Scope of Auditors' Liability, Audit Quality, and Capital Investment

Derek K. Chan () and Kit Pong Wong ()

Review of Accounting Studies, 2002, vol. 7, issue 1, No 5, 97-122

Abstract: Abstract One of the fundamental issues in the discussion of auditors' liability is to whom auditors should be held liable for ordinary negligence under common law. Three judicial viewpoints prevail: the restrictive privity approach, the more liberal Restatement approach, and the most liberal foreseeability approach. To compare these three approaches from an efficiency perspective, this paper develops a model that features an owner-managed firm, an independent auditor, a continuum of unrelated lenders, and an impartial court. Double effort-incentive problems appear for the firm and the auditor. The firm has an additional incentive problem due to the sequential nature of its borrowing. This paper shows that the effort-incentive problem and the sequential borrowing problem of the firm render unambiguous improvements in audit effort/quality, capital investment, and social welfare as the judicial approach governing the scope of auditors' liability becomes more conservative.

Keywords: Auditors' liability; audit quality; double moral hazard; sequential borrowing; underinvestment (search for similar items in EconPapers)
Date: 2002
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DOI: 10.1023/A:1017983614986

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