Abstract In this paper, I demonstrate that the quasi‐rents earned in audits undermine an auditor's independence By considering the incentives of the auditor and the client and the interaction between them, I conclude that auditor will maintain his or her independence if the firm‐specific quasi‐rents are zero, but compromise his or her independence if the quasi‐rents are positive. The extent of the compromise is an increasing function of the quasi‐rents, since the auditor will propose that a higher value be reported in the financial statements when the quasi‐rents increase. I also show that disputes between the auditor and the client increase as the scope for errors for an auditor's test increases. When the error scope is large, the client becomes more aggressive in preparing a proposal while the auditor becomes more cautious.

This paper studies the impact of liability rules and damage awards on audit effort and the value of an audit (the net benefits to society of an audit) when an auditor and an investor may settle before proceeding to trial. It is demonstrated that audit effort increases with size of the damage award, but may decrease with the rigor of the auditing standards. For a given level of damage award, allowing pre-trial settlements may reduce the value of the audit despite the reduction in the deadweight legal costs. On the other hand, if the damage award is optimally chosen, then allowing settlements increases social welfare. With an appropriately set damage award, strict liability standards result in the first-best outcome, while the first-best result cannot be obtained with vague negligence rules.

Abstract. Account balances are typically subjected to separate audit procedures (e.g., accounts receivable and inventory). Two or more assertions about a single financial balance may be subjected to separate tests (e. g., completeness and existence). Two or more transaction streams combining to form a single balance (e. g., sales on account and cash receipts on account combine into accounts receivable) may be tested separately. A financial balance may be subdivided into two or more account components for separate testing (e.g., retail accounts receivable and wholesale accounts receivable). In all of these audit testing scenarios, the question arises as to the appropriate way to combine or aggregate the evidence gathered from separate tests of subpopulations into an overall conclusion about the amount of audit risk being borne, that is, the risk of a material amount of misstatement remaining undetected in the overall population at the conclusion of such separate audit tests. A number of algorithms and heuristics have been proposed for combining audit risks at the subpopulation level into overall risk conclusions about audit risk at a more aggregate level. Some of the heuristics involve piecemeal evaluation of individual subpopulations to draw overall conclusions about the financial statements as a whole. This paper analyzes one such approach, the Poisson distribution‐based “max rule,” for combining judgments of audit risk based on tests of subpopulations. This prescription has been interpreted to mean that the overall risk of material misstatement in a population is the maximum of the audit risks computed with respect to the individual subpopulations, but we believe that such an interpretation is incorrect. Furthermore, given the literature that has promoted the max rule, some auditors could misapply the concurrency property of the Poisson distribution. Although the max rule may be justified at the planning stages of the audit, we show that, if it is used at the evaluation stage of the audit, it can lead to underestimation of the upper error limit and overall risk faced upon completing tests of subpopulations and should not be used to evaluate results of audit procedures applied to subpopulations to draw overall audit conclusions. Résumé. Les soldes des comptes sont habituellement assujettis à des procédés de vérification distincts (comptes clients et stocks, par exemple). Deux assertions ou plus relatives à un même solde financier peuvent être assujetties à des sondages distincts (intégralité et existence, par exemple). Deux chaînes d'opérations ou plus qui se combinent pour produire un même solde (ventes à crédit et encaissements sur les ventes à crédit donnant lieu, par exemple, aux comptes clients) peuvent faire l'objet de sondages distincts. Un solde financier peut être subdivisé en deux éléments ou plus pouvant être soumis à des sondages distincts (comptes clients, ventes au détail, et comptes clients, ventes en gros). Peu importe le scénario, cependant, une question se pose: quelle est la façon appropriée de combiner ou d'agréger l'information probante livrée par les différents sondages appliqués aux sous‐populations en une conclusion globale relative à l'importance du risque lié à la vérification, c'est‐à‐dire le risque qu'il subsiste une quantité importante de déclarations erronées non détectées dans l'ensemble de la population, au terme de ces sondages de vérification distincts. Bon nombre d'algorithmes et de méthodes heuristiques ont été proposés pour combiner les risques liés à la vérification obtenus à l'échelon des sous‐populations de manière à pouvoir tirer des conclusions relatives au risque global lié à la vérification à un échelon supérieur. Certaines de ces méthodes heuristiques font intervenir l'évaluation à la pièce des différentes sous‐populations dans le but de formuler des conclusions générales au sujet des états financiers dans leur ensemble. Les auteurs analysent l'une de ces méthodes, la « règle du maximum » basée sur la distribution de Poisson, visant à combiner les jugements relatifs au risque lié à la vérification établi à partir des sondages auxquels les sous‐populations sont soumises. Selon l'interprétation qui en est faite, cette règle signifie que le risque global qu'il se trouve une erreur importante dans une population équivaut au maximum des risques liés à la vérification calculés pour les différentes sous‐populations; or, selon les auteurs, cette interprétation est inexacte. En outre, compte tenuque des chercheurs ont préconisé la règle du maximum, certains vérificateurs pourraient appliquer à mauvais escient la propriété de concurrence de la distribution de Poisson. Bien que l'application de la règle du maximum puisse être justifiée dans les phases de planification de la vérification, les auteurs démontrent que, si elle est utilisée à l'étape de l'évaluation de la vérification, elle peut conduire à une sous‐estimation de la limite supérieure de l'erreur acceptable et du risque global auquel est assujettie la réalisation des sondages appliqués aux sous‐populations; ils concluent que la règle ne devrait pas être utilisée pour évaluer les résultats des procédés de vérification appliqués aux sous‐populations dans le but de tirer des conclusions globales relatives à la vérification.

Abstract In this paper, we investigate whether federal judge ideology, ceteris paribus, affects auditor litigation risk and auditor behavior. We find that auditors whose client firms are in jurisdictions dominated by liberal judges are more likely to be sued and make higher payouts to plaintiffs when sued. Furthermore, these client firms are more likely to receive going‐concern opinions and pay higher audit fees. Finally, we find no evidence that the quality of audited financial statements is affected by judge ideology. The evidence documented in this paper indicates that federal judge ideology affects auditor litigation risk and some aspects of auditor behavior.

A fundamental unresolved issue is whether information asymmetries underlie investors' predisposition to invest close to home (i.e., domestically or locally). We conduct experiments in the United States and Canada to investigate agents' portfolio allocation decisions, controlling for the availability of information. Providing participants with information about a firm's home base, without disclosing its specific identity, is not sufficient to change investment behavior. Rather, participants need to know a firm's name and home base. Additional evidence indicates that participants have a greater perceived familiarity with local and domestic securities and, in turn, invest more in such securities.

Abstract This paper derives the impacts of legal system characteristics and auditing standards on auditor behavior (audit quality), and analyzes the determination of optimal auditing standards under different legal regimes. Legal regimes are characterized by differences in the uncertainty concerning the outcome of legal proceedings (termed vagueness of legal systems) and differences in the average size of damage awards. Auditing standards as determined by standard setters can vary in both toughness and vagueness. Our analysis provides implications for the adoption of International Standards on Auditing ( ISA ). Countries, such as the United States, where auditor legal liability is significantly more onerous than the global norm are not likely to adopt ISA , since these standards may not induce auditors to provide the optimal level of audit quality. Conversely, the adoption of ISA by countries, such as China, where the legal system makes the recovery of damages from auditors quite difficult, is not by itself likely to result in a high level of audit quality. Furthermore, our model suggests that auditor rotation can help improve audit quality, but only in certain circumstances.

We develop a measure to capture an audit firm's competitive position in a local audit market based on the transaction costs of changing audit firms included in DeAngelo's (1981) multi-period audit pricing model. Our competition measure reflects the size difference between the largest audit firm in a market specified by client industry at the city level and the other audit firms operating in that market. We find that audit fees of a client decrease as this size difference increases. This result suggests that smaller audit firms charge lower audit fees because of their competitive disadvantage to the local largest firm.