Auditors' Liability, Vague Due Care, and Auditing Standards

Review of Quantitative Finance and Accounting, 11 (1998): 183–207© 1998 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.

Auditors’ Liability, Vague Due Care, and AuditingStandards

RACHEL SCHWARTZJohn M. Olin School of Business, Campus Box 1133, One Brookings Drive, Washington University, St. Louis,MO 63130-4899

Abstract. This paper expands the set of previously considered liability rules to include a negligence liabilityrule with a vague specification of due care. Auditors who are negligent in conducting their audit are liable forlosses that result from reliance on misstated financial statements. However, what constitutes negligence forauditors is not clearly specified in the law. Consequently, courts often resort to Generally Accepted AuditingStandards (GAAS) and Statements on Auditing Standards (SAS) as benchmarks for determining due care. Aliability regime that consists of a vague negligence rule supports and amplifies the credibility of auditingstandards. While auditing standards alleviate some of the vagueness that is inherent in the legal standard, theyalso form a lower bound on due care, since an audit of a quality that is lower than the quality that auditingstandards require would be considered negligent. Thus, the vague specification of due care enables auditors tocommit to audit quality as pronounced in auditing standards. This paper explores this link between professionalstandards and auditors’ legal liability. It establishes that the commitment to auditing standards could not havebeen as credible as it is, if auditors’ liability was determined based on the strict liability rule, or based on anegligence rule with a clearly specified due care, since under these two liability rules courts would not need torefer to auditing standards to establish fault. The paper also demonstrates that a legal regime where auditstandards are used as a benchmark to evaluate negligence is not the same as a legal regime where due care isdefined clearly. Therefore, previous studies that assumed a negligence regime with clear due care may haveoverstated the effort level that is induced by legal liability.

Key words: Auditors’ liability, negligence, vague due care, auditing standards

1. Introduction

This paper expands the set of previously considered liability rules to include a negligencerule with a vague specification of due care. Previous studies on auditors’ liability haveassumed that liability is determined either by the strict liability rule or by the negligencerule that is complemented by a clear specification of due care. Refining the notion ofnegligence enhances our understanding of the mechanism that enables a credible com-mitment to auditing standards.

Generally Accepted Auditing Standards (GAAS) and Statements on Auditing Standards(SAS) affect the public’s perception of audit quality since the auditor’s effort is notreadily observable.1 However, the incentive to comply with these standards is tied directlyto the penalties for non-compliance. Although the profession imposes sanctions on audi-tors who deviate from professional standards, its enforcement power is limited. But,auditors’ legal liability for damages resulting from reliance on misstated reports that wereprepared negligently does carry significant monetary penalties.2 The association between

Kluwer Journal@ats-ss10/data11/kluwer/journals/requ/v11n2art4 COMPOSED: 07/01/98 3:20 pm. PG.POS. 1 SESSION: 66

legal liability and professional standards is not trivial. For example, most product liabilitycases are subject to strict liability, which implies that the producer is liable for damagesthat are caused by defective products whether or not he was negligent. In a strict liabilityregime professional standards may provide guidance to the members, but will not affectthe legal liability to which the members are exposed. In contrast, auditors’ liability fortheir “product”—the auditor’s opinion on the financial statements—is based on a negli-gence theory and is thus limited to the cases where the auditor was negligent.

A casual review of the liability rules that pertain to auditors reveals that whennegligence-based theories of liability are applied to auditors, the associated due care levelsare not clearly specified. Auditors are typically sued under one or more of the following:Section 11 of the Securities Act of 1933, Section 18(a) of the Securities Exchange Act of1934, or Rule 10b-5 of the 1934 Act.3 None of these laws clearly defines the due careexpected of an auditor. In fact, what constitutes due care seems to have evolved over time.A proof of negligence is the key to auditors’ liability, and violation of auditing standardsis considered prima facia evidence of having provided a negligent audit.4

Under a vague specification of due care, the auditor has a positive probability of beingfound not negligent at any effort level. However, when auditing standards are specified, acare level that is substandard would be considered negligent by the court, since violatingGAAS is prima facia evidence of negligence. Thus, by specifying a standard, the auditorincreases his expected liability at any effort level that is lower than the standard, henceincreasing his incentive to expend more effort than would be optimal in the absence ofstandards.

While the idea that a standard may be a way of increasing average quality levels in anindustry is not new (see Leland [1976], Shaked and Sutton [1981]), previous research hasviewed standards as creating barriers to entry. Also, viewing professional standards assignals regarding the quality of the output is not specific to auditors. What is unique to theaccounting world is that in the context of auditing, the enforcement power of standardsarises from the unique situation of negligence-based liability with a vague specification ofdue care, which leads courts to resort to professional standards as a reference to ascertainliability.5

The contribution of this paper is that auditors’ due care is modeled as inherently vague,and consequently the role of auditing standards extends beyond internal communicationbetween members of the profession. This is in contrast to previous research in the area ofauditors’ liability, which assumed either the negligence rule, where a clear definition ofthe due care level is specified, as in Balachandran and Nagarajan [1987], or the strictliability rule (Melumad and Thoman [1990], Nelson, Ronen and White [1988]). Dye[1993] ties auditing standards with legal liability and studies how auditors’ attitudestowards standards vary with wealth. However, in his model there is no distinction betweenauditing standard and due care, and therefore there exists no uncertainty regarding thelevel of due care. Contrary to Dye [1993], in this paper auditing standards are not assumedto be due care. Rather, standards are used by courts as a benchmark for determining duecare.

The remainder of the paper is organized as follows. Section 2 describes the model anddiscusses how the demand for liability arises from the special market conditions unique to

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the audit market. Section 3 describes the effort levels under strict liability and under thenegligence rule when due care is defined clearly. Section 4 refines the existing notion ofnegligence rules by investigating the effect of vague due care, and the effort that is theresult of a legal regime that combines vague due care with auditing standards. The paperconcludes with a summary in section 5.

2. The model

A firm is seeking to raise capital in the form of additional equity. The knowledge of thefirm’s real value is required by potential shareholders as an input in their decision making.This value is unknown at the time of the decision, but will be revealed in the future. Thefirm’s manager issues a report in the form of financial statements which disclose hisestimate of that value; however, the report may be biased because the manager’s contractwith the current shareholders may create incentives for misreporting.6 A contract betweenpotential investors and current shareholders, or the manager, that would impose penaltiesfor misreporting, will not alleviate the problem since the current shareholders liability islimited to their claims in the firm, and the manager has insufficient wealth to guarantee theinvestment. In order to obtain a reliable report, potential investors require an independentassessment of the value and thus hire an independent external auditor to audit the state-ments. The auditor exerts effort e [ [e, e] in the audit process,7 which enables him to forma judgment of the firm’s real value.8 The auditor’s effort is not readily observable, there-fore, the auditor’s fee cannot depend on the auditor’s effort.9 The auditor’s compensationalso cannot depend on the output—the audited report. Such a dependency may provide anincentive for the auditor to compromise his independence, and for U.S. auditors it wouldconstitute a violation of the Code of Ethics’ ban on contingent fees (Rule 302).10

The auditor is assumed to be independent, that is, he will not issue a clean opinion ifhe finds that the financial statements contain material misstatements.11 Issuing an adverseor qualified opinion places the auditor at risk of being replaced.12 If the auditor alsoprovides management advisory services (MAS) for the client he audits, he may be in-clined to compromise his independence in the audit task in order to retain the MAScontract.13 However, such a compromise of independence violates the Code of Profes-sional Conduct (Miller and Bailey [1995]) and exposes the auditor to loss of reputation.In order to focus on the effort choices that auditors face, I assume in this paper that theauditor does not compromise his independence.

Auditors’ independence implies that auditors will not issue clean opinions for state-ments they find misleading, but audit technology is not perfect, and statements that theauditor believes to present fairly the firm’s value might be incorrect. The magnitude of thedeviation of the reported value from the real value, D, is assumed to decrease stochasti-cally in the auditor’s effort.14 Investors who make investment decisions based on the(potentially misstated) audited financial statements may incur losses, L, that increasestochastically with the magnitude of the deviation, D.15 After the firm’s real value isrealized, an assessment is made of the deviation of the real value from the reported value.

AUDITORS’ LIABILITY, VAGUE DUE CARE, AND AUDITING STANDARDS 185


The auditor may be liable for financial damages that result from reliance on a misstatedreport.16 The following time-line summarizes the sequence of events:

auditor hired;fees agreed upon;auditor exerts ef-fort e; audited fi-nancial state-ments published

investment deci-sions are made;losses L may re-sult from relianceon the statements

firm’s value anddiscrepancy D re-alized

lawsuits may bebrought againstthe auditor

2.1. The value of an audit

When financial statements are audited, the amount and magnitude of misstatements arereduced. Consequently, losses that could have resulted from the misstatement are avoided.The value of the audit, V(e), arises from this reduction in losses, and is defined as thebenefit of an audit, B(e), net of the audit cost, C(e).17 The value of an audit is formallygiven by

V~e! 5 B~e! 2 C~e!.

The benefit of an audit, B(e), is formally defined by the difference between expectedlosses that would occur if no audit was in place, denoted by E,18 and the expected lossesgiven an audit:19

B~e! 5 E 2 *0

`

*0

`

L•h~L?D!•g~D?e!dLdD.

The effort that maximizes the audit value is denoted by e* and formally given by:

e* 5 argmax@e,e#

V~e!.

The next section discusses why inducing an effort level that results in an audit of highvalue requires legal liability for auditors whose reputation considerations do not providesufficient incentives to work hard.

2.2. Why impose liability?

The audit contract does not allow for significant fee variations from the pre-agreed fee andtherefore is not contingent on the effort. The ban on contingent fees implies that auditing

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fees cannot depend on the auditor’s report. That is, audit fees, once agreed upon, do notvary with output or effort.

The equilibrium fee for an audit, as determined in the negotiation between the auditorand the client, can range from the audit cost to its benefits, depending on auditor/clientbargaining power. That is, the auditor will not accept the engagement unless the feeexceeded the cost, and the client will not hire the auditor unless the fee is lower than thebenefit derived from the audit. Let eE denote the equilibrium level of effort, as perceivedby both the auditor and the client. The equilibrium audit fee, when no liability is imposed,is set in a bargaining process where the auditor’s bargaining power is denoted by u, andthe client’s bargaining power is 1 2 u, u [ [0, 1]. The fee is given by (1 2 u)C(eE) 1uB(eE) 5 C(eE) 1 uV(eE), which implies that the auditor’s equilibrium rent, (fee minuscost), is [C(eE) 1 uV(eE)] 2 C(eE) 5 uV(eE). V(eE) is the value of the audit when theequilibrium effort is exerted; thus the auditor’s rent, uV(eE), is the auditor’s share of theaudit value, where the size of the share depends on the auditor’s bargaining power u. Sincethe value of the audit is maximized at e*, the auditor’s rent, which is a portion of the auditvalue, will also attain its maximum at e*. When the auditor cannot credibly commit toexerting that effort level, the auditor’s dominant strategy is to minimize the cost ofperforming the audit by applying the lowest level of care e. When the fees are ex post fixedand no legal liability is imposed, the auditor cannot extract the potential rent, uV(e*), butrather only a lower rent uV(e).

Although reputation consideration might mitigate this effect, an auditor with a shorttime horizon, having no liability imposed on him, cannot be motivated to adopt anythingbut the lowest possible effort level, e, which will be the equilibrium effort level.20 Whileconcern about the effect of current action on future reputation may alleviate an auditor’smoral hazard problem in effort selection, not all auditors have a long horizon for repu-tation considerations to produce an appropriately high quality audit.

An equilibrium which always induces the lowest possible audit quality is of concern toboth investors and auditors, and is socially undesirable. Increasing the audit effort isdesirable by investors, who would obtain more valuable information for their decisionmaking. It is also desirable by the auditor, whose rent is a fraction u of the audit value, andthus he could extract higher rents if his audit is of higher value. What seems to be a naturalsolution—having the fee depend on either the input or the output—is not a feasiblesolution in the audit market for the reasons discussed above. The alternative means tomotivate the auditor is to impose penalties for low effort, external to his contract with theclient.

A close examination of the auditors’ world reveals that both the profession and thelegislature take measures to discourage low quality audits: the profession by promulgatingstandards and the legislator by imposing legal liability. The interesting conclusion thatarises from studying the two seemingly independent mechanisms is that the mechanismset forth by the auditors in the form of professional promulgations compliments theincentives set forth by the legislators, in the form of legal liability for negligent audits.However, this interaction between auditing standards and auditors’ liability occurs onlybecause due care for auditors is not clearly defined, which induces courts to resort toauditing standards for reference on due care. The literature on auditors’ liability hastraditionally assumed either the strict liability rule or the negligence rule with a clear due



care (which will be referred to as clear negligence). The next section provides a shortoverview of these liability rules and the effort they induce, in order to provide benchmarksfor comparing these effort levels to the effort that is induced by the vague negligence rulethat is presented in section 4.

3. Auditors’ effort under strict liability and under clear negligence

The extent of the losses that may result from reliance on a potentially misstated auditedfinancial statement depends on the size of the misstatement, which stochastically varieswith the effort that the auditor exerted. If the auditor is held liable for these losses, hisliability would be limited to the lower of the loss or his wealth, W. The expected liabilityof an auditor who exerts effort e, conditioned on being found liable, is denoted by EL(e)and is given by:21

EL~e! 5 *0

`

*0

`

min@L, W#•h~L?D!•g~D?e!dLdD.

3.1. Strict liability

Under strict liability the auditor is held liable for damages resulting from reliance on amisstated financial report, independent of the amount of effort exerted. This implies thathis effort affects the distribution of misrepresentations and resulting losses, but does notaffect the conditional probability of being held liable, which equals 1 at all effort levels.Formally,

Prob~liable?e,strict! 5 1 ; e [ @e, e#

Thus, the expected liability of an auditor who operates under strict liability and exertseffort e is equal to EL(e), since he is found liable at all effort levels. The auditor choosesan effort level that maximizes his fees net of the cost of the audit and the expectedliability. Denote the effort induced by strict liability by es. This effort level is given by

es 5 argmax@e, e#

fee 2 C~e! 2 EL~e!.

Since the fees do not vary with the actual effort, the above maximization problem isequivalent to the auditor minimizing the sum of the cost of the audit and the expectedliability. Formally,

es 5 argmin@e, e#

C~e! 1EL~e!.

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Although strict liability shifts all losses from investors to auditors, the effort level that itinduces may be lower than the socially optimal effort, because the auditor’s liability islimited to his wealth. This result is established in Lemma 1.

Lemma 1. The effort that is induced by strict liability may be lower than the sociallyoptimal effort because the auditor’s liability is limited to his wealth.

One might expect that strict liability will induce the auditor to work harder than anyother liability rule, since it imposes liability on the auditor with probability 1, at all effortlevels. Contrary to that intuition, I show in the next section that the negligence rule witha clear due care (designated clear negligence), can induce an effort level that is higherthan the effort level induced by strict liability.22

3.2. Clear negligence

A negligence-based liability rule levies liability on the auditor for damages caused byreliance on a misstated audited report, only if he failed to exercise due care. A Due Carelevel is that effort level, denoted by h, that defines the minimum care that an auditor isrequired to exercise in order to avoid liability. An auditor who exerts effort levels that arebelow the due care level will be liable for all damages. The auditor bears no liability if hecomplies with the due care requirement. That is, the probability that an auditor is liable ifdue care is clearly defined is either 1, if the effort is below due care, or 0, if the effortexceeds due care, as presented in figure 1.

An auditor who operates under clear negligence and exerts effort levels that are belowthe due care level is exposed to the same expected liability as under the strict liability rule,but he bears no liability if he complies with the due care requirement. The expectedliability for an auditor who operates under a negligence rule, if due care is defined clearly,is given by:

EL~e?clear negligence! 5 HEL(e) for e , h0 for e $ h

Figure 1. The auditor’s probability of being held liable if due care is clear and set at h



Undoubtedly, strict liability imposes greater liability than clear negligence. Neverthe-less, clear negligence can induce a higher effort level: Consider the case where due careis set at h0 5 es 1 « (« . 0), that is, « effort units higher than the effort level exertedunder strict liability. If the auditor exerts effort level eS, which is lower than due care, histotal cost will be the direct cost of effort plus the implied expected liability, C(es) 1EL(es). If he complies with due care by exerting effort level h0 5 es 1 «, he bears onlythe direct cost of effort, C(es 1 «), and faces no liability. For “small enough” «,

C~es 1 «! , C~es! 1 EL~es!,

thus the auditor prefers to exert h 5 es 1 « rather than es.The above example demonstrates that clear negligence can result in a higher audit

quality. The argument is summarized in Proposition 1, which also provides the upperbound on the quality that can be induced by clear negligence.

Proposition 1.

(a) A clear negligence rule can induce an effort level that is higher than the effort levelinduced by strict liability.

(b) The highest level of due care that the auditor will comply with, denoted by h, shouldbe set such that the auditor is indifferent between complying with it and exerting theeffort he would have exerted if the legal regime consisted of the strict liability rule.That is,

C~h! 5 C~es! 1 EL~es!.

Note that if a clear definition of due care were provided by the legislature, then legalliability would not provide support for compliance with auditing standards since compli-ance with due care is sufficient to shield the auditor from liability. In order to see howauditing standards draw credibility from the legal system, it is essential to refine the notionof the negligence rule. The recognition that the definition of due care is vague enables usto explore the interaction between auditors’ professional standards and auditors’ legalliability. The next section refines the notion of a negligence rule and explores the impactof the vague definition of due care on audit effort.

4. Vague due care and audit effort

In practice auditors are not provided with clear due care. The reasons are related to thecosts of implementing a clear negligence rule. A well defined due care specificationaccurately sets forth the level of care to be taken for all audit cases. Since there exists awide range of conditions which vary across audit cases and over time (e.g. technology,industry, firm size), it is conceivable that the appropriate due care should be dynamically

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crafted to reflect these conditions. This would result in a very detailed and complicated listof potential circumstances and their corresponding due care levels, which is costly for thelawmaker to compile and dynamically update.23 What is observed in practice is a negli-gence rule with a vague due care definition, (designated vague negligence), in which theappropriate amount of care is not specified in the law.

The uncertainty regarding the due care specification is resolved, ex post, via courtsruling in specific lawsuits against auditors. This uncertainty implies that neither the au-ditor nor the relying parties know ex ante whether an audit will be considered negligentor not. I assume that the auditor, the firm that is being audited, and outsiders who rely onthe audit, all share the same beliefs about what constitutes due care. These beliefs aresummarized in the probability distribution P(h). The analysis does not assume any spe-cific functional form for vague due care, and is robust to any non-degenerate distributionfunction.24 Negligence is determined by comparing the effort exerted by the auditor to duecare as determined by the court. Thus, although the specific level of due care is unknownex ante, a higher effort level would have a lower probability of being found negligent. Thespecific shape of the graph that describes how an auditor’s probability of being held liablevaries with effort depends on the specific functional form of P(h), but for all possibledistributions it will be downward sloping, with a value of 1 at e 5 e, as presented inFigure 2.

The expected liability of an auditor under vague negligence equals the probability ofbeing found negligent times the expected liability if found negligent, EL(e). Formally,

EL~e?vague negligence! 5 prob~e , h!•EL~e!

The effort level that the auditor exerts, ev, minimizes his total ex ante expected costs:

Figure 2. The auditor’s probability of being held liable if due care is vague



ev 5 argmin@e, e#

C~e! 1 prob~e , h!•EL~e!

Unlike strict liability, where the auditor is always liable for losses resulting frommisstatements, when operating under vague negligence, legal liability is triggered onlywith some positive probability. Although it may seems intuitive to conclude that strictliability induces higher effort levels than vague negligence, because strict liability carriesa certain liability while vague negligence implies only probabilistic liability, this is notalways true. The probabilistic nature of vague negligence generates two counter-effects onthe auditor’s incentives to work hard: On one hand, at any level of effort there is somepositive probability that the auditor will be found non-negligent and will not have tocompensate relying parties for their damages. This reduces the expected liability of theauditor and thus reduces his incentive to work hard relative to strict liability. On the otherhand, the probability of being found negligent is decreasing in effort. Thus, by workingharder the auditor can reduce the probability that he would be found negligent, andthereby he can decrease his expected liability. This effect would motivate the auditor towork harder than he would work under strict liability. The net effect of these two counterforces depends on the specific form of the beliefs regarding uncertain due care and cannotbe determined in general. Thus we cannot make a general statement about the whethervague negligence induces higher or lower levels of effort relative to the level of effort thatis induced by strict liability. However, vague negligence cannot induce an effort level thatis higher than the highest effort that clear negligence can induce. The intuition here is thatcomplying with clear due care shields the auditor from liability, whereas under vaguenegligence there is some probability of liability imposed on the auditor at any effort level.Thus, if the level of clear due care is such that the auditor does not comply—thatis—complete immunity from liability is not sufficiently valuable to justify the cost ofcompliance with that clear due care, the auditor will not exert such an effort level undervague negligence where such immunity is not guaranteed. That is, the effort that vaguenegligence can induce may be higher or lower than the effort that strict liability caninduce, but not higher than the effort that clear negligence can induce. This argument issummarized in Proposition 2.

Proposition 2.

(a) Auditors’ effort under the vague negligence liability rule may be higher or lower thanthe effort that is induced by the strict liability rule.

(b) The effort exerted under any vague due care never exceeds the highest clear due carethat an auditor would be willing to comply with. That is, ev , h.

The power of this result comes from the fact that it is not limited to a specific class ofdistributions of uncertain due care P(h). This result holds for every possible non-degenerate distribution of vague due care. As I have argued above, an auditor’s liability isnegligence-based but it is not accompanied by clear due care. Proposition 2 is useful informing an upper bound on the effort that is exerted under vague due care.

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The lack of a clear specification of due care is the source of credible commitment thatliability lends to auditing standards. In the context of legal liability, auditing standards canplay a role only when the negligence rule is implemented with vague due care. That isbecause if strict liability would be imposed, the auditor is held accountable regardless ofhis effort, so compliance with auditing standards cannot serve as a defense. When oper-ating under a clear negligence rule, negligence is determined by comparing the effort toa clearly defined due care. Once again, compliance with auditing standards would beirrelevant. In contrast, in a vague due care setting, the court might resort to auditingstandards in order to determine negligence.

4.1. Vague due care and auditing standards

Vague negligence implies that any audit work has some positive probability of beingfound non-negligent. Even if the auditor is found liable, his liability is limited to the lowerof the loss or his wealth. These two elements decrease the auditor’s incentive to work hardrelative to the socially desirable effort level. Even though a vague due care rule providesan incentive to work harder in order to reduce the probability of being found negligent, itis possible that the latter effect is outweighed by the former, and as a result the auditorexerts an effort level that is lower than the socially optimal effort: ev , e*. Recall that theauditor’s rent is a fraction of the audit value, and that both the audit value and theauditor’s rent are maximized at e*. However, if the auditor’s ex post rational choice ofeffort leads him to exert a low level of effort, he would only receive the corresponding lowrent. If the auditor could commit to an effort level that is higher than ev, he would be betteroff. In this section I demonstrate how auditing standards may be used as the means bywhich the auditor can commit to a higher audit quality. Note, though, that commitment toauditing standards could not be that strong if the negligence standards were clearly definedin the law.

The vague definition of due care implies that courts often appeal to GAAS in an attemptto ascertain due care (Hagen [1987]). Thus, GAAS constitutes an important element indetermining auditors’ negligence. However, professional standards are not a perfect sub-stitute for due care because complying with GAAS does not immunize the auditor fromliability (Jurinsky [1987]). In United States v. Simon25 (also known as the ContinentalVending case) the court instructed the jury that proof of compliance with generallyaccepted standards was “evidence which may be very persuasive but not necessarilyconclusive that he acted in good faith, and that the facts as certified were not materiallyfalse or misleading.” In Bily v. Arthur Young26 the California Appellate Court held that thecorrect test in a negligence case is the standard of expertise and diligence common to theprofession, as proved by expert witnesses testifying about the facts of the specific case. Onthis issue, GAAP or GAAS are relevant but not definitive. Thus, compliance with profes-sional standards is not a complete defense. However, violation of them is consideredprima facia evidence of having provided a negligent audit: In Rhode Island HospitalNational Bank v. Swartz, Bresenoff, Young and Jacobs,27 the Fourth Circuit Court ofAppeals indicated that to fulfill the duty of care, a CPA firm must comply with GAAS and



specifically the auditing pronouncements of the American Institute of Certified PublicAccountants (AICPA).

The above review of how courts view auditing standards implies that GAAS is con-sidered to be the minimum requirement of care rather than the due care level itself. Irepresent the effect of standards, S, on the court by the modified probability functionP(h . S). The probability that an auditor who exerted effort e will be found negligent, ifsued, when the professional standard is S, is given by prob(e , h . S)512P(e . S). SinceGAAS is considered by the court to be a minimum requirement, any effort that is lowerthan the professional standard is considered negligent:

prob~e , h ? S! 5 1 for e , S.

Setting a standard might reduce the probability that any effort level higher than thestandard will be found negligent. This might enhance the motivation for self regulationand may also provide an additional incentive to set high standards. However, in this paperI focus on the commitment for a higher audit quality that the standards create; thereforeI ignore this feature in order to not get sidetracked by modeling the strategic gamebetween the auditor and the court. I abstract from that influence the standard may have onthe court by assuming that without loss of generality, prob(e , h.S) 5 prob(e , h) fore $ S. Thus, the introduction of a standard modifies the auditor’s probability of beingfound negligent as follows:

prob~e , h ? S! 5 H 1 if e , S

prob~e , h! if e $ S

This probability is graphically depicted in Figure 3.Auditing standards modify the auditor’s expected liability. If he exerts an effort that is

lower than the standard, he is liable with probability 1 for losses that result from relianceon his misstated report. That is, the standards increase the expected liability for all effortlevels that are sub-standard. As a result, once a standard is set above the vague negligence

Figure 3. The auditor’s probability of being held liable if due care is vague and auditing standards are S

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effort, it may be less costly to work harder and to comply with the standard than to providea sub-standard audit quality at the lower effort level, ev. If it is less costly to comply withthe standard than to provide a lower audit quality, the auditor can commit to the higherquality by setting a standard. This argument is summarized in lemma 2.

Lemma 2. There exists a standard higher than ev to which the auditor can crediblycommit.

The audit profession may use auditing standards as a device for committing to providea pre-specified audit quality. Setting the standard lower than the actual effort is irrationalsince this will result in fees that reflect an audit quality which is lower than the actualquality provided. Recall that audit rent is given by uV(eE) and thus increases with per-ceived equilibrium audit value; therefore the profession would like to set the standard ashigh as possible (although not higher than the socially optimal effort). But, the standardshould not be set higher than the level that the auditor can credibly commit to: Setting thestandard higher than the effort that auditors would exert is also irrational since the clientwill perceive that as a non-credible commitment and therefore will not pay a fee thatreflects the too-high standard. Denote the highest standard that an auditor is willing tocomply with by S. This is the highest standard that an auditor can credibly commit to. Thishigh standard is set such that the auditor is indifferent between complying with and notcomplying with. If the auditor does not comply with the standard he faces liability withprobability 1 if the audited financial statements are misleading. The effort level thatminimizes the total cost in that case is the effort level that the auditor exerts under strictliability. That is, if the auditor chooses not to comply with auditing standards, his bestchoice is the effort exerted under strict liability, es. Therefore, the highest auditing stan-dard that the auditor can credibly commit to is set such that the cost of complying with itequals the total cost to the auditor under strict liability:

C~S! 1 prob~S , h!•EL~S! 5 C~es! 1 EL~es!.

The highest attainable standard might be higher than the socially optimal care level. Inthat case, if the auditor sets the standard at this high level, it will be ex post rational forhim to comply with the standard, but his rent will be lower than its maximum potentiallevel. Since the value of auditing attains its maximum at e*, the auditor’s rent which is ashare of this value is also higher at that effort level than at any other level: uV(S) ,uV(e*). To avoid this situation, the auditor will not set a standard that is higher than e*.Denote the preferred standard by S*. Formally, the auditor’s preferred standard is S* 5min [S, e*].

The highest standard is higher than the effort exerted under vague negligence, ev, butwithin the current framework, ev could be higher or lower than es, thus the rank of Srelative to es is not trivial. In Proposition 3, I prove that the highest standard is indeedhigher than the effort chosen under strict liability, es, though it does not exceed themaximum clear due care that the auditor is willing to comply with, h. The reason stemsfrom the fact that complying with a clear due care shields the auditor from liability, while



complying with an auditing standard does not guarantee that outcome. As a result, theexistence of auditing standards allows for a higher quality audit than attainable under strictliability or plain vague negligence, but not higher than the maximum attainable underclear negligence, as stated in Proposition 3.

Proposition 3. A vague negligence regime where courts use auditing standards as abenchmark for determining negligence results in an audit quality that is higher than thatinduced by strict liability, but does not exceed the highest quality attainable under clearnegligence. That is es , S* , h.

Figure 4 presents a comparison of effort levels that are induced by the various legalregimes.

5. Summary

Previous studies have assumed that auditors’ liability is determined either by the negli-gence rule or by strict liability. A negligence rule is theoretically complemented by a clearspecification of due care—that care level that is required of a non-negligent auditor.Hence, studies that examined auditors’ strategies under the negligence rule implicitlyassumed the existence of such a clear specification. A casual observation of the laws underwhich litigation is brought against auditors would reveal, however, that they contain onlygenerally worded prohibitions against negligence. The reasons are related to the cost

Figure 4. The effort levels induced by strict liability, clear negligence, vague negligence, and vague negligencecombined with auditing standards

196 RACHEL SCHWARTZ


associated with acquiring the information necessary for establishing the appropriate duecare, and the cost of a complete specification of various due care levels that are appro-priate for different audit cases.

This paper has expanded the set of previously considered liability rules to include anegligence rule with a vague specification of due care, which was designated vaguenegligence. The effort that is induced by vague negligence is strictly lower than the highesteffort that is implementable under clear negligence. Thus, an analysis of the effort im-plications of a negligence rule that assumes a clear specification of due care when noneexists, overstates the effort exerted by auditors and the resulting audit quality.28

Refining the notion of negligence allows for another contribution to the existing bodyof literature, that is, an understanding of the mechanism that enables a credible commit-ment to auditing standards. A liability regime that consists of a vague negligence rulesupports and amplifies the credibility of GAAS: In this regime auditing standards wereshown to be used by courts as the lower bound on due care. As such, any effort that isbelow the standard would be considered negligent and would therefore result in heavymonetary penalties. Thus auditing standards enable auditors to commit to audit qualitythat is higher than the quality attainable under vague due care. This commitment is madepossible by the penalties of non-compliance that are imposed by the legal liability and theabsence of clear due care. The internal mechanism of quality assurance, namely GAAS,interacts with the external mechanism of legal liability to ensure a minimum quality thatis credibly committed to by the profession. Another way for credible commitment couldbe forming a reputation over time. This is outside the scope of the current paper as itrequires a multi-period model while this paper explores a single-period model.

The effort that an auditor exerts in preparing his opinion was assumed to be unobserv-able unless the relying parties sue the auditor: Court procedures were assumed to perfectlyreveal this effort. As Polinsky and Shavell [1989] point out, legal errors are inevitable.Thus, while most of the uncertainty that auditors face in liability stems from the missingspecification of the due care level, some uncertainty could be attributed to the imperfectobservability of effort by the court. In that case, auditing standards will not be able toeliminate fully the uncertainty because even an auditor who exerted a substandard effortmay escape liability due to a potential error in observing his effort. Relaxing the simpli-fying assumption of perfect observability by the court would somewhat weaken the com-mitment power of standards, but the results are robust: The effort that is chosen by anauditor faced with vague due care increases when auditing standards are set.29 The resultsare also robust to the auditor’s risk preferences.

My model assumed that the auditor is sued for all losses regardless of size and mate-riality, and that there are no litigation costs. In practice, auditors are held liable only if thedeviation of the estimate to which they attest differs materially from the real value.Imposing a materiality requirement on litigated cases reduces the auditor’s expectedliability since he is not responsible for losses that result from immaterial deviations.Recognizing explicitly that litigation is costly and that consequently a lawsuit will bebrought only if the expected recovery exceeds litigation costs for the claimant furtherreduces the circumstances under which parties damaged by an auditor’s report pursueclaims against the auditor. If the expected recovery is lower than the litigation costs, no


Kluwer Journal@ats-ss10/data11/kluwer/journals/requ/v11n2art4 COMPOSED: 07/02/98 8:19 am. PG.POS. 15 SESSION: 85

suit will be brought against the auditor. Although relaxing these assumptions affects theexpected liability of the auditor, it does not affect any of the results that are derived in thispaper.

Finally, the discussion of auditing standards assumed that these standards are clearlydefined and can be applied to every audit case. In practice, one can think of manysituations where the auditor cannot simply apply the standards, either because they arebroadly defined or because they do not provide guidance on all possible dimensions. Aninteresting extension to the current paper would be to treat both the auditor’s effort andthe audit standards as multi-dimensional. Then in some dimensions, audit standards maybe clear, as in this paper, while in other dimensions they would be vague. The main themeof the current paper, which may be considered a special case of the more general view ofstandards, would remain the same. That is, even though audit standards do not clarify whatis required of the auditor in all dimensions, they do provide clear guidelines on a subsetof dimensions. On that subset, the auditor could use those standards as a means to committo a higher audit quality.

Appendix A: Summary of notation and assumptions

Notation Description

e [ [e, e] Auditor’s effortD Deviation of the reported value from the realized valueG(D.e) CDF of deviations given an effort levelL Losses suffered by investorsH(L.D) CDF of losses given a deviationB(e) Benefit of an auditC(e) Cost of an auditV(e) Value of an audite* Value-maximizing effort levelu Auditor’s share of the audit valueW Auditor’s wealthEL(e) The auditor’s expected liability conditioned on being found liableh Due careh The highest due care that an auditor will comply withh Vague due careP(h) The probability distribution that summarizes the beliefs regarding due carees Auditor’s effort under strict liabilityev Auditor’s effort if due care is vagueS Auditing standardsS The highest level of standards that the auditor will comply

198 RACHEL SCHWARTZ


Appendix B: Proofs

Proof of Lemma 1. Audit value is maximized at e*, that is given by:

e* 5 argmax@e, e#

V~e! 5 E 2 *0

`

*0

`

L•h~L?D!•g~D?e!dLdD 2 C~e!.

First order conditions:

dC~e*!/de 5 2d @*0

`

*0

`

L•h~L?D!•g~D?e!dLdD#/d~e!

The auditor’s best effort under strict liability, eS, is given by:

es 5 argmin@e, e#

C~e! 1 *0

`

*0

`

min@L, W#•h~L?D!•g~D?e!dLdD.

First order conditions:

dC~es!/de 5 2d @*0

`

*0

`

min@L, W#•h~L?D!•g~D?e!dLdD#/d~e!

rewritten as:

dC~es!/de 5 2d @*0

`

*0

W

L•h~L?D!•g~D?e!dLdD#/de

2 d @*0

`

*W

`

W•h~L?D!•g~D?e!dLdD#/de.

sgn dC~e*!/de 2 dC~eS!/de 5

sgn 2d @*0

`

*W

`

L•h~L?D!•g~D?e!dLdD#/de 1 d @*0

`

*W

`

W•h~L?D!•g~D?e!dLdD#/de

Invoking the First Order Stochastic Dominance assumptions,

dH~L?D!/dD , 0, dG~D?e!/de . 0:



2d@*0

`

*W

`

L•h~L?D!•g~D?e!dLdD#/de 1 d @*0

`

*W

`

W•h~L?D!•g~D?e!dLdD#. 0

which implies

dC~e*!/de 2 dC~es!/de . 0.

Since C(e) is increasing and convex, the above expression implies that the effort exertedby an auditor of limited wealth is lower than the effort that maximizes audit value:

es , e*. m

Proof of Proposition 1. (a) Under strict liability the auditor exerts effort eS and his totalcost is the direct cost of effort plus the implied expected liability, C(eS) 1 EL(eS). SinceEL(es) is positive, and C(e) is continuous and increasing in e, there exists « . 0 such that

C~es 1 «! , C~es! 1 EL~es!.

Consider the case where due care is set at h0 5 es 1 «, that is, « effort units higher thanthe effort level exerted under strict liability. If the auditor exerts effort level es, which islower than due care, his total cost will be the direct cost of effort plus the implied expectedliability C(es) 1 EL(es). If he complies with the due care, by exerting effort level h0 5 es

1 «, he bears only the direct cost of effort,

C~h0! 5 C~es 1 «!.

If the auditor does not comply with due care, he will face a certain liability if his reportwould be misleading. Recall that the effort level that minimized the total cost undercertain (strict) liability was given by

es 5 argmin@e, e#

C~e! 1 EL~e!.

Since the cost of complying with a due care level set equal to h0 is lower than the cost ofnot complying and exerting eS, that is,

C~h0! 5 C~es 1 «! , C~es! 1 EL~es!,

the auditor prefers to exert h0 5 eS 1 « rather than eS.(b) Denote the highest due care that an auditor is willing to comply with by h. The

proof involves two parts. First I will show that in order for h to be due care that the auditoris willing to comply with, the cost of implementing it cannot be higher than the leastcostly negligent effort. Then I will show that the cost of complying with h is not lowerthan the least costly negligent effort.

200 RACHEL SCHWARTZ


Part 1:

If C~h! . min@e, e#

C~e! 1 EL~e! 5 C~es! 1 EL~es!,

then the auditor prefers a negligent behavior, which is less costly, to complying with duecare. Thus h is not due care that he will comply with.

Part 2:

If C~h! , min@e, e#

C~e! 1 EL~e!,

then, by continuity of C(e), there exists another due care, h 1 g . h such that

C~h! , C~h 1 g! 5 min@e, e#

C~e! 1 EL~e!,

in which case the auditor is willing to comply with h 1 g. That would imply that h wasnot the highest due care he complies with. m

Proof of Proposition 2. (a) We need to prove that the effort that is induced by vaguenegligence may be higher or lower than the effort induced by strict liability.

The effort that is induced by the strict liability rule is given by:

es 5 argmin@e, e#

C~e! 1 EL~e!.

The first order condition for the effort that is induced by strict liability is:

dC~es!/de 5 2dEL~es!/de.

The effort that is induced by vague negligence is given by

ev 5 argmin@e, e#

C~e! 1 @1 2 P~e!#•EL~e!

and the first order condition is:

dC~ev!/de 5 2@1 2 P~ev!#dEL~ev!/de 1 dP~ev!/de•EL~ev!%.

Recall that 1 2 P(e) , 1, dP(e)/de . 0, EL(e) . 0, and dEL(e)/de , 0.Thus,

2@1 2 P~e!#•dEL~e!/de 1 dP~e!/de•EL~e!



may be greater than or smaller than

2dEL~e!/de,

and therefore es may be greater than or smaller than ev.(b) First I will prove that if an auditor chooses not to comply with a clear due care set

at h0, he will choose a strictly lower level of effort when operating under vague negli-gence. Then I will prove that vague negligence induces effort levels that are strictly lowerthan h.

First step:If an auditor chooses not to comply with h0 it implies that a negligent behavior is less

costly than adopting that due care h0:

C~es! 1 EL~es! , C~h0!.

Since prob(e ,h) , 1, we know that

C~es! 1 prob~eS , h!•EL~es! , C~es! 1 EL~es!.

By definition, ev is the least costly effort under vague negligence, thus:

C~ev! 1 prob~ev , h!•EL~ev! # C~es! 1 prob~eS , h!•EL~es!

i.e.,

C~ev! 1 prob~ev , h!•EL~ev! , C~h0!.

The expected liability prob(ev , h)·EL(ev) is positive; hence

C~ev! , C~h0!,

which implies ev , h0 since C(e) is an increasing function.Second step:I proved above that if an auditor prefers to not comply with clear due care, the effort

that he exerts under vague negligence is lower than that under clear due care. By definitionthe auditor will always refuse to comply with any due care that is set above h. That impliesthat the effort induced by any vague due care cannot exceed h:

Since ev , h ; h [ [h, `), then ev , h. m

Proof of Lemma 2. The lowest total cost of not complying with a standard is given by:

C~es! 1 EL~es!

202 RACHEL SCHWARTZ


Since prob(e , h) , 1 for e . e,

C~es! 1 prob~es , h!•EL~es! , C~es! 1 EL~es!

By definition, ev is the least costly effort under vague negligence:

C~ev! 1 prob~ev , h!•EL~ev! , C~es! 1 prob~es , h!•EL~es!

Pick S0 . ev such that,

C~ev! 1 prob~ev , h!•EL~ev! , C~S0! 1 prob~S0 , h!•EL~S0! , C~es! 1

prob~es , h!•EL~es!.

Since

C~es! 1 prob~es , h!•EL~es! , C~es! 1 EL~es!,

it implies:

C~S0! 1 prob~S0 , h!•EL~S0! , C~es! 1 EL~es!.

Thus the auditor prefers complying with S0 to the best non-complying effort, es. m

Proof of proposition 3. The proof is presented in two parts. First I prove that es , S*, andthen that S* , h.

Part 1: A proof that eS , S*.1.1 The case where S* 5 SIn this case we need to prove that S . es.Consider two possible cases: es , ev and es . ev.Case 1: es , ev

Lemma 2 showed that there exists a standard higher than ev that the auditor will complywith. Since S is the highest of these standards- S . ev. If es , ev, then S . ev . es.

Case 2: es . ev

The highest standard an auditor will comply with is that standard whose cost equals thecost of non-compliance:

C~S! 1 prob~S , h!•EL~S! 5 C~eS! 1 EL~es!

thus

C~S! 1 prob~S , h!•EL~S! . C~es! 1 prob~es , h!•EL~es!.



Since es . ev, S . ev, and ev is the effort that minimizes C(e) 1 prob(e , h)·EL(e), es

and S are both on the increasing portion of C(e) 1 P(e , h)·EL(e), thus

C~S! 1 prob~S , h!•EL~S! . C~es! 1 prob~eS , h!•EL~es!

implies

S . es.

1.2 The case where S* 5 e*Lemma 1 showed that that eS , e*, and thus eS , S* if S* 5 e*.Part 2: A proof that S* , hAgain, there may be two cases: S* 5 e*, and S* 5 S.

Case 2.1: S* 5 e*,If S* 5 e*, then e* , S because by definition of S*, S* [ min[e*, S]. Thus, S* , S.Lemma 2 established that S , h. Therefore, S* , S , h.

Case 2.2: S* 5 S.First I will prove that S , h.By definition,

C~S! 1 prob~S , h!•EL~S! 5 C~es! 1 EL~es!,

and

C~h! 5 C~es! 1 EL~es!.

It follows that

C~S! 1 prob~S , h!•EL~S! 5 C~h!,

and since prob(S , h)·EL(S) . 0,

it also follows that

C~S! , C~h!.

Since C(e) is increasing in e, C(S) , C(h) implies

S , h.

If S* 5 S, then S* , h. m

204 RACHEL SCHWARTZ


Notes

1. Auditing standards also communicate to members of the profession the required procedures and quality ofperformance (see e.g., Kell, Boynton, and Ziegler [1986], Pany [1994], and Robertson [1993]).

2. The Accountants Coalition [1994] reported that in 1991, 1992, and 1993, the collective cost for the Big Sixof judgments, settlements, and legal defense, net of insurance recoveries was $477M, $598M, and $667M,which amounts to 9%, 10.9%, and 11.9% (respectively) of revenues from accounting and auditing.

3. Section 11 of the 1933 Act imposes liability for purchasers’ losses resulting from a material misstatementor omission on both the issuing firm and the auditor unless they can prove that they were not negligent.Section 18 of the 1934 Act imposes liability for both purchasers’ and sellers’ losses. Rule 10b-5 underSection 10(b) of the 1934 act contains generally worded prohibitions against misrepresentations, omissionsand fraud.

4. In Rhode Island Hospital National Bank v. Swartz, Bresenoff, Young and Jacobs, the Fourth Circuit Courtof Appeals indicated that to fulfill the duty of care, a CPA firm must comply with GAAS and specificallythe auditing pronouncements of the American Institute of Certified Public Accountants (AICPA).

5. In the law and economic literature on liability, Calfee and Craswell [1984] and Craswell and Calfee [1986]study the question of uncertain due care but their results are limited to the conclusion that an uncertain duecare level might cause over-compliance or under-compliance with the socially desired effort level. Bycontrast, I show that an uncertain due care will never result in more effort than that attainable under a clearand certain due care.

6. See e.g. Healy (1985) for the effect of compensation contracts on managers’ choice of reporting.7. A table of notation appears in appendix A.8. For related research that explores the role of an auditor in valuation issues see Datar, Feltham, and Hughes

[1991].9. Although auditors submit bills that charge clients by hours, their fee rarely deviates materially from the fee

that was agreed upon at the start of the engagement. That is, audit fees are set prior to the actual audit workand once agreed upon will not increase even if more hours are exerted. If during the audit work the auditorfinds new information that makes it necessary to extend the audit work, he can negotiate that extension’s feewith the client. Again, once agreed upon, the fee will not vary with hours but is rather fixed at the agreedupon amount.

10. For further discussion on the effects of contingent fees see Dye, Balachandran, and Magee [1990].11. If the auditor’s estimate materially differs from the manager’s estimate three scenarios are possible: (1) the

manager will agree to adjust the report such that the auditor could state in his opinion that the financialstatements present fairly and in all material respects the value of the firm; (2) the manager will refuse toadjust the statements and the auditor will issue an adverse opinion; or (3) the manager will refuse to adjustthe statements but nevertheless the auditor will issue an unqualified opinion.

12. Chow and Rice [1982] find that a qualified opinion has a positive and significant impact on a firms’ decisionto replace the auditor in the following year.

13. For a discussion of the potential threat that MAS poses to auditors’ independence, see e.g. Beck, Frecka andSolomon [1988], Dopuch and King [1991], and Simunic [1984].

14. Denote by G(D.e) the cumulative distribution function of deviations for a given level of effort. G(D.e) isassumed to be ordered by reversed first order stochastic dominance (i.e., e0 , e1 ⇔ G(D.e0) , G(D.e1)),satisfies the concavity of distribution function condition, and is twice continuously differentiable. Foranother approach to modeling the interaction between effort (sample size) and errors see Patterson [1993].

15. Denote the cumulative distribution function of losses given a deviation by H(L.D). This family of CDFs isassumed to be ordered by first order stochastic dominance (i.e., dH(L.D)/dD , 0).

16. The audited financial statements are considered by many to be the joint product of managers and auditors,(see e.g. Antle and Nalebuff [1991], and therefore both would be sued in cases of losses that result fromreliance on misstated reports. Due to the Joint and Several liability that auditors are exposed to, and oftenbeing the “Deep Pocket” defendant if not the only solvent defendant, the auditor is de facto a singledefendant.

17. C(e) is twice continuously differentiable, increasing, and convex: dC(e)/de . 0, d2C(e)/de2 . 0.



18. The expected losses that would occur if no audit service was provided do not vary with the level of effortthat is exerted when audit is provided. Therefore, these expected losses are denoted by a constant E.

19. h(L.D) is the density function corresponding to the cumulative distribution function H(L.D); g(D.e) is thedensity function corresponding to the cumulative distribution function G(D.e). Given the assumptionsregarding these two families of CDFs as presented in footnotes 14 and 15, B(e) is increasing and concave.

20. For a similar conclusion, see Sarath and Wolfson [1993].21. For tractability purposes I make the simplifying assumption that the auditor is sued for all losses regardless

of their size or the materiality of the deviation. If investors incur litigation costs and can only sue for lossesthat result from material misstatement, the expected liability of the auditor will be lower. None of the resultsin this paper would be affected by this simplifying assumption. Modified proofs of the results and adiscussion of investors’ litigation strategies when this simplifying assumption is relaxed are available fromthe author.

22. A similar result appears in Shavell [1987].23. Another rationale for vague due care is associated with the existence of an equilibrium. Consider the case

where clear due care exists, and the auditor’s effort can only be verified through costly court procedures. Ifthe auditor complies, and the investors sue him for damages, they will incur litigation costs but recovernothing from the auditor since his compliance shields him from liability. Consequently, if the cost ofexerting due care is lower than the total cost of a non-complying effort, investors will perceive the auditorto be complying and thus will not file a lawsuit. Knowing that no threat of litigation exists, no auditor willhave an incentive to exert any effort level above the minimum. If that is the case, the investors’ best responsewould be to sue, which again will change the auditor’s best response to complying. In such a setup, noequilibrium can be attained in a clear negligence regime. For a similar result see Melumad and Thoman[1990].

24. P(h) [ (0, 1) ; h [ (e, e]; P(e) 5 0.25. United States v. Simon, 425 F.2d 796(2d Cir. 1969), cert. denied, 397 U.S. 1006 (1970)26. Bily v. Arthur Young & Co., 271 Cal. Rptr. 470 (Cal. App. 1990), rev. granted 798 P.2d 1214 (Cal. 1990).27. Rhode Island Hospital National Bank v. Swartz, Bresenoff, Young and Jacobs, 455 F .2d 847 (4th cir. 1972).28. Legal liability serves the dual purpose of promoting fairness and efficiency. The focus of this paper was

legal regimes and the audit effort that they induce. Thus, the paper concentrates on the efficiency aspect oflegal liability, rather than on fairness and equity.

29. Auditing standards which are used as a benchmark for determining due care lead to an increased audit effortbecause they increase the expected liability that an auditor faces. In a vague due care regime with nostandards, the expected liability is P(e , h)·EL(e). When standards are set forth, the modified expectedliability is P(e , h.S)·EL(e) where P(e , h.S) 5 1 if e , S and P(e , h.S) 5 P(e , h) , 1 for e $ S.If the effort is not perfectly observable, then instead of e, the court will observe e, and the auditor’s expectedliability will depend on e and on e as follows: If no standards are set forth then the expected liability is P(e, h.e)·EL(e). When standards S are set forth, the expected liability will be P(e , h.e, S)·EL(e) where P(e, h.e, S) 5 1 if e , S and P(e , h.e, S) 5 P(e , h) , 1 for e $ S. The introduction of standards increasesthe expected liability and therefore the level of effort that the auditor chooses to exert.

Acknowledgment

I would like to thank the members of my dissertation committee, Bala Balachandran, RonDye, Bob Magee, and Bill Rogerson, for many helpful discussions. I am also grateful toNick Dopuch and Ron King for helpful suggestions. The comments of two anonymousreferees, and workshop participants at Berkeley, University of Chicago, Minnesota, NewYork University, Northwestern, Rochester, Rutgers, Washington University in St. Louis,Waterloo, and Yale are gratefully acknowledged.

206 RACHEL SCHWARTZ


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Documents

Auditors' Liability, Vague Due Care, and Auditing Standards