Strategic interaction in auditing: An analysis of auditors' legal liability, internal control system quality, and audit effort

This paper presents a model in which a firm's owner, an auditor, and outsid e investors strategically interact. The owner's investment in the quality o f the firm's internal control system and the auditor's effort jointly affec t the informativeness of the auditor's report on the firm's financial state ments. If the auditor's legal liability to investors is large, then an effi ciency loss arises because the owner underinvests in the internal control s ystem and the auditor overinvests effort. On the other hand, if the liabili ty is small, then an efficiency loss arises from the owner's overinvestment and the auditor's underinvestment, Regulators can improve allocative effic iency by changing the auditor's legal liability. However, in our model, it is impossible to completely eliminate the efficiency loss by changing the a uditor's liability alone, because no damage award can induce both the owner and auditor to make socially optimal investments in the internal control s ystem and audit effort. We also interpret recent changes in the regulatory environment in the context of our model.