Title: Is honesty the best policy? A game theory perspective of auditing

Authors: P. Ben Chou; Wei Xu; Asokan Anandarajan; Dennis Valenti

Addresses: School of Management, New Jersey Institute of Technology, University Heights, Newark, NJ 07102-1982, USA. ' School of Management, New Jersey Institute of Technology, University Heights, Newark, NJ 07102-1982, USA. ' School of Management, New Jersey Institute of Technology, University Heights, Newark, NJ 07102-1982, USA. ' School of Management, New Jersey Institute of Technology, University Heights, Newark, NJ 07102-1982, USA

Abstract: We extend and refine the welfare game developed by Coate et al. (2002) in two directions. First, by allowing the client and auditor to choose their strategies sequentially, we show that the most efficient equilibrium is that the client moves first to honestly report earnings, which is followed by the auditor that chooses to perform a normal audit. Second, by including the possibility that the client can corrupt the auditor with side payments, which results in a failed audit, the regulator can impose an ex ante flexible penalty level that increases in proportion to the client's maximum benefits from misstating earnings. Such a preemptive regulation makes the most efficient equilibrium obtainable in which the client will move forward to report earnings honestly, followed by the normal audit strategy chosen by the auditor, even when the auditor may not be independent.

Keywords: auditing; game theory; auditor independence; bounded rationality; mixed-strategy Nash equilibrium; regulation; side payments; subgame perfect Nash equilibrium; corruption; flexible penalties; misstated earnings.

DOI: 10.1504/IJBAF.2012.047357

International Journal of Behavioural Accounting and Finance, 2012 Vol.3 No.1/2, pp.88 - 106

Available online: 16 Jun 2012 *

Full-text access for editors Access for subscribers Purchase this article Comment on this article