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Journal of Accounting and Public Policy xxx (2003) xxxxxx

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Going-concern judgments: an
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experimental test of the self-fullling
prophecy and forecast accuracy
Robert R. Tucker a,*, Ella Mae Matsumura b,
K.R. Subramanyam c
a
Fordham University, Accounting & Taxation Area, 314 Oak Street Apt. B,
Ridgewood, NJ 07450, USA
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b
University of Wisconsin-Madison, USA
c
University of Southern California, USA
Abstract
12 Statement on Auditing Standards No. 59 requires auditors to assess whether sub-
13
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stantial doubt exists about a clients ability to remain a going concern. This study re-
14 ports an experimental economic test of a game-theoretic model of that judgment.
15 Competing behavioral predictions are based on loss avoidance, risk seeking, altruism,
16 and adversarial play. We also examine how strategic dependence aects auditors and
17 clients propensity to depart from equilibrium.
18 The auditor conveys to the client a forecast on business survival and the intention to
19 express a clean or going-concern opinion. The client can attempt to avoid a going-
20 concern opinion and its potential self-fullling prophecy eect by switching auditors.
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21 Several subjects played pure strategies consistent with loss avoidance, adversarial play,
22 and risk seeking. Nevertheless, the experimental results support the models prediction
23 that the rst treatment variable, self-fullling prophecy, leads auditors to express fewer
24 going-concern opinions and leads clients to switch auditors more frequently, particu-
25 larly when the audit evidence has low forecast accuracy. The second treatment variable,
26 forecast accuracy, also has a signicant eect on subject behavior. However, in contrast
27 to the models predictions, inaccurate forecasts did not lead auditors to express more
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28 clean opinions but led clients to switch auditors more frequently.

29 2003 Published by Elsevier Inc.
*
Corresponding author. Tel.: +1-201-670-4984; fax: +1-212-765-5573.
E-mail address: atucker458@aol.com (R.R. Tucker).
0278-4254/$ - see front matter 2003 Published by Elsevier Inc.

doi:10.1016/j.jaccpubpol.2003.08.002
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2 R.R. Tucker et al. / Journal of Accounting and Public Policy xxx (2003) xxxxxx
30 Keywords: Experimental economics; Loss avoidance; Adversarial; Altruism; Auditing; Going

31 concern opinions and self-fullling prophecy
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32 1. Introduction
33 The sensational Enron and WorldCom bankruptcies led congressional

34 committees to ask why the auditors did not alert the public to the rms in-
35 herent riskiness. Weiss (2002) found that out of 228 bankrupt public compa-
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36 nies, Enron and 95 other companies received clean opinions in the year prior to
37 bankruptcy. The far-reaching consequences of such collapses justify research
38 aimed at improving the quality of auditors going-concern judgments.
39 Maintaining the professions ethical standards of independence and integrity
40 in the face of client pressure is particularly dicult with going-concern deci-
41 sions because the judgment is complex, with unavoidable uncertainty. A key
42 complication is the self-fullling prophecy eect, that is, when the auditors
43 public expression of doubt, in itself, hastens a companys end, particularly one
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44 whose viability rests on trust and a high stock price, as did Enrons and
45 WorldComs. Since client bankruptcy can also negatively aect the auditor, we
46 test whether the auditors judgment is aected when the going-concern report
47 contributes to a self-fullling prophecy.
48 We also examine how noise in the auditors forecast of client viability aects
49 the auditors reporting ability. Recently, the Panel on Audit Eectiveness
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50 (2000, pp. 5963) called for clearer guidance in dening a going-concern

51 problem, procedures for evaluating the problem, and requirements for dis-
52 closing the problem. Clarifying and providing more detailed guidelines for
53 auditors going-concern reporting should facilitate reducing noise in the au-
54 ditors forecast of client viability. We study the eect of decreasing the noise in
55 a context where clients apply economic pressure and thereby challenge the
56 auditors independence.
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57 Our study involves experimental economic tests (Davis and Holt, 1993) of a
58 game-theoretic models predictions. Only a few experimental economic studies
59 examine a substantive auditor-reporting decision connected to possible auditor
60 switching (e.g., Schatzberg (1994, pp. 3355) and Mayhew (2000, pp. 599
61 617)). Previous analytical studies using game theory to analyze auditor
62 switching as a function of audit evidence and reporting include Dye (1991, pp.
63 347374), Teoh (1992, pp. 123), and Lennox (2000, pp. 321337). Unlike these
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64 studies, our study incorporates the self-fullling prophecy eect and examines
65 strategic behavior before the auditor issues a report. Auditors and clients are
66 more likely to confront the going concern question early in an annual audit as a
67 result of the recent release of SAS No. 100 (AICPA, 2003) on interim nancial
68 reporting, which requires such a review with interim as well as year-end re-
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R.R. Tucker et al. / Journal of Accounting and Public Policy xxx (2003) xxxxxx 3
69 ports. In addition, after the reports issuance, the auditors and clients range of
70 strategic options and outcomes diminishes, making the issue less consequential.
71 More closely related are the experimental study of Tucker and Matsumura
72 (1998, pp. 179217) and the analytical study of Matsumura et al. (1997, pp.
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73 727758). Our game-theoretic model builds on that of Matsumura et al., which
74 assumes that subjects are risk neutral, they maximize only their own wealth,
75 they never respond emotionally when the other players decision causes them to
76 lose money, and they follow and anticipate high-level strategic thinking
77 (Bloomeld, 1997, pp. 517538). We develop and test competing predictions
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78 based on loss avoidance, risk seeking, adversarial play, and altruism to provide
79 a perspective on the game-theoretic model and to aid in interpreting the results.
80 Partly due to these alternative models, this study includes extensive descriptive
81 and statistical analyses of individual subject behavior based on independent
82 observations. Finally, this paper incorporates a test of strategic dependence.
83 In our experiment, auditors convey to the client an intention to issue a clean
84 or going-concern report based on a forecast judgment. Upon learning that a
85 going-concern opinion is imminent, the client decides whether to switch au-
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86 ditors to obtain a positive probability of a clean opinion. The clients credible
87 threat to switch auditors complicates the auditors reporting decision. The
88 auditors reporting judgment is complicated further by two factors: a self-ful-
89 lling prophecy eect, and potential inaccuracy (noise) in the auditors fore-
90 cast. Specically, if the auditors going-concern report is self-fullling, then the
91 game-theoretic results predict that the auditor will express fewer going-concern
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92 opinions to avoid losing an audit fee, and the client is more likely to switch
93 auditors if a going-concern opinion is imminent. Moreover, an auditor is more
94 likely to express a clean opinion as the accuracy of the auditors forecast of
95 client viability decreases.
96 The paper contributes to the literature in several ways. Our tests reveal that
97 the game-theoretic model is useful in interpreting many subjects behavior and
98 in fully describing some subjects behavior. The competing predictions gener-
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99 ated by alternative decision models also had notable explanatory power. These
100 results suggest that one model alone is inadequate to aptly describe the variety
101 of decision patterns exhibited. Specically, the experimental results support the
102 directional prediction that auditors express fewer going-concern opinions when
103 the auditors report is self-fullling. However, the percentage of going-concern
104 opinions expressed far exceeded that predicted by the analytical model (72%
105 versus 0%). In addition, clients who anticipated receiving a going-concern
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106 opinion switched auditors more frequently when that opinion was self-fulll-
107 ing, though not as frequently as predicted (40% versus 100%). Loss avoidance
108 best explains these dramatic and surprising dierences from predictions. If the
109 relatively small experimental penalties for auditors and clients had this inu-
110 ence, it is worth considering whether the larger penalties faced by practicing
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111 auditors and clients might similarly make their reporting and switching deci-
112 sions more conservative.
113 Weaker forecast evidence aected behavior but not as predicted analytically.
114 Auditors did not express more clean opinions, but clients did switch auditors
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115 more aggressively. Also, the experimental results strongly support Bloomelds
116 hypothesis that increases in strategic dependence lead players to play farther
117 o-equilibrium.
118 The remainder of the paper is organized as follows. Section 2 discusses the
119 studys two treatment variables. Section 3 presents the steps in the experiment,
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120 and Section 4 describes competing decision models. Section 5 states and dis-
121 cusses the major hypotheses and predictions. Sections 6 and 7 describe the
122 experiment and the experimental results, respectively. The nal section presents
123 the papers conclusions.
124 2. Issues
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125 2.1. The self-fullling prophecy eect
126 A unique aspect of the going-concern decision is that a going-concern report

127 may actually contribute to the demise of an otherwise viable client. Early ev-
128 idence on this eect was obtained primarily through experimentation (Kida,
129 1980, pp. 506523), surveys and interviews (Mutchler, 1984, pp. 1730; Wil-
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130 liams, 1984, pp. 1219; Carmichael and Pany, 1993, pp. 3558), and profes-
131 sional observation, (Bell, 1991, pp. 1420). Dopuch et al. (1986, pp. 93117)
132 provided empirical evidence that going-concern opinions are associated with a
133 signicant decline in stock price on average. Others have attempted to docu-
134 ment the self-fullling prophecy eect empirically. Pryor and Terza (1999) and
135 George et al. (1996) nd a positive and signicant self-fullling prophecy eect
136 and provide additional evidence on its strength and immediacy. One purpose of
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137 our study is to determine the ramications of this eect for the strategic in-
138 teraction between the auditor and client with regard to reporting and auditor-
139 switching behavior.
140 2.2. Noise in assessing the clients going-concern status
141 This study operationalizes noise by varying the level of inaccuracy in the
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142 auditors going-concern forecast. Future uncertainty only partially accounts

143 for the noise in the auditors forecast of client viability. Noise might also arise
144 should the auditor collect insucient or unreliable evidence, misinterpret re-
145 sults, or misinterpret the professions objective as evidenced by the between-
146 auditor inconsistency in interpreting subjective phrases such as substantial
147 doubt exists found in US Statement on Auditing Standards No. 59. Evidence
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148 also exists that auditors consider factors other than those needed to satisfy
149 professional standards, such as size (Pryor and Terza, 1999; Louwers, 1998, pp.
150 143156), default status even when it is not well correlated with business ter-
151 mination (Chen and Church, 1992, pp. 3049; Louwers, 1998, pp. 143156),
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152 and the auditors potential loss function (Hopwood et al., 1994, pp. 409432).
153 The noise variable merits study for at least two reasons. First, this variable is
154 the variable most controllable by practitioners and the accounting profession
155 as a whole. Second, the eect is socially signicant. For example, noise may
156 partially explain Weiss (2002) nding that 42.1% of the public companies that
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157 went bankrupt during 2001 and the rst half of 2002 received clean opinions on
158 their prior annual report. Empirical evidence suggests that auditors render
159 more going-concern opinions the clearer their audit and reporting responsi-
160 bilities (Raghunandan and Rama, 1995, pp. 5063), and the less ambiguous the
161 probability of bankruptcy (McKeown et al., 1991, pp. 113).
162 3. Sequence of steps in the game-theoretic model and experiment

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163 Our 2 2 between-subjects experiment involves two treatments: a self-ful-
164 lling prophecy eect and forecast inaccuracy. Each game involves strategic
165 interaction between two players assuming the roles of auditor and client. The
166 game tree depicted in Fig. 1 supplements the narrative below by providing a
167 concise graphical overview of the game and experiment, and Table 1 provides a
168 more complete denition of the variables used below. All variables or pa-
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169 rameter values, information, and payos relevant to a particular cell were
170 common knowledge to the auditor and client. The steps of each game in the
171 experiment closely parallel the steps in our game-theoretic model.
172 3.1. Initial state determination

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173 The computer plays the role of nature and determines the clients future
174 statebusiness termination (B) or survival (S)which is unknown to the client
175 and auditor at the beginning of the game. In the experiment, the prior prob-
176 abilities of the two states are equal, 1 which suggests that this is a high-risk
177 engagement.
178 3.2. Audit forecast judgment

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179 During the course of an audit, the auditor accumulates evidence that pro-
180 vides the basis for an imperfect forecast judgment of the clients viability. The
1
We assume the auditor can a priori identify clients in nancial distress. Within this subset of
high-risk clients, P B 0:5 might be reasonable.
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Fig. 1. Sequence of events given a forecast.
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Table 1
Summary of variables and parameters
Auditor payos
AFS $1:35 Present value of future quasi-rents anticipated from a surviving client.
AFB $0:00 Present value of future quasi-rents anticipated from a defunct client.
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D $0:05 Expected cost of client dismissal. This represents a reputational cost and
potential loss of the current years audit fee.
Ca $0:60 Cost of reputation damage and possible legal implications from incorrectly
issuing a going-concern report. Reputation damage would include the loss of
or decrease in fees from existing and prospective clients.
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Cb $0:80 Legal costs and reputation damage resulting from incorrectly issuing a
standard report when a going-concern report was appropriate.
Client payos
PV $0:90 Present value of future payos to the client from managing a surviving rm.
This encompasses managerial compensation including stock options,
increased reputation, and goodwill from managing a successful business.
L $0:70 Loss in benets to the client from receiving a going-concern report only when
the rm survives. This includes reductions in stock price, increased
probability of management takeover, and loss of reputation in the labor
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market.
SW $0:20 Transaction cost from auditor change. This includes both actual cost of
auditor change (switch) and the adverse reputational eect in nancial
markets.
Probabilities
P B 0:5 The prior probability of business termination known to both the incumbent
auditor and the client.
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e The probability a binary forecast received by the incumbent auditor is

incorrect. Let B denote business termination, S denote business survival, yB
denote a forecast suggesting business termination, and yS denote a forecast
suggesting survival. We assume PryS jB PryB jS e and
PryB jB PryS jS 1 e. In the experiment, the level of error in the
binary forecast is either high, eH 0:45 (in cells EH -NoSFP and EH -SFP), or
low, eL 0:35 (in cells EL -NoSFP and EL -SFP).
pClean 0:50 The probability that the alternative auditor will issue a clean opinion.
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pFail Generic term for the unperturbed posterior probability of business termi-
nation. That is, pFail may represent pBB PrBjyBB , pSB PrBjySB , or
pss PrBjySS , where pBB indicates the auditor combined two forecasts
yielding a joint forecast of business termination.
sf The perturbation in the posterior probability of business termination
induced by the self-fullling prophecy. In the experiment, the self-fullling
prophecy eect was either high, sf H 0:4 (in cells EL -SFP and EH -SFP), or
low, sf L 0 (in cells EL -NoSFP and EH -NoSFP).
psf The perturbed posterior probability of business termination, given a going-
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concern decision in conjunction with a self-fullling prophecy eect. In the

experiment, this probability is operationalized as
psf minf1; pFail sf H g minf1; pFail 0:4g.
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181 client knows the auditors forecast, y, as it seems reasonable that the auditor
182 would justify the appropriateness of a going-concern opinion to the client. On
183 the other hand, if the auditor intends to issue a clean opinion, the clients in-
184 formation set is irrelevant, as there is no reason to switch auditors.
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185 We combine two forecasts of S or B to generate three imperfect forecasts,
186 ySS , yBS , and yBB (labeled forecasts 1, 2, and 3, respectively), with ySS sug-
187 gesting client survival, yBB suggesting business termination, and yBS providing
188 a neutral middle case. 2 The neutral case depicts a challenging audit where the
189 auditors evidence cannot predict client survival. In such a setting, the auditor
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190 is more likely to manifest the eects of economic incentives and strategic
191 considerations. The forecast is imperfect because the two underlying forecasts
192 comprising it are inaccurate with probability e. We assume the underlying
193 forecasts are statistically independent, conditional on the true underlying
194 state.
195 One of the two treatments in the experiment is the level of forecast inac-
196 curacy. The level depends on the error in the binary forecasts and is either high,
197 eH 0:45, or low, eL 0:35. As dened in Table 1 and shown in Fig. 1, pfail
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198 denotes the generic posterior probability of business termination for a given
199 forecast. 3
200 3.3. Auditors reporting decision
201 Based on the auditors forecast, P B, the payos, the level of self-fullling
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202 prophecy eect, and an expectation of the clients response, the auditor pri-
203 vately expresses to the client an intention to render either a clean or going-
204 concern opinion. The computer network relays this intention, displaying it on
205 the clients computer screen.
206 The self-fullling prophecy eect occurs only if the client retains an auditor
207 who issues a going-concern opinion. Our model assumes that this eect in-
208 creases the probability of business termination to psf > pFail . The experiment
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209 operationalizes this increase in probability by increasing the self-fullling
2
This characterization also permits a test of a recent proposal by Weiss (2002) to the United
States Senate that called for three levels of going-concern report: (1) clean, (2) warning, and (3)
going-concern.
3
If the forecast inaccuracy is high, then the posterior probability of business termination, given
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forecast 1 (ySS ), is computed as follows:

P ySS jB e2H 0:452 0:2025 and P ySS jS 1 eH 2 0:552 0:3025
P ySS jBP B e2H P B
P BjySS 1
P ySS jB P B P ySS jSP S e2H P B 1 eH 2 1 P B
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Table 2
Probabilities of business termination given dierent levels of forecast noise
EL -NoSFP EL -SFP EH -NoSFP EH -SFP
P(Bjforecast) P(Bjforecast, GCR) P(Bjforecast) P(Bjforecast, GCR)
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Forecast 1 0.23 0.63 0.40 0.80
Forecast 2 0.50 0.90 0.50 0.90
Forecast 3 0.77 1.00 0.60 1.00
GCR auditor issues a going-concern report; B business termination; forecast 1 yss , forecast
2 yBS , and forecast 3 yBB ; EL -NoSFP: Low forecast error, no self-fullling prophecy; EL -SFP:
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Low forecast error, self-fullling prophecy; EH -NoSFP: High forecast error, no self-fullling
prophecy; EH -SFP: High forecast error, self-fullling prophecy.
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If the self-fullling prophecy eect is absent, then P(Bjforecast) is unaected by the auditors
report.
**
Given a self-fullling prophecy eect (sf H 0:4 in the experiment), P(Bjforecast,
GCR) P(Bjforecast 0:4, or 1, whichever is smaller, that is, with a self-fullling prophecy, the
self-fullling prophecy with sf sf H 0:4 implies that PBjforecast; GCR
minf1; PBjforecast 0:4g.
***
The computation of this probability is provided in Eq. (1) in footnote 3. The other
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P(Bjforecast) probabilities are computed similarly.
210 prophecy variable, sf, from sf L 0:0 to sf H 0:4. When the self-fullling
211 prophecy variable is set at sf H 0:4, P BjySS in Eq. (1) in footnote 3, will be
212 perturbed from 0.4 to 0.8. The generic perturbed probability, psf , is the smaller
213 of one or (pfail sf H ). 4
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214 The experiments four cells, EL -NoSFP, EL -SFP, EH -NoSFP, and EH -SFP,
215 result from crossing two levels of forecast inaccuracy (eL 0:35 or eH 0:45)
216 with the two levels of self-fullling prophecy eect (sf L 0:0 or sf H 0:4).
217 Subjects received the forecast number and the associated probability of busi-
218 ness termination reported in Table 2.
219 The auditors penalties for inaccurate reporting, Ca (i.e., penalty for incor-
220 rectly issuing a going-concern report) and Cb (i.e., penalty for incorrectly is-
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221 suing a standard report), promote error avoidance. Note that these payos
222 represent expected values. One interpretation of Ca and Cb is that Ca ($0.60)
223 includes a high probability of a relatively small penalty (e.g., loss of client fees),
224 and Cb ($0.80) includes a low probability of a large penalty resulting from an
225 audit failure.
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4
Characterizing the self-fullling prophecy eect as additive is useful for illustration and is
roughly consistent with the ndings of George et al. (1996); however, it is not suggested that it is
perfectly descriptive. A fruitful area for future empirical and analytical research is to dene more
precisely the functional form of the sf variable or, possibly, to create a model that endogenizes the
eect.
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226 Two incentives potentially decrease auditor objectivity. First, clean opinions
227 ensure that the auditor does not suer the expected cost of dismissal by the
228 client, D $0:05. Second, if the opinion tends to be self-fullling, rendering a
229 clean opinion makes it more likely that the auditor will receive audit fees from
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230 a surviving client (AFS $1:35) rather than from a defunct client (AFB $0).
231 AFS and AFB represent the present value of future quasi-rents anticipated from
232 a surviving and defunct client, respectively. However the client denes audit
233 quality, the AF variables reect the auditors reputation for delivering such
234 quality of service but do not include the expected long-term implications of this
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235 periods report.
236 3.4. The clients switching decision and the potential successor auditors decision
237 We assume the client becomes aware of the auditors intention in sucient
238 time to engage another auditor and thus prevent the incumbent auditors de-
239 cision from becoming public. 5 If the auditor declares the intention to render a
240 clean opinion, the game ends, as it is presumed that the client will retain the
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241 auditor. Otherwise, the client decides whether to accept the opinion and retain
242 the auditor or incur the cost to replace the auditor and obtain a second opinion
243 from an alternative auditor, played by the computer.
244 The clients strategy will depend on the auditors forecast, the switching cost
245 (SW $0:20), and the probability that an alternative auditor will issue a clean
246 opinion, pClean 0:5. 6 A surviving client must also consider the potential self-
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5
SAS No. 59 requires that auditors inquire with management regarding any mitigating factors
which would allow the company to remain a going concern, and SAS No. 100 requires that auditors
address the going concern issue when involved with interim reports.
Professional regulations (AICPA, 1986, 1997) and SEC 8-K (SEC FRR 34, 1989) requirements
to the contrary, in a high-risk audit situation, the client might act strategically to inhibit the free
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ow of information between auditors, possibly through threat of legal action (e.g., the Lincoln
Savings and Loan case (Knapp, 1996, pp. 5568)). Moreover, because the incumbent auditor does
not actually issue an opinion in our scenario, remaining silent entails less legal risk.
6
pClean 0:5 seems reasonable given that KPMG gave clean opinions on 57% of the publicly
listed companies they audited that went bankrupt (Weiss, 2002). Some of the justications for
modeling the second auditors decision as independent include: (1) The clients perception of nding
another auditor with dierent reporting behavior is overly optimistic. (2) Though the auditors
forecast is common knowledge, the client need not agree with the auditors perception. (3) The
client, now alert to the audit professions perspective, anticipates manipulating the evidence
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obtained by the successor auditor, (4) The client believes a subpopulation of auditors exist who lack
competence (i.e., ability, knowledge, work eort, audit approach) (Williams, 1988, pp. 243261; St.
Pierre and Anderson, 1984, pp. 242263), lack independence (Barnes and Huan, 1993, pp. 223
238), interpret subjective elements of the accounting standards dierently, or possess dierent risk
preference or marketing strategies, or (5) despite professional standards and SEC requirements to
disclose the reasons for the switch in an 8-K, a free ow of communication may not exist between
predecessor and successor auditors.
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247 fullling prophecy eect, the present value of managing a viable rm

248 (PV $0:90) and the cost (L $0:70) associated with erroneously receiving a
249 going-concern opinion from either the current or the successor auditor. If the
250 client terminates operations, the present value of future payos is normalized
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251 to zero (PV $0) for simplicity.
252 3.5. Payo distribution
253 At the conclusion of each game, the computer displays the payo screens,
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254 which convey all decisions made, the cash payo for the game, and the cu-
255 mulative cash payo totaling all completed games. Also displayed are the
256 random numbers generated to determine the clients outcome as well as the
257 outcome itself both before and after the self-fullling prophecy eect. Table 3
258 shows all possible cash payos for both players and panel C of Table 4 reports
259 the equilibrium predictions based on the parameters used in this study.
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260 4. Competing decision models
261 One objective of this research is to investigate the relative predictive power
262 of other decision models. Kachelmeier (1996) and Kachelmeier and King
263 (2002, pp. 219232) suggest that the benets of experimentation are more
264 fully tapped if one considers both the economic incentives of a strategic model
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265 and the behavioral forces that might challenge these incentives. To this end,
266 treatment manipulations and economic incentives were purposely not de-
267 signed to smother strong behavioral tendencies, which, though contrary to
268 equilibrium prediction, might reect behaviors exhibited by real world audi-
269 tors.
270 The rst four alternative decision models predict auditorclient behaviors
271 that are independent of treatment level or forecast type, as follows, where
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272 Going Concern indicates that the auditor intends to issue a going-concern
273 report:
Decision model Auditors opinion Clients decision

Loss avoidance Going concern Retain
Adversarial Going concern Switch
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Altruism Clean Retain

Risk seeking Clean Switch
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12

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R.R. Tucker et al. / Journal of Accounting and Public Policy xxx (2003) xxxxxx
Table 3
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Payo possibilities for both players
Failed Survived Failed Survived Failed Survived Failed Survived
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Auditors Report GCR Clean Clean GCR GCR GCR GCR GCR GCR
going-concern report
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Clients decision N/A N/A Switch Switch Switch Switch Retain Retain
New Auditors Report N/A N/A Clean Clean GCR GCR N/A N/A
Audit fee (AF)
Dismissal cost (D)
Cost of Type I error (C )
Cost of Type II Error (Cb )
Auditors cash payo
$0.00
)$0.80
)$0.80
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$1.35
$1.35
)$0.05
)$0.05
)$0.05
)$0.05
)$0.05
)$0.05
)$0.05
)$0.05
$0.00
$0.00
$1.35
)$0.60
$0.75
Clients cross payo (PV)
Cost of Auditors Type I Error (L)
$0.00 $0.90 $0.00 $0.90
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$0.00 $0.90
)$0.70
$0.00 $0.90
)$0.70
No. of Pages 33, DTD = 4.3.1

Switching cost (SW) )$0.20 )$0.20 )$0.20 )$0.20
Clients net cash payo $0.00 $0.90 )$0.20 $0.70 )$0.20 $0.00 $0.00 $0.20
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GCR auditor issues a going-concern report.
*
The probability of the clients outcome is aected by the audit report issued in the self-fullling prophecy cells EL -SFP and EH -SFP.
Table 4

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Optimal strategies and expected returns by forecast and cell
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Panel A: Expected returns for each strategy pair by forecast and cell
Forecast Auditor/client strategy EL -NoSFP EL -SFP EH -NOSFP EH -SFP
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Pair Auditor Client Auditor Client Auditor Client Auditor Client

1 Clean opinion 0.86 0.69 0.86 0.69 0.49 0.54 0.49 0.54
GCR-switch )0.05 0.22 )0.5 0.18 )0.5 0.13 )0.05 0.09
GCR-retain 0.58 0.15 0.28 0.07 0.45 0.12 0.15 0.04
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2 Clear opinion 0.28 0.45 0.28 0.45 0.28 0.45 0.28 0.45
GCR-switch )0.05 0.08 )0.05 0.03 )0.05 0.08 )0.05 0.03
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GCR-retain 0.38 0.10 0.08 0.02 0.38 0.10 0.08 0.02
3 Clear opinion )0.31 0.21 )0.31 0.21 0.06 0.36 0.06 0.36
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GCR-switch )0.05 )0.07 )0.05 )0.10 )0.05 0.02 )0.05 )0.02
GCR-retain 0.17 0.05 0.00 0.00 0.30 0.08 0.00 0.00
Panel B: Summary of the optimal strategies for the client receiving a going-concern opinion
Forecast EL -NoSFP EL -SFP EH -NOSFP EH -SFP
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1 Switch Switch Switch Switch
2 Retain Switch Retain Switch

3 Retain Retain Retain Retain
Panel C: Summary of the equilibrium auditor/client strategy pairs
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1 Clean Op. Clean Op. Clean Op. Clean opinion
2 GCR-Retain Clean Op. GCR-Retain Clean opinion
3 GCR-Retain GCR-Retain GCR-Retain Clean opinion
GCR auditor issues a going-concern report; EL -NoSFP: Low forecast error, no self-fullling prophecy; EL -SFP: Low forecast error, self-fullling
prophecy; EH -NoSFP: High forecast error, no self-fullling prophecy; EH -SFP: High forecast error, self-fullling prophecy.
Forecast 1 ySS , forecast 2 yBS , and forecast 3 yBB .
*
Nash equilibrium.
13
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276 The fth alternative decision model, follow the forecast, assumes subjects
277 base their decisions only on the forecast received, ignoring economic incen-
278 tives.
279 The loss avoidance and risk seeking models relax the game-theoretic
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280 models assumption that the players are risk neutral. The adversarial and
281 altruism decision models are motivated by prior experimental studies of
282 bargaining games (e.g., the Ultimatum and Dictator games (Boles et al.
283 (2000)) that nd that subjects do not act in the assumed egoistic manner.
284 Instead, they consider the other players outcomes. Moreover, apparent
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285 emotional reactions to perceived unfairness, altruism and retaliation, lead to
286 non-Nash solutions (Guth et al., 1982, pp. 367388; Forsythe et al., 1994, pp.
287 347369). Davis and Holt (1993) summarize the literature on Ultimatum and
288 Dictator games and conclude that strategic considerations do aect the rst
289 movers generosity, but they are not the whole story. This experiment bears
290 some similarity to the Ultimatum game in that the auditor has rst-mover
291 advantage and the client can retaliate at some cost by switching auditors,
292 suggesting that similar forces could aect the strategic interaction in this
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293 experiment.
294 Though the experimental treatments do not aect the predicted behavior of
295 these alternative decision models, the propensity to behave in the predicted
296 manner varies in intensity among the four cells in our experiment. Table 5
297 reports the intensity by designating (1) as the highest predicted average and (4)
298 as the lowest. For example, holding the noise level constant, the SFP makes a
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299 going-concern opinion more likely for an adversarial auditor and less likely for
300 a loss-avoiding auditor. For comparison, Table 5 includes the game-theoretic
301 predictions. The predicted client strategies presuppose that the auditor declared
302 an intention to issue a going-concern opinion because experimentally, the client
303 has no decision otherwise.
304 4.1. Loss avoidance

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305 Loss avoidance is a likely characterization of many real-world auditors

306 whose nancial and human capital are tied up in the rm and who do not
307 want to forfeit their investment in reputation by issuing an erroneous opinion.
308 Experimentally, subjects are uncertain regarding the other players utility
309 function, level of rationality, and decision model. This uncertainty in con-
310 junction with a strong desire to avoid losing money can lead some players to
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311 exhibit loss-avoiding behavior (Tversky and Kahneman, 1992). For simplicity,
312 suppose loss-avoiding subjects seek to minimize their maximum loss. We
313 develop the predictions for auditor and client using the following procedure:
314 (1) We predict that the auditor will avoid the largest absolute dollar loss
315 ()$0.80) in Table 3 by always expressing a going-concern opinion. Similarly,
316 upon receiving a going-concern opinion, clients retain the auditor, as
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Table 5
Predictions of auditor and client behavior by cell and decision model
Game Theory Loss avoidance Risk seeking Adversarial Altruism
Forecast 1
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Auditor
EL -NoSFP Clean(2) GC(3) Clean(2) GC(2) Clean(2)
EL -SFP Clean(1) GC(4) Clean(1) GC(1) Clean(1)
EH -NoSFP Clean(4) GC(1) Clean(4) GC(4) Clean(4)
EH -SFP Clean(3) GC(2) Clean(3) GC(3) Clean(3)
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Client
EL -NoSFP Switch(2)a Retain(3) Switch(2) Switch(1) Retain(1)
EL -SFP Switch(1)a Retain(4) Switch(1) Switch(3) Retain(3)
EH -NoSFP Switch(4)a Retain(1) Switch(4) Switch(2) Retain(2)
EH -SFP Switch(3)a Retain(2) Switch(3) Switch(4) Retain(4)
Forecast 2
Auditor
EL -NoSFP GC GC(1) Clean(2) GC(2) Clean(2)
TED
EL -SFP Clean GC(2) Clean(1) GC(1) Clean(1)
EH -NoSFP GC GC(1) Clean(2) GC(2) Clean(2)
EH -SFP Clean GC(2) Clean(1) GC(1) Clean(1)
Client
EL -NoSFP Retainb;a Retain(1) Switch(2) Switch(1) Retain(1)
EL -SFP Switcha Retain(2) Switch(1) Switch(2) Retain(2)
EH -NoSFP Retaina Retain(1) Switch(2) Switch(1) Retain(1)
EH -SFP Switcha Retain(2) Switch(1) Switch(2) Retain(2)
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Forecast 3
Auditor
EL -NoSFP GC(1) GC(1) Clean(4) GC(4) Clean(4)
EL -SFP GC(2) GC(2) Clean(3) GC(3) Clean(3)
EH -NoSFP GC(3) GC(3) Clean(2) GC(2) Clean(2)
EH -SFP Cleanb GC(4) Clean(1) GC(1) Clean(1)
COR
Client
EL -NoSFP Retain(1)a Retain(1) Switch(4) Switch(2) Retain(2)
EL -SFP Retain(2)a Retain(2) Switch(3) Switch(4) Retain(3)
EH -NoSFP Retain(3)a Retain(3) Switch(2) Switch(1) Retain(1)
EH -SFP Retain(4)a Retain(4) Switch(1) Switch(3) Retain(4)
GC Going-concern opinion; (1) highest predicted average for all cells; (2) second highest, etc.
a
Predictions of client switching behavior presume the auditor expressed a going concern opinion.
b
Rankings are not given because the decision makers strategy changes across cells.
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317 switching exposes them to the largest absolute dollar loss of )$0.20. (2) Given
318 the decision and forecast, we use panels A and B of Table 4 to rank the
319 desirability of the decision across cells. (3) If two cells have identical expected
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320 returns, we break the tie by minimizing the opportunity loss of this decision
321 versus the alternative anticipating the other partys trembling hand. 7
322 4.2. Risk seeking
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323 Audit failures sometimes result from risk seeking behavior by auditors as
324 well as clients. Audit partners, such as Jose Gomez in the ESM Government
325 Securities case (Knapp, 2001, pp. 1528) or David Duncan and Joseph Ber-
326 ardino in the Enron case (CNN/Money, 2002) were aware of the risks to their
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327 careers and their rms reputations, yet they accepted those risks. Even if less
328 common, risk-seeking behavior warrants consideration because it could lead
329 an auditor to underweight the consequences of an audit failure and emphasize
330 the gains (e.g., higher audit and consulting fees, status in rm) derived from
331 accepting the client-preferred position. For simplicity, we assume the risk-
332 seeking individual always prefers the decision that makes possible the largest
333 payo. Consequently, regardless of forecast, the auditor always prefers to
334 express a clean opinion, and the client who receives a going-concern opinion
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335 always switches auditors (see Table 3). 8
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7
In this case, the auditors opportunity loss is the dierence between the auditors expected
returns for (1) expressing a clean opinion and being retained and (2) expressing a going concern
opinion and being retained or replaced in accordance with the clients assumed decisions. For
example, if the auditor receives forecast 2 and the client responds as indicated in panel B of Table 4,
then the auditors opportunity loss for cell EL -NoSFP is 0:28 0:38 0:10, since the clients
optimal strategy is to retain. However, in cell EL -SFP, the client nds switching optimal; thus, the
opportunity loss is much higher 0:28 0:05 0:33. No further criterion exists to break the
COR
ties because both NoSFP cells, EH -NoSFP and EL -NoSFP, provide identical expected returns, as
do the two SFP cells.
The rankings for all forecasts are determined with similar logic. For forecast 1, we use this
procedure and nd that the EL cells are tied 0:86 0:05 0:91 and EH cells are tied
0:49 0:05 0:54. In contrast to the forecast 2 situation, we are able to use a further pro-
cedure to distinguish between the tied cells (NoSFP and SFP), given the forecast inaccuracy. We
assume that some clients exhibit a trembling handthat is, upon receiving a going concern
opinion, they will retain the auditor at least some of the time. Alternatively, we can assume that the
loss-avoiding auditor perceives the client to be like-minded, and therefore the client seeks to avoid
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the loss of $0.20 that results only if they switch (see Table 3). For example, in the forecast 1 case, the
opportunity loss would be 0:86 0:58 $0:28 for cell EL -NoSFP and 0:86 0:28 0:58 for
cell EL -SFP.
8
If the auditor were to express a clean opinion, of course the client would prefer to retain;
however, experimentally, the client makes decisions only if the auditor expresses a going concern
opinion. Consequently, our prediction of client behavior is that they will switch auditors, making
possible the $0.70 payo (Table 5).
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336 4.3. Adversarial decision model
337 Subjects might engage in adversarial play if they hold the other player ac-
338 countable, perceive the other player to be unfair or insensitive to their out-
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339 come, or seek to deter unwanted behavior. In general, an auditor who wishes to
340 hurt the client will propose a going-concern opinion and the clients retaliates
341 by switching auditors. More emotional play is anticipated in the self-fullling
342 prophecy cells because the auditors decision aects the clients outcome.
343 Though curtailed by recent legislation, clients still can penalize the auditor by
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344 declining to purchase non-audit services as well. This partial loss of potentially
345 lucrative fees would allow the client to apply pressure on an on-going basis.
346 Loss-avoiding and adversarial auditors both choose to express going-con-
347 cern opinions regardless of forecast type (see Table 5). However, the experi-
348 mental treatments have the opposite eect on their level of desire. The SFP
349 only makes the adversarial auditor more likely to give a going-concern opinion
350 because it causes greater loss to the client (see Table 4). Like the risk-seeking
351 client, the adversarial one always prefers to switch auditors in the face of a
TED
352 going-concern opinion. However, the criteria used to arrive at the decision rule
353 dier, and the models predict dierent levels of enthusiasm for the decision rule
354 across cells (see Table 5). For example, the adversarial clients desire increases
355 when (1) no SFP exists and (2) forecast error is low for forecast 1 or high for
356 forecast 3. 9
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357 4.4. Altruistic decision model
358 Other subjects may consider the other players welfare but act altruistically.
359 In the real world, clients are under no professional duty to remain independent
360 of their auditor and frequently choose auditors who they know and like. As
361 auditor tenure lengthens and the client hires professionals from their audit rm
362 (e.g., Enron), this bond can deepen. Becker (1976) and Farnell (2002) provide
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363 several reasons why altruism, helping another at a cost to oneself, persists in
364 equilibrium in the survival of the ttest. Like the risk-seeking auditor, the al-
9
We determined these predictions by evaluating the most negative eect on the other player
according to the expected returns in Table 4. If the negative eect on the auditors expected returns
was the same for two cells, then the clients level of desire was determined by his own expected
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return. Consider the clients ranking of this strategy for forecast 3 (i.e., 2, 4, 1, 3) in Table 5. The
auditors economic expected loss should the client switch rather than retain is
0:17 0:05 0:22 in cell EL -NoSFP, 0 0:05 0:05 in cell EL -SFP,
0:30 0:05 0:35 in cell EH -NoSFP, and 0 0:05 0:05 in cell EH -SFP. One rationale
for behaving adversarially is to motivate the opponent to change strategies. Though the same loss is
meted out in cells EH -SFP and EL -SFP, the adversarial client prefers EH -SFP because it is more
likely the auditor will change strategy since changing would increase the auditors expected return.
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365 truistic auditor will always give a clean opinion, and the altruistic client will
366 always retain the auditor. However, the altruistic auditors preference for this
367 decision strategy (see Table 5) depends on the strategys eect on the clients
368 expected returns. Specically, this desire increases if the SFP exists or if fore-
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369 cast 3s error is high.
370 The altruistic client always retains the auditor, thus enabling the auditor to
371 avoid the sure loss stemming from dismissal. To the extent the clients consider
372 their own payo in addition to the auditors, retention is more likely in cells
373 without the SFP and, in the case of forecast 3, when the forecast error is high.
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374 4.5. Follow the forecast
375 A nal decision model captures the behavior of a highly professional auditor
376 or one that is naive. Specically, the model assumes subjects do not base their
377 reporting judgments on economic incentives and strategic consequences in their
378 reporting judgments, but rather, merely follow the forecast. That is, if the
379 forecast predicts that the client will terminate operations, the auditor expresses
TED
380 a going-concern opinion. Conversely, if the forecast predicts survival, the au-
381 ditor expresses a clean opinion. Finally, when the forecast is neutral, the au-
382 ditor randomizes between clean and going-concern opinions, which we dene
383 as a reporting average between 0.4 and 0.6 (where 1 clean opinion and
384 0 going-concern opinion).
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385 5. Hypotheses
386 5.1. Self-fullling prophecy
387 H1 and H2 test the eect of the self-fullling prophecy (SFP) on the initial
COR
388 auditors reporting decision and on the clients decision to switch auditors.
389 Three cell-to-cell comparisons of equilibrium predictions, 10 reported in panel
390 C of Table 4, form the basis for testing H1. Forecast 2 provides two contrasts.
391 The auditor expresses an intention to issue a going-concern opinion in the no-
392 SFP cells, EL -NoSFP and EH -NoSFP, but expresses a clean opinion in the SFP
393 cells, EL -SFP and EH -SFP. Similarly, in the high forecast error condition for
394 forecast 3, the auditor expresses a going-concern opinion in EH -NoSFP and a
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395 clean opinion in EH -SFP. These three contrasts form the basis for H1. If any
10
The equilibrium predictions are based on the experiments operationalizing the self-fullling
prophecy eect by increasing the self-fullling prophecy variable, sf, from 0 to 0.4. If
sf sf H 0:4, then the generic perturbed probability is the smaller of one or (pFail sf H ), that
is, the smaller of one or psf . The variable sf corresponds to psf pFail .
ARTICLE IN PRESS
396 auditors manifest altruistic or risk-seeking behavior (i.e., expresses clean

397 opinions) in NoSFP cells or loss avoidance and adversarial behavior (i.e., ex-
398 presses going-concern opinions) in SFP cells, then this will mute the eect of
399 the SFP.
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H1: The auditor will express more clean opinions when a going-concern opin-
ion contributes to a self-fullling prophecy (sf H 0:4) than when it does
not (sf L 0:0).
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403 In general, increases in the self-fullling prophecy variable (sf H ) make it
404 more likely the client will switch auditors. Referring to Eq. (A.1) in the ap-
405 pendix, as psf increases, p^clean decreases under the reasonable condition that the
406 clients expected return from operating a surviving company exceeds the ex-
407 pected loss resulting from receiving a going-concern opinion, that is, PV > L, a
408 condition that holds in this experiment ($0.90 > $0.70). Further, as p^Clean de-
409 creases, it is less likely that the condition for auditor retention, pClean < p^Clean ,
410 will hold. Of course, the auditor forms rational expectations about the clients
TED
411 decision and can avoid dismissal by expressing a clean opinion. For the pa-
412 rameters in this experiment, the client is not predicted to switch in equilibrium
413 (see panel of Table 4). However, if other players employ a dierent decision
414 model, then the players best response is to play o-equilibrium also. For ex-
415 ample, consider the clients optimal strategies in panels A and B of Table 4. For
416 forecast 2, if the auditor expresses a going-concern opinion, the clients optimal
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417 response is to switch auditors in the SFP cells, but retain them in the NoSFP
418 cells. These two contrasts in predictions form the basis for H2.
419 On the contrary, if subjects exhibit loss avoidance or altruism, then they will
420 always retain the auditor despite the SFP eect. In addition, clients playing
421 adversarial or risk-seeking strategies will switch even when no SFP eect exists.
422 Consequently, the manifestation of these alternative decision models will work
423 for the null hypothesis and against the alternative stated below.
COR
H2: Given that the auditor expresses a going-concern opinion, the client will
switch auditors more often when such an opinion contributes to a self-ful-
lling prophecy (sf H 0:4) than when it does not (sf L 0:0).
427 5.2. Noise

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428 The purpose of H3 below is to investigate the eect of forecast noise on the
429 auditors reporting decision. In general, as noise increases, the auditor ex-
430 presses fewer going-concern opinions because noise lowers the posterior
431 probability of business termination (pFail ) making it less likely that expression
432 (A.2) will hold. Intuitively, with less precise evidence, the auditors decision
433 process might be more inuenced by economic incentives. For forecast 3, the
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434 contrast between the equilibrium predictions in cells EL -SFP (going-concern

435 opinion) and EH -SFP (clean opinion), found in panel C of Table 4, form the
436 basis for testing H3. Regardless of treatment, auditors exhibiting loss avoid-
437 ance or adversarial behavior would always express a going-concern opinion,
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438 whereas altruistic or risk-seeking auditors would express a clean opinion.
439 Consequently, these competing predictions work against H3 stated below:
H3: The auditor will issue more going-concern opinions as the forecast error
decreases.
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442 5.3. Strategic dependence
443 Bloomeld (1997) nds that players have more diculty determining their
444 optimal strategies when the optimality of their decision is highly dependent on
445 the other players decision. Such a situation exists in this experiment, moti-
446 vating H4. For forecasts 2 and 3, when forecasts are inaccurate and the self-
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447 fullling prophecy is in eect, the auditor and client have much higher expected
448 returns if they cooperate (clean opinion-retain) than if they do not (going-
449 concern-switch). Bloomeld nds that both auditor and manager play farther
450 from equilibrium when strategic dependence is greater. We measure the dis-
451 tance between the equilibrium or comparative static prediction and the audi-
452 tors and clients decisions and then compare this measure for the cells with the
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453 lowest (EL -NoSFP) and highest strategic dependence (EH -SFP). We compute
454 this distance by subtracting the analytical models prediction (1 clean;
455 0 going-concern; 1 switch; 0 retain) from each subjects average to cal-
456 culate a revised average.
H4: Auditor reporting averages and client switching averages will be farther
from predicted when strategic dependence is high than when it is low.
COR
459 6. Subjects and experimental procedures
460 The subject pool consisted of 160 students at a large Midwestern university.
461 For each of the four experimental cells, we conducted a 212-h session with a
462 cohort of 10 subjects (ve assigned to the auditors role and ve to the clients
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463 role). After completing a subject consent form, subjects received the written
464 instructions, which the experimenter read aloud. After answering clarifying
465 questions, the experimenter administered a pre-experiment questionnaire to
466 test the subjects understanding of the instructions and to correct any re-
467 maining misconceptions. Roles were rotated during the two practice sequences
468 of 25 games, and no cash was paid. In all other respects, these practice rounds
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469 were identical to the subsequent 30-game experimental sequence. Subjects

470 played the same role throughout the experimental sequence but were randomly
471 re-paired with someone playing the opposite role at the beginning of each
472 game. Through a post-experiment questionnaire, subjects provided demo-
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473 graphic data and described their thought processes.
474 The experimenter guaranteed that no one would owe the experimenter
475 money. Endowments of $2.40 for auditors and $0.60 for clients were therefore
476 given at the beginning of the sequence. Payos for the session ranged from
477 $3.75 to $23.50. These payos and the expected payos from each decision
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478 were deemed sucient to make the incentive salient to subjects and to domi-
479 nate inconsequential, non-economic inuences.
480 7. Experimental results
481 Several measures were taken to promote independence among the 30 peri-
482 ods of the experimental sequence so as to more closely mirror the models
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483 single period structure. Nonetheless, for the purpose of statistical analysis, we
484 dene an independent observation as a subjects average response during the
485 30-period sequence. Because each auditor encounters several realizations of
486 forecast 1, 2, and 3 during the sequence, each has 3 averages. For each forecast,
487 we base our analysis of auditor reporting on 80 observations (20 subjects 4
488 cells). The client was able to respond only when the auditor expressed a going-
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489 concern opinion. For forecast 1, only 41 auditors expressed going-concern

490 opinions; consequently, we obtained only 41 switching averages. Eighty
491 switching averages are available for forecasts 2 and 3.
492 To measure the strength of the treatment eects and their interaction, we
493 model subject behavior using regression and two sample comparison t-tests
494 and report the results in Table 6. The non-parametric MannWhitney tests
495 generated similar results, and the interaction terms were not signicant and
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496 therefore are not reported. Table 7 shows reporting and switching averages and
497 provides statistics on the number of subjects playing pure or randomized
498 strategies. To detect any learning or other behavioral changes during the 30-
499 game sequence, we divided the data into two 15-game periods and re-ran all
500 statistical tests. The tests revealed no period eect. Tables of individual subject
501 behavior are available from the authors by request.
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502 7.1. Hypotheses H1 and H2: the self-fullling prophecy eect
503 We rst consider forecast 3. The results reported in Tables 6 (panel A) and 7
504 support hypothesis H1, which predicts that, in equilibrium, auditors form
505 fewer going-concern opinions when issuing such an opinion increases the
506 prospect of client demise. The SFP eect and the concurrent potential loss of
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Table 6
Regression results on client switching and auditor reporting
Panel A: Auditor Reporting Model
Reporting average b0 b1 Forecast inaccuracy b2 self-fulfilling prophecy e
where: high (low) forecast inaccuracy cells were coded 1 (0), sf H 0:4 (sf L 0) cells were
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coded 1 (0), and clean (going-concern) opinions were coded 1 (0).
Forecast 3 Data
Expected sign Coecient t-Statistic Signicance level
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Intercept 0.15 3.93 0.000
Forecast inaccu- + )0.001 )0.01 0.99
racy
Self-fullling + 0.078 1.74 0.04
prophecy
Panel B: Client Switching Model

Switching average b0 b1 Forecast inaccuracy b2 self-fulfilling prophecy e
where switching (retaining) decisions were coded 1 (0)
TED
Forecast 2 Data
Intercept 0.35 5.66 0.000
Forecast inaccu- 0.05 0.77 0.44
racy
Self-fullling + 0.13 1.92 0.03
prophecy
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Forecast 3 Data
Intercept 0.17 3.76 0.000
Forecast inaccu- 0.19 3.76 0.000
racy
Self-fullling 0.02 0.43 0.66
prophecy
COR
The data upon which the client switching averages are based were gathered by auditor rather than
by client. The coecients of regressions for the auditor or client observing Forecast 1 or auditors
observing Forecast 2 are not statistically signicant nor are any interaction terms; consequently,
these are not reported.
*
p-value based on a one-tailed test.
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507 the engagement and audit fees cause the auditor to express a clean opinion,
508 though the auditors evidence (i.e., forecast 3) suggests client bankruptcy.
509 Specically, a t-test of the reporting averages for forecast 3 between the high
510 error cells, EH -NoSFP 0.13 and EH -SFP 0.28 (see Table 7), revealed a
511 signicant dierence in the predicted direction p 0:02, that is, an increase in
512 the SFP increased the dependent variable, percentage of clean opinions.
JPP 6119
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Table 7
Auditor reporting and client switching behavior
COR
Cell Auditor Client
Number with a pure strategy Reporting Number with a pure strategy Randomized Switching
average average
GT GC Clean FTF GT R SW
Forecast 1
EL -NoSFP
EL -SFP
16
12
0
0
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16
12
16
12
0.93
0.88
3
7
3
2
3
7
0
1
0.60
0.82
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EH -NoSFP 13 0 13 13 0.90 4 5 4 1 0.38
EH -SFP 13 1 13 12 0.82 6 4 6 5 0.52
Forecast 2
EL -NoSFP
EL -SFP
EH -NoSFP
EH -SFP
0
1
0
3
0
0
0
0
3
1
1
3
2
4
3
3
TED
0.65
0.64
0.66
0.64
7
4
4
5
7
7
4
4
5
4
4
5
8
9
12
11
0.40
0.44
0.37
0.59
Forecast 3
EL -NoSFP 7 7 0 7 0.17 11 11
PRO 1 8 0.19

EL -SFP 9 9 0 9 0.21 9 9 0 11 0.17
EH -NoSFP 9 9 0 9 0.13 8 8 0 12 0.34
OF
EH -SFP 0 5 0 5 0.28 6 6 1 13 0.40
Clean Clean opinion; GC Going-concern Opinion; SW Switch auditors; R Retain auditor; GT Game Theoretic Decision Model; Ran-
domized Randomized strategy; FTF Follow the Forecast Model; (1) highest predicted average for all cells; (2) second highest predicted average
for all cells, etc.
*
Auditor reporting average assumes 1 Clean opinion and 0 going-concern opinion.
**
Client switching average assumes 1 Switch auditors and 0 retain the auditor.
23
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513 Moreover, the percentage of clean opinions for the SFP cells (EL -SFP (0.21)
514 and EH -SFP (0.28)) was signicantly higher than in the NoSFP cells (EL -
515 NoSFP (0.17) and EH -NoSFP (0.13)) (i.e., SFP 0:245 > NoSFP 0:15, at
516 p 0:04). These results support H1. Still, the reporting averages for cells EL -
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517 NoSFP, EL -SFP, EH -NoSFP, and EH -SFP (i.e., 0.17, 0.21, 0.13, and 0.28)
518 varied considerably from the models equilibrium point predictions (0, 0, 0, 1,
519 respectively). The predicted behavior overshoots the mark in anticipating the
520 extent to which auditors will succumb to client pressure. Krishnan et al. (1996)
521 nd empirical evidence that auditors treat switchers more conservatively in
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522 issuing an audit opinion. The alternative decision models investigated provide
523 a potential explanation for Krishnans nding and for the dierence between
524 predicted and actual behavior, particularly the disparity in EH -SFP.
525 Of the decision models proposed, more auditors displayed a pure strategy
526 consistent with loss avoidance or adversarial models than that of the game-
527 theoretic model, as seen by comparing the number of going-concern and clean
528 opinions to the models predictions in Table 7. Given the pattern of going-
529 concern averages across cells, this seems driven more by loss aversion than by
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530 an adversarial strategy. Though no auditor chose altruism or risk seeking as a
531 pure strategy, 10 auditors had reporting averages of 0.5 or higher (1 clean;
532 0 going-concern) and 50 of the 80 were non-zero. Moreover, ve of these 10
533 were in cell EH -SFP, the cell in which the model predicted clean opinions. Also
534 note that the number of clean opinions expressed in cell EH -SFP may have been
535 further suppressed by the aggressive switching behavior of clients (pre-
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536 dicted 0, actual 0.4, where 1 switch and 0 retain). Future experiments
537 that allow repeated play, face-to-face contact, longer periods of interaction,
538 and elements of cooperation could increase the probability of observing al-
539 truistic behavior.
540 For forecast 2 data, the auditors reporting average was nearly identical
541 across cells (0.65). Therefore, the main eect and two simple eects were not
542 signicant and do not support H1. Before concluding complete absence of a
COR
543 treatment eect, one needs to examine the clients behavior and consider the
544 interactive nature of the game. Note that forecast 2 implies a 50% probability
545 of business termination (without a SFP eect) across all cells. Without an in-
546 formative forecast, auditors were more susceptible to other inuences such as
547 client pressure, economic incentives, and concern for others welfare.
548 To consider the eect of client pressure, rst examine Fig. 1 and the audi-
549 tors expected returns reported in panel A of Table 4 for the non-SFP cells (EL -
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550 NoSFP and EH -NoSFP) given forecast 2. These expected returns hold in
551 equilibrium if the client retains the auditor. However, as seen in Table 7, the
552 forecast 2, NoSFP switching average of 39% diers from the equilibrium
553 prediction of 0%. Since this switching average was relatively constant
554 throughout the sequence, it is reasonable that auditors held this expectation of
555 client behavior. Given the clients behavior and the expected return alternatives
ARTICLE IN PRESS
556 found in panel A of Table 4, the non-aggressive auditor would be better o

557 expressing a clean rather than a going-concern opinion in the NoSFP cells
558 because this provides the greater expected return of 0:28 > 0:21
559 0:050:39 0:380:61, where 0.21 is the expected return from declar-
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560 ing an intention to express a going-concern opinion based on the probabilities
561 in the experiment. 11 Consequently, the auditors departure from equilibrium
562 play in the NoSFP cells (65.5% actual versus 0% clean opinions predicted) can
563 be interpreted in two ways: (1) as a rational response to o-equilibrium, ag-
564 gressive switching behavior by the client, and/or (2) as auditor altruism or risk-
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565 seeking. Few auditors adopted a pure strategy; however, all eight that did
566 followed strategies consistent with altruism or risk seeking (see Table 7). The
567 risk-seeking model seems more apt, for if the auditors had been altruistic, one
568 would expect a similar number of subjects manifesting this behavior across
569 forecast levels. Instead, Table 7 reports that the numbers of subjects adopting a
570 pure strategy of clean opinions were 54, 8, and 0 for forecast 1, 2, and 3, re-
571 spectively, which reects reasoning mindful of strategic self-interest.
572 Relative to the equilibrium prediction, we observe an excess of clean opin-
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573 ions in cells without the self-fullling prophecy due to the realization and
574 anticipation that clients would act adversarially, and a shortage of clean
575 opinions in cells with the self-fullling prophecy due to loss avoidance or ad-
576 versarial play by auditors. Considering that the reporting average in all cells
577 was approximately 0.65, it would seem that the naive follow-the-forecast
578 model, which predicts reporting averages between 0.4 and 0.6 for forecast 2,
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579 would be most predictive. However, although most auditors randomized their
580 strategies, they tended to favor one opinion over the other. As a result, only
581 15% of the reporting averages fell between 0.4 and 0.6. Though the forecasts
582 were highly signicant in predicting aggregate reporting behavior, the follow-
583 the-forecast model provides little additional explanation or understanding of
584 individual behavior. Studying the audit reports of public companies, Weiss
585 (2002) also found a dramatic dierence in individual audit rm performance
COR
586 in alerting investors to bottom-line problems.

587 We can also examine the clients response to the o-equilibrium play of the
588 auditors. Consider hypothesis H2. In the case of forecast 2, clients anticipating
589 a going-concern opinion will switch auditors in the SFP cells (cells EL -SFP and
590 EH -SFP) but will retain otherwise (see Table 4). The regression results in panel
591 B of Table 6 support hypothesis H2. Clients switched auditors more frequently
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11
Using this probability and the auditors expected returns for GCR-switch and GCR-retain with
forecast 2 in panel A of Table 2, an auditors expected return from declaring an intention to express
a going-concern opinion was ((expected return from replacement)(probability the client will
switch) + (expected return from retention)(probability the client will retain the audi-
tor)) (()0.05)(0.39) + (0.38)(1)0.39)) 0.2123.
ARTICLE IN PRESS
592 in SFP cells than in non-SFP cells (also see Table 7; SFP 0.515 (0.44 +
593 0.59)/2 > NoSFP 0.385 (0.40 + 0.37)/2, at p 0:03). Note that it is largely
594 the simple eect of the SFP when the forecast error is high that drives this
595 result (EH -SFP 0:59 > EH -NOSFP 0:37 at p < 0:001).
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596 In conclusion, the SFP eect did aect subject behavior. With forecast 3, the
597 self-fullling prophecy led auditors to express more clean opinions to avoid the
598 loss of clients and client fees, thus supporting hypothesis H1. However, with
599 forecast 2, auditors did not respond to the SFP as predicted. Thus, the second
600 test of H1 failed to reject the null. One explanation is that clients were more
PRO
601 aggressive in switching auditors than predicted in the no-SFP cells (cells EL -
602 NoSFP and EH -NoSFP). Consequently, the auditor expressed more clean
603 opinions in these cells as a rational response to the o-equilibrium play of the
604 client, an eect possibly reinforced by auditor risk seeking. Clients switched
605 auditors more frequently when going-concern opinions were self-fullling, and
606 this eect was strongest in the high-forecast-error cells. This result supports
607 hypothesis H2. It also suggests that clients facing the SFP are more likely to
608 switch auditors if they perceive that support for the auditors opinion is weak.
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609 7.2. Hypothesis H3: accuracy of audit forecasts of clients business termination
610 Hypothesis H3 predicts that the auditor will issue more clean opinions when
611 the support for the opinion is weaker, that is, when the forecast is more in-
612 accurate. This did not occur. On average, forecast inaccuracy did not lead
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613 auditors to express more of the client-preferred clean opinions.

614 For forecast 2, forecast accuracy is irrelevant because it is non-predictive,
615 implying a 50% probability of business termination across all cells; conse-
616 quently, the investigation of the eects of forecast inaccuracy focuses on
617 forecast 3 data. The analytical model predicts that auditors will express more
618 clean opinions when forecasts are inaccurate. As reported in Table 7, the dif-
619 ference between the reporting averages for cells EL -SFP and EH -SFP (0.21 and
COR
620 0.28) was not signicant (p 0:25); consequently, hypothesis H3 is not sup-
621 ported. The average of clean opinions for cell EH -SFP, though nominally
622 higher than for cells EL -SFP and EH -NoSFP in the predicted direction, is at
623 some distance from the predicted equilibrium (EH -SFP 0.28 versus 1.00
624 predicted) and deserves some explanation.
625 Many subjects exhibited loss avoidance. As reported in Table 7, 30 of the 80
626 auditors played a pure strategy of always expressing a going-concern opinion
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627 upon observing forecast 3. The auditors pattern of reporting averages across
628 cells is more consistent with the intensities predicted for loss avoidance than for
629 adversarial play. Also, written responses from the post-experiment question-
630 naires and feedback from discussions with subjects during the post-experiment
631 debrieng period suggest that several subjects played to avoid large losses.
ARTICLE IN PRESS
632 Loss avoidance could mute the eect of the treatments in cell EH -SFP in the
633 following manner. If the auditor expresses the non-equilibrium going-concern
634 opinion, the deepest downside risk is )$0.05, if dismissed by the client. On the
635 other hand, expressing a clean opinion exposes the auditor to a downside risk of
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636 )$0.80. Though the auditors expected return from expressing a clean opinion
637 ($0.06) exceeds that for a going-concern opinion ($0), a loss avoiding subject
638 might prefer to express a going-concern opinion and avoid the larger downside
639 risk. Analogizing to the professional setting, risk-averse auditors would forego
640 higher expected returns and would not yield to client pressure but would express
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641 a going-concern opinion if their evidence suggested it was appropriate.
642 The client equilibrium behavior in the experiment was not expected to be
643 aected by forecast 3s accuracy. However, clients did switch auditors more
644 aggressively in high-error cells. As Table 7 reports, the combined switching
645 average for the low-error cells (the average of EL -NoSFP (0.19) and EL -SFP
646 (0.17)), is less than that for the high-error cells (EH -NoSFP (0.34) and EH -SFP
647 (0.40))(low error 0.18 < high error 0.37; p < 0:001 in a two-tailed test). The
648 eect was also strong for both contrasts: EL -NoSFP 0:19 < EH -NoSFP
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649 0:34 (p 0:03) and EL -SFP 0:17 < EH -SFP 0:40 (p < 0:01), where both
650 are two-tailed tests.
651 The model aids in explaining these results. Panel A of Table 4 permits a
652 comparison between the low- and high-error cells for forecast 3. Specically,
653 the expected returns were lower (i.e., )0.07 and )0.10 versus 0.02 and )0.02)
654 and the opportunity loss higher (i.e., 0.12 and 0.10 versus 0.06 and 0.02, re-
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655 spectively). As the model predicted, most clients did not switch auditors.
656 However, for those that did, the pattern of switching averages across cells most
657 closely resembles the ranking predicted by the risk-seeking model. Conse-
658 quently, given some risk seeking or o-equilibrium play by subjects, we would
659 expect less auditor switching in cells with low forecast error.
660 7.3. Hypothesis H4: strategic dependence

COR
661 We nd strong support for hypothesis H4 in that auditors and clients de-
662 cisions were generally much farther from equilibrium when strategic depen-
663 dence was high than when it was low. We computed a measure of the distance
664 of each subjects average from that predicted by the analytical model. We
665 performed t-tests comparing the overall revised averages for the high-strategic-
666 dependence cell (i.e., EH -SFP) with that in the low-strategic-dependence cell
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667 (i.e., EL -NoSFP). The t-tests for both auditor and client strategic dependence
668 using forecast 3 data were highly signicant. Forecast 1 data were sparse for
669 clients, so the test was run only on auditor data and was signicant (p 0:04).
670 The results for forecast 2 were mixed. The auditors results did not support
671 strategic dependence and the client results were only partially supportive. One
672 explanation is that the forecast error did not change, thus reducing the level in
ARTICLE IN PRESS
673 strategic dependence. When the No-SFP cell data were pooled with the SFP
674 cell data for forecast 2, the test for strategic dependence was marginally sig-
675 nicant (p 0:06). Awareness that the auditors expected return is quite de-
676 pendent on the clients decisions forewarns the profession of the heightened
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677 need for professional skepticism in high-strategic-dependence situations.
678 8. Conclusions
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679 This paper uses experimental economic methods to investigate the relative
680 predictive power of a game-theoretic model vis-a-vis other decision models,
681 namely loss avoidance, risk seeking, adversarial, and altruistic. The game-
682 theoretic model analyzes the strategic interaction between the auditor and a
683 risky client when the auditor chooses whether to express a going-concern
684 opinion and the client decides whether to switch auditors. We investigate the
685 eects of the self-fullling prophecy and the reliability of the auditors forecast
686 of client viability on the decisions of both auditor and client. We also tested
TED
687 Bloomelds (1997) hypothesis that strategic dependence leads subjects to play
688 farther from equilibrium.
689 Our experimental results indicate that both auditor and client decisions are
690 aected by the self-fullling prophecy eect, but depend on the nature of the
691 auditors evidence. When the auditors evidence provided a non-informative
692 prediction about client viability, the self-fullling prophecy eect manifested
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693 itself through the behavior of the client rather than that of the auditor. In
694 contrast, when informative evidence suggested business termination, clean
695 opinions occurred more frequently in cells with the self-fullling prophecy than
696 without it, but occurred far less frequently than the game-theoretic model
697 predicted. The loss avoidance model aids in explaining this result. Most au-
698 ditors chose not to cave in by giving the client-preferred clean opinion, thus
699 demonstrating a willingness to sacrice expected returns in order to minimize
COR
700 losses. This should be a welcome result for the accounting profession, partic-
701 ularly since real-world auditors face far greater penalties from rendering in-
702 appropriate clean opinions than those to which our subjects were exposed.
703 Consistent with the loss avoidance model but inconsistent with our equi-
704 librium prediction, auditors obtaining evidence suggesting business termina-
705 tion did not express more clean opinions when forecast accuracy decreased.
706 Such evidence did aect client behavior, however, as clients switched more
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707 aggressively. Though contrary to prediction, the model remains useful in in-
708 terpreting this result, because this departure from equilibrium play occurred
709 more frequently in high forecast error cells, where the expected costs of such
710 departures were lower. Though few clients always switched, many who did
711 switch exhibited a pattern consistent with risk seeking. Clients may also have
712 experienced less dissonance in dismissing an auditor whose evidence was weak.
ARTICLE IN PRESS
713 In summary, the results suggest that the game-theoretic model is descriptive
714 of many subjects behaviors and is useful in interpreting the behavior of other
715 subjects even if they played far o the equilibrium path. Of the competing
716 models, loss avoidance occurred most frequently, and led auditors and clients
OF
717 to be more conservative in their reporting and switching behavior. Consistent
718 with risk seeking behavior, 13% of the auditors expressed clean opinions over
719 50% of the time despite evidence to the contrary. On the other hand, advers-
720 arial and altruistic models did not appear descriptive. Forecasts were attended
721 to, but the follow-the-forecast model provided little additional insight into
PRO
722 individual auditor behavior. Finally, supporting Bloomelds strategic-depen-
723 dence hypothesis, we nd that subjects do play farther from equilibrium when
724 their payos are more dependent on others decisions.
725 Left for future research is the redesign of the model resulting from the ex-
726 perimental results and a more precise, endogenous characterization of the self-
727 fullling prophecy. Modeling auditorclient dierences in their forecasts of
728 bankruptcy would permit one to view switching behavior in a dierent way.
729 Also warranting research is the explicit consideration of reputation eects on
TED
730 strategic decision-making in repeated play setting which would allow subjects
731 greater opportunity to cooperate or retaliate. Moreover, this would increase
732 the likelihood of detecting altruistic and adversarial behaviors. The experiment
733 revealed that a signicant number of subjects attempted to avoid large losses,
734 and a smaller number focused more on the upside reward and than on the
735 downside risk. The risk takers liberally expressed clean opinions despite evi-
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736 dence to the contrary. Regardless of frequency, the consequences of such risk-
737 taking behavior and resultant audit failures justify further examination. Future
738 models should encompass all risk preferences and might examine how ethical
739 standards, sanctions, and compunctions interact with risk preferences to de-
740 crease the frequency of audit failures.
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741 9. Uncited reference
742 AICPA (1988)
743 Acknowledgements
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744 The Graduate School of the University of Wisconsin-Madison and the

745 University of Illinois at Chicago provided funding for this project. The authors
746 also wish to acknowledge the helpful comments of Paul Beck, Brian Mayhew,
747 David Smith, Tony Steele, and the workshop participants at the University of
748 Illinois at Champaign-Urbana and the University of Illinois at Chicago.
ARTICLE IN PRESS
749 Appendix A
750 A.1. Equilibrium strategy sets
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751 The analysis that follows is a variation of that in Matsumura et al. (1997,
752 pp. 727758). For simplicity, we assume both players are risk neutral. If the
753 incumbent auditor intends to issue a clean opinion, the client has no incentive
754 to switch auditors and, thus, retains the incumbent (see Fig. 1). Alternatively, if
755 the incumbent auditor expresses a going-concern opinion, we derive the au-
PRO
756 ditor/client pure strategy Nash (subgame perfect) equilibrium strategies by
757 beginning with the clients decision and using backward induction to determine
758 the auditors reporting decision. At node 1 in Fig. 1, the client compares the
759 expected payos of replacing the auditor with that of retaining the auditor.
760 Thus, the clients optimal strategy is to retain the auditor if
SWpsf l pClean PV SW Ll psf l pClean
SWpFail pClean PV SW1 pFail pClean
TED
< PV L1 psf ; or
SW
pClean < p^Clean : A:1
L1 psf psf pFail PV
762 At node 2, the incumbent auditors optimal reporting strategy depends on
763 the clients optimal strategy at node 1. If expression (A.1) holds, the client will
764 retain the incumbent auditor even if that auditor expresses a going-concern
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765 opinion. The auditor will do so if the expected return exceeds that from ex-
766 pressing a clean opinion, that is, if
pSf AFB 1 psf AFs Ca
> pFail AFB Cb 1 pFail AFs ; or
Ca 1 psf pFail psf pFail AFS AFB
A:2
COR
pFail > :
Ca Cb
768 If expression (A.1) does not hold, then the client will replace the incumbent
769 auditor who expresses a going-concern opinion, which the auditor will do if
770 and only if
D > pFail AFB Cb 1 pFail AFs ; or
AFS D
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pFail > : A:3

AFS Cb AFB
772 The right-hand side of Eq. (A.1) contrasts the costs of switching (numera-
773 tor) with the costs of not switching (denominator). Intuitively, if the proba-
774 bility of receiving a clean opinion from a replacement auditor becomes large
775 relative to the cost of switching, the client prefers to switch. The intuition
ARTICLE IN PRESS
776 behind expression (A.2) is that the auditor will express a going-concern opinion
777 if the probability of business termination (left-hand side) becomes large relative
778 to the cost of rendering a going-concern opinion. The right-hand side of ex-
779 pression (A.2) compares the cost of rendering a going-concern opinion (nu-
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780 merator) to the total costs of both type I and II errors (denominator).
PRO
781 References
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JPP 6119 No. of Pages 33, DTD = 4.3.

Journal of Accounting and Public Policy xxx (2003) xxxxxx

28 clean opinions but led clients to switch auditors more frequently.

0278-4254/$ - see front matter 2003 Published by Elsevier Inc.

30 Keywords: Experimental economics; Loss avoidance; Adversarial; Altruism; Auditing; Going

33 The sensational Enron and WorldCom bankruptcies led congressional

50 (2000, pp. 5963) called for clearer guidance in dening a going-concern

126 A unique aspect of the going-concern decision is that a going-concern report

140 2.2. Noise in assessing the clients going-concern status

142 auditors going-concern forecast. Future uncertainty only partially accounts

162 3. Sequence of steps in the game-theoretic model and experiment

172 3.1. Initial state determination

178 3.2. Audit forecast judgment

e The probability a binary forecast received by the incumbent auditor is

concern decision in conjunction with a self-fullling prophecy eect. In the

200 3.3. Auditors reporting decision

209 operationalizes this increase in probability by increasing the self-fullling

forecast 1 (ySS ), is computed as follows:

247 fullling prophecy eect, the present value of managing a viable rm

252 3.5. Payo distribution

Decision model Auditors opinion Clients decision

Altruism Clean Retain

3 September 2003 Type

No. of Pages 33, DTD = 4.3.1

3 September 2003 Type

No. of Pages 33, DTD = 4.3.1

304 4.1. Loss avoidance

305 Loss avoidance is a likely characterization of many real-world auditors

322 4.2. Risk seeking

336 4.3. Adversarial decision model

357 4.4. Altruistic decision model

386 5.1. Self-fullling prophecy

396 auditors manifest altruistic or risk-seeking behavior (i.e., expresses clean

427 5.2. Noise

434 contrast between the equilibrium predictions in cells EL -SFP (going-concern

459 6. Subjects and experimental procedures

469 were identical to the subsequent 30-game experimental sequence. Subjects

480 7. Experimental results

489 concern opinion. For forecast 1, only 41 auditors expressed going-concern

502 7.1. Hypotheses H1 and H2: the self-fullling prophecy eect

Panel B: Client Switching Model

No. of Pages 33, DTD = 4.3.1

556 found in panel A of Table 4, the non-aggressive auditor would be better o

586 in alerting investors to bottom-line problems.

613 auditors to express more of the client-preferred clean opinions.

660 7.3. Hypothesis H4: strategic dependence

741 9. Uncited reference

742 AICPA (1988)

744 The Graduate School of the University of Wisconsin-Madison and the

750 A.1. Equilibrium strategy sets

pFail > : A:3

805 Roundtable. American Institute of Certied Public Accountants, New York.

849 (Suppl.), 113.

865 accountants. The Accounting Review 59, 242263.

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