Current Issues in Auditing American Accounting Association

Volume 7, Issue 1 DOI: 10.2308/ciia-50359

2013
Pages P22–P29

PRACTITIONER SUMMARY

New Evidence on an Old Question:

Does Lowballing Undermine Auditors’
Independence or their Clients’ Investment
Decisions?
Darius J. Fatemi

SUMMARY: This paper summarizes Fatemi (2012), which reports the results of an
experiment exploring the influence of audit fees on auditor and client decisions. The
results indicate that clients are more likely to make choices that maximize a firm’s value to
shareholders when evidence of audit fee lowballing exists. When clients exhibit a past
history of misstatements, auditors exhibit higher levels of skepticism as evidenced by an
increased frequency of testing. Auditors’ interpretations of test results reveal that they are
subject to the psychological effect of motivated reasoning in the presence of lowballing
when they are hired by their clients (but not when hired by investors), in that they place
more confidence in the quality of tests that support their clients than in equivalent tests
that are unsupportive. This article explains these findings and discusses their
implications.

Keywords: auditor independence; lowballing; auditor selection; client decision making;

motivated reasoning.

INTRODUCTION
Questions have long existed over the role that audit fees have on decisions made by auditors
and their clients (e.g., CAR 1978; IFAC 2010). Particular attention has been directed toward audit
fees that follow a lowballing pattern. When lowballing occurs, clients hire auditors who offer low

Darius J. Fatemi is an Assistant Professor at Northern Kentucky University.

This article is based on a paper resulting from my dissertation, and I am therefore deeply grateful to my committee
members at Indiana University: Ed Hirt, Peggy Hite, Laureen Maines, and Geoff Sprinkle (chair).
All opinions expressed in this paper are my own.
Submitted: August 2012
Accepted: November 2012
Published Online: November 2012
Fatemi P23

initial fees, after which auditors must charge higher fees and focus on client retention in order to
realize a profit over the course of the client relationship. Resulting concerns raise questions about
whether auditors can be independent in these situations, and what the resulting impact would be
on clients and the quality of financial statements. If client managers do not expect auditors to act
objectively, they may perceive that misstatements can be successful in misleading investors,
reducing their incentives to incur costs that improve the true value of the company.
Fatemi (2012) provides evidence on this issue by examining auditors’ level of investigation
and their clients’ decisions in an experiment that controlled for both the existence of lowballing and
which party selects the auditor (i.e., client or investor).1 Further, the study measured auditors’
interpretation of audit test results under the different settings. The paper represents the first study
that incorporates auditor retention concerns in which the presence of lowballing in each
auditor-client relationship was controlled by experimental conditions. It examined this dynamic in a
setting that included a role for outside investors, facilitating a direct look at the cause-and-effect
relationship between lowballing and its consequences for auditors and their clients.
The experiment involved an artificial (i.e., experimental) market in which auditors, managers,
and investors interacted via computer terminals over multiple periods. In each period, managers
chose between two possible internal investments. While the immediate cost to a manager was
lower with the choice of one investment, the long-term value of the firm was greatest when
managers were willing to incur the extra costs associated with the other investment. After
managers learned the value of their asset, they would issue a disclosure of its value. Auditors
could then test the accuracy of the disclosure and decide whether to agree or disagree with the
manager’s disclosure. Finally, outside investors bid on the assets.2
Fatemi (2012) observed that, when lowballing exists, client managers are more likely to make
investment decisions that maximize their firm’s value, consistent with an expectation by managers
that disclosures of high asset values would be viewed more credibly by investors in this setting.
However, they resort to suboptimal investment decisions when auditors are not paid according to a
lowballing pattern, but instead receive a constant rate for each term of an engagement. Auditors, in
turn, make investigation decisions that reflect past manager behavior, performing more tests in
markets characterized by misleading manager disclosures. The study also found that, when
auditors are selected by managers (but not when selected by investors) in a lowballing scenario,
they show an inclination to assign more confidence to test results that are favorable to the audit
client than to those that are unfavorable.
The results suggest that lowballing may not have the deleterious effect on clients and auditors
that has been feared. In contrast, when auditors employ a lowballing pricing strategy, the fee
structure actually may encourage client managers to make value-enhancing decisions for their
firms, and there is no observable decrease in the objectivity of audit reports under such a fee
structure. However, supplemental analyses do indicate that lowballing places auditors selected by
client managers at risk of assigning too much confidence to their test results, suggesting that
auditors should take steps to prevent the potential adverse consequences. Audit committees may
also be able to reduce the impact of this effect through an emphasis on the auditor’s responsibility
to shareholders and careful examination of the audit plan.

1
Academic studies have used observed auditor behavior as a gauge of the auditor’s independence of thought
and action in given situations.
2
The presence of investors was integral to Fatemi’s (2012) experiment (as explained in a subsequent
discussion). However, Fatemi (2012) focuses on the decisions made by auditors and client managers, providing
information on investor bids only in supplemental analyses. This summary follows a similar approach.

Current Issues in Auditing

Volume 7, Issue 1, 2013
Fatemi P24

THEORETICAL BACKGROUND
Lee and Gu (1998) developed a model that compares a lowballing setting to one in which
auditors are paid the same rate each period. In the model, each setting leads to the same total
revenues for the auditor so that only the pattern of the fees, and not the total amount, would
explain any differences in auditor, client, and/or investor behavior. Fatemi’s (2012) experiment is
based on Lee and Gu’s (1998) model, and it used two analogous experimental settings that
determined the fee structure. If the appearance of lowballing had not been a directly manipulated
experimental variable, it would have been difficult to distinguish whether a behavior observed in
the presence of lowballing was attributable to lowballing itself, or to some other factor that
simultaneously gave rise to the lowballing. For example, prior research has shown that, when the
appearance of lowballing is not directly controlled by the experimenter, its occurrence is
attributable to factors such as the individual auditor’s personality characteristics (e.g.,
aggressiveness or cooperativeness [Schatzberg and Sevcik 1994; Calegari et al. 1998;
Schatzberg et al. 2005]) or by the auditor’s economic position in the market (Milgrom and
Roberts 1982; Saloner 1987; Lee and Gu 1998). Fatemi (2012) avoids these issues by
examining the effect of lowballing in a controlled setting.
According to Lee and Gu (1998), when future fees are higher relative to current fees (i.e., a
lowballing setting), auditors are more likely to do what is necessary to ensure client retention.
Because Lee and Gu (1998) incorporate investors into their model, they predict that investors’
desire for accurate reporting will influence auditors’ decisions. In a market setting, managers can
capture larger amounts of capital from investors if they can provide them with credible, favorable
information, with this credibility contingent upon independent auditing. Consequently, the higher
future fees that are observed under lowballing would encourage managers to make decisions that
increase the true intrinsic value of a company, because investors would have more confidence in
information purporting assets to be of high value in this setting. In terms of Fatemi’s (2012)
experiment, which also incorporated investors through the use of a market design, mangers would
be more likely to choose a high-return investment in a lowballing setting than in a flat-rate scenario.
Note that, while the predictions rely on a role for the investor, Lee and Gu (1998) explicitly state
that this role does not require investors to be the party that selects the auditor. Investors provide
capital to the managers and, to attract capital, managers rely on credible auditors. As a result, the
auditor’s ability to be retained is directly influenced by the auditor’s reputation for accuracy; and
when the proceeds from retention are especially important to an auditor’s profit margin (as they are
under lowballing), this incentive for accuracy is enhanced.
In a related line of research in psychology, individuals have been found to participate in
motivated reasoning. That is, a person who is choosing between multiple options will assign
greater weight to evidence that supports their preferred decision (Kunda 1990; Russo et al. 1996).
Hsee (1995) found that this unequal weighting is exacerbated when a numerical quantity important
to a decision maker is provided as a range of possible values instead of as a single value, because
the decision maker can overweight the likelihood that the more favorable values within the range
apply in a given situation.
In Fatemi’s (2012) experiment, participants acting as auditors were informed that their tests
had an accuracy rate of somewhere between 61 and 99 percent, but they were not told that the
actual computerized accuracy was 80 percent. Withholding the actual accuracy from the auditors
provided a mechanism to test the effect of motivated reasoning. While client managers in the
experiment could earn higher profits by hiring auditors with a reputation for reliability, they would
also be more likely to receive a larger bid from investors when their disclosures were supported by

Current Issues in Auditing

Volume 7, Issue 1, 2013
Fatemi P25

auditors than when they were not. On the other hand, investors’ demands on auditors were
simpler, as they would merely seek reliable auditing according to the psychological theory of
ambiguity aversion, according to which investors would desire accurate reporting in order to
minimize uncertainty (cf. Mayhew and Pike 2004). Therefore, when auditors were hired by
managers, they would face an incentive to avoid disagreements with the manager; consequently,
their assessments of testing accuracy were expected to be higher for tests favorable to managers
(those supporting a high equity value) than for those unfavorable to managers (those indicating a
low equity value). When auditors were selected by investors, no differences in accuracy
assessments were expected.

EXPERIMENT
Participants in the experiment included 150 undergraduate accounting majors separated into
groups of ten, with three auditors, three managers, and four investors in each group. The ten
members of a group interacted with each other in two successive experimental markets, and those
two markets comprised an experimental session. Data were collected in 15 experimental sessions,
with each session using a different group of ten individuals. An experimental market incorporates a
role for investors by allowing them to bid against each other for assets offered by managers. Its
use lends realism by approximating a public company’s reporting environment; further, it provides
a robust test of psychological factors that may influence individuals. For example, a manager’s
inclination to avoid necessary costs, which would undermine firm value, or an auditor’s inclination
to interpret uncertain information with a bias, may be countered by disciplinary forces arising from
an investor’s ability to decide whether to provide capital. A market experiment therefore helps
ascertain the degree to which client manager and auditor decision making is affected by the
financial incentives created by investors.
Each group of ten individuals was randomly assigned to separate experimental conditions: the
audit fee structure was characterized by either a lowballing pattern or a flat rate, and either the
manager or the investor selected the auditor. All auditors lost money on the initial engagement in
the lowballing condition, but experienced higher profits upon retention than under a flat rate;
expected revenues accumulating across multiple periods for retained auditors were equivalent for
the two conditions. Before an experimental session began, all participants read a set of instructions
and participated in practice rounds to familiarize themselves with the fee structure and audit
selection process that applied to their situation.
As noted previously, client managers in the experiment chose between two private investment
options, labeled Bin 0 and Bin 1. Bin 0 resulted in a low-value asset with certainty; Bin 1 cost more
but had a 60 percent chance of producing an asset of high value, making it the economically more
attractive option for investors. The payoff structure was identical to that of Mayhew and Pike
(2004), and it created a risk-return relationship in the bin choices. As a result, the experiment
combined the decision to take on more risk with the decision to choose the more lucrative
investment. After observing the resulting value of their asset, managers disclosed an asset value
of Low or High to investors. Auditors then could either agree with the manager’s disclosure, or they
could perform a test of the asset’s value and, based on that test, choose whether to agree or
disagree with the manager. After each test, auditors entered a private assessment, unknown to the
other participants, of the perceived accuracy of their additional testing. Investors then bid on the
assets. The highest bidder would receive the difference between the value of the asset and the
amount offered to the manager. In addition, each investor would receive 10 percent of one
manager’s profits, creating incentives similar to that of existing shareholders. In subsequent

Current Issues in Auditing

Volume 7, Issue 1, 2013
Fatemi P26

periods, the auditor’s selector would choose whether to rehire the auditor or hire a new one, and
the process would begin anew. Relevant to this summary of the experiment, three data items were
recorded throughout the experiment: the frequency with which managers chose the high-return
investment, the frequency of auditor objectivity violations (instances in which the auditor agreed
with a manager’s favorable disclosure without testing it or in spite of a conflicting test result), and
auditors’ assessments of testing accuracy.

RESULTS
Regardless of which party selected the auditor, managers chose the high-return investment
more often under a lowballing audit fee structure than under a flat-rate fee structure. Overall, as
shown in Figure 1, managers chose the high-return investment 83 percent of the time in markets
with lowballing, while managers in the flat-rate settings chose the high-return investment only 62
percent of the time. Consistent with predictions outlined in the Theoretical Background section,
managers indicated in a post-experiment questionnaire that they expected assets disclosed to be
of high value to generate higher bids from investors under lowballing than under a flat-rate audit
fee structure. Investors supported these expectations, supplying bid amounts that were over 30
percent higher for such assets when auditors were paid under a lowballing fee pattern. The
occurrence of auditor objectivity violations, in which the auditor agreed with a manager’s favorable
disclosure without testing it or in spite of a conflicting test result, was found to follow a different rule:
regression analyses and post-experiment responses (not detailed in this summary) indicate that,
after managers created high-valued assets, auditors tended to find managers’ subsequent high
disclosures more credible and less necessary to test. The fraction of the time that auditors
committed objectivity violations (63 percent and 60 percent in the lowballing and flat-rate settings,
respectively, as shown in Figure 1) was equal across payment schemes. Note that managers and
investors were unaware of whether an auditor had performed testing and could only see whether
an auditor had reported accurately. There was no discernible difference between an auditor who
correctly agreed with a manager without testing and one who had correctly agreed after testing. As
a result, auditor accuracy was visible to participants, but the experimental measure of objectivity
violations was only visible to the experimenter.
Further analyses revealed that motivated reasoning occurred when managers selected
auditors. Specifically, in the lowballing setting (in which retention ensured the auditor higher profits
than under the flat rate), auditors perceived testing to be 87 percent accurate after results that
supported a manager’s claim of a high asset value, whereas tests that were unsupportive of the
manager were perceived to be 84 percent accurate. Because of the small variation in auditors’
assessments of testing accuracy, the difference of three percentage points is statistically
significant. Experiments are better at diagnosing whether an effect occurs than at measuring the
real-world impact of an effect. Whether this difference would be more pronounced under a different
design, and furthermore whether it would translate to a difference in audit outcomes in actual
practice, is left unanswered by the experiment. Nonetheless, the results demonstrate the existence
of a psychological effect in which auditors placed more confidence in the quality of their tests when
the results agreed with the hiring manager’s assertion. However, in the flat-rate scheme, with the
auditor’s reduced financial incentives for agreement with the manager, and under investor
selection, in which disagreements with managers would not threaten an auditor’s possibility for
retention, accuracy assessments did not differ according to whether the test results were favorable
or unfavorable to the manager.

Current Issues in Auditing

Volume 7, Issue 1, 2013
 Fatemi

FIGURE 1
Manager Investment Choices and Auditor Objectivity Violations

Managers had a choice between two internal investments. The top line shows the percentage of time that a manager chose the investment that yields a higher
expected asset value.
The bottom line shows the percentage of time that objectivity violations occurred, defined as instances in which auditors either agreed with a manager’s disclosure of
high asset value without testing it or agreed in spite of a conflicting test result.
The audit fees followed one of two patterns. Under a flat rate, auditors received the same fee for each audit. Under lowballing, the initial engagement was performed at
a loss, after which all subsequent engagements generated higher profits than those obtained under the flat rate.

Current Issues in Auditing

Volume 7, Issue 1, 2013
P27
Fatemi P28

DISCUSSION
While one must be careful in drawing inferences from a single study, the results, if they are
robust to future investigations using alternative techniques, would suggest that lowballing’s
influence on market participants may be more nuanced than previously thought. The results of
Fatemi (2012) would suggest that client managers will endeavor to maximize the true intrinsic
value of their firm when auditors are paid by this method. From an economic perspective, then,
total market surplus would be higher when lowballing is present. Previous studies have suggested
that lowballing can have negative consequences (e.g., Magee and Tseng 1990; Dopuch and King
1996), either because auditors are unwilling to incur costs in an initial engagement when profits are
low, or because managers do not expect objective auditing when an auditor’s financial
dependence on retention is higher. Fatemi (2012) differs from prior studies by using a market
experiment that explicitly incorporates a role for investors who desire credible auditing. A direct
role for investors was also built into Lee and Gu’s model (1998), which also indicates positive
consequences from lowballing.
On the other hand, the heightened dependence on retention created by lowballing does
appear to subject auditors to motivated reasoning effects. When the financial incentives were
strong, auditors exhibited greater confidence in results supporting the manager than in those
presenting conflicts. Alternatively, the fact that the motivated reasoning effect is absent when
investors select the auditor suggests that, even under lowballing, a transfer of auditor selection
authority can combat this effect.
Fatemi (2012) provides an alternative view of lowballing to practitioners, suggesting that
auditors who engage in this pricing strategy may not be undermining either their ability to act
independently from managers, or managers’ incentives to engage in value-maximizing activities
for their companies. In fact, investors play an important role in the process that can reverse the
negative effects that have been suggested to exist in the presence of lowballing. Ultimately,
shareholders desire reliable auditing, and managers possess a similar requirement so that
favorable financial reports will be viewed credibly by the capital markets. Supporting this finding,
supplemental analyses in Fatemi (2012) found that auditors were more likely to be hired and
retained when auditors had a reputation for accuracy, and this was true regardless of whether the
client or the investor selected the auditor. Whereas disagreements with the client manager
negatively impacted auditor retention only when the client selected the auditor, a reputation for
reliable auditing positively influenced an auditor’s likelihood for retention across settings.
While it is difficult to extrapolate an experimental measure for the magnitude of its impact in
practice, auditors should take caution in noting that they may be subject to the psychological effect
of motivated reasoning. This is a subconscious effect that caused auditors to view test results that
supported a position consistent with the interests of the party hiring them with more confidence
than test results supporting an opposite position. Simply being aware of a bias can help counter it
(Uhlmann and Cohen 2007), especially when an individual deliberately considers alternative
possibilities to reduce overconfidence (Arkes 1991), so auditors can defend against this effect by
being cognizant of it when they are hired by their clients. Further, auditors that perceive an
especially strong financial incentive to concur with managers might increase planned testing,
seeking additional corroborating information in uncertain situations. Reminders from the audit
committee that the auditor’s client is the shareholders may also mitigate this effect. Relevant to this
finding, the results of the experiment are supportive of further efforts to heighten the independence
of the audit committee through increased accountability to investors.

Current Issues in Auditing

Volume 7, Issue 1, 2013
Fatemi P29

REFERENCES
Arkes, H. R. 1991. Costs and benefits of judgment errors: Implications for debiasing. Psychological Bulletin 110 (3):
486–498.
Calegari, M. J., J. W. Schatzberg, and G. R. Sevcik. 1998. Experimental evidence of differential auditor pricing and
reporting strategies. The Accounting Review 73 (April): 255–275.
Commission on Auditors’ Responsibilities (CAR). 1978. Report, Conclusions, and Recommendations. New York, NY:
CAR.
Dopuch, N., and R. R. King. 1996. The effects of lowballing on audit quality: An experimental markets study. Journal of
Accounting, Auditing and Finance 11 (Winter): 45–68.
Fatemi, D. J. 2012. An experimental investigation of the influence of audit fee structure and auditor selection rights on
auditor independence and client investment decisions. Auditing: A Journal of Practice & Theory 31 (August): 75–
94.
Hsee, C. K. 1995. Elastic justification: How tempting but task-irrelevant factors influence decisions. Organizational
Behavior and Human Decision Processes 62 (June): 330–337.
International Federation of Accountants (IFAC). 2010. Handbook of the Code of Ethics for Professional Accountants.
New York, NY: IFAC.
Kunda, Z. 1990. The case for motivated reasoning. Psychological Bulletin 108 (November): 480–498.
Lee, C.-W. J., and Z. Gu. 1998. Low balling, legal liability and auditor independence. The Accounting Review 73
(October): 533–555.
Magee, R. P., and M. C. Tseng. 1990. Audit pricing and independence. The Accounting Review 65 (April): 315–336.
Mayhew, B. W., and J. E. Pike. 2004. Does investor selection of auditors enhance auditor independence? The
Accounting Review 79 (July): 797–822.
Milgrom, P., and J. Roberts. 1982. Limit pricing and entry under incomplete information: An equilibrium analysis.
Econometrica 50 (March): 443–459.
Russo, J. E., V. H. Medvec, and M. G. Meloy. 1996. The distortion of information during decisions. Organizational
Behavior and Human Decision Processes 66 (April): 102–110.
Saloner, G. 1987. Predation, mergers, and incomplete information. RAND Journal of Economics 18 (Summer): 165–
186.
Schatzberg, J. W., and G. Sevcik. 1994. A multi-period model and experimental evidence of independence and
‘‘lowballing.’’ Contemporary Accounting Research 11 (Summer): 137–174.
Schatzberg, J. W., G. R. Sevcik, B. P. Shapiro, L. Thorne, and R. S. O. Wallace. 2005. A reexamination of behavior in
experimental audit markets: The effects of moral reasoning and economic incentives on auditor reporting and
fees. Contemporary Accounting Research 22 (Spring): 229–264.
Uhlmann, E. L., and G. L. Cohen. 2007. ‘‘I think it, therefore it’s true’’: Effects of self-perceived objectivity on hiring
discrimination. Organizational Behavior and Human Decision Processes 104 (November): 207–223.

Current Issues in Auditing

Volume 7, Issue 1, 2013