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«Abstract The persisting familiarity threat of auditors continuously raises regulatory concerns, which are reflected in a recently proposed compulsory ...»

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Does a long-term personal relationship between an auditor and a client invoke conscious

misjudgements or unconscious biases? An experimental analysis


The persisting familiarity threat of auditors continuously raises regulatory concerns, which are reflected in a

recently proposed compulsory audit firm rotation in the European Commission Green Paper. The aim of this paper

is to shed light on auditors’ cognitive drivers of bias inherent in a long-term personal relationship with the client.

We examine whether a long-term personal relationship invokes a conscious misjudgement because of a mutual long-term financial interest or an unconscious bias invoked by affective motives and unconscious needs. The paper combines two theories – incentive based motivated reasoning (Kunda, 1990) and need based motivation theory (McClleland, 1987). We analyse the problem with a two-player perfect information sequential game on 104 students. We find that the positive effect of a personal relationship on biased decision-making is mediated by a long-term financial interest rather than by affective motive such as friendship. Unconscious needs are also found to influence subjects’ decisions. The need for affiliation positively affects auditors’ bias and gets accentuated in a personal relationship, whereas the need for achievement, which reinforces the auditor’s independent opinion helps him resist the pressure from the client. Limitations of the study are attributable to the experimental method of analysis. The study is an original empirical investigation of the drivers of behaviour in the auditing setting.

Key words: auditing, personal relationship, unconscious needs, financial dependence, affect Jel: M42

1. Introduction Auditor’s independence is considered to be the most important characteristic of audit profession due to its impact on the audit quality and confidence in financial reporting. Despite a major reform in 2006 (EU Directive 2006/43/EC), auditor’s independence remains a hotly debated issue by the European regulators (the European Parliament, 2013; Brunsden, 2013), practitioners and the research community. The European Commission’s Green Paper recognizes 1 that despite mandatory rotation of lead auditors on a regular basis, the threat of familiarity persists (European Commission, 2010).

A personal relationship that develops in the course of long tenure of an auditor with the same client remains indisputably one of the main determinants that undermine auditor’s independence. Although a vast number of experimental studies confirmed the effect of a personal relationship on auditors’ choices (Hackenbrack and Nelson, 1996; Prentice, 2000;

Kadous, Kennedy and Peecher, 2003; Blay, 2005; Kadous, Magro and Spilker, 2008), a closer examination of their method reveals that these studies eventually investigated a personal relationship as a source of financial dependence. Moore, Tanlu and Bazerman (2010) hypothesised that a personal relationship creates affective motive beyond financial incentive, but they didn’t find the effect significant neither in a stand-alone analysis nor in joint testing of financial incentives and a personal relationship. Slapničar, Zaman Groff and Lončarski (2012) improved the experimental measurement of a personal relationship and found significant influence of both a personal relationship and financial incentives on auditors’ decisions. They further examined whether with the introduction of auditor’s practice risk both incentives cease to play a role on auditor’s choices. Interestingly, they found that the oversight effectively mitigates bias arising from financial incentives, while it has no effect on bias arising from a personal relationship. Authors thus infer that a personal relationship gives rise to unconscious bias because subjects seem not to be aware of it and cannot debias their choice despite of the oversight risk. The authors, however, did not attempt to measure unconscious motives of the subjects more directly.

Our study continues this line of inquiry. Its aim is to analyse whether a long-term relationship between an auditor and a client creates affective or financial incentives. In other words, we explore whether the auditor’s choice is deliberate and depends on a conscious incentive based on the belief that a long-term relationship assists mutual financial interest or on

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advances incentive based theory of motivated reasoning (Kunda, 1990) by shedding light on the controversy whether motivated reasoning is a conscious or unconscious cognitive process.

According to Forgas (1995) there is little place for affect in motivated reasoning as it is strongly influenced by a directional goal if the two are incongruent. This is, however, not the case in a long-term relationship between an auditor and a client, during which the two incentives become aligned.

External incentives such as financial goals and aroused affect do not entirely account for human behaviour. Another important driver of behaviour are unconscious needs (McClelland, 1985; Khandekar, 2012). According to the motivational needs theory unconscious needs permanently influence one’s behaviour (McClelland, 1987). We therefore complement our analysis of incentives by unconscious needs and look at how incentives and needs combine in pursuing a goal. In particular, we hypothesise that the need for affiliation, i.e. the need to affiliate with people, the desire to please them, is likely to positively affect the auditor’s support of the client’s preference, particularly in a long-term relationship with the client. The need for achievement, i.e. the need to excel in results, on the other hand, is assumed to influence auditors’ behaviour in the opposite way such that they resist client’s preferences.

To analyse these questions we conducted a between-participants randomized two-period sequential game, using a two (personal relationship vs. no personal relationship) by one factorial design with randomly distributed covariates. A total of 104 finance and accounting students participated in the experiment, in which they assumed the roles of the auditors and the clients.

The results of the experiment confirm that a personal relationship has a significant positive effect on the auditors’ decision in favour of their clients in the first round. To support the clients’ preferences auditors in a personal relationship significantly more often gave up their short-term outcome to build up a long-term relationship. In analysing what explains the effect of

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play a role. It is the desire to establish a long-term future business relationship with the client that seems to mediate a positive effect of a personal relationship. The unconscious needs for achievement and affiliation are also found to significantly influence the decision in the predicted direction. We find that a personal relationship increases the effect of the need for affiliation and that auditors with a high need for achievement that have a need to excel fight back the pressure in the personal relationship.

The study is an original empirical investigation of the drivers of decision-making in an auditor-client setting. Our results contribute to the findings in prior literature by showing that in the heart of biased decision-making is a long-term financial benefit for both parties. We suggest that unconscious bias arises from unconscious needs, rather than by affect created in a long-term relationship, however, a personal relationship seems to accentuate the need for affiliation. The paper contributes to a body of literature investigating biases in auditor’s decision-making, building on motivated reasoning and motivational needs theory. Understanding underlying cognitive processes created by various incentives and needs importantly conduces to the insight into the effectiveness of different regulatory measures intended to alleviate auditor’s independence threat. Such evidence may add to the recent regulatory discussions on measures against auditors’ dependence.

The paper is further structured as follows. Section two provides the theoretical background and develops the hypotheses. Section three presents the design of the experiment and the methodology of the research. Section four provides the results of the analysis. Section five discusses the findings and concludes with implications.

2. Theoretical background and hypotheses

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behaviours associated with negative incentives (Bernstein and Nash, 2008). According to Johnstone, Sutton and Warfield (2001) auditors’ decisions may also be trimmed down to direct and indirect incentives. Direct incentives include actual or potential financial benefit. The adverse influence of financial incentives on auditor’s decision-making in a long-term relationship has been extensively examined and the findings are largely consistent (DeAngelo, 1981; Farmer, Rittenberg and Trompeter, 1987; Mednick and Previts, 1987; Lord, 1992; Blay, 2005; Moore, Tetlock, Tanlu and Bazerman, 2006; Moore et al., 2010). Indirect incentives, on the other hand, derive from circumstances, which make it difficult for the auditor to maintain objectivity. A long-term personal relationship between an auditor and a client has been found to create situations in which the auditor is hesitant to act with professional rigor and unwilling to impair a relationship with a client (Johnstone et al., 2001).

According to theory of motivated reasoning (Kunda, 1990), direct and indirect incentives create directional goals that lead to cognitive biases. Whilst there is little dispute that economic dependence has influenced auditors’ decision-making, more controversy surrounds a personal relationship. Knap and Knap (2012) suggest that exaggerated desire to please a client is not regarded as a cognitive bias, but as a common symptom of impaired auditor’s independence, whereas Neuberg and Fiske (1987), Moore et al. (2010) and Slapničar et al. (2012) propose that a personal relationship creates unconscious, affective bias.

Kunda (1990) and Blay (2005) suggest that information processing and a decision invoked by a directional goal occurs unconsciously. There are, however, two indications that bias may occur deliberately. The first one is that bias takes place only if choices are ambiguous: in such a setting, the decision-maker is able to support the choice with seemingly objective arguments, although if the opposite directional goal is present he may make a case for precisely reverse arguments. The second indication is the empirical finding that professionals are susceptible to

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decision-making (Kadous et al., 2003; Blay, 2005; Kadous et al., 2008, Hope and Langli, 2010).

Despite acknowledging that two directional goals, financial incentives and a personal relationship, lead to biases, the research in auditing has downplayed the distinction between both. In most papers, a personal relationship equals a long-term financial benefit. The first paper that simultaneously examined both incentives is the Moore et al. (2010) study. While their experimental results do not confirm a significant effect of a personal relationship on auditor’s decision-making neither in the absence nor in the presence of financial incentives, the authors show that the subjects internalize their role of auditors and are unable to debias their decision in a different role (Moore et al., 2010).

Slapničar et al. (2012) continued the investigation of a personal relationship. They refer to a number of studies explaining the development of affect in a long-term relationship (c.g.

Neuberg and Fiske, 1987; Bamber and Iyer, 2007; Nelson, 2009). By strengthening the measurement of a personal relationship, they find significant effects of both financial incentives and personal relationship on biased decision making, suggesting that a personal relationship creates different basis to bias as financial incentive. Furthermore, they report that the oversight risk significantly mitigates bias arising from financial incentive, whereas a personal relationship almost completely offsets this effect. Subjects in a personal relationship condition committing bias were in their study insensitive to oversight risk. The authors interpret this finding as an indication of bias that arises from affect.

Our study differs from the previous studies in that it focuses on the question whether a personal relationship invokes a deliberate misjudgement because of conscious decision-making process to maximise financial interest or unconscious bias due to affective decision-making, which does not serve exclusively to the maximisation of financial interest.

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exception than the rule and that affect1 is involved in almost every decision (Forgas, 1995).

Emotions are relied on in evaluating incentive value of choices (Damasio, 1994). Kahneman (2011) defines two modes of thought: system 1 being fast, instinctive, emotional, subconscious and system 2 being slower, more deliberative, logical and conscious. Kahneman (2011) uses terms affective and subconscious interchangeably. According to the author people make most of the decisions in system 1, but a certain event can make them switch to system 2. Kahneman’s theory accommodates both conscious and unconscious explanations of auditors’ motivated reasoning: it may be unconscious until auditors become aware of a practice risk, which makes them switch to system 2.

According to Forgas (1995) motivated reasoning involves highly predetermined and directed information search patterns which serve to a pre-existing goal. This judgmental strategy is one of the least susceptible strategies to the influence of affect. In case that prevailing affective state of the decision-maker is incongruent with the goal, affect is unlikely to influence judgements.

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