Auditorss Liability to Third Parties

Abstract

We examine the near-privity rule that increases the auditor’s legal liability exposure by considering a debtholder who can sue the auditor and recover damages when there is an audit failure. We show that the increase in the auditor’s legal liability induces the auditor to choose more informative and more conservative efforts. While the increased informative effort has a favorable spillover effect that increases the equityholder’s expected payoff, the increased conservative effort induces a bias, i.e., decreases the likelihood of reporting a true good state as good, and thus induces an adverse spillover effect that decreases the equityholder’s expected payoff. As such, when the conservative effort bias is small, the favorable spillover effect dominates the adverse spillover effect and the equityholder prefers the near-privity regime.