The Auditor and the Firm: A Simple Model of Corporate Cheating and Intermediation
We apply a game-theoretic model to the analysis of the recent spate of corporate scandals in which firms have cheated their investors, often with the aid of external auditors. We characterize the different types of equilibria that obtain for different parameter ranges in an auditor’s absence (the parameters we consider being “early signal accuracy” – a measure of transparency – and “withdrawal costs” – a measure of the liquidity of investments). We also analyze whether and under what conditions the presence of an informed auditor could lead to an improvement in the sense of honest behavior replacing cheating as the firms’ equilibrium strategy. In doing so we take into account the auditor’s incentives to collude with his clients or extort from them. We use our results to derive some policy predictions including those relating to the Sarbanes-Oxley reforms, and contrast the case of a firm-hired intermediary (like an auditor) with the situation in which an intermediary is hired by investor consortia. Interestingly, we find that mandatory disclosure of audit fees could guarantee honest behavior, in equilibrium, for much of the parameter space in which cheating would have prevailed in an auditor’s absence – as investors are able to check that audit fees lie in a range which removes incentives to cheat for the auditor and his clients. Such disclosure would need to be backed by heavy penalties for false disclosure. We also find that while firm-hired intermediaries have a non-monotone reaction to improvements in public transparency, initially favoring and then opposing them, investor-hired intermediaries unambiguously dislike improvements in public transparency. We argue that frequent rotation of an auditor’s clients may have costs, not just benefits.
|Date of creation:||Sep 2005|
|Publication status:||Published in SMU Economics and Statistics Working Paper Series|
|Contact details of provider:|| Postal: 90 Stamford Road, Singapore 178903|
Phone: 65-6828 0832
Fax: 65-6828 0833
Web page: http://www.economics.smu.edu.sg/
More information through EDIRC
|Order Information:|| Email: |
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Garey Ramey & Joel Watson, 2002.
Journal of Law, Economics and Organization,
Oxford University Press, vol. 18(2), pages 362-384, October.
- Garey Ramey & Joel Watson, 1999. "Contractual Intermediaries," Cowles Foundation Discussion Papers 1235, Cowles Foundation for Research in Economics, Yale University.
- Ramey, Garey & Watson, Joel, 1999. "Contractual Intermediaries," University of California at San Diego, Economics Working Paper Series qt49p1c23g, Department of Economics, UC San Diego.
- Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
- Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
- Douglas W. Diamond & Raghuram G. Rajan, "undated". "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
- Craswell, Allen & Stokes, Donald J. & Laughton, Janet, 2002. "Auditor independence and fee dependence," Journal of Accounting and Economics, Elsevier, vol. 33(2), pages 253-275, June.
- Diamond, Douglas W, 1991. "Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 689-721, August.
- Greif, Avner, 1993. "Contract Enforceability and Economic Institutions in Early Trade: the Maghribi Traders' Coalition," American Economic Review, American Economic Association, vol. 83(3), pages 525-548, June. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:siu:wpaper:15-2005. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (QL THor)
If references are entirely missing, you can add them using this form.