LOW BALLING, LEGAL LIABILITY AND AUDITOR INDEPENDENCE

We construct a dynamic multi-agent moral hazard model to analyze the i nteractions among the firm owner, the manager and the auditor. Moral h azard may arise in hierarchical agency because a rational monitoring a gent may accept a side payment from the monitored agent for misreprese nting information to the principal. This multi-agent moral hazard prob lem is the essence of the concern for auditor independence. We show th at a ''low-balling'' compensation scheme and the auditor's legal liabi lity constitute an efficient dynamic contracting mechanism for hierarc hical agency. In particular, low balling serves as a substitute for le gal liabilities for maintaining auditor independence. Low balling redu ces the transaction costs associated with the audit engagement relativ e to the flat-fee structure and can actually improve auditor independe nce.