Do Managers Prefer the Highest Audit Quality? Experimental Evidence.

What is it about?

We study individuals interacting in experimental markets to determine what audit quality managers prefer. Midway through each market, we introduce an auditor that is guaranteed to conduct a high-quality investigation and report their findings honestly and observe how often this auditor is hired. We find that a majority of managers, on average, avoid hiring this auditor. We set forward loss aversion as a potential explanation for this behavior, whereby managers prefer hiring auditors with less than the highest reputation for quality. Managers essentially accept lower returns on high-valued assets by hiring these auditors in order to allow more flexibility in reporting lower-valued assets as high-value.

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Why is it important?

This is important because much of the prior literature on audit quality demand assumes that managers demand the highest-quality auditor in order to resolve information asymmetry for investors and reduce price-protecting behavior (i.e., investors paying lower amounts due to greater uncertainty associated with lower-quality auditors). Our results force auditing scholars and practitioners to reconsider this fundamental agency-theoretic assumption for future research and practice.

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