The Auditor's Loss Function and Investors' Perceptions of Audit Effectiveness: Effects of Regulatory Change

Abstract

In this dissertation, I examine the effects of regulatory changes that affect the auditor's loss function on investors' perceptions of audit effectiveness. Specifically, I examine two changes intended (1) to improve audit efficiency and (2) to reduce auditor liability exposure. The first regulatory change, which was recently enacted, is the replacement of Auditing Standard 2 (AS2) with Auditing Standard 5 (AS5). The second regulatory change, which is currently a hypothetical change, is the passage of litigation reform aimed at limiting the auditor's liability exposure following an alleged audit failure. I examine perceived audit effectiveness rather than actual effectiveness because actual audit effectiveness is unobservable by investors. In an experiment using 101 MBA students as proxies for individual investors, I find that both changes are perceived by investors as reducing the amount of testing performed by the auditor when performing the internal control audit. I also find that both regulatory changes negatively affect investors' perceptions of audit effectiveness. Following the change in the auditing standard, experienced and inexperienced investors predict opposite stock price movement and, as a result, make different investment allocation decisions. In performing supplemental analyses, I find significant gender differences in predicted future stock prices, but not in perceptions of audit effectiveness or in perceptions of internal control quality.