The effects of information availability on the benefits accrued from enhancing audit-firm reputation

Abstract

This paper reports on a laboratory experiment that examines the effect of market setting and reputation enhancement on audit prices, profits, and number of contracts. Klein and Leffler (1981) The role of market forces in assuring contractual performance. Journal of Political Economy, 89, 615–641 provide theory related to reputation effects based on the availability of perfect ex-post quality (of the audit) information. Such information is not routinely available within audit markets. Therefore, the assumption of the availability of perfect ex-post quality information was relaxed to reflect a more realistic market in which audit quality must be inferred from information related to audit failure. Findings are that restricting the information available in this manner significantly affected the market's response to the auditor's attempts to establish a reputation. While the markets for which perfect ex-post quality information was provided closely followed the model's expectations, the limited information markets did not—auditors who attempted to enhance their reputation were unable to charge significantly higher prices and correspondingly made significantly lower profits.