Auditing, Governance and Reporting: an Experimental Investigation

We use a controlled laboratory setting to experimentally examine the role of auditing and market-based-governance in restraining managerial expropriation and inaccurate financial reporting. Managerial expropriation is broadly defined as the enabling of all actions that opportunistically transfer wealth from investors to managers through understatement of realizable income. Similarly, auditing is broadly defined as all the auditing and governance systems that increase the likelihood of accurate reporting of realizable income. Market-based governance is operationalized by a device (poison pill) that entrenches managers. The results of the experiment reveal that the market converges to equilibrium even without auditing. However, auditing reduces expropriation, attracts more capital and thereby increases the overall welfare, after accounting for the cost of auditing. Further, we show that poison pill adoption results in a demand for more audit and lower net inflow of capital. The effect of poison pill on expropriation is mixed. These findings have significant implications for regulators and policy makers in that the social welfare is likely to be higher under a regime of minimum audit and governance standards compared to a regime without such mandates. Preliminary Draft: Do not quote ‡ Department Of Economics & Finance, City University of Hong Kong, Hong Kong. E-mail: [email protected] ‡ School of Accounting and Finance, The Hong Kong Polytechnic University, Hong Kong. Email: [email protected] § We thank Samuel Cheung Chun Bon for providing programming assistance with the experiment. Funding for this research by the Hong Kong UGC through CERG grant#543407 and City University of Hong Kong through SRG grant#7002163 is acknowledged.