Investors' Perceptions of Audit Quality: Effects of Regulatory Change

Abstract

In an experiment using MBA students as proxies for individual investors, I examine the effects of two important regulatory changes on investors’ perceptions of audit quality. The first change examined is from a bottom-up coverage-based approach for auditing internal controls to a more top-down risk-based approach. The second change is litigation reform further limiting auditor liability exposure following an alleged audit failure. I find that investors perceive a reduction in audit quality following each of the two regulatory changes. These observed effects are mediated by a perceived focus on efficiency for the new auditing standard and by a perceived change in the auditor’s economic incentives following the proposed litigation reform. I also find that investors believe the perceived reduction in audit quality will lead management to invest fewer resources in internal controls.

Keywords: audit quality, investor perceptions, internal control, auditor liability