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Low balling, legal liability and auditor independence.

Chi-Wen Jevons Lee^1,2; Zhaoyang Gu¹

¹ Tulane University. 1 · ² Hong Kong University of Science and Technology. 2

Abstract We construct a dynamic multi-agent moral hazard model to analyze the interactions among the firm owner, the manager and the auditor. Moral hazard may arise in hierarchical agency because a rational monitoring agent may accept a side payment from the monitored agent for misrepresenting information to the principal. This multi-agent moral hazard problem is the essence of the concern for auditor independence. We show that a "low-balling" compensation scheme and the auditor's legal liability constitute an efficient dynamic contracting mechanism for hierarchical agency. In particular, low balling serves as a substitute for legal liabilities for maintaining auditor independence. Low balling reduces the transaction costs associated with the audit engagement relative to the flat-fee structure and can actually improve auditor independence.

DOI

10.2308/tar-1325295

Volume

73 (4)

Pages

533-555

Language

en

Export

BibTeX

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