Academic journal article Academy of Accounting and Financial Studies Journal

Audit Partners' Individual Risk Preferences in Client Retention Decisions

Academic journal article Academy of Accounting and Financial Studies Journal

Audit Partners' Individual Risk Preferences in Client Retention Decisions

Article excerpt

ABSTRACT

Recent research has focused on audit firms' client portfolio management choices, assuming firms are motivated to reduce overall business risk consistent with Expected Utility Theory. However, Prospect Theory predicts individuals make risk seeking choices when faced with potential losses, perhaps including losing the revenue from terminating an existing client. This study examines the effect of individual audit Partners' risk preferences in the context of whether to retain or terminate a risky audit client. The results indicate individual Partners' risk attitudes have a significant effect on their decisions whether or not to retain a risky audit client. Implications for audit practice and future research are discussed.

INTRODUCTION

Prior research has shown auditors' decisions to accept clients are influenced by the auditors' perceptions of the client's business risk and the auditor's business risk (Johnstone 2000). These risks, in turn, are influenced by the perceived strengths and risks of various financial and nonflnancial information (Pratt and Stice 1994; Bell et al. 2002). Subsequent client portfolio decisions also are associated with auditor's business risk such as the client's business risk and likelihood of fraud ((Johnstone and Bedard 2003, 2004). Prior research has assumed auditors' client portfolio (i.e., acceptance and retention) decisions follow predictions of Expected Utility Theory, i.e., risk neutrality. However, Prospect Theory predicts individuals faced with a prospective loss will respond with risk seeking behavior. Prior research has not addressed the potential influence of auditors' individual risk aversion or risk seeking on business risk decisions when prospects for loss are salient.

The potential influence of individual-level differences in risk preference is important for several reasons. First, an aggressive, risk seeking approach to managing business risks can lead to increased liability judgments and settlements, impairing profitability for the firm at best, and to dissolution (as in the case of Arthur Andersen) at worst. Second, an overly cautious, risk averse approach can lead to reduced profitability as well, since profitable opportunities may be missed. Third, existing models for assessing business risks associated with client continuance do not explicitly recognize and weight Partners' individual differences in risk assessment (Bell et al. 2002). Fourth, prior research suggests that group decision making, which one might expect to cancel out individual differences, may actually produce greater divergence instead of convergence in attitudes (Moscovici and Zavalloni 1969; Carnes et al. 1996). Fifth, to the extent individuals are unaware of the underlying differences in their assessments of risk, group discussions can be misdirected. For example, outward disagreement may focus on a client's audit or business risk (Johnstone 2000; Choi et al. 2004) when the underlying source of disagreement between two partners or groups of partners is the difference in the partners' own attitudes toward acceptable risk.

The purpose of this research is to test whether audit partners ' individual risk preferences with respect to business risk evaluations affect their evaluations to retain or to terminate an existing, risky client. We extend recent experimental and empirical audit research on client portfolio management (Johnstone 2000; Johnstone and Bedard 2003, 2004; Hackenbrack and Hogan 2005) by including consideration of partners' individual risk preferences. We extend prior research (Farmer 1 993) that has examined lower level auditors' risk preferences on audit risk by extending the inquiry to audit partners and business risk decisions.

This study provides the first evidence of the effects of individual audit partners' risk seeking, risk aversion, and risk neutrality attitudes in a business risk context. Our findings indicate partners' individual risk preferences have a significant influence on their client retention assessments. …

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