderof the audit team the partner will strongly influence the preferences of the manager .

3. The significance of the results for the independent variables was unaffected whenmonths of experience was included in the regression equations . Moreover, experiencewas negatively correlated with budgeted hours, suggesting that more experienced audi-tors reduced hours to a greater extent than less experienced auditors . Therefore, includingsome auditors with relatively low experience (i .e. staff) in this study biases againstfinding support for the hypotheses since relatively less (more) experienced auditorsappear less (more) susceptible to reducing audit work in response to fee or partner pres-sures .

4. Subjects were also asked to respond on a seven point Likert scale to the followingstatements (with 1 indicating disagree and 7 indicating agree) : (1) I decide how manyhours to include in preliminary time budgets (mean = 3 .72, standard deviation 2.07) ; (2)I decide which tests to include in preliminary time budgets (mean = 3 .61, standard devi-ation 1 .95) ; (3) My firm often bills on a fixed fee basis (mean = 5 .61, standard deviation


43

1.17) ; (4) I know the client fee prior to preparing the preliminary time budget (mean =3 .72, standard deviation 1 .99) . Responses indicate these auditors are involved in programplanning and are often aware of the audit fee . None of these variables were significantin the regression equations, and the significance of the results for the independent vari-ables was not affected when these variables were included as covariates .

5. Consistent with Peecher (1996) and Tan et al . (1997), auditor responses werereviewed by accounting faculty. Although firm personnel would also be appropriate asreviewers, it was more expedient to use faculty reviewers . The review was one of themeasures employed to instill accountability among subjects . The faculty review, provi-sion of summary responses to a partner of the firm, as well as requiring auditors toprovide their names were viewed as sufficient to accomplish this objective .

6. In the design of the experiment we considered a more extreme form of partnerpressure such as "cut hours by 30%" (Kermis & Mahapatra, 1985) . However, this manip-ulation was not used because it could have created a demand effect . Moreover, basedon discussions with firm personnel, and a review of the literature, an extreme form ofpartner pressure may be unrealistic given partners concerns about potential litigation(Marxen, 1990).

7. Auditors' mean rating for case realism was 4 .7 on a 7 point Likert scale with 1being not realistic and 7 being very realistic, suggesting subjects viewed the case asrealistic .

8 . To be consistent with prior research (Houston, 1999), and the audit approach usedby the participating firm, auditors were asked for a combined inherent and control riskassessment. Auditors' risk assessments were included as a covariate in all analyses andwere not statistically significant . Also, information on total budgeted hours for the auditwas gathered and results with these data are similar to those for the revenue cycle .

9. In a pilot test some auditors in the no partner pressure condition were confusedwhen asked about the level of partner pressure because no information was provided onthe partner's views . Thus, questions regarding partner pressure were only given to 12auditors in the no partner pressure condition during the initial round of data collection .Auditors were asked to respond on a seven point Likert scale to the following state-ment (with 1 indicating disagree and 7 indicating agree) : "In the situation presented inthe New England Company case, I felt pressure to reduce the number of budgeted audithours because of the partner in charge of the audit ." The mean for the no partner pres-sure group is significantly lower than the mean for partner pressure group (2 .83 vs . 4.14,t = 2.50, p = 0 .01), indicating the partner pressure manipulation was successful .

10. Regression results are identical when total budgeted hours (or tests) or net changein budgeted hours (tests) are used as the dependent variable . Histograms of total budgetedhours and tests indicate that they are normally distributed . Also, the results are qualita-tively similar when MANOVA is used to analyze the data for hours and tests .

11 . Consistent with the audit approach taken by the participating firm, budgeted hoursare assigned by test category . Hours are not assigned to individual tests .

12. The sum of hours in Table 2 is less than total hours in Table 1 because Table 1total hours include hours of control testing and hours of review by seniors, managersand partners. The results for hours of control testing and hours of review by seniors,managers and partners were not significant when analyzed separately . These findingsmay be due to the smaller size of the client . That is, it is likely to be more efficient toperform substantive tests than control tests for such a client (Mock & Wright, 1999,1993). Further, the small number of hours needed at the higher staff levels (prior year

44


budget seniors 15 hours, manager 10 hours, partner 5 hours) provides little opportunityto reduce these hours. A minimum number of hours may be considered necessary .

ACKNOWLEDGMENTS

We wish to gratefully acknowledge the valuable comments received fromStephen Asare, Vicky Arnold, Jean Bedard, Jeff Cohen, GaneshKrishnamoorthy, Rich Houston, James Hunton, Robert Ramsey, GregTrompeter, and the participants of the 1999 Auditing Mid-Year meeting andthe 1999 Annual meeting of the AAA .

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