Academic journal article Economic Inquiry

Information Asymmetry and Competitive Bidding in Auditing

Academic journal article Economic Inquiry

Information Asymmetry and Competitive Bidding in Auditing

Article excerpt

I. INTRODUCTION

Recent events in the financial markets have focused attention on the nature of contracts between auditors and their clients. The auditor-client relationship has profound consequences for the financial markets as a whole, as amply demonstrated by the failures of large public companies, such as Enron, and the subsequent demise of Arthur Andersen, one of the premier auditing firms. Once formed, the auditor-client relationship for public companies usually extends many years, as those companies rarely switch auditors. Thus, study of factors that influence the market for initial audit engagements is of theoretical and practical importance. However, in the past there has been little empirical evidence about how contracts between auditors and clients are made and structured. The purpose of this article is to investigate company managers' decisions to engage competitive bids from prospective auditors or to privately negotiate with a single firm to obtain audit services. Private negotiation in this market is fairly prevalent. Rarely provided empirical data from a large firm show that during our sample period, only half of their bids for public and soon-to-be-public companies were faced with competition from other bidding firms.

In this article we use the economics of information, as expressed, for example, by Akerlof (1970) and Arrow (1972), to explain why companies seeking a provider of audit services would choose to use private negotiation with a single audit firm when in most cases a lower cost and/or higher-quality bid could be obtained using competitive bidding. (1) The issue of market participants' seemingly anomalous choice to use private negotiation rather than competitive bidding is not new to the economics literature. As one explanation for the choice of private negotiation, McAfee and McMillan (1988) and Harstad (1990) cite the costs associated with setting up a bidding contest and dealing with multiple bidders. In the audit market context that we study, these costs fall primarily on company managers. Thus we agree that cost avoidance is probably a factor influencing preference for private negotiation.

We propose and test two additional explanations based on information asymmetries. First, we predict that managers of companies with greater risk of fraud will be more likely to use private negotiation to attempt to select a sympathetic auditor and/or to avoid disclosure of potentially negative information to multiple bidders. Second, we predict that managers of companies subject to higher agency costs will be more likely to use competitive bidding to establish initial auditing engagements. Using a recent sample of bid proposals made by a large firm to prospective U.S. clients, we find support for our prediction regarding companies at greater risk of fraud but do not find support for our prediction

regarding agency costs.

II. PRIOR LITERATURE AND EXPECTATIONS

The function of the financial statement audit is to provide assurance that financial information provided by company managers is accurate and reliable according to generally accepted accounting principles. In so doing, the audit function decreases the asymmetry between managers' superior information about the true value of the company and the information possessed by outside stakeholders (e.g., investors and creditors as suppliers of capital). Formally, the audit committee of a company's board of directors has the responsibility to arrange service from an audit firm, but in practice managers generally have significant influence on audit firm bid solicitations. This occurs because managers are the primary day-to-day contact between the company and its audit firm and may even be former audit firm employees. Thus we consider company managers to be the primary parties involved in the decision to obtain an auditor through private negotiation or competitive bidding. (2) In this scenario, theories related to asymmetric information are particularly appropriate in predicting potential implications of the disparity between a manager's information about a company's true value and the information possessed by outsiders, including auditors and suppliers of capital. …

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