Scope of Auditors' Liability, Audit Quality, and Capital Investment

40 Pages Posted: 3 Aug 2001

See all articles by Derek Chan

Derek Chan

University of Hong Kong - Faculty of Business and Economics

Kit Pong Wong

University of Hong Kong

Multiple version iconThere are 2 versions of this paper

Date Written: July 2001

Abstract

One of the fundamental issues in the discussion of auditors' liability is to whom auditors should be held liable for ordinary negligence under common law. Three judicial viewpoints prevail: the restrictive privity approach, the more liberal Restatement approach, and the most liberal foreseeability approach. To compare these three approaches from an efficiency perspective, this paper develops a model that features an owner-managed firm, an independent auditor, a continuum of unrelated lenders, and an impartial court. Double effort-incentive problems appear for the firm and the auditor. The firm has an additional incentive problem due to the sequential nature of its borrowing. This paper shows that the effort-incentive problem and the sequential borrowing problem of the firm render unambiguous improvements in audit effort/quality, capital investment, and social welfare as the judicial approach governing the scope of auditors' liability becomes more conservative.

Keywords: Auditors' liability; Audit quality; Double moral hazard; Sequential borrowing; Underinvestment

JEL Classification: D62, D82, K13, L51, M41, M49

Suggested Citation

Chan, Derek K. and Wong, Keith Kit Pong, Scope of Auditors' Liability, Audit Quality, and Capital Investment (July 2001). Available at SSRN: https://ssrn.com/abstract=277931 or http://dx.doi.org/10.2139/ssrn.277931

Derek K. Chan (Contact Author)

University of Hong Kong - Faculty of Business and Economics ( email )

K.K. Leung Building
Pokfulam Road
Hong Kong
China
+852 3917-8357 (Phone)
+852 2858-5614 (Fax)

Keith Kit Pong Wong

University of Hong Kong ( email )

Faculty of Business and Economics
University of Hong Kong
Hong Kong, Nil Nil
Hong Kong
(852) 2859-1044 (Phone)
(852) 2548-1152 (Fax)

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