The Impact of Damage Apportionment on Internal Control System Quality and Financial Reporting Accuracy

Reinhard Schrank

Abacus, 2021, vol. 57, issue 2, 251-296

Abstract: This paper investigates how damage apportionment between auditor and auditee affects the quality of the internal control system (ICS), the supplied audit quality, and social welfare. The analysis takes place in a setting where the audit is not only required to meet obligations towards the primary addressees of the audited report, but where the auditor assumes a public responsibility that also makes them responsible for the losses of ‘foreseeable third parties’. Using a game‐theoretic model, I show that shifting liability away from the auditor towards the auditee can lead to higher audit quality but lower ICS quality. The empirical evidence shows that internal controls and external auditing can be either complements or substitutes. Furthermore, assigning all the damages to the auditor leads to a Pareto‐efficient allocation of ICS quality and audit quality. This finding justifies the common ‘deep pocket’ assumption in the auditing literature.

Date: 2021
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