Auditor independence, incomplete contracts and the role of legal liability

Abstract

We develop a model in which there is conflict of interest between the management and the shareholders of an organization. Incompleteness of contracts prevents a simple contracting solution to this problem. We suggest that auditors can play a role in aligning the conflicting interests. However, this result is dependent on auditors maintaining independence from management. Again however, incompletenesses in contracting causes difficulties because it may be hard to ensure that auditors maintain this required independence. In this context, the imposition of potential legal liability (punishment) on the auditor, may be an important commitment mechanism for the auditors, making it credible that they will not collude with the management. In order to give our model institutional structure we study how this collusion may take place through the reappointment concerns of the auditor. In the reappointment game, we consider how legal liability levels could be chosen so that it becomes credible to expect that auditors will not implicitly collude with management and provide a low duty of care.