The Audit Arrangements Of The Legal System And Investor Protection Study

This thesis constructs a model which explores the impact of auditors'legal liability on investment and audit quality. The model focuses on the impact of damage measures on investments. The potential liability of payments creates an incentive for the auditor to work hard; however, the potential liability payments can also provide insurance for investors while the state of nature is bad. Indeed, if damages are measured based on actual investments, investors can over-investing and get more liability payments. Thus, the wealth is transferred from the auditors to investors and this lead to an over-investment in risky assets, relative to a socially optimal level, even the audit quality is high. When removing the association between actual investments and liability payments, a socially optimal level of investment can be induced. A legal regime that can induce the socially optimal effort level consists of a strict liability rule with a damage measure that is independent of the actual investment. Under this circumstance, the social welfare is maximized and the social cost is minimized.There has been an enormous increase in auditing standards and increase in litigation against auditors. This thesis also demonstrates how equilibrium audit fees depend on both the informational value of the audit and the option value of the claim financial statement users have on the auditor's wealth in the event the audit is determined to have beensubstandard. Auditors'attitudes toward auditing standards are studied when the regulating liability rules are limited or infinite, and characteristics of optimal liability rules are evaluated.