Financial Effects of External Auditing_Research Paper Study

8/8/2019 Financial Effects of External Auditing_Research Paper Study

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Financial Effects

of

External Auditing

Gorazd Brumen and Leon Bodgan Stacescu

University of Zrich, Swiss Banking Institute

Studied by:Ramit Gupta and Rajat Kashyap Kumar

Shaheed Sukhdev College of Business Studies, University of Delhi


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Introduction

Share price maximization is the managementobjective

How does auditing effect this objective?

What happens to the auditing effort chosen bythe firm in presence of debtholder-shareholderconflict?

What is the appropriate amount of auditors

compensation? Questions above are answered under the

assumption of a free-market economy. Therefore,a firm may even choose no auditing at all.


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Why is auditing required?

Shareholders value companies in their portfolios

differently under the condition of incomplete

information.

This adds a noise component to the economy,

increasing volatility in the share price.

CARA Gaussian risk-averse investors on the other

hand will invest only if the volatility is low. Therefore, the firm will have to choose auditing

to reduce this volatility caused by noise.


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Opposite effects of auditing

On one hand auditing reduces uncertainty,

leading to a higher share value.

On the other hand though, auditing costs arefar from negligible. In 2005, the top four

auditing firms aggregate revenue was $70bn.

The auditing effort chosen by the firm will be

determined by the interaction of these two

aspects of auditing.


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Simple model of Auditing


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The firms auditing benefit has a call-option

like structure w.r.t. the overall noise in theeconomy and a put option-like structure w.r.t.

the formation of information channel C.


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Auditing in view of

Debt holder-Shareholder Conflict

What auditing effort would debtholders and

shareholders choose in order to maximizetheir securities value?

What is the auditing value added to bothtypes of agents?


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The optimal auditing effort R from the perspective ofdebtholders and shareholders is different.

The debtholders require auditing protection at highleverage levels while the shareholders are made worse offat every leverage level.

Shareholder value decreases non-linearly with increasingleverage ratio, a consequence of auditing costs.

Additionally, the stock values under auditing are strictlybelow their values for a non-audit company. This is the

consequence of the arbitrage model stocks are viewed ascall options, which increase with increasing volatility,commanding that the auditing effort demanded by theshareholder is strictly below that of debtholders.


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Strategic considerations regarding

auditing

Issue of negotiating powerwhich party

offers the contract Case 1 Firm offers the auditing contract and

the auditor either accepts or declines.

Case 2 Two auditors simultaneously submitauditing offers. The firm chooses the one

closest to the optimal level.


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The following proposition states that the first

best is achieved when the firm offers anauditing contract whereas the market breaks

down when the negotiating power is with the

auditor.


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Result (a) states that the auditor accepts theauditing level proposed by the firm.

Result (b) states two things: first, competition reduces the auditing effort

(as well as audit fees for the company) secondly, auditing effort under laissez faireeconomy is below the optimal level

Result (b) supports the provisions of the SarbanesOxley Act of Rotating external auditor. A repeatedoffer game can potentially solve this problem.


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A model of Auditors Compensation

Assumption firm is composed of n identical

business units.

Each of these units is a source of cash flows.

Firm may possibly invest in resources intoauditing of each individual unit.


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A result ofI

nformation Theory tells us that themore business units there are, the smaller

proportion of money invested (per business

unit) has to be invested in order to reduce the

perceived volatility of that unit to a desiredlevel.

In plain terms, larger firms have an auditing

advantage over smaller firms since the cashflow reduction in one unit implies similar

reduction in all other units.


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v(k) is the value of k firms business units

without auditing and v(A,k) is the value underexternal auditing:

f is the returns to scale function.{If we assume that for all x, yR the value v(k) = f(k)( 2) (and

correspondingly v(A, k)), where

the function f satisfies the Cauchy condition

f(x) + f(y) f(x + y),

we account for business-unit synergies}.


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The total market capitalization of the firm isthen:

The last formula above can also be expressed

as:


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The size of the auditors contribution to the firm

value does not depend on the mean productionlevel of firms business units and is

proportional to the marginal contribution F of

each business unit.

More importantly, the value of auditorscontribution is not proportional to the added

auditing value to every business unit.

Auditing therefore exhibits intrinsic economies of

scale.


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Conclusions

The paper develops a model of optimalauditing behavior when cash flows to the firmare observed perfectly by the firm and

imperfectly by the outsiders.

In order to reduce this volatility, the firm has

the possibility to choose an external auditorwhose report reduces this volatility asperceived by the outside investors.


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The benefit to the firm is increasing with

increasing noise in the economy, decreasingwith auditing costs, and increasing also with

average absolute risk aversion in the economy.

For all parameters, there exists a cut-off

above (below) which no auditing is optimal.

The model answers positively to the question

of regulation of auditors, which all reduce the

overall economic noise.


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The shareholders and debt holders disagree about

the optimal amount of auditing. Auditing primarily

shield debtholders, whereas the shareholders benefit

from increased price volatility.

In a setting where the firm and outside investors donot observe the level of economic noise perfectly,

the decisions on optimal auditing are the same as

before, but based on the signal the agents receive

about the economic noise variable.

Finally, auditing in a multi-firm setup exhibits intrinsic

economies of scale.

Documents

Financial Effects of External Auditing_Research Paper Study