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Imperfect information, insurance, and auditors' legal liability

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  • BALA V. BALACHANDRAN
  • NANDU J. NAGARAJAN

Abstract

. This paper analyzes the incentive effects of alternative legal systems on the auditor's decision making process. The first system, termed strict liability, holds the auditor liable whenever there is a loss, and the second system, termed negligence, holds the auditor liable for losses arising from the auditor's deviation from a prescribed due care standard. The auditor is assumed to have ex ante limited knowledge of the financial state of the client and the standard setting process. He revises his beliefs on the client's financial state based on a costless signal that may be interpreted as an internal audit report. The analysis shows that signal “quality†and auditor's perception of the client's financial state jointly determine the level of liability required to induce the auditor to adopt a socially optimal due care level. As in Simon's (1982) Model, negligence with supplementary insurance is preferred to strict liability. Further, negligence is shown to operate with less information than strict liability, in contrast to models such as Green (1978) and Shavell (1978). Résumé. Cet article analyse les effets incitatifs de systèmes juridiques alternatifs sur le processus décisionnel du vérificateur. Le premier système, dit de responsabilité stricte, considère le vérificateur responsable à chaque fois qu'il y a une perte, et le deuxième système, dit de négligence, considère le vérificateur responsable des pertes résultant de sa déviance d'une norme prescrite. Le vérificateur est supposé posséder ex ante une connaissance limitée de la situation financière du client ainsi que du processus de normalisation. Il révise ses opinions portant sur la situation financière du client à la lumière d'un signal sans frais qui peut être assimilé à un rapport de vérification interne. L'analyse montre qu'un signal «qualité» ainsi que la perception du vérificateur quant à la situation financière du client déterminent conjointement le niveau de responsabilité requis pour inciter le vérificateur à retenir un niveau de soin raisonnable socialement optimal. De même que le modèle de Simon (1982), le système de négligence avec assurances additionnelles est préféré à la responsabilité stricte. De plus, il est montré que le système de négligence fonctionne avec moins d'information que le système de responsabilité stricte, par opposition à d'autres modèles tels Green (1978) et Shavell (1978).

Suggested Citation

  • Bala V. Balachandran & Nandu J. Nagarajan, 1986. "Imperfect information, insurance, and auditors' legal liability," Contemporary Accounting Research, John Wiley & Sons, vol. 3(1), pages 281-301, September.
    • Handle: RePEc:wly:coacre:v:3:y:1986:i:1:p:281-301
    DOI: 10.1111/j.1911-3846.1986.tb00639.x
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    References listed on IDEAS

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    1. Lucian Arye Bebchuk, 1984. "Litigation and Settlement under Imperfect Information," RAND Journal of Economics, The RAND Corporation, vol. 15(3), pages 404-415, Autumn.
    2. A. Mitchell Polinsky & William P. Rogerson, 1983. "Products Liability, Consumer Misperceptions, and Market Power," Bell Journal of Economics, The RAND Corporation, vol. 14(2), pages 581-589, Autumn.
    3. Michael Spence, 1977. "Consumer Misperceptions, Product Failure and Producer Liability," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 44(3), pages 561-572.
    4. Marilyn J. Simon, 1982. "Diagnoses and Medical Malpractice: A Comparison of Negligence and Strict Liability Systems," Bell Journal of Economics, The RAND Corporation, vol. 13(1), pages 170-180, Spring.
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