A game-theoretical model of a financial statement audit

Abstract: In this paper we developed a game theoretical model in order to examine the equilibria when preparing a financial statement about the firm’s performance. The model is a dynamic signalling game in which the firm sends a message about its performance to the auditor. The auditor receives the message but does not know the actual performance of the firm. The auditor has the possibility to investigate the message in case he expects this message is exaggerated. When he finds exaggeration he is rewarded with a bonus and the firm is punished with a fine. When the auditor has a large incentive to investigate a message the firm is likely to play a strategy where the probability he gets caught exaggerating is low. When the auditor has no incentive to investigate a message the firm simply chooses the strategy that is most aligned with its desire to exaggerate.