Regulating the Market for Audit Services : A Game Theoretic Approach

We apply game theory to model how alternative mandatory audit firm rotation regimes can affect the strategic interaction between auditee and auditor firms, and analyze potential consequences on detection risk and impairment of auditor skepticism. The major results suggest that, (1) relative to an initial state with no rotation requirement but high probability for impaired auditor skepticism, imposing either short-term or long-term mandatory audit firm rotation will remove the threat to auditor skepticism and lead to higher audit fees and lower detection risk; (2) relative to long-term mandatory audit firm rotation, imposing a short-term rotation will lead to lower audit fees and higher detection risk, resulting from greater informational frictions. We further find that supplementary regulatory instruments such as increased scrutiny of the auditee and/or auditor can be used to lower the detection risk and increase the audit quality. The public policy and empirical implications of our findings are discussed