No abstract

Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision because “Two heads are better than one.” Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free‐riding problem between audit firms and reduce audit evidence precision. We further derive a set of empirically testable predictions comparing audit evidence precision and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.

To restore investors' confidence in the reliability of corporate financial disclosures, the Sarbanes-Oxley Act of 2002 mandated stricter regulations and arguably increased auditors' liability. In this paper, we analyze the effects of increased auditor liability on the audit failure rate, the cost of capital, and the level of new investment. We focus on a setting in which, with imperfect auditing, a firm has better information than investors about its prospects and seeks to raise capital for new investments in a lemons market. The equilibrium analysis derives corporate reporting and investing choices by the firm, attestation opinions by the auditor, and valuation by rational investors. Three empirically testable predictions emerge: although increasing auditor liability decreases the audit failure rate and the cost of capital for new projects, it also decreases the level of new profitable investments. 1 We should note that SOX did not explicitly raise auditors' liability. However, early evidence suggests audit liability is higher after SOX. For example, Rashkover and Winter [2005] argue that civil monetary penalties have increased because SOX empowers federal courts and the SEC to impose equitable remedies for violations of federal securities laws. Ghosh and Pawlewicz [2008] document that audit fees after SOX are higher partially because of higher legal liability due to an audit failure. Also see the references cited therein. 2 asymmetry and the lemons premium. However, the auditor's attestation is imperfect; the auditor must make a judgment call based on limited information; therefore, the auditor's opinion is subject to unintentional errors. The auditor, after observing imperfect audit evidence, may unknowingly attest to financial statements that under-or over-value existing equity. An increase in the liability for audit failures may reduce the incentive for new profitable investments. Because the auditor's attestation is subject to possible audit failures, an increase in the liability for such audit failures induces the auditor to become more conservative in his interpretation of financial disclosures. As a result, the firm needs to choose its corporate disclosure strategy and investment decision based on its anticipation of both the investors' valuation and a possible audit failure. When a firm has private information about its existing equity, the chance of receiving understated financial statements increases. As long as the new shareholders cannot infer the true value from the understated reports, the lemons problem will depress the firm's valuation, thereby increasing the firm's cost of capital and making new investments less likely. In sum, our results identify an economic consequence of SOX the literature has not previously asserted: the increase in the auditor liability after SOX has the countervailing effects of decreasing both audit failures and new investments.Our study suggests several implications of SOX for investors, auditors, and policy makers. In the presence of information asymmetry between ...

While there have been vast discussions on the materialistic benefits of continuous improvement from the Toyota and Honda experiences, the academic literature pays little attention to information sharing. In this study, we construct a dynamic adverse selection model in which the supplier privately observes her production efficiency, and in the contractual duration the manufacturer obtains an informative but imprecise signal regarding this private efficiency. We show that despite the disclosure of proprietary information, information sharing may benefit the supplier; the supplier's voluntary participation is more likely to occur when the shared information is rather imprecise. On the other hand, our analysis also reveals that this information sharing unambiguously gives rise to an upward push of the production quantity, and may sometimes lead to an upward distortion that ultimately hurts the supply chain. We also document the non‐trivial impact of the timing of information sharing on the supplier's incentive to participate.

W e consider a two-stage principal-agent screening environment in a decentralized supply chain with retailers, distributors, and a supplier. The retailers possess private information regarding their local market profitabilities. The distributors can partially observe the retailers' profitabilities and are heterogeneous with regard to the precision of that information. The supplier determines the level of production, but knows neither the local market profitabilities nor the precision of the distributors' information. The supplier first allocates finished products to distributors, and the distributors then contract with local retailers with a capacity constraint. We find that due to the distributors' superior information, the quantity distortion on the retailers' side is mitigated, and the upstream information asymmetry subsequently affects the quantity allocation among the downstream retailers. The supplier may not benefit from contracting with the distributors. In addition, no distributor is excluded based on the heterogeneity of the information precision, even though some distributors do not have better information than the supplier. In the numerical examples, we further analyze how the local market heterogeneity and inventory costs affect the capacity allocation, the retailers' payoffs, and the supply chain profits. We document some counter-intuitive quantity allocation rules that arise from the distributors' information advantage.Note 1 For example, AmBev, the largest beverage company in Latin America, imports and distributes Pepsi-Cola, Heine-ken and Skol to local resellers through its own network. The wine and spirits imported by the National Distributing Company are sold throughout the United States by over 50,000 retailers. Contracting with more than 160 regional dealers, Hyundai Car (UK) imports and sells vehicles overseas through these dealers. US Lumber imports forest products from Europe, Canada, South America, and Mexico to meet customers' demands in different states.