Is honesty the best policy? A game theory perspective of auditing

P. Ben Chou, Wei Xu, Asokan Anandarajan and Dennis Valenti

International Journal of Behavioural Accounting and Finance, 2012, vol. 3, issue 1/2, 88-106

Abstract: We extend and refine the welfare game developed by Coate et al. (2002) in two directions. First, by allowing the client and auditor to choose their strategies sequentially, we show that the most efficient equilibrium is that the client moves first to honestly report earnings, which is followed by the auditor that chooses to perform a normal audit. Second, by including the possibility that the client can corrupt the auditor with side payments, which results in a failed audit, the regulator can impose an ex ante flexible penalty level that increases in proportion to the client's maximum benefits from misstating earnings. Such a preemptive regulation makes the most efficient equilibrium obtainable in which the client will move forward to report earnings honestly, followed by the normal audit strategy chosen by the auditor, even when the auditor may not be independent.

Keywords: auditing; game theory; auditor independence; bounded rationality; mixed-strategy Nash equilibrium; regulation; side payments; subgame perfect Nash equilibrium; corruption; flexible penalties; misstated earnings. (search for similar items in EconPapers)
Date: 2012
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