Risk Aversion and Audit Markets

Abstract

Standard setters aim to improve the audit quality of financial audits. We thus analyse the provided and demanded audit quality from risk-averse agents’ perspective. The auditor’s level of care and marginal fee are nonmonotonic with respect to individual risk aversion. Hence, engaging a highly risk-averse auditor may result in low audit quality but high auditor’s marginal fee.

The institutional audit environment is designed for stakeholders relying on the audit performance. Thus, we focus on the assessment of auditor performance from risk-averse stakeholders’ perspective, finding that low to medium risk averse stakeholders focus on audit quality in terms of a low material-error-probability. In contrast, highly risk averse stakeholders primarily focus on (limited) liability in the event of a culpable audit-failure. Consequently, standard setters must be aware of stakeholders’ risk aversion when designing a reasonable institutional audit framework.

Crucially, the results of our analysis reveal that the quality of financial audits depends on auditors’ risk aversion. We show that concerning auditors’ private risk aversion, stakeholders’ willingness to pay for an audit may be impaired due to their uncertainty of the auditor’s risk aversion. We consider this finding important in the context of standard setters aiming to enhance the functionality of audit markets.

We conclude that discussing audit quality necessitates the consideration of stakeholders’ risk aversion and their respective marginal fees. Thus, our analytically derived results should be of interest for audit-related policy-making and empirical audit research.

Keywords: financial auditing, audit effort, audit market, risk averse agents, audit quality, decision making, analytical analysis

JEL Classification: M42, M48