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Auditors’ Liability to Lenders and Auditor Conservatism

Author

Listed:
  • Pei-Cheng Liao

    (Department of Accounting, College of Management, National Taiwan University, Taipei 10617, Taiwan)

  • Suresh Radhakrishnan

    (School of Management, University of Texas at Dallas, Richardson, Texas 75080)

Abstract

We examine the near-privity rule that increases the auditor’s legal liability exposure by considering a debtholder who can sue the auditor and recover damages when there is an audit failure. We show that the increase in the auditor’s legal liability induces the auditor to choose more informative and more conservative efforts. Although the increased informative effort has a favorable spillover effect that increases the equityholder’s expected payoff, the increased conservative effort induces a bias—that is, decreases the likelihood of reporting a true good state as good—and thus induces an adverse spillover effect that decreases the equityholder’s expected payoff. As such, when the conservative effort bias is small, the favorable spillover effect dominates the adverse spillover effect, and the equityholder prefers the near-privity regime.

Suggested Citation

  • Pei-Cheng Liao & Suresh Radhakrishnan, 2020. "Auditors’ Liability to Lenders and Auditor Conservatism," Management Science, INFORMS, vol. 66(8), pages 3788-3798, August.
    • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:8:p:3788-3798
    DOI: 10.1287/mnsc.2019.3302
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    References listed on IDEAS

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