AUDIT PRICING, AUDITOR CHANGES, AND THE WINNER'S CURSE

This paper presents a two-period model of the audit market. In the first period, all auditors have symmetric information and adopt identical bidding strategies. In the process of performing the audit, the incumbent auditor learns the actual costs, thereby becoming informationally advantaged in the second period. In the model presented, unlike earlier ones found in the literature, audit costs include both a component common to all potential auditors and a private component that varies across auditors. The common component of auditor costs gives rise to a ‘winner's curse’ scenario. A winner's curse is said to exist because a non-incumbent bidder who does not take into account the superior information of the incumbent would be expected to generate a loss from winning the audit engagement. The adjustment of bids by sophisticated auditors to compensate for the winner's curse is shown to play a significant role in determining the degree of low-balling (first-period price cuts) and auditor turnover. In the model, low-balling is not associated with loss of audit quality. Additionally, it is shown that it is in the interest of the client to structure audit selection in a manner that gives rise to low-balling.