The Economic Consequences of Alternative Auditor Liability and Legal Cost Allocation Rules: An Equilibrium Analysis

Abstract

Eliminating joint and several liability and the American legal cost allocation rule have been singled out to be the two most needed legal reforms by the major accounting firms. Some remedies have been proposed by the accounting profession and the legal community. This paper develops a model to analyze economic consequences of alternative legal environments facing public accountants. In particular, our model shows the essential effects of possible features such as proportionate liability and legal fee shifting on audit effort, litigation frequency, and social welfare. The analysis identifies conditions under which replacing joint and several liability with proportionate liability, and/or a requirement that the loser at the trial pays the winners' legal costs would lead to a lower audit effort as well as a lower litigation frequency. The decreased audit effort and decreased litigation frequency have counterbalancing effects on social welfare, and hence, making the social effect of a change of liability rule and/or legal cost allocation rule very difficult to determine. The key point that the analysis reveals is that a comparison of liability regimes cannot be limited to the investigation of the audit effort (quality) that those regimes induce. The comparison must also include the incentive to bring suit, and associated costs and benefits of changes in audit effort and litigation frequency. Without fully understanding how a particular legal system would affect the real costs and benefits of audits, it is difficult to determine whether a legal system that induces more extensive or intensive auditing is desirable or not.

JEL Classification: D61, K13, M41