Legal Damages and Auditor Efforts

Conventional wisdom holds that an auditor's optimal response to an increase in legal exposure is to double his efforts in finding errors in his client's financial reports. This paper's main result is that in a market setting where clients shop for opinions and auditors must compete for clients, the conventional wisdom may fail. Increased damages affect all auditors reducing the competition among auditors for clients. Thus, an auditor can reduce his legal exposure by reporting more conservatively instead of working harder. The main result is mitigated if client firms also face legal damages, and clients are more conservative in preparing their unaudited financial statements. It is more likely that a client claiming good news is truly good, and the auditor has an incentive to work harder to confirm this good report and satisfy his client. This incentive to work harder to please his client may prevent the auditor from retreating into conservatism when damages are increased. Finally, if the auditors' report space were continuous, as with a continuum of client types, the main result is reversed; additional damages would (weakly) increase the auditor's efforts. With a continuum of possible reports, the competition is not eliminated as damages increase; only the range of reports which the auditors offer is reduced. Since the competition cannot be eliminated, and the incumbent cannot resort to conservatism to reduce his legal exposure, the auditor works hard