wang and tuttle - 2009 - the impact of auditor rotation on auditor–client negotiation

Applying this model to an audit setting, the current period’s audit outcome equates to the substantive outcome of the immediate negotiation while the ability to retain a client over mult

The impact of auditor rotation on auditor–client negotiation

Karl J Wanga,*, Brad M Tuttleb,1

a The Patterson School of Accountancy, University of Mississippi, Oxford, MS 38677, United States

audi-in turn, alter the willaudi-ingness of the auditor and the client to cooperate duraudi-ing negotiation The results suggest that withmandatory rotation auditors adopt less cooperative negotiation strategies, producing asset values that are more in line withthe auditor’s preferences than with the client’s preferences and more negotiation impasses

Ó 2008 Elsevier Ltd All rights reserved

‘‘All of the technical aspects [of auditing] are

important but they can’t substitute for the

pri-mary skill, which is the art of negotiation.”

–Michael Buxbaum

The CPA Journal, 72(5), p 80, May 2002

Introduction

This paper reports the results of an experiment

designed to investigate process differences in

audi-tor–client negotiation under conditions with and

without mandatory audit firm rotation (hereafter,

mandatory rotation) Prior experimental researchshows that client-preferred reporting by auditors isless likely under mandatory rotation (Dopuch,King, & Schwartz, 2001) The present study builds

on previous findings by adding negotiation to theauditor–client mix and then, using the negotiationprotocols, explores the process that producesaudited asset values This research methodologyenables us to look inside each negotiation script todetermine the negotiation strategies used by bothparties, and to relate these strategies to the negoti-ated outcomes

Negotiation applies to auditing (Gibbins,Salterio, & Webb, 2001; McNair, 1991; Nelson,Elliott, & Tarpley, 2002; Ng & Tan, 2003) becausefor many financial statement accounts (1) uncer-tainty exists about the true value to report, and (2)different incentives exist for managers and auditors(c.f., Murnighan & Bazerman, 1990) Uncertainty

0361-3682/$ - see front matter Ó 2008 Elsevier Ltd All rights reserved.

implies that a range of possible and reasonable

val-ues exist so that the selection of any one particular

value is not necessarily right or necessarily wrong

ex ante In this context, differing incentives can lead

client managers and auditors to prefer different

val-ues within the range of possibilities Hence,

negoti-ation in an auditor–client context is a natural

process of reconciling differences in

incentive-induced preferences within a range of possibilities

and not necessarily about truthful versus deceitful

reporting as has been explored in much of the

exist-ing auditexist-ing literature

We draw upon process theories of negotiation to

predict the nature and outcome of auditor–client

negotiations Negotiation theories developed in a

social context suggest that concerns for self and

for the other party in the relationship dominate

the negotiation process (c.f., Bazerman, Curhan,

Moore, & Valley, 2000) Extending these theories

to an economic context,Savage, Blair, and Sorensen

(1989) link concern for self to the substantive

out-come of the immediate negotiation episode and

con-cern for the other party to the economic benefits one

expects from a continued relationship Applying

this model to an audit setting, the current period’s

audit outcome equates to the substantive outcome

of the immediate negotiation while the ability to

retain a client over multiple audit periods provides

continued economic benefits and motivates concern

for the relationship

Mandatory rotation affects the auditor’s

con-cern for the relationship The possibility of

retain-ing the same client indefinitely provides incentives

for the auditor to prefer the same financial

state-ment values as does the client in order to maintain

a good relationship with the client even when these

values conflict with those preferred by investors

(c.f., Fisher, Frederickson, & Peffer, 2006; Zhang,

1999) Mandatory rotation diminishes the expected

future benefits to the individual auditor who is

negotiating and thus alters the auditor’s concern

for the relationship from a negotiation

perspec-tive.2 In addition, the costs of ending the

relation-ship differ to both the auditor and the client with

mandatory rotation than without mandatory

rota-tion Based on these theoretical considerations, wepredict the negotiation strategies that each party ismotivated to adopt Specifically, we predict, andfind, that mandatory rotation results in the auditorbeing more likely to adopt non-cooperative negoti-ation strategies and that the negotiation is morelikely to end in impasse

This study contributes to the auditing literature

by combining experimental economics methodswith real-time negotiation/verbal protocol analysismethods developed in the negotiation communica-tion literature This combination enables us to pro-vide a more complete image of the process thatproduces the experimental outcome, the processthat is both issue and incentive driven The adoption

of this research methodology also contributes to thenegotiation literature as it attempts to capture theunique aspects of negotiation activity As Davis

mes-sage-space and the real-time nature of unstructurednegotiation create a larger set of strategies than istypically considered in traditional economicresearch Our results may stimulate negotiationresearch outside the context of auditing In addi-tion, our study contributes to the negotiation litera-ture also in that we find support for the dualconcern theory in a highly institutionalized setting

in which rotation of the negotiation parties occurs.The remainder of this paper proceeds as follows:The next section provides the theoretical back-ground and develops the hypotheses Section

‘‘Method” outlines our research method, Section

‘‘Results” presents the results, and ‘‘Discussion”section concludes the paper with a discussion ofthe results and limitations of the study

Literature and hypothesesAuditor–client negotiation

A number of studies investigate issues pertinent

to auditor–client negotiations (e.g., Antle &Nalebuff, 1991; Beattie, Brandt, & Fearnley, 2000;Demski & Frimor, 1999; Farmer, Rittenberg, &Trompeter, 1987; Goodwin, 2002; Nelson et al.,2002; Ng & Tan, 2003; Trotman, Wright, & Wright,2005; Zhang, 1999) These studies generally suggestthat auditor–client negotiations can materially affectfinancial statements while identifying a number ofaccounting and other contextual issues that impactauditor–client negotiations Other studies, which

we will briefly review below, have looked specifically

2

We acknowledge that with only a limited number of large

accounting firms, the loss of the audit engagement may result in

an increase in other non-audit revenues While this situation

mitigates the audit incentives to the firm, the benefits of increased

non-audit revenues may not specifically accrue to the individual

auditor who is negotiating.

at the process of auditor–client negotiation with

implications for how mandatory rotation may affect

this process

Gibbins et al (2001)develop a process model of

auditor–client negotiation They use this model to

analyze a survey of 93 partners in large audit firms

and draw several conclusions related to our study

They find that auditor–client negotiation is a

nor-mal part of auditing and that audit partners view

negotiation as a part of client service in which

audi-tors help produce appropriate financial statements

They also find that at the start of the negotiation,

the partners believe that a range of mutually

accept-able outcomes exist and do not typically expect the

final outcome to be the same as their initial position

Within this setting, both clients and auditors hold a

mutual desire to reach agreement Interestingly,

their data suggest that retention risk affects the

whole process of auditor–client negotiation

Contin-uing this line of research,Gibbins, McCracken, and

audi-tors and clients and analyze the problem solving

process used by eight matched audit partner–CFO

dyads These studies, however, reflect a

presump-tion that the auditor–client relapresump-tionship is on-going

Most studies of auditor–client negotiation share this

assumption and so do not examine how incentives

imbedded in an on-going relationship drive

audi-tor–client negotiations or how changes in incentives

as a result of a mandatory rotation policy impact

such negotiations

influ-ence of engagement risk and auditor negotiation

experience on negotiations Using computer

simu-lated clients, they infer the negotiation strategies

of audit managers and partners based on their

open-ing and final bids Specifically, they infer a

contend-ing strategy when the final bid is the same as the

opening bid, a concessionary strategy when the final

bid is closer to the client’s initial position than to the

auditor’s opening bid, and an integrating strategy

when final bids are closer to (but not the same as)

the auditor’s opening bid They find that auditors

with less client negotiation experience use more

con-cessionary negotiation strategies when engagement

risk is high While Brown and Johnstone investigate

negotiation strategy, they only simulate the client

therefore holding its negotiation strategy constant

Furthermore, they only infer the negotiation

strat-egy based on the negotiated outcomes In dynamic

negotiations, i.e., those in which both sides actively

participate, it is possible for more than one strategy

to arrive at similar outcomes depending upon thestrategy of the opponent (Pruitt & Carnevale,1993; Pruitt & Rubin, 1986) Hence, negotiationstrategy can be ascertained only by measuring thenegotiation strategy directly from the negotiationitself

Several studies examining certain negotiation tics of auditors and clients are also related to ourstudy Using decision case methodology, Hatfield,Agoglia, and Sanchez (2005), for example, find thatauditors use reciprocity tactics when faced with anon-cooperative client Sanchez, Agoglia, andHatfield (2007)find that reciprocity tactics influencethe client into accepting more proposed auditadjustments and feeling better about the process

and client initial negotiation positions and tactics,and find that auditors, compared to clients, are lesswilling to make concessions in negotiations Thesestudies, however, do not consider the economic con-ditions in which such negotiation tactics were used.The results of these studies may not hold whenincentives that drive auditor–client negotiationsare changed

Mandatory rotationSeveral recent studies specifically examine thepossible effects of mandatory rotation Usingdecision case methods, Hatfield, Jackson, and

adjust-ments are more conservative under the conditions ofeither audit partner rotation or audit firm rotation.However, Hatfield et al only look at proposedadjustments and not at the final booked adjust-ments Proposed adjustments are ‘‘pre-negotiation”whereas final booked adjustments are likely to benegotiated outcomes Daniels and Booker (2006)

find that the imposition of mandatory rotationalters loan officers’ perceptions about auditor inde-pendence but not about audit quality Kaplan and

do not have the similar perception of the effect ofmandatory rotation on auditor independence, con-sistent with the GAO study (2003) In contrast,

accruals in the quasi-mandatory rotation ment actually implemented in Korea tended to below, suggesting a substantial impact of mandatoryrotation on financial reporting These studies, how-ever, do not examine the effect of mandatory rotation

environ-on auditor–client interactienviron-ons

In a seminal study,Dopuch et al (2001)

experi-mentally test the effect of mandated auditor rotation

and mandated auditor retention (in non-rotating

periods) on auditors’ willingness to issue

client-preferred reports They find that mandatory

rota-tion changes the interacrota-tion between the auditor’s

reporting decision and the client’s investing

deci-sion Specifically, they find that mandatory rotation

reduces the willingness of the auditor-subjects to

issue client-preferred reports and the willingness of

the client-subjects to invest (which would reduce

the risk of auditor misreporting)

Unlike the present study, Dopuch et al do not

examine the process of an auditor and a client

directly negotiating a reporting choice This

limita-tion restricts the generalizability of Dopuch et al.’s

findings with respect to two processes that are

criti-cally important to auditing: client reporting decision

and negotiation While our study helps to extend the

generalizability of Dopuch et al., its primary

contri-bution is that it directly examines the process by

which the auditor and the client reach a reporting

decision It provides new understanding about

audi-tor–client negotiation strategies under the condition

of mandatory rotation

Negotiation as a social process

A primary theory of negotiation as a social

pro-cess is dual concern theory (Pruitt & Carnevale,

1993) According to this theory, individuals

mod-ify their negotiating strategy by taking into

account their individual incentives and their

rela-tionship to the other party That is, the theory

posits that concern for one’s self and concern for

the other party influence the negotiation strategy

eco-nomic context by both recognizing that the

pri-mary motivators in a business setting are

economic outcomes and defining economic

out-comes in terms of relationship.3 They characterize

two general types of negotiations One type

includes negotiations in which ‘‘negotiators aremotivated to establish or maintain positive rela-tionships and willingly share the pie throughmutually beneficial collaboration.” Hence, concernfor the other party derives not so much out ofconcern for the other’s well-being but out of adesire to maintain a mutually beneficial economicrelationship The other type of negotiationinvolves ‘‘substantive outcomes that can benefitone negotiator only at the expense of the other”(p 38) This latter concern for the substantive out-come motivates negotiators to ‘‘discount the rela-tionship and claim as much of the pie aspossible.” From an auditor–client engagementpoint of view in which economic forces are domi-nant, concern for the substantive outcome of thenegotiation equates to a focus on the current per-iod’s financial statements while concern for theother party results in a focus on maintaining theauditor–client relationship over continued engage-ments Because audits can be characterized as aseries of repeated negotiations from year to year,concern for the relationship implies that auditorsand clients attempt to ensure the continuation ofengagement even if it comes at the expense ofthe current year’s negotiation Before we describehow mandatory rotation influences these concerns,first, we should note that both concerns for sub-stantive outcome and for the relationship can vary

in degree, resulting in four basic combinationsleading to four basic negotiation strategies as illus-trated in Fig 1

According toSavage et al (1989), when tors are less concerned about the relationship, theyare more likely to adopt a non-cooperative strategy.For instance, negotiators who have low concerns forboth the substantive outcome and the relationship

negotia-3 See Bazerman et al (2000) for a comprehensive review of

negotiation research and Gelfand, Major, Raver, Nichii, and

O’Brian (2006) for an outline of recent developments Up until

recently, academic work in negotiations had been ‘‘the province

of mainly economists of game theory and its applications ”

(Lewicki, 1997, p 589) One limitation with this body of

knowledge, according to Greenhalgh and Chapman (1995) , is

its failure to address relationships – the most common element in

real-world negotiations and a particularly important element in

auditor–client negotiations.

Unilateral Negotiation Strategies

Concern for Substantive Outcome

High

A Integrating Strategy

B Obliging Strategy

Low

C Contending Strategy

D Inaction Strategy

Fig 1 Unilateral negotiation strategies (Adapted from Savage

et al (1989) )

tend to adopt a strategy of inaction as shown in cell

D ofFig 1 Inaction strategies are typically

associ-ated with the goal to avoid a loss Such strategies

may exhibit wait-and-see behavior that results in

agreement only if something viewed as a gain is

offered For example, the auditor may ignore the

cli-ent’s request for negotiating a mutually agreeable

asset value to report and stick to the most

conserva-tive approach when client punishment is unlikely

(Antle & Nalebuff, 1991) Likewise, negotiators

who are unconcerned about the relationship but

who are concerned about the substantive outcome

are more likely to adopt a contending strategy as

shown in cell C of Fig 1 Negotiators who adopt

a contending strategy actively argue for their own

positions without considering the costs to the other

party or parties For example, the client may press

the auditor to accept an aggressive accounting

treat-ment by using, explicitly or implicitly, a dismissal

threat Inaction and contending strategies do not

rely on cooperation to achieve agreement

On the other hand, when negotiators are more

concerned about the relationship, they will be more

likely to adopt a cooperative strategy For instance,

as shown in cell A ofFig 1, negotiators who have

high concerns for both the substantive outcome and

the relationship are more likely to adopt an

integrat-ing strategy Negotiators who adopt an integratintegrat-ing

strategy may seek a mutually compromising, ‘‘fair”

agreement that is somewhere between the two

oppos-ing initial positions Alternatively, they may propose

‘‘win–win” solutions to the negotiation by

introduc-ing a new issue and/or a new solution that neither

party initially considered For example, the auditor

and the client may both agree to concessions within

the current period or over a series of periods as

sug-gested byDopuch et al (2001) In like manner,

nego-tiators who have low concerns for the substantive

outcome but high concern for the relationship tend

to adopt an obliging strategy Negotiators who adopt

an obliging strategy seek agreement to maintain the

relationship with less regard to its cost to their current

payoffs Integrating and obliging strategies rely on

cooperation to achieve agreement

To implement the dual concern model in an

audi-tor–client negotiation setting, we identify the

eco-nomic incentives associated with each party’s

actions concerning financial reporting in the

rota-tion and non-rotarota-tion regimes That is, we define

how the auditor’s and the client’s concerns change

as a function of the economic conditions that varies

with whether mandatory rotation is imposed In

absolute terms, auditor–client relationships and cific audit outcomes are very important to both cli-ents and auditors In relationship to the variousnegotiation contexts manipulated in the presentstudy, however, the two dimensions differ in relativeimportance Hence, we frame the discussion interms of one negotiation setting relative to othernegotiation settings We first outline the effect ofmandatory rotation on the negotiation strategies

spe-of the auditor followed by a discussion spe-of its effects

on the client’s negotiation strategies

Auditor negotiation strategies

We first assume that whether or not mandatoryrotation is imposed, the auditor is guaranteed theaudit fee for the current year and that the currentfee amount is unaffected by any negotiation regard-ing the financial statements We further assume ahealthy client without risk of insolvency so thatthe risk of litigation is relatively low While theseassumptions do not describe every client, we believethat they represent the general audit environment.Together, these assumptions work to lower an audi-tor’s concern for the immediate substantiveoutcome

On the other hand, the current audit ment contains incentives for auditors to be con-cerned about their long-term relationship with theclient The Government Accounting Office (GAO,

environ-2003) reports that the average auditor tenure forFortune 1000 companies is 22 years Likewise, astudy published by Fulcrum Financial Group

sample have had the same auditor for 50 or moreyears, with the average tenure of this group being

75 years Although the opportunity costs to a largeaudit firm from losing a single client may be mini-mal, individual partners and managers (who aredoing the negotiation) face very high personalopportunity costs related to their reputations and

to possible lost long-term profits for their offices ifnegotiations fail (Defond, Francis, & Carcello,2005; Francis, Maydew, & Sparks, 1999; Reynolds

& Francis, 2000) Under these economic incentives,auditors may be willing to concede some items inthe short term in order to preserve the long-termrelationship with their clients, as suggested by someproponents of mandatory rotation (Benson, 2002;Imhoff, 2003; Wolf, Tackett, & Claypool, 1999).Hence, we argue that the auditor’s concern for thesubstantive outcome is relatively low compared to

their concern for the on-going relationship.4Given

that the concern for this relationship is higher

with-out mandatory rotation and lower with mandatory

rotation, as we will explain below, we propose

‘‘Obliging” as the dominating strategy for auditors

without mandatory rotation and ‘‘Inaction” as the

dominating strategy for auditors with mandatory

rotation, as displayed inFig 2

Mandatory rotation potentially affects an

audi-tor’s incentives during a negotiation in three ways:

First, in the final audit year before the rotation

occurs, it removes much of the possible reputation

effects to the auditor arising from an auditor

switch.5 This freedom from reputation effects

accrues to the individual auditor both from inside

and outside of the firms, reducing the auditor’s

con-cern for the relationship with the client Second, in

non-final years, mandatory rotation reduces the

prospect of long-term rents arising from subsequent

audits beyond the limit As a result, the auditor’s

concern for the relationship is reduced, which is

the argument typically employed by mandatory

rotation proponents (e.g.,Gietzmann & Sen, 2002;

Third, mandatory rotation alters the market for

cli-ents by increasing the number of clicli-ents looking for

new auditors in any given year, thus dramatically

reducing the auditor’s concern for the relationship.6

In summary, we argue that without mandatoryrotation, auditors have relatively low concern forthe substantive outcome and relatively high concernfor the relationship compared to auditors with man-datory rotation This in turn leads to the greateradoption of obliging strategies during negotiation

We also argue that, with mandatory rotation, tors have relatively low concerns for both substan-tive outcome and the relationship, which leads to

audi-a greaudi-ater use of inaudi-action straudi-ategies These audi-argumentsare formalized in the following hypotheses regard-ing auditor strategies in auditor–client negotiations:H1 : Mandatory rotation affects the negotiationstrategies used by auditors

H1a : Auditors will use an obliging negotiationstrategy more frequently without mandatoryrotation than with mandatory rotation.H1b : Auditors will use an inaction negotiationstrategy more frequently with mandatoryrotation than without mandatory rotation.Client negotiation strategies

When negotiating with the auditor, the clientmanagement (client) has strong reasons to be con-cerned with the substantive outcome Unlike theauditor, who receives a guaranteed audit fee, cur-rent period financial statements can influence theclient’s immediate compensation Hence, the clienthas strong incentives to influence the outcome ofthe current negotiation as set forth in the earningsmanagement literature (c.f., Defond & Jiambalvo,

1993) Imposing auditor term limits has no impact

on these incentives as they are endogenous to theauditor–client relationship We, therefore, assertthat client concern for substance in the negotiatedoutcome is relatively high regardless of mandatoryrotation

In terms of concern for the relationship, withoutmandatory rotation the client generally benefitsfrom a good relationship by avoiding switchingcosts associated with training a new auditor Theseswitching costs are thought to be substantial

the relationship In addition, clients that switchauditors can incur political costs associated withmarket perceptions of opinion shopping.7We assert

4 If one alternatively assumes that the auditor’s concern about

the substantive outcome of the current negotiation is high, the

auditors’ specific negotiation strategy changes from contending to

inaction As pointed out by a reviewer, neither strategy involves

cooperation and the gist of our predictions holds.

5

We implement our experiment in an anonymous setting, thus

precluding reputation effects while allowing us to focus on the

other effects of mandatory rotation Analysis of the negotiation

scripts revealed that no one ever made an effort to identify who

their opponent was.

6

Mandatory rotation increasing the negotiating auditor’s

ability to replace a lost client is a critical distinction between an

audit environment with mandatory rotation and the current audit

environment Assuming that the average auditor tenure is 22

years or more, it follows that less than 5% of clients are in the

market for new auditors in any given year Hence, at the

individual office level, a partner involved in the negotiation

knows that the likelihood of replacing the client is very small.

However, should the auditor term be limited to just four years as

has been advocated by some ( US Senate, 2002 ), one out of four

clients every year will be looking for a new auditor As a result,

the prospects of replacing a lost client when mandatory rotation

is imposed are improved The fact that audit firm rotation

dramatically alters the availability of replacement clients is a key

difference between audit firm rotation and audit partner rotation

that has not been considered in previous studies.

7

There may be, however, some limited circumstances, such as a switch from a non-Big-Four auditor to a Big-Four auditor, in which this may not be the case.

that market perceptions of opinion shopping by the

client are more likely in the early years of an

audi-tor–client relationship and are more likely for more

frequent switches These political costs are

consid-ered to be substantial and to be present without

mandatory rotation and in the non-final years with

mandatory rotation This suggests that in all these

circumstances, the client’s concern for the

relation-ship will be high

In the final year under mandatory rotation, a

change in auditor after the current period is

auto-matic so the client incurs the same switching costs

(i.e., those related to efficiency) regardless of the

outcome of negotiations However, the automatic

change in auditor prevents investors from

attribut-ing this event to opinion shoppattribut-ing without

addi-tional information Hence, the client is unlikely to

experience political costs in this year regardless of

the reason for the change This suggests that in

the final year under mandatory rotation, the client’s

concern for maintaining a long-term relationship

with the auditor is lower than in non-final years,

as illustrated inFig 2

As illustrated in Fig 1, clients who have highconcerns for the substantive outcome and high con-cerns for the relationship are more likely to adopt

an integrating strategy of negotiation This occurswhen mandatory rotation is not imposed and innon-final years when it is imposed On the otherhand, in the final year under mandatory rotation,with high concern for the substantive outcome butlow concern for the relationship, clients are morelikely to adopt a contending strategy These predic-tions are summarized in the following hypotheses:H2 : Mandatory rotation affects the negotiationstrategies used by clients

H2a : Clients will use an integrating negotiationstrategy more frequently without mandatoryrotation than with mandatory rotation, particu-larly in the final year before rotation takes place.H2b : Clients will use a contending negotiationstrategy more frequently with mandatoryrotation, particularly in the final year beforerotation takes place, than without mandatoryrotation

Relative Concern for Relationship and Substantive Outcome And the Tendency to Adopt Specific Negotiation Strategies a

Lower Higher Lower Higher Lower Higher

Unilateral Negotiation Strategy

More Obliging

More Integrating

More Inaction

More Integrating

More Inaction

More Contending

Panel B: Interactive Strategies

Interactive Negotiation Strategy

Trusting Collaboration

Trusting Collaboration

Principled Collaboration

& Soft Competition

Focused Subordination

Responsive Avoidance

& Firm Competition

Principled Collaboration

& Soft Competition

Fig 2 Relative concern for relationship and substantive outcome and the tendency to adopt specific negotiation strategies (In absolute terms, auditor–client relationships and specific audit outcomes are very important to both clients and auditors In relationship to the various negotiation contexts manipulated in the present study, however, the two dimensions differ in relative importance thus leading to the prediction that the use of the various negotiation strategies will differ across conditions.)

Negotiation outcomes

Particularly in the final year under mandatory

rotation, the auditor appears to wield complete

power over the client The economic prediction in

this case is that no negotiation will take place and

that auditors will simply dictate their positions to

their clients However, the literature on ultimatum

and dictator games, in which one party has

com-plete power over the other (c.f., Davis & Holt,

1993; Kagel & Roth, 1995), suggests that people

do not strictly adhere to economic predictions but

often follow social norms related to fair play even

when given complete power over another

individ-ual Hence, we make comparative predictions,

rec-ognizing the relative economic power rather than

the absolute economic power that dictates

equilib-rium predictions without considering the impact of

social factors Notice fromFig 2that both auditors

and clients tend to use cooperative strategies

(oblig-ing and integrat(oblig-ing) without mandatory rotation

but tend to use non-cooperative strategies (inaction

and contending) when mandatory rotation is

imposed To the extent that cooperation leads to

successful negotiation, the following hypotheses

H4 : More negotiations will end in impasse with

mandatory rotation than without mandatory

rotation

When an agreement is reached, the party that

uses an obliging strategy is more likely to receive a

lower payoff and the party that uses an inaction

strategy is more likely to receive a higher payoff than

the party that uses other strategies (Pruitt &

Fig 2, leads us to predict

H5 : Negotiation outcomes will be closer to

audi-tors’ preferences with mandatory rotation and

closer to the clients’ preferences without

man-datory rotation

Negotiation theory recognizes that individual

negotiators may tend towards certain unilateral

strategies but that these strategies can change over

time after interacting with the opponent as shown

in Panel B of Fig 2 For instance, Savage et al

unilaterally adopts an obliging strategy while theopponent adopts an integrating strategy, they bothmay possibly evolve into using a strategy of collab-oration based on trust The key point fromFig 2isthat the various interactive strategies that are perti-nent to this study retain their cooperative or non-cooperative nature from their root unilateral strate-gies (Greenhalgh & Chapman, 1995) For instance,all low cooperation unilateral strategies depicted in

emphasize competition The high cooperation lateral strategies shown in Fig 2 may evolve intotrusting collaboration or subordination Becausepeople evolve into using integrative strategies thatare either cooperative or non-cooperative in a man-ner that reflects their cooperation under their initialunilateral strategies, predictions about negotiatedoutcomes are likely to be the same Furthermore,

uni-to design a study that investigates the use of tive strategy requires complex negotiations over anextended time For these reasons, we only examineunilateral strategies

integra-MethodParticipants and experimental taskFifty-four graduate business students partici-pated in a laboratory negotiation experiment con-ducted over six sessions with nine participants ineach session The typical participant was 26.2 yearsold with 3.7 years of work experience About 44% ofthe participants were women

Within each session, four participants were domly assigned the role of manager (i.e., client)and five participants were assigned the role of veri-fier (i.e., auditor) Together in pairs, one managerand one verifier negotiated a value to be reportedfor an asset Hence, each session consisted of fourpairs of negotiators with one verifier in each periodsitting out and thus earning zero fees for thatperiod

ran-In all negotiations, managers and verifiers sharedthe same set of information indicating the range andassociated probabilities of the actual value of theasset, as shown in Fig 3 The actual value of theasset for each negotiation period was pre-deter-mined using a computer-generated random processconsistent with the probabilities shown in Fig 3.The actual value of the asset was revealed to both

managers and verifiers after each negotiation period

was over

Experimental manipulations

Negotiation, including auditor–client

negotia-tion, is a process by which two or more parties

hav-ing different preferences arrive at a joint decision

(Murnighan & Bazerman, 1990) Thus,

understand-ing preferences is key to understandunderstand-ing negotiation

Preference differences can arise because of

informa-tion asymmetry between the client and the auditor

(Gibbins et al., 2001) or because the client and the

auditor operate under different incentives (Zhang,

1999) Because our predictions are based on changes

to client and auditor incentives as affected by

mandatory rotation, we hold information to be

symmetric and allow only incentives to affect the

negotiators’ preferences.8

The experiment manipulates mandatory

rota-tion at two levels (mandatory rotarota-tion imposed,

yes versus no) between subjects Participants in

the mandatory rotation (MR) condition were told

that ‘‘Each manager–verifier pair continues to

negotiate with each other for up to three periods

as long as the verifier continues to accept the

man-ager’s submitted values.” In this condition, when

the same negotiating pair reached the third period

together, the computer screen automatically

showed a message reminding both that it was their

final period Participants in the no mandatoryrotation (NoMR) condition were told that ‘‘Eachmanager and verifier pair continues to negotiatewith each other for an unlimited number of periods

as long as the verifier continues to accept the ager’s submitted values.”

man-The consequences of a negotiation impasse tothe verifier are determined by the market for cli-ents Recall that the negotiations took place in alaboratory and in groups of nine participants con-sisting of four managers and five verifiers Theaddition of one more verifier than manager cre-ated a competitive market such that if a negotia-tion fails and the relationship is terminated, themanager is guaranteed a new verifier but the ver-ifier may or may not be reassigned to a new man-ager as described below.9In the NoMR condition,

if a negotiation fails, the verifier can only be signed to a new manager if another manager–ver-ifier pair also fails to reach an agreement Thedata suggest that after an impasse in the NoMRcondition, the verifier often had to wait three ormore periods before being reassigned to anothermanager In the MR condition, if a negotiationfails, the verifier has the same chance to be reas-signed to a new manager as in the NoMR condi-tion plus the chance to be reassigned to anymanager that had reached the three-period termlimit The data suggest that in the MR condition,after a failed negotiation the verifier was immedi-ately reassigned to another manager in two ofthree instances and was reassigned in the next fol-lowing period in the remaining instances

reas-The consequence of an impasse to a manager is a40% reduction in earnings for the period, represent-ing the political costs incurred by the manager Thiscost is imposed in all periods in the NoMR condi-tion and the MR condition except in a third (final)consecutive period in the MR condition with thesame verifier in which political costs do not apply.Procedures and negotiation rules

After arriving in the computer lab and receivingtheir role assignments and a computer, the partici-pants began by reading written instructions Theinstructions were pre-tested to clearly communicate

8 Some prior studies manipulate negotiator preferences by

providing less information to auditors than to clients Arguably,

differences in opinion can occur with full information on both

sides The present study assumes that the auditor performs

sufficient tests, etc in order to arrive at the same probability

distribution as the client thus controlling for information

asymmetry.

9

The decision to have one out of five auditors without a client (i.e., 20%) is constrained by the availability of subjects and a desire not to make the auditor’s incentive to avoid an impasse too strong (such as two out of five).

Asset Value Distribution

Value ($)

Probability

of being true

Probability

of being too high

the incentives and mechanics of the experiment The

participants then completed two practice periods

Practice periods did not affect earnings and are

excluded from hypotheses testing Following other

negotiation studies (Roth, 1995), we set each period

to last two and a half minutes After the two

prac-tice periods, 18 negotiation periods were conducted

for each session In order to prevent end of game

antics, the participants were not told how many

periods the experiment would last At the

conclu-sion, cash earnings were determined and the

partic-ipants paid and excused Each session lastedapproximately 1 hour and 15 minutes

To begin each period of negotiation, a managersubmitted an asset value on the computer screendepicted in Fig 4 After receiving the manager’sproposal, the verifier could choose to accept thesubmitted asset value or to negotiate with the man-ager on the computer screen depicted in Fig 5.Negotiations proceeded by typing messages backand forth in a text box and by the manager propos-ing new asset values on the computer screen The

Fig 4 Manager screen.

Fig 5 Verifier screen.

verifier could accept the value submitted by the

manager at any time before the period ended Once

the verifier accepted a value submitted by the

man-ager, the period of negotiation ended and the actual

value of the asset as well as each party’s earnings for

that period were shown in a message box on the

computer screen

If the verifier did not accept a value submitted by

the manager before the negotiation time ran out, the

period ended in impasse The manager then was

randomly paired with a new verifier in the following

period and the verifier was randomly reassigned to

another manager, if available, within the constraintthat verifiers were not reassigned to the same man-ager they had just left

PayoffsThe experimental instructions showed payofftrees for both managers and verifiers correspond-ing to the participant’s respective experimentalcondition as shown in Fig 6 Payoffs for manag-ers are first described followed by payoff forverifiers

Panel A: No Mandatory Rotation

Managers’ Payoff:

Yes Verifier’s Acceptance

Accepted value > Actual value

No 60% Actual value (in any first and second periods with the same verifier), or 100%

Actual value (in any third period with the

Verifiers’ Payoff:

$100 50% (Accepted Value Actual value)

Yes Accepted value > Actual value

$100

Fig 6 Payoffs.