Reputation building and the demand for auditing

Abstract

The purpose of this dissertation is to examine the role auditor reputation plays in the demand and supply of audits and to examine the process by which an auditor builds a reputation for audit quality. The goal is to begin to develop a comprehensive theory of the demand for auditing and the incentives this demand creates for the supply of audits. Scott (1984) cites a lack of theory capturing the precise nature of the auditor's contribution to a production and exchange economy. This paper uses an experimental economy and related model to examine the role of an auditor's reputation for delivering high quality audits in such a multiple period economy. A theory of the demand and supply of audits is necessary to help assess the need for regulation of the audit market. The need for regulation in existing audit markets has been questioned by some members of the auditing profession (Arthur Andersen, et. al. 1992). In response, experimental economic markets (EEM) research has examined different regulatory regimes (Dopuch and King 1992, Dopuch et. al., 1994). However, this research has not examined whether reputation can serve as a substitute for regulation in motivating the supply of high quality audits. Existing EEM research has provided some evidence of reputation effects in general (DeJong, et. al., 1985, Dopuch and King 1991) but has produced limited evidence of auditor reputation. Unlike prior EEM research, this paper explicitly examines auditor reputation. Three different experimental treatments were used to test the derived model: one treatment with robot investors and two treatments with human investors. The robot investor replications produced strong support for an auditor reputation model. Two of six human investor replications supported an auditor reputation model while the other four collapsed into markets for lemons. The markets suggest that the managers' demand for audit quality drove the level of audit quality supplied by auditors. When the managers did not demand and auditors did not supply high quality audits, the markets collapsed.