The Impact of Risk and the Potential for Loss on Managers’ Demand for Audit Quality

Abstract

We use experimental economic markets to investigate the impact of risk and the potential for loss on managers’ demand for audit quality. We posit that managers’ audit quality preferences are influenced by these two important contextual factors, which are often not considered or are difficult to isolate in prior research. We specifically predict and find evidence that risk significantly reduces managers’ average demanded audit quality level and likelihood of hiring the best available auditor in the market. We also find evidence that the potential for loss, and to a lesser extent its interaction with risk, reduce managers’ likelihood of hiring the best available auditor. Our results, based on manipulating risk and the potential for loss, provide evidence that risk aversion and loss aversion influence managers’ audit quality demand. In supplemental analyses, we show that our results are robust to alternative economic explanations. Our results suggest these two common contextual factors influence the demand for audit quality.