Financial Statement Audits, a Game of Chicken?

This paper uses the intuition from the game of chicken to model client-auditor financial reporting and audit effort strategies. Within an ethical context, our model is concerned with the client misreporting and its detection by the auditor. The paper uses a welfare game (similar to the game of chicken) to more formally model client-auditor strategies. The welfare game is then extended to provide additional insight into ethical and audit effort issues. Such a welfare game provides equilibrium in mixed strategies. This mixed strategy solution makes possible four outcomes from the game: 1) Financial Statements are fairly presented by client and the auditor performs a normal audit, 2) Financial Statements are fairly presented by client and the auditor performs an extended audit (over auditing), 3) Financial Statements are misstated by client and detected by the auditor, and 4) Financial Statements are misstated by client and not detected by the auditor (audit failure despite no intended unethical action on the part of the auditor). The first extension of the welfare game allows clients to be ethical or unethical clients. Unethical clients are rewarded for misreporting because the auditor wishes to minimize audit effort for ethical clients. The second extension allows the client to unknowingly misstate the financial statements; the client "strategy" then becomes random (a play of nature). The auditor must distinguish between this random play and the strategic play of the welfare game. Finally auditor ethics are considered and the influence of auditor ethics on reducing failed audits.