Investor-Specific Auditing

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Abstract

Investors are the ultimate users of financial statements and the intended beneficiaries of audits. However, different investors can possess different styles which will influence their processing of financial statements and thus valuation outcomes. In the paper, I incorporate investor style into a game between a manager and an auditor to examine how investor style will affect misstatement and auditing. I find that auditing effort will increase while overstatement will decrease when the investor is more aggressive in valuation. Not only will tight auditing standards reduce the welfares of the manager and the auditor, but tight standards may also make the investor worse off. Optimistic auditors can outperform pessimistic auditors in investor protection under lax standards. Although auditing always benefits the investor, a higher quality audit can make it harder for the investor to break even from participation relative to a lower quality audit when standards are moderate. Optimal auditing standards that best protect investors are investor- and auditor-specific. A number of empirical predictions are discussed and alternative explanations to existing findings are proposed.

Author

• Kai Gu, University of Houston