This study aims to examine how firms choose an auditor in the presence of bilateral information asymmetry between insiders and outsiders regarding firms’ economic performance.
This study presents a one-period reporting bias game with a firm’s risk-neutral manager and investors in the capital market, in which a manager with private information chooses an auditor and reports earnings to investors who acquire their own information. The analysis focuses on the possibility that the manager engages an auditor to constrain earnings management as a commitment device to minimize reporting error cost.
The results show that the manager’s optimal auditor choice is determined based on investor sensitivity to the earnings report, and managerial incentives for earnings management, discounted by the uncertainty of reporting errors. The results for optimal auditor choice are counterintuitive: engaging a higher-quality auditor could seemingly be associated with aggressive earnings management.
This study advances the understanding of the theoretical basis of firms’ auditor choice in the context of market investors’ information acquisition when auditors exercise their discretion in reporting. This issue has received limited attention in the extant literature.
