We study a principal's choice to centralize or delegate decisions to an agent when delegation can be used to encourage the agent to communicate potential problems. We find that the principal may choose centralization either to exercise better control over the agent's actions or to provide stronger incentives. Delegation emerges in equilibrium only if the costs of effort to acquire information for both the principal and the agent are sufficiently high. We find that increases in the principal's penalties for an incorrect decision may increase the principal's expected payoff, owing to optimal organizational responses. In addition, catastrophic risk, the risk of incorrectly accepting a defective audit (or product), may be greater under centralization than under delegation. Furthermore, catastrophic risk can be increased by well‐intentioned legislative efforts to decrease such risk by, for example, increasing the agent's penalties for failing to take a corrective action, because the organizational structure may change.

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The accounting profession has raised concerns that excessive liability exposure renders audit firms unwilling to provide audit services to risky clients, limiting the prospective clients' ability to raise external capital. We address this concern in a model in which the auditor evaluates the riskiness of the client before accepting the client engagement. We consider a setting in which a shift to stricter legal liability regimes not only increases the expected damage payments from the auditor to investors in case of audit failure, but also increases litigation frictions such as attorneys' fees. The main finding is that the relationship between the strictness of the legal regime and the probability of client rejection is U-shaped. Our model suggests that in environments with moderate legal liability regimes, the client rejection rate is lower than in environments with relatively strong or relatively weak legal regimes.

We consider how auditors assess the risk of fraudulent financial reporting and plan their audit where a possibly fraudulent auditee anticipates the assessment and planning process. The auditor uses the auditee's (possibly fraudulent) earnings report to revise his beliefs about the likelihood of fraud when formulating an audit plan. We find that as underlying earnings increase, a fraudulent auditee increases reported earnings. In turn, as the auditee's reported earnings increase, the auditor increases audit effort. We also find that the auditee (who knows the auditor will use the report for audit planning) selects reports that increase his own expected payoff, relative to reports he would select if the auditor did not observe the report before finalizing the audit plan. By contrast, the auditor is no better off using the auditee's report for audit planning. Inherent risk, detection risk, and overall audit risk can increase when the auditor uses the auditee's report. Thus, because of the dynamic interaction between the auditor and auditee, procedures that aid in assessing audit risk may not reduce that risk or result in more efficient audits.

Protection of outside investors depends on the detection and punishment of resource diversion by corporate insiders, including managers and controlling shareholders. We focus on the role played in investor protection by self-interested auditors operating in a competitive audit market. In our setting, auditors represent the mechanism whereby detection of diversion occurs. We show that markets with relatively greater auditor penalties for audit failures and greater insider penalties for detected resource diversion have larger total investment levels, a higher proportion of the firm held by outsiders, higher audit resource investment, higher audit fees, and higher expected investment returns.