An Experimental Investigation into Reputation Effects and the Demand for Auditing Services

Posted: 16 Apr 1998

See all articles by David Finley

David Finley

Simon Fraser University (SFU) - Accounting Area

William S. Hopwood

Florida Atlantic University - School of Accounting

Robert R. Tucker

Fordham University - Accounting Area

Date Written: August 1996

Abstract

This research investigates the relationship between reputation and two types of agency costs, namely those associated with auditing and those associated with value-reducing activities of management resulting from their capitalizing on asymmetric information by misreporting income. A competitive-market model is used as a basis for developing and empirically testing hypotheses using an experimental-markets approach. This model includes (1) contracting between risk-neutral owners and risk-averse managers that allows risk sharing, (2) information asymmetry favoring managers over owners, (3) public financial reporting by managers, (4) the presence of endogenously-priced costly auditing that can be demanded by either management or owners, and (5) opportunities for managers to engage in value-reducing activities that are not directly observable by the owners. Two main hypotheses are set forth, both of which are found to be supported by formal statistical tests based on the data from the experimental markets as conducted in this study: (1) reputation effects reduce total agency costs. Further, these results show that agency cost reductions from reputation effects include both an increased rate of honest reporting by managers and a reduction in the demand for auditing by owners; and (2) the market rewards honesty and penalizes dishonesty in reporting.

JEL Classification: M41, M49, D23, D82, L14, C91

Suggested Citation

Finley, David and Hopwood, William S. and Tucker, Robert R., An Experimental Investigation into Reputation Effects and the Demand for Auditing Services (August 1996). Available at SSRN: https://ssrn.com/abstract=2733

David Finley

Simon Fraser University (SFU) - Accounting Area ( email )

Burnaby, British Columbia V5A 1S6
Canada

William S. Hopwood

Florida Atlantic University - School of Accounting ( email )

University Tower
220 SE 2 Avenue
Fort Lauderdale, FL 33301
United States

Robert R. Tucker (Contact Author)

Fordham University - Accounting Area ( email )

Graduate School of Business
113 W. 60th Street
New York, NY 10023
United States
212-636-6121 (Phone)

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