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Corporate Governance, Reputation Concerns, and Herd Behavior

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Author Info

  • Barbara Schöndube-Pirchegger

    () (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg)

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    Abstract

    This paper offers an explanation for audit committee failures within a corporate governance context. We consider a setting in which the management of a firm sets up financial statements that are possibly biased. These statements are reviewed/audited by an external auditor and by an audit committee. Both agents report the result of their audit, the auditor acting first. The auditor and the audit committee use an imperfect auditing technology. As a result of their work they privately observe a signal regarding the quality of the financial statements. The probability for a correct signal in the sense that an unbiased report is labelled correct and a biased one incorrect, depends on the type of the agent. Good as well as bad agents exist in the economy. Importantly, two good agents observe identical informative signals while the signal observed by a bad agent is uninformative and uncorrelated to those of other good or bad agents. The audit committee as well as the auditor are anxious to build up reputation regarding their ability in the labor market. Given this predominate goal they report on the signal in order to maximize the market’s assessment of their ability. At the end of the game the true character of the financial statements is publicly learned and the market uses this information along with the agents’ reports to update beliefs about the agents’ type. We show that herding equilibria exist in which the auditor reports based on his signal but the audit committee .herds. and follows the auditor’s judgement no matter what its own insights suggest.

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    File URL: http://www.ww.uni-magdeburg.de/fwwdeka/femm/a2007_Dateien/2007_06.pdf
    File Function: First version, 2007
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    Bibliographic Info

    Paper provided by Otto-von-Guericke University Magdeburg, Faculty of Economics and Management in its series FEMM Working Papers with number 07006.

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    Length: 23 pages
    Date of creation: Feb 2007
    Date of revision:
    Handle: RePEc:mag:wpaper:07006

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    Related research

    Keywords: corporate governance; audit committee; game theory; herding;

    This paper has been announced in the following NEP Reports:

    References

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    1. Arya, Anil & Mittendorf, Brian, 2005. "Using disclosure to influence herd behavior and alter competition," Journal of Accounting and Economics, Elsevier, vol. 40(1-3), pages 231-246, December.
    2. Revsine, Lawrence, 2002. "Enron: sad but inevitable," Journal of Accounting and Public Policy, Elsevier, vol. 21(2), pages 137-145.
    3. Benston, George J. & Hartgraves, Al L., 2002. "Enron: what happened and what we can learn from it," Journal of Accounting and Public Policy, Elsevier, vol. 21(2), pages 105-127.
    4. Ozerturk, Saltuk, 2005. "Board independence and CEO pay," Economics Letters, Elsevier, vol. 88(2), pages 260-265, August.
    5. Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Working Papers _004, University of California at Berkeley, Haas School of Business.
    6. Scharfstein, David. & Stein, Jeremy C., 1988. "Herd behavior and investment," Working papers WP 2062-88., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    7. Bebchuk, Lucian A. & Fried, Jesse M., 2003. "Executive Compensation as an Agency Problem," Berkeley Olin Program in Law & Economics, Working Paper Series qt81q3136r, Berkeley Olin Program in Law & Economics.
    8. Lucian Arye Bebchuk & Jesse M. Fried, 2003. "Executive Compensation as an Agency Problem," NBER Working Papers 9813, National Bureau of Economic Research, Inc.
    9. Mark L. Defond & Rebecca N. Hann & Xuesong Hu, 2005. "Does the Market Value Financial Expertise on Audit Committees of Boards of Directors?," Journal of Accounting Research, Wiley Blackwell, vol. 43(2), pages 153-193, 05.
    10. Welch, Ivo, 2000. "Herding among security analysts," Journal of Financial Economics, Elsevier, vol. 58(3), pages 369-396, December.
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