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Auditor independence, incomplete contracts and the role of legal liability

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  • Daron Acemoglu
  • Miles Gietzmann

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.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal European Accounting Review.

Volume (Year): 6 (1998)
Issue (Month): 3 ()
Pages: 355-375

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Handle: RePEc:taf:euract:v:6:y:1998:i:3:p:355-375

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References

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  1. Kofman, Fred & Lawarree, Jacques, 1993. "Collusion in Hierarchical Agency," Econometrica, Econometric Society, vol. 61(3), pages 629-56, May.
  2. Daron Acemoglu, 1995. "Corporate Control and Balance of Powers," CEP Discussion Papers dp0239, Centre for Economic Performance, LSE.
  3. Milgrom, Paul R, 1988. "Employment Contracts, Influence Activities, and Efficient Organization Design," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 42-60, February.
  4. Acemoglu, Daron, 1994. "A Dynamic Model of Collusion," CEPR Discussion Papers 1027, C.E.P.R. Discussion Papers.
  5. Allen, Franklin & Gale, Douglas, 1992. "Measurement Distortion and Missing Contingencies in Optimal Contracts," Economic Theory, Springer, vol. 2(1), pages 1-26, January.
  6. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  7. Dye, Ronald A., 1991. "Informationally motivated auditor replacement," Journal of Accounting and Economics, Elsevier, vol. 14(4), pages 347-374, December.
  8. Oliver Hart & John Moore, 1990. "A Theory of Corporate Financial Structure Based on the Seniority of Claims," STICERD - Theoretical Economics Paper Series /1990/217, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  9. Tirole, Jean, 1986. "Hierarchies and Bureaucracies: On the Role of Collusion in Organizations," Journal of Law, Economics and Organization, Oxford University Press, vol. 2(2), pages 181-214, Fall.
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Cited by:
  1. Stefan Sundgren, 1998. "Auditor choices and auditor reporting practices: evidence from Finnish small firms," European Accounting Review, Taylor & Francis Journals, vol. 7(3), pages 441-465.
  2. Steven Maijoor & Roger Meuwissen & Luc Quadackers, 2000. "The effects of national institutions on audit research: evidence from Europe and North America," European Accounting Review, Taylor & Francis Journals, vol. 9(4), pages 569-587.
  3. Clive Lennox, 1999. "Non-audit fees, disclosure and audit quality," European Accounting Review, Taylor & Francis Journals, vol. 8(2), pages 239-252.
  4. Ann Vanstraelen, 2000. "Impact of renewable long-term audit mandates on audit quality," European Accounting Review, Taylor & Francis Journals, vol. 9(3), pages 419-442.

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