Auditor independence when management attempt to mislead: a rational economic analysis

We examine the economic factors affecting the auditor’s independence when management wishes to mislead investors. By means of a single person decision-theoretic model, we show that, in the absence of transaction costs, audited financial statements are unlikely to be biased. However, when transaction costs in the form of legal costs are introduced, bias is likely to occur. By means of a game-theoretic model, we also examine two areas of information asymmetry and the economic factors involved causing a ‘rogue auditor’ compared with a ‘professionally correct’ auditor to fail to act independently. We also examine the implications of this both at the micro and public policy level and whether the ‘bad auditors’ will drive out the ‘good auditors’. We find that the ‘good corporations’ have an incentive to drive out the ‘bad auditors’. However, whilst investors have negligible information about audit quality, scandals such as Enron and Arthur Andersen are likely to occur.