Strategic Interaction in Auditing : An Analysis of Auditors' Legal Liability, Internal Control System Quality, and Audit Effort

This paper presents a model in which a firm's owner, an auditor, and outside investors strategically interact. The owner's investment in the quality of the firm's internal control system and the auditor's effort jointly affect the informativeness of the auditor's report on the firm's financial statements. If the auditor's legal liability to investors is large, an efficiency loss arises because the owner under-invests in the internal control system and the auditor over-invests effort. On the other hand, if the liability is small, an efficiency loss arises from the owner's over-investment and the auditor's under-investment. Regulators can improve the allocative efficiency by changing the auditor's legal liability. However, in our model, it is impossible to completely eliminate the efficiency loss by changing the auditor's liability alone, because there does not exist a damage award that induces both the owner and auditor to make socially optimal investments in the internal control system and audit effort. We also interpret recent changes in the regulatory environment in the context of our model