Business School

1. Business School The Influence of a Self-Interest Threat to Auditor Independence and Emotion on Auditors’ Inventory Judgments Janne Chung – York University Jeffrey Cohen – Boston College Gary Monroe - UNSW

2. Using an experiment, we investigate the effects of ethical conflict and emotion on auditors’ inventory judgments We manipulate emotion and self interest threat in an experimental case and ask auditors what inventory value they will recommend for the client in the case materials We expect that the presence of a self interest threat will lead individuals to value the client’s ending inventory less conservatively We expect that a more positive emotion will lead to less conservative inventory judgments compared to a more negative emotion. We expect an interaction effect between self interest threat and emotion The results confirm our expectations Overview of the paper

3. Introduction We examine whether the presence/absence of a job offer from an audit client affects auditors’ judgments • Job offer during the audit of the client creates a potential conflict of interest (self-interest threat) We examine the effect of emotion on audit judgment • Affective states including emotion have a long history in the psychology literature, but have been largely overlooked by auditing researchers • We extend the findings in the psychology literature to the audit profession and contribute to our understanding of how emotion could affect audit judgment

4. Introduction Psychology literature reports that affective state (mood) impacts ethical decision-making • Apart from Connelly et al. (2004) who examine management issues using college students, no study has examined the effect of emotion on ethical decision-making • With the exception of Cianci and Bierstaker (2009) who examine the effects of moods on ethical decision-making in a hypotheses-generation task, we are not aware of any other auditing study that has examined this issue • Therefore, we examine the interaction effects between emotion and the presence (absence) of an self interest threat on audit judgment

5. Ethical conflict People tend to respond to conflicts of interest through decision-making biases (Bastedo 2009). • When individuals are presented with situations where personal self-interest is contrary to ethical behavior, their response is potentially one of self-interest. This bias is unconscious, which makes it difficult for people to recognize that their decision is affected by self-interest (Moore and Loewenstein 2004) • Self-interest may play a role in strengthening people’s decision heuristics such as unconsciously biasing even routine decision-making (Chugh, Bazerman, and Banaji 2005; Simon, 1957; Tversky and Kahneman 1974). • Conflicts of interest create ethical dilemmas that influence an individual’s independence (Premeaux 2004)

6. Ethical conflict When a client makes a job offer to an audit team member, it could create a conflict of interest for the audit staff member • auditor may act as an advocate for the client by making decisions that are in the client’s favor, for example, by signing off on less conservative asset or liability values. H1: Participants who read case materials containing a conflict of interest expect an auditor to act out of self-interest by recommending less conservative inventory values to the audit manager compared to participants who did not read case materials containing a conflict of interest.

7. Emotions Positive affect • results in positive views of the judgment context • leads to more positive judgments of self and others (Clore et al. 1994) • more likely to overestimate the likelihood of favorable events occurring and underestimate the likelihood of unfavorable events occurring (Nygren et al. 1996) • Chung, Cohen and Monroe (2008) find that positive affective state (mood) leads to less conservative inventory valuation by auditors

8. Emotions Negative affect • results in negative views • leads to more negative evaluations and actions (Forgas 1992) • Kadous (2001) demonstrates that negative emotions in an auditor negligence case affected jurors’ judgment of auditors - higher levels of negative emotion resulted in a more negative evaluation of auditors and higher penalties were handed out to them • Chung, Cohen and Monroe (2008) find that negative affective state (mood) leads to more conservative inventory valuation by auditors

9. Emotions We manipulate emotion as positive, neutral and negative H2: Participants in the negative emotion condition expect an auditor to recommend inventory values to the audit manager that are more conservative compared to auditors in the positive emotion condition.

10. Joint effects of self-interest and emotion H3a: Positive-emotion participants who read case materials that contained a job offer expect an auditor to make significantly less conservative judgments relative to all other conditions. H3b: Negative-emotion participants who read case materials that did not contain a job offer expect an auditor to make significantly more conservative judgments relative to all other conditions. H3c: Positive-emotion participants who read case materials that contained a job offer expect an auditor make significantly less conservative judgments relative to negative-emotion participants who read case materials that did not contain a job offer.

12. Participants 96 (49 males and 47 females) auditors with 4+ years of experience – 51 in-charge seniors and 45 supervisors or managers • average age - 30 years • average working experience - 101 months • average accounting working experience - 91 months • average auditing working experience - 84 months • average of 13 inventory audits • 76% worked for Big 4 firms Paid $50 for participating

13. Experiment Participants read experimental materials about an audit client. First, read information concerning Pat, an in-charge audit senior whose career progression is on track • To create self-interest threat, half read case materials informing them that Pat is considering accepting a very attractive job offer from the client and he had not disclosed this • Other half read case materials that did not contain a job offer Next, all participants were told that Pat is assigned the inventory section of the audit of an electronics manufacturing company

14. Experiment All participants given same background information about the client, e.g., history of client, financial statements, information on corporate governance Detailed information specific to the current year’s audit of inventory was provided • Participants informed that procedures for this section of the audit had been satisfactorily completed • However, difference of opinion between Pat and the client regarding the valuation of inventory • Initial audit testing indicated caused Pat to estimate inventory should be valued at $136,000,000 compared to the client’s carrying amount of $148,000,000

15. Experiment Participants informed that Pat meets with client’s financial controller (FC) to discuss possibility that inventory may be overstated, next course of action to take, and possibility of hiring independent valuers • At this point, the emotion manipulation was introduced. Participants read the conversation between Pat and the VP • Positive emotion - materials describe a kind, helpful, and courteous FC • Neutral emotion – materials describe a FC who is neither mean nor kind, helpful nor unhelpful, and discourteous nor courteous • Negative emotion – materials describe a mean, unhelpful, and discourteous FC

16. Experiment Based on the conversation between Pat and the FC, the services of two independent appraisers (A and B) are secured and both return a range of valuations that are lower than the client’s with A’s being lower than B’s. • A: 129,600,000 – 134,000,000 • B: 137,400,000 – 140,600,000 Participants then answered two questions • What inventory balance would Pat recommend to the audit manager? • What inventory balance would you recommend to the audit manager? • they wrote down the value Participants then responded to manipulation checks and provided demographic data.

17. Manipulation checks Pleasure, Arousal, and Dominance (PAD)scale used to measure emotions and responses to environmental stimuli • PAD scale does not purport to measure emotions per se, instead it assesses the perceived pleasure, arousal and dominance elicited by a set of environmental stimuli • Pretesting indicated our case materials only triggered the Pleasure dimension so we only included scales relating to that dimension • 7 items anchored by: pleased (annoyed); hopeful (despairing); happy (unhappy); satisfied (unsatisfied); relaxed (bored); contented (melancholic); and stimulated (relaxed) • Responses on a 7-point scale – we sum the scores for the 7 items – higher score is more negative

18. Manipulation checks Results for PAD • positive 17.4 (6.6) • neutral 24.1 (6.2) • negative 35.5 (4.5) ANOVA and Games-Howell tests used to test differences • positive-emotion participants experienced higher pleasure than neutral-emotion participants (p < .001) • neutral-emotion participants experienced higher pleasure than negative-emotion participants (p < .0001) Self rated their expertise – relatively high - 5 out of 7 Rated realism of case materials – good - 4.8 out of 7

19. Results More conservative is lower value

20. Results

21. Results Contrast coding used

22. Results