Access

You are not currently logged in.

Access your personal account or get JSTOR access through your library or other institution:

login

Log in to your personal account or through your institution.

If you need an accessible version of this item please contact JSTOR User Support

Legal Recourse and the Demand for Auditing

David E. Wallin
The Accounting Review
Vol. 67, No. 1 (Jan., 1992), pp. 121-147
Stable URL: http://www.jstor.org/stable/248023
Page Count: 27
  • Subscribe ($19.50)
  • Cite this Item
If you need an accessible version of this item please contact JSTOR User Support
Legal Recourse and the Demand for Auditing
Preview not available

Abstract

Accounting information plays an important role in a decentralized economy. It is a primary way for managers to make assertions about the past performance, current condition, and future prospects of their firms. The auditing of these accounting disclosures is purported to provide value to the economy for several reasons (Baiman 1979; Baiman et al. 1987; Blazenko and Scott 1986; Evans 1980; Scott 1984). Without accurate firm-specific information, investors may align their portfolios in a less-than-optimal fashion, resulting in an inefficient allocation of resources in the society. The public-good feature of auditing may prevent the less efficient private search for firm-specific information. Additionally, auditing is argued to assuage the divergent preferences of managers and investors. Included in these divergent preferences is managerial motivation to manipulate the accounting information to hide perquisite consumption or imply appropriate production, investment, or financing decisions. Investors anticipate these conflicting goals and price protect themselves, forcing managers to bear the residual loss (Jensen and Meckling 1976). Because of managers' motivation to avoid that loss, auditing can be purchased to provide credibility to managerial disclosures necessary to distinguish among firms of differing quality. With auditing in place, firm managers can reap the benefits of those actions expected to improve the firm's prospects. Research into managerial incentives to disclose and the effects of disclosures on other managerial actions is at an early stage. The analytical assertions of full disclosure when fraudulent disclosures are not possible are well known (Dye 1985; Grossman 1981; Grossman and Hart 1980; Milgrom 1981; Milgrom and Roberts 1986), and the body of experimental research is growing (Forsythe et al. 1989; King and Wallin 1990a, 1991). Only recently has either analytical or experimental research been conducted in environments permitting fraudulent disclosure (Dopuch and King 1991, 1992; Dopuch et al. 1989; Kachelmeier 1991; King and Wallin 1990a, 1990b; Wallin 1990). In particular, progress on the formulation of models of the demand for auditing has only recently been made. These models are argued to be at best embryonic (Baiman 1979; Scott 1984) and have typically ignored the possible effects of other mechanisms that may solve the problems that auditing addresses. An important aspect of this article is an investigation of the effect of legal recourse, which allows investors to sue when disclosures are believed to have been fraudulent. The analysis presented here concludes that the threat of lawsuit will cause less frequent fraudulent reports. Importantly, legal recourse also allows the manager to benefit from costly effort, such that the level of effort expended will be that which maximizes societal benefit. The central purpose of this study is to investigate the demand for auditing in environments both with and without legal recourse. Formal models are developed and tested that investigate the extent to which managers and investors can achieve a cooperative solution when no mechanism exists to aid that cooperation. The analysis and tests are performed in an environment in which the time horizon is not known. This extends the work of Dopuch et al. (1989) by constructing a base-line environment where the demand for auditing is not derived from the backward induction of a single-period equilibrium. Thirty-two experimental markets were conducted. The results show a demand for auditing, regardless of whether legal recourse was present. The availability of either auditing or legal recourse induced a higher level of managerial effort, the highest occurring when both options were available. Both auditing and legal recourse reduced a tendency for investor overbidding, but only legal recourse reduced the proportion of fraudulent disclosures.

Page Thumbnails

  • Thumbnail: Page 
121
    121
  • Thumbnail: Page 
122
    122
  • Thumbnail: Page 
123
    123
  • Thumbnail: Page 
124
    124
  • Thumbnail: Page 
125
    125
  • Thumbnail: Page 
126
    126
  • Thumbnail: Page 
127
    127
  • Thumbnail: Page 
128
    128
  • Thumbnail: Page 
129
    129
  • Thumbnail: Page 
130
    130
  • Thumbnail: Page 
131
    131
  • Thumbnail: Page 
132
    132
  • Thumbnail: Page 
133
    133
  • Thumbnail: Page 
134
    134
  • Thumbnail: Page 
135
    135
  • Thumbnail: Page 
136
    136
  • Thumbnail: Page 
137
    137
  • Thumbnail: Page 
138
    138
  • Thumbnail: Page 
139
    139
  • Thumbnail: Page 
140
    140
  • Thumbnail: Page 
141
    141
  • Thumbnail: Page 
142
    142
  • Thumbnail: Page 
143
    143
  • Thumbnail: Page 
144
    144
  • Thumbnail: Page 
145
    145
  • Thumbnail: Page 
146
    146
  • Thumbnail: Page 
147
    147