Legal Regimes, Damage Apportionment Rules, and Auditor Independence - Theory and Experimental Evidence

Abstract

This paper reports the results of four laboratory experiments designed to examine whether an appropriate legal system, which is a combination of legal regime (strict vs. negligence) and damage apportionment rule (joint-and-several vs. proportionate), may serve as an effective mechanism to enhance auditor independence. I adopt the laboratory experiments to test a series of hypotheses derived from a one-period game theoretic model in which the auditor may commit either a technical or an independence audit failure. Several important findings are documented. First, the experimental results confirm the analytical model's prediction that there is a trade-off among auditor's effort, audit failure, and firm's new investments. This trade-off implies that no single legal system can induce higher audit quality, reduce technical audit failure, improve auditor independence, and encourage firm's investment simultaneously. For regulatory purpose, a strict legal regime together with a proportionate damage rule can effectively decrease technical audit failure, improve auditor independence, and encourage firm's investment despite the fact hat audit quality also decreases. This trade-off also accentuates the importance of incorporating auditor's independence strategy into the examination of auditor's legal liability. Second, the auditors' independence is impaired less often than the model prediction because they recognize the compromise of independence to be unethical. In addition, the auditors exert more high effort under the proportionate rule than under the joint-and-several rule because they perceive the former to be relatively fair in the occurrence of a technical audit failure. Finally, an emphasis on damage apportionment rule is by itself not enough to improve auditor independence and motivate firm's investment. A replacement of the negligence regime by a strict regime seems to be more useful than a replacement of the joint-and-several rule by a proportionate rule in achieving these goals.