Managers' Strategic Reporting Judgments in Audit Negotiations

SUMMARY Prior research has largely characterized audit negotiations as a dyadic relationship between auditors and managers. However, the Sarbanes-Oxley Act (SOX) substantially enhances the audit committee's oversight responsibilities for the financial reporting and auditing processes. Thus, negotiations post-SOX may be viewed as a triadic relationship that now involves the audit committee with the authority to scrutinize audit negotiations. Consistent with auditors considering their relative bargaining power and expectations of counterpart behavior, Brown-Liburd and Wright (2011) find that auditors are most contending when the audit committee is strong and the past relationship is contentious. We extend Brown-Liburd and Wright (2011) by examining the joint effects of these factors on managers' pre-negotiation judgments. We posit that rather than mirror auditor behavior, managers make different judgments because they have a different perspective and set of incentives than do auditors. Prior research suggests that managers are more flexible, more accurately determine their counterpart's goals and limits, and are more likely to use certain negotiation tactics than auditors. Further, managers have incentives to maximize the current outcome while maintaining their firm's reporting reputation. As such, managers will be less aggressive in responding to a contentious past auditor relationship, particularly in the presence of a strong audit committee that may ask difficult questions and potentially intervene against their favor. However, managers will act more aggressively to capitalize on a cooperative past auditor relationship, particularly in the presence of a weak audit committee that is passive or persuadable. To examine these two boundary conditions, we conduct an experiment with 137 experienced CFO/controllers. We find strong evidence supporting our expectations that managers act as if both the audit committee and the auditor jointly play important roles in ensuring high financial reporting quality. JEL Classifications: M41; M42.