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.