Article1999

Legal Penalties and Audit Quality: An Experimental Investigation*

45 citations0/0 files storedContemporary Accounting Research

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Auditing, Earnings Management, Governance Experimental Behavioral Economics Studies Law, Economics, and Judicial Systems

Abstract

Abstract The purpose of this paper is to investigate the impact of legal penalties on audit quality under different legal regimes. We investigate whether audit quality is affected differentially due to the complexity inherent in legal regimes and the frequency of imposing legal penalties. Economic theory predicts that players adopt equilibrium strategies that reflect the expectation that a penalty will be incurred, but the actual occurrences of penalties, if consistent with this expectation, should not prompt an individual to modify his or her strategy. However, learning theory suggests that players' choices will be repeated in the future based on outcomes. We found that penalties triggered both increases and decreases in effort, and seemed to introduce a “shock” that increased the variability of effort. We also observed a “funnel” effect — that is. greater changes in effort closer to the imposition of penalties, and smaller changes as more periods go by without a penalty.

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References

1998Predicting How People Play Games: Reinforcement Learning in Experimental Games with Unique, Mixed Strategy Equilibria 1995Learning in extensive-form games: Experimental data and simple dynamic models in the intermediate term 1980Strict Liability versus Negligence 1994The Production of Audit Services: Evidence from a Major Public Accounting Firm 1994Economics in the Laboratory 1994Lawsuits against Auditors 1997Progress in Behavioral Game Theory 1994Auditor Litigation and Modified Reporting on Bankrupt Clients

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