Ronald R. King

The Effects of Lowballing on Audit Quality: An Experimental Markets Study:

The purpose of this study is to investigate the potential effects of low-balling on audit quality. Critics of the audit industry often allege that the practice of lowballing (charging fees below the marginal cost of an audit) provides a potential incentive for auditors to reduce their audit quality in order to be retained for future engagements with a client. We investigated this issue using experimental methods that had subjects (verifiers) providing a verification service for sellers of assets. Our results indicate that lowballing did not materially reduce service quality, relative to benchmark settings without lowballing when subjects interacted in markets. However, lowballing did have a material effect in a setting with the combined conditions of a high degree of lowballing and no competitive market for the services.

Experimental tests of disclosure with an opponent

Abstract This paper presents the results of 32 experimental markets designed to test hypotheses based on Wagenhofers (1990) disclosure model. The model predicts the existence of multiple disclosure equilibria in cases where a manager balances the effects that disclosures can have on two sets of external agents: investors and an opponent. The experimental results support the partial-disclosure equilibrium over the full-disclosure option. Additionally, a lower level of disclosure was observed in those markets in which the discloser repeatedly interacted with information receivers. Lower disclosure reduces the level of proprietary costs which is beneficial to the information sender.

Voluntary Disclosures When Seller's Level of Information Is Unknown

In this paper we report the results of experimental markets designed to test a disclosure model based on the models of Dye [1985] and Jung and Kwon [1988]. These authors show that when receivers of information do not know whether senders possess private information, the senders will not fully disclose their private information. Their models were motivated by the discrepancy between the theoretical predictions for voluntary disclosures and empirical results. In the theoretical area, Grossman [1981] and Milgrom [1981] predicted that private information will be fully disclosed when disclosures are credible and receivers know the holder has private information; agents disclose to identify themselves as not possessing the worst possible information. Watts [1977] argued that voluntary disclosure will occur because of market pressures and the threat of regulatory intervention. Beaver [1977; 1988] described how auditing and legal liability may induce full disclosure. Nevertheless, empirical research indicates full disclosure is not always observed (e.g., Penman [1980] and Seligman [1986]).

An Experimental Investigation of Approaches to Audit Decision Making: An Evaluation Using Systems‐Mediated Mental Models

The objective of this research is to articulate a decision-making foundation for the systems audit approach. Under this audit approach, the auditor first gains an understanding of the auditees economic environment, strategy, and business processes and then forms expectations about its performance and financial reporting. Proponents of this audit approach argue that decision-making is enhanced because the knowledge of the system allows the auditor to focus on the most important risks. However, there has not been an explicit framework to explain how systems knowledge can enhance decision-making. To provide such a framework, we combine mental model theory with general systems theory to produce a hypothesis we refer to as a systems-mediated mental model hypothesis. We test this hypothesis using experimental economics methods. We find that (1) subjects make systematic errors under the setting without an organizing framework provided by the systems information and (2) the presence of an organizing framework resulted in lower reporting errors. Importantly, the organizing framework significantly enhanced decision-making in the settings where the environment changed. Establishing a decision-making foundation for systems audits can provide an important building block that, in part, can contribute to the development of a more effective and efficient audit technology - an important objective now when audits are facing a credibility crisis.

An Analysis of Settlement and Merit Under Federal Securities Law: What Will Be the Effect of the Reform of 1995?

In this paper we develop a game-theoretic model to (i) investigate settlement incentives under two different legal regimes: the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995, and (ii) assess the correspondence between settlements and merits for these two regimes. We model settlement negotiations in a game with three players; a plaintiff and two defendants (a firm/manager and an auditor). We find that the negotiation process ends in settlement rather than litigation under both legal regimes. However, the regimes elicit different negotiation strategies on the part of the plaintiff which, in turn, precipitates different settlement/merits disparities. We find that under the 1995 Reform, equilibrium settlements reflect the underlying merits for the auditor more closely for a broad range of parameters, although not for all parameter levels.

An experimental investigation of super majority voting rules: Implications for the financial accounting standards board

Abstract The objective of this research is to investigate some basic issues related to the effects of different voting rules. Specifically, this research addresses (1) how simple majority and super majority rules for adoption of committee decisions may affect committee decisions and (2) how the inclusion of a party with veto power may influence a committees decisions. Hypotheses are developed based on the theory of the core and are tested experimentally. The results of 24 committee sessions provided mixed support for the model.

Using Experimental Economics in Auditing Research

My objective in this chapter is threefold: (a) to provide a brief overview of the basic features of the experimental economics paradigm, (b) to review some of the auditing research that has used this paradigm, and (c) to offer some possibilities for future research, with an emphasis on identifying issues that might encourage the integration of experimental economics and behavioral auditing research. Experimental economics refers to a research paradigm that uses controlled laboratory conditions to investigate the relative predictive ability of economic theories. Implicit in the approach is a focus on how individual behavior is influenced by economic markets and institutions.1 The impetus to investigate how, and to what extent, economic institutions and markets effect individual behavior stems in part from the results of behavioral research.

Optimal level of fraudulent disclosure when litigation is costly

In this article, we show that the effects of a legal system depend on the cost of litigation. For very low levels of legal costs, an equilibrium exists where the manager always fraudulently reports firm quality (i.e., always reports “good news”) and the investors bring suit any time firm earnings are low. For an intermediate range of legal costs, there exists an equilibrium where the frequency of fraudulent reporting is an increasing function of the costs of litigation. In this equilibrium, investors will follow a mixed strategy of bringing suit. With high legal costs, the manager always issues fraudulent disclosures and the investors never bring suit. When legal costs are not high, the threat of lawsuits removes moral hazard and adverse selection problems. The dead-weight loss from lawsuits creates a demand for auditing and may cause the manager to manipulate the amount of retained ownership.

Accounting Standard-Setting Institutions and the Governance of Incomplete Contracts

“A constant problem of the accounting profession lies in the development of procedures to keep pace with changing economic conditions.” Charles Couchman, President, American Institute of Accountants, 1932.1 “New and extremely difficult problems are constantly arising in the wake of innovative business techniques.” The Wheat Committee, 1972.2 “The Board recognizes that financial reporting must adapt to a world in which change is a continuing, even accelerating process.” Dennis Beresford, Chairman, Financial Accounting Standards Board, 1991.3