This paper reports the results of two experiments, each consisting of six sessions, designed to investigate difficulties that arise in estimating expected litigation costs in an auditing game. In each experimental session, the game consists of a series of periods in which sellers submit sealed offers to computerized buyers and, if hired, choose an effort level (low or high). The effort level affects the certain (direct) and uncertain (litigation) costs of performing the engagement. Across the two experiments, we vary the uncertainty surrounding the determination of the expected litigation cost. Our results strongly suggest that cognitive limitations hinder sellers' abilities to estimate total expected litigation costs. Across both experiments we observe a nontrivial number of suboptimal effort choices. Moreover, as the uncertainty of determining the expected litigation cost increases, the frequency of observed fee offers below the total expected cost of an engagement increases markedly.
JEL classification: M40, C91
Key words: auditing, litigation costs
The authors gratefully acknowledge the financial support of the Certified General Accountants of Canada. They also thank Linda Bamber, Mike Bamber, Arnie Schneider, and workshop participants at the University of Georgia for helpful comments. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Ping Zhang, School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario, Canada N2L 3C5, 519/884-0170 ext. 2672, firstname.lastname@example.org; Bryan K. Church, DuPree School of Management, Georgia Institute of Technology, Atlanta, Georgia 30332, 404/894-3907, email@example.com; or Lucy F. Ackert, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8783, 404/498-8810 (fax), firstname.lastname@example.org.
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