Auditors' Liability, Investments, and Capital Markets: A Potential Unintended Consequence of the Sarbanes-Oxley Act

Journal of Accounting Research, Forthcoming

54 Pages Posted: 8 Apr 2012 Last revised: 11 Apr 2012

Mingcherng Deng

City University of New York (CUNY) - Baruch College

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation

Toshi Shibano

Columbia Business School

Date Written: April 4, 2012

Abstract

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.

Keywords: Auditing, audit liability, information asymmetry, capital market

JEL Classification: M49, G31, G38

Suggested Citation

Deng, Mingcherng and Melumad, Nahum D. and Shibano, Toshi, Auditors' Liability, Investments, and Capital Markets: A Potential Unintended Consequence of the Sarbanes-Oxley Act (April 4, 2012). Journal of Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2034539

Mingcherng Deng (Contact Author)

City University of New York (CUNY) - Baruch College ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
611 Uris
New York, NY 10027
United States
212-854-2475 (Phone)

Toshi Shibano

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

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