Principal-Agent Analysis on How Legal Risks Affect Audit Fees and Quality

Abstract

This article develops a principal-agent multi-period model that ties legal risks, auditing fees and internal accounting practices. The principal is the auditing firm and the agent is the client firm. The client firm can improve its credibility by improving its internal auditing practices, which results in lower audit fees to the auditor firm. It is found that in equilibrium, there is a credibility threshold level that firms should meet and which depends on the legal risks associated with accounting practices and audit errors. If, as result of strict legislation, a firm is below the threshold it will pay above optimal auditing fees. In this case, the firm should make a single, immediate improvement to reach the optimal level. Additionally, only firms whose credibility is close to the threshold are affected if government increases legal scrutiny. More credible firms are not adversely affected by the stricter legal climate.