Low Balling, Legal Liability and Auditor Independence

Abstract

We construct a dynamic multi-agent moral hazard model to analyze the interactions among the firm owner, the manager and the auditor. Moral hazard may arise in hierarchical agency because a rational monitoring agent may accept a side payment from the monitored agent for misrepresenting information to the principal. This multi-agent moral hazard problem is the essence of the concern for auditor independence. We show that a ?low-balling? compensation scheme and the auditor's legal liability constitute an efficient dynamic contracting mechanism for hierarchical agency. In particular, low balling serves as a substitute for legal liabilities for maintaining auditor independence. Low balling reduces the transaction costs associated with the audit engagement relative to the flat-fee structure and can actually improve auditor independence.

JEL Classification: M49, D40