The Auditing Game : The Dark Side of the Private Provision of a Public Good

The aim of auditing is to protect active and potential investors from accounting fraud. However, the large number of auditing scandals demonstrates that auditing has a dark side. This dark side of auditing is the topic of this paper. Correct auditing is a public good, provided by private auditing firms that are paid by the audited enterprise itself. Auditing firms, therefore, may be dubbed as agents of two principals, the audited firm and the public. Reputation theory conjectures that reputational concerns of auditors and the reputational costs of auditors’ failure prevent shallow and fraudulent behavior of auditors. In contrast, empirical evidence does not support this claim. While it may be irrational for a large audit firm (such as Arthur Andersen LLP) to sacrifice its reputational capital for a single client by doing superficial audits (such as WorldCom), it may be quite rational for the engagement partners of the auditing firm to do so. The result might be a conspiracy against the public and investors. Because of inelastic supply of experienced auditors and a highly concentrated market of big auditing firms, reputational losses due to auditing scandals for the audit firms’ local partners and staff seem to be rather small. In order to protect the public and investors from superficial auditing, neither higher legal transparency requirements nor higher fines for auditing failures are very helpful. Rather than further tightening laws, insider information by whistleblowers, short-sellers and investigative journalists can be more effective in detecting and deterring intentional and unintentional misinformation from auditors and firms