Is The Investor Invests If And Only If S = G

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Suppose the investor invests if and only if s=g . The following three Lemmas characterize how reputation is revised following audit reports and observed expected cash flows. The results in turn explain how auditors ' incentives line up with market belief, reputation revision, and choice of effort.

Lemma 1 shows that reputation is revised upwards when a report g is followed by a good(G) outcome. This result follows from Assumption 1 and the intuition is straightforward. An auditor is rewarded with a higher reputation whenever there is a correspondence between the report and observed true state. On the other hand, the history (g,B) is followed by downwards revision of reputation. In other words, an auditor is penalized with a lower
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In the case of no investment, the reputation revision is less stark than what it is when there is an explicit discrepancy between the report and the outcome. This ensures that the auditor is rewarded with a higher reputation when he detects a bad project as bad. The lower the values of alpha and epsilon , the starker is the reputation revision. In fact, with perfect monitoring and hat{gamma}=1 , reputation is revised all the way to zero.

Suppose the auditor 's reputation is such that the auditor is hired with probability 1 in the second period. Lemma 3 implies that at any such reputation heta , the auditor 's expected payoff from expending effort with hat{gamma}=1 , is strictly greater than his expected payoff from expending effort with hat{gamma}=0 . In other words, gains from high effort are higher if the investor believes that the auditor is diligent. An “informative” auditor exerting effort generates audit reports with higher precision than he would without effort. Consequently, reputation revisions are starker and payoffs are more sensitive to actions, when the investor expects the auditor to expend effort.

Proposition 1 states that the auditor is diligent for a range of reputation where loss of reputation can push the auditor out of business and/or the incremental gains from building reputation are strictly higher than the cost of exerting effort. For the lower range of reputation [0, heta^{1}) the auditor is not hired in the second
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