Auditor Reputation Losses and Legal Liability Damages

Abstract

This paper studies the effect of imposing legal liability damages when an auditor also faces reputation losses. The auditor is uninformed about his ability but is concerned about avoiding a decline in the outside market’s perception about his ability due to the loss in future clients. Reputation losses alone provide incentives for the auditor to supply costly audit quality, but with legal liability damages, there is an option of noncompliance, when audit quality is lower than the minimum threshold set in the standards. Imposing legal liability damages may cause the auditor to choose noncompliance with lower audit quality than what would be optimal with only reputation losses. With compliance, if standards are lax, audit quality is higher than the minimum threshold because of reputation concerns. In equilibrium this is costly to the auditor because the market is not fooled and discounts high audit quality. With noncompliance, the auditor has lower costs, but incurs expected legal liability damages. If the legal liability damages are not too high, then noncompliance allows the auditor to commit to a lower audit quality. Further, when considering preferences for the strictness of standards, the investors always have a preference for stricter standards than the auditor.