Auditor liability rules under imperfect information and costly litigation: the welfare-increasing effect of liability insurance

Abstract

This paper examines auditor liability rules under imperfect information, costly litigation and risk-averse auditors. A negligence rule fails in such a setting, because in equilibrium auditors will deviate with positive probability from any given standard. It is shown that strict liability outperforms negligence with respect to risk allocation and the probability that a desired level of care is met by the auditor if competitive liability insurance markets exist. Furthermore, our model explains the existence of insurance contracts containing obligations a type of contract often observed in liability insurance markets.

Auditor Liability and Business Investment*

“…On the other hand, Coffee (2004) suggests that gatekeepers face strict liability with modified penalties. As a matter of fact, strict liability has long appealed to both academics and the courts (see, e.g., Shavell 1980Shavell , 1987Hardy 1994;Ginsburg 1995;Schwartz 1997;Zhang and Thoman 1999;Ewert, Feess, and Nell 2000;Yen 2000;Partnoy 2001).…”

Should we trust the gatekeepers?

“…However, given that we are not interested here in analysing the behavior of managers, nor issues of collusion, or other instances of joint liability of managers and gatekeepers, but only the gate-keeping efforts of auditors and lawyers, we treat managers' behavior as exogenous. A similar assumption, in Ewert, Feess, and Nell (2000). 16 This assumption is made without loss of generality.…”

“…leged (confidentiality) than those of auditors, securities underwriters, and other gatekeepers in the corporate context 6 . It is hard to deny, though, that, all the differences with auditors notwithstanding, lawyers do play, in many situations involving the operations of corporations, a substantial gate-keeping function, to the extent that they screen and verify the legality of planned actions, disclosure and filings before a wide variety of private and public outsiders 7 . Clear examples of these relevant gate-keeping functions of lawyers can be found in the area of corporate disclosures by issuers to raise capital both in the equity market and in private finance.…”

“…Others stress the feature of gatekeepers as reputational intermediaries who provide necessary verification or accreditation services to agents operating in a given market or activity: Coffee (2004). 7 Most commentators, albeit emphasizing the distinctiveness of the lawyers' gate-keeping role, accept its existence: Painter (2004), Coffee (2003Coffee ( , 2004, Henning (2004), Zacharias (2004). For a dissident view, see Fisch and Rosen (2003).…”

Auditors’ liability with overcompensation and reputation losses

“…3 2 This literature focuses on the effect of performance-based audit fees (Radhakrishnan 1999), compares several and joint liability and proportionate liability (Hillegeist 1999), and asks how the possibility to settle a lawsuit affects auditors' care in the first place (Boritz and Zhang 1997, Smith and Tidrick 1998, Zhang and Thoman 1999. Balachandran and Nagarajan (1987) and Ewert et al (2000) address the issue of auditor liability insurance. Dye (1993) analyzes the effect of limited liability due to auditors' limited wealth.…”