Managerial Auditing Journal

Incentive contracts and time pressure on audit judgment performance

Hua Lee,
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Hua Lee, (2012) "Incentive contracts and time pressure on audit judgment performance", Managerial
Auditing Journal, Vol. 27 Issue: 3, pp.263-283, doi: 10.1108/02686901211207492
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Incentive
Incentive contracts and time contracts and
pressure on audit judgment time pressure
performance
263
Hua Lee
Department of Accounting, Hong Kong Shue Yan University, Received 2 May 2011
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North Point, Hong Kong Reviewed 7 August 2011

Accepted 18 August 2011
Abstract
Purpose – The purpose of this paper is to explore the effects of varying motivation induced by
financial incentives and common uncertainty caused by time pressure on audit judgment performance.
Design/methodology/approach – The experimental method is used to examine how financial
incentives and time pressure affect audit performance, based on predictions by both economic and
behavioral theories. The relative performance contract and the profit sharing contract are two
incentive schemes considered. To achieve the incentive effect on subjects when conducting the
experiment, all subjects were compensated with real cash rewards, according to their incentive
contracts as randomly assigned.
Findings – As predicted, major results show that both incentive contract and time pressure affect
audit judgment performance. The audit performance is generally better under the relative performance
contract than under the profit sharing contract. Additionally, it is demonstrated that an increase in
the level of time pressure significantly improves recall, recognition, and total efficiency under both
types of incentive contracts, but impairs recall and total performance, particularly under the relative
performance contract. Moreover, the reduction of recall and total performance under the relative
performance contract is significantly greater than under the profit sharing contract. Nevertheless, in
this case, the relative performance contract still outperforms the profit sharing contract.
Research limitations/implications – The findings suggest the relative superiority of the relative
performance contract in comparison with the profit sharing contract in improving auditors’ judgment
performance for structured tasks.
Practical implications – The relative performance contract would motivate junior auditors to exert
more effort to increase their performance in the work environment of increased time pressure. The
audit firms may incorporate relative performance evaluations into incentive schemes, to improve
junior auditors’ performance for structured tasks.
Originality/value – The paper is of value to audit firms in the design of performance-contingent
incentive contracts.
Keywords Auditors, Incentive schemes, Performance appraisal, Performance evaluation,
Relative performance, Profit sharing, Time budget
Paper type Research paper

1. Introduction
Financial incentive has been recognized as an essential factor influencing effort
and performance. The use of relative performance information in contract design
Managerial Auditing Journal
The author is grateful to the Editors and two anonymous reviewers for their valuable comments. Vol. 27 No. 3, 2012
Comments from the reviewers and participants at the American Accounting Association 2011 pp. 263-283
q Emerald Group Publishing Limited
Northeast Region Annual Meeting and the Second International Conference of the Japanese 0268-6902
Accounting Review, at Kobe University, are appreciated. DOI 10.1108/02686901211207492
 MAJ produces a benchmark for performance comparison and evaluation among agents.
27,3 This may induce agents to exert more effort and improve performance, or alternatively,
generate psychological burden on them and impair their performance. Particularly in
the highly competitive auditing environment with a stringent time constraint on audit
tasks, auditors may have to restrict their attention and energy to completing audits,
which should result in better or worse performance. In the work environment of
264 increased time pressure, which type of incentive scheme may lead to comparatively
superior performance is of interest to this paper. The purpose of this paper is to
examine the effects of time pressure and two incentive schemes – profit sharing and
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relative performance – on audit performance.

One of the fundamental issues in behavioral audit research is knowledge-related
determinants of audit judgment performance, the so-called expertise paradigm
(Frederick and Libby, 1986; Libby and Frederick, 1990; Ashton, 1990; Frederick, 1991;
Choo and Trotman, 1991; Libby and Luft, 1993)[1]. However, as Libby (1995) points
out, most related studies make two assumptions, which appear to be inconsistent with
existing evidence. First, the motivation and the resulting cognitive effort do not vary
among individuals and exceed the minimal requirements of learning and task
performances. Second, the environmental factor, such as time pressure, is considered
only when it affects the relationship between both knowledge and ability on
performance. This paper relaxes these assumptions and examines the association
among financial incentives, time pressure, and audit performance.
For the first assumption, Libby and Lipe (1992) find that the extent of effects of
motivation and cognitive effort on judgment performance depends on the incentive
contract type and process, the knowledge base, and task structure[2]. For the second
assumption, economics and behavioral research give inconsistent predictions on
whether a change in environmental uncertainty influences decision performance[3].
This paper examines how time pressure, an environmental factor, together with
incentive schemes, affect audit performance (recall and recognition performances).
In addition, this paper explores the relative usefulness of the two incentive schemes on
audit performance in response to an increase in the level of time pressure.
I use an experimental method to examine the effects of two incentive schemes and
time pressure on audit judgment performance. Unlike most related studies in mimicking
reward for the experiment, I compensate all subjects based on their performance.
The main results are consistent in part with economic theory and in part with behavioral
theory. Both incentive contract and time pressure significantly affect subjects’ total
audit judgment performance in recall and recognition tasks. The total performance
under the relative performance contract is significantly better than under the profit
sharing contract when time pressure is low or when time pressure is high with high
incentive coefficients. Additionally, increasing the level of time pressure significantly
improves recall, recognition, and total efficiency under both types of incentive contracts,
but impairs recall and total performances under the relative performance contract.
Moreover, the decline of recall and total performances under the relative performance
contract is greater than under the profit sharing contract. Even so, in this case the
relative performance contract still yields significantly superior performance when
compared to the profit sharing contract. The overall evidence suggests that, with either
level of time pressure, high or low, the relative performance contract has stronger
incentive effect on junior auditors than the profit sharing contract.
 Consequently, the relative performance contract is more valuable for CPA firms to Incentive
improve junior auditors’ judgment performance compared to the profit sharing contract contracts and
in structured audit tasks.
This study complements related studies in that it provides evidence on the association time pressure
between financial incentives and audit performance, with time pressure taken into
account. There are three implications of the findings in this paper. First, as per
Frederickson’s (1992) argument, a related study should simultaneously consider the 265
impact of both economic and behavioral perspectives on decision performance so as to
raise the external validity of the study. Second, as effort is not observable but the resultant
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output is measurable and of the main concern, related studies can center on the positive
relation between financial incentive and decision performance. An appropriately designed
performance-based financial incentive would encourage agents to exert more effort to
improve their performance. Lastly, confronting the severe pressure of time budget in
performing audits, the CPA firms can design a performance-contingent contract for junior
auditors based on relative performance evaluation for superior performance in
comparison with the profit sharing contract.
Section 2 explores related studies and develops hypotheses. Section 3 details the
experimental method. Section 4 explains the results and Section 5 concludes the paper
with a suggestion for future research.

2. Related literature and hypothesis development

This study is related to McDaniel (1990), Libby and Lipe (1992) and Frederickson (1992).
McDaniel (1990) examines the effects of time pressure and program structure on audit
performance. She finds that, when the time pressure is low, structured audit programs
result in higher audit effectiveness and efficiency. As time pressure increases,
audit efficiency increases but audit effectiveness decreases. Libby and Lipe (1992)
investigate the effect of monetary incentives at different points in time on cognitive
effort and examine the interaction between cognitive process and incentive[4]. They
argue that the cognitive process involved in encoding and retrieving requires varying
effort levels, which lead to changes in performance. Frederickson (1992) uses a
management accounting experiment and finds that, as common uncertainty increases,
the level of effort significantly increases correspondingly under the relative performance
contract, but not under the profit sharing contract. Moreover, the level of effort is found
to be higher under the relative performance contract than under the profit sharing
contract.
This paper differs from McDaniel (1990) in that it explores the effects of financial
incentive and time pressure on decision performance. By manipulating time pressure in
limiting it to a high level, I analyze how it affects audit performance in the presence of
financial incentive, and whether one incentive scheme outperforms the other. In contrast
with Libby and Lipe (1992) and Frederickson (1992), considering that effort is
unobservable and that the measurable performance is most important, I examine the
effect of incentive contract type, through cognitive effort, on audit performance[5]. As one
of the common uncertainties facing auditors is the time pressure, this paper investigates
the effect of a tight time limit on audit performance and audit efficiency under two
incentive schemes. I investigate which incentive scheme results in better performance
with recall and recognition tasks in the presence of time pressure.
 MAJ 2.1 Economics hypotheses
27,3 Consider a case of agency problem in which the principal hires an agent to engage in
production activity. To solve the moral hazard problem, the output of the agent
determines the agent’s wage, as the output is an observable signal related to the agent’s
unobservable effort. However, due to the uncertainty of the production activity, both
the random state of nature and the level of effort determine the level of the output[6].
266 Therefore, the optimal wage contract is to set a risk-sharing rule so that the agent
partially shares the risk of fluctuations in output caused by random events and is a
function of the level of output (Holmstrom, 1979)[7].
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In addition to the level of the output, the principal is assumed to be able to observe a
signal that is related to the level of the agent’s effort. If the agent’s wage is a function of
the level of output and this signal, then the precision of the wage function will be
increased. Some scholars use analytical models to explain the role of informative signal
in multi-agents settings, particularly in improving the efficiency of contract using
relative performance information[8]. Holmstrom (1982) indicates that when all agents
face some common uncertainty, their output reveals information about their level of
effort. If the degree of common uncertainty increases, the relative performance
evaluation raises the proportion (amount) of uncertainty that can be filtered from the
agent’s evaluation. Therefore, the ability of relative performance information to filter
more uncertainty improves risk sharing between the principal and agents (Baiman and
Demski, 1980; Holmstrom, 1982; Wolfson, 1985; Frederickson, 1992).
The relative performance contract differs from the profit sharing contract in that
former takes into account the performance comparison factor. That is, in addition to the
base pay and incentive pay that is in direct proportion to an agent’s output, each agent’s
output is further compared with the average output of all agents, which is used as a
benchmark of expected performance. If an agent’s output is greater (smaller) than the
average output of all agents, he will receive more (less) relative-performance-based-pay.
Facing severe competition among agents, the agent is induced to exert more effort either
to earn more reward or avoid penalty. Hence the output under the relative performance
contract is expected to be greater than under the profit sharing contract.
The agent’s performance under relative performance contract is better than that
under the profit sharing contract in the following three cases:
(1) there is no interaction of production behavior among individual agents, in
which case there is systematic risk such that there is positive correlation among
the agents’ verifiable noisy performance measures (Holmstrom, 1982;
Mookherjee, 1984; Itoh, 1993);
(2) there is a correlation among the agents’ production environment uncertainty
factors in multi-agents settings; and
(3) the agents’ production processes are considerably interacted and the correlation
coefficient of performance measure exceeds a threshold (Itoh, 1992).
Under these circumstances, the agent’s performance with the relative performance
contract is expected to be superior to the profit sharing contract.
Time pressure is one of the environmental variables that affect decision
performance (Libby and Luft, 1993; Bonner and Sprinkle, 2002). Auditors regularly
face tight time constraint when performing audits and issuing audit reports, since all
listed companies must file financial reports attested by auditors to the SEC within
 specified timelines. The audit firms must operate efficiently and effectively to maintain Incentive
their competitiveness in the audit market. Holmstrom (1982) demonstrates that contracts and
changes in the level of common uncertainty do not affect the level of effort. If time
pressure is regarded as an environmental variable, then an increase in time pressure time pressure
does not affect effort and hence performance, assuming a positive correlation between
effort and performance[9]. Moreover, the audit performance is expected to be better
with the relative performance contract than with the profit sharing contract, even for 267
an increase in the level of time pressure. These explanations yield the following null
hypotheses:
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H1A. Ceteris paribus, given an incentive scheme, increasing the level of time
pressure changes the recall performance, recognition performance, and total
audit judgment performance.
H2A. Ceteris paribus, given a level of time pressure, neither the recall performance,
recognition performance; nor total audit judgment performance under the
relative performance contract is better than under the profit sharing contract.

2.2 Behavioral and psychological hypotheses

Based on Zajonc’s (1965) mechanistic theory and Ferris et al.’s (1978) cognitive-oriented
theory, Triplett (1898) documents, based on the perspective of behavioral theory, that
the agent performs better in a multi-agents environment, because of the social influence
of performance. Ferris and Mitchell (1987) further reconcile the above two theories by
applying the saliency of social influence. They argue that more than two agents
performing the same task can produce an appropriate performance indicator, so the
level of salience is high. The agent will change his expectation on effort exerted
through social learning, social comparisons, and modeling. Therefore, when the source
of social influence increases a specific agent’s salience, social influence has more
influences on a cognitive process. In this case, the comparability of performance and
the similarities among agents should be taken into account, as both are positively
affected by the uncertainty shared by the agents. Frederickson (1992) argues that
under the profit sharing contract, the comparison of performance among agents is less
salient and, individual performance, instead of relative performance, is more
emphasized. The use of relative performance evaluation creates more competition
among agents, induces them to exert more effort, and thus improves an agent’s
performance. As predicted by agency theory, the above analysis shows that audit
performance under the relative performance contract is expected to be better than that
under the profit sharing contract.
Moreover, an increase in environmental uncertainty has more influence under the
relative performance contract, because it raises the comparability of agents’
performances and the similarity in behavior of comparison agents, and thus the
saliency of relative performance information. The increase in saliency of relative
performance information leads to more cognitive activities and more similar behavior
for all agents. As agents are aware of the comparison of their performance against one
another, the saliency of comparisons and competition among agents will be increased.
Thus, agents are expected to exert more effort to improve their performance in
response to the increased competition (Beck and Seta, 1980; Locke, 1968; Ferris and
Mitchell, 1987; Frederickson, 1992). Therefore, audit performance under the relative
 MAJ performance contract is better than that under the profit sharing contract when the
27,3 common uncertainty is increased.
In contrast, research in psychology has documented an inverted-U function between
arousal and performance using a pressure-arousal-performance framework (Yerkes
and Dodson, 1908)[10]. The inverted-U relation between arousal and performance
exists because increasing arousal reduces irrelevant cues and improves performance,
268 but continuous reduction in the amount of cues negatively affects relevant cues and
impairs performance (Easterbrook, 1959). Eysenck (1986) suggests that incentive and
anxiety provide the basis for monotonic processes to produce first positive and then
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negative relations between arousal and performance. Incentives typically induce

increased attention and effort and result in better performance. However, high levels
of incentive frequently induce anxiety and bring intense pressure that can lead to an
increase in the level of psychological arousal, which harms performance (Baumeister,
1984; Baumeister and Showers, 1986; Eysenck, 1986; Weick, 1983; Ashton, 1990).
The pressure of completing audits within a strict time constraint is particularly
prevailing in the audit industry, which typically demonstrates a strong cyclical peak
and low season. Survey evidence by Rhode (1978) shows that substantial time pressure
may impact negatively on auditors’ performance in audits[11]. Time pressure may
produce psychological burden and cause a negative effect on outcome, though the audit
efficiency is improved (McDaniel, 1990). An increase in time pressure leads to an
increase in decision errors and a decrease in effectiveness (Pachella, 1974). Survey
evidence by Lightner et al. (1982, 1983) and Alderman and Deitrick (1982) indicate that
substantial time pressure could negatively impact planned audit effectiveness.
McDaniel (1990) finds that increasing time pressure reduces audit effectiveness[12].
To sum up, the inverted U-shaped function between pressure and performance
means that increasing the degree of time pressure will first raise performance until an
optimal point, and then the performance will start to decline in response to a high
degree of time pressure. Too much pressure may harm performance. Consequently,
whether an increase in the degree of time pressure improves performance hinges on the
level of time pressure. Moreover, whether the relative performance contract induces
more output than the profit sharing contract also rests on the level of time pressure.
The agents’ performance responds more strongly to the increased time pressure under
the relative performance contract than under the profit sharing contract.
Figure 1 shows the relation between time pressure and performance. The inverted-U
function between time pressure and decision performance in the relative performance
contract is expected to have a steeper slope than in the profit sharing contract. When
there exists a positive relation between time pressure and performance, the relative

Performance

Relative performance

Figure 1.
Time pressure and audit Profit sharing
performance under two
incentive contracts Time pressure
M
 performance contract yields better performance than the profit sharing contract. When Incentive
there exists a negative relation between time pressure and performance, the contracts and
performance under the relative performance contract is still better until the point M,
and only worse when the level of time pressure exceeds M. With the negative time pressure
association before M, which incentive contract produces superior performance depends
on the level of time pressure.
We need not concern ourselves with extremely low or extremely high levels of time 269
pressure. On the one hand, it will not be realistic to suppose a practice by auditing firms
to permit too relaxed a work environment, given the nature of the occupation. On the
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other hand, quality of work dictates that too punishing a degree of stress will lead to
seriously degraded performance and an error-filled output. By manipulating a moderate
to high level of time pressure, I expect to capture a negative association between time
pressure and performance. These explanations yield the following null hypotheses:
H1B. Ceteris paribus, given an incentive scheme, an increase in the level of time
pressure does not reduce the recall performance, recognition performance, or
total audit performance.
H2B. Ceteris paribus, given a level of time pressure, neither the recall performance,
recognition performance nor; total audit judgment performance in the relative
performance contract is better than that in the profit sharing contract.
H3. Ceteris paribus, increasing the level of time pressure does not cause a larger
amount of changes in recall performance, recognition performance, and total
audit judgment performance under the relative performance contract than
under the profit sharing contract.
H4. Ceteris paribus, given an incentive scheme, an increase in the level of time
pressure does not increase recall performance, recognition performance, and
total audit efficiency.

3. Research method
Prior studies investigating the impact of experience on audit judgments find that it
depends on task complexity. The experience effect on judgment performance is
considerable when task complexity is unstructured or semi-structured. The performance
of more complex or unstructured task is significantly affected by experience (Frederick
and Libby, 1986; Libby, 1985; Abdolmohammadi and Wright, 1987). The experience
effect is unimportant for structured tasks (Ashton and Kramer, 1980; Hamilton and
Wright, 1982; Abdolmohammadi and Wright, 1987). To control the effect of task
difficulty, I follow Frederick (1991) and Libby and Lipe (1992) in choosing a structured
task of internal control over the purchasing cycle as the experiment. The judgments
involved in internal control are relatively more structured, compared to other audit
decisions. Past studies (Ashton and Kramer, 1980; Hamilton and Wright, 1982) indicate
that students may be reasonably good surrogates for experienced auditors for internal
control task. Thus, using students as surrogates for experienced auditors in making
judgments for structured tasks is suitable. The findings can be extended to practical
implications for audit firms without loss of generality.
Unlike most related studies in just mimicking reward for doing the experiment,
I compensate all subjects based on their individual performances. However, because
 MAJ of limited budget for subjects’ reward in conducting the experiment, 42 undergraduate
27,3 accounting majors with an average of 30 term credit hours of accounting courses
participated in the experiment. All subjects are randomly assigned to six groups
consisting of two levels of time pressure and two types of incentive schemes with two
sets of incentive coefficients.
This paper adapts the experiment materials in Frederick (1991) and Libby and Lipe
270 (1992). All programs begin with general instructions on how accountants understand
the internal control systems, their purpose, the tasks involved in the experiment, and
the length of time for the experiment. The subjects are then given the information on
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monetary reward for the experiment. Following the financial incentive information,
I then give students a list of internal control related to the purchasing cycles with
28 items for memorizing. The 28 items of internal controls over the purchasing cycle is
validated by Frederick (1991) and shown in Table I. There are seven minutes for all
subjects to read and memorize these internal controls. The subjects are advised to
study the items carefully because during the recall phase they need to do two tasks on:
(1) Recall – to recall and write all items they can remember.
(2) Recognition – to recognize whether selected items are listed in the internal
controls or not.

Subjects are next asked to provide some background information that serves as a
distraction task. Following the demographic data, the subjects are asked to recall and
write down as many of the listed internal controls as possible. Then a 20-item
recognition task is presented, where the subjects are asked to indicate whether each
item has been included in the original list of internal controls. Finally, the experiment
ends with debriefing questions. The experiment materials includes six steps:
(1) general instructions;
(2) presentation of 28 internal controls;
(3) demographic questions;
(4) free recall of controls;
(5) recognition task; and
(6) debriefing questions.

The three programs (and experimental conditions) differ in the incentive schemes
offered to the subjects and the time for recall and recognition tasks (as discussed below).
The level of time pressure and type of incentive contract are manipulated in a 3 £ 2
factorial design. There are six different programs used for six groups consisting of two
level of time pressure, high and low, and two types of incentive contract, profit sharing
and relative performance with two sets of incentive coefficients. Two levels of time
pressure are imposed by restricting the length of time for the recall and recognition
tasks, with one low (14 minutes) and one high (eight and half minutes). Subjects in the
low level of time pressure groups have ten minutes and four minutes to complete the
recall task and the recognition task, respectively; while those in the high level of time
pressure groups have six minutes and two and half minutes to complete the recall task
and the recognition task, respectively[13].
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Panel A: list presented for encoding a

There is a separate and independent purchasing department
There is an approved list of suppliers
There are written authorization procedures and limits of buying power (T)
Prenumbered purchase orders are used and controlled (T)
Purchase orders are properly authorized
There is a separate and independent receiving department
Access to receiving areas is adequately controlled
There is adequate control over direct shipments from suppliers to customers (T)
Goods received are physically verified
Prenumbered receiving reports are used and controlled (T)
Receiving reports are checked for descriptions and quantities by the department
goods are routed to
Invoices are received by accounts payable department directly from mail opener
Invoices are checked for prices, quantities, and mathematical accuracy (T)
Invoices are matched to receiving reports (T)
Receiving reports are matched to purchase orders
Prenumbered vouchers are used and controlled
Vouchers are properly authorized
There is a separate and independent cash disbursements department
Check signers are authorized by board of directors
Prenumbered checks are used and controlled (T)
Paid invoices are effectively cancelled (T)
After signing, checks are handled and mailed by independent party
Spoiled checks are mutilated and kept on file
Journal entries are standardized
Batch totals of invoices are checked to total of invoices recorded
(continued)

Internal control attributes

Incentive

time pressure
contracts and

271

Table I.
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27,3

272
MAJ

Table I.
There are regular reconciliations of the accounts payable subsidiary ledger to the
general ledger (T)
Regular summaries of journal entries are prepared and reviewed to ensure all
standard entries have been made (T)
Assets are periodically inspected and reconciled to the records
Panel B: recognition items not presented on the original list (foils)
Typeb Item
O Payroll preparation is segregated from timekeeping
P There is a separate and independent accounts payable department
P Purchase requisitions are properly authorized
P Check signers are required to review supporting documents before
signing
O Deposits are checked independently and deposited promptly
O Reconciliation of cash receipts to specific invoices is made prior to
posting
P There are regular comparisons of expense accounts to budgets
O Shipping documents are matched to sales invoice
O Prenumbered sales orders are used and controlled
P Receiving reports are sent directly to accounts payable department
Notes: aT indicates that the item was included on the recognition list (a target); bP indicates a foil item chosen from purchasing cycle controls, and O
indicates a foil chosen from other cycles
Source: Frederick (1991) and Libby and Lipe (1992)
 Two types of incentive contract with flat pay and incentive pay are manipulated Incentive
between subjects. The flat pay for each subject is two dollars and 57 cents (in US dollars). contracts and
The profit sharing contract provides for a subject 64 cents and 64 cents for every
item correctly recalled and recognized, respectively, as follows: time pressure
Reward ¼ $2:57 þ $0:64xi þ $0:26yi , where xi and yi is subject i’s number of items
correctly recalled and number of items correctly recognized, respectively. To understand
the effect of incentive coefficients on performance, the second set with higher incentive 273
coefficients is stipulated as: Reward ¼ $2:57 þ $0:9xi þ $0:39yi . The relative
performance contract adds performance comparison factors to incentive variables,
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and so the reward is $2:57 þ $0:64xi þ 0:26yi þ $0:64ðxi 2 x Þ þ $0:26ð yi 2 y Þ, where x

and y denote the average number of items correctly recalled and items correctly
recognized for subjects within the group, respectively. The second relative performance
contract with higher incentive coefficients is as follows:
$2:57 þ $0:9xi þ $0:39yi þ $0:9ðxi 2 x Þ þ $0:39ð yi 2 y Þ. Thus, under the two relative
performance contracts, a subject whose performance is better than the average receives
more reward, while a subject with worse performance receives less reward.

4. Results
Two subjects do not complete the experiments and are deleted from the analysis. Table II
presents the time spent on the recall task and recognition task, and the incentive
coefficients for both profit sharing contract and relative performance contract. To
impose time pressure on subjects in two tasks, low (high) level of time pressure means
that time spent on recall and recognition is ten (six) and four (two and half) minutes,
respectively. The above time constraints for recall task are between 50 and 80 percent of
that spent by subjects with no time constraint in the experimental tasks of Libby and
Lipe (1992). The total time on two tasks for low (high) level of time pressure is 14 (eight
and half) minutes. As explained in the previous section, there are two sets of incentive
coefficients, where the higher coefficients are labeled as H (high) and L (low).
Table III presents sample statistics of recall, recognition, total performance, and
reward in US dollars. Total cost for all subjects’ reward approximately amounts to
$642. The maximum and minimum reward under the profit sharing contract is $20.96
and $8.49, respectively, while the maximum and minimum reward under relative
performance contract is $22.38 and $10.8, respectively. The relative performance
groups generally outperform the profit sharing groups, regardless of the level of time
pressure. Subjects in the profit sharing groups on average correctly recall and
recognize 9.6 and 14.8 items of internal control, respectively. Subjects in the relative

Incentive scheme Profit sharing Relative performance

Incentive coefficientsa Low Low High Low Low High
Time pressure Low High High Low High High

Recall time (minutes) 10 6 6 10 6 6

Recognition time (minutes) 4 2.5 2.5 4 2.5 2.5
Total time spent (minutes) 14 8.5 8.5 14 8.5 8.5 Table II.
Time spent on recall and
a
Note: Low (high) incentive coefficients mean that subjects receive 64 (90) and 26 (39) cents for each recognition task, and
item correctly recalled and recognized, respectively incentive coefficients
 MAJ
Incentive scheme Profit sharing Relative performance
27,3 Incentive coefficientsb Low Low High Low Low High
Time pressure Low High High Total Low High High Total

Recall (# correct) 10.00 9.93 8.91 9.60 14.49 11.20 11.27 11.8
(3.54) (2.39) (3.19) (2.96) (2.17) (2.75) (2.23) (2.81)
274 Recognition (# correct) 15.43 13.86 15.14 14.80 17.57 16.00 17.00 15.3
(2.44) (3.93) (3.29) (3.24) (1.90) (2.58) (2.00) (3.09)
Total (# correct) 25.43 23.79 24.06 24.40 32.06 27.20 28.27 27.1
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(5.45) (5.18) (4.28) (4.83) (2.35) (4.49) (1.74) (5.10)

Maximum pay (US$) 20.45 16.21 20.96 20.96 22.38 20.06 21.86 22.38
Minimum pay (US$) 8.49 10.03 12.60 8.49 14.02 10.80 15.31 10.80
Table III. Notes: Standard divisions in parentheses; a# correct means number of items correctly answered;
b
Time, performance, and low (high) incentive coefficients mean that subjects receive 64 (90) and 26(39) cents for each item
reward statistics: meansa correctly recalled and recognized, respectively

performance groups on average correctly recall and recognize 11.8 and 15.3 items of
internal control, respectively[14]. In general, given an incentive contract, when the level
of time pressure increases, recall, recognition, and total performance all deteriorate[15].
Table IV shows means of audit efficiency statistics with standard division in
parentheses. Following McDaniel (1990), the recall (recognition) efficiency is defined as
number of items correctly recalled (recognized) divided by time spent on the recall
(recognition) task. Increasing the level of time pressure generally improves recall
efficiency, recognition efficiency, and total efficiency under both types of incentive
contract. In addition, given a level of time pressure and incentive coefficients, the recall
efficiency, recognition efficiency, and total efficiency under relative performance
contract are greater than that under the profit sharing contract.
Knowledge and task difficulty are controlled for two reasons. First, the effect of
knowledge on performance is well documented in behavioral audit literature, as the
so-called “expertise paradigm” (Bonner and Louis, 1990; Bonner and Pennington, 1991;
Libby, 1995). Second, as noted in the previous section, task complexity may influence
of the effect of experience on judgment performance. Therefore, to control for potential
factors which might influence the experiment results, I use one-way ANOVA analysis
to demonstrate that these potential factors are controlled.

Incentive scheme Profit sharing Relative performance

Incentive coefficienta Low Low High Low Low High
Time pressure Low High High Total Low High High Total

Recall efficiency 1.000 1.655 1.486 1.380 1.449 1.867 1.879 1.730
(0.354) (0.398) (0.531) (0.501) (0.217) (0.458) (0.372) (0.400)
Recognition efficiency 3.857 5.543 5.985 5.133 4.393 6.400 6.800 5.852
(0.610) (1.574) (1.300) (1.524) (0.476) (1.033) (0.800) (1.330)
Total efficiency 1.816 2.798 2.813 2.476 2.280 3.197 3.326 2.934
(0.389) (0.610) (0.515) (0.682) (0.164) (0.525) (0.204) (0.575)
Table IV.
Means of audit efficiency Notes: Standard divisions in parentheses; alow (high) incentive coefficients mean that subjects receive
statistics 64 (90) and 26 (39) cents for each item correctly recalled and recognized, respectively
 Table V shows the one-way ANOVA analysis, grouped by either incentive scheme or Incentive
time pressure, and indicates that, the F-values of all items are not significant at 1 percent contracts and
of significance level. This suggests that the results are not influenced by an individual’s
risk attitude or interest on the experiment, difficulty of the recall or recognition tasks, and time pressure
cumulative grade point average (GPA) for accounting-related courses or
cumulative GPA for all courses. Thus, the potential factors influencing the results are
controlled. 275
Consistent with the behavioral and psychological prediction of H1B, Table VI shows
that given a relative performance contract, increasing the level of time pressure
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significantly reduces subjects’ recall performance (F ¼ 6.275) and total performance

(F ¼ 6.243) at 5 percent of significance level. As mentioned in the previous section, the
relative performance contract imposes more stress on subjects than the profit sharing
contract, and so a more significant decline is found in the performance in response to the
increased time pressure. These results moderately support psychological theory of H1B.
The finding that increasing the level of time pressure does not significantly change the
recognition performance is consistent with the economic prediction of H1A.
However, it is also possible that the reduction of time is not substantial enough to
force considerable pressure on the subjects, with the reasons shown in the previous
section. Given a profit sharing contract, auditors’ performance in both recall and
recognition tasks does not significantly decline when the level of time pressure
increases. This is possibly because, in this case, subjects are aware of their reward in
direct proportion to their performance. Though the level of time pressure is increased,
their benchmark of reward may be zero. Without doing the experiment, they receive no
pay; as long as they are allowed to participate in the experiment, they receive both flat
pay and performance-contingent pay. These findings are consistent with H1A, based on
the agency theory.
In sum, the recall and total performances under the relative performance contract
are consistent in part with the behavioral prediction. The recognition performance

Incentive scheme Time pressure

Grouped by F-value Pr . F F-value Pr . F

Individual risk attitude 1.700 0.118 1.292 0.320

Interest of experiment 1.024 0.479 1.083 0.444
Difficulty of recall task 1.704 0.117 3.200 0.020 Table V.
Difficulty of recognition task 0.883 0.608 0.814 0.642 ANOVA analysis of
Cumulative GPA – accounting-related courses 1.179 0.358 1.070 0.449 controlling factors
Cumulative GPA 1.317 0.272 1.077 0.444 influencing performance

Total Recall Recognition

Performance F p-value F p-value F p-value

Profit sharing contract 0.334 0.574 0.002 0.965 0.807 0.387 Table VI.
Relative performance contract 6.243 * 0.028 6.275 * 0.028 1.485 0.246 Association between
time pressure and
Note: Significant at: *5 percent level performance
 MAJ under the relative performance contract and both recall and recognition performances
27,3 under the profit sharing contract are consistent with the economic perspective.
In Table VII, the F-value of 5.982 indicates that given a high level of time pressure and
high incentive coefficients, audit total performance under the relative performance
contract is significantly better than that under the profit sharing contract. The F-values
of 8.418 and 8.176 mean that, given a low level of time pressure, audit total performance
276 and recall performance under relative performance contract are significantly superior to
that under the profit sharing contract at 5 percent of significance level.
The Fstandard divisions in parenthesesvalue of 3.144 for recognition task in the low
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time pressure groups is marginally significant, while others are not. There are three
possible reasons for the insignificance of recognition performance. First, these findings
which indicate that increasing the level of time pressure generally does not change the
recognition performance are actually consistent with the economic prediction of H1A.
The time pressure does not affect the relationship between incentive contract and
judgment performance.
Second, however, it is also possible that the reduction of time is not substantial
enough to force considerable pressure on the subjects. The reasons for not setting a
strict time constraint are explained in the previous section. Future study may explore
the effect of time pressure on auditors in greater depth by setting more levels of time
budget for subjects in the recognition task. However, a balance between usage of
language and reading capabilities needs to be taken into account.
Lastly, the change in the recognition performance is less sensitive to a change in the
incentive scheme. As Libby and Lipe (1992) document, the subjects’ incentives to exert
effort in encoding and retrieval generate smaller improvements in the recognition tasks
than in the recall tasks of the internal control system. Hence, it is more difficult to
detect a significant change in the recognition performance in response to a change in
the incentive scheme. Overall, the above evidence is moderately consistent with
predictions of H2A and H2B, in that recall and total audit performance when time
pressure is low and total performance when time pressure is high with high incentive
coefficients under the relative performance contract outperform those under the profit
sharing contract.
Table VIII shows that in responding to an increase in the level of time pressure, the
reduction of total performance and recall performance under the relative performance
contract are significantly different from that under the profit sharing contract
(F ¼ 7.107 and 6.493). This result holds for a test of reduction of performance in
percentage (F ¼ 4.46 and 4.147). These results are consistent with H3. The reduction of
audit performance under the relative performance contract is significantly more than

Total Recall Recognition

Performance F p-value F p-value F p-value

Time pressure – higha 5.982 * 0.031 2.568 0.135 1.750 0.211

Time pressure – highb 1.715 0.215 0.816 0.384 1.452 0.251
Table VII. Time pressure – low 8.418 * 0.013 8.176 * 0.014 3.144 0.102
Association between
incentive scheme and Notes: Significant at: *5 percent level; atwo groups of high level of time pressure with high incentive
performance coefficients; btwo groups of high level of time pressure with low incentive coefficients
 that under the profit sharing contract, when the time pressure is increased. Incentive
Nevertheless, as the statistics shown in Table II indicates, audit performance under the contracts and
relative performance contract outperforms that under the profit sharing contract.
The results in Table IX are consistent with the predictions of H4. Given either profit time pressure
sharing or relative performance contract, auditors’ recall efficiency, recognition
efficiency, and total efficiency are all significantly improved when the level of time
pressure increases. Lastly, two-way ANOVA analysis in Table X indicates both time 277
pressure and contract type significantly affect audit performance (F ¼ 8.341 and 3.49);
while the interaction term is not significant.
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5. Concluding remarks
This paper examines the impacts of incentive schemes and time pressure on audit
decision performance. The major findings indicate that both incentive contract and
time pressure affect total audit judgment performance. Both agency theory and
behavioral theory predict that decision performance would be superior under the
relative performance contract compared to the profit sharing contract in certain cases.
The experimental results are generally consistent with this prediction. The recall and
total audit performances are generally better under the relative performance contract
than under the profit sharing contract.

Total Recall Recognition

Table VIII.
Performance F p-value F p-value F p-value
Changes in audit
Reduction in amount 7.107 * 0.021 6.493 * 0.026 0.010 0.922 performance between two
Reduction in percentage 4.460 * 0.056 4.147 * 0.064 0.394 0.542 incentive contracts
when the time pressure
Note: Significant at: *10 and * *1 percent levels is increased

Total Recall Recognition

Performance F p-value F p-value F p-value

Profit sharing contract 12.895 * * 0.004 10.586 * * 0.007 6.984 * 0.021

Relative performance 19.445 * * 0.001 4.657 * 0.052 23.348 * * 0.000 Table IX.
Association between time
Note: Significant at: *10 and * *1 percent levels pressure and efficiency

Source of variation SS df MS F p-value

Time pressure 170.529 1 170.529 8.341 * * 0.008

Incentive scheme 71.360 1 71.360 3.490 * 0.074
Interaction 16.818 1 16.816 0.823 0.373
Within 490.686 24 20.445 Table X.
Total 749.393 27 Effects of time pressure
and incentive contract
Note: Significant at: *10 and * *1 percent levels type on performance
 MAJ By manipulating a high level of time pressure on recall tasks, the findings show that
27,3 audit performance on recall tasks under the relative performance contract responds
negatively to an increase in the level of time pressure, though, in this case recall,
recognition, and total audit efficiency are all improved under both contracts.
As predicted by psychological and behavioral research, increasing the level of time
pressure causes a more decelerated reduction under the relative performance contract
278 than under the profit sharing contract. Even so, audit performance under the relative
performance contract still generally outperforms the profit sharing contract. The above
evidence suggests that, with either level of time pressure, high or low, the
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incentive effect of the relative performance contract on auditors will be stronger than
that of the profit sharing contract. Collectively, for designing an incentive contract, the
results suggest that CPA firms should use relative performance evaluation for junior
auditors in conducting structured tasks such as internal control, premised upon them
not being put under “too much time pressure”. Offering relative performance incentive
contracts for difficult but attainable goals may help junior auditors achieve their best
performance and create maximum benefit for CPA firms.
There are three major implications of this study. First, as per Frederickson’s (1992)
argument, a related study should simultaneously consider the impact of both economic
and behavioral perspectives on decision performance so as to raise the external validity
of the study. Second, effort is conceptually defined as intensity and duration. Many
related studies analyzing the relation between incentive and effort use duration as an
operational definition of effort, due to the fact that intensity of effort cannot be
objectively measured. However, evidence in this paper indicates that the same duration
for subjects yields varying performances. Moreover, audit performance that is
measureable and is of the main concern. Therefore, I focus on the impact of different
incentive schemes on audit performance by increasing the level of time pressure.
Future study may shed light on the influence of incentive contract types on audit
performance. Lastly, in designing incentive contracts, CPA firms may refer to our
experimental design and results. Too much pressure on a time limit to conduct a task
harms decision performance. Other things being equal, given a level of time pressure,
audit performance under relative performance contract is better than under the profit
sharing contract. This result holds under most circumstances even for an increase in
the level of time pressure. Consequently, the relative performance contract would
motivate agents to exert more effort to improve their performance.
The limitations of this study are twofold. First, increasing the level of time pressure
does not significantly change the recognition performance is consistent with the
economic prediction of H1A. It is also possible this insignificance effect is related to a
failure in the manipulation of high level of time pressure. However, this may serve as a
pointer or new direction for future research. Second, the results of this study may not
be directly extended to those tasks with less structure or more difficulties. Although
the subjects do not have working experience in audit, past studies demonstrated the
adequacy of using them as surrogates for experienced auditors for structured task.
Nevertheless, future research may further investigate the relation between incentive
schemes and audit judgment performance for less structured tasks or tasks demanding
a higher level of difficulties. Whether relative performance contract or profit sharing
contact is more useful for senior-level auditors to improve their performance in
conducting audits with high levels of task complexity deserves future research.
 Notes Incentive
1. The major factors influencing audit judgment performance are ability, knowledge, contracts and
motivation, and environment, whereby knowledge is also affected by ability, motivation, and
environment (Libby and Luft, 1993; Libby, 1995; Bonner and Sprinkle, 2002). time pressure
2. Moreover, the effects of monetary incentive on effort and judgment performance are also
affected by cognitive characteristics (Awasthi and Pratt, 1990), and the presence of decision
aid (Ashton, 1990). As a result, motivation and cognitive effort do affect judgment 279
performance.
3. Libby and Lipe (1992) is an exception. The environmental variables are those conditions,
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circumstances, and influences surrounding a person who is doing a task such as task
structure, time pressure, assigned goals, accountability, feedback, and monetary incentives
(Libby and Luft, 1993; Libby, 1995; Bonner and Sprinkle, 2002). According to agency theory,
given an incentive contract, the degree of environmental uncertainty does not affect the
agent’s effort level and performance. However, behavioral research shows a possible positive
or negative association between environmental uncertainty and effort on performance
(Frederickson, 1992).
4. Perceptual differentiation is an individual’s ability to perceptually abstract from a complex
setting specific familiar concepts or relationships. As predicted, Awasthi and Pratt (1990)
find evidence in support of positive relation between monetary and incentive effort,
measured by time spent on the task. They find that the positive association between
monetary incentive and performance depends on whether the decision maker possesses
cognitive skill such as perceptual differentiation. Frederick (1991) examines how auditors
with different levels of expertise retrieve their knowledge of internal controls from memory.
He suggests that an auditor’s retrieval of internal controls from memory depends on his
experience and how he organizes his knowledge.
5. Effort consists of intensity and duration of attention (Libby and Lipe, 1992). The operational
definition of effort for many studies is duration, because of the difficulty in measuring
intensity. However, the subjects perform differently in their intensity of attention. Given the
same duration, the stronger the intensity, the better is the performance. The present study
constrains the duration of effort for different groups of subjects and focuses on the
effect/output of effort, which is the judgment performance, after controlling for confounding
factors such as knowledge and task complexity. As long as the intensity of attention is
positively affected by monetary incentives, ceteris paribus, judgment performance will
increase as well.
6. This contract is a second-best contract as it is based on a noisy signal and leads to efficiency
loss. The level of output is a noisy signal of the level of effort.
7. The profit sharing rule with a linear incentive contract, a base salary and incentive payment
in linear proportion of output, is an example of the optimal compensation.
8. When the proportion of common uncertainty to total uncertainty increases, so does the
signal-to-noise ratio of relative performance information. The relative performance
information filters out common uncertainty caused by environment. Thus, the relative
performance information, though a noisy signal, becomes more valuable for contracting
(Holmstrom, 1982).
9. As noted in Section 2 of this paper, to solve the moral hazard problem, as effort is
unobservable, the principal needs to design an incentive scheme positively associated with
observable output (performance), since the output is an observable signal related to the
agent’s unobservable effort. Therefore, empirical studies usually examine the relation
between incentive scheme and performance, instead of the link between effort and
performance.
 MAJ 10. Optimal performance exists at a moderate level of arousal and optimal arousal is inversely
related to task difficulty (Eysenck, 1986). Arousal is a psychological response to pressure
27,3 and may be thought of partly as “motivation” from the standpoint of social-psychology.
11. Rhode (1978) finds that more than 50 percent of the 1,526 AICPA members admitted that
time pressure is the major reason to signing off on audit steps that are not covered without
noting the omission or performing at a quality lower than firm standards during the course
280 of an audit.
12. The meaning of audit effectiveness defined by McDaniel (1990) is conceptually the same as
“audit ( judgment) performance” in this paper. McDaniel (1990) defines audit effectiveness as
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percentage of items correctly identified, adjusted for sampling adequacy. Following Libby
and Lipe (1992), the present study defines audit judgment performance, including recall and
recognition performances, as the number of items correctly recalled and recognized,
respectively, or collectively described as (audit) judgment performance.
13. Time constraint is determined with reference to Libby and Lipe (1992) with modifications. In
the paper by Libby and Lipe (1992), subjects use personal computers to read and write in
their native language, English, to do the experiment. No time constraint is imposed for
subjects in doing the experiment. The subjects in the performance-contingent incentive
groups on average take 12 minutes in the recall task and less than three minutes in
the recognition task, excluding the time spent on cycling through computer screens. The
recognition task requires subjects to retrieve information from their memory and make
judgment as to whether the items for selection are presented in the internal controls, after
reading every item in the list. I adjusted slightly the time constraint upward for the
recognition task because, in conducting the task, subjects mainly spend time in reading
individual item. Reading English for those who are not using their native language is more
time-consuming than for native speakers. The present study adjusts downward the time
budget to reflect time pressure for the recall task, since subjects mainly spend time in writing
the internal control items they recalled. When a time constraint is set for subjects, it is
expected that subjects will do the tasks faster so as to finish recalling all the items. The time
budget is closer to what occurs in the real world of the audit profession.
14. The experimental results are comparable with those in Libby and Lipe (1992). The items
recalled (10 in the profit sharing with low time pressure of ten minutes, and 14.49 in the
relative performance with low time pressure) is comparable with Libby and Lipe (1992),
where subjects in the encoding group spent 12 minutes in the same task and correctly
recalled 12.3 items. The items recognized (around 16-17 in the relative performance or
14-15 in the profit sharing, both with the high time pressure of 2.5 minutes) are also
comparable with Libby and Lipe (1992), where subjects in the encoding group spent
2.2 minutes in the same task and correctly recalled 16.5 items.
15. Time pressure and incentive coefficients may have counterbalanced effects on performance.
The statistics shown in Table III indicate that, under the relative performance contract (profit
sharing) with low-incentive coefficients, when recognition time is reduced from 17.57 to
16 (15.43 to 13.86), recognition performance decreases. However, recognition performance is
improved from 16 to 17 (13.86 to 15.14) when incentive coefficients are high. Similarly, the
pattern of recall performance under both types of incentive schemes with different incentive
coefficients when time pressure is changed shows the same results as that of recognition
performance. Thus, the negative effect of time pressure appears to be offset by the positive
effect of incentive coefficients on recognition performance. These two counterbalanced effects
weaken the change in performance caused by time pressure and incentive coefficients and
increase the difficulty in detecting significant difference in the judgment performance.
Therefore, future study may refine the manipulation of time constrain and incentive
coefficients when investigating similar issues.
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About the author

Hua Lee is an Assistant Professor at Hong Kong Shue Yan University, with research interests in
audit quality, auditing litigation, and performance evaluation. Hua Lee can be contacted at:
ahlee@hksyu.edu

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