Auditors' Liability, Investments, and Capital Markets: A Potential Unintended Consequence of the Sarbanes-Oxley Act
City University of New York (CUNY) - Baruch College
Nahum D. Melumad
Columbia Business School - Accounting, Business Law & Taxation
Columbia Business School
April 4, 2012
Journal of Accounting Research, Forthcoming
To restore investors' confidence in the reliability of corporate financial disclosures, the Sarbanes-Oxley Act of 2002 mandated stricter regulations and arguably increased auditors' liability. In this paper, we analyze the effects of increased auditor liability on the audit failure rate, the cost of capital, and the level of new investment. We focus on a setting in which, with imperfect auditing, a firm has better information than investors about its prospects and seeks to raise capital for new investments in a lemons market. The equilibrium analysis derives corporate reporting and investing choices by the firm, attestation opinions by the auditor, and valuation by rational investors. Three empirically testable predictions emerge: although increasing auditor liability decreases the audit failure rate and the cost of capital for new projects, it also decreases the level of new profitable investments.
Number of Pages in PDF File: 54
Keywords: Auditing, audit liability, information asymmetry, capital market
JEL Classification: M49, G31, G38
Date posted: April 8, 2012 ; Last revised: April 11, 2012
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