Audit Quality, Legal Liability, and the Audit Market Under Risk Aversion

This paper studies how auditors' risk aversion shapes the audit market and how it interacts with legal liability. The main pillar of the analysis is that the relation between risk aversion and the supplied audit quality is generally non-monotone. Because futile audit costs augment the severity of a liability loss, extending legal liability decreases the audit quality of sufficiently risk-averse auditors in the absence of any strategic interaction. Linking auditors' supply of audit services with firms' demand, the model predicts that relaxing the negligence rule aids in breaking up the current Big-N oligopoly, because more risk-averse auditors disproportionately benefit from a reduction in liability risk. However, whether audit standards should be razor-sharp or deliberately vague depends on the level of investor protection and the cost-efficiency of the audit technology. It turns out that new technologies like blockchain offer a chance for regulators to foster Big-N audit quality and de-concentrate the industry at the same time