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Legal Penalties and Audit Quality: An Experimental Investigation

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  • RONALD R. KING
  • RACHEL SCHWARTZ

Abstract

The purpose of this paper is to investigate the impact of legal penalties on audit quality under different legal regimes. We investigate whether audit quality is affected differentially due to the complexity inherent in legal regimes and the frequency of imposing legal penalties. Economic theory predicts that players adopt equilibrium strategies that reflect the expectation that a penalty will be incurred, but the actual occurrences of penalties, if consistent with this expectation, should not prompt an individual to modify his or her strategy. However, learning theory suggests that players' choices will be repeated in the future based on outcomes. We found that penalties triggered both increases and decreases in effort, and seemed to introduce a “shock†that increased the variability of effort. We also observed a “funnel†effect — that is. greater changes in effort closer to the imposition of penalties, and smaller changes as more periods go by without a penalty.

Suggested Citation

  • Ronald R. King & Rachel Schwartz, 1999. "Legal Penalties and Audit Quality: An Experimental Investigation," Contemporary Accounting Research, John Wiley & Sons, vol. 16(4), pages 685-710, December.
    • Handle: RePEc:wly:coacre:v:16:y:1999:i:4:p:685-710
    DOI: 10.1111/j.1911-3846.1999.tb00601.x
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    References listed on IDEAS

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    Cited by:

    1. Christensen, Brant & Schmardebeck, Roy & Seidel, Timothy, 2022. "Do auditors’ incentives affect materiality assessments of prior-period misstatements?," Accounting, Organizations and Society, Elsevier, vol. 101(C).
    2. Florian Baumann & Tim Friehe & Pascal Langenbach, 2020. "Fines versus Damages: Experimental Evidence on Care Investments," Discussion Paper Series of the Max Planck Institute for Behavioral Economics 2020_08, Max Planck Institute for Behavioral Economics, revised Mar 2024.
    3. Christensen, Brant & Lei, Lijun (Gillian) & Shu, Sydney Qing & Thomas, Wayne, 2023. "Does audit regulation improve the underlying information used by managers? Evidence from PCAOB inspection access and management forecast accuracy," Accounting, Organizations and Society, Elsevier, vol. 106(C).
    4. F. Greg Burton & T. Jeffrey Wilks & Mark F. Zimbelman, 2011. "The impact of audit penalty distributions on the detection and frequency of fraudulent reporting," Review of Accounting Studies, Springer, vol. 16(4), pages 843-865, December.
    5. Frederick W. Rankin, 2004. "Coordinating Effort under Team†Based and Individual Incentives: An Experimental Analysis," Contemporary Accounting Research, John Wiley & Sons, vol. 21(1), pages 191-222, March.
    6. Theodore Eisenberg & Christoph Engel, 2016. "Unpacking Negligence Liability: Experimentally Testing the Governance Effect," Journal of Empirical Legal Studies, John Wiley & Sons, vol. 13(1), pages 116-152, March.
    7. Hung-Chao Yu, 2011. "Legal systems and auditor independence," Review of Accounting Studies, Springer, vol. 16(2), pages 377-411, June.
    8. Paul J. Beck & Martin G. H. Wu, 2006. "Learning by Doing and Audit Quality," Contemporary Accounting Research, John Wiley & Sons, vol. 23(1), pages 1-30, March.
    9. Kendall O. Bowlin & Jeffrey Hales & Steven J. Kachelmeier, 2009. "Experimental evidence of how prior experience as an auditor influences managers’ strategic reporting decisions," Review of Accounting Studies, Springer, vol. 14(1), pages 63-87, March.
    10. Giuseppe Attanasi & Laura Concina & Caroline Kamaté & Valentina Rotondi, 2020. "Firm’s protection against disasters: are investment and insurance substitutes or complements?," Theory and Decision, Springer, vol. 88(1), pages 121-151, February.
    11. Vera Angelova & Olivier Armantier & Giuseppe Attanasi & Yolande Hiriart, 2014. "Relative performance of liability rules: experimental evidence," Theory and Decision, Springer, vol. 77(4), pages 531-556, December.
    12. Martin G. H. Wu, 2006. "An Economic Analysis of Audit and Nonaudit Services: The Trade†off between Competition Crossovers and Knowledge Spillovers," Contemporary Accounting Research, John Wiley & Sons, vol. 23(2), pages 527-554, June.

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