| Auditors have argued that legal damage awards are excessive, and advocated legal reform. Legal liability is imposed on auditors because the users of audited financial statements cannot observe audit quality. Apparently, a larger award will induce higher audit quality, and larger benefit of auditing. What then is the socially optimal audit quality? This paper will help policy makers assess the following issues. What are the tradeoffs determining the socially optimal audit quality? How do the optimal quality, and economic decisions of client firms, investors, and auditors vary with alternative liability regimes?; I construct a model where audit report influences the client firm's production decisions, and the costs and benefits of audit quality are explicit. The audit technology is such that the auditor's report could be in error even without deliberate attempt to mislead. However, the probability of audit error can be decreased by putting more resources into the audit. Three alternative liability regimes are analyzed; a 'misstatement' regime, a 'negligence' regime, and a 'strict liability' regime. In the misstatement regime, the auditor incurs legal liability if his report was misleading. In the negligence regime, the auditor is liable when his report was misleading and that he was negligent. In the strict liability regime, the auditor is liable when the firm suffers some publicly observable catastrophic event like bankruptcy. I derive the optimal audit quality, the optimal damage award, and the equilibrium audit fee, and compare welfare consequences for each regime. |
