Ping Zhang


Three essays on auditor independence and auditor liability

The financial statements of a firm are negotiated products between a manager and an auditor. To prepare the financial statements, the manager wants the reported values to be as favourable to him as possible, while the auditor has an incentive to have an unbiased estimate reported. This goal incongruence can cause a conflict of interest between the manager and the auditor, and auditor independence can be affected by this conflict.

A result of this thesis suggests that, given the firm-specific quasi-rent to an auditor is positive, the auditor always compromises her independence. The magnitude of the compromise is a decreasing function of auditor liability and an increasing function of the quasi-rent. The result also suggests that the auditor compromises more when a managerial advisory service is supplied jointly with an audit service.

Auditor liability is necessary to maintain the value of an audit. However, a high auditor liability is not always beneficial for investors. Another result of this thesis suggests that auditor liability should not exceed the deadweight costs resulting directly from an audit failure. Otherwise, the auditor's decision on the audit test effort and on the type I and type II error rates ~l not be optimal for investors, that is, their welfare is then not maximized. Auditor liability also has effects on the audit market. To maximize their welfare, investors have incentives to have the firm hire an auditor whose effective liability structure is similar to the optimal liability structure. The effective auditor liability structure is determined by the auditor's wealth level, insurance coverage, and bankruptcy cost. Very wealthy auditors, very poor auditors, auditors with high insurance coverage, and auditors subject to high bankruptcy costs may not be attractive to investors.

Finally, this thesis claims that a firm always invests in a positive net present value project if there is information asymmetry on the firm's current type between the current investors and the manager. However, if the manager has more information on the quality of a new investment opportunity than the investors, a positive net present value project may be abandoned, and there exists an optimal liability to a prospectus auditor which maximizes investors' welfare.