The Market for Liars: Reputation and Auditor Honesty
University of Minnesota - Twin Cities - Department of Economics
University of Bristol
ISER Discussion Paper No. 587
In the model there are two types of financial auditors with identical technology, one of which is endowed with a prior reputation for honesty. We characterize conditions under which there exists a two-tier equilibrium in which reputable auditors refuse bribes offered by clients for fear of losing reputation, while disreputable auditors accept bribes because even persistent refusal does not create a good reputation. The main findings are: (a) honest auditors charge higher fees, and have economic profits accruing to reputation; (b) as the fraction of auditors who are honest increases, the premium charged by reputable auditors eventually decreases, which diminishes the incentive to refuse bribes; (c) if the fraction of honest auditors exceeds an upper bound, there does not exist a two-tier equilibrium; (d) thus the reputation mechanism may be undermined by entry into the honest segment of the industry, if it is possible; (e) increasing auditor independence increases the upper bound.
Number of Pages in PDF File: 27
Keywords: auditing, reputation, adverse selection, auditor independence
JEL Classification: M41, D82, G14working papers series
Date posted: September 22, 2003
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