Reputation concerns and herd behavior of audit committees – A corporate governance problem

This paper offers an explanation for audit committee failures within a corporate governance context. The management of a firm sets up financial statements that are possibly biased. These statements are audited/reviewed by an external auditor and by an audit committee. Both agents report the result of their work, the auditor acting first. Both use an imperfect technology that results in a privately observed signal regarding the quality of financial statements. The audit committee as well as the auditor are anxious to build up reputation in the labor market. Given this predominant goal they report on the signal in order to maximize the market’s assessment of their ability. At the end of the game the true character of the financial statements is revealed to the public with some positive probability. The market uses this information along with the agents’ reports to update beliefs about the agents’ abilities. We show that a herding equilibrium exists in which the audit committee “herds” and follows the auditor’s judgement no matter what its own insights suggest. This result holds even if the audit committee members are held liable for detected failure. However, performance based bonus payments induce truthful reporting at least in some cases.