Effects of Reputation and Economic Dependence on Auditor Strategic Interactions

Aims: To investigate the influence of reputation loss and economic dependence on auditor strategic interactions.

Study Design: We consider two risk neutral parties, an enterprise and an auditor, and sort the auditors as high-quality (Big 4) and low-quality (non-Big 4) to match actual situations. Then, a game model is established. We assemble the two new parameters of economic dependence and reputation loss into the model and wish to understand whether different types of auditors would adopt different stratagems if their concerns of economic dependence and reputation are different.

Methodology: A basic model for the backward induction of the Game Theory is established. We assume that an auditor is risk-neutral and that he seeks to maximize his profit. We set three decision points for an audit. First, we decide the input level of screening; second, we decide whether to accept the assignment; and third, we decide the level of audit effort. Four strategic interactions are derived and payoff of each strategic interaction is computed from the preliminary analysis. Finally, an equilibrium analysis between Big 4 firms and non-big 4 firms is performed.

Results: Big 4 firms would choose a strong-screening and low-audit-effort strategy to avoid high-risk clients because they risk larger reputation loss than non-Big 4 firms. However, non-Big 4 firms would choose a weak-screening and high-audit-effort strategy since economic dependence is a high priority for them.

Conclusion: Based on the results of the modeling, in the current environment, Big 4 firms face litigation risks after increased legal liabilities of audit failure, so they must bear the litigation cost and reputation loss and may even go out of business. Likewise, non-Big 4 firms not only face more litigation risks due to increased liabilities of audit failure but also are confronted by low-balling competition.