THE EFFECTS OF INCENTIVES AND AUDITS ON TRANSFER PRICE NEGOTIATIONS IN A DEFLATIONARY CONTEXT SAKTHI MAHENTHIRAN AND RUSS KERSHAW

ABSTRACT This laboratory experiment investigates the effects of a performance incentive scheme and financial audit threats on transfer price negotiations. Three hypotheses are developed, based on a review of transfer pricing, budget goal setting, incentive, and auditing literatures. Experimental data are gathered over multiple periods of negotiations from forty eight students, and are analyzed using repeated measure ANOVA. The outcome measured is firm profits. The results show that bonus incentive scheme and audit threats have no effect on firm profits. However, the interaction between the performance based bonus incentive scheme and an audit threat is significant. With both management controls, bonus incentive and audit threats, firm profits are significantly lower than under a bonus incentive scheme only. Possible reasons for these results are explored in the discussion section. In a deflationary pricing environment, study findings have implications for designing a negotiated transfer pricing mechanism in the presence of performance based incentive schemes and financial audit threats. INTRODUCTION With increasing globalization, it has become common for multinational corporations (MNC) to locate their manufacturing operations in one (developing) country, while the market for the finished product is in another (developed) country. For example, many firms in the garment, shoes (e.g. Nike), and computer chip (e.g. Intel) industries operate under this scenario. Because of heavy capital investment in manufacturing facilities and the need to absorb related fixed costs, the manufacturing divisions of decentralized MNCs often have incentives to operate at full capacity. In fact, MNCs have developed management control systems that encourage high levels of production. For example, in the Asian Pacific Ryan Co. case (Lakshmanan & Ramanan, 1997), a daily manufacturing profit report was prepared to ensure that the companys Indonesian plant maximized production. A corporate policy that promotes production can result in a situation where the demand and supply for a product are not in equilibrium. When supply exceeds demand, a deflationary environment can develop. Recently, many firms have experienced this environment due to rapid advances in technology, increased global competition, and changes in economic conditions around the world. In decentralized MNCs that have significant intra company trade, price deflation may cause division managers to approach transfer price (TP) negotiations differently. For instance, in the absence of price deflation, the manager of a buying division may not be concerned about inventory obsolescence or over valuation. However, in a deflationary environment, the same manager may be worried about acquiring inventory that may become obsolete or over valued. In such a setting, the buying manager may try to negotiate lower transfer

prices and may not be willing to buy all that is produced. This type of behavior during transfer price negotiations is not consistent with a production maximization policy and may negatively impact firm profits. Choosing a TP mechanism that promotes goal congruency while maintaining divisional autonomy is an important aspect of a decentralized firms management control system (Greenberg et al., 1994; Grabski, 1985). Goal congruency refers to the extent to which divisional managers consider both the divisions and the firms overall profitability during TP negotiations. In addition to integrating divisions and properly motivating managers, an important objective of a TP system is compliance with GAAP (Wu & Sharp, 1979; Tang, 1980). GAAP requires that inventory be carried at the lower of cost or market value (ARB 43, 1953). With price deflation, a write down of inventory from cost to market value can reduce the divisions profitability. Given a policy of high capacity utilization, all divisions are likely to be allocated a portion of the inventory write down to increase managers awareness of the need to recover the firms investments (Demski, 1982; Ugras & Lipka, 1999). Two common management controls used to promote goal congruency and ensure compliance with GAAP are bonus incentive schemes and threats of financial audits (Anthony & Govindarajan, 1998; Chow et al., 1995). This study examines the effects of using these traditional controls with a negotiated TP system on divisional managers behaviors and firm profits. Prior research suggests that the use of incentive schemes can influence managers TP negotiation behavior and affect firm profits (Greenberg et al., 1994; Chalos & Haka, 1990). However, these studies did not examine this issue in a deflationary pricing environment and did not allow subjects to participate in the budget goal setting process. This study extends this line of research by investigating the effects of a bonus incentive scheme on TP negotiations and firm profits in a deflationary setting when budget participation is allowed. A financial audit that reduces a divisions profits because of inventory adjustments due to lower market prices relative to cost can affect TP negotiations and firm profits. The effect may be similar to allocating corporate costs to divisions (Anthony & Govindarajan, 1998). In a deflationary environment, the threat of an audit may cause managers to negotiate lower transfer prices, resulting in lower intra firm sales and firm profits. This effect may be particularly strong when a bonus incentives scheme is used in the presence of an audit threat. Over multiple periods, this combination of management controls may motivate managers to reduce the transfer price to avoid the audit and to establish an easily achievable goal in order to receive the bonus. However, such a negotiation strategy is not congruent with the firms strategy of maximizing production and profits. Accordingly, this study examines the proposition that a bonus incentive scheme will influence managers to negotiate higher transfer prices and quantities, which translates into higher firm profits. In contrast, financial audit threats that can cause a reduction of divisional profits will influence managers to negotiate lower transfer prices and quantities, resulting in lower firm

profits. Further, over multiple periods, the threat of audits may interact with a bonus incentive scheme and influence managers to negotiate lower transfer prices and quantities, reducing firm profits. A computerized, multi period transfer pricing experiment was performed to examine these predictions. The results of the experiment provide partial support for the expected positive effects of a bonus incentive scheme and do not support the proposed negative effect of an audit threat. However, the results provide strong support for the expected interaction between the bonus incentive scheme and the threat of audits. A discussion of the relevant theoretical issues leading to the hypotheses is presented next, followed by sections describing the methodology and results. The paper concludes with a summary of the findings and a discussion of their implications. LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT Several surveys suggest that about one fifth of the large US corporations use a negotiated TP system (Vancil, 1979; Borkowski, 1990). Furthermore, Borkowski suggests that in the presence of market price uncertainties, the use of negotiations is likely to be primary TP system. Therefore, in a deflationary pricing environment, it is useful to study the effects of common management controls on negotiated TP. Recent studies have used firm profit as the operational proxy measure for the effectiveness of TP negotiations (Dejong et al., 1989; Chalos & Haka, 1990; Greenberg et al., 1994). Higher firms profits are the result of more optional transfer quantity and transfer prices. Therefore, a firms management controls should promote effective TP negotiations that make higher firm profits possible. Effect of Incentive Schemes on Budgetary and TP Negotiations Budget goals serve both a planning and a motivational purpose by being the standard against which the actual performance of divisions and the managers are evaluated (Nayler & Ilgen, 1984; Brownell, 1982). However, Young (1985) and Chow et al. (1988) suggest that greater participation by managers in goal setting can result in higher slack creation. These studies found that slack creation is a function of the type of incentive schemes used to evaluate and reward managers. Studies by Young (1985) and Chow et al. (1988) found that managers tend to build more slack, in part, by setting lower budgets targets relative to their capabilities, especially, under a slack inducing pay scheme. In this type of pay scheme, subjects are rewarded with a higher bonus rate when actual performance exceeds budgeted performance. Slack creation can be avoided by using a truth inducing pay scheme, which typically has the following bonus (B) function B= by b (y-y), where y is the budgeted performance, y is the actual performance, and b is the rate of pay. Researchers such as Groves and Loeb (1979), and Banker and Datar (1989) have also suggested similar but more complex truth inducing pay schemes. Typically, under a truth inducing pay scheme, managers are penalized for performing above the budget. Use of such truth inducing pay schemes may not be realistic and have not been observed in practice (for a review, see Chow et al, 1995).

In the experimental studies by Chow et al. (1998, 1995), participative goals were directly established for single period experiments without negotiations between the experimenter (i.e., supervisor) and the subjects. However, the task in this study is multi period negotiations, therefore, TP negotiations are used as the means of participation to indirectly influence the budget goals that are established to evaluate divisional managers. Figure 1 (Box 1) shows that participation in negotiations sets the stage for managers involvement in how the y are evaluated and rewarded. Chow (1983) found that assigned goals (with low to high levels of difficulty) and type of incentive schemes (fixed pay, piece rate, and budget based) can independently and jointly affect performance. Moderate to difficult goals in combination with a budget based incentive scheme resulted in higher performance compared to having no goals or a fixed pay scheme. Fasteas and Hirst (1989) found that providing a goal and using a budget based incentive scheme contributes to higher performance only when the goal is easy to achieve. They suggest that these joint effects may not extend to higher ranges of goal difficulty. Thus, goal difficulty is an important issue because managers may not be motivated by a budget goal if it is perceived to be difficult. Figure 1 (Box 2) emphasizes the moderating effect of goal difficulty on firm profit, which can be influenced by managers participation in negotiation. In this study, we assumed that if a goal was set at 50% of the previous periods actual divisional profits, it would then be perceived as an achievable budget goal. Studies examining TP negotiations have also found that the type of incentive scheme can influence the firm profits (Greenberg et al., 1994; Chalos & Haka, 1990). Greenberg et al. found that a mixed incentive scheme rather than a divisional incentive scheme provided significantly higher firm profits. While under a divisional incentive scheme, managers rewards are based on their divisions performances; under a mixed incentive scheme, managers rewards are based on the entire firms profit. Contrary to Greenberg et al. (1994), Chalos & Haka (CH) (1990) found that in a negotiated TP context, a divisional incentive scheme improved firm profits. Further, CH found that regardless of the incentive scheme used, the presence or absence of market price uncertainty significantly increased the profit differences between divisions. Thus, CH (1990) suggests that increased uncertainty negatively affect goal congruency between the divisions and the firms objective. Neither of these studies allowed subjects to participate in influencing budget goals. Further, prior studies have not examined TP negotiations in a deflationary pricing environment. This study extends this line of research by investigating the effects of incentive schemes on TP negotiations and firm profits when budget participation is permitted in a deflationary environment. Economic theory of incentives predicts that the use of performance based bonus plans induce greater effort and attracts more productive workers and, therefore a higher level of performance is realized. (Banker et al., 1996; Awasthi & Pratt, 1990). In the retail industry Banker et al. (1996) found that sales increased when a bonus plan was implemented, and found the effect to persist and increase over time. In their study, sales employees were given a sales goal. If actual

sales exceeded the goal, employees were entitled to a bonus that was a fixed percentage of the excess sales. In this study, the amount of bonus compensation depends on the extent to which the actual performance exceeds budgeted performance, but in addition, managers could make a significant contribution towards establishing budget goals. Hence, our expectation is that the firm profits will be greater with a bonus incentive scheme than without a bonus incentive scheme. Thus, our first hypothesis states that: H1: in a deflationary environment with negotiators who have achievable goals, the firms profit will be higher in the presence rather than in the absence of a bonus incentive scheme. Financial Audits and Transfer Price Negotiations In lab experiments, Chow et al. (1995) found that a linear profit sharing scheme along with an audit threat was more effective in deterring subordinate misrepresentations than when a complex truth inducing incentive scheme was used. Based on their findings, Chow et al. (1995) concluded that this might be the reason why most companies use combinations of simple organizational control to achieve a diverse set of objectives. Financial audits are an organizational reality for publicly traded multinational firms and their divisions. Experimental and field researchers have shown that audits can deter inappropriate subordinate behavior such as non conformance with rules, regulations, and producers (Anderson & Young, 1988; Churchill et al., 1982). Churchill et al. (1982) provided the following useful guidelines to bring about conforming behavior with audits: have (a) audit criteria, (b) a pending audit against the criteria, and (c) established penalties for non conformance. Newman and Noel (1989) observed that only recently has research begun to empirically address the behavioral issues in agency models and in negotiation problems in accounting. Murningham and Bazerman (1990) published an influential paper introducing negotiations to accounting and auditing. These authors suggest that interactions in accounting and auditing can be viewed as a negotiation system. Consequently the focus of recent audit studies have been on auditors behavior or on pricing of audit services (Calegari et al., 1988; Elitzur & Falk, 1996; Walo, 1995). These studies do not consider managers reactions to audits, which is the focus of this study. A separate stream of literature, which does focus on management behavior, suggests that managers manipulate or smooth profits to achieve various objectives that are motivated by self interest (Ackley, 1994; Pentaland, 1993). These studies only implicitly assume negotiations by auditors and managers over various issues such as audit fees or reported profit that are of personal interest. However, these studies do not explicitly focus on negotiations per se. on the contrary, this study explicitly examines the effect of an audit threat as an independent control mechanism that can effect managers negotiations, which in turn can influence the negotiated outcome, company profits. In a deflationary environment, such an audit threat may lead to sub optimal TP negotiations and lower company profits. An audit can result in an adjustment to the divisions profit because of inventory adjustment due to lower market prices relative to cost is likely to be viewed by divisional managers as an allocated corporate cost (Urgras & Lipka, 1999). Since the

audit adjustment is related to conditions in the external market over which a manager has little control, a marketing manager who is going to be audited may perceive more uncertainty about the allocation of a common cost than a manager who is not going to be audited. Further, with a depressed market, a higher transfer price can increase the likelihood of the need for and the size of an audit adjustment. In multi period negotiations, this fear could manifest itself as a lower transfer price, and a lower transfer quantity relative to the optimum. This would translate into lower intra firm sales and lower firm profits for the firm. Therefore, in a deflationary environment, a firm that uses a negotiated TP, along with audit threats, may experience results that may be less than optimal and less congruent with the forms production maximizing goal. This leads to our second hypothesis, which states that: H2: in a deflationary environment, the firms profit will be lower in the presence of an audit threat than in the absence of such a threat. Figure 1, shows how the threat of audits can influence managers TP negotiations. We believe that managers profit manipulation behavior would first manifest itself in the goals they negotiate that would be used latter to evaluate and reward them. Joint Effects of Incentives and Audits on TP Negotiations In a deflationary environment, the use of a bonus incentive scheme in the presence of an audit threat may distract a manager who is concerned about achieving the divisions goal and his or her bonus. An audit adjustment that lower the divisions profit makes the achievement of the budget goal more difficult. Therefore, the motivational effects of having a budget goal and exceeding it may not persist in the presence of audit threats. Hence, audit threats that are perceived as being an integral part of the TP system may negatively affect firm profits. Over multiple periods, an audit threat in the presence of a budged based incentive scheme may induce managers to lower the transfer price (i.e., to avoid the audit) and budget goal in order to easily achieve the bonus. Thus, the combination of bonus incentive and audit threats may motivate a divisional manager to pursue a negotiation strategy that is not congruent with the firms strategy of maximizing production and sales. Negotiations may be less effective and firm profit lower when a bonus incentive and an audit threat are present than when either is present. The broken arrows in Fig. 1 flow in the opposite direction to that stated in H1. These broken arrows suggest that in the presence of a bonus incentive scheme and an audit threat, managers are motivated to negotiate lower budget goals. By setting easier budget performance targets, managers may counter the positive effects of the bonus incentive scheme, resulting in lower firm profits. This leads to our third hypothesis, which is stated as: H3: in a deflationary environment, firm profit will be lower in the presence of a both a budget based incentive scheme and an audit threat than when either of these management controls is present without the other.