Auditors’ Liability to Lenders and Auditor Conservatism

35 Pages Posted: 15 Feb 2018 Last revised: 16 Jun 2018

See all articles by Pei-Cheng Liao

Pei-Cheng Liao

National Taiwan University - Department of Accounting

Suresh Radhakrishnan

JSOM, University of Texas at Dallas

Date Written: April 19, 2018

Abstract

We examine the near-privity rule that increases the auditor’s legal liability exposure by considering a debtholder who can sue the auditor and recover damages when there is an audit failure. We show that the increase in the auditor’s legal liability induces the auditor to choose more informative and more conservative efforts. While the increased informative effort has a favorable spillover effect that increases the equityholder’s expected payoff, the increased conservative effort induces a bias, i.e., decreases the likelihood of reporting a true good state as good, and thus induces an adverse spillover effect that decreases the equityholder’s expected payoff. As such, when the conservative effort bias is small, the favorable spillover effect dominates the adverse spillover effect and the equityholder prefers the near-privity regime.

Keywords: conservatism, legal liability, near-privity, spillover

JEL Classification: D86, M41, M42

Suggested Citation

Liao, Pei-Cheng and Radhakrishnan, Suresh, Auditors’ Liability to Lenders and Auditor Conservatism (April 19, 2018). Available at SSRN: https://ssrn.com/abstract=3117710 or http://dx.doi.org/10.2139/ssrn.3117710

Pei-Cheng Liao

National Taiwan University - Department of Accounting ( email )

1 Sec. 4, Roosevelt Road
Taipei 106, 106
Taiwan
+886-2-33661127 (Phone)
+886-2-23638038 (Fax)

Suresh Radhakrishnan (Contact Author)

JSOM, University of Texas at Dallas ( email )

Mail Stop SM 41
800 West Campbell Road
Richardson, TX 75080
United States
972-883-4438 (Phone)
972-883-6811 (Fax)

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