| Abstract: | We model a firm's investment decision, an auditor's effort‐rendering behavior, audit fees, and prices of the firms under two auditor liability rules: strict liability and negligence liability. We show that an auditor's effort level is socially optimal under strict liability, while it is not generally so under negligence liability. Furthermore, both the firm owner's expected benefit and the audit fee are higher under strict liability than under negligence liability. We define the legal error under negligence liability as the difference between the assessed audit effort (that is, the estimate of audit effort made by the court) and the actual audit effort and prove that the greater the variance of the legal error, the more incentive an auditor has to exert effort under negligence liability compared with strict liability. Finally, the number of investments being undertaken could be higher under strict liability because more firm owners are willing to hire auditors to go public. |
