Deneckere 9631817 Auditors serve an important function in modern market economies. By independently verifying companies' financial statements they provide credibility to the corporate accounts. Without this credibility, investor confidence would be lacking, and companies would face a much higher cost of raising capital. Recently the audit profession has been rocked by a string of well-publicized scandals, in which large corporations unexpectedly failed shortly after receiving clean audit reports. Examples include the Savings and Loan debacle in the US, and the collapse of BCCI, Maxwell, Polly Peck and the Mirror Group in the UK. These experiences have resulted in an unprecedented level of legal liability costs, threatening the health of the audit industry (in the US, in 1993 the big six spent in excess of 20% of their revenues on legal defense costs, and in the UK the cost of liability insurance has increased 37.5-fold in 10 years). The scandals have also undetermined the public's confident in the effectiveness of the service offered by auditors, and have resulted in a series of policy proposals designed to regulate the industry more tightly. The contribution of this project consists of developing tools which can identify the impact of various regulatory policies on the audit profession. Models of audit behavior currently do exist, but most of them are static in nature, and focus on the role of auditors in providing increased internal control. They are therefore ill suited for analyzing policies which entail dynamic effects (such as mandatory rotation of auditors), and whose primary intent is to benefit outside parties (such as investors and creditors). In addition, those models do not study the determination of equilibrium accounting fees, a crucial element in evaluating auditors' incentives to build up and maintain a reputation. More specifically, this project develops a game theoretic model that describes the interaction between public account firms, their clients and interes t third parties. This model underlines the crucial role of reputation in maintain auditor independence, and is used to analyze the impact of limits on the tenure of auditors (mandatory rotation).
