The effects of incentives and audits on transfer price negotiations in a deflationary context

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.