Auditor Liability and Client Acceptance Decisions

The audit profession has long argued that excessively burdensome legal liability imposed on auditors hinders capital formation by increasing the likelihood that audit firms will reject potential clients, particularly high risk firms, leaving such firms with limited access to capital markets. However, in equilibrium, a change in the legal environment will also have an impact on the audit fee, as the entrepreneur can compensate the auditor for the increased risk since it allows him to raise capital from investors at lower cost. Thus, the equilibrium implications of increased auditor liability on client rejection rates are not as obvious as implied by the audit profession’s arguments. In our forthcoming Accounting Review paper entitled Auditor Liability and Client Acceptance Decisions, we examine the implications of the legal liability environment for the auditor’s decision to accept or reject risky clients, the level of audit quality (given acceptance), and the level of the audit fee, in a setting where the auditor spends costly resources to evaluate the prospective client prior to making the acceptance decision.

In particular, we consider a setting in which an entrepreneur requires capital to undertake a new project and seeks that capital through outside investors. In order to investigate the effects of the litigation environment on the probability that good-type clients get rejected, we consider three components of that environment: i) the strictness of the legal liability regime, which is interpreted as the probability that the auditor will be sued and found liable after an audit failure, ii) damage payments from the auditor to investors in case of a successful lawsuit against the auditor, and iii) other litigation costs incurred by the auditor such as criminal penalties, attorney fees, or reputation loss.

We show that under reasonable assumptions about the level of expected damage payments, an increase in any of these litigation components results in an increase in both audit quality and the equilibrium audit fee. However, when considering the probability of client rejection, it is important to carefully distinguish between the three components of the liability environment. We first show that an increase in the potential damage payments to investors leads to a reduction (not to an increase) in the client rejection rate. A higher expected damage payment implies that the entrepreneur has to offer the auditor a larger audit fee. Otherwise, the audit engagement would become less attractive to the auditor which would lead to a lower evaluation effort and hence a higher rejection rate. However, the increase in the audit fee does not involve a real cost to the entrepreneur. If investors expect a larger damage award from the auditor in case of an audit failure, investors are willing to give the entrepreneur better financing conditions. The entrepreneur in turn can use these savings to compensate the auditor for the increased liability exposure. We call this the triangle effect. Hence, a change in the damage payment has no direct effects on the evaluation effort and the rejection rate.

However, there is also an indirect effect since a larger potential damage award induces the auditor to adopt an audit of higher quality (after accepting the client) which delivers more accurate information about the investment project and hence leads to improved investment decisions. The anticipation of a better investment decision increases the value of the entrepreneur’s investment opportunity in the initial stage. Since this investment opportunity is lost if the auditor rejects the engagement, the entrepreneur is more eager to attract the auditor. To do this, the entrepreneur increases the audit fee by an amount that is larger than the increase in the auditor’s expected damage payment, which results in a higher evaluation effort and a lower rejection rate. This result is reversed if litigation frictions increase. When litigation frictions are higher, the auditor will find the engagement with the client less attractive and hence will have a weaker incentive to carefully evaluate the client, which increases the rejection rate. Of course, the client can counteract this negative effect by offering a larger audit fee, but in this case a real cost is involved because the triangle effect does not hold. As a result, the equilibrium rejection rate increases with higher litigation frictions.

Because a shift in the strength of the legal regime affects both the expected damage payments to investors as well as expected litigation frictions, a change in the legal regime involves two opposing effects. Depending on which effect is stronger, a change in the legal regime either increases or decreases the probability of client rejection. In particular, we show that the relationship between the strength of the legal liability regime and the client rejection rate is U-shaped. Our model therefore predicts that clients are less likely to be rejected in environments with moderate legal regimes compared to environments with relatively strong or relatively weak legal regimes.

The full paper is available for download here.