Legal regimes, audit quality and investment.

Abstract

Abstract This paper presents an analytical model that explores the impact of auditors' legal liability on audit quality and investment. The model is particularly concerned with the impact of damage measures on investments. The threat of liability payments creates an incentive for the auditor to work hard: however, the potential liability payments can also provide an "insurance" for investors in the event the state of nature is bad. Indeed, if damages are measured based on actual investments, investors can increase the liability payments by over-investing. Thus, the potential transfer of wealth from auditors to investors can lead to an over- investment in risky assets, relative to a socially optimal level, even with a high-quality audit. A socially optimal level of investment can be induced by removing the association between actual investments and liability payments. In my model, a legal regime that can induce the socially optimal level of investment, while still motivating the auditors to exert the socially optimal effort level, consists of a strict liability rule with a damage measure that is independent of the actual investment.

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