Auditor Liability Rules under Imperfect Information and Costly Litigation

This paper examines auditor liability rules under imperfect information,costly litigation and risk averse auditors. A negligence rulefails in such a setting, because in equilibrium auditors will deviatewith positive probability from any given standard. It is shown thatstrict liability outperforms negligence with respect to risk allocation,and the probability that a desired level of care is met by the auditorif competitive liability insurance markets exist. Furthermore, ourmodel explains the existence of insurance contracts containing obligations- a type of contract often observed in liability insurance markets.