This study investigates how companies' threats to dismiss auditors and their engagement in opinion shopping influence auditor independence and audit quality, which in turn affect misstatements in financial statements. It also examines how outsiders' reactions to auditor switching influence opinion shopping. The results indicate that neither the predecessor auditor's nor the successor auditor's independence is compromised by dismissal threats and opinion shopping. Further, the successor auditor's audit quality exceeds the predecessor auditor's audit quality. In addition, auditor switching decreases potential understatements and increases potential overstatements in financial statements, and the capital market's and the successor auditor's reactions to auditor switching reduce the benefits of opinion shopping to companies. Additionally, the study sheds some light on the potential effects of both the Sarbanes-Oxley's restriction on non-audit services and mandatory auditor rotation or retention. The paper also derives a rich set of empirical implications.

We develop a theoretical framework to study the effects of expensing versus capitalization of investment expenditures on capital market asset prices, corporate investment, and investment efficiency. We use a two‐period model in which the financial reports at the end of the first period influence the price of the firm. In the first period, the current owner makes an investment decision that yields returns during the first and the second periods. We highlight the benefits and costs of the matching principle in GAAP and identify conditions under which less disclosure improves investment efficiency. We find that, in terms of investment efficiency, expensing beats capitalization if and only if the expected growth rate is high, the growth volatility is large, or the earnings persistence is small. We also offer testable empirical implications for accounting choice and for real earnings management.

We develop a theoretical framework to investigate (1) both the determinants and the consequences of auditor conservatism in a capital market setting and (2) the implications of Section 201 of the Sarbanes-Oxley Act for auditor conservatism and investment efficiency. We derive three primary results. First, by adjusting the mix of audit and nonaudit fees, companies with high business risk induce auditor conservatism, while companies with low business risk induce auditor aggressiveness. Second, if auditor conservatism is in force, a greater client pressure on auditors improves audit quality; but if auditor aggressiveness is in force, a greater client pressure on auditors impairs audit quality. Third, the nature of a firm's investment inefficiency (overinvestment or underinvestment) depends on its auditor's attestation (conservative or aggressive). Our analysis also implies that a mandatory restriction of nonaudit services imposed by Section 201 may decrease audit quality and damage investment efficiency.

We show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports, so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. Mark-to-market accounting is essential when bank leverage levels are high, and is more likely to be necessary as banks' asset risk or specificity increases.

Conventional wisdom holds that joint audits would improve audit quality by enhancing audit evidence precision because “Two heads are better than one.” Our paper challenges this wisdom. We show that joint audits by one big firm and one small firm may impair audit quality, because, in that situation, joint audits induce a free‐riding problem between audit firms and reduce audit evidence precision. We further derive a set of empirically testable predictions comparing audit evidence precision and audit fees under joint and single audits. This paper, the first theoretical study of joint audits, contributes to a better understanding of the economic consequences of joint audits on audit quality.