Audit Error, Managerial Incentives, and Information Sharing

This paper studies the effect of losses due to audit error on audit quality when the auditor's report of earnings is used for managerial compensation and the auditor can learn about the firm's productivity environment by observing the manager's effort. If the auditor observes the manager's effort, he can tailor the audit quality perfectly to the productivity state. However whether the audit quality, and thus compensation, increases or decreases relative to when the auditor is uninformed, depends on whether the losses due to legal liability are more or less than auditor's loss of audit fees due to client or reputational loss. The increase or decrease in audit quality affects the manager's marginal productivity, which affects his compensation. Overall, the principal prefers the auditor to observe the manager's effort when the losses due to legal liability are more significant than the loss of audit fees due to client loss and the incentive problem is less significant, or when losses due to legal liability are less significant and the incentive problem is more significant