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Auditor independence, incomplete contracts and the role of legal liability

  • Daron Acemoglu
  • Miles Gietzmann

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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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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  1. 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.
  2. Oliver Hart & John Moore, 1990. "A Theory of Corporate Financial Structure Based on the Seniority of Claims," NBER Working Papers 3431, National Bureau of Economic Research, Inc.
  3. Kofman, F. & Lawarree, J., 1990. "Collusion in Hierarchical Agency," Working Papers 91-01, University of Washington, Department of Economics.
  4. Allen, Franklin & Gale, Douglas, 1992. "Measurement Distortion and Missing Contingencies in Optimal Contracts," Economic Theory, Springer, vol. 2(1), pages 1-26, January.
  5. Acemoglu, D., 1994. "Corporate Control and Balance of Powers," Working papers 94-22, Massachusetts Institute of Technology (MIT), Department of Economics.
  6. Paul R. Milgrom., 1987. "Employment Contracts, Influence Activities and Efficient Organization Design," Economics Working Papers 8741, University of California at Berkeley.
  7. Acemoglu, Daron, 1994. "A Dynamic Model of Collusion," CEPR Discussion Papers 1027, C.E.P.R. Discussion Papers.
  8. 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.
  9. Dye, Ronald A., 1991. "Informationally motivated auditor replacement," Journal of Accounting and Economics, Elsevier, vol. 14(4), pages 347-374, December.
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